Do it yourself

 A Newsweek story couple of weeks ago (see here) highlighted that Americans may not be splurging the $1400 stimulus checks given by the Biden administration. As per the story, a survey has found that “Americans are generally saving about 42.6% of the third federal stimulus payments, up from 37.2% and 36.4% of the second and first stimulus checks respectively”. It is pertinent to note that the latest stimulus payment of $1400 is larger than the first two, which were $1,200 and $600 respectively. The Survey also finds out that little over one third of the latest payment has been used to repay debt, as compared to 37.4% and 34.5% respectively for the previous two stimulus checks.

This data could be interpreted in different ways. The most common interpretation is that the recipients may be saving the money to get some more clarity on the Covid-19 conditions and come out in hoards to spend in next couple of years (2022-2023). Few are interpreting it as harbinger of a structural change in the US consumer behavior. It is suggested that the shock of global financial crisis (GFC, 2008-09) and Covid-19 may result in curtailment of overspending habits of average American.

(The following is with inputs from www.zerohedge.com)

In its latest earnings report, JP Morgan drew attention towards another dimension of this phenomenon. The bank highlighted that “in Q1 its total deposits rose by a whopping 24% yoy and up 6% qoq to $2.278 trillion, while the total amount of loans issued by the bank was virtually flat sequentially at $1.011trnn (down 4% yoy). This implies that for the first time in history, loans to deposit (LTD) ratio of largest bank in USA is below 50% for the third consecutive quarter. Similarly, at Bank of America, the second largest American Bank after JPM, the amount of total outstanding loans is below GFC levels, implying NIL loan growth for 12years. In fact, the aggregates at the top four US Banks indicate, no loan growth for past 12years while deposits have doubled in this period.

Prima facie, this divergence is unprecedented. Traditionally, loans and deposits have not diverged to this large extent. However, if we juxtapose this divergence to the unprecedented amount of money printed by US Federal Reserve (QE) in post Lehman era (2008), this divergence may not appear too blatant; for the amount of excess deposits accumulated over past 12years is approximately equal to the amount of excess reserves injected by the Federal Reserve in that period.

This obviously has changed the traditional paradigm that banks create money through extending loans and in the process fractional banking builds the reserves at Federal Reserve. This time Federal Reserve has created money and that money is lying in banks as deposits. The velocity of money has crashed to lowest levels. This is the primary reason why trillions of dollars in new money printing have not resulted in any inflationary pressure so far; even though the equity markets have been factoring in bouts of hyperinflation for more than a year now.

The question now is “how this situation shall get corrected?”

Many analysts expect the situation to revert to the traditional paradigm as Fed begins to taper in 2022. It is estimated that tightening of liquidity from Fed would force banks to lend aggressively, at a time when the deposits may be shrinking. A couple of years of aggressive lending and withdrawal of deposits will restore the balance in financial markets. The collateral would be higher interest rates and higher inflation.

I am neither an economist nor a research analyst. I am therefore not eligible to make an intelligent comment on this situation. Nonetheless, my naïve view is that this saving glut has only allowed QE to persist for so long; which means, QE has been nothing but a book entry to sooth the nerves of markets. The collateral of QE has been massive reverse transfer of wealth, from poor to the rich by way of wealth erosion for poor (joblessness, negative rates, asset price erosion) and disproportionate rise in wealth of top 10%.

In my view, this tiger ride (QE) will end only when the rider (excess saving deposits) perish. I am however not yet inclined to believe that this will happen the way it is popularly believed, i.e., Fed tapering, higher rates, inflation, aggressive lending and higher investment & consumption demand. I have a feeling it will happen through currency redundancy. The USD and EUR deposits may just become irrelevant over years, as new independent currencies become popular establishing a parallel global monetary system. The small savers will carry this cross, as has been the case always.

 Over past couple of weeks, I had exciting interactions with some professionals from the IT capital (Bengaluru), Pharma Capital (Hyderabad), Engineering capital (Chennai), Financial Capital (Mumbai) and political capital (Delhi) of India. From these interactions I learned that a definite new paradigm is emerging in Indian commercial space. The following are some key take away from my interactions:

1.    Traditionally, a majority of Indian entrepreneurs have not aimed for global scale in their businesses. Despite a rich history in the areas like culinary and textile, few businesses of global recognitions and scale could be created in these areas. However, now the first generation entrepreneurs have materially widened their vision. Many of them are now working on business ideas with global markets and scale in sight. No eye now widens on the mention billion dollar figures.

2.    The skills in Artificial Intelligence are becoming common place. In late 1990s Indian youth acquired skills in basic programing and coding of computer programs. This helped them crossing ocean in hoards and make a good career. A similar phenomenon is developing in artificial intelligence skills. The difference however is that unlike 1990s, now a large proportion of the young professionals want to become entrepreneur of independent professionals. They are not looking just good salary. I am sure a few of them would certainly be able to repeat the fables of Bill Gates, Jack Ma, Jeff Bezos et. al.

3.    The best part is that there is a strong start up ecosystem already in place. There are numerous investors who are willing to risk money on a good idea. Not many are looking at government for support. In fact, if I were to take my sample as representative, the only support neo entrepreneurs are seeking from the government is (i) less interference; and (ii) supportive tax structure.

4.    A lot of people of Indian origin, who are settled abroad are positive on Indian skills and entrepreneurship. They are helping the new ideas with financial and technical support. Many of them appear to be keen to have substantial exposure to Indian startup ecosystem.

5.    Though, the visibility of startups in technology enabled financial services (FinTech), retail, food delivery, and gaming is highest, some amazing developments are happening in the area of agriculture technologies, space technology, engineering design, water management, logistics management, pharmaceutical research and healthcare.

After this round of discussions, I am even more convinced that we have already entered into a business and economic paradigm. I believe that over next couple of decades, maximum value creation shall happen in businesses with technology leadership. Intellectual property shall derive significantly higher premium over conventional property. “Services” will continue to be key driver of economy rather than “Goods”; notwithstanding the government’s focus on manufacturing and construction.

On the negative side, the pace of elimination of smaller businesses, which cannot invest in technology and are not equipped to become ancillary of a large business, will continue to accelerate. The inequalities shall rise on multiple levels – economic, skills, access and opportunity.

 Prices of industrial metals and base metals have risen rather sharply in past few months. Most prices are now ruling at multiyear high levels. Though it is not clear whether this trend continues to be driven by the “supply shock” or a “demand shock” is driving the prices of higher.

Actually, it could be a mix of both the factors. For example, growth of electric mobility and accelerated adoption of reviewable (solar & wind) energy could be driving the demand of copper faster than the supply; where China’s curbs on steel production to control emission levels may have extended a supply shock to global trade. Similarly, the massive Covid stimulus by developed countries (e.g., US announcing massive stimulus for infra building) may have added to demand acceleration for steel and aluminum etc. while renewed mobility restrictions in many jurisdictions, Suez logjam, container shortages etc. may have added to supply restrictions.

There are some conspiracy theories also in the works. Couple of which I heard go like this:

(i)    Fearing further intensification of trade war with US, EU, Quad etc., China may be building strategic reserves of many commodities, causing an artificial scarcity in global markets.

(ii)   The global currencies face the prospects of getting materially debased after trillions of dollars in fresh printing, over and above the global financial crisis (GFC 2009-10) printing. Traders may therefore prefer to invest in physical commodities and independent (digital) currencies rather than fiat currencies.

Famous economist Nouriel Roubini, in his latest blog wrote, “Make no mistake: inflation’s return would have severe economic and financial consequences. We would have gone from the “Great Moderation” to a new period of macro instability. The secular bull market in bonds would finally end, and rising nominal and real bond yields would make today’s debts unsustainable, crashing global equity markets. In due time, we could even witness the return of 1970s-style malaise.”

A fund manager friend, who has been resisting investing in commodity stocks because he believed that it is purely a supply shock driven phenomenon and cannot be sustainable, is not finding the rally irresistible. His reaction yesterday was not entirely unexpected, when he said, “Inflation will kill this market. Till then buy commodities. Exactly opposite of what I have been believing for a year now. I am finally succumbing and buying xyz @$$$.”

It is part of my investment strategy not to invest in commodity stocks, except for short term trading purposes. To that extent, I am not too concerned about the price action in commodity stocks. Nonetheless, I continue to believe that most of the current forecasts for commodity inflation may not be fully factoring in the impact of some emerging trends like:

(a)   United global action on climate change may result in some dramatic change in consumption patterns across the world. This shall definitely impact the demand supply equilibrium of many commodities.

(b)   Acceleration in trends digitization of transactions, remote working, consumption of services (robots for housemaids, digital games for actual games, animation over normal entertainment, AI generated customizable digital books for physical books etc.)

(c)    Wider changes in food preferences, especially sugar, animal protein, simple carbs etc.

(d)   The rising inequalities of income, wealth and access to technology, may result in sever contraction in discretionary consumption.

(e)    One of the prolonged side effects of the pandemic could be acceleration in demographic degeneration of global population. As per some thoughts it could have impact of fertility and it could also impact the will to procreate.

It may be pertinent to note the following in this context:

·         US President Joe Biden has invited 40 world leaders to the Leaders’ Summit on Climate on 22-23 April, 2021. The agenda apparently is “to underscore the urgency – and the economic benefits – of stronger climate action.  It will be a key milestone on the road to the United Nations Climate Change Conference (COP26) this November in Glasgow.”

·         Reportedly, the summit will be preceded by United States announcing “an ambitious 2030 emissions target as its new Nationally Determined Contribution under the Paris Agreement.

·         “South Korea is developing the world’s largest offshore wind farm, generating up to 8.2 GW of power. The $42.8 billion project is part of the country's aim to become carbon neutral by 2050.”

·         A few months ago, Chinese premier Xi Jinping also surprised the global markets by announcing that “China will aim to hit peak emissions before 2030 and for carbon neutrality by 2060.”

·         India has also made commitment reduce greenhouse gas emission intensity of its GDP by 33-35 per cent below 2005 levels by 2030.

·         Many global companies have decided to include “Work From Home” and ‘Work From Anywhere” in their regular business plans.

Obviously, none of it impacts the portfolio today and I plan to hold on to my present metal and sugar sector stocks’ for few more weeks. Also, I am not planning to add duration to my debt portfolio anytime soon. Nonetheless, I do not subscribe the hypothesis of a sustained bout of high inflation over next few years. I believe that technology and climate change efforts will consume most of the money floating around in the world and in 15-20years the world will become a much better, cleaner and safer place to live and work.

In the context of India stock markets, I found the following two things worth noting on Tuesday:

(i)    A number of brokerages wrote strategy notes urging the clients to use the recent “lockdown fear” led correction in stock prices as a good opportunity to buy stocks. Apparently, the strategy appeared to be driven by (a) deep fall followed by a sharp recovery in 2020; and (b) belief that the abundant global and local liquidity and low interest artes will continue to support equity markets for couple of more years at least.

(ii)   The IT sector stocks corrected rather sharply after the bellwether TCS announced a decent set of number for 4QFY21 and encouraging commentary for FY22. This highlights, in my view, that markets expectations may be running rather high in terms of corporate performance and payouts. There is virtually no margin for any disappointment on earnings or payout front.

Some research reports have taken note of the intensifying second wave of Covid-19 infection cases, and cautioned against the likely adverse impact of the incremental restrictions on mobility due to this. For example-

“The Economic data released yesterday showed that the restrictions & sporadic lockdowns in response to the fresh wave of coronavirus infections started impacting the overall demand & growth. The IIP contracted 3.6% for February 2021, mainly on account of a steep contraction in the manufacturing output. Meanwhile, India's retail inflation rose to a 4 month high of 5.52% in Mar (5.03% in Feb & 5.91% in Mar 2020) as food prices soared.” (Aditya Birla Capital)

“The sporadic lockdowns/mobility curbs & night curfews put in place across key economic hubs in India in the past few days are likely to cost the nation $1.25 bn/wk. Taking into account rolling COVID curbs, if the current restrictions remain in place until the end of May, estimate is that the cumulative loss of activity could amount to around $10.5 bn, or ~0.34% of annual nominal GDP. However, the impact on the Q1FY22 nominal GDP is likely to be higher, shaving ~1.4% from the same.” (Barclays Bank)

The Nomura India Business Resumption Index (NIBRI) dropped sharply to 90.7 for the week ending 4 April from 94.6 the prior week, ~9.3pp below the pre-pandemic normal. This is its steepest weekly decline since mid-April last year. Accordingly, Nomura has cut the 2021 GDP forecast for India to 11.5% from the earlier 12.4%.” (Nomura Securities)

It is pertinent to note that currently, Nifty valuations (one year forward PER) are at 15% premium to the long term (10yr) average; and the market consensus is expecting ~32% earnings growth in FY22 followed by ~18% growth in FY23. Obviously, the expectations are running high, leaving little room for any disappointment.

Even after the recent episodes of sporadic mobility restrictions impacting the business and consumer sentiments, and downgrade of overall GDP growth for FY22, the consensus earnings estimates have been cut by less than 2% for FY22.

In my view, we may see further downgrades in both macroeconomic growth and earnings growth estimates for FY22. I am not sure if market may be forced to de-rate the equities’ valuation by these downgrades, but any rerating would certainly be difficult.

Currently, market consensus appears to be working with Nifty EPS of Rs640-650 for FY22 and Rs750-770 for FY23. I would prefer to be somewhat conservative and work with Rs590-610 for FY22 and 680-700 for FY23.

This means, I may be mostly ignoring the benchmark indices and focusing on businesses which I found (i) reasonably valued; and/or (ii) having very high visibility of growth, in spite of Covid-19 related obstructions. Because the Lord has commanded that “Blessed are the meek: for they shall inherit the earth” (Bible, Mathew 5:5)

Just when everything appeared to be settling nicely, the volatility in Indian equity markets has increased materially. The sharp corrections at any hint of adverse event highlights the jitteriness (and to some extent lack of conviction) of market participants. Considering that household investors (and traders) have increased their participation in the market significantly in past 6-8 weeks, the pain quotient of any sharp correction from here could be significantly higher.

Evidently, while the benchmark indices are now mostly flat for past 8-9 weeks, the sectoral shifts have been meaningful. Investors have adopted inflation (commodities) and cyclical recovery (mid and small cap) as a primary investment theme. Financials, discretionary consumption and realty sectors have witnessed a major “move out”.

The investors positioning seems to be, inter alia, based upon the following premise:

(a)        The earnings recovery witnessed in 4QFY21 shall continue for most of the FY22 and FY23.

(b)   The inflation which has been mostly a “supply shock” phenomenon in past three quarters will become a “demand shock” as cyclical recovery continues to gather pace and supply response lags the demand surge.

(c)    End of forbearance period for loans may lead to accelerated delinquencies, especially from MSME sector.

(d)   RBI shall continue to pursue accommodative monetary policy, regardless of the fiscal conditions, inflationary pressures and pace of cyclical recovery.

(e)    The companies may further improve on the multiyear high margins achieved in 2HFY21 and justify PE rerating of mid and small cap stocks.

The investors’ positioning is mostly based on promise of higher fiscal spending and incentives for setting up new manufacturing capacities. Obviously the assumptions suffer from a certain degree of dissonance.

Stress in MSME sector that is driving financials down is not reflected in sharp outperformance of mid and small cap stocks. Fears of lockdown, poor income growth etc. are reflecting in underperformance of discretionary spending (auto, media, realty etc.) but the “demand shock” expectations in metals etc. contradict this positioning. Service sector underperformance also mostly belies the cyclical recovery thesis.

The participants’ positioning also does not fully factors, in my view, the recently added high risk dimension to the RBI’s monetary policy. So far the quantitative easing (money printing) has been the domain of the jurisdiction having a universally acceptable currencies (US, EU, Japan, UK). RBI has ventured into this with a partially convertible currency. This could be a two edged sword. Could make INR highly volatile and impact the CAD.

The following excerpts from some recent global research are worth noting:

“US producer price inflation has jumped to a 10-year high. Business surveys suggest pipeline price pressures continue to build with some surveys suggesting a greater ability to pass higher costs onto consumers. This will add to the upside risks for CPI in coming months and increasingly points to earlier Federal Reserve policy action.” (ING Bank NV)

“China’s renewed focus on de-carbonisation leading to steel capacity cuts, strong domestic demand and muted global coking coal costs are likely to sustain high steel margins globally over FY22-23E. Lower Chinese export rebate as suggested (for months now) in media articles can discourage Chinese steel exports further. India domestic HRC price ex- Mumbai stands at c. INR 60k/t , significantly higher than JM/street assumption of INR 48k/t, while the landed China price at c. INR 68.7k/t leaves significant room for further price hikes in the domestic steel circuit.” (JM Financial Research)

“After two consecutive quarters of solid earnings beats and upgrades, we expect another strong quarter, aided by a deflated base of 4QFY20 and healthy demand recovery for the large part of 4QFY21 – as attested by high-frequency indicators. Performance is expected to be healthy despite headwinds of commodity cost inflation in various sectors. The key drivers of the 4QFY21 performance include: a) Metals – on the back of a strong pricing environment and higher volumes; b) Private Banks and NBFCs – on moderation in slippages and improved disbursements / collection efficiency; c) a continued strong performance from IT – as deal wins translate into higher revenues; d) Autos – as operating leverage benefits offset commodity cost pressures; and e) Consumer Staples and Durables – on strong demand recovery despite commodity price inflation. MOFSL and the Nifty are expected to post a healthy two-year profit CAGR of 16% and 14%, respectively, over 4QFY19–4QFY21” (Motilal Oswal Securities)

“If our growth projections were to come to fruition, India’s economy would pass the US$6.4 trillion mark by 2030, with per capita income at US$4,279 – reaching the upper middle income country threshold. This implies a real GDP growth of 6% and nominal growth of 10-10.5%. A key ingredient to our forecast is our estimate that manufacturing as a share of GDP will rise from approximately 15% of GDP currently to 20% by F2030, implying that its goes from US$400bn to US$1175bn. We believe that the thrust toward a manufacturing-led growth will set in motion the virtuous cycle of productive growth of higher investment - job creation - income growth – higher saving - higher investment and India would be one of the few large economies offering high nominal productive growth.” (Morgan Stanley)

I shared my investment strategy with readers in December 2020. I expected 2021 to be one of the most difficult years for investors in terms of high volatility, poor expected returns from diversified portfolios and continued low return expectations from cash and debt. After 3months into the year, I am even more confident about my view.

I continue to believe that to generate normal return on the financial asset portfolio one would need to maintain a certain degree of flexibility in portfolio. A part of the portfolio may be dedicated to active trading, at least in 1HFY22. I am therefore not changing my investment strategy for next 6months at least.

I may share my current investment strategy as follows:

Asset allocation

I shall continue to maintain high flexibility in my portfolio, by keeping 30% of my portfolio as floating, while maintaining an UW stance of equity and debt.

Large floating allocation implies that I shall be trading actively in equity.

(a)   The fixed equity allocation would be 40% against 60% standard.

(b)   The fixed debt investment would be 20% against 30% standard.

(c)    I would park 10% in cash/money market funds.

(d)   30% of portfolio would be used for active trading in equities and debt instruments.

My target return for overall financial asset portfolio for FY22 would be ~7 to 7.5%.

Equity investment strategy

I would continue to focus on a mix of large and mid cap stocks. The criteria for large cap stocks would be growth in earnings; while for midcaps it will be mix of solvency & profitability ratios and operating leverage.

(a)   Target 6% price appreciation from my equity portfolio;

(b)   I shall be overweight on IT, Insurance, Healthcare, Agri input and large Realty stocks. I shall maintain my underweight stance on lenders for at least 1HFY22.

(c)    For trading I will focus on large cap liquid stocks.

Miscellaneous

I have assumed a relatively stable INR (Average around INR74/USD) and slightly higher short term rates in investment decisions. Any change in these assumptions may lead to change in strategy midway.

I would have preferred to invest in Bitcoin, but I am not considering it in my investment strategy due to inconvenience and unease of investing.

Factor that may require urgent change in strategy

·       Material rise in inflation

·       Material change in lending rates

FY21 in retrospect

After FY09, the current financial year (FY21) has been the most eventful year in most respects – social, economic, financial, ecological, science, and geopolitical.

Socio-economic disaster: The spread of SARS-CoV-2 (Covid-19) virus that started sometime in last quarter of 2019 was declared a global pandemic in March 2020. The pandemic engulfed the entire world in no time, causing tremendous loss to human life and global economy. The mobility of people was restricted in most countries substantially. The economic activities were also curtailed only to the “essential” activities. Consequently, the global economy faced a technical global recession as most major economies recorded negative growth during 1HFY21.

The pandemic this had disastrous socio-economic consequences. Millions of jobs were lost and workers displaced; smaller businesses which could not bear the cost of lockdown faced closure or were further scaled down; loss of lives traumatized families; and millions of poor children who could not afford cost technology access were rendered out of schools. The inequalities rose sharply, further widening the social, economic and technology divide that has been hindering the global growth since the global financial crisis (GFC, 2008-09). It is estimated that millions of families across Latin America, Eastern Europe, Asia, Africa, and Indian subcontinent, that were brought out of poverty in past couple of decades face the specter of slipping back into the abyss.

Financial profligacy of gargantuan proportion: The pandemic and consequent economic lockdowns evoked unprecedented response from governments and central bankers across the world. The amount of fiscal and monetary stimulus created is unprecedented; even much higher than the quantitative easing done post GFC. This has certainly put question marks over sustainability of global debt (over $15trn still yielding negative return); ability of governments to support the poverty alleviation efforts.

Ecological awareness: One of the positive outcomes of the pandemic has been the rise in awareness about the ecological conservation. The partial lockdown of commercial activities demonstrated how the mother nature could heal itself within few weeks. The urban population which was moving away from the nature was reconnected with roots. This awareness may certainly accelerate the execution of global climate change action plans, saving the planet from imminent disaster.

Scientific advancement: The pandemic prompted a vaccine development program at unprecedented scale and speed. The scientists world over worked to develop an effective vaccine for the SARS-CoV-2 infection in no time. Never in the human history an effective antidote to a potent virus has been developed at such alarming speed. It is estimated that in next 3-5years the entire global population could be inoculated against this virus. The experience gained in development and administration of Covid-19 vaccine may be extremely useful in fast tracking the efforts for development of vaccines for other major infections like HIV and H1N1 etc. It shall also help in eradicating or controlling many deadly diseases in African continent, thus bringing the most endowed and most poor continent in the global economic mainstream.

Trade and Geopolitical tension: An intense trade war between the two major trade partners, viz., USA and China, had started couple of years ago. Besides, trade tensions were also rising between China-Japan, India and China and US and EU. The conspiracy theories behind origination of SARS-CoV-2 virus from Wuhan province of China, further deteriorated the trade conflicts into geopolitical tension. Some major economies and global corporations decided to reduce their dependence on imports from China; and use of Chinese technological firm’s services and equipment. India and China also had a material buildup at Northern borders. China intensified the efforts to build strategic block with allies like Iran, Sri Lanka, Pakistan, North Korea etc. These developments shall have a far reaching impact on the global economic and geopolitical situation. The full impact of this may be known in next decade or so only.

Indian markets

The initial reaction of Indian markets to the pandemic was that of panic. The prices of equities and bonds crashed precipitously. The panic however subsided soon as the government took some strong measures to control the spread and mitigate the damage due to economic slowdown. The FY21 journey of Indian markets could be summarized as follows:

Nifty rallied hard, catching the participants by surprise

Nifty is ending FY21 (all Nifty data till 29 March 2021) about 20% higher than its December 2019 closing level. Nifty rallied hard in October –December 2020 quarter as the unlock exercise started and earnings upgrade cycle kicked in. By November 2020 all Covid-19 related losses were erased.

The strong market rally in fact caught many participants by surprise as the divergences from the real economy became too evident. The rally was apparently supported by the fact that the large organized players have not only survived the lockdown well but gained material market share from the smaller unorganized players. Multiple stimulus packages announced by the government and consequent abundant liquidity also have helped the rally.

The rally however appears to have tired in 4QFY21, for lack of triggers.

India with over 75% (Nifty TRI) gains is the second best market (after South Korea 78%) amongst all global major markets. It outperformed peers like Brazil (21%), China (25%), and Indonesia (40%); and developed markets like UK (21%), US (48%), France (37%) and Europe (36%), .

The momentum however has slowed down considerably in 4QFY21. In the current quarter, India (up 4%) is sharply underperforming US (8%), Japan (7%). Germany (8%). Even though it is still outperforming its emerging market peers like Brazil, China, Indonesia etc.

Consumption lags, cyclicals, IT & Pharma shine, smallcap outperform; FPIs’ big buyer

Metals, IT, Auto, Realty and Pharma have been the top performing sectors in FY21. Consumers have underperformed massively. Financials performed in line with the benchmark indices.

Broader markets (small and midcaps) and Alpha strategies sharply outperformed the benchmark indices. The market breadth has been mostly good (8 out of 12 months).

Net institutional flows were not great (less than $9trn) considering the abundance of liquidity and lower rates. FPIs though poured over $27bn in secondary equity market alone.

Gold disappointed; broader markets underperform on 3yr basis

Despite the huge rally in benchmark indices and broader markets, the household investors continue to be disappointed. One of their favorite asset class ‘gold” has underperformed majorly. Intuitively, gold ought to have done well in a crisis marred year. Gold ETFs have returned almost nothing in FY21 and are down over 10% in the current quarter.

Mid and small cap stocks have given superlative return in FY21. However, if we account for the massive underperformance of preceding two financial years, the performance of broader markets continues to remain below par.

Debt market jittery about large borrowing program

The government has managed the FY21 borrowing program well without any noticeable damage to bond markets or private credit. The bond market returns for FY21 have therefore been more than decent. However, in past 3months, rising global yields and huge Rs12trn borrowing for FY22 has kept the debt market on the tenterhook. A steeper yield curve due to abundant liquidity and RBI’s efforts has further queered the pitch for bond investors.

The Reserve Bank of India managed the markets well. It avoided direct monetisation of government borrowings and supported the government borrowing by all means available to it. At end of the day, RBI may close FY21 with a ballooned balance sheet equal to the size of 30% of GDP.

INR recovers from panic fall, stable around Rs73/USD

On announcement of lockdown, INR had a panic fall upto RS78/USD. It however recovered the entire lost ground within 5 months, and has been mostly stable around Rs73/USD in 2HFY21.

India’s macro conditions remain challenging despite the complete recovery from recession. Pre pandemic, Indian economy was growing at the long term rate of ~6% (5yr rolling CAGR). Due to collapse of growth in FY21 (-8%), the trajectory has slipped to ~4%. Recovering back to even subpar ~6% trajectory may take upto 5 years (FY26). Considering that India’s demographic needs require consistent 8-9% growth, led by high job creating construction and manufacturing sectors, the growth challenges may not abate anytime soon.

To make the matter worse, the inflation has become sticky and persisting close to upper bound of RBI’s tolerance range. Though RBI has made it abundantly clear that Indian economy cannot tolerate rise in interest rates at this point in time, any further easing of policy rates is virtually ruled out.

Quasi stagflation (for lack of a better term), has therefore emerged as a major policy challenge in FY21.

Conclusion

To sum up, FY21 had been a challenging year. It has dented the core of global as well Indian economy. The markets have come out from it mostly unscathed. It would be interesting to see how FY22 unfolds. I will share my investment strategy for FY22 tomorrow.

 The recent order of the Supreme Court regarding classification of NPAs and payment of compound interest for the period of moratorium has reignited a debate on the state of Indian financial sector. The order of Supreme Court has been received by markets as a relief, as it removes a regulatory overhang and paves way for the banks to proceed with recovery of NPAs. Nonetheless, the next few quarters need to be watched closely for any precipitous rise in bad loans; especially if the recovery appears faltering.

Past few years have been quite challenging for Indian financial services sector. A decade of massive infrastructure building exercise (1998-2008) resulted in significant advancement of demand and therefore unviable projects in key sectors like housing, roads, power, civil aviation, metal & mining, SEZs, Ports etc. resulted in a multitude of stalled and unviable projects. Administrative and regulatory irregularities in allotment of natural resources to private parties led to judicial action, compounding the problem of failed projects. Demonetization (2016) and implementation of nationwide uniform Goods and Services Tax (GST, 2018) led to permeation of stress of MSME sector, especially the unorganized sector. The lockdown induced by Covid-19 pandemic (2020) further exacerbated the stress in this sector.

The process of recognition of the stress in sectors like infrastructure, metal & mining, telecom etc. started with changes in rules in 2014 & 2015. However, the real impetus was provided by implementation of Insolvency and Bankruptcy Code in 2017. The process started in right earnest with identification of top 12 (dirty dozen, 2017) non performing accounts by RBI and initiation of resolution process under IBC. Closer scrutiny of large stressed accounts resulted in collateral damage in terms of exposing of frauds and fraudulent lending at some NBFCs (IL&FS & DHLF) and Banks (Yes Bank, PNB, PMC etc.)

In past 4years, the process of NPA recognition and resolution accelerated; though not at the desirable speed. This entire process has resulted in emergence of some key trends in financial markets:

·         Many weak banks have been identified. Some in public sector of these have been merged with relatively stronger banks. Some in private or cooperative sector have gone under rehabilitation (including management change) process.

·         Most banks have resorted to raising fresh capital to strengthen their capital adequacy. The government has also provided fresh capital to stronger banks.

·         Couple of large non banking financial companies (IL&FS and DHFL) have faced action under IBC. This resulted in massive losses to mutual funds who had been a major lenders to these companies. This has resulted in tightening of funding of NBFCs by mutual funds.

·         The restructuring of perpetual bonds (AT-1) of Yes Bank, triggered a rethink on the risk profile of this important source of capital for banks; thus narrowing the window of raising capital for banks.

·         In view of the elevated stress level, most banks have materially tightened the credit assessment standards. This has resulted in sustained slow-down in credit growth, especially to low rated companies and MSMEs.

·         To manage the rise in deposits, due to fiscal & monetary stimulus and lower consumption during stressed times, many banks have resorted to increased emphasis on high margin personal loans. This trend threatens to put incremental stress on bank’s finances if the recovery falters due to relapse of pandemic or otherwise.

As per the latest Financial Stability Report (RBI, January 2021):

·         Macro-stress tests for credit risk show that SCBs’ GNPA ratio may increase from 7.5 per cent in September 2020 to 13.5 per cent by September 2021 under the baseline scenario. If the macroeconomic environment deteriorates, the ratio may escalate to 14.8 per cent under the severe stress scenario.

·         Stress tests also indicate that SCBs have sufficient capital at the aggregate level even in the severe stress scenario but, at the individual bank level, several banks may fall below the regulatory minimum if stress aggravates to the severe scenario.

·         The overall provision coverage ratio (PCR) improved substantially to 72.4 per cent from 66.2 per cent over this period. These improvements were aided significantly by regulatory dispensations extended in response to the COVID-19 pandemic.

·         At the aggregate level, the CRAR of scheduled urban co-operative banks (SUCBs) deteriorated from 9.70 per cent to 9.24 per cent between March 2020 and September 2020. NBFCs’ credit grew at a tepid pace of 4.4 per cent on an annual (Y-o-Y) basis as compared with the growth of 22 per cent a year ago.

·         In the latest systemic risk survey (SRS), respondents rated institutional risks, which comprise asset quality deterioration, additional capital requirements, level of credit growth and cyber risk, among others, as ‘high’.

As per the rating agency ICRA’s estimates, gross NPA worth Rs 1.3 lakh crore and net NPA worth Rs 1 lakh crore were not recognized as of December 31, 2020 due to Supreme Court interim order. These NPA may get recognized in 4QFY21. A recent note ICRA mentioned,

“In ICRA’s outlook for the banking sector for FY2022, we had estimated the Tier I capital requirements for PSBs at Rs. 43,000 crore for FY2022, of which Rs. 23,000 crore is on account of call options falling due on the AT-I bonds of PSBs while the balance is estimated as equity.

“In the Union Budget for FY2022, the Government of India (GoI) has already announced an allocation of Rs. 20,000 crore as equity capital for the recapitalisation of PSBs. If the market for AT-I bonds remains dislocated for a longer period for the reasons discussed earlier, and the PSBs are unable to replace the existing AT-Is with fresh issuances, this would mean that the PSBs could stare at a capital shortfall based on the budgeted capital.

ICRA also expects that the GoI will provide requisite support to the PSBs to meet the regulatory capital requirements, which means that the recapitalisation burden on the GoI could increase, or the PSBs could curtail credit growth amid uncertainty on the capital availability. Apart from Tier I, as mentioned earlier, there could be reduced appetite from mutual funds along with a rise in the cost of issuing Tier II bonds as the limited headroom for incremental investments in Basel III instruments.”

In my view, the theme to play in financial sector may be “consolidation” and “market share gain” by the larger entities (banks and NBFCs) rather than economic recovery and credit growth. Attractively valued smaller entities may be vulnerable to extinction.

 The first monetary policy statement of FY22, scheduled to be made on 7 April 2021, is awaited more for the signals and body language, rather than any monetary policy action.

It is almost a consensus that RBI, like any other major central banker, may not be in a position to cut rates from the present levels. On the other hand, RBI governor has made it clear that “...there is no way the economy can withstand higher interest rates in its current state. It is recovering but certainly not out of the woods yet”. The governor has gone way out of his way to assure the bond market and committed “orderly evolution of yield curve” in public interest.

The bond market has calmed down a bit after aggressive assertions made by RBI governor, but the traders have not retraced their steps. The benchmark 10yr yields are now stable close to 6.2%, much higher than the 5.8% to 5.9% sought by RBI.

Next couple of policy statements would therefore be watched to assess (i) how deep is the RBI’s commitment to keep the yield curve orderly and liquidity ample; and (ii) when RBI would be ready to hike rates.

The equity markets usually do not have a strong correlation with the bond market. However, a negative correlation emerges in months preceding the turning of rate cycle. The current tentativeness and loss of momentum in equity market is indicating that equity traders are also anticipating a turn in rate cycle sometime in 2021. A rate hike or a clear indication about the policy path by RBI could therefore be a positive support for the equity market.

Internationally also financial markets are focused on tapering of bond buying programs of major central bankers and eventual hike in policy rates. As per current estimates, FED tapering may begin sometime in 2022 and rate may not be hiked at least until mid-2023. Notwithstanding the expectations, the markets are definitely indecisive.

In my view, we shall have an extended period of indecision and sideways movement in equity markets before the monetary policy makes its next move. Till then happy trading.

 A visit to local fruit and vegetable market last evening was quite revealing. The summer seasonal fruits like muskmelon (Rs140/kg); safeda mango (Rs180/kg) and watermelon (Rs45/kg), mulberries (Rs350/kg) all appeared becoming unaffordable for common households. Even if we assume that it is still early season and the rates will correct in next few weeks, my experience is that peak season rates are usually not less than 50% of the early season rates. Similarly none of the seasonal vegetables was available less than Rs50/kg.

An article in March Bulletin of RBI highlights that the rate of financial savings of household may have contracted to 10.4% of GDP in 2QFY21 from 21% in 1QFY21. It is also suspected that the household savings rate may have further declined in 3QFY21. The article reads that “The Covid-19-induced spike in household financial savings rate in Q1:2020-21 waned substantially in Q2 in a counter-seasonal manner. While households’ deposits and borrowings picked up, their holdings of currency and savings in mutual funds moderated.” The article suspects that “This reversion is mainly driven by the increase in household borrowings from banks and non-banking financial companies (NBFCs), accompanied by a moderation in household financial assets in the form of mutual funds and currency. Nonetheless, households’ financial savings rate for Q2FY21 ruled higher than that of 9.8% witnessed in Q2FY20.”

The AMFI data on mutual fund flows over past 8 months also corroborates this trend.

The persistent fall in net household savings, especially due to higher household debt must be a matter of serious economic study. While some argue that this fall is a healthy corrective trend indicating towards improving financial inclusion of Indian households. Better access of debt is leading to higher household borrowing and therefore lower net savings rate.

This could be music to the ears of managers at retail banks, consumer finance NBFCs and MFIs; but certainly not a good news for household savers, who are struggling with negative interest rates on their savings (when deflated by their respective household inflation not the official headline CPI data).

I have stated this couple of time household savings is one of the most critical elements of Indian economy. Ignoring it or undermining it, is certainly fraught with grave risk.

During five year period between FY15 and FY20, annual household savings in India have grown 64% from Rs24.4trn to Rs39.91trn. However, in this period the household debt has increased 133% from Rs10trn to Rs23.4trn.

Traditionally, domestic savings, especially household savings, have been a stable and sustainable source of funding for both private as well public investments. Though liberalization of capital controls has opened the doors for foreign capital. It still is not a major source of funding for domestic enterprise. More particularly, the decline in financial savings of households that begun in early 2000's has accelerated in recent years. This has serious implications for the economy and therefore equity markets.

I sincerely believe that the government and policymakers have not taken a holistic view of the problem and the steps taken so far are not only inadequate but to some extent misdirected also.

I feel the issue needs to be analysed comprehensively for making any worthwhile step to augment household savings, especially financial savings. For example, the following questions may need to be answered:

The key cause for this trend, in my view, could be listed as follows:

(a)   Fall in average age of house ownership. Higher income levels in urban areas, rise in nuclear families and rise in real estate prices has prompted people to buy houses earlier in their life cycle.

(b)   Rise in personal automobile ownership.

(c)    Low growth in white collar employment opportunities as compared to growth in workforce has led to phenomenal rise in self owned enterprises leading to diversion of savings to physical assets.

(d)   Rise in gold prices in 2000’s and subsequent rise in household gold holdings.

(e)    Persistent negative real rates in pst two decades.

(f)    Stagnant real wages for past one decade.

There are reasons to believe that the rate of household savings may stay lower or even diminish further. For example, consider the following:

(a)   Consumer prices for households may remain high, even if the rate of yearly inflation moderates. Expenses on items like education, health, energy, transportation, communication, rental, protein, and fruit and vegetable shall continue to rise disproportionate to rise in income. Hence the savings rate may remain lower.

(b)   Material rise in income and wealth disparities post demonetization and GST implementation. Lockdown induced by pandemic has further accelerated the trend of rising disparities.

(c)    Factors like lower investment growth, higher productivity gains through automation & elimination of redundancies, restructuring of PSUs shall continue to impact the employment growth, especially for skilled labor.

(d)   Lower employment opportunity may force more and more people towards self-enterprise, leading to higher household debt.

(e)    Last but not the least, the trend for changes in consumption pattern shall continue. Bicycle and Transistor Radio have already given way to motor cycle and smart phone as essential marriage gift (dowry) in hinterland. The running expenses are to be paid by someone after all - be it the bridegroom, his parents or the bride's parents. Consumption of services like telecom, transportation, health and education may continue to rise, leading to even lower savings.

The economic growth will have to find an alternative source of funding (no capital control) or a way to grow household savings (lower taxes, higher real rates, cheaper houses/rent, good public health/education/transport, and farm employment).

In the meantime, the authorities will have to make some effort to ensure that due to unaffordability of fruits, vegetables and milk, lower middle class does not shifts majorly to unhealthy eating habits. If this happens (if not already happened) the health of Indian society may worsen further. Remember, we are already struggling with very high incidence of diabetes, tuberculosis, hypertension, cardiovascular diseases, cancer and female health issues like PCOD.

As per the latest data available, the capital expenditure (capex) growth the new project announcements were down significantly in 3QFY21, the quality of projects has improved materially. The new public sector projects are mostly in infrastructure sector, with state governments taking the lead over central government. The private sector projects are mostly in manufacturing sector driven primarily by the production linked incentive (PLI) scheme announced by the central government.

On the consumption side, the real wages for non-government non-financial sector have continued to decline for fourth successive quarter in 3QFY21. The employee cost for this sector is presently at lowest level in a decade.

I note the following trends from some recent brokers’ reports relating to new capex.

Phillips Capital analyzed the recent capex data published by CMIE and noted the following:

·         New projects announced in 3QFY21, at Rs 801bn, were lower 22% qoq/89% yoy due to large changes in base quarters coupled with continued challenging environment. Private sector accounted for 86% of new capex announcements. Renewables and mining witnessed strong growth while manufacturing declined sequentially.

·         The execution was poor in 3QFY21, with project completion declining sequentially. Road sector was the only sector that witnessed strong execution.

·         Stalled projects were flat yoy and qoq. These projects now account for 11.5% of all projects under execution. Lack of funds (17%), raw material supply (17%) and other issues (41%) were key reasons for project stalling.

·         The quality of projects remains high. Recent government initiatives on PLI’s have begun reflecting in new projects, particularly in the consumer electronics sector. This trend is expected to gather pace as PLI’s are finalized for Bulk Drugs manufacturing and Automobiles sectors over the next few months. This may further push up the share of manufacturing from c. 30% of new projects in the last three years and result in growth in project announcements in FY22.

As per IIFL Securities “corporate India capex outlook is looking up again (14% Cagr over FY21-23ii) after two years of continuous decline (9% Cagr drop in FY19-21) driven by PLI linked investments and growth in emerging segments like data centres. Telecom, Cement, Auto, Pharma & Healthcare, Consumer Electronics, and Chemicals are the key sectors driving investments.”

The brokerage forecasts “incremental investments worth Rs700bn under the PLI scheme, for various manufacturing sectors. However, given the quantum of incentives doled out and capex intensity, Electronics, Auto and Pharma are likely to be the largest sectors. • Most PLI-related capex will be spread out over 3 years (FY22-24).”

The brokerage notes that most of the PLI segments are light engineering sectors, but will require higher deployment of automation and robotics across various applications (especially in sectors involving large-scale electronics manufacturing from foreign players).