Greed and Fear

 In the first two months of FY24, Indian markets have done well. The market breadth has been strong and; volatility very low. The latest market rally could be described in at least three different ways, viz,

1.    The benchmark Nifty50 has gained ~6.5% from the end of FY23; and the broader market indices like Nifty Midcap100 (~12%) and Nifty Smallcap 100 (~13%) have done significantly well during this period, indicating much improved sentiments. This view would imply that presently the sentiment of greed is dominating the sentiment of fear.

2.    At the current level, Nifty50, Nifty Midcap100 are close to their all time high levels recorded in the 4Q2021 and again in 4Q2022. Whereas Nifty Smallcap100 is still about 20% lower from it’s all time high level seen in early 2022. So effectively the markets have been oscillating in a wider range after the sharp rally post March 2020 Covid panic lows. This view would imply that since the market is now close to the upper bound of its trading range, traders would be looking to pare their long positions; especially because most of the good news (rate and inflation peaking; earnings upgrades; financial stability; etc.) is already well known & exploited; while the fragility in global economy and markets has increased and hence the present risk-reward ratio for traders may be adverse.

3.    From a historical relative valuation perspective – Nifty is currently trading at ~3% premium to its 10yr average one year forward PE ratio. The same premium for Nifty Midcap100 is 14%; while Nifty Smallcap100 is trading at ~2% discount to its 10yr average one year forward PE ratio. The discount of smallcap PE ratio to Nifty PE ratio is presently close to 22%, larger than the 10yr average of 16.5%. The sharp outperformance of smallcap may be a consequence of value hunting rather than greed; and the traders may soon return to Nifty as the valuation gap is filled.

Whatever view one takes, in my opinion, it would make sense to take some money off the table, especially from broader markets and high beta.

India: An economy under transformation

 Last week I  had written (see here) about how the fourth letter of the English Alphabet “D” has gained prominence in the financial market jargon. In particular, I find three “Ds”, viz., Digitalization, Deflation and Demographics most relevant for the economy and therefore markets.

A recent speech of Dr. Michael Patra, Deputy Governor of RBI, as published in the latest monthly bulletin of RBI (May 2023), highlighted some more ‘D” factors that are ushering India into a new age. Besides demographics & Digitalization, Mr. Patra emphasized on Diaspora, Diversification, Diplomacy, Dynamic Federalism, and Decarbonization as key factors in transformation of the Indian economy. The following are some excerpts from his speech:

Diaspora: An outward reflection of India’s demographic bonus is the vibrant expansion of Indian communities across the world. Over the years, our perceptions about the diaspora have also transformed from ‘brain drain’ to ‘brain gain’, spurred by the contributions that Indians have made in various fields in the global arena, including information technology, entrepreneurship, international politics, medicine, arts and culture, with some of them becoming Nobel laureates. It is estimated that over 90 out of 1078 founders of about 500 unicorns in the US are persons of Indian origin.

The Indian economy has been a beneficiary of this dynamic and industrious diaspora. India currently receives the highest flow of remittances in the world at US $ 108 billion in 2022, up by 24.6 per cent from a year ago, and accounting for 3 per cent of India’s GDP. Additionally, Indians residing abroad hold deposits in Indian banks cumulating to US $ 136 billion at the end of February 2023.

Diversification: The Indian economy is undergoing a quiet but fundamental transformation encompassing all its sectors. Perhaps the most striking transformation is occurring in India’s exports of services which have demonstrated pandemic-proofing, rising by above 25 per cent per annum since 2020, and providing valuable support to the viability of the external sector. While software and business services are the main drivers of this robust performance, advances in IT have not only made services more tradable but also increasingly unbundled: a single service activity in the global supply chain can now be fragmented and undertaken separately at different geographical locations. Jurisdictions have accordingly been decentralising and diversifying their supply chains to ensure business continuity. These factors have led to a new channel of IT-enabled services - large multinational corporations (MNCs) are setting up Global Capability Centres (GCCs), which are offshore offices, delivering a wide array of services across IT sector verticals.

India is also becoming a hub for engineering R&D (ER&D) centers as leading multinationals develop their centers of excellence (CoEs) across different business domains. The National Association of Software and Service Companies (NASSCOM) estimates that India will add 500 GCCs by 2026. They are going to be hiring. India’s citizens of the future should prepare for this revolution. The world is coming to our doorstep to fill world-class jobs.

Diplomacy: India is prioritising a reformed multilateralism that creates a more accountable, inclusive, just, equitable and representative multipolar international system for the 21st century. Our priorities include addressing the macroeconomic implications of food and energy insecurity; climate change; strengthening Multilateral Development Banks (MBDs); debt sustainability; strengthening financial resilience through sustainable capital flows; financing inclusive, equitable and sustainable growth; leveraging digital public infrastructure; climate financing; and opportunities and risks from technological change.

Dynamic Federalism: Increasingly, the quality of life and the business environment in India is going to be defined by shifts in the focus of public policy that foster competitive federalism among India’s states in achieving the aspirational goals of sustainable economic development. The freedom to compete allows each state to design, experiment, innovate and reform, given its unique features and challenges, while emulating best practices achieved by peers. An example of the power of competitive federalism is the drive among states to attract private investment, both domestic as well as foreign, by showcasing investment opportunities in each state. The spirit of competitiveness is being promoted at the highest policy levels.

As our states compete for a place in the sun, they will nurture business growth, put in place the best physical and social infrastructure and provide us with improved basic amenities, clean energy, and better health and societal outcomes. Along with foreign investment bringing in new technologies and ideas, we are moving into a national ethos of wider consumer choices and a better standard of living.

Decarbonisation: India and other developing economies are highly vulnerable to climate change due to their limited capabilities in climate science and technology and insufficient funding for adaptation and mitigation. The relative costs of transitioning to a greener path are higher for them than for the advanced economies; undertaking the transition can even push them several places down the development ladder. From the developing world, India has emerged as a leading voice on global climate action that is mindful of climate equity and justice considerations.

India has co-founded the International Solar Alliance (ISA) with France in 2016 and announced a National Hydrogen Mission to increase the dependency on green energy. The Mission LiFE, i.e., Lifestyle for the Environment, launched in 2022, is now a global movement to connect the powers of the people for the protection of the earth.

Dr. Patra ended his speech by invoking Victor Huge’s words- ““Nothing else in the world…not all the armies…is so powerful as an idea whose time has come.” He, like millions of us, too believes that India’s time has come and we must seize it. There are formidable trials and challenges ahead, but they can be overcome if we exploit the comparative advantages.

Beyond the US debt deal

 The US administration has reportedly reached a deal with the Congress majority leader to enhance the debt ceiling on the treasury and mitigate yet another default threat. This, like all previous episodes of default threats and debt ceiling hikes, would inevitably result in more debt, insolent fiscal profligacy and further distortions in capital allocation and unsustainable asset price inflation. At the other end of the spectrum, it could shift a couple of ounces from the weight of global confidence in USD (and hence UST) towards the still nascent movement to de-dollarize global trade.

In this context, the following trends may be pertinent to note, especially for the equity investors.

Negative divergence in OECD debt and yield

The elementary principle of economics is that the price of anything is a function of demand and supply equilibrium. Higher demand pushes the equilibrium to a higher price point and vice versa. However, the bond markets in developed economies have been defying this principle for the past 25yrs. The debt of OECD countries rose sharply post the global financial crisis (GFC) in 2008-09; but the yield on government bonds fell till 2022, creating a negative divergence in bond supply and bond prices.

The situation has shown some signs of reversal in the past one year, but this may not last if the US Federal Reserve decides to begin easing rates sometime in the next 12months, while the latest debt ceiling deal results in a massive rise in bond supplies.

This trend is relevant for equity investors, since this could keep the cost of capital lower, affording much higher price earnings multiples to various businesses.

Deflationary pressures to persist

Post the GFC, the developed economies in particular have struggled with persistent deflationary pressures. Despite unprecedented new money printing and near zero (and negative) rates, major economies faced strong deflationary forces. Consequently, the prices of financial assets and real estate witnessed strong bull markets. The reported debt deal would result in further strengthening of deflationary forces which are structurally aided by the adverse demographic changes and changing consumption patterns.

Indian debt no longer lucrative to USD investors

The spread between US and India benchmark 10yr G-Sec yields (318bps) is presently at its lowest level, at least since the GFC. Given the hedging cost and just 2 notch above junk rating for India G-Sec, presently the Indian bonds may not be very attractive for the USD investors. Though there is not much empirical evidence available to substantiate this, there is a probability of rise in flows to Indian equity, which has been witnessing strong FPI selling for the past couple of years.

Some notable research snippets of the week

Credit-Deposit ratio to moderate after withdrawal of large currency (CARE Ratngs)

RBI announced to withdraw Rs. 2,000 denomination banknotes on May 19, 2023. The total value of these banknotes in circulation constitutes Rs. 3.62 lakh crore as on March 31, 2023.

The addition to the banking deposits due to withdrawal of Rs 2,000 banknotes is not anticipated to be material even under various scenarios which assume that 25%-50% of the currency remains as deposits with the banks. In percentage terms, the additions are expected to be 0.5%-1% of overall deposits in the banking sector. The banking system liquidity was already in surplus at the end of April 2023. The addition of Rs 1.0 lakh crore to 1.8 lakh crore over a period of four months (June 2023 to September 2023) will inject significant short-term liquidity into the banking sector over the next 2 quarters and is likely to reduce the banking sector’s dependence on short term CDs in the near term to some extent and the short-term deposit rates may ease a bit thereby muting the impact of rising deposit rates on NIMs. Even though the time frame of four months is given, CareEdge expects this to be front loaded due to the behavioural pattern of the masses. The banks may use incremental deposits to increase credit growth. Liquidity increase may impact RBI’s OMO during Q1FY24 and Q2FY24.

Credit offtake rose by 15.5% y-o-y for the fortnight ended May 5, 2023, compared to 11.8% from the same period in the last year (reported May 6, 2022). Sequentially, it increased by 0.3% for the fortnight. In absolute terms, credit outstanding stood at Rs.139 lakh crore as of May 5, 2023, rising by Rs.18.6 lakh crore from May 6, 2022, vs 12.7 lakh crore in the same period from the last year. The credit growth continued to be driven by a lower base of the last year (which will likely abate in FY24), unsecured personal loans, housing loans, auto loans, higher demand from NBFCs, and higher working capital requirements.

Credit offtake has remained robust even amid the significant rise in interest rates, and global uncertainties related to geo-political, and supply chain issues. The growth has been broad-based across the segments.

Personal Loans and NBFCs have been the key growth drivers, while other manufacturing-oriented segments could also drive growth. Meanwhile, credit growth is expected to be in sync with the GDP growth in FY24. A slowdown in global growth due to elevated interest rates, and geopolitical issues could impact credit growth, however, the Indian financial system is on more robust footing, vis-a-vis its global peers.

Rural checks: Q1FY24 starts on a weak note (Elara Capital)

Decline in crop prices drags realization: Our rural channel checks show rural demand remains sluggish in April and in the early parts of May as delayed harvest and a decline in the price of key Rabi crops have dragged farmer realization. While the impact of unseasonal rains is not found to be significant, the quality of output has been hampered. Relaxation of quality norms for crop procurement domestically and the decline in global prices have had an impact with prices of key crops declining.

Fall in key input prices yet to be reflected on the ground: The sharp decline in input prices of key agrochemicals is yet to be felt on the ground except in South India, as there was high-cost inventory in the system. We expect the impact of lower agrochemicals prices to be felt from the Kharif season.

Sluggish FMCG demand; Summer portfolio hit in the early days: Delayed harvest and weak realization have dragged FMCG sales. Our distributor checks show volume offtake was weak in April. Further, unseasonal rains and lower-than-usual mercury levels have led to a sharp demand contraction for a usual Summer portfolio for FMCG brands, such as beverages, which saw a huge reduction. Demand sensitivity to prices was found to be high for entry-level stock keeping units (SKU), especially for INR 5-10. Price hikes were passed on in higher SKU, suggesting entry-level demand remains weak. We expect FMCG companies to report sluggish volume in Q1FY24. Moreover, our checks suggest price cuts of inputs have yet to be passed on fully to end-consumers even as grammage hikes have been reported in soaps, detergents, biscuits, and processed food. Unless there is a sharp rise in spend on ads, promotions and freebies, FMCG should be able to report healthy margin in Q1FY24 as well.

Milk prices near their peak; expect a decline from CY24: Our checks show milk output is catching up gradually, with the deficit likely to reduce materially by end-CY23, resulting in lower prices. The impact of COVID-19 and lumpy skin disease on milk supply is beginning to wane and supply is set to rise materially during November-December 2023. This should provide a respite to companies, such as Jubilant FoodWorks, which have seen significant raw materials inflation due to rise in cheese prices.

Good start to the marriage season gives fillip to 2W demand: Our checks show the marriage season has seen a good recovery in demand; hence, entry-level demand for bikes should see improvement on sequential basis. The traction also was good in the two-wheeler category this marriage season as there was preponement of marriages, owing to Adhikmas (additional month in the Hindu calendar), which has reduced the number of auspicious dates in the later part of the year. Supply chain issues for brands, such as Honda, seem to be having a positive impact on demand for Hero MotoCorp bikes.

Currency outlook (Bank of Baroda)

INR under pressure: After remaining stable for most part of the last few months, INR has come under pressure in the last few sessions. In May’23, INR has depreciated by 0.9%. However, bulk of the weakness in INR can be traced back to the last couple of sessions. In fact, since 12 May 2023 (when INR was last below the 82/$ mark), INR has depreciated by 0.6%. Prior to this, INR was fairly steady in a narrow range of 81.5-82/$. This was underpinned by robust macro fundamentals, improvement in external position, lower oil prices and buoyancy in FPI inflows.

So what are the reason behind INR’s rather abrupt and sharp fall?: The most compelling reason for the rupee depreciation is a strength in dollar. In the last few sessions, dollar has once again strengthened amidst strong macro data from the US and hawkish Fed-speak.

This has resulted in markets repricing the trajectory of Fed rate path. While markets widely anticipated that the Fed was done with its rate hike cycle after a final 25bps rate hike last week, macro data since then has dimmed those expectations. Strong labour market, rebound in housing sector, more than expected uptick in households’ inflation expectations as well as positive developments surrounding US debt ceiling have all contributed to the belief that the Fed rate may still be behind its peak.

Reinforcing this view, several Fed members have gone on record to say that inflation still remains a big challenge, warranting even higher rates. As a result, DXY has strengthened by 1.1% in the last 3 trading sessions alone. Most global currencies have seen depreciation.

Another reason, though not as significant, is a moderation in FPI inflows. FPI inflows which were showing some traction since the beginning of the month have lost momentum amidst a weakness in domestic equity markets and safe haven flows.

Will the trend continue?: With the changing narrative around US Fed rate path, some short-term pain for the INR cannot be ruled out. However, the extent of INR deprecation is likely to be mild, aided by effective intervention by the RBI. Fed Chair’s testimony, due later today, will be key in determining the future trajectory of rates and dollar. While the dollar may strengthen in the short-term, as investors await more clarity on the Fed rate trajectory, it is likely to be temporary. Hence, we continue to remain bearish on the domestic currency over the long-term. This will be reinforced by improvement in external outlook, range-bound oil prices, foreign inflows and buoyancy in remittances and services receipts.

Copper price slides as global demand drops sharply (Financial Times)

The price of copper has widened to the biggest discount against its futures equivalent in almost two decades, in a warning sign of a sudden weakening in global demand as China’s economic rebound stalls.

Copper for settlement in two days was $66 cheaper on Monday than buying a contract to deliver the metal in three months’ time, a difference that traders said reflected concerns that China’s industrial rebound was not materialising. The gap between the two prices is the largest since 2006, according to the London Metal Exchange.

The sharp fall in spot price reflects a rapid rise in stockpiles of the metal outside China in LME warehouses, as US and European industrial activity begins to slow after a year of rapid interest rate rises.

Known as Dr Copper for its ability to gauge the health of the global market, the metal is widely used in buildings, infrastructure and household appliances.

Natalie Scott-Gray, base metals analyst at broker StoneX, said that copper prices were starting to be driven by real world signs of weak demand rather than big macroeconomic factors, such as the US dollar and sentiment towards China’s reopening.

“It’s the first physical evidence we’re seeing that demand is being impacted worse than expected in the west,” she said. “It’s the pace of change that has caused the gap”.

The price of copper has fallen 11 per cent in a month to almost $8,000 per tonne, its lowest level since November, in part because China has not grown as fast as expected since it lifted its tough coronavirus restrictions near the end of the last year.

Positive sentiment around the reopening of Asia’s biggest economy helped leading industrial metals to rally more than a quarter between November and January.

“It hasn’t been as dire as this for many a year,” said Al Munro, metals strategist at Marex, a London-based broker. “The bullish scenario was all based on a China rebound which hasn’t materialised as we in the west suffer from an economic slowdown.” (Read more)

India steel index remains in negative zone; near-term outlook bleak (SteelMint)

SteelMint's flagship India Steel Composite Index, a barometer of the domestic steel market, edged lower by 0.8% w-o-w to 150.4 points on 19 May, 2023 compared with 151.6 points, as assessed last on 12 May.

Notably, the Flat Steel Composite Index slipped sharply by 1.2% while the longs composite index witnessed a drop of 0.3% w-o-w.

Amid the general weakness in the domestic steel market, prices have been on a decline; however, flat steel prices seem to be more influenced by global trends, partly due to export market exposure. Long steel prices, on the other hand, are also battling weak demand but the upside comes from low availability of ferrous scrap.

·         Domestic steel prices subdued amid global downturn

·         Coking coal prices drop sharply, bottom not in sight

·         Scrap shortage likely to keep IF/EAF steel market supported

Agri input: NPK producers better placed than DAP (Elara Capital)

The Ministry of fertilisers has reduced H1FY24 Nutrient Based subsidy (NBS) on nitrogen (N), phosphates (P), Potash (K) and sulphur (S) by 22% to INR 76.5/kg, 39% for INR 41.0 per kg, 33% for INR 15.9/kg and 54% to INR 2.8/kg, respectively, vs Q3FY23 subsidy. Based on existing DAP inventory, our channel checks show manufacturers stand to make hardly any profit. NPK remains profitable for the industry.

DAP manufacturers to have a hard time: DAP manufacturers that have an inventory of existing finished goods or raw materials may not incur any material profit. If they are producing through new raw material stock, especially ammonia, then profitability may sustain, given ammonia prices have fallen by more than 50% since March to ~USD 250/tonne. Increased competition from importers is putting pressure on liquidation of domestic stocks.

Imported DAP more profitable than domestically manufactured: At the current subsidy rates, DAP imports below USD 600/tonne are more profitable than domestically manufactured ones. In the past week, DAP prices fell to USD 500/tonne from USD 550/tonne. With declining ammonia prices globally, DAP prices may fall further, implying imports are likely to continue to rise in India in FY24.

NPK manufacturers to make good profit, but lower than H2FY23: NPK manufacturers continue to make good profit even on existing stocks as the phosphate component is lower in other grades except in DAP (18:46:0:0). Profitability would increase further based on newer stocks of ammonia.

Dr. Copper flashes red card

 Three-month future price of copper at COMEX has corrected almost 27% ~US$3.61/lbs from US$4.95/lbs at the end of February 2022.

Moreover, the discount between spot prices three months future at LME widened to the largest since 2006, indicating poor outlook for copper demand in the near term.

Copper prices have fallen over 10% in the past one month alone on disappointing growth data from China. The hopes of a sharp recovery in Chinese growth in near term are fading as more downgrades are indicating. Goldman Sachs reportedly revised its average copper price forecast for 2023 by over 11% to US$8698/t from US$9750/t earlier. Though the optimism over Chinese growth and consequent firmness in copper prices is not lost completely. For example, Bank of America is still maintaining its US$10,000/t copper price forecast for 2023 end in the hope of large demand ramp up as China accelerates spending on its power grid. Nonetheless, the general mood is drifting towards accelerated slowdown in demand.

Since copper is used in infrastructure (power, shipping, buildings etc.) machinery and discretionary consumption (housing, vehicles, appliances etc.) its demand is widely accepted as a lead indicator of the direction of the economy. For its ability to provide a correct prognosis of the health of the economy, the bright metal is popularly known as Dr. Copper.

So, if the latest prognosis of global economy by Dr. Copper is correct—

·         We shall see an accelerated slow-down in global economic activity with little support from China, in the next few months. This shall reflect in poor export demand for India also.

·         The inflationary forces may weaken as tighter money constricts demand further; eventually leading to the next round of monetary easing by the end of 2023 or early 2024. RBI’s growth forecast for FY24 may also get moderated resulting in change in the present “withdrawal of accommodation” monetary stance.

·         Deflation, rather than inflation, could again emerge as the major concern of global policy makers by the end of 2023. Japanese markets that have majorly outperformed the developed peers on easing deflationary pressure could again face pressures.

·         Notwithstanding the Debt Ceiling tantrums and political rhetoric, for global investors bonds may emerge as preferred asset class in near term over equities.

·         Overall, a foundation for a decent equity rally in India over 2024-25 could be laid in the next 6months.

(Inputs from Copper price slides as global demand drops sharply published in the Financial Times)

India’s population may peak much earlier than current estimates

India with one of the largest and youngest populations in the world is an attractive market for most countries and businesses. India is not only the largest importer of edible oil and third largest importer of crude oil; we are a significant importer of goods from small US$0.1toy to a US$200million supersonic jet. India thus offers an attractive market for most producers in the world.

As per Fortune Business Insight The global big data analytics market size was valued at $271.83 billion in 2022 & it is projected to grow @13.5% CAGR to become $745.15 billion by 2030. Compared to this, as per Stockholm International Peace Research Institute (SIPRI) report, in 2020 the global arms trade is estimated to be US$112bn (actual figures may be little higher). Clearly, data and data analytical services are emerging as one of the most product categories globally.

Obviously, most businesses and states who want to do business would be interested in data pertaining to Indian population and markets. Historically, the census conducted every ten years has provided valuable insights into the potential high growth demand areas in Indian markets. Indefinite postponement of the 2021 census by the government is therefore quite intriguing, given that the product (data) this census shall produce would be much more valuable than the cost incurred.

The census is even more critical, if we consider some very points raised by Yi Fuxian in his latest article “China and India Have Fewer People Than the UN Thinks”.

Yi argues that UN’s World Population Prospects (WPP) data about the population of India and China, relied upon by most global agencies, states and businesses, may be far from accurate. As per Yi, “India’s development indicators have improved markedly since its previous census. From 2011 to 2021, the country’s infant mortality rate fell from 44 deaths per 1,000 live births to 27. The secondary-education gross enrollment rate rose from 66% to 78%, and the mean years of schooling among adults aged 20 and older increased from 5.8 to 7.2 years. The contraceptive prevalence rate rose sharply from 54% in 2013-15 to 67% in 2017-19. Consequently, India’s fertility rate may be as low as 1.6-1.7 in 2024, with its population ranging between 1.37 to 1.39 billion, compared to the 1.44 billion projected by the UN.” Accordingly, the UN might be wrong in declaring India as the most populous country.

Yi highlights that the fertility rate of Indians living in countries such as Singapore and Malaysia etc., is similar to the Chinese population living there. Therefore, with social indicators continuing to improve at the current pace, it might be erroneous to believe that Indians will have fertility rate different from Chinese. As per Yi, it is likely that India’s fertility rate will drop below 1.2 by 2050, and its population will peak below 1.5 billion, rather than the 1.7 billion projected by the WPP. Fast-forward to the dawn of the twenty-second century, and the numbers paint an even bleaker picture. While the UN report estimates that India’s population will reach 1.5 billion by 2100, the country’s population could actually fall below a billion.”

It is important to note that “The WPP’s projections of Chinese demographic trends are even more exaggerated. For example, the 1992 WPP estimated that China’s population will reach 1.54 billion by 2025. While the 2022 report revised this figure down to 1.42 billion, the actual figure will likely be closer to 1.27 billion.”

View from 35k feet

 The fourth letter of the English Alphabet “D” has held a prominent position in financial market jargon, at least since the Great Depression in the late 1920s. In the past two decades the terms like Dematerialization, Demographics, Depression, Decoupling, Demonetization, De-Dollarization, Digitalization, Deflation etc., have attracted immense interest from the market participants. Some of these “Ds” have had significant impact on the global economy; while the others have been mostly limited to being topics of interesting discussions and statistical analysis.

In the current Indian context specifically, I find three “Ds”, viz., Digitalization, Deflation and Demographics most relevant for the economy and therefore markets.

The current global situation – investment mix, geopolitics, global trade and gradual shift in strategic power – implies that supply shocks could be more frequent and much more intense in the next decade or so at least.

·         The unusual weather patterns are impacting farm output across the globe. Unseasonal rains, floods, extended periods of drought and heat waves etc. have negatively impacted the food production and livestock. As per a research study conducted in 2021 (see here), due to severity of drought and heatwave crop losses tripled over the last five decades in Europe alone. In India also similar trends have started to emerge in the past few years and are expected to strengthen in the next decade or so.

·         In the past few years, the geopolitical situations in the world have shown marked deterioration. The prolonged war in Ukraine has exposed the fault lines in the strategic power structure of the world that has been prevalent since the demise of the USSR. A drift between the US, China and Russia has never been more conspicuous in the past three decades. This drift has led to the rise in speculation over further intensification of the “deglobalization” trend that has shown some presence in the past one decade.

·         In the past two decades the investment mix in the global economy has shown a marked skew in favor of services, technology and climate change. Accordingly, the investment in augmenting the supply of conventional energy, metals and agriculture, while the demand for these has remained firm. Accordingly, the inflationary pressures have built up in the global economy.

It is widely accepted that digital technologies are bringing in enormous productivity gains; and therefore, is a powerful deflationary force in an otherwise inflationary environment. To quote, Satya Nadella, Microsoft CEO, “the next 10 years won't be like the last 10 years. Digital technology is a deflationary force in an inflationary economy. It is the only way to navigate the headwinds we are facing today”. He added, “This is the age of AI. Hybrid work is here to stay. 73% of workers want flexible remote options to stay. Every organization requires a digital fabric that includes People, Places and Processes.”

The aging demography in the developed world and China is another deflationary force that is countering the inflationary pressures. Even in India, it is likely that the population will peak and begin to age much earlier than previously estimated.

Thus, Digitalization, Deflation and Demographics could be listed as three major trends that will significantly influence the direction of the Indian economy and markets in the next many years.

Hold your horses tight

 The investors and other market participants in their 50s and 60s would recall that there have been at least three occasions in the past three decades when India was considered the next best thing after sliced bread.

Starting with the opening up of the economy in early 1990s, the narrative acquired a much louder echo after Roopa Purushothaman, a non-descript research analyst coined the term BRICS for a report to be published in the name of legendary Jim O’Neill (Chairman Goldman Sachs AMC) in 2001. During the global financial crisis (2008-2010) that weakened many developed economies, India and China emerged as two strongest pillars of support for the global economy, growing in high single digits despite the global crisis. Post Covid, since India has again emerged as one of the fastest growing economies, leaving even China behind, the narrative is again in vogue.

There is absolutely no doubt that the Indian economy has never been intrinsically so strong in the past four decades. The growth is not high but looks sustainable for many years. The efforts to fill infrastructure gaps that started 25yrs ago have begun to show tangible results. In the next five years, India shall have decent physical infrastructure to attract the best of the global manufacturers to produce in India.

However, in my view, the investment theses that rely on this need to be realistic and moderate. Extrapolating the Chinese experience of the 1990s and American experience post WWII, to Indian conditions may lead to disappointment.

For example, the businessmen who travelled to China in early 1990s would recall seeing industrial estates in Zhuhai, China running several kilometers in length; high speed rails etc. We are still far away from that status. Today, China has about 45,000 km of high-speed rail running at a speed of 280-310 km/hour; where we are expecting the first 200km of such trains not before 2026.

There could be little argument over the fact that India has poor productivity in terms of investment/GDP ratio. Every incremental investment of INR yields much lower GDP growth. The largest sector in terms of employment, viz., agriculture is saddled with extremely low productivity.

India’s present market cap is already above its FY23 nominal GDP. To make Indian markets an attractive investment destination on this parameter, GDP needs to grow much faster than the stock market. Assuming a 90% Market cap to GDP is attractive, a US$5trn economy by 2027 (present US$3.5trn) could result in a US$4.5trn market cap in 3yrs. This is 14% CAGR for the next 3yrs with plenty of “ifs” and “buts” thrown in between.

Some market participants love to talk about INR emerging as one of the key currencies in global trade. Given that India’s share in the merchandise global trade is less than 2% and global services it is less than 5%, this proposition does not merit any comment, not even ridicule, at this point in time. I would just like to remind these enthusiastic market participants that we are struggling to get Indian bonds included in global indices for over two decades and there is no visibility of that happening anytime soon.

It certainly feels good when the global CEOs visit India and speak highly about the potential of the Indian economy and people. However, I would not take these comments at their par value in my investment decision making. Many of these comments are made in zest or to promote vested interests, e.g., to get government subsidies under the PLI scheme etc. For example, I feel that Apple is manufacturing locally to save on hefty duties on imports of SKD and fully assembled phones, which makes Apple phones uncompetitive to those who manufacture or fully assemble in India. Both Apple and Samsung do only the assembly work in India, without adding much to the local skill set or technology. The value addition in India is less than 10% in case of iPhones. So, when we read the staggering amount of iPhone exports from India, we need to adjust it for the 90% import content and low revenue to employment ratio of factories assembling iphones.

As I said, I am extremely positive on "India story" for the next decade. In fact, I have never been so positive about the "India story" in my life. But I am not running my excel sheets wild by extrapolating the current numbers by Chinese and American experience in their high growth years. I shall be extremely delighted to get a small premium on the nominal GDP growth over the next decade or so.

Will wolves come this time?

 “The boy who cried Wolf” is one of the most popular Aesop’s Fables. The Fable is about a young shepherd boy who enjoyed fooling the innocent villagers by lying about a wolves’ attack on his herd. Every other day he would raise a false alarm about wolves’ attack on his herd and seek farmers’ help. Trusting him, farmers would leave their fields unattended and rush to protect his herd; only to find that the boy was lying. Over a period of time, he gradually lost farmers’ trust. One day wolves actually attacked his herd. He went to farmers to seek help; but no one trusted him; and he lost most of his sheep. The moral of the story — “when habitual liars are not believed even when they chose to tell a truth”.

The latest episode of political squabble over raising the limits within which the US government could borrow to meet its fiscal deficit, reminded of this inspiring fable. In the past two decades we have seen multiple “debt ceiling crisis” in the US. In the 15 years period from 2001 to 2016, the US Congress raised the debt ceiling 14 times. During President Obama’s tenure of 8 years, the debt ceiling was raised 11 times. Prior to that President Bush’s tenure saw 7 hikes in the debt ceiling. It is also pertinent to note that in the past 100 years, the debt ceiling has only been increased. It has never been reduced, even when the US public debt was reduced.

It is important to clarify that the Gephardt rule, as per which passing of the budget was deemed as an automatic hike in the debt ceiling to meet the approved deficit, was repealed by the Congress in 1995. Since then, appropriation in the budget and means to fund such appropriations are voted separately by the Congress. If the Congress does not vote to hike the debt ceiling in accordance with the appropriation bill, the government will run out of money to meet its interest, salary, social security and other obligations. A default on debt service would inevitably entail a rating downgrade and hike in interest rates that could impact US bond holding of all investors; besides resulting in overall higher interest rate burden on the economy.

Prior to almost every hike in the debt ceiling there had been intense politicking and aggressive posturing by both the parties. The president and treasury secretary contend that not hiking the limit may result in total collapse of the global financial system; while the majority in Congress seeks multiple assurances and concessions before agreeing to the demands.

Going with the tradition, the treasury secretary Janet Yellen has recently stated that “Waiting until the last minute to suspend or increase the debt limit can cause serious harm to business and consumer confidence, raise short-term borrowing costs for taxpayers, and negatively impact the credit rating of the United States”. She further added, “In fact, we have already seen Treasury’s borrowing costs increase substantially for securities maturing in early June.” Also, there has been usual “huge cost to American Public” and “risk of global financial instability” rhetoric being played from the Capitol Hill.

In the past, markets would usually take these warnings seriously and turn jittery. This time however, markets appear relatively much calmer; as if calling the bluff of the politicians. The collective wisdom of the market appears believing that like every previous instance, both the parties would agree to hike the debt ceiling before the 1^st June deadline. Few traders seem to be taking the customary warnings being issued by rating agencies like Moody’s; investment bankers like Jamie Dimon; and Democrat leadership.

The point is whether wolves will actually come this time and eat the complacent traders? Hard to imagine, given the historical context. But would you continue to assign a zero probability to this 8-Sigma event? More on this next week.

All that glitters…

 A stroll through the social media timelines of several self-claimed extremely successful investors and traders (popularly known as finfluencers) would indicate that there are thousands of people who have made extraordinary returns from stock markets in India. Everyone seems to have identified several successful businesses at a very early stage and earned exponential returns by holding it for decades. Everyone seems to have unlimited money to buy more stocks at every market correction, while they would hold on along with their existing positions till eternity.

The narrative presented by these so-called finfluencers is clearly oblivious of the fact that there are not more than a hundred companies in India that have operationally performed consistently for more than a decade. Number of companies that become redundant in each business and market cycle is very high.

There are numerous research reports and messages which rely on “low per capita consumption in India” and “moat” in India. Based on this many “new businesses” (and some established businesses) are given astronomical valuations. In this context, it would be pertinent to note the following:

In the early 1990s, the number of Indian citizens using air transport for travelling purposes was extremely low. There was only one public sector civil airline, viz., Indian Airlines. Then the civil aviation business was opened to private competition. Within a span of 2yr several private airlines started business, e.g., Sahara, NEPC, Damania, East West, Modiluft etc. All these ended as bankrupt in less than a decade. In the second tranche, some more private airlines started business, e.g., Jet Airways, Kingfisher, Deccan Airlines etc. Soon they became very popular with Jet Airways acquiring more than 50% market share (“moat”). These also ended bankrupt, along with Indian Airlines (later Air India).

Similar has been the story with private banks and telecom operators. Many first-generation private banks (Global Trust Bank, Time Bank, Bank of Punjab, Centurion Bank etc.) ended up merging with larger banks. Numerous telecom operators and ISPs ended shutting the shop in less than a decade. This all happened in spite of very low telecom density and poor financial inclusion.

Steel and power sectors have been another anti-thesis for this “moat” and “low per capita consumption”. India still ranks amongst the lowest per capita consumers of steel and power. If we carefully analyze the banking sector crises during the 1990s and 2010s, these two sectors have been largely responsible for huge credit costs to the banks. There have been numerous bankruptcies and debt restructuring in these sectors in the past four decades. Even the sector leaders like SAIL and Tata Steel have been responsible for massive investors’ wealth destruction multiple times in these four decades. Power producers like JP Power, Reliance Power, Lanco, ended bankrupt, while the leaders like NTPC and Tata Power have not yielded any noteworthy return over the past two decades.

I would not be surprised if many of the new age digital businesses also wind up in the next one decade, despite huge scope for growth in businesses like ecommerce, fintech, food delivery, etc.

The point is that arguments like “per capita consumption” and “moat” may not necessarily work in a country where about 60% of the population is dependent on government support for necessities like food, cooking fuel, primary healthcare, education, and transport; and government is constitutionally mandated to keep policy framework largely socialist.

Investors accordingly need to adjust the denominator (total population) appropriately to calculate a realistic per capita number. The “moat” premium should be assigned to a business only after applying appropriate policy risk discount. On the positive side, per capita income for the total addressable market will also be much higher than the official number.

In particular, notwithstanding the finfluencers claims, the investors must consider the following while evaluating a company for investment:

1.    It is not sufficient to only evaluate the debt servicing capabilities of the company. The ability to pay the cost of other factors of production (e.g., wages, rent, dividend, plant and technology upgrade etc.) must also be evaluated.

2.    It is important to assess the dependence of the company on the global economy, especially the stressed developed economy consumers and over regulated Chinese businesses.

3.    Policy risk, especially related to “sin consumption”; competition; business with the government; and economic offences, etc.

4.    Risk of obsolescence of products, technology and IPRs.