Do it yourself

In a keenly watched two-day meeting, the first after the inauguration of the new US President, the Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to pause its kept federal fund rates in 4.25%-4.5% range, after cutting it overall by 1% over its three previous meetings. The decision to pause is governed by a strong and resilient labor market and persisting inflation.

In a post meeting press interaction, Fed Chairman Jerome Powell noted that “The unemployment rate has stabilized at a low level in recent months, labor market conditions remain solid, and Inflation remains somewhat elevated.” He further added that the Fed needs to see “real progress on inflation or some weakness in the labor market before we consider making adjustments.”

Most notably, he emphasized that we're meaningfully above the ‘neutral rate’. He said, “I have no illusion that anyone knows precisely how much that is and but having cut 100 basis points means that it's appropriate that we not be in a hurry to make further adjustments.” (‘Neutral rate’ is a fed rate that is considered neither stimulative nor restrictive of growth under the current circumstances.)

Higher for longer: The market participants have taken this to imply that the current rate cut cycle is certainly not over and may resume after a pause, as the Fed gathers more evidence on inflation. Nonetheless, analysts now appear less sanguine about the lower bound of the present rate cut cycle. The consensus amongst them is emerging that the long-term bottom rate may have risen to 3% from the earlier estimates 2.5%. The ‘Fed pause’ is also being influenced by uncertainties surrounding the new administration's direction - on fiscal, trade, and government spending matters. The Fed officials noted “they don't intend to react until policies reach the implementation stage and begin to impact incoming economic data”.

Markets: Post the Fed decision, stock prices ended lower (S&P500 -0.5%), USD marginally stronger (DXY +0.2%) and benchmark bonds stronger (US 10yr Yield -0.37%).

RBI: The ‘Fed pause’ has made the February 06^th rate cut by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), less certain. There are however more chances that RBI may change its stance to ‘accommodative’ from ‘withdrawal of accommodation’, signaling now growth is a priority over inflation.

India’s real GDP grew by 5.4% yoy during 2QFY25 (July-Sep); the slowest growth rate recorded since 3QFY23. The Reserve Bank of India had forecasted a growth of 7%, just a month ago, while the market consensus was less sanguine at ~6.5%.

For the argument’s sake, some of the slowdown in 2QFY25 could be attributed to a high base (2QFY24 GDP grew at 8.1%). However, it is tough to deny that the Indian economy has been growing below potential in most of the post global financial crisis (GFC-2009) period. In fact, it will not be totally perverse to argue that in the past one decade or so, the potential growth curve itself has moved lower.

For record, the Indian economy has grown at an average rate of 5.8% during the past decade (FY15-FY24). Even normalizing for the Covid-19 lockdown impact, the Indian economy has grown at an average rate of 6.0%, much below the estimated potential growth rate of over 8%. The real GDP had grown at an average rate of 7.8% during the preceding decade (FY05-FY14).

The slowdown in 2QFY25 has been led by the industrial sector, especially, manufacturing and core sector (e.g., mining and electricity) – a sector that has been the highest priority area for the incumbent government in the past decade. Agriculture (3.5% growth) sector did well on the back of a bountiful monsoon; and services also grew at a decent 7.1% led by public administration. On demand side, investments contracted for the fourth consecutive quarter, belying the promise of a massive jump in allocation for capex in the union budgets for FY24 and FY25. Private consumption grew 6% yoy on a low base of 2.6%, but declined qoq, despite the higher DBT.

The fiscal data for April-October 2024 period shows that contrary to its commitment in the union budget, the government has sacrificed capital expenditure in favor of direct cash transfer (DBT) to households. Ahead of key state elections, the government transferred an advance installment of tax devolution to states to meet revenue expense obligations. The central government capex (including on defense) was much lower than the budget targets. The disbursement of the promised capex loans to the states was also lower. Revenue expenditure on education, drinking water and sanitation were restrained to increase DBT allocation.

The popular narrative after the announcement of 2QFY25 GDP data appears to be that high effective rate of taxes and higher interest rates are hurting the growth and fiscal and monetary stimulus may lead to a course correction. I sincerely beg to differ from this hypothesis.

I have often highlighted that the obstacles to the acceleration in India’s growth rate are structural and not cyclical. Inability to adequately exploit our most valuable resources – the human capital and the largest pool of arable land in the world – is the principal reason for below potential growth. Consistent misallocation of capital, adhocism in policy making, lack of a conceptual growth framework, a distorted federal political structure, blatant pursuit of crony socialism, and lack of a long-term socio-economic growth plan.

In this context, it might be pertinent to note the OECD has projected a gradual deceleration in the potential growth rate of the Indian economy in the next four decades, as the marginal productivity of capital declines and contribution from technological progresses diminishes. (Table 1). The potential rate declines, even if in a blue-sky scenario, where India is able to take fuller advantage of its demography and is able to achieve a much higher rate of capital accumulation and employment (Table 2). (see full report here)

(Note: I had last shared my investment outlook and strategy for the financial year FY25 in April 2024. Since then, there have been some changes in circumstances. The global financial system is more stable. Stock markets have done very well. The geopolitical conditions are more stable; and the price situation appears to be in control at both domestic and international levels. The domestic growth continues to surprise on the upside and the external balance is much more stable. The political overhang in the domestic market is over with the general elections. To accommodate these changes, I have made some changes in my outlook and strategy as outlined in April 2024.)

In my view, the stock market outlook in India, in the short term, is a function of the following seven factors:

(1)        Macroeconomic environment

(2)        Global markets and flows

(3)        Technical positioning

(4)        Corporate earnings and valuations

(5)        Return profile and prospects for alternative assets like gold, real estate, fixed income etc.

(6)        Greed and fear equilibrium

(7)        Perception about the political establishment

The outlook for these seven factors for next 6-9 month is as follows, in my view—

Macroeconomic environment – Positive

My outlook for the likely macroeconomic environment in 2H2024 is as follows:

(a)        Inflation: The consumer inflation may average close to the lower bound of RBI’s tolerance bound of 4% to 6%.

(b)        Fiscal Deficit: The fiscal situation of the central government may remain comfortable as the tax collections remain steady and revenue expenditure is controlled further.

(c)        Rates: Expect benchmark yields to average in the 6.85% +/- 15bps range. The RBI may stay on ‘pause’ for now. Deposit and lending rates may stabilize around current levels, the liquidity may ease in the forthcoming busy season as government spending accelerates.

(d)        Current Account: Expect current account balance to stay negative as import growth continues to outpace exports. The deficit may average around 1.25% to 1.5% for 2H2024.

(e)        Savings: Household savings may continue to grow at a slower pace as real wage growth remains poor. Aggregate corporate savings though may be higher due to continued deleveraging and rise in free cash flows.

(f)         Investment: The government investment expenditure may sustain at current pace. Private capex may see further recovery in 2H2024. Overall, investment growth may see decent growth.

(g)        Exchange Rate: USDINR may average close to INR83.5 +/- 1 range on a stable current account and higher Fx inflows.

(h)        Growth: The real GDP growth for FY25 may average around 7% despite a slower global economy, on the back of better manufacturing and good monsoon. Overall, macroeconomic outlook is positive.

Global markets - Neutral

The global analysts and economists are nearly unanimous on the growth stability in 2H2024. The likely monetary easing and stable geopolitical conditions may support growth stability. The outlook for USD is neutral as central bankers remain on a corrective path.

Technical Positioning – Negative

Technically, in my view, the benchmark indices may witness a decent correction in 3Q2024 before a sustained rise. At present level thus Nifty offers a negative risk reward.

Technically speaking, Nifty may move in the 20210-24995 range in 2H2024, averaging above 22635. There could be occasional violations of this range. Buying below 22700 will therefore carry a positive risk reward.

Corporate earnings and valuations - Neutral

The earnings growth momentum is peaking after three years of strong show. The visibility of margin improvement is clouded as capacity utilizations are high and companies are initiating expansion plans. Raw material prices are also now ticking up.

The present forward valuations are slightly above long-term averages based on still marginally optimistic earnings forecasts. However, 2H2024 may not witness a material PE derating as macro fundamentals remain strong and visibility of flows is improving.

Alternative return profile - Neutral

Real estate: Real estate prices may not rise materially in 2H2024 as more supply hits the market higher interest rates begin to bite and government incentives are withdrawn gradually.

Gold: Presently, there is no major trigger for the global gold prices to rise significantly in 2H2024. Save for a major geopolitical escalation, gold offers a neutral to marginally negative risk reward.

Cryptocurrencies: In the past couple of years, Cryptocurrencies have emerged as a notable alternative asset class. Being a new asset class the level of understanding and awareness about this asset class is still low, though the participation has risen exponentially. This combination of low understanding - high participation makes it highly volatile. Nonetheless, its popularity remains high and this trend may continue in 2H2024 as well.

Fixed income: The corporate bond yields and deposit rates appear to have stabilized and may see some downward bias in 2H2024. The yield gap is now not material. Overall, in my view, the return profile of alternatives is neutral for equities.

Greed and fear index – Negative

Historically, the most successful, though intuitive, indicator of greed overtaking the fear in the market is sharp outperformance of small cap stocks over large cap stocks. Besides, the volatility index, another gauge of fear, has remained low despite several concerns emerging.

The recent sharp outperformance of smallcap stocks and unsustainable euphoria in few pockets of the markets, indicate that greed is dominating the sentiments. The Greed and Fear balance therefore is negative presently.

Perception about the political establishment - Positive

Strong commitment to promote manufacturing in India; positive outcome of thrust on self-reliance and firmly controlled fiscal balance is keeping markets’ perception about the political establishment positive. However, any significant losses for BJP in the assembly elections scheduled in 4Q2024 may require a review of this position.

Outlook for Indian markets

In view of the positioning of the above seven key factors, my outlook for the market in 2H2024 is as follows:

(a)   NIfty 50 may move in a large range of 20210-24995 during 2H2024. It would be reasonable to expect low single digit return for the 2H2024 on diversified portfolios.

(b)   The outlook is positive for IT Services, Pharma, Specialty & Agro Chemicals, Capital goods, organized retail and consumer durables. Commodities and Financials are neutral.

(c)    Benchmark bond yields may average 6.85% +/- 15bps for the year. Long duration yields may do better in 2H2024.

(d)   USDINR may average close to 83.5+/- 1 and move in the INR82.5-84.5/USD range.

(e)    Residential real estate prices may ease in most metro and large cities.

Some key risks to be monitored for the market in 2H2024

1.    Weather conditions especially poor distribution of monsoon rains.

2.    Worsening geopolitical situation in Europe and Asia.

3.    A recession forecast for FY26.

4.    Sharp rise in credit cost for lenders.

5.    Unusual rise in rural stress.

2H2024: Investment Strategy

Asset allocation

2H2024 appears to be marginally worse than 1H2024 as the market technical have worsened. Accordingly, I am changing my primary investment objective to “low returns and capital preservation”. I believe that the market may continue to offer attractive opportunities to build a good portfolio for the period beyond 2024.

I shall continue to maintain standard allocation in 2H2024; and increase active trading in my equity portfolio to optimize return. My target return for the overall financial asset portfolio for 2H2024 would be 8% annualized.

Equity investment strategy

I would maintain a 60:30:10 mix of large, midcap and smallcap stocks.

(a)   Target 18% annualized appreciation from my trading portfolio;

(b)   Overweight on Chemicals (specialty and Agro Chem), IT Services, Pharma, organized retail and niche consumer stocks.

(c)    Underweight on financials and avoid PSUs.

The minutes of the last meeting (30 April 2024 – 1 May 2024) of the Federal Open Market Committee (FOMC) of the US were released last week. The discussion provides a decent insight into the policymakers’ thought process about the near-term economic outlook and the likely policy direction.

In the pre-finfluencer era, we used to have gods in the financial markets. Those gods would make an occasional public appearance and talk about their views on markets and investment strategies. The market participant would listen to these gods with rapt attention and follow them religiously. All those Buffets, Mungers, Rogers, Finks, Woods, Jhunjhunwalas, Damanis, et. al. were revered names. Then TikTok, Instagram, and X (formerly Twitter) happened. Financial experts, economists, monetary theorists, and technical gurus mushroomed at the rate of 100 per hour.

Everyone who has traded stocks or crypto for three months is now an expert. They not only try to influence other investors/traders by giving unsolicited advice and recommendations; but also get influenced by the advice/recommendations of others who may not be any better than them. Sometimes it appears that there are more experts in the market than the actual number of investors and traders. Unfortunately, this is the situation worldwide.

Misallocation of capital and unwarranted and avoidable losses are some natural consequences of this phenomenon. However, a more significant consequence is a diminution of traditional correlations.

A multitude of market influencers is driven by individual positioning as against a conceptual understanding of finance and economics. There are no dominating views in the markets. Each influencer is influencing multiple traders and also getting influenced by multiple other influencers. Since more positions are driven by intuitions rather than fundamentals, the divergence between market prices and fair values is wider, and lasting much longer.

For example, consider the following:

Gold and bonds are trading in opposite directions. Gold, traditionally considered a hedge against a drop in real rates, started firming up in 2022. However, now that 2024 rate cuts are getting dropped from foreca500sts, gold has given its best 2-month performance in decades.

This divergence of gold from real rates, against the historical trend, is being explained from a variety of angles. Some believe that a US sovereign downgrade may be imminent. Others explain this as a move away from USD in a worsening geopolitical scenario. However, the equity positioning and tech valuations do not corroborate any of these views.

Similarly, equities and rate expectations are also diverging against the historical trend. In the past six months, S&P500 has rallied 25% despite hopes of 2024 rate cuts fading fast.

Recently, Jamie Dimon, CEO of JPMorgan, was quoted as saying, “We are prepared for a very broad range of interest rates, from 2% to 8% or even more”. Larry Summers, Former Treasury Secretary, a very reputable name in financial markets also said, “You have to take seriously the possibility that the next rate move will be upwards rather than downwards”. Michelle Bowman, FED Governor, also said, “I continue to see the risk that at a future meeting, we may need to increase the policy rate further should progress on inflation stall or even reverse."

But no one appears to be listening to these experts. Professional TikTokers are getting more attention than them. I will not be surprised if the people who trade on their advice learn some basic investing lessons paying a heavy price.

In the past few days, three noteworthy events took place in the global financial markets. These events highlight the policymakers’ dilemma and the uncertainty faced by the financial markets.

First, the Bank of Japan changed its policy stance of “negative interest rates” ending its massive decade-long monetary stimulus exercise to a virtual close. Addressing the press after the policy decision, Governor Kazua Ueda emphasized that BoJ has “reverted to a normal monetary policy targeting short-term interest rates as with other central banks” He also added that “if trend inflation heightens a bit more, that may lead to an increase in short-term rates”.

An overwhelming market consensus now believes that BoJ will hike the policy rates from the present 0-0.1% to 1% in the next year. However, given the massive debt accumulated over the past two decades, Japan may not afford any rate hike beyond 1%.

USDJPY (151.38) is now at its lowest level since 1990.

Second, the Swiss National Bank (SNB) cut its policy rates by 25bps, its first rate cut in nine years. The other European central banks, viz., Norwegian Central Bank (Norges Bank) and Bank of England however decided to maintain the status quo. The decision of SNB was unexpected as the market consensus favored a status quo. SNB did not commit to any further cuts.

This ‘surprise’ move by SNB led the Swiss Franc (USDCHF) and Swiss treasuries to tumble down to their lowest level in eight months.

Third, the US Federal Reserve maintained the status quo on its policy rates, holding the policy rates in a range of 5.25%-5.5%, as expected by the market consensus. The market expectations are now veering around 0-3 cuts this year, against the expectations of 6-8 cuts four months ago. The ‘no-cut’ this year is gaining more support every day.

In the post-meeting press interaction, Fed Chairman Jerome Powell was as non-committal as one could be, leaving the markets confused and speculating. Powell said, “despite high interest rates, economic growth has remained relatively strong and inflation has materially lowered over the past year. Consequently, the FOMC raised its growth and inflation expectations for 2024”. Powell added that “there is still plenty of progress to be made on meeting its 2% inflation target” and hence “the path forward is uncertain.”

After reading the three policy statements carefully, my understanding of the situation is as follows:

·         The central banks are increasingly confident of avoiding any deeper recession in the short term at least (1-2 years). Even the “soft-landing” (shallow recession) appears to be slowly becoming a bear case. The base case is low growth for a longer period.

·         The central bankers are inclined to accept 2-4% inflation as normal. This suits everyone. The governments that have accumulated massive debt over the past decade would be happy if the real rates just stayed negative for long. Savers are happy to earn higher nominal rates on their savings. Corporations are happy to borrow more at negative real rates, buy back their equity, and enhance the market value of their businesses with low earnings growth. We may also see a relative currency depreciation of countries with high external debt (e.g., the US) as a tool for debt management.

·         The popular narrative revolves around “resilient growth”, “sticky inflation” and “calibrated easing”. None seems to be positioned for a Fed rate hike presently. Though the probability may be negligible presently, further strengthening of growth momentum, a strong El Nino, and/or worsening of geopolitical conditions in the Middle East Asia and Central Europe fueling inflation could enhance this probability.

In the Indian context, the RBI has been on pause for over a year now. This is despite inflation consistently remaining close to above the upper bound of its tolerance range of 4-6%; growth surpassing its mostly optimistic estimates; distinct signs of heating in certain pockets of the credit market (especially credit card outstandings and unsecured NBFC lending); and the regulators frequently expressing concerns over excesses in financial markets. RBI has chosen to use tools like withdrawing liquidity through open market operations and nudging NBFCs and banks through advisories to regulate the credit markets.

The popular market narrative in India also revolves around the timing of the cut rather than “cut or hike”. For the financial sector, it means “Margin pressure”, “slower growth”, and “pressure on asset quality”.

RBI’s pause hinders the lenders’ ability to hike the lending rates when the cost of funds is rising due to tighter liquidity and stricter norms. The government has hiked the rates on small savings and EPF. This pressures banks’ cost of deposits. Stricter lending norms might adversely impact the product mix of lenders as the weightage of high-margin personal and unsecured loans reduces. Pressure on low-cost CASA rises as the savers move to high-yield options like corporate bonds, credit funds, and even equities.

In my view, investors should be wary of the free advice of deep value in the banking sector. The large banks are underperforming for a valid reason and smaller banks may have completed their re-rating journey.

The first day of January of the Gregorian calendar is widely celebrated as “New Year” globally. Scientifically speaking, this is just another point in ad infinitum; and no different from the millions of other similar points in the history of mankind. Nonetheless, we celebrate it as a new beginning, after every twelve Gregorian calendar months. The idea perhaps is to take a break from the routine and reflect on events of the past twelve months to review, reassess, revise, retreat a bit if required, and resume. It is common for people to take a pledge on this occasion, to take corrective measures for improving their lifestyles and behavior, and to set new goals for themselves.

Wishing all the readers, family, and friends a very Happy Diwali. May the Lord enlighten all of us and relieve everyone from pain and misery. 

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The growth is slowing across the world. The engines of global growth - India and China – are also expected to slow down in 2024. Most European countries are flirting with recession. Canada is technically in recession. The US growth is stronger than estimates but not enough to support the

Growth decelerating

As per the latest World Economic Outlook report released by the World Bank, global growth has slowed down to 3% in 2023 from 3.5% recorded in the year 2022. The global economic growth is expected to further decelerate to 2.9% in 2024. The advanced economies have grown by 1.5% in 2023 against 2.6% in 2022. Their growth is likely to further decelerate to 1.4% in 2024. Economic growth in Emerging economies is also not accelerating. These economies are expected to grow at the rate of 4% in 2023 and 2024, against 4.1% in 2022.

Though the likelihood of a hard landing in the US may have receded, the risks to the growth still remain tilted to the downside.

Inflation persisting

The growth slowdown could be largely attributed to the effects of the monetary tightening measures taken since 2022. However, despite the sharp growth deceleration, global inflation is likely to stay above 5% in 2024 also. The World Bank expects global inflation to ease to 6.9% in 2023 and 5.8% in 2024, against 8.7% in 2022. In recent weeks, the inflationary expectations have risen again and could contribute—along with tight labor markets––to core inflation pressures persisting and requiring higher policy rates than expected. More climate and geopolitical shocks could cause additional food and energy price spikes.

Geoeconomic fragmentation – risks rising for emerging economies

The rising geoeconomic fragmentation is seen as a key risk to global growth and financial stability. Intensifying geoeconomic fragmentation could constrain the flow of commodities across markets, causing additional price volatility and complicating the green transition. Amid rising debt service costs, more than half of low-income developing countries are in or at high risk of debt distress.

No room for policy error

Given the still high inflation, unsustainable fiscal conditions and high cost of disinflation, there is little margin for error on the policy front. Central banks need to restore price stability while using policy tools to relieve potential financial stress when needed. effective monetary policy frameworks and communication are vital for anchoring expectations and minimizing the output costs of disinflation. Fiscal policymakers should rebuild budgetary room for maneuver and withdraw untargeted measures while protecting the vulnerable.

However, if we juxtapose these economic realities with the market performance, the dissonance is too stark. Formulating an investment policy that balances the macroeconomic and market realities is extremely challenging under the current circumstances.

I shall share my thoughts on this after the Diwali break. I will post next on 17^th November.

 I have often seen that when we fail to find solutions to our problems with the help of science and economics, we tend to look towards the heavens and seek to find answers in philosophy. It is not uncommon for businesses, administrators, and policymakers to seek divine intervention when science and economics are not helping to resolve a problem. The global policymakers and administrators seem to have reached such a crossroads one more time, where the conventional practices, accumulated knowledge, and past experiences do not appear to be of much help. Their actions appear driven more by hope than conviction.

The war in Ukraine; the economic slowdown in China; and the monetary policy dilemma in the US and India are some examples of problems where the administrators and policymakers seem to be hoping for divine intervention. I see the recent speech of the US Federal Reserve Chairman Jerome Powell at the Jackson Hole symposium and the minutes of the last meeting of the monetary policy committee of the Reserve Bank of India in this light.

After 16 months of aggressive monetary tightening, the Fed is not confident whether they have done enough; or they have overdone with tightening or they are lagging behind. He reiterated that the policy is restrictive enough to anchor inflationary expectations, but still expressed fears that the high inflation might get entrenched in the economy and may require treatment at the expense of higher unemployment. Chairman Powell indeed sounded more like a sailor trapped in a storm, when he said, “We are navigating by the stars under cloudy skies”.

The situation in the US, as I see it from thirty-five thousand feet above sea level, is as follows:

·         The US Federal Reserve has hiked the key policy rates from near zero (0.25%) in March 2022 to 5.5% in August 2023. This is one of the steepest hikes in the past four decades.

·         The US financial system faces a serious challenge as MTM losses on the bond portfolios are accelerating; retail delinquencies have started to build up;

·         The positive real rates in the US are now 2% or higher. Despite these restrictive rates, the economy is not showing much sign of cooling down. The probability of growth acceleration in the US economy in the next couple of years is therefore remote.

·         Inflation continues to persist above 4% against a committed target of 2%. The household savings may therefore continue to shrink at an accelerated pace.

·         The mortgage rates are well above 7%, the highest in two decades. Housing affordability is at its worst in history.

·         The US government is paying close to US$1trn/year (about 20% of revenue) in interest on its borrowing, which is an unsustainable level.

·         The cost of borrowing (and interest burden) for the US government shall continue to rise for a few years at least as the Fed reduces its balance sheet, foreign governments cut on their demand for the US treasuries, and the rating of the US government’s debt face further downgrades. The fiscal pressures thus remain elevated.

·         The money supply (M1) in the US at US$19trn is about 4.5x of the pre-Covid levels. It may take years to normalize at the current speed of quantitative tightening (QT) by the Federal Reserve.

·        
The “Lower for Longer” narrative has metamorphosed quickly into “Higher for Longer”. However, analysts, economists, and strategists who are in their 30s may have never witnessed a major rate or inflation cycle in their professional careers. Their assessment of peak rates and peak inflation may be suffering from some limitations.

….to continue tomorrow