What is ailing Indian markets? - 3

In the past couple of days, some readers have uncharitably criticized me for being excessively paranoid; and some others have even accused me of fear mongering. It has been pointed out that I was writing the same stuff in the spring of 2022, while markets did much better in the subsequent two and a half years.

Though I need not respond to every criticism, I would take this opportunity to reiterate my view that the economic conditions in India started to worsen from FY23. Now it is reflecting conspicuously in data. The cyclical improvement in corporate earnings post Covid stimulus and unexpected onslaught of ‘revenge consumption’, was erroneously assumed to be a structural and durable earnings cycle. These erroneous assumptions have actually resulted in a valuation bubble; bursting of which shall cause more pain than timely realization of error and course correction would have.

Remember, over a longer period, stock prices do always converge with the economic realities. However, in the interim phase, stock prices may diverge and stay elevated for a much longer period than a rational mind would assume. But as Friedrich Nietzsche famously said, “The irrationality of a thing is no argument against its existence, rather a condition of it.”

Three consecutive years of superlative returns from the stock market does, in no way, change the fact that Nifty 50 has yielded a return of ~10% CAGR over the past 10 years and ~12% CAGR over the past twenty years. This return is the same or marginally lower than the growth in nominal GDP of India during these periods. In the past five decades, in no period of consecutive 10 years, stock market returns have exceeded the nominal GDP growth by 10%. Excess returns, if any, made in a period of 1-3 years, invariably get normalized over the next couple of years.

The question that everyone needs to honestly answer is “whether you bought stocks, or invest in a business?”

·         If you bought a stock, you were purely speculating about the likely demand and supply dynamics of the market over a near time horizon. You were not bothered about things like the economy and business then; and you should not be bothered about such things now. Stay true to your thesis and respect your risk appetite.

·         If you invested in a business; carefully assessing the intrinsic value and the future growth prospects of such a business, you should be focusing on the business and let the stock price converge to the business fundamentals in the due course. You should exit if your assumptions fail.

If you try to jump between these two boats midstream, you are certain to drown, regardless of your swimming skills.

How much more downside is left?

Under the current circumstances, it is common to hear, “This stock is down 50% from its recent highs. How much more could it fall?” I do not have any straight answer to this question. Actually, I believe that no valid answer exists for this question.

For example, at the close of the market on 12th February 2025 we could say that if the market sustains 22835 for two days and manages to close above 23110, we could see it going again to 23800 level. Else, it would fall to 22425 and then to 22070 level. However, if 4QFY25 results disappoint or February sales figures for auto and cement continue to remain sluggish we may see earnings downgrade and potential market de-rating as macro indicators are likely to remain weak.

If this does not make sense to you, well it actually does not.

The potential downside in a falling market and upside in a rising market are always daily rolling targets. Technical targets are usually conditional (e.g., “if market falls below this level, it could go to that level else…) and generally do not account for exceptional moves. Price targets based on fundamental valuation and historical discounting trends are dependent on materialization of a multitude of complex forecasts regarding likely revenue, profitability, cash flows, capex, project execution, policy environment etc.

As of this morning, the market price of 360/500 constituents of the NSE500 index is down 25% to 75% from recent high levels; the rest 140/500 are down 3% to 25%. If you ask me “how much more these stocks could fall?” I would say, “I do not know”.

Nonetheless, I may highlight, in the 2011-2013 period about 150 NSE500 stocks fell more than 95% from their recent high levels, and most of them could not recover their loss even after ten years. These were the stocks which fell 80% or more after first falling 75% from their recent high levels (from Rs.100 to Rs.25 and then to Rs5). I can just say that there is nothing to suggest that this could not happen again.

 

What is ailing Indian markets? - 2

Little did Edward A. Murphy, Jr., an American aerospace engineer, realize that one of his design advice would become one of most popular epigrams and be termed Murphy’s Law. In the late 1940s, Murphys told his team that “If there are two or more ways to do something and one of those results in a catastrophe, then someone will do it that way.” This advice was later restated by Arthur Bloch in his book Murphy's Law, and Other Reasons Why Things Go WRONG as “Anything that can go wrong, will go wrong.”

In 1997 Sebastian Junger wrote a creative account of the 1991 ill-fated fishing expedition of the boat Andrea Gail from Massachusetts. The boat was caught in a severe sea storm and all the six crew members were reported dead. The book, titled “The Perfect Storm”, was later adapted into a movie with the same title. ‘The Perfect Storm’ is one of the perfect examples of Murphy's law applying in real life situations.

As of this morning, the Indian equity markets appear heading into a perfect storm. Anything that can go wrong appears to be going wrong. Let’s pray Murphy fails this time.

Economy stuck in slow lane

The broader economic growth momentum has stalled, completely negating the impact of the massive Covid stimulus. After a couple of years of denial, most agencies are gradually acknowledging that the real GDP growth might be settling in the 6%-6.5% band. As the latest Union Budget depicts, the fiscal leverage to stimulate growth has now mostly dissipated.

It is worth noting that FY26BE fiscal deficit of 4.4% may appear encouraging in recent context, but is far higher than pre Covid FRBMA mid-term target. Besides, as per FY26BE interest payments are projected to be 37.2% of total revenue receipts (vs ~23% in FY18RE). Obviously, the present debt and deficit levels are not sustainable.

For record, FY19BE projected fiscal deficit at 3.3%; to be cut to 3% of GDP by FY21. If the government aims to achieve this target by FY29, there would be hardly any fiscal leverage available to the government for increasing expenditure.

The central government capex, as percentage of GDP, may have already peaked around 3% of GDP. Even taking into account the state level capex, the total public capex is now stuck at 4%-4.5% of GDP, with significant risk of slippages due to resource constraints and execution failure.

The scope for increasing government consumption (revenue expenditure) is limited and would depend entirely on the tax buoyancy. The finance minister has assumed an income tax buoyancy of 1.4 in her estimates for FY26BE. This implies the government expects 1.4% rise in personal income tax revenue for every 1% rise in GDP. Even the STT collections, which are entirely a function of stock market trading volumes & MF flows, are assumed to be growing 41.8% in FY26.

Even with these aggressive tax revenue assumptions, government revenue expenditure (ex-interest) is expected to settle around 5% of GDP, much lower than ~7.5% seen during pre-Covid years.

Aggressive tax buoyancy assumptions, despite exempting personal income upto Rs12 lacs from income tax, indicate continued pressure on the upper middle-class segment consumption. This is the segment which has provided material boost to consumption growth, especially in the premium segments like SUVs, premium liquor, travel & tourism, clothing etc.

Despite all the efforts and incentives, private capex for new capacity addition has not picked up. Most private capex in the past five year has been in technology (improving productivity), real estate accumulation, brown field expansions, and consolidation through merger and acquisitions. There have been only a handful of greenfield manufacturing projects. Consequently, the share of manufacturing in GDP has not improved (in fact declined marginally). With sub-optimal consumption demand, positive real rates, and global headwinds on exports, the visibility of any material pick-up in the private capex remains low.

Thus, all the macro drivers of growth (consumption, investments, exports) are facing headwinds. At this point in time, it appears unlikely that in the next 4-5 quarters we shall witness any substantial improvements in most of the growth drivers. However, if the Mother Nature gets angry (a hotter winter, just like the warmer winter this time); or the ongoing global trade war triggered by President Trump gets uglier, the things could worsen further and we may witness growth trajectory collapsing further to pre Covid trajectory of 5-5.5%.

Corporate earnings fatigued

After compounding at a rate of ~18% over five years (FY20-FY24), the corporate earnings appear fatigued. Nifty50 FY25E earnings are expected to grow at a meager 2%-3%. As per the current consensus estimates, FY26E Nifty 50 EPS may grow ~12-13% yoy. However, given the macro headwinds, INR weakness, tariff headwinds for exports, persisting slowness in consumption demand, indicate some downside risk to the current consensus estimates.

The earnings growth in the recent past particularly led by banking, commodities (metal & energy) and capital goods & construction sectors.

Recent performance of the banks indicates that the growth drivers are now tired. Asset quality has peaked for most banks. Any further slowdown in the economy may actually trigger a reversal. Some segments like microfinance, unsecured personal loans and gold loans etc. are reportedly already showing considerable deterioration. Beginning of rate cut cycle with emphasis on immediate transmission, indicates that net interest margins may also be closer to peak and might begin to stagnate or moderate from current levels. Rising stress on household balance sheets, slowing demand for automobile and other consumer discretionary items, and slower private capex growth may keep the credit growth under check. Any substantial improvement in earnings growth for the financial sector in the near term is unlikely.

The demand growth for building material, steel, and other metals has moderated in FY25. The management commentary indicates only moderate improvement in FY26 with continuing margin pressures, given low-capacity utilization and lack of pricing power. Durable tariff by the US, might result in EU and Chinese dumping in countries like India, further pressurizing the domestic prices.

Several mega infrastructure projects like expressway, airports, freight corridors etc. are nearing completion. The pipeline of large infrastructure projects is diminishing in size; and the focus is on completion of the stuck projects. The visibility of large contracts for construction companies, except in the power sector, is poor in FY26 at least.

It is important to note that a large part of stock price rise in the past four years has occurred due to PER re-rating in anticipation of strong earnings momentum. Lack of sustained earnings momentum might result in some PE derating also; while there is no case for a further PER rerating.

Overall, any material upgrade in earnings estimates and PER rerating looks unlikely. However, there is a decent probability of earnings slowdown and PER derating persisting through FY26.

Technical indicators pointing to further downside

With a material erosion in stock prices over the course of the past six months, the investors’ buoyancy has eroded to a large extent. The broader markets with over 20% correction from recent highs are already showing a bearish trend. Benchmark indices are down ~13% from their recent highs and are showing distinct technical weakness – trading below all key moving averages. The technical studies indicate 4-5% further downside from the current levels.

However, if the earnings deteriorate and global noise rises, the immediate technical support may break and markets may head for much lower.

The perfect storm

Deteriorating macro, global headwinds, stagnating earnings growth and PER derating, and weak technical positioning could forma perfect storm for the Indian equities. Murphy’s law says it is more likely to happen. Let’s pray Murphy fails this time.

What is ailing Indian markets? - 1

In the past two weeks, three key economic events took place in India. These events aim to provide material fiscal and monetary stimulus to the economy.

·         First, on top of the 50bps cash reserve ratio (CRR) cut in December 2024, the Reserve Bank of India (RBI) announced further infusion of ~Rs1.5 trillion of sustainable liquidity in the banking system.

·         Second, the finance minister Rs one trillion personal income tax concessions, benefitting over 20 million taxpayers.

·         Third, RBI embarked on a rate cut cycle after a long 24 month pause, with a 25bps cut in the policy repo rate. Besides, the RBI also decided to defer the implementation of stringent Liquidity Coverage Ratio (LCR) and project financing norms, which would materially constrict the lending ability of the banks, to at least the end of FY26.

In normal circumstances, this combination of monetary and fiscal stimulus would enthuse the financial markets by igniting the risk appetite of investors and traders. However, this time the markets have mostly ignored the stimulus measures. After some momentary excitement, the markets (equity, bonds and currency) are mostly continuing with their weak trend.

·         Benchmark equity indices are back to their pre-budget levels. Even Nifty Consumer and Nifty Bank – the sectors that were supposed to be primary beneficiaries of the fiscal and monetary stimulus are trading almost at pre-stimulus levels.

·         The benchmark bond yields are back to the pre-budget levels.

·         USDINR is weaker by over one percent in the past couple of weeks.

·         Foreign portfolio investors (FPIs) are persisting with their exit strategy, and have been net sellers in India (including equity and debt) during the months January and February.

·         Stock market volumes are much below one-year average levels.

Obviously, the present circumstances are not normal. It is therefore worthwhile to examine whether Indian markets are passing through a “bear phase” or it is just a “pause” in a secular bull market or a “corrective decline” after a strong bull market. In my view, it is critical because the investment strategy response to these three scenarios is usually very different.

·         In case we are in a bear phase, the strategy should be to underweight risk; focus on safeguarding capital rather than return; orient portfolio towards larger, stronger companies that are more likely to survive through a prolonged rough patch; completely avoid leverage; and consolidate holdings into fewer strong companies.

·         In case it is just a pause, in a secular bull market, the strategy should be ignored the noise and hold on to the growth stocks. This opportunity may be used to rebalance the portfolio for any excesses and deficiencies.

·         In case it is a corrective decline after a strong bull run, investors/traders should be continuously looking for excessive negative price action in good stocks and use the opportunity to buy more using leverage; and overweight risk.

More on this tomorrow.

Devil’s advocate

In the sixteen century the Catholic Church in Rome established an office of the advocatus diaboli (Devil's advocate). The job of the Davil’s advocate was to argue against the canonization of a candidate proposed by the Church. The officer would use all his might to find faults in the canonization process and evidence of miracles attributed to the candidate. It was not necessary that the officer did actually believe in his arguments against the proposed canonization. The idea, apparently, was to avoid inadvertent mistakes and make sure that no underserving candidate gets canonized. Unfortunately, in the late 20^th century, the office of advocatus diaboli has been diluted materially.

I like to often play Devil’s advocate to the popular investment narratives and consensus assumptions. The idea usually is to get more clarity and minimize mistakes in the investment decision making. Continuing with the practice, I would like to question the popular market assumptions about the (a) impact of Rs one trillion tax bonanza announced in the recent union budget and (b) economic impact of the ongoing Mahakumbh.

Tax Bonanza: The finance minister, in her recently presented Union Budget for FY26, has recently announced enhancement of rebate under section 87A from Rs25,000 earlier to Rs60,000. Besides, she also announced restructuring of tax-slabs, lifting the applicability of maximum marginal rate of 30% to the taxable income above Rs24,00,000 from the present Rs15,00,000. These changes would be applicable only for the assessees opting for the “new tax scheme” (where no deductions u/s 80 are allowed). The budget proposals assume that the government would forgo Rs one trillion of tax revenue from these proposals.

The popular market narrative after this announcement has been that the additional cash of rupees one trillion in the hands of middle-class households will boost (i) discretionary consumption and (ii) banking sector liquidity.

In my view, these assumptions may be somewhat misplaced. For, the benefit of slab change is available equally to all assesses opting for the new scheme. The benefit of additional rebate of UPTO Rs35,000 u/s 87A is available to the assesses reporting taxable income between Rs4 lacs and Rs12 lacs and opting for new scheme. A person reporting taxable income of Rs5,00,000 for example will get a rebate of only Rs 5000 u/s 87A. Appx 28% assessees are still filing returns under the old scheme. These assesses are not eligible for any fresh tax concession.

It is common knowledge that the propensity to consume varies with the level of income. People with lower base income usually have a higher propensity to consume and are more likely to spend higher on non-discretionary items. People with higher base income have a higher propensity to save and spend more on discretionary items.

Pertinent to note that tax saving would happen at the expense of lower revenue for the government. Since the deficit is not rising in the same proportion, it is safe to assume that the tax concessions are being given by curtailing government consumption. (For record, the revenue deficit for FY26BE is just Rs966.54 billion against Rs3102.07billion in FY25RE) So net consumption impact of these tax concessions on the economy might be neutral or even negative.

Moreover, in the past three years, the household financial liabilities have seen material rise. It is very much possible that this tax saving is used to pare debt. This could potentially be negative for both credit growth and system liquidity.

I would therefore argue that at this juncture it is almost impossible to correctly estimate the impact of this rupee one trillion tax concession on the economy and markets. It is more likely that it just adds to the consumer confidence, without actually boosting consumption.

Maha Kumbh: Reportedly, more than 450 million devotees are expected to visit the city of Prayagraj to take a dip in the holy rivers. The Uttar Pradesh state and the central governments are reportedly spending over Rs 100 billion in organization of this mega event.

Many analysts have extrapolated these numbers to a massive economic stimulus, assuming a multiplier impact on the economy. One brokerage report for example, mentions creation of over 8,00,000 additional jobs and generation of over Rs two trillion in additional revenue. It estimates Rs340 billion in additional revenue for the hospitality sector, Rs360bn in additional revenue for the transportation sector, Rs30 billion additional spending towards branding and marketing; and Rs50 billion in creation of durable infrastructure.

Having been to the city of Prayagraj multiple times, I find it very hard to believe the projected number of pilgrims attending this Maha Kumbh. Nonetheless, even if I accept the number of 450 million attendees, I know from my experience of attending several such events, 95% of the attendees are from very poor, poor and lower middle class. They either borrow or deplete their meager savings to pay for the travel expenses to make this once in lifetime pilgrimage. They mostly carry their own food, or avail free food. They sleep on streets or mela ground. The 0.01% rich and VIP, who fly in and out of the city on the same day spend the most on transportation; not much on food and hospitality. It is the 4.99% middle class visitors who spend on buying local food, stay in hotels and tents, pay to local transporters (taxi, auto, boat, rickshaw etc.), and take prasad and souvenirs back home.

Such events do provide a material income boost to the local economy, but it increases stress on much higher number of households who spend beyond their affordability; and/or carry disease and injuries back home. Factoring these events to the bottom lines of companies (hospitality, travel, consumption, financial etc.) could at best be a futile exercise. For example, I could not find any significant correlation between the previous mega religious events and companies’ profitability or overall economic growth of the country. Much smaller sporting or entertainment events, in fact, show much better correlation with the economy.

3D view of market – Deleveraging, Demographics and Deflation

“There are events in the womb of time, which shall be delivered in time”. (Othello, William Shakespeare)

Beginning of the current year, I commented that “the trend seen in the past few months is indicating that the conditions might change materially in the next 12-24 months. The macro trends may become ambivalent and unpredictable. Investors may need to make choices; and the return they would earn on their investment portfolios would largely depend on the choices they would make. Making right choices, in my view, would be the central investment challenge for the year 2025.”

Barely one month into the year and it appears that earth already witnessed many seasons. The conditions are becoming more uncertain with each passing day. The 47^th President of the United States (P47), appears in a tremendous hurry to deliver on his promise to Make America Great Again (MAGA). He is using all his negotiating skills to secure good deals for his country. How much success will he achieve with his aggressive approach, we would only know with passage of time. Nonetheless, with his initial actions he has created a fair degree of uncertainty in the minds of his political opponents, trade partners, strategic partners, competitors and markets.

While I continue to maintain that investors would be better off avoiding a macro trade and focusing on individual business stories in the next 12-24 months, the three macro trends worth including in the matrix for identifying and evaluating individual business stories are Deleveraging, Demographics and Deflation.

Deleveraging: The US Fed has contracted its balance sheet by US$2.1trn since the beginning of its monetary tightening (QT) program in April 2022. The total assets held by the US Fed are now lowest since May 2020. It would need to unwind another US$2.7trn to completely undo the Covid related monetary expansion. Besides the US Fed, most other central bankers have shown a tendency to tighten the money supply by reducing their asset holdings. The Bank of England balance sheet is following the same trajectory as the US Fed. BoJ has not expanded its balance sheet in the past couple of years and cut the size of its asset holdings in recent months. Even RBI’s balance sheet has contracted in the past few months.

If we take the plan of P47 at par value, we are staring at one of the biggest fiscal corrections in modern history. Most other major developed and developing countries are also progressing on the path of sustainable fiscal corrections.

 

This macro deleveraging at the global level might reflect in the corporate and household balance sheets sooner than later. But for a major natural or manmade disaster, we should be factoring in sustainable governments, lower rates and adequate household savings in our investment strategies.

Demographics: One of the most critical trends in a large part of the developed world is deteriorating demographics. Most European and LatAm countries, the US, Canada, Japan, China, South Korea, Thailand, etc. have their total fertility rates fallen below the replacement ratio (implying their population is now on a declining path). The proportion of the working age population in these countries is decreasing fast. The population in China has already peaked and the population in India is expected to peak much ahead of the previous estimates of 2050.

This demographic trend appears structural and irreversible. With deeper and wider integration of technological advancement in social and personal life, the need & space for human interaction is on the decline. Financial and professional constraints are adversely impacting the capability and willingness to commit to personal relationships. Stressed and hectic lifestyles are adversely impacting the fertility of humans. There is nothing to suggest that these trends could change in the foreseeable future.

Obviously, the demographic trends will reflect on the aggregate demand as well as the demand mix.

Deflation: The mix of deleveraging, ageing demographics and superior productivity gains through technological advancements may lead to resumption of the pre-Covid deflationary trend. The supply lines disrupted due to Covid related restrictions and geopolitical developments post 2021 have mostly been restored. Save for a totally unexpected development, the current trend appears that a workable global trade balance may be achieved within the next 12-24 months.

With almost all major global market forces (the US, China, Germany, Japan, South Korea, France and the UK account for ~40% of the global trade) focused on repairing and strengthening their domestic economies, it is more likely a mutually beneficial global trade framework will emerge after the initial aggression of the P47 brings all trade partners to the negotiating table. This framework would, among other things, will certainly dampen the inflationary expectations.

The morning after

The general reaction to the Union Budget for fiscal year 2025-26 is mostly positive. Most people have appreciated the commitment to fiscal discipline. Substantial increase in the allocation for rural and urban development programs has apparently come at the expense of lower or no growth in the allocation for food, fuel & fertilizer subsidies, defense and transportation (road and railways).

The most celebrated aspect of the budget is the enhancement of tax rebate under section 87A from Rs25,000 to Rs60,000; and restructuring of tax slabs from the earlier three to six in the new scheme of personal income tax. These changes would result in a potential net tax saving of 2-6% of the post-tax income.

The most debated aspect of the budget is the allocation to the capital expenditure. Analysts are calculating the total allocation for capex using different matrices and thus debating in favor or against the budget.

The budget numbers assume a nominal GDP growth of 10.1% for FY26, which will roughly translate into a 6.5% real GDP growth. The Revenue Secretary, in an interview to the Economics Times, termed this as the trend growth (see here). He emphasized that “more structural measures” are needed to push this trend growth higher to 7%.

I find this the most concerning aspect of the present governance and market narrative. We seem to be totally disregarding the fact that 6.5%-7% real growth is merely sufficient to maintain the current trends in the development of social and physical infrastructure. To achieve the ambition of developed India (Viksit Bharat) all curves affecting the quality of life need to shift much higher. As highlighted by the latest Economic Survey, we would need a sustained 8%+ growth for a couple of decades to become a middle-income country (Viksit Bharat).

This budget or any other recent policy announcement of the government does not show any glide path in that direction. To this extent, the governance and market narrative suffer from an extreme degree of adhocism, opportunism and complacency. A total absence of discussions on structural reforms needed to catapult the economy to 8-10% growth orbit in the popular discourse is a worrisome sign. Being content with a few administrative changes and procedural efficiencies (mostly due to adoption of available technology) as “reforms” might not help much.

I would like to explain this situation with the help of four short stories, which I have narrated before also.

Freedom from bondage: There was this feudal lord, who had enslaved a number of peasants on different pretexts. He would make them toil hard the whole day and give two inadequate meals to survive. Occasionally, on festivals, birthdays of his children, his marriage anniversary, and death anniversary of his parents, he would treat them with a good meal and sweets. Once in 3-4yrs, during winters, he would give them new blankets so that they do not die of cold. In return, the bonded peasants were expected to hail him as protector and great benefactor of the poor. No one ever dares ask for freedom from bondage.

Eat ladoo and hail the minister: Once the home minister of a state visited the Jail on Independence Day. After finishing his speech, he distributed some sweets (Ladoo) and asked the inmates about their problems and what he could do for them. Most complained about mosquitoes and the quality of food. Few wanted new blankets. Some daring one asked for a large screen TV in the library. No convict asked for freedom. The minister granted their wishes and won their adulation.

Save me an extra half kilometer drive: A minister on his election campaign addressed a gathering of a housing society’s members in a posh Bengaluru location. The only request these educated upper middle-class people made to this politician was to “provide a right turn in front of the society gate, as they have to go 500 mtrs ahead to take a U turn” for travelling in the right direction; disregarding the fact that providing this “right turn” would be “wrong” as it would cause huge traffic disruptions and frequent traffic snarls in front of the society gate. No one asked him to give an undertaking that he would not encourage corruption, if elected.

Art of staying relevant: In the late 1980s, I had an opportunity to attend a budget committee meeting of a large medical college cum hospital. The twelve-member committee comprised two doctors, three administrative in-charge, district magistrate (ex-office), local MLA (govt nominee), and five prominent local citizens. The total annual budget of the college was close to Rs230 crores. The committee cleared 73 expenditure proposals worth Rs180 cores in less than one hour. The 74^th item of agenda was a bicycle-shed for Class-IV employees of the college/hospital. The budget sought for this item was mere Rs3.5 lacs. This would have helped over 200 employees coming to work on bicycle, as the scorching heat often resulted in deflation of bicycle tyres. The committee discussed the matter for more than two hours and rejected the proposal. Later, the dean of the college explained that this was the only item on agenda, besides salaries, which all committee members understood fully. They used all their wisdom in discussing this item and saved Rs3.5 lacs for the college, thus justifying their relevance to the college and society! 

Fed pauses, says not in a hurry to cut more

In a keenly watched two-day meeting, the first after the inauguration of the new US President, the Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) decided to pause its kept federal fund rates in 4.25%-4.5% range, after cutting it overall by 1% over its three previous meetings. The decision to pause is governed by a strong and resilient labor market and persisting inflation.

In a post meeting press interaction, Fed Chairman Jerome Powell noted that “The unemployment rate has stabilized at a low level in recent months, labor market conditions remain solid, and Inflation remains somewhat elevated.” He further added that the Fed needs to see “real progress on inflation or some weakness in the labor market before we consider making adjustments.”

Most notably, he emphasized that we're meaningfully above the ‘neutral rate’. He said, “I have no illusion that anyone knows precisely how much that is and but having cut 100 basis points means that it's appropriate that we not be in a hurry to make further adjustments.” (‘Neutral rate’ is a fed rate that is considered neither stimulative nor restrictive of growth under the current circumstances.)

Higher for longer: The market participants have taken this to imply that the current rate cut cycle is certainly not over and may resume after a pause, as the Fed gathers more evidence on inflation. Nonetheless, analysts now appear less sanguine about the lower bound of the present rate cut cycle. The consensus amongst them is emerging that the long-term bottom rate may have risen to 3% from the earlier estimates 2.5%. The ‘Fed pause’ is also being influenced by uncertainties surrounding the new administration's direction - on fiscal, trade, and government spending matters. The Fed officials noted “they don't intend to react until policies reach the implementation stage and begin to impact incoming economic data”.

Markets: Post the Fed decision, stock prices ended lower (S&P500 -0.5%), USD marginally stronger (DXY +0.2%) and benchmark bonds stronger (US 10yr Yield -0.37%).

RBI: The ‘Fed pause’ has made the February 06^th rate cut by the Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI), less certain. There are however more chances that RBI may change its stance to ‘accommodative’ from ‘withdrawal of accommodation’, signaling now growth is a priority over inflation.

Power pain

One sector that is inflicting extreme pain to the investors in Indian equity is ‘power'. The stock prices of almost all companies present in the power sector value chain have corrected 25-50% from their 2024 high levels. The correction in stock prices has been particularly pronounced after the declaration of ‘energy emergency’ by the president of the United States.

In my view there are three factors responsible for this correction, viz., technical, fundamental and sentimental.

Technical: The stocks of companies in the power sector value chain had seen a sharp runup in the past three years. Reasons for enhanced investor’s interest in the sector was underperformance of a few years showing bottom formation on charts; exciting announcements by the government relating to the sector; state electricity board reforms to reduce transmission & distribution losses; power demand growth picking up; and electric mobility and climate control commitment of several governments etc. The enhanced investor interest however took the stock prices quickly into the bubble territory. The stock prices are now correcting to more reasonable levels.

Remember, stock prices usually follow the laws of physics. A pendulum that swings to the extreme right (bubble), never stops immediately at a neutral position. It usually travels the equal distance to the left (distress); then makes some small moves on either side (greed and fear) before settling to a neutral position.

In my view, technically speaking, we may complete the left swing in the next couple of months, and achieve full mean reversion by the summer of 2025.

Fundamental: Enthused by a technical rally, analysts had started translating political promises into numbers and extrapolating these numbers to perpetuity to arrive at fancy valuations. An extended monsoon and a mild winter have resulted in lower power demand in 3QFY25. Some analysts are using this opportunity to correct their highly optimistic projections. Some are also using the pretext of the latest Chinese AI model (DeepSeek) to moderate their electricity and power equipment demand forecast; arguing that the demand for new data centers may be much less than previously estimated.

In my view, power demand growth in India is a function of rising affordability for fans, lights, refrigerators and air conditioners; rising popularity of EVs; more metro rail projects and new electrified rail routes; urbanization; depleting water tables requiring electricity to fetch water from ground; etc. There could be some seasonal slowdown, but structurally demand is set to rise materially over the next couple of decades.

Explosion in data center demand so far has mostly been a spreadsheet phenomenon. Further, assuming that India and other governments allow China to have access to their data through DeepSeek, is also a little far-fetched to me. DeepSeek is just another development (though very significant) in the global technology transition. It will only accelerate the adoption of AI by governments and businesses and trigger a fresh wave of development in the field of AI, using cheaper resources and methods. The impact on the power sector value chain could only be positive.

Sentimental: An energy emergency declared by President Trump has introduced a fair degree of uncertainty in respect of fiscal support to clean energy. This has made investors fearful of the massive investments made in the development of the clean energy ecosystem being rendered useless.

I am not sure if serious investors and responsible states would agree with the President’s outright rejection of climate concerns; and revert back to fossil fuels.

Moreover, in countries like India, where clean energy is not only a medium for climate control, but also a critical resource for achieving energy security and financial stability. Losing focus on development of a strong renewable energy generation base is not an option for us. For context, out of 34GW total capacity added in the year 2024, about 85% was renewables. Solar project constituted ~72% (24.5GW) of the total new capacity addition; with solar contributing 10%. The present project pipeline indicates about 50GW renewable capacity addition during FY25 and FY26.

 

Power sector value chain (generation, transmission, distribution, and consumption) is indubitably one of the decadal investment themes in India. However, to make money, investors need to follow strict discipline and not be unduly influenced by the forces of greed and fear.

 

Prepare for the spring

Presently, the total market capitalization of the NSE is close to Rs415 trillion, almost the same as it was during the last week of May 2024. The benchmark indices like Nifty 50, Small Cap 100, Nifty 500, Bank Nifty etc. are also trading almost at the same levels as prevailed during the last week of May 2024.

Decent returns for the last one-year

The benchmark indices may be down 12-16% lower from their September 2024 highs; but they are still yielding a return of 6-9% for the one-year period.

Average asset under management (AUM) of Equity/Growth mutual fund schemes at the end of May 2024 was appx Rs25 trillion. The six-month period from June to December 2024 saw a net inflow of Rs2.7 trillion in these schemes. For the month of December, the average AUM of these schemes was Rs 31 trillion. This implies over 11% net value gain in these schemes during the June-December 2024 period.

For the full year 2024, the value gain in equity MFs is close to 22%. Most equity-oriented funds have yielded over 10% return in the last one-year period. Some sector funds like Pharma and IT Services, have yielded 18-25% return for the past one year. Even the worst performing sector, viz., Banking funds, are yielding ~7% return.

Why is it sounding like a disaster?

Thus, prima facie, household investors (retail) who invested in equities should not be bothered much by the current correction in the stock prices. But looking at the sentiments of these investors, it sounds like a disaster-like situation. Why is that?

In my view, this disappointment (panic, if you prefer it that way) is a function of multiple factors. Some of these factors could be listed as follows:

Misplaced expectations: Many retail investors have accelerated deployment of funds post general election results in early June. They expected massive reforms in the first few months of the new government, as promised in the election manifesto. Many such investors also believed that victory of Mr. Donald Trump in the US presidential election could also be a very good omen for the Indian economy and markets. They are apparently disappointed on both the frontiers. The Modi 3.0 term has been largely uninspiring so far; where Trump 2.0 is sounding ominous so far. This disappointment is likely making retail investors less optimistic about the future prospects of the Indian equities.

Misallocation: While the mutual fund investments, especially through systematic investment (SIP) method, have been much talked about, empirical evidence indicates that retail investors have materially increased allocation to direct equity investment. For the context, the retail ownership of listed Indian equity is ~23%, all time high. The data on shareholding pattern of various companies indicate that most of retail capital allocation has happened to the popular themes like government capex (defense, railways, roads), clean energy (solar, wind, biofuels), and new commerce (modern retail, ecommerce, platforms, fintech, etc.). Several IPOs from these sectors witnessed phenomenal retail interest, even post listing at huge premiums. The correction in the prices of these stocks has been brutal (40-75% from recent highs). The worst part is that this damage could be permanent, as the bubble in valuation is bursting.

Mistiming: Retail investors may have materially increased their allocation to equity post the July 2024 Budget (closer to all time high prices). The average cost of their holding may therefore be much higher; implying low or negative return in the portfolio despite good positive overall returns yielded by benchmark indices and mutual funds.

It is pertinent to note, while the aggregate number of SIPs is encouraging, the internals are bothersome. The number of SIPs discontinued is alarmingly high. Average age of an SIP in about 2.5 years. In December 2024, about 83% of SIPs were discontinued.

Inexperience: Empirical evidence indicates that there has been a material rise in young new investors in the past four year (Post Covid). Since, the stock prices have risen sharply in this period, without witnessing any substantial correction, most of these investors lack experience to weather the market down cycles. The sharp fall in stock prices in a matter of three months, accompanied with negative news flow (specially about incessant FPI selling) might be making these investors excessively jittery.

Prepare for the spring

While the current market conditions appear like the fall season, the spring may not be far away. It is important that the investor do not become disheartened and prepare for the coming spring. In preparation, the following step must be taken:

·         Remove the plants with rotten or weak roots.

·         Provide nourishment to good plants.

·         Prune the existing plants.

·         Rope new plants.

·         Repair the hedges.

If you do not prepare your garden before the spring sets in, there are good chance of missing the bounty next season would have to offer.

New chapter in Indo-US relations

Mr. Donald Trump has chosen to take some time before speaking with his Indian counterpart Mr. Narendra Modi. Trump has chosen to call the Chinese premier Xi Jinping, even before his inauguration. Prime Minister Modi has apparently sent a written congratulatory message to Trump, instead of calling him. This small pause in the top-level communication has triggered a debate about the shape of Indo-US relations in the near future.

In my view, before drawing any conclusion from Trump’s pause, and writing obituaries of the Indo-US strategic partnership, we must study the evolution of Indo-US relationships. This relationship has evolved over the past 75 years. It is primarily based on mutual need and shared democratic values, and goes much beyond the personal equation of individual leaders.

Prologue

The foundation of Indo-US was laid during the 1949 visit of Prime Minister Nehru’s visit to the US and meeting with President Henry Truman. Nehru was welcomed by everyone he met during his multi week stay in the US. However, Not much was achieved in diplomatic and economic terms.

Ten years later, President Eisenhower visited India for five days, in 1959. He addressed the Parliament and expressed “deep satisfaction at the friendly and cordial relations existing between their two countries, and their firm belief that their common ideals and objectives and their quest for peace will ensure the maintenance and development of the strong ties of friendship between the two countries.” Again, the Indo-US relations did not move beyond exchanging pleasantries.

The first chapter

India co-founded the Non-Aligned Movement in 1961, taking a neutral stand in the cold-war between the USSR and the US. 1962 was an important year in the evolution of Indo-US relationship. This year, the U.S. Agency for International Development signed the Kanpur Indo-American Program to help in the establishment of the first IIT. The program included deployment of American faculty members to develop academic programs and research laboratories at the new university over the next decade. Later, President Kennedy supported India in the Indo-China conflict, recognizing McMahon Line and also providing air assistance and arms. Next year, in 1963 Norman Borlaug, a renowned US Agronomist, visited India and laid the foundation of the Green Revolution. India also benefited from wheat imports from the US under PL-480 “food for peace” program during the 1960s.

1965 saw a material deterioration in the US-Indo relationship as Washington sided with Islamabad in the second major Indo-Pak conflict. The situation worsened further in 1970’s when President Nixon sided with Islamabad during the 1971 Indo-Pak war. This was the time when India signed a 20 year “Treaty of Friendship and Cooperation” with the USSR. The relationship deteriorated further in 1974 when India became the first non UNSC permanent member to conduct a nuclear test.

A reproachment effort started in 1978, after Mrs. Gandhi was defeated in the 1977 general elections. President Carter visited India and Prime Minister Desai reciprocated with a 6-day visit to Washington. However, with the US enacting the Nuclear Nonproliferation Act in 1978, the process was derailed.

Prime Minister Gandhi made another attempt to revive Indo-US relations during her visit to Washington in 1982. She and President Regan largely agreed to increase cooperation and resolve a dispute over nuclear power. Vice president Bush (Sr.) led a high level visit to New Delhi to explore areas of cooperation. However, 1984 Bhopal Gas tragedy again derailed the process.

Post the end of the cold war (1989), for a few years, India and the US had a good working relationship. Prime Minister Rao unleashed substantial economic reforms and expanded economic ties with the US. However, things turned for the worse in the summer of 1998, when prime Minister Vajpayee surprised the US intelligence agencies with a nuclear test and announced India as a full-fledged nuclear power. President Clinton recalled his ambassador to India and imposed severe economic sanctions on India.

A year later in 1999, President Clinton called Pakistan Prime Minister Sharif and nudged him to end the Kargil conflict immediately. In the year 2000, Clinton became the first US President to Visit India since 1978. The visit marked the first step toward forming a durable Indo-US strategic relationship. Clinton agreed to not make signing of CTBT a precondition for Indo-US economic cooperation. The Indo-U.S. Science and Technology Forum was established during this trip, which also marked the beginning of the end of the Cold-War strategic US-Pak alliance. President Bush lifted all US sanctions on India in 2001.

Second chapter

In 2005 a new chapter in the Indo-US relations started. Both countries signed the New Framework for the U.S.-India Defense Relationship, which set priorities for defense cooperation in maritime security, humanitarian assistance/disaster relief, and counterterrorism. They also inked the Civil Nuclear Cooperation Initiative, a framework that lifts a three-decade U.S. moratorium on nuclear energy trade with India. Under the agreement, India agrees to separate its civil and military nuclear facilities and place all its civil resources under International Atomic Energy Agency (IAEA) safeguards. In exchange, the United States agrees to work toward full civil nuclear cooperation with India. (The US Congress and Indian Parliament ratified this deal in 2008.) In October 2005, both countries jointly conducted the largest naval exercise to date, followed by major air and land exercises.

In 2006, President Bush visited India and finalized, with Prime Minister Singh, Singh finalized the framework of the civil nuclear deal and boosted security and economic ties. The nuclear deal made India the only country outside of the Nonproliferation Treaty that has nuclear capabilities and is allowed to participate in nuclear commerce.

In 2007, an 18year old ban on import of Indian mangoes to the US was lifted, marking the beginning of an effort to double the Indo-US trade within three years. Bilateral trade in goods and services totaled around $45 billion in 2006 and rose to more than $70 billion in 2010.

In 2008, Chandrayaan-1 became the first Indian spacecraft to land on the moon. It carried two scientific instruments designed by NASA scientists, marking a significant progress in Indo-US space cooperation (an agreement that existed since 1963).

Third chapter

In 2010, India and the US convened the first U.S.-India Strategic Dialogue. Secretary Clinton lauds India as “an indispensable partner” and President Obama claimed the relationship “will be a defining partnership in the twenty-first century.” President Obama visited India in November. He addressed the Parliament and backed the country’s long-held bid for a permanent seat on the United Nations Security Council. He announced $14.9 billion in trade deals.

In 2012, Secretary of Defense Leon Panetta visited India to bolster military ties. Next year (2013), Prime Minister Singh visited Washington to meet President Obama for the third time in four years to discuss important issues such as security, trade, immigration reform, and the civilian nuclear deal.

In 2014, President Obama invited Prime Minister Modi to the White House. President Obama made his second visit to India in 2015 as Chief Guest at Republic Day celebrations. Ten-year U.S.-India Defense Framework Agreement was renewed for another ten years.

In 2016, the US elevated India to a “major defense partner”, a status no other country holds. This enabled India to enjoy some of the benefits of being a U.S. treaty ally, such as access to defense technology.

In 2017, Prime Minister Modi visited the US to meet President Trump, who raised sharp disagreements with India over trade, climate change, and H-1B visas. Regardless, their joint statement emphasizes strengthening their defense partnership, cooperating on counterterrorism efforts, and boosting economic ties.

In 2018, during a “two-plus-two” dialogue in New Delhi an the Communications Compatibility and Security Agreement (COMCASA) was signed allowing India access to advanced communication technology used in U.S. defense equipment and allows real-time information sharing between the two countries’ militaries.

Fourth chapter

In 2018, the Indo-US relations took a turn towards the south. President Trump terminated India’s preferential trade status, part of a 50yr old program that allows products from developing countries to enter the U.S. market duty free. Trump claimed India has not provided “equitable and reasonable access” to its own market. In retaliation, India slapped tariffs on twenty-eight U.S. products.

In 2020, President Trump made his first official visit to India. India agreed to purchase US$3bn worth of military equipment. However, the two countries could not resolve pending trade issues. Opinions remained divided over agricultural products, tariffs, and other areas.

In 2020 the first in-person meeting of Quad was held, and President Biden hosted Prime Minister Modi for the first time.

In 2023, the Initiative on Critical and Emerging Technologies (iCET), an agreement that aims to expand bilateral technology and defense cooperation is announced. As part of the deal, U.S. officials seek to reduce India's purchase of Russian arms.

Fifth Chapter

I guess, President Trump might look to begin a fresh chapter in the Indo-US relations. Early indicators are pointing that he may look to base the mutual relationship on equality. So far, the US has played the role of a dominant partner helping India to grow faster. President Trump may now seek to rebase the relationship seeking full reciprocity from India on key economic, trade and technology issues.

The Indo-US relationship henceforth may become purely transactional, shedding the pretense of strategic partnership. The Trump 2.0 administration would negotiate hard on tariff concessions; preference in defense and energy procurement; resolution of contentious issues like agriculture tariffs. The US negotiators might use the façade of freedom of speech & religion, persecution of minorities etc. as key negotiating tools.

It will obviously be a tough & volatile transition; especially when the domestic economy is passing through a challenging downcycle. During the previous transitory phases (1970s and Late 1990s), India managed well. Hope this time will not be different. Till then keeping fingers crossed, seat belt tightened, and store filled with emergency supplies.