Smart people learn from history or those who learn from history are smart

In recent weeks, a lot of market participants and commentators have expressed concern about the rising household (retail) investors’ interest in the SME segment of the Indian stock market. It has been highlighted that most of the businesses being listed on this platform may not be genuine and/or sustainable. The regulators have also expressed apprehensions about the widespread manipulation in the prices of several SME stocks. A 400x oversubscription to the recent Rs120mn IPO of a motorcycle dealership in Delhi has provided further impetus to the discussions on this topic.

There are demands that the criteria for listing on SME segments must be tightened and there should be deeper scrutiny of the companies proposing to list on this segment. The regulator, SEBI, is considering these demands and intends to prescribe stricter rules for the SME listings.

In this context it is pertinent to note the following points.

1.    As part of the broader capital market reforms, which included abolition of capital controls and establishment of an autonomous market regulator (SEBI), the Over-the-Counter Exchange of India (OTCEI) was established in 1990. OTCEI was modeled after the NASDAQ trading platform of the US and meant to provide small and medium sized enterprises (SME) a fully automated national platform for raising risk capital.

A number of SME promoters used this platform to raise money in the 1990s. However, the experiment was considered a failure as the listing process lacked adequate scrutiny and ingenious promoters were able to raise money at unsustainable valuations. A majority of the companies that raised money on OTCEI vanished, inflicting substantial losses to the investors.

2.    In the mid-1990s there were 29 recognized stock exchanges in India. The 28 regional stock exchanges (RSEs) helped the local companies to raise risk capital. All these RSEs had floor base trading and physical settlement of securities. A majority of investors in these local companies were also from the same state or region. For example, a company listed only on the Madras Stock Exchange was more likely to have investors from Tamil Nadu as its shareholders, because investors from other regions usually did not have access to the Madras Stock Exchange.

With the advent of the National Stock Exchange (NSE) as a computer based national trading platform, things started to change from 1995 onwards. In a couple of years the Bombay Stock Exchange (BSE) also transformed itself into a computer based national trading platform. Over the next decade and a half, all the RSEs faded into oblivion. Most relevant companies migrated from these RSEs to these two national stock exchanges. But many smaller local companies, listed only on these RSEs, also perished along with them. Not all of those companies were fraudulent. Many of them were just not big enough to qualify for trading on national stock exchanges. Investors in those companies also suffered for a long period; until they made offers to buy back their shares.

The point to ponder over is “did the market participants – regulators, stock exchanges, brokers, investment bankers, investors, etc., - learn any lesson from the OTCEI and RSEs episodes?” To me, prima facie, it appears that the same drama is being played all over again at SME platform; and only the unscrupulous promoters and intermediaries have learnt their lessons from the past failures, and become even more smart.

Opportunity or threat

Last weekend I received an innocuous looking post facto graph from a friend. The chart depicted how the Chinese companies have gained prominence during the first two decades of the twenty-first century. Evidently, these developments have already occurred and are there for everyone to see and feel. There is nothing about this that can be changed.

The graph depicts that the number of Chinese companies in the Fortune Global 500 list have grown from 10 in 2000 to 121 in 2020, a 12.1x rise in two decades. Three Chinese companies now figure in the list of top 10 global companies. The new 111 Chinese entrants in the coveted list mostly replaced the companies from the US (55) and Japan (54). Besides the US and Japan, companies from the major European economies (Britain, Germany and France) have also fallen in their global rankings.

The top 10 ranked global companies are an interesting mix. The list is topped by two retailers (Walmart, 1, USA; Amazon, 2, USA). Besides, it comprises – one utility (State Grid, 3, China); three petrochemical giants (Saudi Aramco, 4, Saudi Arab; Sinopec Group, 5, China; China National Petroleum, 6, China) one consumer electronics (Apple, 7, USA), two healthcare solution providers (UnitedHealth Group, 8, USA; CVS Health, 10, USA) and one investment company (Berkshire Hathway, 9, USA).

Insofar as India is concerned, only 9 companies figure in this list of top 500 global companies. Out of these nine, five are public sector enterprises (LIC, IOC, SBI, ONGC and BPCL) and four are private companies (RIL, Tata Motors, HDFC Bank and Rajesh Exports). RIL (ranked 86), is the top-ranked Indian company in the list of 500.

Since this data is published every year, and I have been observing this evolution of Chinese companies for more than a decade, prima facie I did not find anything exciting in this graph. On a second thought, however, a forceful inquisition perplexed me.

I wondered if the Indian economy has risen to find a place in the top five economies of the world, and is well on the course to enter into the top 3 club in the next few years, why not many Indian corporations have scaled up to the global scale!

I find it worth examining if it is a massive opportunity for the Indian investors or a potent threat.

It could be an opportunity, if we find that there are several Indian companies that are in a position to displace the legacy European and Japanese companies from their leadership position. These large sized companies could offer a material upside to the investors, as these transcend to become global corporations, exponentially growing their revenue and profitability.

It may also be a threat, if we find that the Indian companies are failing to match the global standards of innovation, scale, competitiveness and financial strength. In this case, many of the large companies might be at a risk of losing their respective domestic position as well to the global corporation, as the Indian economy is opened up further to sustain its global standing.

Funding crisis deepening for emerging economies

The latest report of the United Nation Conference on Trade and Development (UNCTAD) highlights that the funding deficit for the developing economies to meet Sustainable Development Goals (SDGs) is rising. As per the report, the gap is now about US$4trn, up from US$2.5trn in 2015 when the SDGs were adopted.

The amount of global foreign direct investment (FDI) has been on decline since peaking at US$2.05trn in 2015. In fact, a percentage of world GDP, FDI peaked at 4% of global GDP in the year 2000 and has been on decline since then. In the year 2023, global FDI fell to US$1.3trn or 1.27% of global GDP.

 

As per a recent Moody’s report, “Global foreign direct investment flows have shrunk in recent years. The COVID-19 pandemic, supply-chain chaos, surging inflation, and tighter funding conditions have taken a toll on global FDI. Investment flows are also being reshaped by economic fragmentation, trade and geopolitical tensions, industrial policies, and supply-chain diversification. But many of the ups and downs in FDI in recent years are due to tighter regulations to thwart the usage of tax havens. These have curbed the flow of investment through conduit economies, especially in Europe. While retreating inflation and easing monetary policy settings might offer some relief, economic fragmentation will hinder the smooth flow of FDI. Climate change will increasingly shape FDI flows in longer term.”

UNCTAD report emphasizes that “Tight financing conditions in 2023 led to a 26% downturn in international project finance, which is crucial for infrastructure investment in areas such as power and renewable energy. As a result, investment in sectors linked to the Sustainable Development Goals (SDGs) fell by more than 10%. The report highlights that agrifood systems and water and sanitation registered fewer internationally financed projects in 2023 than in 2015, when the goals were adopted.”

FDI in China and India shrinking, despite India’s manufacturing push

The Moody’s report highlights that “The drop in FDI flows to developing economies was largely because of shrinking investment in China and India. The world’s second-largest recipient of FDI, China, saw a downturn in 2023. Inflows turned negative in the third quarter as withdrawals and downsizing outpaced new investments. More recent data showed a fresh decline in the second quarter of 2024. FDI into India has also seen better days, falling in recent years despite the country’s push into manufacturing and notable investments from tech giants such as Apple Inc. On the bright side, FDI into Southeast Asia has held at a high level.”

Most renewable energy funds allocated to the developed economies

Although renewable energy investments have nearly tripled since the adoption of the Paris Agreement in 2015, most of the money has gone to developed countries. While developing countries need about $1.7 trillion each year in renewable energy investments – including for power grids, transmission lines and storage – they only attracted about $544 billion in 2022.

The report shows that more than 30 developing countries still haven’t registered a large international investment project in renewables.

And in most of the 10 developing countries with the highest levels of international investment in renewable energy, investment in renewables represents between one tenth and one third of total FDI.

OECD rules impacted FDI

Changes in taxes and regulatory requirements appear to have materially impacted the FDI flows – amount as well as direction. Moody’s report mentions that OECD members “have strengthened regulations to make it harder for companies to locate profits in zero-tax jurisdictions. Also, a revised corporate tax rule in the U.S. in 2018reduced the incentive for U.S. multinationals to reinvest earnings and hold intangible assets abroad, leading to a significant drop in outward FDI that year. These efforts, later bolstered by laws to establish a global minimum tax, have dampened FDI flows to and from low-tax jurisdictions in Europe.

This appears to be macro trend. Nonetheless, it may have implications for the investment portfolios of several investors, especially those investors who are overweight in capital intensive businesses relying on foreign capital for growth. If the decline in FDI flows sustains the current trend, we may see downward revision in growth projections and hence valuation multiples. It is therefore advisable to watch this trend closely over the next couple of years.

Mahadev must prepare to absorb venom, once again

One small cap solar PV module manufacturer stock has yielded a return of 100x in less than two years, since its IPO listing in October 2022. There are many other “clean energy” stocks which have witnessed 5x to 20x rise in their stock prices. In most of these cases, the improvement in business and financial fundamentals of the concerned company is not commensurate with the rise in the stock price.

Sustainability has emerged as one of the major investment themes in the post Covid-19 period. Businesses engaged in the activities related to renewable energy and electric mobility have received substantial massive investments and have seen massive rise in capacity building. Nonetheless, the astronomical rise in the stock prices of companies engaged in basic manufacturing like solar PV cells, EV battery modules, electric scooters, etc., may not be sustainable.

This reminds me of my favorite instance from the Hindu mythology. I have narrated this instance many times before. Let me do it again.

“Once the forces of good (gods) and evil (demons) had a protracted battle. The battle lasted so long that both the groups exhausted all their resources and valor. Completely tired, wounded, frustrated and exhausted, they approached the Savior, Lord Vishnu. The Savior advised them to go and explore the great ocean (Sagar Manthan) to find new resources and vigor to make a fresh beginning.

Following the advice, both the groups went to the great ocean and explored it extensively. During their exploration they discovered a huge amount of wealth and resources that included the Amruta (nectar of the gods) that would immortalize its consumer and Vish (venom) that would destroy whoever consumes it.

Realizing that if demons get the access to Amruta and other resources found during the exploration, it would seriously jeopardize the interest of gods, Lord Vishnu tricked demons and appropriated the entire nectar for consumption of gods.

Lord Vishnu also requested Mahadev, Lord Shiva, to absorb the venom so that it does not harm anyone and the balance of the universe is maintained. Obliging, Lord Shiva drank the entire venom and preserved it in his throat.

Post this, gods became more powerful. But whenever they deviated from the path of common good, they were overpowered by demons and dethroned. Each time only after a great deal of repentance they would be rehabilitated with the help of Lord Vishnu, Lord Shiva or the Mother Supreme.

Over the years I have realized that it is not just a mythological story, emphasizing the victory of good over evil, to be heard during religious ceremonies and forgotten immediately thereafter. It is much more. This applies to all aspects of life, even economics.

The ocean exploration mission (Sagar Manthan) is basically a collaborative research effort to find solution to a problem that afflicts all alike, e.g., a prolonged war like World War, a pandemic like plague, smallpox, HIV AIDS or COVID-19, or a major economic crisis like great depression. The experts collaborate to find solutions like vaccines, hygiene products, UNO, Nuclear deterrents, globalized markets, etc. to mitigate the losses and prevent recurrence of such problems.

In modern economic parlance, ocean exploration is akin to the period of recessions followed by irrational exuberance, fiscal and monetary profligacy, and household extravagance.

When all the participants get tired, frustrated and exhausted from a significant economic weakness, collaborative efforts are needed to stimulate the economic activity. At this time all the stakeholders muster courage, and supported by the 'authority', they do things they would not do in normal times. Invariably, this effort involves excessive and seemingly irrational borrowing, investing and spending. Capacities are built to the scale which are unfathomable during normal times. Usually this drives the asset prices to levels that cannot be explained or justified by conventional methods. These unexplained phenomena are generally described as “bubble” in market parlance. The nectar or the good that emerges from these bubbles is shared by all. However, the venom is consumed only by the financial investors who invariably end up poorer after these bubbles burst.

The financial assets' prices correct upon bursting of bubbles but the productive capacities built during the bubble phase stay for long, supporting and promoting growth and development.

If you are not able to correlate to what I am saying - imagine would India be a ITeS superpower without Y2K or technology bubble during late 1990s! Had we built so many houses, roads, malls, power plants, cement plants etc. during the decade of 2000s but for a subprime credit bubble! Would capital be so easily and cheaply available to Indian entrepreneurs without a QE bubble in the west! The capacities built during these bubbles shall continue to support India's growth and development for long, even though the financial investors lost significant fortunes during 2001-02 and 2008-09 burst periods. Most of the entrepreneurs who built large capacities (power plants, roads, ports, airports, mines, steel plants, housing, etc.) ended up bankrupt or financially weaker, but the capacities they created are benefiting the society.

The global shut down due to Covid-19 in 2020 necessitated the latest round of Sagar Manthan (Ocean Exploration). Sustainability became the key theme of development, attracting massive investment, disregarding the sustainability of the investment itself. A bubble-like situation is developing in the sector.

Like the earlier instances, the renewable energy and electric mobility capacities built in this decade will benefit society for long. However, the financial investors who are investing in the companies building these capacities at valuations driven mostly by ‘hope’ and ‘euphoria’ might suffer for long. Mahadev of economy (financial investors) must prepare to absorb vemon, once again.

Waiting for a divine intervention

Last weekend I visited some villages in the Bareilly, Shahjehanpur and Hathras districts of Uttar Pradesh. I had an opportunity to speak with several medium, small and marginal farmers.

Most medium sized farmers had a good standing crop of paddy and sugarcane. Most of them were, however, circumspect about the final yield, in view of the IMD’s forecast of excess rains in September.

Many small and marginal farmers had lost their pulses and vegetable crops due to heavy rains accompanied by strong winds. They were dismayed and worried about their ability to manage the resources to plant Rabi crops, mostly potato and wheat.

Some of them, who had taken advance from the traders, were also worried about the repayment. None of the small and marginal farmers mentioned the terms like crop insurance, bank loan, Kisan credit card, etc. Thankfully, there is an abundance of fodder for their cattle this time.

After a discussion of 10-12hrs with these farmers, NGO workers helping them with farming & other issues, and village leaders I gathered that the inflation debates in Delhi (in the Parliament & outside) and Mumbai (at the RBI and brokerage offices) may not be relevant for these farmers and common men like me, because—

·            Policymakers and analysts may be oversimplifying a very complex problem. Food inflation in India maybe influenced by a myriad of factors, e.g., (i) farm input prices, which are also affected by terms of trade, INR exchange rates, availability of subsidy, etc,; (ii) energy inflation as many farmers use electric or diesel pumps to water their farms, and motor vehicles to transport their produce to markets; (iii) farm labor wages, which in turn is also a function of multiple factors like food and energy inflation, availability of MNREGA wages, & other government cash payouts, demand from construction sector, etc.; (iv) weather condition affecting the volume of production; (v) productivity, which depends on the quality of soil and inputs, farming methods used and availability of equipment; (vi) cost of funds borrowed by the farmers, which also depends on access to institutional finance; and (vii) distance from the market, etc.

Bringing down food prices or slowing down food inflation may adversely impact about 60% of the Indian population that depends (directly or indirectly) on agriculture for their livelihood. The solution may therefore lie in enhancing productivity, market access, access to institutional finance, energy efficiency & renewable energy, land reforms and crop rationalization. Someone may argue that all this is already being done. True, there are government programs and policies for all these solutions but execution is seriously lacking.

·            Presently, the primary problem for a majority of the Indian household could be “price affordability” rather than “price inflation”. They may need either a substantial rise in their real wages or a material deflation in the prices of their consumption basket to maintain their regular lifestyle.

·            Statistical inflation being debated and analyzed by the policymakers and analysts may be entirely different from what a common household or investor faces (more on this later).

Reading minutes of the MPC’s previous few meetings, it appears that the policymakers might be waiting for a divine intervention to change their policy stance, as hardly any effective step has been taken by them to make life of people easier.

State of the unorganized sector in India

Last month, the National Sample Survey Office (NSSO) released the results of its annual survey of unincorporated sector enterprises (ASUSE). The survey was conducted during October 2022 to September 2023.

ASUSE is conducted to measure various economic and operational characteristics of unincorporated non-agriculture establishments in manufacturing, trade and other service sectors (excluding construction).

The key highlights of the survey are as follows:

Demographics

·         There are 65 million establishments belonging to unincorporated ‘manufacturing’, ‘trade’ and ‘other services sector’ in India. Out of these estimated 65mn establishments, about 55% (35.6mn) are in rural areas and about 45% (29.4mn) in urban areas. 85% (5.53cr) of these units are Own Account Establishments (OAE means no hired worker) and the remaining 15% are Hired Worker Establishments (HWE).

·         Uttar Pradesh (13.82%), West Bengal (12.03%) and Maharashtra (9.37%) have the most number of unincorporated non-agricultural establishments.

·         Maximum number of HWEs has been observed in Maharashtra (13.29%). At the same time, Uttar Pradesh comprising 14.46% of the total OAEs, becomes the State to comprise most of the OAEs of the country.

·         Telangana (43.32%), West Bengal (32.74%), and Karnataka (31.42%) are three states where more than 30% of the proprietary establishments have been run by women entrepreneurs.

·         Most of the owners of proprietary and partnership concerns belong to Other Backward Classes (OBC) (51.9%), followed by Others (30%), Scheduled Caste (SC) (13.2%) and Scheduled Tribe (ST) (4.4%) at all-India level.

Activities

·         Of these 65mn establishments 27.4% are ‘manufacturing’ units; 34.7% are engaged in ‘trade’ and 37.9% render ‘other services’.

·         ‘Other retail trade’ and ‘Manufacture of wearing apparel’ are the top two activity categories in rural areas and rural and urban combined basis also. In urban areas, ‘Other retail trade’ and ‘Other community, social and personal service activities’ reported the maximum number of establishments in the urban sector.

·         Only 3.7% of the total establishments had participation of SHGs, through financial intermediation.

Operations

·         Overall, about 41% of the total unincorporated non-agricultural establishments operate within household premises About 83.7% of HWEs are located on a permanent structure outside household premises; whereas operations of majority (about 46%) of the OAEs are home-based.

·         Only 6.4% of the total establishments reported to have maintained audited books of accounts.

Use of technology

·         23.6% of HWEs and 3% of the OAEs have used computers for business purposes during the survey period.

·         47.7% of HWEs and 16.4% of the OAEs have used the internet for entrepreneurial purposes during the reference period. Use of the internet, for entrepreneurial purposes, has increased to 13.5% from 7.7% in rural and to 30.2% from 21.6% in urban sector during ASUSE 2022-23 as compared to ASUSE 2021-22.

Employment

·         Unincorporated non-agricultural economy employed about 110mn workers during the survey period. in comparison to about 98mn workers during the previous survey, an increase of about 12mn.

·         Out of the total estimated workers, 52% (57.2mn) were from urban areas; whereas 48% (52.4mn) were in rural areas.

·         ‘Other Services’ contributed the maximum share (36.45%) to the total employment followed by ‘trading’ (35.61%) and ‘manufacturing’ (27.94%). ‘Other retail trade’ singly generated about one-third share of total employment at rural, urban and also at all-India level.

·         Overall, 25.63% of the total workers of the unincorporated nonagricultural sector, during the survey period were female.

Economic contribution

·         During the survey period GVA per establishment was Rs2.38lacs, up from Rs 2.25lacs in previous period.

·         GVA per establishment for HWEs (Rs. 8,84,310) was much higher as compared to OAEs (Rs. 1,27,073).

·         Delhi (Rs. 3,72,569) in rural, Chhattisgarh (Rs. 5,09,712) in urban and Delhi (Rs. 4,50,728) for overall (i.e., combined rural and urban) produced the maximum annual GVA per establishment.

·         Average annual emoluments paid to a hired worker was Rs.1.25lacs during the survey period.

·         During the survey period, average fixed assets owned by unincorporated nonagricultural entrepreneurs was Rs. 3.18lacs (vs Rs. 2.81lacs in previous period).

·         Outstanding loans per establishment, on average, were Rs. 50,138 at all-India level.

Employment- Gender gap and skill mismatch remain alarming

The latest Periodic Labor Force Survey (PLFS), released on 16 August 2024 by the National Statistical office (NSO), provides some useful insights into the current employment conditions in the country. The following are some of the key observations from the Survey report.

The Good

·         The employment conditions have improved during 1QFY25. The WPR-U improved for all ages and both genders. The Youth WPR-U improved from 39.3% (1QFY24) to 40.8% (1QFY25). For all workers, WPR-U improved 38.4% to 39.3% during this period.

·         The LFPR-U male workers improved from 57.2% in (1QFY24) to 58.9% in (1QFY25) for youth (15-29yrs) and from 73.5% to 74.7% for all workers above 15yrs of age.

·         Self-employed female workers increased in urban areas from 39.2% to 40% while the number of self-employed male workers in urban areas increased from 39.5% to 40%.

·         Unemployment rate in urban areas has reduced marginally from 6.7% (1QFY24) to 6.6% (1QFY25).

The Bad

·         The percentage of regular wage/salaried employees fell marginally from 49.2% in 1QFY24 to 49% in 1QFY25. There was a corresponding increase in the own account and self-employed workers.

·         The employment in the secondary sector (manufacturing, mining etc.) was lower in 1QFY25. More people were employed in the tertiary sector. Worker employed in the secondary sector reduced from 33.1% in 1QFY24 to 32.1% in 1QFY25.

·         The employment for female workers in “household enterprise helper” category also witnessed decline. Female employed in this sector reduced from 11.9% in 1QFY24 to 11.4% in 1QFY25.

·         The proportion of female workers declined both in agriculture and secondary sectors.

The Ugly

·         LFPR-U for female workers remains very low at 18.2% (1QFY25) vs 54.7% for males; even though it has shown improvement from 16.8% in vs 54.1% in 1QFY24. Even for Young females (15-29yr age) it remains materially lower at 16.4% (vs 50.2% for males).

·         Youth (15-29yr) unemployment in urban areas remains very high at 16.8% (23% for young females); even though it came down from 17.6% a year ago.

·         J&K (29.8%), Odisha (28%), Rajsathan (25.5%) and Assam (23.9%) had the worst youth unemployment in the country in 1QFY25. For young female workers unemployment Himachal (41.6%), Kerala (41.9%), Jharkhand (40.6%) and J&K (52.7%) were the worst state.

Conclusion

The huge gender gap in the labor force continues to be a cause of serious concern. Female workers, especially young (15-29yr) females, are getting much fewer employment opportunities. The gender gap in the workforce is persisting at alarming levels and does not augur well for the acceleration in the growth rate. If we juxtapose this data with the education statistics, we find the bridging of the education gap between male and female population has not resulted in equal opportunity for females in employment.

Another cause of concern is that the unemployment remains materially higher amongst the young workers (16.8%) as compared to overall unemployment level in urban areas (6.6%). The reason could be multifold like unemployability (skill mismatch and/or sub-standard education), reducing employment intensity of GDP, and poor employment growth in manufacturing sector. Nonetheless, it substantially diminishes the demographic dividend for the Indian economy.

Persistently, high ratio of self-employed and casual labor (over 40%), inter alia, indicates (i) lower employment elasticity in the organized sector and (ii) skill mismatch.

Staying put for now

The US Federal Reserve (Fed) Chairman Jerome Powell has provided the much-anticipated fuel to the US markets, which appeared running out of fuel after a shocking job revision. Speaking at the annual Jackson Hole symposium, he unambiguously hinted that “The time has come for policy to adjust” as “inflation has declined significantly. The labor market is no longer overheated, and conditions are now less tight than those that prevailed before the pandemic”. Though he qualified his remarks by adding, “the timing and pace of rate cuts will depend on incoming data, the evolving outlook and the balance of risks”.

These comments read with the minutes of the last meeting of the Federal Open Market Committee (FOMC) provide adequate ground to believe that—

(i)      The current rate cycle has peaked out; and the next policy move will be a rate cut.

(ii)     The policymakers are confident the spike in inflation that occurred in the aftermath of Covid-19 pandemic (massive cash stimulus fueling demand and logistic challenges causing break in global supply chains) has been successfully tamed.

(iii)   The economy is no longer overheated as the pandemic stimuli have been gradually withdrawn, the job market has cooled down, and commodity prices are behaving normally.

Though Mr. Powell did not make it clear that the FOMC will cut rate in the next meeting scheduled to be held on 17-18^h September 2024; the market consensus is assuming it to be a certainty. The debate is now circling around how aggressive the Fed could be in their pursuit of policy easing. Though, Mr. Powell emphasized that the rate cut will be data driven, a majority of market participants are expecting a 25bps cut each on 18^th September, 7^th November and 18 December. Some aggressive estimates are building 50bps cut each in September and December.

I am not competent to comment on the dynamics of the US monetary policy and its implications for the global economy and markets. My concern at this time is limited to how does the likely change in the Fed’s policy stance affects my tine portfolio of investments, if at all.

In this context I note that—

·            In its last meeting, the Monetary Policy Committee of the RBI retained its policy stance of withdrawal of accommodation and maintained the status quo on policy rates by a four to two majority vote.

One of the dissenting members, emphasized that “Global uncertainties continue. The Fed, in indicating a cut in its September meeting, pointed out that since monetary policy acts with a lag they can't afford to wait until they reach their inflation target before cutting. That lag may be responsible for the sharply adverse August jobs report that has stoked recession fears and created market volatility. That a series of small signals were ignored, may have led to a critical large one. Monetary policy needs to act well in time. Spillovers led the global manufacturing PMI into contraction zone in July at 49.7.” (See here)

The other dissenting member was even forceful in his dissent, stressing, “For the last several meetings, I have been expressing concerns about the unacceptable growth sacrifice induced by a monetary policy that is excessively restrictive. The majority of the MPC however do not share this concern, perhaps because they think that the Indian economy is already growing at close to its potential growth rate. I think that such a view reflects (a) an unwarranted pessimism about the growth potential of the economy and (b) an overly sanguine expectation about growth in ensuing quarters. I disagree with both prongs of this assessment.” (See here)

This clearly highlights that despite being warned of the perils of running behind the curve and impairing the growth potential, the MPC decided to retain its stance. Maybe the RBI is not as sanguine about the price stability and growth potential as some of the members of the MPC.

·            The fourteen-month gap (July 2023 to September 2024) between the Fed pause and the first cut would be the second longest in the past five decades. The markets have been anticipating a Fed rate cut for almost a year now.

In this period, the stock markets, both the US and the Indian, have not witnessed any meaningful correction and are already at an all time high level. The question is whether the anticipated rate cut would provide immediate impetus to the markets; or the markets will be worried about further deterioration in economic growth.

It is pertinent to note that empirical evidence suggests that in the past three rate cycles, the US market has fallen 12 to 50% during the Fed rate cuts.

·         The governments in the US and India are not in a position to back up the monetary policy easing with fiscal stimuli.

Under the circumstances, for now I am more inclined to assume that:

·         It is not certain that the RBI will immediately follow the US Fed in cutting rates, unless strong evidence of growth collapsing emerges. Rise in the yield differential may attract stronger flows and support USDINR and markets.

·         A weaker USD may support commodity prices

·         A panic cut by RBI on the other hand may adversely affect the margins of banks (loans get repriced immediately while deposits take longer; CD ratio faces further pressure); and also affect the overall sentiments.

·         The earnings momentum appears to have slowed down in 1QFY25. A sharp cut by RBI might arrest the slowdown in earnings momentum; and also help higher equity valuations to sustain.

·         Negative real rates may adversely affect savers (consumption) and support capex.

I will review my portfolio in accordance with these assumptions in the next review. For now, I am just staying put.

1QFY25 – Earnings held no surprise, optimism moderating

The latest earnings season (1QFY25) is almost over. the ~4% yoy growth in NSE500 profit after tax (PAT) has marginally exceeded the modest expectations of a 3% yoy growth. NSE500 revenue grew ~6% yoy. This is the slowest pace of growth since the covid affected 1QFY21. The refiners and oil marketing companies materially dragged the overall performance. Sequentially, the earnings growth slipped sharply from 4QFY24.

Negative surprises outweigh, smallcap earnings failed the optimism

As per the brokerage Emkay’s report, “the ratio of negative surprises jumped sharply, from 46% to 62% for Emkay coverage and 56% to 66% for the Nifty.” The brokerage however added that “The aggregate numbers were skewed owing to the Energy sector’s 30% YoY PAT drop on a high base. EBITDA margins fell by 20bps YoY to 15.1%, mostly due to a 388bp contraction for the Energy sector – most other sectors delivered strong margins.”

Post the earnings, the consensus Nifty50 EPS witnessed a cut of 1.7% FY25 and 1% for FY26. This is the first earnings cut (though marginal) in almost a year. The Emkay report however emphasized that “The earnings revision trend for small-cap stocks was particularly weak, with zero upgrades of >5%.

 

Lowest PAT, EBIDTA growth in four years

A report by the brokerage house Motilal Oswal’s (MOFSL) highlighted that “Nifty reported the first quarter of a single digit EBITDA growth (5%) in four years, (last time Nifty posted single digit EBITDA growth in Sep’20). Also, 4% PAT growth is the lowest since the Pandemic quarter (June’20).”

MOFSL report further emphasized that “For the MOFSL Universe, the earnings upgrade-to-downgrade ratio has turned weaker for FY25E as 46 companies’ earnings have been upgraded by >3%, while 107 companies’ earnings have been downgraded by >3%. The earnings upgrade/downgrade ratio of 0.4x was the worst since 1QFY21. EBITDA margin of the MOFSL Universe (ex-Financials) contracted 120bp YoY to 16.3%.

 

Fading tailwinds

As per nuvama’s report, “In Q1FY25, BSE500 (ex-OMC) top line and PAT each grew 8–10% unlike FY24, when PAT growth (21%) far outpaced top-line growth (8%). This is owing to fading tailwinds from lower input prices and BFSI credit costs while demand remained weak.”

“Q1FY25 top line remained soft at 8%—sub-10% for a fifth straight quarter. The weakness was led by cyclicals (industrials, and autos)—the leaders of FY24—while consumption, exporters and commodities stabilized at low levels.”

NII weakness percolates down to banks’ bottom line

As per a report by ICICI Securities, credit growth was softer than usual Q1 seasonality due to additional headwinds from muted deposits growth, elevated LDR and deceleration in unsecured personal loans and NBFC segments.

“NII weakness percolated down to the bottom-line with PAT growth of ~8% YoY. On a QoQ-basis, private banks saw NII growth of ~2.5% QoQ while operating earnings were flat and PAT declined 5% QoQ.”

·         Credit growth moderated to ~1.5% QoQ in Q1FY25.

·         Deposits growth slowed down to <1% QoQ). Deposit growth for private banks was healthy at ~17% YoY, but drag from PSU banks (up <10% YoY) slowed systemic deposits growth to ~13% YoY in Q1FY25.

·         CASA growth remains challenging (in single digit YoY) while term deposits continued to do the heavy lifting.

·         Rise in cost of deposits was calibrated, though rate hikes by SBI/HDFCB in Q1 and persistently soft deposits growth suggest risk on the upside.

·         NIM decline was contained partly due to a strong rise in yields on investment. Moderating loan growth and pressure on NIM resulted in slower NII growth. Adj. NII growth for private banks moderated to ~14% YoY (vs. ~16% YoY loan growth).

Management commentary positive

As per the Antique Stock Broking, Overall management commentary has been positive, key takeaways are: a) IT companies believe that lower inflation and interest rate could lead to improvement in the US macro environment; b) Consumer companies are seeing signs of rural recovery which may further accentuate with the above normal monsoon; c) Domestic private capex is seeing traction, particularly in the real estate; (d) Banks have tightened credit filters for unsecured lending. HDFC Bank highlighted that it will grow slower on advances as against deposits in order to bring down loan to deposit ratio.”

Investors should cut the noise and stay focused on earnings

In my view, 2QFY25 and 3QFY25 are critical for investors, especially for household (retail) investors who are predominately invested in smallcap, midcap and narrative (defense, railway, clean energy, China+1, etc.) stocks. If the earnings momentum fails to match their optimism; or headwinds develop in terms of slower global growth momentum and negative flows; these stocks could face sharper correction in 2025.

It is therefore desirable for them to stay focused on earnings and growth momentum rather than bothering about big picture things like geopolitics, the US fed monetary policy; yen carry trade etc.

A family affair

I have received several responses to my post regarding investment in the public sector enterprises (see here).

A majority of respondents do not agree with my hypothesis. Their argument is that any business venture cannot be sustainable if it is not run for profit. For decades, PSEs have incurred losses and have been supported with public money. In the past one decade the policy towards PSEs has witnessed a paradigm shift. The focus has shifted to make PSEs profitable rather than privatize them. It is in the public interest that PSEs make good money and pay dividends and capital gains (on sale of minority interests) to the government, which can be used to finance public services. A majority therefore believes that strong profitability of PSEs is in the interest of the economy in particular, and the broader nation interest in general.

Some agree with my hypothesis that presently the government does not have the constitutional mandate to indulge in “for profit” businesses. They agree that if the government wants PSEs to be run “for profit”, these should better be privatized. The money realized from their sale may be utilized to reduce public debt; build infrastructure; support development of new technologies for futuristic businesses; and most importantly fund agriculture initiatives for enhancing productivity and reforming crop mix.

A few have expressed alternative views. One respondent suggested that profitability of public institutions like IRCTC, CDSL, SEBI, NSE, etc. (which have been essentially created using public money and at public risk) is akin to unduly taxing the common people for availing public services. It is like state electricity boards and municipalities earning profits from supply of electricity, water and other civil services. This is unacceptable, even if the constitutional mandate of pursuing socialist policies is ignored.

I respect all three views. But, I would still maintain that (i) the Government of India has no business to be in business; (ii) the constitutional mandate of socialism prohibits the government from operating “for profit” businesses; and (iii) the objective of PSEs is public service not profiteering.

I may change my view, if the constitutional mandate is changed; these businesses are run on a level playing field with the private enterprise; minority shareholders get the same rights as they have in the private enterprise; and politicians are prohibited from enjoying free perquisites from these enterprises at the expense of the public.

The debate with the readers reminds me of an old bedtime story my grandfather used to narrate.

In a village, there lived a widow with her two sons. Both the sons were lazy and hated studying or working. Once when the annual village fair was going on, the mother prepared some sweets and told her sons to go and sell those sweets in the fair and earn some money. She also gave one rupee each to both the boys for buying food for themselves. Both the sons reluctantly went to the fair, found a shaded place under a big tree and dozed off only to wake up at lunch time. Feeling hungry, the younger boy bought sweets from his elder brother and gave him one rupee the mother had given him. In return, the elder brother bought sweets worth two rupee from the younger one. In one hour, they had sold all their sweets, had satiated their hunger and had also saved the two rupees their mother had given them. Happy and satisfied, they returned home by late afternoon. Of course, to the dismay of their mother.

Relating this story to the present market narrative, I get this.

A public sector company makes ammunition for the Indian defense forces. The Government of India funds the entire budget of the defense forces. Indirectly, the people of India pay for the entire sale of this public company, which is quintessentially owned by them.

Now imagine,

·         The public sector fertilizers companies make profits from selling fertilizer to farmers at profit, who cannot repay their debt and default on loans from public sector banks.

·         A public sector heavy engineering company selling turbines to another public sector company generating electricity and supplying to state electricity boards at profit. The state electricity boards sell this electricity to the public at a loss, which are funded by the government and public financial institutions, run by the taxes paid by the public.

·         A public sector company mining coal and selling to public sector electricity and steel producers at profit. The public, which buys the electricity and steel produced by using this steel is expected to pay for this profit.

Ain’t this the family affair, brothers selling sweets to each other, with zero net output.