What are you doing at 11 AM today?

 When the Finance Minister Ms. Nirmala Sitharaman rises to present the final Union Budget for the fiscal year 2024-25 today at 11 AM, she will be creating a unique record. She will become the first finance minister of India to present six consecutive union budgets (2019-2024, in addition to an interim budget presented in February 2024. Prior to this, the record was held by the former prime minister Morarji Desai, who presented five consecutive union budgets (1959-1963). He had presented two interim budgets (1962 and 1967) also.

Ms. Sitharaman’s record is impressive, in my view, because she has survived the worst economic slowdown and fiscal slippage (FY21 GDP Growth -5.8% and Fiscal deficit of 9.17% of GDP) in the history of Independent India caused by the worst pandemic since 1917 Spanish Flu; a below par election performance of her party in 2024 general elections, apparently due to sub-optimal performance on inflation and employment generation fronts; sharp criticism on GST management from businesses and states; rumors of lack of support from her own party members and family; and persistent calls for her removal from the market participants.

Now coming to the budget to be presented today.

In the post liberalization (1991) days, budget presentations used to be an event of interest to a large section of urban India (Rural India did not have much TV in those days).

Changes in excise duty rates had immediate impact on businesses and household budgets. Introduction of new trains and changes in train fares affected a large number of people. Tax rates were consistently reduced; tax slabs rationalized; tax incentives on investments and savings increased; and basic exemptions increased resulting in many taxpayers getting out of the tax net or their tax liability lowered.

A large number of changes in tax laws would keep students (CA, CS, LLB etc.) also hooked to the budget. Many people would fill fuel tanks of their vehicles to make some savings on likely higher fuel prices, and buy one month of liquor and cigarette stocks a day before the budget presentation.

But nowadays nothing of this sort happens.

Goods and Services Tax and excise duty is now not part of the finance bill. Most of it is managed by the GST Council; through notifications issued from time to time, or by the respective state budgets. New trains are not announced in the budget and fares hikes are also announced outside the budget. Income tax rates have mostly stabilized. Only minor changes in the return filing and assessment procedures are announced in annual budgets.

Presently, the emphasis of the government is on bringing more people into the tax net and increasing the effective tax rates. In the past decade Tax Collection at Source (TCS) for a variety of transactions has been implemented. A variety of cess have been imposed to augment the tax collection. Incentives on investment and savings are being withdrawn gradually.

The budget documents are more like colorful corporate presentations. These omit much more information than these include. The budget speeches sound like the election manifesto of the ruling party. The finance ministers frequently announce “intent” to launch random programs in future, with no money provided in the current year’s budget.

For electronic media it is a major marketing event to enhance their TRPs and revenue. In essence, the format of their election coverage and budget coverage is the same. There is absolutely no correlation between the pre-election & pre-budget analysis, and forecasts to the actual outcome. Also, it is difficult to make any sense from the post-election and post-budget analysis and commentary.

Hours of airtime have already been spent on the pre-budget analysis this year also. Besides, hundreds of reports have been printed to guide investors about the investment themes that may emerge from the budget. What I gather from various sources is that the  five most common points of the pre-budget speculations this year are:

What will the finance minister do with the bounty (Rs2.11trn) it received from the RBI as dividend? Whether the excess funds will be used to reduce the fiscal deficit; or these will be used to fund some populist programs to win forthcoming assembly elections; or these will be granted to the key NDA allies (JDU and TDP) to meet their demand for additional resources for their respective states.

Will allocation for Capex be increased materially or focus will shift to consumption and social programs? It is basically a speculation on the impact of the latest Lok Sabha elections on policy making.

Will the impetus to private capex be enhanced? The speculations are broadening the scope of PLI schemes; relaxation in FDI norms for certain sectors; etc.

Will the finance minister afford more cash in the hands of households to support consumption growth – the missing piece in India’s growth in the past few years? The speculations are tax relief for salaried classes; disincentive for 80C savings; increase in cash payout for farmers etc.

Will there be any change in the Long-Term Capital Gains tax regime? There are speculations of more uniformity in LTCG rules for various asset classes.

A majority of the market participants watch the budget speech to take advantage of swing trade opportunities that may arise from uttering some specific jargon by the finance minister. The empirical evidence shows some gain and most lose money in this joyride.

I am taking my daughters shopping today at 11AM and will be reading the Finance Bill and other budget documents in the evening.

What about you?

A visit to the street

I had an opportunity to meet a group of market participants and industry representatives at a corporate event this week. The discussions over lunch and tea revolved around the three broader topics – (a) State of equity markets; (b) Expectations for the final Union Budget for FY25; and (c) Corporate performance. Unsurprisingly no one was interested in discussing politics, geopolitics and the US Fed’s policy.

Equity markets

Most people were satisfied with the performance of markets in general and their personal portfolios in particular. Almost everyone believed that the stock prices will continue to rise for the next couple of years at least; though there could be some intermittent corrections. Everyone appeared prepared to invest more money in stocks. The return expectations from equity investments were in high teens on the lower side.

With a few exceptions, most people appeared market cap agnostic in their investment strategy. In fact, the awareness about SME segment stocks surprised me. Both mutual fund and stock folios are well diversified across market cap segments.

Everyone had a story to tell about multi-bagger stocks, especially PSU Banks, Defense, Railways and power sector stocks. Some were proud to own a couple of them since the IPO. Some regretted selling them too early and buying again. Some rued missing this once in a decade opportunity.

Most market participants lamented the losses traders are incurring in the derivative trading. However, none admitted to be trading in derivatives himself/herself.

A significant number of participants claimed a material elevation in their lifestyle due to the gains made from strong market performance. These gains resulted in the form of higher fee/brokerage income and gains. Move to a larger/expensive house and more frequent foreign vacations were too top cited indicators of lifestyle elevation.

Union Budget

None of the participants expected any material change in income-tax rates or rules. It is felt that other than minor tinkering in standard deduction or slab structure, no other change may be made this time. Most expect the fiscal consolidation and focus on infrastructure to continue. No one spoke confidently about “coalition dharma” impacting the budget, but everyone would like to see if it does.

There was enthusiasm about railway and defense allocations. However, most of it appeared to be driven by portfolio positioning rather than any rational explanation.

Corporate performance

The market participants and industry people were most sanguine about the performance of power, telecom, construction and healthcare & pharma sectors. The opinion was divided vertically about the financials, commodities and manufacturing sectors. IT Services and Consumers appear to be carrying least expectations.

Note: This is based on casual discussions with a very small group of people. It may not be close to the real picture. Readers may like to dig deeper and seek views of a larger group. I shall be happy if any reader wants to add or challenge any of these notes.

2H2024 - Market strategy and outlook

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

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

(1)        Macroeconomic environment

(2)        Global markets and flows

(3)        Technical positioning

(4)        Corporate earnings and valuations

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

(6)        Greed and fear equilibrium

(7)        Perception about the political establishment

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

Macroeconomic environment – Positive

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

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

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

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

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

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

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

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

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

Global markets - Neutral

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

Technical Positioning – Negative

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

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

Corporate earnings and valuations - Neutral

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

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

Alternative return profile - Neutral

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

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

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

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

Greed and fear index – Negative

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

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

Perception about the political establishment - Positive

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

Outlook for Indian markets

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

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

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

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

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

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

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

1.    Weather conditions especially poor distribution of monsoon rains.

2.    Worsening geopolitical situation in Europe and Asia.

3.    A recession forecast for FY26.

4.    Sharp rise in credit cost for lenders.

5.    Unusual rise in rural stress.

2H2024: Investment Strategy

Asset allocation

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

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

Equity investment strategy

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

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

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

(c)    Underweight on financials and avoid PSUs.

1H2024 – Buoyancy all around

The first half of the year 2024 has been good for global markets. Despite disappointment on rate cuts, geopolitical concerns, sticky inflation, and political changes in many countries, stocks, precious metals, industrial commodities and crypto made a steady move up with very relatively low volatility.

A notable feature of the global market movement in 1H2024 was the stark underperformance of Asia ex Japan, even though the Japanese equities being the best equity markets amongst the major global markets. Brazil also underperformed despite a decent rally in commodities.

Another notable feature of global markets was the narrow market breadth of US markets. Though the benchmark indices scaled new highs, it was mostly due to parabolic rise in a handful of technology stocks.

At present equity markets appear strong on the back of a resilient demand environment, well anchored inflationary expectations and peak interest rates. Fears of earnings failing to match the stock price rise, escalation in geopolitical tensions, spike in energy prices, uncertainties about the policy direction post the US presidential elections, and erratic weather conditions are some points of concern.

India performance – 1H2024

Indian markets performed very well in the first half of the year 2024. Though Indian equities underperformed the developed markets in line with the global trend, it did very well within the emerging market universe. The key highlights of the India market performance could be listed as follows:

·         The benchmark Nifty50 gained ~10.5% during 1H2024; while the Midcap (+20.7%) and Small Cap (+21%) did much better. Consequently, overall market breadth has been strong.

·         Two third of the market gains came in the month of June 2024, post the elections. This was contrary to the pre-election consensus that BJP failing to secure a majority on its own may result in sharp decline in market.

·         The total market capitalization of NSE is higher by ~21%; more than gains in the benchmark indices – implying that stronger gains have occurred in the section of the market beyond indices.

·         The number sector outperforming the benchmark indices far outnumbers the sector underperforming. The rally was led by Realty, PSUs (mostly power, defense, and railway), Auto, infra and energy. The Capital Goods and Heavy Engineering sector have been the flavor for the period. Particularly, the businesses catering to sectors like defense, railways, and road construction did extremely well. Banks, IT Services and FMCG were notable underperformers.

·         Ship builders were the notable outperformers amongst the individual stocks. No conspicuous sectoral trend was seen for the losers.

·         Institutional flows to the secondary equity markets were positive for five out of the six months. 1H2024 witnessed a total flow of ~INR3559bn, despite FPIs outflows of Rs320bn. The correlation of institutional flows with Nifty returns remained poor (~48%).

·         The rates, currency and yields were stable in 1H2024. Policy rates were unchanged; while money market rates were marginally higher by 15bps. Deposit rates did not see much change while lending rates were higher by 10-15bps.

·         The overall Indian yield curve shifted lower and flattened completely, as the RBI maintained the status quo on policy stance.

·         The economic growth surprised on the higher side with the Indian economy recording a growth of 8.2% for FY24, beating all forecasts materially. Fiscal balance also improved with FY24RE fiscal deficit coming at 5.8% and FY25BE of fiscal deficit at 5.1%.

·         CPI inflation has inched closer to the lower bound of the RBI’s tolerance band of 4%-6% with May’24 CPI inflation number coming at 4.75%.

• Corporate performance has shown resilience in recent quarters, with sales growth recovering, margins improving and RoE rising. Banks reported consistent improvement in the asset quality and profitability.

Unravelling the myth of SIP

 Rising participation of household (retail) investors in the Indian stock markets has been a topic of interest for the past couple of years. Most analysts and strategists have highlighted this as a key factor behind a sustained rise in the benchmark indices and low volatility, despite subdued foreign flows. Even the Prime Minister and many senior ministers made it a point in their campaign in the recently concluded general elections.

In particular, a consistent rise in household investments in the mutual funds through systematic investment plans (SIP - a popular method to automatically invest a predetermined amount at predetermined intervals) has been cited as a strong support for the Indian equities.

Most market participants are confident about this support to the Indian equity markets and its positive impact on the valuation, volatility and breadth of the market. I acknowledge the rise in the participation of household investors in equity markets. I am however not very confident about its sustainability and impact on the market performance. I would like to see more scientific evidence of growth in SIP and its impact on markets.

In this regard I find the following data points noteworthy.

·         The share of household savings in the gross national savings has been declining for the past many years. India’s gross savings rate stood at 29.7% of gross net disposable income (GNDI) in 2022-23, with households contributing 60.9% of aggregate savings against a ten year average of 63.7%.

·         The share of net financial savings in total household savings has seen a declining trend in the past decade. It stood at 28.5% in 2022-23, from an average of 39.8 per cent during 2013-2022.

·        Net financial savings of households have declined to 5.3% of GDP (FY23) from an average of 8% during the last decade (2013-2023).

·         The sharp rise in household financial savings during the pandemic (51.7% of total household savings in 2020-21) has been drawn down subsequently, as in many other economies, and shifted towards physical assets.

·        Bank deposits, provident fund and insurance continue to dominate the composition of household savings deployment. Post Pandemic there is some shift towards shares, debentures and mutual funds category, but it does not denote any change in the long term trend.

·        SIP flows have risen in the past few years. The rise has been quite remarkable in the post pandemic period. As per AMFI data, from Rs 43921 crores in FY17, SIP flow rose to Rs199219 crores in FY24.

 

·        However, if we see on a relative basis (as a percentage of market capitalization), SIP flows have not seen much growth in the post pandemic period. In fact, at the current run rate, FY25 SIP flows as a percentage of market capitalization would be almost the same as FY19.

 

Consumer finance – Dawn or dusk

 Low household credit in India has been a long running theme for investors in India. In the past three decades, I have observed that almost every presentation made by brokers, money managers, investment advisors, lenders, companies catering to discretionary consumption etc., has highlighted this phenomenon. The market participants and companies have consistently emphasized on low household credit as a single most significant factor enhancing the growth potential of, particularly, financial services and discretionary consumption sectors.

However, in the past one year, the narrative seems to have changed somewhat. These days, it is not uncommon to find rising household credit being cited as a key risk to financial stability. The Reserve Bank of India and many analysts have mentioned this factor as a key stress point for the financial stability.

The latest Financial Stability Report released by the RBI notes that “At 40.1 per cent of GDP26, the stock of household debt in India is relatively low when compared to other EMEs, but in relation to GDP per capita, it is comparatively high. With overall household savings declining to 18.4 per cent of GDP in FY:2022-23 from an average of 20.0 per cent of GDP over 2013-2022, and coupled with an increasing trend in financial liabilities, household debt warrants close monitoring from a financial stability perspective.” It further notes, financial liabilities of households have risen in the post-pandemic period, as reflected in the surge in retail loan growth for financing both consumption and investment. Alongside, agricultural and business loans have also grown. Notably, more than two-thirds of borrowers are of prime and above credit quality.

In the post pandemic period, sector wise retail credit growth has remained the strongest. Personal loans have grown almost at 1.5x pace compared to overall credit growth. The growth of unsecured personal loans (including Credit card receivables, Consumer durable loans and Other personal loans) in banks from March 2017 to March 2023 stood at CAGR – 21.0 % outpacing the personal loan growth which exhibited a CAGR of 19% during the same period. Unsecured personal loans account for almost 1/3^rd of the overall bank’s personal loan credit of ~Rs. 41 lakh crores as of March 31, 2023.

Financial inclusion, transformation of consumer behavior, change in lenders’ focus, and enhanced leveraging of technology in lending are some of the reasons cited for the sharp rise in household credit. Household savings hitting almost 50 year low (~5% of GDP) is also one of the reasons for rise in household credit.

As per the recent data released by the RBI regarding sectoral deployment of the credit, the retail credit (constituting 1/3rd of the overall non-food credit) growth stood strong at 17.8% YoY in May’24. Within the Retail segment, credit growth stood strong across Housing (16.9% YoY), Vehicle Loans (17.9% YoY), Loans Against Gold Jewellery (29.7% YoY) and credit card outstanding (26.2% YoY).

It requires an in-depth study to establish whether the rising household credit is sustainable and good for the Indian economy, hence the markets, or a cause of concern.

As I mentioned earlier, this is something which everyone was looking forward to for a long time. Now since it is materializing, should markets be celebrating it or being worried about it!

In my view, dominance of consumers over producers is a natural evolution of growth. Almost every developed and middle-income economy has witnessed this transition in their course of development. India shall be no exception. The concern could be if it is too early for this transition in India, given the high level of poverty, infrastructure inadequacies, energy insecurity, and inadequate legal and regulatory framework.

I am not competent to comment on this. Maybe some experts will conduct deep research to conclude whether the “consumer finance” is already a mature theme in India or still a sun-rise sector. This will determine what kind of valuations should be afforded to the institutions extending unsecured personal loans.

De-stressed India!

The Reserve Bank of India (RBI) recently released the half yearly Financial Stability Report (FSR). A key highlight of the latest FSR is RBI’s confidence in the resilience and sustainability of growth in the Indian economy.

The report notes “heightened risks and uncertainties” in the global economy and financial system, while highlighting the “remarkable resilience” and receding risks of a hard landing. It also cautions, “While near-term prospects are improving, pitstops in the last mile of disinflation, high public debt, stretched asset valuations, economic fragmentation, geopolitical tensions, climate disasters and cyber threats present downside risks. Emerging market economies (EMEs) remain vulnerable to external shocks and spillovers.”

Regardless, the RBI finds the Indian economy on a strong footing. It notes, “Strong macroeconomic fundamentals and a sound and stable financial system have supported the sustained expansion of the Indian economy. Moderating inflation, a strong external position and ongoing fiscal consolidation are anchoring business and consumer confidence. Domestic financial conditions are buttressed by healthy balance sheets across financial institutions, marked by strong capital buffers, improving asset quality, adequate provisioning and robust earnings.”

In particular, the report highlights the robustness of the financial system, boosted by rising profitability, improving asset quality. It notes, “Return on assets (RoA) and return on equity (RoE) are close to decadal highs at 1.3 per cent and 13.8 per cent, respectively, while gross non-performing assets (GNPA) ratio and net nonperforming assets (NNPA) ratios fell to multi-year lows of 2.8 per cent and 0.6 per cent, respectively. This has helped SCBs to maintain strong capital buffers: their capital to risk-weighted assets ratio (CRAR) and the common equity tier 1 (CET1) ratio at 16.8 per cent and 13.9 per cent, respectively, stood well above the regulatory minimum in March 2024.

It is pertinent to note that in the latest systemic risk survey (SRS, May 2024) the RBI had categorized all major risk groups to domestic financial stability as “medium”.

Some of the key highlights of June 2024 FSR are listed below:

Global scenario

·         The global financial system remains resilient and financial conditions stable despite an uncertain and challenging backdrop marked by last mile disinflation process, elevated public debt, geopolitical tensions and economic fragmentation.

·         The International Monetary Fund (IMF) has projected global growth to remain steady at 3.2 per cent in 2024 as in 2023, 0.3 percentage points higher than in its October 2023 World Economic Outlook update.

·         The threat of a looming debt crisis cannot be overemphasized. Coexistence of high debt levels and elevated interest rates can feed a vicious cycle of financial instability through impairment of government and private-sector balance sheets. The frenetic expansion of global public debt in recent years has accentuated concerns about its sustainability. These worries are exacerbated by elevated interest rates and rollover risks for many overburdened economies. Global public debt has increased to 93.2 per cent of GDP by end-2023- nine percentage points above its pre-pandemic level.

·         A key feature of the evolving global economic outlook has been the recent alignment between market expectations and policy stances. The resilience of growth has allayed fears of hard landing and pushed out expectations of early interest rate cuts

·         While several near-term risks have receded, the global financial system continues to face heightened uncertainty surrounding the outer-term outlook for both financial markets and financial institutions. According to the IMF, the medium-term outlook is characterized by weak productivity and retreat in globalization and global growth is expected to decline by more than a percentage point by the end of 2020s compared to the pre-pandemic average.

·         The latest monetary policy cycle has witnessed a departure from past patterns when monetary tightening was associated with risk-off sentiment and decline in prices of riskier assets. To the extent valuations are stretched, sudden shocks could precipitate stress that spreads contagiously across financial market segments through correlated sell-offs and band-wagon effects.

·         Stretched asset valuations have been coterminous with a strong US dollar (USD) as market expectations have gravitated towards prospects of higher interest rates in the US than in other economies. Besides interest rate differentials and currency depreciations, risks to the global economy, especially the EMEs, are being transmitted through multiple channels. First, commodity prices and the USD are moving in tandem in a break from their historical inverse behaviour11 (Chart 1.18). This can compound inflationary pressures for EMEs, especially commodity importers, dampening consumer spending, investment and economic growth. Second, the strong USD can increase debt service costs and prompt rating downgrades, limiting their access to global capital markets. Third, capital flows could become even more volatile.

·         Private credit, which is essentially provided by non-bank lenders to corporates on a bilateral basis, has grown four-fold over the last ten years, emerging as a major source of corporate financing among middle-market firms that have low or negative earnings, high leverage, and lack of high quality collateral.

Domestic economy

·         The Indian economy and the financial system strengthened by solid macroeconomic fundamentals and healthy balance sheets of financial institutions, are exhibiting robust growth and greater resilience. India’s contribution to global growth is rising and currently stands at 18.5 per cent in 2023-24.

·         There are several positives in the near-term economic outlook. The resilience of the external sector has supported India’s overall macroeconomic stability. The merchandise trade deficit narrowed to US$ 238.3 billion in 2023-24 from US$ 264.9 billion in the previous year. Downside risks to this outlook stem from global slowdown and spillovers, geopolitical risks and their impact on supply conditions and commodity prices, slack in the rural economy and uncertainties related to weather conditions.

·         Corporate sector resilience has been bolstered by strengthening balance sheets and steady earnings. Increased capitalisation of profits has augmented equity of non-financial corporates (NFCs) and supported deleveraging. This is reflected in declining debt-to-equity and NFC debt-to-GDP ratios relative to AE and EME peers.

·         Fiscal consolidation, buoyant tax collections and improvement in the quality of spending have been the distinguishing features of the Union Government’s fiscal position. All major deficit indicators of the Union Government are projected to show further improvement. The GFD is pegged at 5.1 per cent of GDP in 2024-25 (BE), 46 basis points lower than in 2023-24.

·         Domestic financial conditions have generally eased since the December FSR, in line with the movements in system liquidity. This is reflected in the easing of money market rates and government securities yields. The weighted average call rate (WACR) generally remained within the policy corridor.

·         The sovereign yield curve has bull flattened (i.e., long-terms rates fell faster than short-term rates), supported by improving fiscal dynamics, anchoring of inflation expectations and positive sentiments in response to inclusion of Indian government securities in global bond indices29. As a result, the average term spread in the G-sec market (10-year minus 91-day Treasury Bills) narrowed to just 16 bps during January-May 2024 from 35 bps during July-December 2023.

Indian Equity markets

·         Supported by strong macroeconomic fundamentals, healthy corporate balance sheets, robust earnings outlook, stable financial conditions and sustained inflows into domestic mutual funds, the Indian equity market has been consistently outperforming its EME peers.

·         A standard discounted cash flow model suggests that the rise in the overall Nifty 50 index since March 2022 appears to have been driven mainly by improved earnings projections and to a lesser extent by investors’ risk appetite (declining equity risk premium). Extending the model to analyse the returns on midcap index shows that investors’ higher risk appetite is the major driver of returns when compared to improved earnings projections.

·         FPI inflows to Indian capital markets rose sharply during 2023-24. After being net sellers to the tune of US$ 5.5 billion (equity- US$ 5.1 billion, debt- US$ 0.4 billion) in 2022-23, foreign portfolio investors made second highest recorded net investments of US$ 41.0 billion in 2023-24 in equity (US$ 25.3 billion), debt (US$ 14.2 billion) and hybrid (US$ 1.5 billion) segments. FPI flows, however, turned negative with net outflows of US$ 3.9 billion in the current financial year so far (up to June 12, 2024). On the other hand, domestic investors remain bullish on Indian equities and provide support to the market even during periods of sharp FPI outflows.

Financial system stress in India

The financial system stress indicator (FSSI), indicated gradual easing of stress during H2:2023-24. The decline in stress indicators has been broad-based, except for the NBFC and money market segments. The decline in government debt market stress was the primary contributor to the improvement in the overall FSSI, aided by fall in long term yields as well as volatility and higher net foreign portfolio debt inflows.

The moot point is whether this time (unlike 2008-09) the Indian economy can successfully decouple from the stressed advanced economies and sustain the higher growth path even when the advanced economies and weaker emerging economies struggle to grow!

EW, notwithstanding

 EW, notwithstanding

My friend’s daughter who completed her MBA recently, has become an amateur trader, just like many of her peers. She has started self-learning technical analysis while trading in stocks, crypto, gold and currencies. During my visit to their place last weekend, she showed me the following 50 years charts of gold prices in USD and INR terms respectively. She wanted my views on the divergence in chart patterns and likely trends in the near future.

I am not well versed with technical analysis, particularly the Elliot Wave analysis. I am also not sure if she has drawn the wave cycles correctly on the charts. But assuming she has plotted the cycles correctly, prima facie, it appears that in USD terms gold price cycle is close to peak (wave 5 terminating) and is poised for a massive correction of 35-50%; whereas in INR terms the correction (wave 4) could be much lower and the subsequent peak (wave 5) much higher.

I imagined various scenarios and found only one plausible scenario, i.e., gold prices in USD term fall 50% in the next wave; INR depreciates 25% to Rs105/USD in the meantime; and the government of India hikes the duty on gold imports further by 10%. In this case, it is possible that gold prices in INR terms falls 25-30% to mark the wave 4.

I find this scenario frightening. A sharp depreciation in INR accompanied with 25-30% gold prices (which is widely presumed to be safe haven), could hurt several household investors who have aggressively invested in gold and foreign equities in the past year.

Regardless, I am not paying much attention to this analysis. In my view, it is more important to understand why the gold prices surged in 1979-1982; 2006-2010 and 2020-2024.

Between 1979 and 1982, interest rates more than doubled worldwide, dramatically raising the cost of loans. The U.S. dollar exchange rate improved, making the dollars needed to repay loans more expensive. Widespread recession dried up the markets for the exports of developing countries. Real prices for the export commodities that were essential to the developing economies fell to their lowest levels since the Great Depression.

One of the reasons for the widespread recession was sharp rise in crude oil prices during 1970s, that led to huge flows of US Dollars (World’s most preferred currency for trade) towards oil exporting Arab economies which were too small in size to absorb these dollars. These countries channelized these flows (popularly called petrodollars) to western banks which in turn lent it to the developing economies that had just started to industrialized. A stronger dollar made servicing these loans difficult, triggering a cycle of defaults, asset price crash and recession.

The story in 2006-2010 was similar. Unsustainable lending led to sharp rise in asset prices and inflation, followed by collapse of banking system, EM currencies, and commodity prices.

In recent years central banks and governments unleashed unprecedented monetary easing and fiscal support to mitigate the impact of Covid-19 pandemic. The monetary base of developed countries witnessed parabolic rise. Supply chain disruptions caused inflation to spike. Withdrawal of Covid-19 stimuli is now raising the specter of growth slowdown. Geopolitical realignments are threatening the supremacy of USD as world’s reserve currency triggering risk of USD weakening.

Now the question is, do we expect-

·         Interest rates to rise from here

·         USD to strengthen substantially from here, such that USD borrowers face material currency risk

·         Inflation to spike materially from current levels

·         Lending standards to deteriorate putting banking system at risk

·         US growth to materially outperform the emerging economies’ growth

·         World returning to gold standard in foreseeable future.

If not, then there is little empirical support for gold prices to rise materially from the current level; Elliot Wave projections notwithstanding.