Cognitive dissonance

Last week an appeal purportedly issued by Birla Institute of Technology & Science (BITS), Pilani, to its alumni, seeking their help in the placement of its current students went viral on social media. The appeal mentioned that the global economy may be experiencing its worst slump in decades, with around 4 lac employees being laid off since January 2022. The cost-cutting measures taken by the small and large businesses have resulted in hiring restrictions (including at the campus level) and a funding winter. It added, that the hiring slowdown has deepened in recent months. Some other top-level higher education institutions have also reported challenges in campus placements.

As per a Mint report, the total headcount of the top five IT services firms in India has fallen by ~65000 during the year 2023. About five million aspirants applied for 60000 police constable posts in UP. The applicants' ordeal in traveling to the examination center and then returning disappointed due to paper-leak was also discussed widely on social media. In a seemingly unrelated occurrence, the market capitalization of the US tech company reached close to USD2trn, about half of India’s GDP. The stock price of the company has risen ~20x in the past five years.

In my discussions with friends on this aspect of the economy, the three most common suspicions were:

(a)   If the condition of the economy is so bad, why are the equity markets booming?

(b)   If the job crisis is so severe, why is the incumbent government so popular, especially among the youth?

(c)   The development of Artificial Intelligence (AI) is still in the early stages. How many more job losses shall we witness in the coming years due to automation?

I will be happy to hear readers’ views on this cognitive dissonance; before I share my random thoughts tomorrow.

Keep the option open

 My recent interactions with many market participants indicated that selling deep Out of Money (OTM) options (mostly Call Options) on the last day of the weekly option expiry days (e.g., Wednesday for Nifty Bank and Thursday for Nifty50) has become a very popular trading strategy for many high networth individuals (HNIs). By pledging stocks, mutual funds, and bank deposits as margin money, HNIs claim to be enhancing their overall returns by 6% to 8% p.a. using this trading strategy.

Surprisingly, most brokers and money managers, who run this strategy for their clients, are selling this as a risk-free strategy arguing that a move of 5% of more in Nifty50 or Bank Nifty on the expiry day is unlikely. An option of strike price 5% away from the current index value will hence expire worthless.

There are three points to be considered in this regard, in my view.

1.    In recent years we have not witnessed large (5% or more) daily moves in benchmark indices. In fact, we have hardly seen moves of more than 3% on a daily closing basis in the past 5 years. Nonetheless, terming this strategy as risk-free is highly inappropriate. During 2007-2013 there were more than 40 daily moves of 5% or more. There were more than five daily moves of 10% or more in Nifty during that period. Under the present global economic and geopolitical conditions, it would be unreasonable to completely rule recurrence of multiple large moves.

Considering that the premium earned on selling deep OTM options on the expiry day is minuscule, theoretically, a sudden large move can negate years of earnings in one single day.

2.    The composition of market activity in India has materially changed since the global financial crisis days when 3-5% daily moves in the index were not uncommon. In FY08, before the global financial crisis, the single stock futures (inarguably the riskiest derivative product) comprised 58% of the total derivative segment turnover, whereas the safest product index options were just 10%. In FY23 Index options were 97.7% of the derivative segment turnover, while stock futures were just 0.5%. Obviously, the systemic risk is now minimal. The potential losses are very well defined and adequately provided for through stringent margins.

3.    The rise in popularity of option trading presents a moral dilemma for the regulators. No prizes for guessing that the counterparty to the OTM options sold by HNIs in their trading strategy are mostly small traders for whom an OTM option is nothing but a lottery ticket.

As per a Bloomberg report, in 2023, Indians traded a whopping 85.3 billion options contracts. No other country trades such humongous volumes of options contacts annually, not even the United States (US). For perspective, in 2023, the United States traded 11.2 billion options contracts, while Brazil traded only 2.4 billion contracts, and the data from the rest of the world is almost comparatively negligible. In India, 35% of options trades are done by small (retail) traders.

As per a Securities and Exchange Board of India's (SEBI) January 2023 study, 90% of active retail traders lose money trading options and derivative contracts. As per the latest available data, these small (retail) traders collectively lost $5.4 billion (nearly Rs 44,848 crore) in trading options in the year ending March 2022. On average, loss makers registered a net trading loss of close to ₹50,000.

Unlike most western and Asian countries, in India, there are very few legal avenues for betting. Only nine states in India permit legal lottery business. Other legal betting avenues like horse racing, casino etc. are also accessible to a limited proportion of population (mostly HNIs). Under these circumstances, “betting” on options is the most convenient alternative available to people who aspire to become rich “by luck”.

The dilemma for regulators is whether they should keep this avenue of betting open with adequate safeguards, or close it for small traders, just like the lottery business was banned in many states during the 1990s.

In my view, the regulator should keep this option open with due safeguards, lest the aspirants may be forced to resort to illegal/unregulated means and lose even more.

An unpopular opinion

The benchmark Nifty50 scaled a new all-time high-level yesterday. Analyzing the current market trends, I get some signals that suggest that a significant correction (8% to 10%) in the benchmark Nifty50, though not imminent, is certainly on its way. I feel not imminent, because (i) the top stocks that could have caused an immediate slump are notably underperforming the Index, and (ii) a much deeper correction ought to occur first in the broader market indices that materially outperformed Nifty50 in the past one year.

YTD2024, the benchmark Nifty50 has been supported mostly by the energy, healthcare, and auto sectors; while the heavyweight financials and consumers have massively underperformed. Though there are no significant triggers for a strong recovery in the financial and consumer sectors, a technical upmove cannot be ruled. This might result in a Nifty50 spurt before a correction sets in.

It is pertinent to note that a correction in the outperforming energy (ex-Reliance), auto, and healthcare sectors may not trigger a material correction in Nifty50, as the weightage of these sectors is not enough to trigger a major correction in Nifty50.

I guess that a deeper and more meaningful correction is more likely to occur in a traditionally weaker market period of May and June. I say so for five simple reasons.

a)    The number of large daily movements in benchmark indices on closing, as well as intraday basis, has increased substantially in the past month. This trend usually weakens the technical fabric of the market.

b)    There are clear category preferences visible in investors' activities along with unreasonably higher valuations in preferred categories. Normally a sign of a bubble in the market.

c)     Policy focus is driven by the market and the market is obsessed with policy focus. Usually, this harmony of market and policy is unsustainable - because it leads to misallocation of resources and higher volatility due to political events.

d)    Despite higher interest rates, a larger number of household investors are driven to equities. Logically, it is an unsustainable trend.

e)     The household investors’ participation in highly speculative options trading is scaling new highs. Historically this trend has never ended well. (more on this tomorrow)

f)      Policy rate cut speculations, that had initially driven the global equity rally, are losing steam. A hawkish Fed in March might adversely impact the risk-on mood.

I will be the happiest person on this earth to be proven thoroughly wrong on this count. But till it happens, I shall hold this view and stay cautious on my equity portfolio.

 

State of industry in India

Last week, the National Statistical Office (NSO) released the outcome of the latest Annual Survey of Industries (2021-2022). The survey results provide important insights into the current state of the Indian industry. Some key highlights of the survey results are as follows:

·         Growth: The year 2021-22 witnessed a sharp rise in level as well as in the growth of the majority of the important economic parameters like invested capital, input, output, GVA, net income, and net profit registered by the sector and even surpassed the pre-pandemic level in absolute value terms.

·         The main drivers of this growth in 2021-22 were industries like the Manufacture of Basic metal, Coke & Refined Petroleum Products, Pharmaceutical Products, Motor vehicles, Food Products and Chemical and Chemical products. These industries, taken together, contributed about 56% of the total GVA of the sector and showed GVA growth of 34.4% and output growth of 37.5% in comparison to 2020-21.

·         Employment: The estimated number of persons engaged in this sector in 2021-22 has exceeded the pre-pandemic level (that is 2018-19) by more than 9.35 lakh. The top five states employing the highest number of persons in manufacturing were Tamil Nadu, Gujarat, Maharashtra, Uttar Pradesh, and Haryana.

·         Wage Growth: Average emoluments also registered an increase with the average salary earned per employee in this sector had gone up by 1.7% in 2020-21 and by 8.3% in 2021-22 in comparison to the respective previous years.

·         Regional dispersion: The top five states, taken together, contributed about 53% of the total manufacturing GVA of the country in 2020-21 as well as in 2021-22. Gujarat remained at the top in 2020-21 and in the second position in 2021-22 while Maharashtra ranked first in 2021-22 and second in 2020-21. These two states were followed by Tamil Nadu, Karnataka, and Uttar Pradesh in both years.

·         Key produce: Food (16.35%), Non-metal minerals (11.87%), Textile (6.86%), Fabricated Metal (6.44%), Rubber and Plastic products (6.01%) were the top category of operational factories.

·         No. of factories: There was a total of 2,00,576 operational factories in India at the end of FY22. About 49400 or about one-fifth of the total factories were inoperational. About 51% of the total operational factories were in the top 5 states – Tamil Nadu (15.76%); Gujarat (11.63%), Maharashtra (10.16%), Uttar Pradesh (7.03%), and Andhra Pradesh (6.24%). Gujarat factories were the most capital-intensive (18.43% of total fixed capital).

·        
Debt: Manufacturing units had a total of Rs13971 billion loan outstanding at the end of FY22. The average interest cost of these loans was 11.7%.   

 Not so defensive

Self-reliance in the defense sector has been one of the major investment themes in the past three years. Besides dedicated public sector defense manufacturers, the stocks of many equipment and service providers to the Indian defense establishments have seen a sharp upmove. In the melee to own “defense stocks,” many investors have ignored the basic principles of investment and buying stocks of these companies at any price.

I had written a cautionary post about this many months ago (see here). The trend has only strengthened in the past six months. Stocks, even remotely associated with the defense sector, have seen hyperbolic moves. I feel the interest in the sector that was driven initially by optimism, may have crossed over the realm of exuberance.

  

My takeaway from Putin’s interview

Recently, an interview (watch here or read here) with Russian President Vladimir Putin has been trending in the media worldwide. In this two-hour seventeen minute long interview, President Putin touched upon many important issues concerning global economics and geopolitics. Experts from the world over are analyzing the interview from multiple angles, e.g., strategic, political, geopolitics, economics, etc. Most analysis I have come across is deeply biased. The starting point of most comments is the trustworthiness of President Putin. Most Western analysts seem to be rejecting Putin’s assertions as mere propaganda; while the analysts from Eastern and Southern analysts are using the contents of the interview to justify their opinions about the US agencies (deep state) and NATO.

In India, pro-establishment media and experts have mostly refrained from commenting on the interview; whereas the critics of the establishment have used this opportunity to emphasize that President Putin has answered many tough questions while Prime Minister Modi chooses not to answer media questions. I have not seen much discussion in Indian media on the assertions made by President Putin.

As a tiny fish in the pond, I am incapable of making any intelligent comments on matters of global or even national importance. Nonetheless, I found the following three things in the interview that interested me as a small investor.

·         “China's economy has become the first economy in the world in purchasing power parity; in terms of volume, it overtook the US a long time ago. The USA comes second, then India - one and a half billion people, and then Japan, with Russia in the fifth place.”

This is the only mention of India in this 2:17:19 hrs. interview. Indonesia got much more prominent mentions. China was repeatedly mentioned as a formidable global power. The recent trade trends are suggesting that near-shoring, friend-shoring, and China-proxy-shoring are emerging as more popular trends. Indonesia, Mexico, Vietnam, etc. are emerging as much stronger gainers of the China+1 strategy as compared to India.

·         President Putin made it clear, in no uncertain terms, that the era of global peace that prevailed particularly in the post-Cold War period is mostly over. We are entering an era of mutual mistrust; frequent disruptions; persistent and potent threats of a larger war; and redistribution of global power.

This implies that (i) defense spending will increase for most nations; (ii) given the current state of the stretched fiscal position of most developed nations, the collateral damage of higher defense spending will be humanitarian aid; (iii) Rising mistrust may also result in tightly closed borders, adversely impacting immigration; (iv) Volatility in markets will rise materially; and (v) USD will face persistent pressures.

It appears too early for India to claim self-reliance in defense production. It is also early to anticipate that India could become the fulcrum of any major global alliance in the next few years. This means we could face serious trade and foreign policy challenges soon. The recent performance of the government in this regard is not very inspiring.

·         President Putin hinted that Artificial Intelligence (AI) needs to be regulated and there must be a global understanding on this subject.

Failure to reach a wider understanding may pose a similar (if not greater) risk to the global peace and stability as the stockpile of nuclear weapons did in 20^th century. Misuse of AI could be devastating. The US and China are miles ahead of India in the development and deployment of AI in most areas, especially defense technology.

The implications for my investment strategy are as follows:

·         The sentiment of nationalism apart, for small investors like me it may not make much sense to place significant bets on the China+1 theme. To global investors markets like Indonesia and Mexico may offer better opportunities.

·         We should embrace higher volatility. The post global financial crisis (GFC) era of low volatility may be over in the next few quarters.

·         Overstretched fiscal positions and the specter of war may keep rates elevated for longer than presently anticipated, even if China accelerates the export of deflation. The cost of global capital could rise for Indian entrepreneurs.

·         It may not be a great idea to buy USD-denominated assets for small investors.

·         Defense production and AI will remain relevant themes for many years. But buying these at any price may not be a good idea. (more on this tomorrow. 

A summer of discontent

Earlier this week, Prime Minister Narendra Modi claimed that the incumbent ruling dispensation (NDA) shall return to power in 100 days with a much larger majority. The popular political debate is now getting narrowed to the question “whether NDA will return to power with 300/545 seats or 400/545 seats”.

On the other side of the globe, the political debate in the US is also fast reaching the point where the most relevant question would be “Who will Donald trump defeat in the November presidential elections?”

The ever-forward-looking financial markets are not oblivious to these more likely political outcomes. It is therefore safe to assume that the current prices have factored in the election victories of Modi and Trump. Thus, from a political viewpoint, one should not anticipate a significant upside to the financial markets. An unexpected election outcome may though result in a material downside.

In the latest episode of Greed & Fear, Christopher Wood (of Jefferies), said about the US markets, “The stock market is priced for an idealized soft landing while the money markets are priced for a degree of monetary easing which only seems likely in the event of a recession. The fed fund futures are now discounting 144bps of rate cuts this year. On the US stock market, the Nasdaq 100 is now trading at 24.4x one-year forward earnings and the Russell 2000 is trading at 22.6x, compared with 19.6x for the S&P500, according to Bloomberg.”

The summer in the US is therefore going to be full of discontent. A soft landing (further earnings downgrades, slower consumption, and rising financial stress) may limit the upside in stocks while the Fed pushing the rate cut beyond May’24 may cause restlessness in the bond markets.

Back in India, the chances of any further re-rating of equities are getting slim.

·         Private consumption slowdown is now well accepted. The interim budget has made it clear that even public consumption is not likely to improve anytime soon.

·         The budgetary allocation for capital expenditure in the sunrise sectors Defense, Railways, Utilities, etc. has seen meager growth in FY25BE. The valuations of the stocks of these sectors may not see any further PER re-rating. The returns from here logically should be similar to the earnings growth in these businesses. Any disappointment in execution may however see a sharp sell-off.

·         Decelerating global growth shall keep export growth under check. The downward shift in growth trajectories of the US and China could also spill over to India through several transmission channels, such as trade in goods and services, commodity prices, and investment.

·         RBI has also made it clear that going forward it is not an all-blue-sky scenario for the Indian economy this summer. The risks to inflation and growth are at best balanced. The bond markets may not be fully pricing in the downside risks.

I do not want to sound like a party pooper. Nonetheless, I am happy to use this spring for repairing my roof, servicing my air-conditioner, and oiling my vehicle. Just in case, there is a cloud burst, sudden heat wave, or flood warnings needing immediate re-location.

Avoid indulging in misadventures

As the market participants look forward to hearing Governor Das later this morning, it is pertinent to take note of a recent report by Moody’s Investors Service, cautioning about strengthening headwinds, tight funding conditions, and rising geopolitical threats for Asia Pacific region.

The report emphasizes that “A downshift in China's economic growth rate and a cyclical slowdown in the US will weigh on Asia-Pacific (APAC)'s credit conditions in 2024. Peaking inflation globally will provide space for monetary tightening cycles to slow, but financial conditions will remain difficult for the weakest rated issuers. Meanwhile, geopolitical risks will continue to shape business decisions.”

Interest rates: Moody’s does not expect central banks in the region to hike rates further. However, it believes that interest rates will remain elevated and decline only gradually. The possibility of occasional rate increases to guard against unexpected inflationary pressures is also not ruled out. Given that policy rates will remain above levels seen in the last decade, this will increase borrowing costs and hamper growth. Refinancing and liquidity risks will be highest for frontier markets and high-yield issuers.

Growth: Moody’s projects the weighted average of real GDP growth for the 25 sovereigns in APAC to decelerate to 3.6% in 2024 from 4.4% in 2023, reflecting the slowdown in China and broadly lackluster global economic conditions, including the cyclical slowdown in the US.

Though APAC growth may continue to outperform that of most other regions. The slowdown in China is expected to be mitigated by robust domestic demand in large emerging markets, such as Indonesia and India.

Geopolitics: It is expected that geopolitics will remain a primary concern in 2024. Competition over trade and technology between China and the US; and escalation of military conflicts in the Middle East continue to pose risk. However, it could be an opportunity only for economies with strong manufacturing bases and good infrastructure, such as Vietnam, Thailand, and Malaysia.

Credit outlook: The share of stable outlooks in APAC across sectors has declined from last year, reflecting a weaker economic backdrop. Nonfinancial companies and financial institutions in China will continue to face difficult credit conditions in 2024. This contrasts with a stable outlook for nonfinancial companies and financial institutions in the rest of APAC. Refinancing risks will remain elevated for nonfinancial companies reliant on the high-yield market.

Outlook for sovereigns negative: In addition to risks from slower growth for the region, still tight funding conditions are likely to weigh on the ability of governments to achieve deficit consolidation and debt reduction. Larger debt burdens with higher interest rates have also led to a significant deterioration in debt affordability.

Slowing policy rate tightening in the US could alleviate some currency pressures for both higher-rated and lower-rated sovereigns. Currency weakness in APAC has been pronounced amid the US dollar’s broad strength since 2022. A stabilization in bilateral exchange rates with the US could bring some relief to holders of foreign currency debt.

The short point is that regardless of what Governor Das says today, conditions warrant investors to exercise some extra caution and not indulge in any misadventure with their hard earned money.

Shanghai to Ayodhya

Shri Ram Janmabhoomi Teerth Kshetra (SRJBTKshetra), a public trust, is building a grand temple dedicated to Lord Rama at his birthplace in Ayodhya of Uttar Pradesh. Recently, the consecration ceremony of Lord Rama’s idol at the temple was performed with great fervor. To facilitate the devotees visiting the temple, the Government of Uttar Pradesh and the Central Government are investing in developing civil infrastructure in and around the Ayodhya town. Reportedly, the Master Plan 2031 envisages the redevelopment of Ayodhya to be completed over 10 years with an investment of over Rs 85,000 crore.

This is expected to establish Ayodhya town prominently on the world tourist map. It is pertinent to note that just three years ago, Ayodhya was a small municipal town with a population of approximately 70000 with poor civil infrastructure. Impressed by the government’s investment in Ayodhya’s civil infrastructure, Global brokerage firm Jefferies commented in a report, “The grand opening of the Ram temple at Ayodhya by PM Modi on Jan 22nd, is a big religious event. It also comes with a large economic impact as India gets a new tourist spot which could attract over 50 million tourists per year. An Rs 85,000-crore makeover (new airport, revamped railway station, township, improved road connectivity, etc.) will likely drive a multiplier effect with new hotels & other economic activities. It can also set a template for infra-driven growth for tourism”.

Incidentally, it is not Ayodhya alone. This is, apparently, the template of development chosen by the government. In the past few years, the government’s emphasis has been on the development of infrastructure, especially logistic infrastructure, and encouraging private enterprises to build manufacturing capacities taking advantage of improved infrastructure and logistic facilities.

It is pertinent to note that the contribution of manufacturing to India’s economy peaked in the mid-1990s and has been on the decline since then. In the year 2022, manufacturing contributed 13.3% to India’s GDP, the lowest level since 1967.

Earlier some East Asian countries, and lately China, used this strategy to accelerate their economic growth with mixed outcomes. Though years of high growth ensured a decent quality of life for their citizens, none has been able to become a developed economy. The high growth phase could not be sustained even for two decades. The economies are now mostly growing below par. In recent years, Chinese economic growth has also been decelerating. The authorities have clearly shown a tendency to shift focus on domestic consumption to support the economy.

The Indian economy has mostly been dominated by services on the supply side and consumption on the demand side. Now there is a concerted effort to change the model to manufacturing and investment-led growth.

The questions that need to be examined in this context are:

·         Given the fact that the Indian economy may probably be in its last decade of demographic dividend, is it desirable to cut spending on building social infrastructure, reduce the education and healthcare budget, and invest in long gestation infra projects?

·         Agricultural sector contribution to India’s GDP has been stagnating around 16-17% for a long time. The proportion of the population directly dependent on this sector is close to 44%. Would it not be better to invest in developing agro-technology, infrastructure, and logistics than focusing on manufacturing (with much lower employment intensity now) to make growth sustainable, faster, and equitable?

·         What is the probability that in one decade India can meaningfully increase its share in global manufactured trade? Curtailing domestic consumption to augment exports may be a high-risk strategy at this point in India’s economic growth journey. Of course, if it is successful, the rewards may be exciting. But the odds do not look great at this point.

·         Self-reliance in defense production, full energy security, and net exporter status in manufactured electronics, are three key expected outcomes of the current policy direction. Healthcare, higher education, advanced technology, water, urban planning, etc. are some of the areas that are getting lower priority than required. Failure to achieve the outcomes could prove to be exponentially disastrous.

The point is that this midway diversion in the growth strategy could be fraught with significant risk. Our social, political, cultural, and economic structures are not the same as China’s. Adopting the Chinese strategy of economic growth and development may neither be desirable nor effective, in my view.

Also read

View from my standpoint

View from my standpoint

ले दे के अपने पास फ़क़त इक नज़र तो है, क्यूँ देखें ज़िंदगी को किसी की नज़र से हम —साहिर लुधियानवी

Last Thursday, the finance minister presented an interim budget for the fiscal year 2024-25. The budget presentation had two part – (i) rhetorical and (ii) substantive.

The first part included a speech about the performance of the governments led by Prime Minister Narendra Modi for the past 10 years and promises for the next 23 years. The finance minister spoke about how in 2014 their government inherited an economy that was in shambles; and how they have pulled it out from a total mess and put it on the fast track to achieve the status of a developed nation by the year 2047; when we would celebrate 100 years of our independence from the colonial British rule. The finance minister also promised to implement a slew of development schemes over the next five years. She however refrained from listing any specifics or financial details.

The second part included (i) the accounts of the government for FY24; (ii) fiscal proposals for FY25, and (iii) a vote on account to meet the government’s expenses till a new government is formed and a full budget is approved by the parliament. This is the part that needs to be discussed and analyzed.

Fiscal prudence – achievement vs desirability

The finance minister presented that the fiscal deficit target for FY24 has been revised downward to 5.8% (Budget estimates (BE) 5.9%) and budgeted a fiscal deficit for FY25BE at 5.1% of GDP. She emphasized that the government is well on course to achieve the FRBMA target of a 4.5% fiscal deficit by FY26. The sharp improvement in the fiscal deficit has been received well by most. A tight balance is particularly commendable given the impending general elections. In my view, we need to ponder deeply over the following five points:

1.    At this stage of economic development, whether this degree of fiscal tightening is desirable? FY24RE shows that to meet the fiscal targets, the government has cut capex spending also. Is it appropriate to save on capital expenditure to meet fiscal targets? FY25BE growth in capex spend on key sectors is very moderate.

2.    FY25BE further confirms the trend of the past three years that the government is systematically cutting its consumption expenditure, subsidies, and social sector spending while allocating more for manufacturing and export incentives. Should investors assume that our economy is taking a left turn toward the Chinese model of growth (primarily manufacturing and infrastructure capacity building) from a largely consumption and social sector capacity building led growth?

3.    The budget does not explain why Rs one trillion, 50-year interest-free loan to states shall not be considered part of the fiscal deficit. For all practical purposes, it’s a drain on the center’s finances that will likely never be returned.

4.    Interest expense now constitutes 25% of the total government spending. There is no indication that this proportion will come down any time soon. On the contrary, with fiscal deficit staying at 4% of GDP or above for at least three more years, and greater reliance on high-cost small savings funding of deficit, it is likely that the proportion of interest in total expenditure may rise further. Under these circumstances, the sovereign rating of India may not see any upgrade anytime soon.

5.   With the current valuations of PSEs, disinvestment looks increasingly improbable. The government has not presented an alternative plan for fundraising so far.

 

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