Vijay Kumar Gaba: repo

Showing posts with label repo. Show all posts

Wednesday, April 3, 2024

FY25 – Market Outlook and Strategy

In my view, the stock market outlook in India, in the short term of one year, 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, and cryptocurrencies, etc.

(6) Greed and fear equilibrium

(7) Perception of the political establishment

The outlook for these seven factors for the next twelve months is as follows, in my view—

Macroeconomic environment – Neutral

My outlook for the likely macroeconomic environment in FY25 is as follows:

(a) Inflation: Consumer inflation may average well within the RBI tolerance band of 4% to 6%. However, food inflation may continue to be erratic and cause occasional violations of the upper range.

(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. I do not expect any significant deterioration in fiscal conditions due to elections scheduled in April-June 2024. No major tax/duty concessions are expected. Any major improvement in fiscal balance would depend on acceleration in asset monetization. The outcome of the general election will be a key factor in this regard. A change in regime could possibly push the FRBM Act targets further by 1-2 years.

(c) Rates: Expect benchmark yields to average in the 7.2% +/- 30bps range. The RBI may remain on pause in the first half and may deliver a 35-50bps cut in the second half depending upon the monsoon and global trend. No major change may be seen in deposit and lending rates as liquidity remains tight and credit demand remains elevated.

(d) Current Account: Expect the current account balance to stay negative for most of the year as import growth continues to outpace exports. The deficit may average around 1.3% to 1.6% for FY25.

(e) Savings: Household savings rate may continue to decline as real wage growth remains poor. Aggregate corporate savings may also decline as capacity utilization increases and corporates embark on capex plans.

(f) Investment: The government investment expenditure may slow down in 1HFY25 due to fiscal constraints and election-related restrictions. Private capex may maintain its 2HFY24 trajectory. Overall, investment growth may see decent growth in FY25.

(g) Exchange Rate: USDINR may average close to INR84 +/- 1 range on a negative current account and elevated inflation.

(h) Growth: The real GDP growth for FY25 may average around 6.25% +/- 50bps despite a slower global economy. A poor monsoon could impact the growth negatively by 50-60bps.

Overall, the macroeconomic outlook is neutral.

Global markets and flows - Neutral

Markets: Global analysts and economists are nearly unanimous on the growth recession in FY25. Most markets are currently pricing some rate cuts and monetary easing to mitigate the impact of economic slowdown. Any disappointment on this count may impact global markets adversely.

Flows: The outlook for the USD is now neutral as the US Fed is not expected to deliver aggressive rate cuts. Flows towards emerging markets may therefore remain down in FY25 as yields in developed markets remain attractive.

Technical Positioning - Neutral

In my view, the benchmark indices may go through a technical correction in 1QFY25. The indices offer a balanced risk-reward at the current level. A correction of 6-8% would make the market attractive again.

Technically speaking, Nifty may move in a wider range of 18475-24995 in FY25, averaging above 19885. Buying below 20650 will carry a positive risk reward.

Corporate earnings and valuations - Neutral

The earnings momentum may slow marginally as banks, energy, and metal earnings growth peaks in FY25. No major acceleration in earnings is expected from FMCG companies. Power, Capital goods, and Pharma are the notable sectors that are expected to deliver a decent delta in earnings. Overall, expect a 15-17% earnings growth.

The visibility of the improved margins sustaining is decent. Higher capacity utilization may warrant capex, hence the beginning of a re-leveraging cycle from FY25. RoE therefore may not improve materially in the next couple of years.

Alternative return profile - Positive

Real estate: Real estate prices rise cycle may peak in FY25 as higher interest rates, withdrawal of tax incentives, and slowdown in demand due to slower employment growth may weigh on demand.

Gold: Gold prices have recently rallied on the back of expectations of rate cuts by central bankers and persistent buying by some large central banks. A stronger USD and resilient growth may halt the recent run-up in gold prices. Save for a major geopolitical escalation, gold offers a neutral to marginally negative risk-reward from the present level.

Cryptocurrencies: In the past few 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 FY25 as well.

Fixed income: The corporate bond yields and deposit rates may see some downward bias in FY25, as policy rates peak and begin to descend. The yield gap that favors bonds presently may be sustained for most of FY25.

Overall, in my view, the return profile of alternatives is positive for equities.

Greed and fear index - Negative

Historically, the most successful, though intuitive, indicator of greed overtaking the fear in the stock market is the outperformance of small-cap stocks over large-cap stocks. The volatility index, another gauge of fear, has however inched higher in the recent weeks.

The sharp outperformance of smallcap stocks in FY24 indicates that greed dominates the sentiments presently. This sentiment may change in 2HFY25. The Greed and Fear balance therefore is unfavorable presently.

Perception about the political establishment - Positive

Strong commitment to promote manufacturing in India; the positive outcome of thrust on self-reliance, controlled fiscal balance, and recent election victories are keeping markets’ perception about the political establishment positive. The incumbent is forecasted to perform well in the general elections. This may further strengthen the positive perception.

Outlook for Indian markets

Given the positioning of the above seven key factors, my outlook for the market in FY25 is as follows:

(a) Nifty 50 may move in a large range of 18475-24995 during FY25. It would be reasonable to expect a low double-digit return for the year on diversified equity portfolios.

(b) The outlook is positive for non-bank financials, fossil fuels, construction materials, metals, capital goods, infrastructure, specialized technology, pharma & healthcare, and modern retail. The outlook for automobiles is neutral. FMCG and Chemicals may underperform in 1HFY25.

(c) Benchmark bond yields may average 7.20% +/- 30bps for the year. Shorter end yields may continue to do better in 1HFY24, while longer duration may do better in 2HFY24.

(d) USDINR may average close to 84+/- 1 and move in the 82-86/USD range.

(e) Residential real estate price rise cycle may peak in FY25. Commercial real estate may continue to perform better.

Some key risks to be monitored for the market in FY25

1. El Nino strengthening and adversely impacting monsoon; leading to an unusual rise in rural stress.

2. Material worsening of geopolitical situation in Europe and Asia.

3. A large credit event causing a market freeze.

4. A deeper recession in developed economies that may spill into 2025 as well.

5. Sharp rise in commodity prices due to production/logistic disruptions; restocking; displacement of USD etc.

6. General election results contrary to expectations.

Wednesday, March 27, 2024

Add a pinch of salt to free advice

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.

Wednesday, January 24, 2024

Long bond – cognitive dissonance

I had an opportunity to meet with a group of investors last week. The discussion revolved around the present market conditions and the likely direction of equity and bond markets over the next few months. The views about the equity markets were divergent. However, the views about the bond markets were surprisingly similar. A substantial number of people believed that the interest rates have peaked and may move lower in the next 6 months. Long bonds thus appeared as a consensus trade. Almost all of them have been advised by their respective advisors (or friends) to increase the “duration” of their debt portfolio to avail maximum benefit of the declining interest rates.

A deeper inquisition highlighted several interesting issues related to the “long duration” positioning of the investors. I want to share some of these issues with the readers to seek their views in this regard.

· Most of the investors were not fully conversant with the concepts like “duration” and “modified duration” of bonds. They believed “residual maturity” and “duration” are the same things.

“Modified Duration” is a measure of the sensitivity of bond prices to the change in interest rates. Simply put, if a one percent move in bond yields results in a 5% change in the underlying bond prices, the bond is said to have a modified duration of 5yr.

The point to remember is each category of bonds reacts differently to the change in repo rate by RBI. Government securities, corporate bonds, and low-rated (junk or high-yield) bonds will react in different measures to any policy rate change.

· Even professionals like Chartered Accountants and MBAs assume a direct correlation between bond yields and RBI policy rates.

Interest rates (and bond prices) are a function of the demand and supply of credit. RBI policy rates do provide a broader direction to the credit demand and supply, but it is not necessary that in the near-term RBI rates and bond prices will have a direct correlation.

For example, if the fiscal deficit for FY25 is budgeted at more than the presently forecasted 5.3%, the supply of fresh bonds to be issued may be higher resulting in lower bond prices; even if RBI stays put or implements a 25-35bps cut in repo rates over the next 6months. Long-duration bonds may not yield any capital gains or may result in some MTM losses.

In recent years, the government has relied heavily on high-cost small savings to fund its fiscal deficit. Besides, RBI has systematically constricted the banking system liquidity. This has put pressure on deposit flows to commercial banks, resulting in higher costs of funds for banks. Bank lending rates have shown a tendency to rise even though RBI is stayed put for the past six months. Retail inflation has been sticky (closer to the upper bound of the RBI tolerance band) and the WPI inflation has shown a tendency to rise in recent months. FDI flows have slowed down materially in 2023. FPI flows have also reversed in recent weeks.

In my view, there is no strong argument to support the assumption of RBI cuts. Besides, equity market positioning (sharp rise in private capex, rise in consumer credit, and discretionary spending) supports higher credit demand. Logically, the long bond trade appears more driven by emotions and speculation than an economic argument. It is also a case of cognition dissonance in case you are also long on growth, credit, and capex on your equity portfolio.