Do it yourself

The State Minister for Finance, recently informed Lok Sabha that the government had stopped printing of the currency notes of Rs2000 denomination in 2019 itself. This step has been taken to prevent hoarding of currency and curb the circulation of black money in the economy. It is pertinent to note in this context that Rs2000 denomination notes were introduced in 2016 post cancellation of the then prevalent currency notes of Rs1000 and Rs500 denomination. That step, in the first place, was also apparently taken to curb the circulation of black money in the economy.

Besides, the color of money {white, black, pink (Rs2000), green (INRUSD) etc.} which remains an active topic of discussions, the temperature of money is also becoming a topic of interest. Rise in the stock and flow of “hot money” is becoming a worry for authorities. “Hot money” could be loosely defined as the liquid money that flows very fast across asset class and jurisdictions in search of short term trading opportunities. This money usually has no commitment to any asset class (debt, equity, commodities etc.) category (emerging markets, developed markets etc.) or country. Both, the entry and exit of hot money to any class, category or country usually are disruptive, due to high speed and force of such flows.

Multiple bouts of stimulus provided by governments and central banks to counter the slowdown induced by the pandemic related safety measures, seems to have created billions of dollars in “hot” money. This hot money is apparently fueling the asset prices world over. The prices of most liquid assets, like publically traded equities, crypto currencies, precious metals have gained maximum; though the prices of physical assets like metals, real estate etc. have also gained materially.

As per some reports, recently “Beijing officials and policy advisers have been highly critical of US President Joe Biden’s newly signed US$1.9 trillion American Rescue Plan, warning that it could cause massive capital flows and imported inflation that could exacerbate domestic financial risks from already high debt levels."

Zhang Xiaohui, former assistant governor of the central bank, was reported to have said that “The [US Treasury bond] yield hike driven by inflation expectations will lead to a revaluation of asset prices, or even turmoil in financial markets. Domestic markets are unlikely to remain unresponsive.” This is seen as a caution that Chinese domestic markets will respond to rising rates, and should rates spike even more, Chinese assets face a world of pain.

Relative to China, India has not received much of hot money in 2020 and 2021 (YTD). The total FPI flow in India in past 12months (net flows in equity plus debt in secondary markets) is less than US$5bn. Much of this flows are apparently through ETF route, which is usually not hot money.

In past couple of years the securities’ market regulator the Securities and Exchange Board of India (SEBI) has amended many rules and implemented some new ones to bring the functioning of Indian securities markets further closer to the international standards. Being a signatory of the International Organization of Securities Commissions (IOSCO), a global body of securities market regulators, SEBI is mandated to implement global standards of market regulations in India, especially in the area of investor protection, systemic safety, and prohibition of unethical and fraudulent market practices.

Some of the more discussed and criticized latest standards introduced by SEBI are –

(a)   Segregation of financial intermediation and advisory functions. In line with the best global practices, to avoid potential conflict of interest and bring objectivity in advice, Investment Advisors have been prohibited from offering financial intermediation (MF distribution, brokerage etc.)

(b)   Tightening of norms relating to margining of leveraged trades and financing of such trades. This has been apparently done to minimize the systemic risk of markets; improve financial stability and minimize the cases of risk taking beyond capacity by traders and brokers.

It is important to note that in past 25years, in times of crisis, Indian securities market functioning has been commendably stable.

To put this discussion in context, few readers have asked about my views on the recent listings of couple of financial intermediaries. While as usual I would refrain from commenting on individual stocks. However, I have some strong views on this sector, which I would like to share with my readers:

1.    The financial intermediation sector is set to transform in next five years. The changes that started a decade ago will accelerate at dramatic speed.

We shall see accelerated elimination of marginal and smaller players and consolidation of mid-sized and larger intermediaries, as Technology begins to overwhelm the manual execution and even advisory function.

2.    The experience of telecom sector will be replicated in securities’ market. The execution services will become “free”, just like voice calls, and come as part of bundle of services. The primary service will be “advisory” and “access” to global markets and products.

3.    Debt market will become bigger than equity market with most of the development and innovation happening in that segment.

So far the skills for debt trading are limited mostly to the primary dealers, their associated entities and a handful of intermediaries specializing in mobilization of corporate debt. The biggest opportunity for intermediaries perhaps lies in this segment.

4.    Financialization of agri produce trade would be another large opportunity that will unfold on next decade.

5.    Mutual Fund Industry shall be dominated by low cost passive investing (ETFs). Index making and management services will become prominent and dominant (ala MSCI).

After some exciting action post presentation of Union Budget for FY22, the benchmark indices have moved sideways with heightened intraday volatility. The broader markets have definitely outperformed suggesting some superlative returns for the investors. However, when assessed from the rout of small and midcaps in 2018 and 2019, it is clear that broader markets may not have actually yielded much return, even to the investors who have stayed put for 3year. For example, Nifty Smallcap100 index has not yielded any return for past 3years; and Nifty Midcap100 return is only slightly better than the bank deposit return since March 2018.

Notwithstanding the massive visual gains recorded by equity prices in past 12 months, the portfolio returns for most investors may have been below par.

The returns on debt part of the portfolio have been poor, with real returns being negative in many cases. For a large proportion of investors, debt part is usually equal to or more than the equity part.

Since global financial crisis (2008-09), gold has also found prominent place in asset allocation of numerous investors. The efforts of government to popularize financialization of gold through gold bonds etc., have also motivated household investors to invest in gold. For past one year, the return of gold funds is close to zero. The three year return of gold funds is less than savings bank accounts.

Regardless of the outperformance of small and midcap stocks, it is important to assimilate that usually these stocks are much smaller part of an average portfolio. Any superlative return on this part of the portfolio, may not necessarily translate in outperformance of overall portfolio.

A simplified analysis of sectoral performance of Indian equities highlights the following:

(a)   The euphoria created by the brave and revolutionary budget has not lasted much. Nifty is almost unchanged for past five weeks.

(b)   Optically, it appears that budget ignited risk appetite for growth trade. It is believed that big money rotated towards cyclical sectors like commodities, infrastructure, automobile, etc. post budget. The aggressive disinvestment agenda underlined in the budget also attracted huge interest in public sector stocks. Consequently, metals, energy, infra, PSEs, and Realty sectors have outperformed since presentation of budget. Whereas, the favorites of post lock down period, i.e., consumers, pharma and media have yielded negative return since then. IT has also underperformed YTD.

The fact is that metals are participating in a global rally (reflation trade) and may not have much correlation to budget proposals. Energy sector performance is highly skewed due to Reliance Industries performance, which is popular due to its retail and telecom ventures rather than its energy business. Infra outperformance has actually diminished post budget, as compared to past 12months performance.

Auto sector has yielded no return since budget; and financial services have actually underperformed Nifty.

(c)    Assuming that most household investors and fund managers believed in this Cyclical growth trade story and have started to rotate from the defensive and secular businesses like IT, Pharma and Consumers in post budget period and the rotation may be completed in next couple of months. I would like to wager that it will be time for outperformance of IT, Pharma and Consumers by the time monsoon hits the Mumbai coast.

(d)   Private sector banks have underperformed their public sector peers over past one year period. Much of this outperformance of PSBs has occurred post budget. Valuation gap, promise of reforms and recapitalization, improving balance sheets are some of the primary reasons for this outperformance. Watch out for any disappointment on these parameters.

Bond market is obviously not happy with the state of fiscal and macroeconomic factors. Recent sharp rise in Covid cases has also raised the specter of “relock”. Year end “adjustments” may also play some part in markets in next couple of weeks. In my view, it’s time for some extra caution rather than exuberance. Preserving wealth should be a priority at this point in time over maximizing profit.

The history appears to be repeating itself for the n^th time in the stock market. The small time enthusiasts, who normally join the band wagon right at the top of the market cycle, have once again jumped into the market arena. Completely overwhelmed by the left-out syndrome, they are queuing in hordes in front of the counters where they had lost their fortunes, not long ago. Many of these scrips are trading at a fraction of the price they were trading 3years ago. Some notorious stocks that have inflicted huge losses to the investors and traders in past decade are also topping the volumes charts again. A strong urge to prove a point, rather than greed, appears to be the dominating factor here. Everyone wants to prove that it was their bad luck rather than lack of financial acumen, which caused them loss last time. I wish luck favors these traders this time. But in my heart I know for sure, this is not going to be the case. They will again lose! No regulator, no matter how strong and vigilant, can protect them.

There is a poplar fable in the stock market literature. Usually it is narrated by the market seniors after the bubble has already burst. Like every time before, this fable aptly summarizes the present state of affairs of stocks markets world over. The story goes like this:

“Once upon a time in a village a man appeared and announced to the villagers that he is willing to buy monkeys @ Rs. 10 each. The villagers lured by his offer, went out in the forest and started catching monkeys. The man bought thousands @ Rs. 10 and as supply started to diminish and villagers appeared tiring in their effort, he revised his offer. He announced that now he would buy monkeys @ Rs. 20 each.

This renewed the efforts of the villagers and they started catching monkeys again. Soon the supply diminished even further and people started going back to their farms. The man increased his offer rate to Rs. 25. The villagers would now spend hours in the forest to catch even a few monkeys. Soon no monkey was left in the forest. The man would coax the villagers every day to go and get more monkeys. The villagers would try their best but in vain. As the frustration grew, the man made the offer even more lucrative. He announced that he would now buy monkeys @ Rs.50 each! But there was no monkey.

The man left his servant in the village and left for the city. In the absence of the man, the servant told the villagers, "Look at the monkeys in the big cage that my principal has collected. To help the poor villagers, I am willing to cheat my master. I will sell these monkeys to you @ Rs. 35 each, so that you could sell them back to my master @ Rs. 50 when he comes back from the city.”

The villagers queued up with all their saving to buy the monkeys. Soon the servant had sold all the monkeys back to the villagers. He then also left for the city with all the money he had collected. Thereafter, no trace of the man or his servant could be found by the unsuspecting villagers. They were left with a large troop of monkeys and hope of selling them back to a willing buyer someday. In the meantime, they would be forced to feed and take care of simians.”

 Notwithstanding the buoyancy in stock market, the economy has shown some clear signs of fatigues in February. The post lock down recovery from September onwards appears to be pausing, as pent up consumer demand has subsided and rise in raw material prices has dampened the sentiments. Some signs of economy pausing could be read from the following:

(a)   GST payments in February (for collections in January) have declined after rising for three consecutive months.

(b)   E-Way collection in February were also much below the December levels.

(c)    Exports have been mostly flat for the month of January and February; while imports have declined from the December levels.

(d)   Non food credit growth slowed down further in January.

·         The Industrial credit contracted -1.3% in January. The contraction was led by large industrial credit, which constitutes ~82% of industrial credit and de-grew 2.6% YoY. Within industrial credit, sectors such as infrastructure (led by telecom), metals and all engineering saw persistent YoY de-growth.

·         Service sector credit growth slowed to 8.4% (yoy) in January against 9.5%

·         Personal loan growth slowed down to 9.1% (yoy), the slowest rate in 10year. Home loan growth 7.7% was lowest in a decade despite easing rates.

·         MSME credit grew at meagre 0.9% (yoy), despite all the incentives, programs and schemes for promoting and protecting the credit flow to MSME sector.

(e)    In January the eight core sectors’ output growth slowed down to 0.1% (yoy) from 0.2% (yoyo) in December.

·         Cement production fell by ~5.9% YoY in January 2021 according to the core industries data released by the Government of India. The YTD demand continues to be weak with the fall of ~16.6% as indicated by the data.

·         As per a recent report of Nomura Securities, “Indian steel demand dropped 6% m-m for Feb-21 (though 7% y-y) as buying interest from large construction majors turned sluggish on high prices. Key infra names have slowed down execution. Further, major stockists and distributors are holding decent inventories and seem reluctant to procure material at higher prices. Demand growth y-y has been boosted by double digit demand growth in key segments like autos, white goods and consumer durables, according to Steelmint.”

(f)    As per another recent report by Nomura securities, “The Nomura India Business Resumption Index (NIBRI) fell to 95.2 for the week ending 7 March vs 98.1 in the prior week, indicating that the gap from the pre-pandemic normal has slipped to 4.8pp from only 0.7pp a fortnight earlier. Both the Apple driving index and the Google retail & recreation indices have taken a hit, while workplace mobility continued to improve. Power demand fell by - 8.5% w-o-w (sa) vs 4.2% in the prior week, while the labour participation rate also fell to 39.8% from 40.6% previously.”

A visit to here tier two cities of Uttar Pradesh over last weekend was quite educating. I came back with few new learnings and stronger conviction in couple of themes that I have been following for past couple of years.

We visited the temple of our family deity in Agra. The temple is being renovated completely from the inside. The donations for the renovation are being accepted in digital mode. The devotees, many of them from lower middle and poor families were pleased to pay Rs10-50 through UPI etc. It was very clear that people across the socio-economic strata have internalized the digital mode of payment. Another evidence of this trend was available at Fatehpur Sikri monument.

The CNG bus that takes the tourists from parking upto the monument charges Rs10 as fare. The bus operator was accepting payment of Rs10 through digital mode. All tourists, villagers and urbanites alike, were happy to scan the QR codes. The monument entrance fees Rs45 per person, is payable only in digital mode now and even the ticket needs to be booked online. This may be a temporary Covid-19 measure, but no one seemed bothered about this. All tourists appeared happy about the procedure as it saved them from standing in long ticket queue. Poor phone connectivity though was an annoyance with some. WiFi enabled smartphone was no issue as all tourists were carrying one. The local tourist guide, the local handicraft shop and local dhaba all accepted digital payment as if it was a norm.

I came out even more convinced that digitalization of financial transaction shall become a norm rather than exception in net 5-7years. A further simplification of the procedure and improvement in digital connectivity may even accelerate the process. Cash economy that is believed to have impeded the growth of Indian economy for past 7 decades shall shrink materially with this. The government however needs to make sure that the cost of digital access does not increase from the present level and quality of digital access improves materially.

The second theme that has bothered me for past few years is the general public attitude towards respect for intellectual property rights of others. Use of pirated software, photocopied books, spurious books sold on traffic signals and footpaths, unauthorized copies of branded clothes etc. is unapologetically common. Propriety and ethics are not taught in schools. It is common to see parents encouraging their wards to buy the “cheaper” alternative regardless of its legality and authenticity.

Travelling to Moradabad from Agra via Ghaziabad and Hapur, I registered something that I would usually ignore.

In Ghaziabad there is a fast food joint called “Bhatura King”. The name and logo used by this chain is cannily similar to the global chain of quick service restaurants, “Burger King”.

On 25kms stretch from Hapur to Garh Mukteshwar, there are at least 50 Shiva Dhaba, each claiming to be the “original”. The people who have traveled on NH24 from Delhi to Moradabad, Rampur etc. would remember that Shiva Dhaba is a popular food joint having a strng recall value. Similarly, there are over 50 Gulshan Dhaba, each claiming to be “original” between Mathura and Palwal. Panchhi Petha is a world famous brand of Agra. In Agra city itself there over 500 shops claiming to be Panchhi Petha stores. Similar is the story with Bikaner Sweets, Aggrawal Sweets in Delhi NCR region.

There are two points in this:

(1)   The respect for the intellectual property rights of others is scant.

(2)   The recognition of brand value and need for its protection is also scant, though it has started to grow in recent times.

I have highlighted this earlier also that many mega Indian business ideas are nothing but poor copies of the globally successful businesses. Some examples are, PayPal – PayTM; AirBnB – Oyo; Swiggy – Zomato; Walmart – Big Bazaar; Amazon – Flipkart; etc.

The theme in this is Jugaad.

The culture of Jugaad, in my view, has harmed Indian economy and society much more than it has helped. This culture has hampered the growth, innovation, scalability, and competitiveness significantly, in my view.

For investment purposes, I have been consciously avoiding business, ideas and themes that are based on Jugaad and/or violate the IPRs of other entities. I would like to see a strong and comprehensive initiative on part of the government, civic administration, academia etc. to change this culture.

On a side note, I wonder which sector the Fintech companies will fit in – IT or Financials; or we will have to define a new sector for all new business that help in digitalization of our lives.

 There are lots of events happening in global markets which cannot be full explained through conventional wisdom or empirical evidence. In my view, lot of these events are unintended consequences of policy actions, geopolitics and trade conflicts.

For example, there is a massive rally in the global commodity prices, despite poor demand and growth outlook for next few years at least. The recovery to pre Covid level may not entirely explain the rise in commodity prices much beyond the 2019 levels. Popularization of electric mobility etc. can explain gains in some commodities, but not in steel, coal, crude etc.

The forecasts of a commodity super cycle sound mostly unconvincing, given (i) worsening demographics of the world; (b) restricted mobility; (c) seriously impeded purchasing power of people; (d) already stretched limits and diminishing marginal utility of fiscal and monetary stimulus; (e) technology evolution focusing on reversal of trends in labor migration; and (f) diminishing chances of a full-fledged physical war amongst large countries; etc.

Material changes technologies related to construction, manufacturing and transportation etc. also leading to material changes in the demand matrix for various commodities like steel, cement, copper, coal etc.

The outrageous rise in economic inequalities globally also mean that investment rate in poor countries will continue to decline for next many years, as the economic power gets more and more concentrated in the hands of few rich nations.

I therefore feel that the price trends in the global markets are deeply influenced by the factors other than economics. Even though the defeat of Donald Trump in US presidential elections has taken the trade conflicts away from headlines and front pages; the trade war that started few years ago is far from over. Besides, geopolitics is also playing a large role in global markets.

In past two years, China has been making conscious efforts to reduce its holdings of US Treasuries and building large reserves of physical industrial commodities. The global investors appear selling Chinese assets (leading to massive tech rout in China) and buying other emerging markets, in line with the global enterprises’ China+1 policy.

The unintended consequences are that world is facing shortages of rare earths, semi-conductors, and shipping containers and struggling with the rising prices of commodities. China which had been exporting deflation to the world for the past 10years has suddenly become exporter of inflation to the world.

The markets focusing more on US yields and USD cross rates, might be missing the point that Chinese aggression on commodities can derail the entire AI led Tech revolution for at least 4-5yrs, if it continues to choke supply of rare earths and semi-conductors. This derailment of global trade and therefore growth is a bigger worry than inflation at this point in time.

It is pertinent to note in this context that today China is hosting its annual gathering of National People’s Congress, its biggest political meeting, to approve the plan to propel Chinese economy to the top of the world, ahead of US. At the center of the new plan will be Beijing’s push to develop new technologies and cut the nation’s reliance on geopolitical rivals such as the U.S. for components like microchips. As per some experts, that should mean allocating more resources to science and technology, with spending on research and development targeted at around 3.5% of GDP over the period

Another case in point is the sharp rise in the price of sugar in global markets. This rise has occurred despite the higher than expected production in India and over 10.6MT carry over stock. But for MSP of Rs31/kg mandated by the government, the glut should have resulted in domestic prices falling to much below the cost of production. Also, but for export limitations and logistic constraints, Indian supplies could bring down the global prices to much lower levels. Visualizing this as signs of impending global food inflation cycle may not be appropriate.

The semi-conductor shortages are hurting manufacturing of white goods, electronic items and automobile, etc. This could have meaningful second round impact on other sectors of economy. Thankfully, the border conflicts and political rhetoric have not impacted the Indo-China trade materially. But India gaining advantage at the expense of China due to China+1 policy could have some repercussions in the short to medium term. The capacity building in India needs to take place now. A delay of even one year could potentially render much of this capacity redundant as global enterprises find alternatives or reconcile with China.

The short point is that US bond yields and USD exchange rate, etc. are least of the worries for our markets and economy, presently. Laying too much focus on these may only distract us from bigger threats and even bigger opportunities.

Whereas the investors have enough good opportunities to invest in markets, the traders are facing many challenges. The biggest challenge is that most trading opportunities are available in the cyclical businesses like commodities and automobile. The price movements in these stocks are sharp and quick on both sides.

Since most of these stocks (metals, sugar, paper, cement, textile, power, auto etc.) have already gained significantly from their recent lows and are no longer available at cheap valuations, the margin of safety in trading these stocks is obviously low. In past couple of decades, the commodity cycles have been short and deep. If this cycle also turns out to be a usual cycle, against a super cycle as widely assumed, the corrections could be quick and deep.

In these circumstances, most of the traders, especially the smaller ones, are forced to trade with small quantities. The holding period is much smaller, mostly less than a week. Profits/losses are booked at much smaller amount. The number of stocks traded is much larger and the quality of stocks being traded is deteriorating with every rise in the prices.

Some readers and trader friends have asked for my views on trading opportunities in the market. I must say, trading in stocks is certainly not my domain of expertise. This requires completely different skills and training. Nonetheless, since a question has been put to me, I must try to answer with whatever knowledge and experience I have. In my view—

·         In past one month the benchmark indices have been mostly directionless. However, we have witnessed heightened volatility in this period. Usually, this phenomenon is witnessed close to the top or bottom of the market cycle. We may not be close to the peak of the market, but certainly we are not close to the bottom either.

·         The risk reward for the traders is negative. The market upside may be limited to 5-7%, whereas the downside could be in the range of 18-20%, even if the indices retrace 35-40% of the up move from lows of March 2020.

·         The traditional signals for correction – Market to GDP, yield differential, EBIDTA Margins peaking, distance from 200EDMA – are clearly visible but being ignored by the market.

·         The rally in commodities is totally counterintuitive and may be driven more by hopes of continuing supply constraints. The inventory buildup may in fact hurt both the hoarder and the financier in mid-term.

·         Most of the IPOs to be launched in 2021 are new economy businesses. The structure of the market is clearly shifting away from the conventional cyclical businesses, in line with the global trends. Tech enables financial services (Fintech), E-Commerce platforms, ITeS, AI etc are likely to get maximum allocation of new money. Intuitively, the market activity shall be dominated by the non-cyclical technology driven businesses. Healthcare and financials may also continue to remain in the trading arena. But commodities and utilities should logically be waiting on the sidelines for another decade at least.

 An impromptu discussion with my friend, & favourite fund manager, yesterday was quite disconcerting. We raised some pertinent questions and tried answering those questions with even more pertinent questions; the answers though remained elusive.

The discussion started from my yesterday’s note (see here) which highlighted that despite signs of recovery, India’s GDP may contract in 4QFY21 and may barely grow at 1% CAGR during twp year period (FY20-FY22). Also, some suspect, FY22 may also not be as good (10%+ yoy growth) as presently anticipated. Some of the questions that did not have clear answers were—

·         How could market be excited about cyclicals, especially commodities, with 1% CAGR growth over FY20-FY22?

·         If logistic constraints are leading to higher commodity prices, should investors be not worried about manufacturers who face raw material shortages, higher input cost in a demand driven market?

Most auto manufacturers have already cautioned about poor supply of semi-conductors and rising commodity prices as key risk factors.

·         Do we see enough capacity building projects to justify sharp rise in prices of base commodities like cement and steel?”

Especially when average capacity utilization remains below optimal and ministers are complaining about price manipulation and RBI is cautioning about plateauing recovery.

·         In which pocket of the market this extreme stress in sectors like MSME, intermediation, hospitality, etc is getting reflected?”

Logically, this stress must reflect on retail lenders (NBFCs & Banks) and consumers discretionary (due to lower income on poor employment & business closer etc.) and commercial real estate, at least. The trends in market are however not showing any sign of this stress!

It is widely acknowledged that MSME sector is in a terrible state. The pandemic has tremendously helped the large corporates with deep pockets to gain market share at the expense of MSME units.

·         Is Indian economy prematurely rushing to complete its “Americanization”?

With consolidation of businesses into top 100-200 entities, we may soon have 5% population growing, 60-65% population just surviving from payday to payday, and the rest 30-35% being taken care of by the government. Is this model desirable for India?

The general principle is that when you fail to get answers from economics and history, you may look upwards and seek answers in philosophy. My philosophical answer to the market conundrum is “Hope is a good thing, maybe the best of things, and no good thing ever dies”.

The GDP data for 3QFY21 and second advance estimates for FY21, released by CSO last Friday has evoked mixed response from economists. While the positive growth number (0.4%) for 3QFY21 has been received with a sigh of relief (as it ends the technical recession), the downgrade of full year FY21 estimates from -7.5% to -8%, implies a negative growth print for 4QFY21. Presently, growth estimates for 4QFY21 range between -0.8% to -1.5%.

The slowing momentum in 4QFY21 has also resulted in changes in FY22 growth estimates; which now mostly range between 10-11%. This implies a normalized growth of about 1% CAGR over FY21-FY22.

I have highlighted this issue earlier also. For common man nominal GDP is more important because lot of variables like effective taxation, budgetary allocations for development and social welfare, subsidies, salaries of public servants, etc. are calculated as a factor of the nominal GDP. Lower nominal GDP essentially means lower income for people and lower tax revenue for the government.

For example, the sharper fall in nominal GDP has resulted in sharper rise in effective rate of indirect taxes; which impacts the common people more, resulting in increase in income inequality and social injustice

In my view, the fall in nominal GDP over past 7-8years has been more worrisome than the real GDP. The nominal GDP growth rate has almost halved during FYFY13 and FY20. One of the better part of FY21 GDP estimates is that the decline in nominal GDP seems to have been arrested. With larger inflation tolerance range of RBI, hopefully this trend might get reversed in due course.

Insofar as the enthusiasm over positive GDP growth print is concerned, I would like to highlight the concerns raised by Dr. Pranab Sen, former Chairman of Indian Statistical Commission. As per Dr. Sen-

·         Recent GDP data is indicative of the slowing growth momentum and suggests that Q4 is not going to be great.

·         Investments (Gross capital Formation) is worrying for FY22 also.

·         Negative growth in 3QFY21 in Public Services is a source of worry, as it highlights resource constraints for the government.

·         The government expenditure that contributed significantly to the GDP growth numbers, includes significant amount of repayments of past dues. The growth in actual expenditure on real goods and services or creation of demand is not significant.

On the positive side, the growth in construction and manufacturing sector is encouraging; while agriculture growth stays strong. Given the expected record Rabi crop this season, the agriculture growth is expected to stay strong in 4QFY21 also. This gives hope that the normalized GDP growth may return to pre Covid level (FY19) in FY23-FY24.

It is however pertinent to note that pre Covid growth rate was quite dismal, in all respects. Moreover, we may not achieve the 6% long term growth (5yr CAGR) trajectory for till FY25 at least.

In a significant move for the banking industry, the central government has proposed to lift the embargo on grant of government business to private banks. Whereas, de facto the government has always favored public sector banks for grant of government business, the de jure embargo was imposed in 2012 post global financial crisis to protect the small savers and public entities from a potential collapse. Initially the embargo was imposed for a period of 3years; but it was extended further in 2015; through some private sector banks with public sector legacy (ICICI, Axis etc) were continued to be permitted to conduct some part of the government agency business. As per the latest announcement, the embargo is proposed to be lifted completely.

This announcement has come at a time when the government would be starting the process privatize couple of public sector banks (PSBs), and diluting its shareholding in other PSBs. In past couple of decades, many public sector undertakings have faced serious consequences due to dilution of government patronage to their business and/or introduction of private sector competition in their field of operations, e.g., Air India, BHEL, BEML, STC, MMTC etc. Obviously, lifting of this embargo will seriously impact the profitability of many smaller PSBs. Even larger PSBs will be impacted to some extent. The already subdued valuations of PSBs will naturally get further discounted. Banks like Jammu and Kashmir Bank, which substantially rely on government business, could face serious issues of sustainability.

The moot point therefore is whether liberalization in grant of government and public sector business must inevitably result in destruction of public sector wealth, or the liberalization could be better managed.

On a different note, RBI appears to be quite concerned about the financial markets and economic growth. RBI governor has been categorical in cautioning about crypto currencies. He has also raised the issue of divergence between performances of economic performance and stock market repeatedly. He has also raised concern over second round effect of fuel prices on economic growth.

Whereas, the financial markets and bond markets are fast pricing in an economy “overheating” scenario with sustainable rise in inflation, RBI has reiterated its commitment to continue with “accommodative” policy stance. In recent past, multiple bond auctions by RBI have devolved due to lack of demand at RBI cut off yields.

Obviously there is a divergence in RBI and market’s outlook about the price and yield scenarios. This implies either of the following two scenarios:

(i)    RBI is running behind the curve. If this is the case, the market shall be ready for a rate shock, whenever RBI does the catch up Act. Last time I remember this happened was during Subba Rao tenure, when multiple hikes were implemented in short span of time.

(ii)   RBI assessment of economic and earnings growth is closer to reality. In this case, also markets may be surprised negatively as it is pricing in a sharp recovery in earnings over FY22-23.

Historically, the disagreements\ between market consensus and RBI have not ended well for markets. I hope, this time it is different.

The latest earning season (3QFY21) has been one of the best in recent times. Companies across sectors reported encouraging revenue growth. The margins also improved on the back of lower input cost and wage rationalization. Accumulated demand (due to two quarters of lockdown) and festive season may have a significant role to play in the demand growth during 3QFY21. It is anticipated that as the economy continues to open up further as vaccination drive accelerates and mobility restrictions are eased further, the demand growth may sustain for few more quarters. The demand environment is also supported by the counter cyclical fiscal policy and continued accommodative stance of monetary policy.

The quarterly earnings surprised many analysts on both EBIDTA and PAT level; while on top line the surprises were lesser in number. For Nifty companies, on aggregate basis, EBIDTA margins and PAT margins were flat. However, after adjusting for exceptional losses in Bharti Airtel and Tata Motors, picture does not looks that disappointing.

In 3QFY21, double digit top line growth in metals, mining, cement, construction and manufacturing also augurs well for the macro growth. In fact, the cement industry reported third consecutive quarter of good results with EBITDA/mt for the whole industry coming in at Rs1,000+. It was due to continuation of strong pricing and lower operating costs as witnessed during the first two quarters of FY21. The industry witnessed volume growth of 5.6% YoY after 2 quarters of decline. This these trends support the view that Indian economy may recover to a normalized 5%+ growth trajectory in FY23. Of course it is not something to celebrate, but it does provide a whiff of relief that the fears of a deeper recession have been alleviated completely.

The markets however appear to be discounting an all clear blue sky scenario, which might be little over optimistic. Cost advantages available in 3QFY21 are dissipating fast with sharp rise in raw material & energy prices and normalizing wages. Considering that EBIDTA margins in 3QFY21 may already have reached close to their all-time high in case of many large companies like Hindustan Lever, the earnings growth expectations from the current level may some room for disappointment.

After a spate of highly optimistic commentary oover past three months, some voices of caution have started to emerge. Analysts at BofA see rising commodity prices and bond yields as key risk for Indian equities in near term. A recent note from BofA research read, “With the Nifty already at our year-end target of 15,000, continuation of a broad-based market rally appears unlikely.” The research notes that steel, cement, crude, coal, copper, aluminium, iron ore, palm oil and caustic soda are the key commodities relevant for the Nifty companies and prices of these commodities are up by up to 75% since June 2020.

Similarly, Nomura analyst sees ‘rising number of Covid cases, higher commodity prices, rising in trade and current account deficit and rising bond yields as key risks to Nifty rally in the near term.

At CLSA, while earnings estimates for for over 2/3^rd of coverage stocks have been raised after 3QFY21 earnings, recommendation downgrades by analysts are about 3x the number of recommendation upgrades; with valuation.

A note from ICICI Securities also notes that “Margins largely augmented by ‘cost control’ and product mix even as input prices continued to put pressure on gross margins in general. This phenomenon is continuing in Q4FY21 as evidenced by further rise in ‘manufacturing inflation’ component within WPI to 5% largely driven by metal prices.”. The note also cautions that rise in credit cost may surprise negatively for some financials.

A note from IIFL Securities notes that, “The steady margin improvement up to the previous quarter, driven by aggressive cost-cutting measures and benign input costs, has paused for now. Normalising activity and rising input costs are putting pressure on EBITDA margins.”

After the upgrades, the Nifty earnings is now expected to grow @20% CAGR over FY20-FY23 period, with FY22 EPS growth estimated to be over 33% yoy. Obviously, the current earnings estimates do not leave any room for disappointment. 4QFY21 and 1QFY22 earnings seasons must therefore be keenly watched. Any sign of disappointment on either revenue growth or EBIDTA margins may cause significant volatility in the market.

Crypto currency (e.g. Bitcoin) is proving to be the best asset class for the Covid-19 infected FY21. Most crypto currencies have yielded astronomical returns in a year that suffered the worst synchronized global recession since the great depression of 1930s. Against this, the traditional safe haven Gold, Swiss Franc (CHF), USD and US Treasuries have yielded insignificant return. USD Index (DXY) in fact has declined over 10% YTD FY21. Silver is the only traditional asset, besides equities, that has yielded strong return in past 11 months.

Regardless, the overwhelming consensus amongst global strategists appear to be favouring gold and silver as overweight in asset allocation of non-institutional investors. Most wealth managers and investment strategists are suggesting upto 15% allocation to gold (for example see here). Many globally popular and prominent traders, chartists and strategists have suggested a massive bull market in Silver in next couple of years (see here)

Meeting with a senior asset allocator last week was quite revealing in this context. The gentleman advocated 10% allocation to gold, besides 10% allocation to global equities (mostly US equities). He strongly advised to avoid crypto currencies; though he expects a rather lucrative trading opportunity in silver. On a little deeper probing, he offered the following rationale for his asset allocation strategy:

(a)   Given the status of quantitative easing (money printing) by major central banks, global hyperinflation is inevitable. It is only a matter of time when the prices of all real assets and commodities explode. In these circumstances gold will provide safety cushion to the portfolio.

(b)   Stagflationary situation in US could lead to sharp depreciation in USD value and chances of return to gold standard could enhance.

(c)    Gold-Silver ratio is breaking out on technical charts. From a 10yr high of 120, the ratio has already corrected to 60. Technically it is expected to test the 10yr low level of 30 in short term. This implies a sharp rise in silver prices.

(d)   Unwinding of monetary stimulus would also lead to unwinding of carry trade in USD and EUR. This may lead to reversal of flows away from emerging markets to developed markets. Therefore buying some developed market equity is desirable. It is also desirable from (i) diversification viewpoint and (ii) strategic viewpoint, i.e., to take stake in global businesses doing very well.

His arguments were quite convincing on first hearing. But on second thought these left me mor confused than ever. What I could not understand from his detailed presentation was:

(a)   If a hyperinflationary situation does materializes as popularly believed, won’t I have much serious problems to deal with. How 10% gold will solve these problems?

(b)   If USD and EUR get debased due to excessive money printing, INR will naturally appreciate against USD. Since gold is mostly priced in USD terms, won’t any appreciation in gold in USD terms will get neutralized by appreciation in INR vs USD.

(c)    What is the guarantee that gold does not suffer from the same malaise as USD? Is it totally improbable that the physical stock of gold has been leveraged many fold to issue paper gold?

(d)   Why can’t the targeted Gold-Silver ratio be achieved through fall in gold prices rather than rise in silver prices?

(e)    If USD and EUR do get debased, why would an alternative currency not emerge to maintain stability in global trade?

(f)    Since anticipated hyperinflation is mostly expected to be the outcome of a supply shock rather than a demand surge, a further dose of quantitative easing might be in order to encourage building of new capacities. If that is the case, then the whole premise of higher yields and hyperinflation might fail.

(g)    If USD and EUR debasement is a serious concern, then how does investing in global equities make sense?

(h)   A hyperinflationary condition may lead to material monetary tightening in India. Higher rates shall then warrant serious de-rating of equity valuations which are assuming prolonged period of lower rates and lower inflation. Even real estate may also suffer from poor demand due to higher rates in that case. We may need to worry more about INR debasement in that case rather than USD or EUR!

Many more such questions bothered me for couple of days, before I reminded me of the following basic learnings from the first chapter of my investment strategy book:

1.    India has 1.38bn people who need to eat & wear clothes, want decent healthcare, and aspire to have a decent shelter of their own. These needs and aspirations will continue to create many decent investment opportunity for me in India for next few decades at least.

2.    A tiny investor like me should never bother about diversifying the investment portfolio too much. A totally unproductive commodity like gold and mostly unknown animals like foreign equities are for large investors and traders with much stronger risk appetite. I should be happy with ordinary assets like high quality domestic equity (businesses which I can see and feel everyday); debt to my government and some large corporates; a house for myself; share in portfolio of good rental properties; and some liquid money in bank. Chasing few extra bps of returns is meaningless and fraught with risk which I can hardly afford. I cannot afford to risk even a single penny for earning few bragging rights.

3.    An information that has travelled seven seas to reach a commoner like me has no arbitrage value. If I know that USD hegemony is under threat; hyperinflation is on the anvil; silver is going to rise astronomically, then I must strongly believe that these happening will NOT shock the markets in any manner whatsoever.

For a large part of 20^th century Coal was a very important part of our lives. Railways, which were the largest medium of long distance inland travel, operated mostly on coal. An overwhelming proportion of electricity was generated using coal. The black gold was also a key ingredient for producing steel, cement, aluminium, copper, and a variety of chemicals. Things began to change slowly in second half of 20^th century and change accelerated in the last quarter of the century. Petroleum and Natural Gas started to gain share as major source of transportation fuel, electricity production, industrial feed stock and medium for cooking. From last decade of 20^th century, the share of renewable sources in India’s energy mix is also rising consistently. Nonetheless, coal remains the most important source of energy for Indian consumers and industry.

As per the latest data published by USEIA, “primary energy consumption in India has nearly tripled between 1990 and 2018, reaching an estimated 916 million tons of oil equivalent. Coal continued to supply most (45%) of India’s total energy consumption in 2018, followed by petroleum and other liquids (26%), and traditional biomass and waste (20%). Other renewable fuel sources make up a small portion of primary energy consumption, although the capacity potential is significant for several of these resources, such as solar, wind, and hydroelectricity.”

The agency further noted that “India was the third-largest consumer of crude oil and petroleum products after the United States and China in 2019. The gap between India’s oil demand and supply is widening. Demand for crude oil in 2019 reached 4.9 million b/d, compared to less than 1 million b/d of total domestic liquids production.”

Also “Diesel remains the most-consumed oil product in India, accounting for 39% of petroleum product consumption in 2019, and is used primarily for commercial transportation and, to a lesser degree, in the industrial and agricultural sectors.”

It is also important to note that out of the most 30 polluted cities in the world, about two third are in India. About 1.7million deaths (about one fifth of all deaths) are attributed to pollution every year (see here). It is also estimated that India loses about 1.4% of GDP every year due to pollution.

The India’s thrust for use of electricity as primary transportation fuel must be assimilated in this background. In my view, there are two primary objectives for increasing the share of electric mobility:

(a)        Achieving energy security, by reducing reliance of imported fossil fuels; and

(b)        Reducing carbon emission by vehicles.

As per a study by KPMG India, by 2030 India should expect EV penetration of 65-75% in 3W; 25-35% in 2W and 10-15% in personal 4W and 20-30% in commercial 4W and about 10-12 in overall busses.

In my view, like mobile telephony and digital payment, the pace of acceleration in adoption of EVs would surprise most of the analysts and administrators. The usage of EVs would only be limited by the lacunae in ecosystem rather than the willingness of users.

Innovative solutions for faster development of EV ecosystems are already being devised. Business models such as battery swapping would alleviate the need for millions of charging points, for example.

Three things must be taken care of in developing the EV ecosystem in the country:

(i)    Power generation through renewable sources must be accelerated materially. Charging EV batteries with thermal power will not serve the purpose of pollution control.

(ii)   India should try to become self-reliant in manufacturing of EVs, including all components. Otherwise, EV related import will replace fossil fuel import defeating the purpose of security.

(iii)  A strong framework for end disposal of used batteries and EVs must be established beforehand.

Insofar as investment ideas in listed space are concerned, I believe it will be a mixed bag for most existing OEMs and component manufacturers. Some will gain, some will lose and some might become redundant. The new crop of entrepreneurs which will focus exclusively on EVs will have plenty of gainers. I shall keep a watch for opportunity to invest early in some of these new ventures as and when they list; for I am too small to invest in an unlisted enterprise.

In Sri Ganganagar town of Rajasthan, the retail price of petrol has reached in three digits for the first time in Indian markets. This is culmination of a series of price hikes over past one year. Over 25% rise in domestic retail fuel price has happened when the average global crude prices have been much lower. Even on yoy basis, the brent crude prices are almost unchanged presently; and INR is stronger by over 5% as compared to USD.

The consistent rise in transportation fuel, when the consumers were deep in distress, economy was struggling and crude prices were falling sharply, has invited sharp criticism of the government. It is pertinent to note that all subsidies on transportation fuel were removed some years ago and presently none of the transportation fuel is subsidized. Therefore the rise in fuel prices cannot be attributed to rationalization of subsidies. Social media is also full of satirical memes about the consistently rising fuel prices.

In this context, it is also pertinent to note the following:

(i)    Retail fuel prices started rising sharply from May 2020, when the first of various Covid-19 stimulus packages was announced by the government.

(ii)   The rise in fuel prices has occurred when the consumption had declined.

(iii)  Most part of the rise in retail fuel prices could be attributed to additional duties and cess imposed by central and state governments.

India’s annual oil consumption is over 19 billion barrels approximately worth Rs9.5trn. A 10% hike in duties and cess on retail oil price would be Rs1trn, more than the amount provided for distribution under direct cash transfer (PM KISSAN) scheme to 12million rural poor.

A valid question to ask therefor would be “is the government using duties and cess on retail fuel prices for the purpose of wealth redistribution and socio-economic equity?”

In my view, it is a complex problem and needs much deeper study. On the face of it may appear a straight forward transfer of money from those who could afford (consumers of transportation fuel) to those who need it badly. However, if we consider the following propositions, the issue may not appear as simple.

(a)   Meeting a significant part of the rise in social sector expenditure and subsidies through higher duties and cess on transportation fuel has allowed the government to keep fiscal balance in check with lower than anticipated market borrowings, allowing RBI to keep the benchmark yields and borrowing cost for large borrowers at relatively lower level.

It would be interesting to examine, how much “large borrowers” have benefitted from lower interest rates and stronger INR, as compared to the loss on higher fuel cost.

(b)   For businesses higher fuel cost is mostly a pass through expense, meaning the incidence of higher fuel cost is passed on to the end consumer. Given that the propensity to consume is much higher at the bottom of the pyramid, implying that on relative basis the poor people may be hit more by the rise in consumer products due to higher fuel prices.

(c)    The cost of travel in public transport has not increased in tandem with the rise in transportation fuel. The rise in transportation fuel duties could also be a design to implicitly encourage people to use public transport.