Vijay Kumar Gaba

The quarterly result season has started on an encouraging note with IT Services major TCS announcing mostly inline 4QFY22 and FY22 numbers. Although I do not assign much importance to the quarterly results in the context of my investment strategy, I shall be watching this season very closely, for three reasons:

In past couple of weeks, some news items, and market & economic trends have attracted my attention. All these news items & trends somehow reflect on the reflation trade that has dominated the global markets for past few months.

The rise in commodity prices in past one year is seen mostly a function of a combination of demand and supply side factors. Post global financial crisis (GFC 2008) the investment in new capacities had slowed down considerably. The economic lockdown due to outbreak of pandemic further curtailed the supply of many industrial commodities. The logjam at Suez Canal further impacted the supply chain. The supply of commodities obviously could not match the recovery in economic activity as the economies began to open up.

The trillions of dollars in pandemic related stimulus further boosted the demand, as all three activities, viz., consumption, capex and trading got boost from worldwide stimulus. The US government’s plan to invest US$1trn in building nation’s deteriorating roads and bridges and fund new climate resilience and broadband initiatives is also expected to lead the further rise in demand for industrial commodities like steel and copper.

1.    A newspaper reported that HDFC Bank has received Rs300bn in prepayments in the quarter ended June 2021. These prepayments were reportedly made primarily by the companies in commodities and infrastructure sectors.

2.    A famous Kolkata based investment manager publically made a very persuasive case for investment in a public sector steel company, implying that in the given circumstances the share price of the company could potentially see a 3 fold rise in next one year. He also claimed that their portfolio schemes are presently invested in all metal stocks.

4.    The analysts at Phoenix Capital Research noted that “One of the key drivers of stocks prices since the March 2020 bottom has been the Fed’s interventions. The Fed spent a total of $3 trillion between March and June 2020. It briefly dipped between June and July 2020 but has since increased at a steady pace courtesy of the Fed’s $120 billion per month Quantitative Easing (QE) program.

However, all signs point to the Fed reducing these interventions going forward. With jobs numbers like those from July (900K+ jobs were created), the unemployment rate down to 5.4% again, and inflation roaring (CPI is clocking in over 5%), the Fed is effectively out of reasons to continue its month interventions at the current pace. Add to this the fact that numerous Fed officials are calling for a taper to QE and even rate hikes, and it’s clear the Fed is on the verge of announcing that it will be reducing its money printing very soon.”

It is pertinent to note that the GDP estimates for another large economy (India) have also been revised downward at least twice in past 4months, by almost all global agencies.Obviously, this cannot be good news for the traders staking their money on continuing reflationary trade.

The International Energy Agency (IEA) cut forecasts for global oil demand “sharply” for the rest of this year as the resurgent pandemic hits major consumers, and predicted a new surplus in 2022.

The announcement led to sharp correction in crude oil prices to the three months prior levels.

7.    The last move of about half of emerging market central bankers was hike in policy rates or policy tightening. Obviously, the days of monetary easing are behind. This shall definitely check the runaway inflationary expectations and therefore impact the reflation trade. 

8.    A BollombergQuint report highlighted that “Indian companies are running out of room to absorb rising raw material costs, which could force the central bank to unwind stimulus faster-than-expected and threaten a stock market rally that has earned billions for investors. Companies from the Indian unit of Unilever Plc to Tata Motors Ltd., the owner of the iconic Jaguar Land Rover, are increasingly complaining about pricier inputs and are frustrated at not being able to fully pass on costs to consumers reeling from the pandemic-induced economic shock. But it is only a matter of time before the pass- through happens, warn economists.

While its a tough balancing act, companies are mindful that something will have to give in eventually. In this case, it could mean higher prices being passed to consumers gradually as a recovery gets stronger in Asia’s third-largest economy.”

10.  Earlier this week, the US Senate gave bipartisan approval to a US$1 trillion infrastructure bill to rebuild the nation’s deteriorating roads and bridges and fund new climate resilience and broadband initiatives.

The plan reportedly includes, US$550 billion in new federal spending, to expand high-speed internet access (US$65bn); build/rebuild roads, bridges, etc (US$110 billion); airports (US$25 billion); and the most funding for Amtrak since the passenger rail service was founded in 1971. It would also renew and revamp existing infrastructure and transportation programs set to expire at the end of September.

11.  Back home, financials have are sharply outperforming the commodities since past three weeks. The market is telling that metals, sugars etc. have reached their peak margin and peak valuations. Using the strong price cycle, many large commodity companies have repaired their balance sheets. Consolidation by way of IBC process has also helped the larger companies. It is time that these companies may be thinking about the next capex cycle. Sugar companies have already embarked on a major capex cycle to set up new ethanol capacities. Steel companies are already planning major capacity additions. As per media reports SAIL is looking to expand capacities by 12-14 mt at its steel plants at Bokaro and Rourkela.

The popular inflation hedge trade (gold and silver) has done much worse than the overall commodity universe; whereas Bitcoin (perceived to be one of the most riskiest and volatile asset presently) has done very well.

Conclusion

These are still early days to conclude anything from the above cited news items and trends. Nonetheless, in my view, the following deductions from viewpoint of investment strategy may be considered reasonable:

·         The sharp run up in commodity prices is factor of supply constraints and demand stimulus. There are indications that supply constraints may ease as economies open up further; demand may cool down as monetary stimulus are gradually withdrawn and pent up demand subsides.

·         The commodity price inflation is now testing the limits of the industrial consumers (manufacturers). Any further rise from here shall be passed on to the last consumers, who would have much lower absorption capacity in absence of further stimulus checks. It is reasonable to assume that normal demand supply equilibrium will settle at a lower level only.

·         The balance sheets of commodity and infrastructure companies have seen substantial improvement in past one year. These two sectors accounted for more than half of the stress in the banking system. Besides, the credit growth is likely to pick up as companies rush to augment capacities to meet the increased demand and avail new government incentives for manufacturing sectors.

·         The conventional wisdom suggests that now it’s the turn of financials and capital goods manufacturers to do well. Commodities can wait for FY24 to have their turn again.

 The strong rally in global metal prices, and consequently metal producers, appear to be faltering. Chinese authorities have taken a number of measures to calm down the steel and iron ore market. Iron futures have fallen sharply in past couple of weeks. Besides, steel and base metals like copper and aluminium have also corrected sharply from their recent high levels.

A few brokerages who were extremely bullish on metals from midterm viewpoint have also turned little cautious. For example, in a recent research note JM Financial stated that

“The recent spike in the headline inflation in several countries, including in the US, has been led by steep rise in global commodity prices, including metals, soft commodities and crude oil prices….”.

“For us the rally over the past 12 months was fairly predictable. But things are not as clear looking forward. We believe that market indicators have run far ahead given the context of the underlying strength of the economic recovery that is still nascent and significant supply side factors including production cuts by China in case of steel, by OPEC in case of crude oil production, and bottlenecks across various input items. Given our assessment of still weak pricing power in the manufacturing sector despite the recovery, the rising cost and inflation pressures can slow growth and consumption. There can also be supply responses to steep rise in commodity or input prices. Both these will cool off the commodity rally. Indeed the recent news indicates that the supply-demand equation for Chinese steel is now weighing on the other side.”

The note concludes that the historic low pricing power of manufacturers is incongruent with the high commodity inflation and therefore unsustainable. It is felt that “The probability of pick up in output prices in response to rising cost is lower than decline in commodity prices.”

But there are other brokerages like (Kotak on Aluminium and Nomura & CLAS on Steel) which have not yet considered revising their outlook.

A recent note by Kotak Research emphasized that “Chinese aluminum smelters are facing environment-led production restrictions whereas capacity cap is limiting future additions. With strong sequential demand recovery, global utilization has reached a decade high, has limited spare capacity and thin pipeline of fresh additions.” The brokerage accordingly forecasts “a deficit market from CY2022E to keep aluminum prices elevated and upgraded our price assumptions by 30%/19% for FY2022/23E.”

The rating agency CARE, expressed a balanced view in a recent note. It highlighted that “The demand for base metals looks strong as more countries emerge from the pandemic with strong recovery anticipated in the global economy. Economic data from US and European market have improved since April and the US dollar trended lower which is also giving supporting metal prices. The current demand fundamentals for copper, aluminium and tin are robust and future supply will need to respond to increased demand.” The bullish view was however qualified by risk from Chinese action. It read, “, on the downside risk Chinese authorities have announced that they will track commodities prices more closely, and are prepared to take measures to steady raw materials prices. High commodity prices will also increase the project cost of infrastructure development activities announced by the major economies to tide over the pandemic driven slowdown. High commodity prices of copper and aluminium will also increase the cost of transitioning to green energy and may lengthen the time taken to reach the climate goals.”

The market however seems to be embracing the idea of peak commodity inflation with Nifty Bank outperforming Nifty Metal by 7-8% in past 3days. It is to seen whether this divergence is beginning of a new trend or just a minor correction in a midterm trend.

 “Commodities” is the most important buzzword in equity markets these days. Chartists, analysts, economists, strategists and traders et. al. are predominantly talking about stocks of commodity companies. The strong rally in the stocks of commodity producers is primarily based on the material rise in the global commodities’ prices, especially in past one year.

I analysed the market performance since announcement of first lockdown (25^h March 2020). I also looked at the market performance in three other timeframes, viz.,

(i)    Since January 2021, because most of the restrictions announced in March 2021 were lifted, US elections were completed and vaccine launches had already begun.

(ii)   Since February 2021, because a market exciting budget was presented with strong on infra building and fiscal discipline; and UK exit from EU was complete, and global trade had started to normalize.

(iii)  Since April 2021, when a second wave of pandemic started to hit few states of India badly

The following are some of the key trends observed in the performance of market in these time frames.

1.    “Metals” have been a clear outperforming sector over all timeframes. Nifty Metals has returned 255% since Lockdown 1.0, more than double of the second best performing sector, i.e., Nifty IT (121%). Auto (109%) and Pharma (108%) are other sectors that outperformed Nifty (90%) in this timeframe.

2.    Pharma has materially underperformed metals over all timeframes. Which sounds bit counterintuitive, given the pandemic situation.

3.    FMCG is a top underperformer over all timeframes, despite huge social sector support, resilient rural sector, and strong corporate performances. Some of this could be explained by significant outperformance of FMCG sector in previous year

4.    Media is another noticeable laggard, despite work from home, lockdown, etc.

5.    Despite huge outlay for capacity building in 2020 stimulus packages and FY22budget, Infra sector has performed mostly in line with the benchmark Nifty over these timeframes.

6.    Realty has been the worst performing sector over all these timeframes.

7.    PSU Banks have outperformed their private sector peers in 2021. This is in line with PSEs in general outperforming Nifty in current year.

8.    Announcement of much awaited scraping policy does not seem to have nay impact on auto sector. Nifty Auto is down 4% since budget.

9.    The positive momentum that was created in reality sector last year due to duty incentives and lower rates seems to have subsided. Nifty Realty has underperformed materially after Budget.

10.  In FY22 so far, Only commodities and pharma have yielded meaningful return.