Some notable research snippets of the week

Indian IT: Precariously Placed (Jefferies Research)

An unexpected decline in revenues: During 4QFY23, aggregate revenues for Top-5 IT firms declined by 0.8% QoQcc - first QoQ decline in 11 quarters - the key disappointment. While revenues in 4Q were especially impacted by sequential decline in Communication and Tech verticals, growth across verticals moderated sequentially. In local currency terms, Americas and Europe both witnessed de-growth, indicating weakness in both regions. Aggregate growth for mid-sized firms was a bit better than large IT firms though they all disappointed in 4Q. TCS and Coforge disappointed the least while Infosys' reported the weakest results.

... derails margin recovery: Aggregate margins for our coverage universe contracted by 20bps QoQ and were 40bps below our expectation, mainly due to revenue miss. Employee cost (-120bps) weighed on margins due to muted growth, while Subcontracting costs (+50bps) and others overheads (+40bps) supported margins. Margin contraction was due to a 40bps compression in margins for large sized firms, partly offset by 100bps margin expansion for mid-sized firms. All large IT firms disappointed on margins, with TechM and Infosys being the weakest. LTIM drove aggregate margin expansion for mid-sized firms.

Intensifying pain in the sector: IT firms continued with cautious commentary on demand environment, highlighting a cut in discretionary IT spends. While bookings were supported by cost takeout and efficiency deals, revenue growth is being impacted by project deferrals, delayed ramp-ups and project cancellations. While Europe seems to be holding better than muted expectations, the worsening sentiment in America (~60% of aggregate revenues) was the key negative. Furthermore, IT firms have turned more cautious on the pricing environment.

Among verticals, IT firms highlighted weakness in Communication, Tech, BFSI, Retail and Mfg verticals.

Slower growth remains a risk: Aggregate headcount for IT firms declined by 8k in 4Q – the second straight quarter of decline - similar to the decline seen in 2020 during Covid. Declining headcount along with a pricing outlook suggests sharp moderation in FY24 - also evident from the FY24 revenue growth guidance given by Infosys/HCL Tech/LTIM. Additionally, IT firms expect a soft 1H, also evident from Wipro's guidance for 1QFY24 of -3 to -1% QoQcc.

A weak exit and a soft 1H implies a tougher ask for 2HFY24, which would necessitate large deal wins/ramp-ups - the absence of which could drive disappointments to consensus US$ revenue growth expectations of 7% in FY24. Our aggregate FY24 revenue growth is 110bps below consensus.

Stay Selective: A weak 4Q and heightened caution led to a 1-6% cut in FY24/25 consensus EPS estimates. The back-ended growth implies further risks to consensus estimates, which could drive further derating. Our FY24/25 EPS estimates are 1-11% below consensus and with the sector still trading at 8% premium to its 10-yr average and 13% premium to Nifty, we remain selective 

Three make-or-break crises impacting the US (ING Bank)

There is a thread running between the three crises being felt in the US right now. The inflation crisis was borne from the pandemic, a politically toxic one. The looming debt ceiling crisis stems from politicking that is more aggravated than ever. And the third crisis is a banking one, in part brought on by a Fed reacting to the inflation crisis. Where now?

Banking crisis development as measured by the Regional Bank Index and FRA / OIS – risky but tolerable

There are a number of indicators that we can track to help assess where we are and where we are likely to get to. Let’s start with the banking story, and the small and regional bank stress on deposits in particular. Here the US Regional Bank Index tracks sentiment. It was at 120 a couple of months back. It’s now at 80. In the rear view mirror the pandemic took it down to 60. Before that, the Great Financial Crisis saw it dip to 40. That’s the potential doom leap, from 80 to 40 ahead. The question is, will it?

So far the answer is probably not. We look here at the 3mth FRA / OIS spread for guidance. It essentially measures the premium that banks impliedly need to pay over risk free rates in forward space. Currently the 3mth FRA / OIS spread is at about 40bp. It spiked to 60bp when Silicon Valley Bank went down. Having journeyed back down to the low 20’s bp, the crescendo in the First Republic story saw it re-edge higher. As the Great Financial Crisis broke some 15 year ago the FRA/OIS spread quickly got up to 70bp, and then gapped to over 150bp.

We’re nowhere near that. The simple reference of neutrality would be the 20’s bp. We are practically double this right now. Troubling, but not discounting a collapse of the system or anything like that.

Inflation crisis resolution as measure by market breakeven inflation rates – reasonably optimistic

The genesis of bank stresses in part reflects the switch in the stance of Fed policy to tightening on mounting inflation concern. Such concern has eased but has not gone away – latest core PCE readings still identify the US as a “5% inflation” economy.

But there is some good news coming from market inflation break-evens, as derived from the difference between conventional Treasury yields and real yields on inflation protected securities. These inflation break-evens not only have 2% handles right along the curve, but moreover are far closer to a big figure 2% than 3%.

In fact, the 2yr breakeven has just this week dipped below 2%. If that’s what gets delivered, the Fed’s hiking job is done and dusted, and indeed the ground is laid to rationalise future cuts. While interest rate cuts likely coincide with higher consumer delinquencies and corporate defaults, and there is a feedback loop to the stresses in the banking system, where pressure in the commercial real estate sector remains under immediate scrutiny. This would become further acute should these inflation expectations not be realised, making in more difficult for the Fed to execute those cushioning cuts.

Debt ceiling crisis as measure by US sovereign Credit Default Swaps – Concerning but fixable

And as we navigate this course, we face into a debt ceiling dilemma laced with political menace that is so intense as to risk a default. Just one missed interest rate payment would imply a default. Market concern on this front is quite elevated, with 5yr Credit Default Swaps now in the 75bp area. This is the highest since the Great Financial Crisis, and is at the widest spread over core eurozone, ever. While there is no cross default in Treasuries, where one defaulted bond pulls the rest into a defaulted state, there would still be a material tarnishing of the Treasury product even if just one interest payment were missed.

Many players would not want to take on the risk of having a defaulted bond on  their books, and the collateral value of Treasuries would come under scrutiny. One default should not take down the system if holders are immediately made whole through a swift resolution of the debt ceiling. But at this same time things could unravel quite quickly and uncontrollably. In essence the entire global financial system is at threat. Note though that while US CDS is indeed elevated, it’s also far from discounting an actual default, it’s just playing the (mild) probability of default.

India strategy: Improved macro, unchanged micro (Kotak Securities)

The market has lapped up the recent improvement in India’s macro—(1) peaking interest rates and (2) better external position (BoP). We hope that the improved macro percolates into better micro over the next few months. 4QFY23 results and management commentary underscored subdued domestic demand in consumption and weak global demand in the outsourcing (IT) sectors. We expect a gradual recovery in domestic consumption over the next 2-4 quarters. Valuations are at risk without a quick recovery.

Improving outlook on global inflation, but muted growth outlook: The global inflation outlook has improved in recent months, as a result of monetary tightening across major DMs, although core inflation has stayed high (see Exhibits 1-2). The progress on inflation has allowed the US Fed to pause its rate hike cycle, but bond markets are pricing in cuts after a brief pause.

We believe the growth outlook may weaken as DM central banks will likely keep rates at peak levels for an extended period of time. Economic conditions are still fairly strong in most DMs.

India’s macroeconomic outlook has improved: India’s macroeconomic outlook has improved with (1) peaking inflation and comfortable inflation trajectory and (2) an improving external sector outlook.

The country’s interest rates may have peaked in the current cycle, which may address concerns about the negative impact of higher interest rates on housing demand. The RBI had already paused its rate hike cycle at its April meeting on expectations of moderation in inflation.

Micro outlook remains muted: Domestic micro remains subdued, with 4QFY23 earnings slightly ahead of our muted expectations. The beat is largely because of lower-than-expected tax rate in the case of RIL. In fact, both consumer and IT companies reported weak results.

We note continued weakness across most consumption categories in 4QFY23), although lending remained robust. Outsourcing companies were impacted by a weak global demand environment.

We expect moderate earnings growth over FY2024-25 (see Exhibit 13), with low scope for earnings upgrades across sectors. We would not rule out earnings downgrades in the consumer discretionary space, as the underlying factors for the current spell of weak demand may sustain for another 2-3 quarters.

‘Rich’ valuations of ‘growth’ stocks may result in further de-rating: The Indian market is trading at reasonable valuations compared with recent history and bond yields after lackluster returns over the past 18-20 months. However, most ‘growth’ stocks, especially in the consumption, investment and outsourcing space, are trading at expensive valuations, despite increasing near-term demand issues and medium-term risks of disruption. Financials remain reasonably valued and appear attractive in the context of a likely healthy credit cycle over the next 1-2 years.

India: Credit offtake remains robust in April’23

Credit offtake rose by 15.9% year on year (y-o-y) for the fortnight ending April 21, 2023. In absolute terms, credit offtake expanded by Rs.19 lakh crore to Rs.138.6 lakh as of April 21, 2023. The growth has continued to be driven by personal loans, NBFCs, and higher working capital requirements.

•      Deposit witnessed a slower growth at 10.2% y-o-y compared to credit for the fortnight ended April 21, 2023. The short-term Weighted Average Call Rate (WACR) has reached 6.70% (as of April 28, 2023) from 3.63% as of April 29, 2022, due to a rise in policy rates and lower liquidity in the system.

•      The Credit to Deposit (CD) Ratio as of April 21, 2023, rose sequentially to 75.7% from 75.0% in the previous fortnight due to incremental credit offtake at Rs 0.1 lakh crore compared to a fall in incremental deposit at Rs 1.4 lakh crore.

India Steel: Healthy spreads despite recent price cut (ICICI Securities)

Major steel companies have pruned their HRC list price by Rs2,000-3,000/te in order to restore the parity wrt imports. Traders were anticipating a price cut in May23’ over the last few weeks, resulting in domestic HRC price progressively reducing by Rs1,000/te in the month of Apr23’. HRC export price from India was down sharply by US$40/te last week, tracking China’s FOB price. Spot HRC spread, however, continues to remain healthy. Factoring in the latest price cut, it is still at Rs33,000/te (Q4FY23: 26,375/te). Hence, we expect profitability of steel companies to improve in Q2FY24.

In China, the focus is shifting from demand revival to possible production cuts in H2CY23 which might undermine global iron ore prices further, but may lead to lower exports. That said, in their respective Q1CY23 result commentaries, global players have indicated an improving demand environment with higher margins in Q2CY23. We maintain our positive outlook on ferrous space led by higher spot spreads; we would keep a close tab on exports from China.

India Chemical: Export witnessing revival, demand stability maintained (SMIFS)

Our chemical channel checks suggest that pickup of demand is gathering with most factories operating at 60-65% utilization up from 35% and expect it to gather pace because supply channel inventory is minimum & demand is witnessing uptick. Majority of commodity chemical prices are witnessing a rebound from the bottom on anticipation of strong demand in the coming months.

Despite global headwinds, India remains on a strong footing in chemicals led by increasing interest of global companies to source from India to de-risk their supply chain, increasing share of speciality chemicals in overall product mix and robust capex aligned by chemical companies to capture future growth. For Indian chemical companies, the coming quarter i.e Q4FY23 is witnessing improvement in margins sequentially owing to rebound in exports volumes and domestic demand firming up. The full recovery in margins should be visible in Q1FY24.

Pharma segment is witnessing rebound in demand & correction of major API prices seems to be over. Agrochemicals demand is steady owing to higher crop prices, though high channel inventory could impact sales in the near term. Shipping rates and container availability have reached pre covid levels. Currently, crude oil prices are trading in a narrow band which will provide stability in downstream chemical prices of basic chemicals which will aide margins in the coming quarters. Valuations of most chemical companies seems reasonable factoring in largely the pain gone by & seems ripe for bottom fishing opportunities for those investors who wish to play on the recovery cycle going ahead. The cautious approach in chemicals is the impact of the global slowdown amid lingering recession worries which remains a watchful factor.

India Building Materials: A stampede to paint the town? (Investec)

Building material proxies have sought to widen Total Addressable Market (TAM) citing variety of reasons. We highlight moat for each category is different and often beyond demand push vs. brand pull. Bundling, store economics and business to applicator to take centre stage going forward and only few winners to emerge. Our new trademark / ROC database highlights more entrants into attractive paints category and concur with house view on increasing competitive intensity here.

Chasing TAM – push or pull: BM names have sought to widen TAM by venturing into multiple categories and have cited rationale of a) growth optionality, b) channel synergies, c) connect with influencers, d) connect with applicators, e) better capital deployment (vs higher pay-outs) and e) incremental RoCE. Based on our checks with channel/ influencers, the mantra is simple, brand pull works where products are visible post installation (faucetware, paints, even tanks); if not, applicator/ store economics (bundling) dictate push. We cite companies with healthy B/S have resorted to cash burn or chase volumes at cost of quality, not the best proposition.

TAM isn’t enough, need enablers to execute same: While cumulative TAM for BM categories (paints, construction chemicals, adhesives, consumer durables, bathware, ceramics, plumbing, wood+) is at $30b+ and headline growth rates/economics attractive, we find underlying enablers often lagging. For e.g., we cite ceramic plays who forayed into bathware ~7-8years back, and despite strong brand/distribution have achieved little (<Rs3b revenues p.a.).

We cite multiple reasons for disappointment in above case: a) Applicator: mason doesn’t fix a faucet, it’s a plumber (i.e., mason isn’t a plumber and DIY is still some time away), b) Ceramics is a dead product vs. faucet, a live product. Hence, after-sales is key, c) Channel’s willingness to cross-sell: Despite bathware potentially offering better margins and return ratios, selling bathware implies more hassle (vs. ceramics), given after-sales and number of parts.

Trademark/ROC checks: Based on our new proprietary database, we find several new players ready to foray into paints as a category, which is large attractive segment with incrementally high competitive intensity. We find Pidilite (brand: Haisha), Adani (into TiO2), Hyderabad Industries (HIL IN, NR), Wonder Cement as potential entrants, besides, known ones like Grasim.

Few winners: Several coverage plays have ventured into the paints category, and we expect only a few to thrive.

Stupid is not brave

“Courage is the strength in the face of danger, pain or grief, while stupidity refers to behavior that shows lack of good sense or judgement.”

From recent interactions with the market participants, I conclude that the recent ~8% rally in the benchmark Nifty50 has materially obliterated the fear of major correction in stock prices from their minds. Of course, most of them are conscious of the factors like financial sector crisis in the developed markets, especially the US; recession like conditions in some of the major global economies; and high real rates impeding the global growth that may have serious repercussions for the Indian economy and businesses. They also seem to be mostly ignoring the unusual weather conditions and possibility of a serious slowdown in exports, and acceleration in FPI outflows if the credit conditions continue to tighten further in the developed economies.

It may be pertinent to note that banks in the US are tightening credit in response to fed rate hikes, economic uncertainty, and money supply contraction. Historically this has led to a marked slowdown in growth, deflation, rise in employment; large number of bankruptcies and significant sell off in global risk assets.

Average 30yr fixed rate mortgage in the US is at ~6.5% and 5yr auto loans rates at ~7.5% are close to the highest in two decades. Might be this time it is different, but it would be imprudent to completely ignore the risk.

Do you also not see elephant on the couch

The response for my post yesterday (This summer don’t go nowhere) is overwhelming; though not fully surprising.

Most investors have concurred with my view that Indian equities may be on the cusp of a multiyear structural upcycle. Many of them therefore see no point in waiting for a 5-6% correction and would like to invest more in the current market.

There are some, who agree that given the rising uncertainties in the global markets it is more likely that volatility increases materially. It is therefore prudent to wait for the storm to pass. The consensus within this group appears that if we are looking at a secular bull market for 4-5 years, benchmark indices could match or even exceed their best returns of 2003-2007 (~40% CAGR). Waiting for 3-4months may not hurt much. The wait may actually allow time for deeper analysis and a better opportunity.

Most traders disagreed with my view that the risk reward for trading at this point in time may be adverse. They feel that there is a strong momentum on the upside and traders have a decent chance to gain by flowing with the current. They are mostly betting on a further 5-7% rally in Nifty, that would take it to new highs.

Only a small proportion of traders agree with my view that the Nifty50 may top out in the 18450 +/- 150 range and correct all the way back to 17170-17250 range. Hence, the risk reward in the current market is adverse. Only three (out of 60 odd) respondents believe that a global credit is more likely than not and this could cause a much deeper (albeit temporary) dip in the Indian markets, presenting a once in three year buying opportunity.

Obviously, presently greed is the dominant sentiment in our markets and most participants are willing to ignore the global conditions as “mostly irrelevant” to our markets. Playing ostrich, they would like to turn a blind eye to the strong evidence of markets always reacting in tandem with the major global markets in cases of crises; even if the depth and duration of correction may not be the same.

The most interesting reaction that I got from readers was however beyond the “buy or sell” predicament. This relates to the confidence of market participants. Almost all respondents strongly believe in the decoupling of India from the western developed economies. They believe that India shall grow faster and stronger in next 8-10 years, notwithstanding the slowing growth in the developed world.

The most alarming part was that most of them were conspicuous in their desire to see a deeper recession in the US and Europe. They strongly believe that a deeper recession in US and Europe will accelerate the process of power shift to Asia, benefitting India and China. Besides decoupling, they appear to be fully supporting the theories of deglobalization and de-dollarization.

These latest interactions with the market participants have made me believe that the market may not only be running ahead of fundamentals, but also becoming overconfident. A trader taking a leveraged long position on the premise of a deeper US recession and decline of USD’s supremacy cannot end well; though I sincerely wish this time all assumptions of traders come true. Amen!

I would like to interact with many more market participants to enlarge my sample size and do a deeper analysis over next couple of weeks. I will be happy to receive more views and opinions from the readers of this post.

This summer don’t go nowhere

 In the later part of the eighteenth century, St. Leger Stakes, a popular horse race, was started as the last leg of the popular British Triple Crown. The race would be held at Doncaster Racecourse in South Yorkshire in September of every year. Soon it became a fashion amongst the British elite – aristocrats, investors, and bankers etc. – to liquidate their financial investments; escape from London heat, move to countryside to rejuvenate, and return only in autumn after the St. Leger Stakes race was over. This practice was described as “Sell in May, go away and don't come back till St. Leger's Day.”

Later, as the US stock markets gained more prominence over London markets, the adage was rephrased as “Sell in May and come back in October”, to coincide with Halloween.

Various research studies observed there is decent evidence to conclude that stock markets’ returns during November-April period usually outperform the returns during May-October period. Based on these observations of seasonality of stock market returns, many trading strategies were developed that involved tactically moving money away from stocks at the beginning of the month of May to other asset classes, especially agri commodities like wheat and corn which were cheap due to arrival of fresh crops; and return back to equities in October.

In 1990, “Beating the Dow” by Michael O’Higgins and John Downes popularized the investment strategy “sell in May and go away”. Bouman and Jacobsen (2002) popularized this strategy by naming it “Halloween effect”. Later a research paper by K. Stephen Haggard and H. Douglas Witte (2009) had shown investing in a “Halloween portfolio” provides risk-adjusted returns in excess of buy and hold equity returns even after consideration of transaction costs.

However, latest research has shown that the Halloween effect may be weakening. As per a recent Reuter study (see here) Over the last 50 years, the S&P 500 (.SPX) has gained an average of 4.8% between November and April, and just 1.2% between May and October, according to Reuters calculations. However, this pattern fades over a shorter time-frame.

Over the last 20 years, the out-performance of November-April over May-October narrows to 1%. Over 10 years, November-April has underperformed May-October by 1 percentage point and over the last five years, it's underperformed by 3 percentage points. It might be time to find words that rhyme with "November".

Indian markets have rallied strongly in the past 5-6weeks. The benchmark Nifty is higher ~9% from its March 2023 lows; while Nifty Smallcap100 is higher by ~12%. The rally in stock prices has corresponded to some strong macro data and better than expected 4QFY23 earnings. The bond yields have eased materially; RBI has indicated a pause in its tightening cycle; inflation has eased within RBI’s tolerance range; CAD has improved; GST collections are at all time high; lead economic indicators like freight haulage, auto sales, power demand etc. are improving.

The question is what should be the course of action for Indian investors and traders – especially in view of the dark clouds gathering over developed economies. Should they be selling into this rally and wait for better opportunity; or hold on to their positions and build upon these further.

My view is that technically markets may be inching closer to the upper bound of the trading range; hence the risk reward for traders appears negative at current price points. However, from macroeconomic and corporate fundamentals viewpoints, the markets seem to be embarking on a structural bull market that may last for over 5years. Therefore—

(i)    Traders may lighten their positions and look for lower entry points to reenter. Though the opportunity may present itself much earlier than October.

(ii)   Investors may hold on to their existing investments; and look forward to lower entry points for increasing their equity allocations.

In both cases, it is important that traders/investors stay alert and actively look for opportunities, regardless of how hot and dry this summer turns out to be.

Fed hikes 25bps

 The Federal Open Market Committee (FOMC) of the Federal Reserve of the US announced another 25bps hike, taking its key fed fund rate toa target range of 5.00 to 5.25%. This unanimous decision of the FOMC is the 10^th straight hike in the past twelve months. With this hike, the effective fed fund rate is now highest since the global financial crisis. Besides the hike, the Fed also maintains the plan to shrink the balance sheet each month by $60 billion for Treasuries and $35 billion for mortgage-backed securities.

…claims banking system “strong and resilient”

Noting the concerns in the financial markets, especially those arising from the failure of Signature Bank, Silicon Valley Bank and First Republic Bank, the FOMC emphasized that "The U.S. banking system is sound and resilient. Tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks."

…reiterates “growth modest”, “job gains robust” and “inflation elevated”

The FOMC noted that recent data suggest that growth has been modest while “job gains have been robust” and inflation is “elevated.” Reiterating its commitment to the 2% inflation target, the Committee cautioned about the further slowdown in economic growth due to tighter credit. FOMC post policy meeting statement read, “tighter credit conditions for households and businesses are likely to weigh on economic activity, hiring, and inflation. The extent of these effects remains uncertain. The Committee remains highly attentive to inflation risks.” This is very similar to what the FOMC had stated in previous policy statement in March 2023, which had come just after the collapse of Silicon Valley Bank and Signature Bank.

…stops short of saying “pause”

The latest FOMC statement omitted the previous wording ““some additional policy firming” and instead said it “will take into account various factors “in determining the extent to which additional policy firming may be appropriate”. Analysts largely interpreted this change as a signal for pause from the next meeting in June 2023; though no one suggested that any policy easing may be imminent.

What did RBI achieve in one year of monetary tightening?

It’s almost a year since the Reserve Bank of India shifted the course of its monetary policy stance and embarked on the path of monetary tightening and withdrawal of accommodation to reign in runaway inflation. In the course of its journey in the past one year, RBI reversed the entire 250bps of rate cuts made during 2019-2020. 

Besides hiking the policy repo rate, RBI also enforced correction in banking system liquidity to check the demand side pressures on inflation. The banking system liquidity that was running in excess of rupees eight trillion a year ago, has been completely neutralized.

Impact of monetary tightening

It is very difficult to assess the direct impact of the RBI’s monetary policy action and its consequences. Nonetheless, it is pertinent to note how various sub segments of the economy have moved in the past one year. This movement could have been caused by a variety of factors, RBI tightening being one of them.

Inflation

The Consumer Price Index Inflation (CPI) has eased from 7.04% (yoy) in May 2022 to 5.66% (yoy) in March 2023. After mostly staying above the RBI tolerance band of 4% to 6% for more than 15%, the latest inflation reading is within the band, though still closer to the upper bound. If we adjust it for high base effect, material easing in global commodity prices, and significant improvement in supply chains, in the past one year, the direct impact of RBI policy on demand side pressure may not be material. Besides, given the chances of a below par monsoon due to development of El Nino in the Pacific Ocean, the food inflation may spike again challenging the sustainability of the recent fall in CPI inflation.

Money supply and credit

In the past one-year broader money supply (M3) in India has grown at a higher pace than the trend seen in the past one decade; and currently stands at INR227.8trillion.

The commercial banks have not passed on the entire 250bps hike in the policy repo rate to the borrowers. On average lending rates have risen 130 to 150bps. It is pertinent to note that movement in lending rates in India is mostly not in tandem with the policy repo rates. Lenders were also slow in cutting the rates while RBI was in easing mode. Regardless, now since the RBI has already signaled a pause, the probability of material rise in lending rates from the current level is low; implying that the policy rates are more of a signaling tool rather than a driving force for the commercial rates. The commercial rates are more of a function of demand and supply.

In FY23, the overall bank credit grew from Rs118.9trillion to Rs136.8trn, registering a growth of 15%, highest since 2014. Though some moderation in credit growth has been seen in the past one quarter.

The fastest growing segments of the bank credit in the past one year have been personal loans (especially unsecured loans) and financing to NBFCs, (much of this could also be consumer financing related). This clearly suggests that higher rates may not have deterred the demand much.

Growth

There is little evidence to show that the tighter monetary policy of the RBI in the past one year may have directly impacted the economic growth materially. Nonetheless, the growth momentum has definitely slowed down and is not seen picking up from the present low levels in any significant manner over the next 12months. Though the RBI has forecasted FY24 real GDP to grow at 6.4%; most private forecasters estimate the growth to remain slightly below 6%. Declining global growth and poor weather conditions could be the two major factors in the lower trajectory of growth.

Yield curve

The benchmark 10yr bond yields in India are now at the same level as these were a year ago. The short to mid-term yields (30days to 5yr) have risen sharply in the past one year. In the past six month in particular, the overall yield curve has moved down noticeably, except in the 30days to 1yr timeframe where the yields are still higher. Apparently, the poor liquidity in the banking system has resulted in higher near term rates, without impacting the demand materially – more of a lose-lose situation.

To conclude, I would believe that the aggressive tightening by RBI in the past one year, was more of a reaction to the global trend, ostensibly to preempt the outflows and pressure on INR, rather than to stabilize prices and calibrate demand. Given that USDINR has weakened by over 7% in the past one year; and foreign investors have been net sellers in the past twelve months, it could be concluded that RBI would have been better pursuing an independent monetary policy commensurate with the assessment of local conditions and requirements.

I understand the “not for this, things could have been much worse” argument fully and will reply to that some other time.

Some notable research snippets of the week

Economy: Activity holds up; strong sequential rebound led by seasonality (Nirmal Bang)

Early data for March’23 indicate that 78.1% indicators were in the positive territory on YoY basis, up from 68.8% in Feb’23. Final data for Feb’23 indicate that 71.4% indicators were in the positive territory on YoY basis.

On a sequential basis, there was a sharp rebound in March’23, led by seasonality. Around 75% indicators were in the positive territory in March’23, up from 50% in Feb’23. Final data for Feb’23 indicate that 34.7% indicators were in the positive territory.

Urban unemployment edged up to 8.5% in March’23 from 7.9% in Feb’23. Rural unemployment rose to 7.5% in March’23 from 7.2% in Feb’23.

Rural wages have sustained their rebound since mid-FY23 and rose by 8.1% YoY in Jan’23 vs. 7.6% YoY jump in Dec’22. In other rural indicators, tractor sales continued to hold up, growing by 13.7% YoY in March’23 vs. 20% YoY growth in Feb’23 (up by 32.9% MoM). Two wheeler (2W) sales grew by 9% YoY in March’23 (up 8.8% YoY in Feb’23) and were up by 14.2% MoM.

Motor Vehicle sales grew by an estimated 12.8% YoY in March’23 and were up by 12.2% MoM. Commercial Vehicle (CV) sales grew by 12.8% YoY in March’23 (up 3.2% YoY in Feb’23) and were up by 27.8% MoM. Passenger Vehicle (PV) sales grew by 4.5% YoY in March’23 (up 11% in Feb’23) and were flat MoM.

The S&P Global Manufacturing PMI improved to 56.4 in March’23 from 55.3 in Feb’23. Manufacturing as measured by the Index of Industrial Production (IIP) grew by 5.3% YoY in Feb’23.

The S&P Global Services PMI moderated to 57.8 in March’23 from a 12-year high of 59.4 in Feb’23. Traffic indicators moderated from peak levels or were largely flat. Diesel consumption was up by 1.1% YoY in March’23 (up 7.4% YoY in Feb’23) and petrol consumption was up by 6.8% YoY in March’23 (up 8.8% YoY in Feb’23).

Banks’ credit-to-deposit ratio continued to inch up and stood at 75.8% in March’23. Bank’s non-food credit growth continued to moderate gradually and stood at 15.4% YoY in March’23 (up 15.9% YoY in Feb’23), although it was up 1.8% MoM. Deposit growth continued to remain under pressure at 9.6% YoY in March’23 but it was up 1% MoM.

Near-term outlook for economic activity remains uneven (ICRA)

External demand is expected to be cautious following the ongoing geopolitical tensions and continuing Monetary Policy tightening by major Central Banks of some advanced economies, which could weigh on merchandise and services exports.

The GoI has enhanced high-multiplier capital spending in the Union Budget for FY2024. The large pipeline of infra projects, scheduled to be completed in FY2024, will aid in pushing project commissioning and thereby support investment demand. Timely execution remains the key.

Private sector capex is likely to pick up in FY2024 amid the rise in value of new project announcements, improving capacity utilisation levels, PLI schemes and GoI initiatives pertaining to clean energy. Besides, the GoI’s capex push has the potential to ‘crowd-in’ private capex.

Consumption of services remains quite robust while demand for goods is somewhat uneven. A sustained moderation in inflation would be the key to support consumption of low- and middle-income households.

India strategy: Behind the relief rally are incipient concerns on banking (Systematix)

India’s ranking moves up amid optimistic projections, while ROW factors in a recessionary scenario: Following the relief rally post the recent global banking debacle, our global ranking for Nifty has moved up from 13 to 6 since the end Feb’23 on the back of only a modest downgrade F1 EPS by 0.5% compared to the pervasive cuts in expected earnings and ROEs for major global benchmark indices reflecting the deepening worries about a global recession. Notably, European benchmarks, China, and the US have seen sharper declines. India’s upgrade is despite rich valuations- Nifty (49% higher than the global average F1 PE of 14.4x) and Sensex (57% higher). India’s growth optimism embodies a decoupling thesis of sorts, which is unsustainable.

India earnings outlook: Further earnings downgrade potential remains: We expect further downside surprises to earnings due to a) lower than expected margins (as also demonstrated by initial 4Q results), b) deceleration in bank credit growth, c) slowing urban demand, and d) weak real GDP growth (4.4% in 3QFY23) amid global spillovers. Rural demand is on a moderate revival path. Hence, the forward consensus projection for NIFTY EPS growth of 14.3% CAGR (FY22-FY25E) is significantly optimistic; we continue to expect downgrades.

Episodic bounties for Indian banks dissipating now: Extending our earlier UW view on banks and BFSI sectors in general, our latest analysis and evidence fortify prospects of deceleration in lending growth and re-emergence of NPA cycle. Sectoral allocation of bank lending for Feb’23 reinforces the evidence that there is a broad-based deceleration in industrial lending even as lending to retail and NBFC remains robust. We believe with a lag the latter will also see a moderation. The slowdown in mortgage lending could be a precursor. In a scenario of credit growth decelerating to 10% from the current 15% and retail inflation falling from 6.7% to 5%, the GNPA ratio could rise by 200bps!!

Rising probability of rural wage-price; OW on consumption remains: The structural rise in dependence on the Agri sector, trend rise in cereal consumption, and the weather anomalies point towards the sustenance of rising wage-price spiral and higher terms of trade for the Agri sector. The expected drags on non-agri rural from lower remittances from urban areas and cutback in rural allocation in the Union Budget are juxtaposed against the imperative of the upcoming state and general elections. These will eventually force populism favoring the rural sector, Hence, our OW views on staples and agri sector remain supported.

Steel industry faces cost-competitiveness test as EU implements CBAM (CRISIL)

The cost of India’s steel exports to the European Union (EU) could rise as much as 17% following full implementation of the Carbon Border Adjustment Tax Mechanism (CBAM), which mandates stringent disclosures and purchase of carbon credits to offset the impact of emissions. Accounting for greenflation, which will drive overall steel prices higher, the total impact could be as high as 40%.

Under the mechanism, which the Council of the EU and European Parliament have agreed to implement from October 1, 2023, importing EU nations will seek quarterly disclosures across seven emission-intensive sectors from April 2024, and to gradually penalise emission differentials between 2026 to 2034 through purchase of carbon credits to bridge the cost differential with steel produced in the EU.

The seven sectors – iron and steel, aluminium, cement, fertilisers, electricity, as well as chemicals and polymers — account for ~35% of India’s exports to the EU in the merchandise space.

The EU move is a part of a long series of global emission-reduction measures implemented in recent years — such as COP26, under which India committed to Net Zero by 2070, and COP27, under which the milestone targets have been made more aggressive.

To be sure, the “common but differentiated responsibilities” formalised under United Nations Framework Convention on Climate Change have placed enhanced flexibilities on developing economies, providing them an opportunity to choose differentiated timelines for meeting Net Zero goals.

However, regulations such as CBAM, through which the EU wants to prevent an increase in outsourcing of product manufacturing to countries where implementation linked to carbon emission reduction is slower than in the EU — plugging carbon leakage as it were — may go a step beyond and force specific industries to expediate implementation or face heightened risk for business loss or cost-competitiveness.

Under CBAM, exporters will need to make quarterly reporting of emissions starting October 1, 2023, and from December 31, 2025, buy Emissions Trading System (ETS) certificates for their greenhouse gas emissions.

In the absence of a carbon-neutral technology, industries have been allocated free allowance starting at 100% in 2025 and ending at 0% by 2034. The ETS tax would be gradually applicable to the portion that does not enjoy the allowance.

Dollar’s rate advantage is narrowing (ING Bank)

The week has started with the market leaning again in favour of European currencies and the dollar losing some ground. The price action in short-dated bonds showed a reinforcement of European hawkish bets while the whole US Treasury yield curve inched lower.

While a 25bp hike next week by the Fed does not look under discussion, Fed rate expectations have remained rather un-anchored and volatile when it comes to future policy moves. This continues to leave ample room for speculation about Fed Chair Jerome Powell’s tone in terms of future guidance. While data will clearly play a role, recent developments in the US banking sphere are creeping back onto investors' radars. First Republic Bank reported a larger-than-expected drop in deposits in its quarterly results, sparking a new round of heavy selling in the stock after a prolonged period of calm.

Should there be fresh instability in US banking stocks, dovish Fed bets may gather more momentum, and despite its safe-haven status, the dollar could stay on the back foot to the benefit of European currencies backed by hawkish central banks and without an excessively high-beta to sentiment.

Engineering and Capital Goods (Nuvama)

India’s capex landscape has been growing energetically since FY19, evident in governmentspending data and nominal GDP growth (Exhibit 1). This begs the question– where is the money being spent? Our study of India’s capex data notes a definite uptick in ordering across ‘three key legs’ of capex growth – Railways, Renewables and Power T&D coupled with conventional industrial/infra capex. We also observe a strong degree of conviction in opportunities in new age frontiers such as EV ecosystem, data centres and defence. This brings to the surface multi-year growth opportunities in transmission and railways – each potentially bagging meaty orders (INR120–150bn annually for HVDC transmission; INR250–350bn annually for locos plus trainsets product value for railways).

Transmission: The power demand-supply dynamic in India (link) clearly spells out that, if India is to avoid a power deficit by FY28–30, its plan of adding 30–40GW/year of renewable energy (RE) comes to stand as more of ‘a need’ than ‘a choice’. The natural deduction is that this will need to be connected, and to connect RE at this scale an equally large transmission capex is imperative (INR2.4tn as per CEA estimates; Exhibit 6). Given the backdrop, we estimate PGCIL’s capex (a barometer for India’s transmission capex) will likely double over the next two–three years. Hence, a fresh capex cycle in power transmission has already begun after a gap of ~4–5 years. Capex is expected across high voltage (rising CAGR) and medium/low voltage range (bulk of volumes), at the ISTS level. CEA estimates INR2.4tn to be spent in this area over FY24–30. India plans to add transmission lines/substations in the 400–800KV range, along with four large HVDC projects (worth approx. INR1tn).

Railways/new age capex: The mega push in rail capex will benefit the entire industrials value chain over this decade. Cyclically strong industrial capex (conventional segment) along with new-age areas such as EV ecosystem, data centres, RRTS/metros, wastewater management, warehouse and logistics, defence, smart infra etc. will continue to drive order inflows especially in low/medium voltage T&D products and relevant equipment suppliers through the next decade.

The growth story continues with > 1,100 loco orders expected annually for the next 2–3 years (vs. 700 till FY21). Of ~1,000 VB train sets, ~302 have been ordered and 600–700 more VB train orders are expected in future. Siemens is present across locos and trainsets (partner required) and we factor at least one more large loco/train set order by FY25E (INR100bn).

Industrial equities across our coverage universe have significantly re-rated over the past ~12–24 months, led by high industrial capex/infra momentum, which is evident in order inflows growth (across sector) and margin expansion (not yet broad-based). Most MNC equities  are currently trading above their long-term medians.

FMCG - Macro situation yet to recover (IIFL Securities)

For FMCG to grow well, good income growth in the low-income consumers is required. These consumers have two main sources of income viz Farm income and wages. Previously, when Farm income and wage growth is robust, FMCG companies tend to post strong sales growth and vice versa.

Past 20 years can be divided into 3 periods: FY00-06 when sales growth was weak, FY07-14 when it was strong and FY15-20 when it was weak again. The strong/weak periods of FMCG growth coincided with strong/weak periods of Farm inflation and Wage inflation.

Wage growth improving: While writing our CY23 outlook, the real rural wage growth (for Sep ’22) was -2.7%. It has now improved to -0.5% (for Jan ’23), but is still not healthy enough to boost growth. Moreover, Non-agri real wage growth is even poorer at -1.4%, denoting slow pickup in economic activity outside of agriculture. The improvement over past few months is led by both nominal wage growth improving and inflation moderating. While currently still lacklustre, the trend if continued will be positive for FMCG players. We need real wage growth at ~2% or higher to sustain good volume growth.

Farm inflation moderating: While real wage growth has shown some small improvement, our proprietary IIFL Farm index has been lacklustre since past few months, and is showing a 3% YoY inflation in Feb’23. Vegetable prices, down ~20% is the main reason, despite cereals and milk prices witnessing double-digit inflation. Moreover, assuming that prices remain stable at current levels, YoY inflation will trend lower than the current 3% for each of the next 12 months.

We need further sequential inflation to pick up for the YoY growth to continue meaningfully. Over the past 3-5 months, the index has been largely flat. For FMCG growth to be strong, we need Farm inflation equal to or higher than CPI.

How to play the sector: Visibility of a good growth is better for Food companies in near term. Investors with short-term horizon can invest in Food companies, whereas HPC investors may require a slightly longer horizon. We recommend that investors start off with large companies currently in absence of visibility on the time and extent of recovery, and then shift into smaller companies in inverse proportion to the strength of the expected recovery as and when macro indicators suggest it. This is because large companies are better suited to weather the storm on account of their strong brands, better management talent, systems and processes. Smaller players tend to have a leverage to recovery as consumers as well as wholesalers increase the repertoire of categories and brands when demand conditions are robust.

Microfinance Industry Beats Covid Blues, Likely to Grow by 25% in FY24 (CARE Ratings)

The Microfinance industry (MFI) experienced a growth spurt in 9M FY23, expanding at a rate of 12% Y-o-Y due to a favourable macroeconomic climate and renewed demand from tier-III cities, which has led to a surge in disbursements over the past few months. NBFC-MFIs have surpassed banks in the overall microfinancing landscape, constituting approximately 38% of the total outstanding microfinance loans as of December 31, 2022, compared to 36% for banks.

CareEdge Ratings anticipates growth momentum to continue, with the NBFC-MFI portfolio growing at a rate of 20%-25% over the next 12-18 months. However, an increase in interest rates, high inflation, or another wave of Covid-19 could potentially impede economic growth and, as a result, impact the Microfinance sector adversely.

The removal of the lending rate cap by the Reserve Bank of India (RBI) has enabled MFIs to engage in risk-based pricing, which has boosted net interest margins (NIMs) and, in turn, increased returns on total assets (RoTA).

Credit costs have declined from their peak in fiscal year 2021 but still remain higher than pre-Covid levels, with a portion of the restructured book slipping into NPA. We expect NIMs to continue improving, resulting in RoTA rising to approximately 3.25% for fiscal year 2024, aided by controlled credit costs of approximately 2.5% for the same year.

Asset quality, although on an improving trend, still remains moderate as compared to the pre-Covid level owing to additional slippages arising from the restructured portfolio. The MFI sector has taken the cumulative impact on the credit cost of around 13% of average assets from FY21 to H1FY23 due to Covid-19. However, with an improving collection efficiency trend, GNPA is expected to improve to 3.5% and 3% in FY23 and FY24 respectively from a peak of 6.26% for FY22.

In terms of capital structure, NBFC-MFIs have managed to raise ₹3,010 crore of equity in 9MFY23, compared to ₹1,506 crore and ₹1,431 crore in FY2021 and FY2022, respectively, indicating a renewed interest from investors.

Nevertheless, due to the current global turbulence, investors are likely to exercise greater caution and selectivity in the future. Additionally, with increased support from investors and rising disbursement levels, the gearing level was 3.7x and 3.6x as of March 31, 2022, and December 31, 2022, respectively. We anticipate that the gearing level for the MFI sector will moderately increase to around 3.9x by March 31, 2024.

NBFC-MFIs Outpace Banks

The microfinance industry has experienced a shift in market share, with NBFC-MFIs overtaking banks for the first time in four years. While banks held a dominant position during the Covid-19 period, the growth rate of NBFC-MFIs has now surpassed that of banks, resulting in NBFC-MFIs commanding a higher market share in the overall microfinance sector. As of 31st December 2022, NBFC-MFIs contributed around 38% to the outstanding overall microfinance loans, compared to banks' 36%. With a growth rate of around 20% till 9MFY23, NBFC-MFIs are currently leading the industry.

Trends in direct tax collection

 Recently, the Central Board of Direct Taxes (CBDT) released the latest data on direct collection in India. The data highlights some interesting trends in direct tax payments in India. In particular, the following points are noteworthy:

Personal taxes growing faster than corporate taxes

The growth in personal income tax has been far higher relative to corporate tax collections. In FY12 personal tax collection amounted to 53% of corporate taxes. The proportion of personal tax relative to corporate taxes.

Top 5 states contribute 3/4^th of total tax collection

Top five states contributed about 73% of the total tax collection in FY22. Out of these the top 3 states (Maharashtra, Delhi and Karnataka) contributed over 61% of the total tax collection in FY22. Though separate city wise data is not available, the anecdotal evidence suggests that the top 3 cities (Mumbai, Delhi and Bengaluru) may be contributing over 30% of the total tax collections. This highlights the massive regional disparities existing even after 75yrs of independence.

BIMARU states continue to lag in tax collection growth

The states of Telangana and Chhattisgarh have recorded over 100% growth in their tax collection over the past five year. Telangana collection grew 687% from Rs3,452cr in FY17 to Rs27,184cr in FY22. The collection for Chhattisgarh increased 112% from Rs3679cr to Rs7783cr over this period. Karnataka, Haryana and Gujarat were other amongst the top five highest.

The so called BIMARU states of Bihar, Madhya Pradesh, Uttar Pradesh remained at the bottom in terms of the growth in tax collections. The primary reason for this trend could be the dominance of the agriculture sector in these states which is outside the purview of direct taxes to a material extent.

Direct tax ratio in total revenue moderating

The proportion of direct taxes in the total tax collections peaked in FY10 at 61%, from a low of 36% in FY01. This ratio has now moderated to 52% in FY22. After implementation of nationwide GST in FY18, this ratio has remained consistent at 52%.

 

Tax to GDP ratio stagnating close to 6%

From a low of 3% in FY02, the Tax to GDP ratio of India improved to 6.3% in FY08. Since then, it has mostly remained in the 5.5% to 6% range, except for Covid years of FY20 and FY21. Adjusted for Covid impact, Tax to GDP ratio has shown a consistent and gradual rise in FY16.

Tax collection cost efficiencies not improving in tandem with use of technology

The cost of collecting income tax has less than halved over the past two decades. However, since FY08, it has not shown any material improvement; where this period has seen massive investment in technology.