Do it yourself

Friday, December 1, 2023

Some notable research snippets of the week

Economy: Momentum continues (Phillips Capital)

Latest data for the week ending 28th November saw pick-up in activity. Energy consumption, railway freight and Maharashtra property registrations improved W-o-W while vehicle registrations dipped slightly from the Diwali associated strength in registrations. Economic and industrial activity in India has been progressing well post the strong festive season. Q2FY24 GDP data is estimated to be strong around 7%. With FII flows turning positive and Indian growth fundamentals remaining strong, equities are expected to trend higher after remaining range-bound for a prolonged period.

Industrial data: (1) Energy consumption grew by 2% wow vs. -1% drop in the previous week; 4% higher yoy. Consumption saw 21% growth yoy in October vs. 10% in the previous month. (2) E-way bill generations surged to a record high with 9% mom growth; 31% yoy growth in October vs. 10% in the previous month. (3) Daily railway freight tonnage improved by 2% wow vs. 3% growth in the previous week; monthly freight registered 9% yoy improvement in October vs. 7% growth in the previous month. (4) Vehicle registrations at an all-India level fell by -7% wow vs. 25% growth in the previous week. Registrations down by -13% yoy in October, but saw 6% mom growth; PVs/2Ws saw -8%/-18% decline yoy while MHCV was up 16%. (5) Property registrations in Maharashtra (excluding Mumbai) improved by 12% wow vs. 4% growth in the previous week; Registrations was 20% higher yoy in October vs. 11% in the previous month. (6) FASTag toll collection volume growth at 13% yoy in October vs. 15% growth in the previous month.

Macro data: (1) Net new EPFO subscribers increased to 1.72mn in September from 1.50mn in the previous month, registering 15% mom growth. (2) LAF deficit worsened to average Rs -1,1342bn vs. Rs -735bn in the previous week. (3) CIC fell wow; yoy growth at 4%. (4) Bank credit improved by Rs 1,422bn fof as on 3rd November; growth at 16% yoy. (5) Food stock increased by 14% mom in November vs. -8% dip in the previous month; 7% growth yoy.

IBC Resolution Timelines Continue to Lengthen for Creditors (INDIA Ratings)

The recovery timelines under the resolution through the Insolvency and Bankruptcy Code (IBC) route continue to lengthen with those resolved in 2QFY24 touching an all-time high of 662 days for financial creditors with a consistent increase across all creditor classes for the past three years. Process-related challenges such as legal tussles between stake holders, case execution bandwidth, delay in judgments, information asymmetry and a lack of standardisation (e.g. valuation process) are leading to elongated timelines.

On the other hand, recoveries for financial creditors have stabilised in the range of 33% to 35% though operational creditors have shown some uptick in recoveries from to 18.3% in 2QFY24 from 16.5% in 2QFY23. In Ind-Ra’s opinion, recoveries from the resolution are slowly reverting to the pre-IBC days after the initial success when they were in the range of 40%-45%. This could further delay a deepening of the bond markets, which, besides information asymmetry, are exposed to significant losses in the event of a default by the issuer, given their unsecured nature. In comparison with other resolution mechanisms, IBC has displayed an improved level of recoveries.

The experience of liquidating assets also shows extended timelines for recovery for all asset classes and recoveries in the region of 5% to 10% with financial creditors on average recovering lesser than operational creditors.

While liquidation remains the option which has shown the maximum closures under IBC, its lower realisations is likely to encourage creditors to seek resolutions either outside the IBC or register only those cases under IBC where the recoveries through resolution are likely to be higher.

Realisation Stay Lower and Timelines Stretched Further: The average time taken for closure during 2QFY24 was 493, 468 and 394 days for FCs, OCs and CDs, respectively, which is the highest since FY21.

Liquidation Continues to Dominate Closure of CIRP: The closure through the resolution plan route in 2QFY24 saw a slight improvement compared to that in 2QFY23. While the resolution through liquidation saw a 2% yoy dip in 2QFY24, it remains the most preferred route with 44% of overall cases being closed through liquidation.

Gap Between Admission and Closure Reduces This is the first time since 1QFY22 that the cases closed during the quarter have been higher than those admitted. In 2QFY24, the gap between the closed cases and admitted cases reduced; in this quarter, the cases closed were 292 more than those admitted 232.

HH Fin savings fall: Appearances can deceive (IIFL Securities)

We argue against popular perception that fallen HH Fin savings (down from 11% to 5.1% of GDP in 13yrs) have hurt deposit growth and will hurt investments (as they have been largely financed by HH savings) and/or cause CAD to widen. We argue that investments drive savings, and not vice versa, and policy response has to focus on investments. What will help is if the gap between NGDP growth and Borrowing Cost rises, incentivizing investments, as happened in the naughties. The chances of this are reasonably bright for India in the medium term.

Investment drives savings, not vice versa: Of late, Indian consumption has indeed risen and savings fallen, but more due to investments falling. 70 year data shows that consumption growth is far less volatile than investments’ and when the latter accelerates, consumption as % of GDP falls, and savings % naturally rises. Barring episodes of crude spiking, CAD broadly stayed stable, averaging 2.4% of GDP. These trends have held, almost monotonically, for decades. Also, overall deposits are down from Covid high but at LT mean (68% of GDP).

But ICOR has deteriorated and growth has worsened globally: Further, compared to other emerging economies, India’s savings and investment, each currently at around 30-31% of GDP, are respectable, though down over a 15 year period. In our 15 country sample including EMs and DMs, almost everywhere, growth has slowed down and ICOR worsened, a significant deterrent to investments globally. But India’s ICOR has been amongst the best in our sample over the past 2 decades.

What can trigger investments? In India, consumption (and HH non-mortgage debt) has risen in past decade, but this is insufficient to spur demand and trigger investments. Further, a widely believed inflection point for GDP growth at around the $2,000 per capita GDP mark ($ 4,000 in PPP terms) is not evident from our 15 country sample except in the case of China. What can help is if the NGDP growth – Borrowing Cost (G-BC) gap, currently 2-3ppt for India, rises. This gap was very high for most sample countries during the naughties boom. In India, low inflation, strong govt. revenues and tax buoyancy, policy friendliness (barring politics risk), inflows from JP Morgan bond index inclusion, all point to G-BC gap expanding uniquely. We remain optimistic over the medium term.

Debt-fuelled consumption can sustain for a while: Decline in overall HH savings has been due to increase in HH consumption – up from almost 56-57% of GDP in FY07-13 to around 61% currently. Consequently, we see HH physical savings / investment (in RE, which is the mirror image) fall from 14-16% of GDP to around 12% and net financial savings falling to 9-11% to around 5-7%.

IT Services: Budgets ain’t budging (JM Financial)

A soft OND will likely cap off a challenging 2023 for IT Services companies. Most available guidance for the quarter have even quantified it. We therefore pored over the most recent earning commentaries from global players to distill early signs of 2024 outlook. Seasonal weakness aside, underlying volumes appear stabilising. Unexpected ramp-downs are less frequent now. Deep budget cuts in 2023 have raised hopes of some let up next year. But a soft discretionary environment is unlikely to see a rapid rebound. IT budget increases, if at all, are likely to be limited and incremental. Capgemini hopes of demand inflection in 2024, but does not see that in Q1. Cognizant reckons that in aggregate, 2024 starting point is similar to 2023’s.

Hyperscalers, although pointing at attenuating optimization trends, have not called out a reversal yet. A potentially soft start to the year could lock-in pricing at current levels, nullifying chances of price hikes through 2024. These could put the Street’s FY25 estimates at risk. Hopes of rate cut in US could support multiples. But that would barely offset potential earning moderation, in our view, limiting meaningful upside. Relatively benign outlook by mid-scale digital players suggest mid-cap’s relative outperformance could continue.

Q4CY23 - No respite: Q4 is likely to see a double whammy. Hopes of budget flush have waned. Likely impact of furloughs, on the other hand, seems to have elevated. CAP says clients are squeezing early to bring down their technology cost. CTSH’s Q4 guidance is wider than usual to reflect heightened uncertainty. EPAM will witness planned ramp down from EU clients. Amdocs’s Telco clients are reducing discretionary spend, including legacy modernization. Unsurprisingly, most available guidance imply sequential decline.

2024 budget – a sneak peek: Budget discussions have started. There are reasons to be hopeful. CAP believes that after deep cuts in 2023, clients need to get projects done in 2024. TWKS is hearing from clients that budget pressures are starting to ease. But these do not necessarily equate to any imminent budget expansion. In fact, TWKS mentioned that client mood (in their budget discussions) is still very cautious. CTSH cited limited visibility around discretionary spend. It feels 2024 start is similar to 2023’s. Even CAPP ruled out any demand inflection at least till Q1, reflecting low near-term visibility. Our checks indicate flattish budgets for 2024.

Digital providers’ optimism not extrapolatable: Surprisingly, mid-scale digital providers (EPAM, DAVA, GLOB) sounded upbeat in their outlook. This is at slight odds with a more circumspect view of scaled GSIs. EPAM is seeing stability in client program and budgets, specifically in North America. GLOB has been a standout player in terms of growth and expects the momentum to sustain. DAVA expects growth recovery from Q3FY24 (AMJ quarter). Note, these players suffered material client specific challenges in past few quarters which now seem behind them, explaining their optimism. Their specific situations however make the extrapolation difficult, in our view.

Smaller deals and pricing: CTSH stated that ACV of recently won large deals will start contributing from 2024, aiding growth. However, declining smaller (<USD 5mn) deals offset that. Almost 50% increase in its average deal duration – from two to three years – indicates the extent of deceleration in smaller deals. Besides, smaller deals result in better pricing transmission. A still uncertain environment means annual pricing is likely to get locked-in at current levels, leaving little scope of price increases through 2024.

Read through for Indian IT: Ramp-up of large deals underpin the Street’s confidence on large-cap IT’s FY25 revenue growth. But deflationary pressure from declining smaller deals is not appreciated enough, in our view. A likely flattish budget for 2024 means the pressure on smaller/discretionary projects is unlikely to relent anytime soon. We therefore see risks to the Street’s FY25 estimates. NIFTY-IT is up 5% over the past one month, likely on hopes of US rate-cuts in 2024. That could support multiples, but barely to offset EPS cuts, in our view. Mid-caps with growth momentum are better bets.

Banking: A closer look at credit costs and other aspects (Yes Securities)

We took a closer look at 1HFY24 credit costs and other aspects of all our coverage banks and drew the following key conclusions (1) Banks whose normalized credit cost run rate most exceeds or matches FY24E consensus are IIB, RBL, KMB, HDFCB, DCB and IDFCB (2) Banks whose normalized credit cost run rate most lags FY24E consensus are BOB, INBK, AXSB, SBI, FED and ICICI (3) Banks with the largest proportion of loan book impacted by the new RBI risk weight guidelines are DCB, RBL and IDFCB (4) While NIM may see lesser volatility going forward, there are multiple moving parts to monitor in this regard (5) AXSB and INBK have the most improved liability profile over the past 12 months, achieved without resorting to premium SA rates (6) AXSB and BOB are the largecap banks with the most improved fee income traction over the past 12 months.

Banks whose normalized credit cost run rate most exceeds or matches

FY24E consensus are IIB, RBL, KMB, HDFCB, DCB and IDFCB Notably, these are the banks that are either (1) already in our least preferred list (RBL, KMB, IDFCB and DCB, in descending order) or (2) was in our least preferred list till recently (HDFCB) or (3) has been in the middle of our pecking order (IIB). We believe that normalized credit cost in 1HFY24 gives us a good directional sense of credit cost for full year FY24E because we do not think credit cost should likely decline in 2HFY24 in an environment where interest rates are elevated and will remain so for some time.

Banks whose normalized credit cost run rate most lags FY24E consensus

are BOB, INBK, AXSB, SBI, FED and ICICI Again, notably, these are the banks that are already in our most preferred list (BOB, AXSB, SBI, INBK, ICICI and FED, in descending order). We believe that comparing normalized credit cost in 1HFY24 to Bloomberg consensus is key to understanding how banks are delivering compared with what is priced in.

Banks with the largest proportion of loan book impacted by the new RBI

risk weight guidelines are DCB, RBL and IDFCB The proportion of loan book impacted for DCB, RBL and IDFCB are 31.6%, 29.7% and 26.5%, respectively. This is assuming LAP book is also impacted. Our coverage banks would see an erosion of CET1 ratio ranging between 42-135 bps due to the new risk weight guidelines. The risk weight guidelines, as such, do not necessitate common equity capital raise by our coverage banks. The guidelines are more a pronouncement on what segments the RBI feels the banking sector should slow down in.

While NIM may see lesser volatility going forward, there are multiple moving parts to monitor in this regard

Tactically, BOB, INBK and SBI have a larger share of non-EBLR floating rate loans at 63%, 59% and 42%, respectively, which implies some residual potential of yield rise from upward MCLR book repricing. Structurally, over FY18-23, IDFCB, RBL, AXSB and ICICI have seen the greatest decline in share of low-yield loans, amounting to 17.4%, 11.1%, 10.9% and 8.2% points, respectively. We do not regard the loan book mix of IDFCB and RBL to be optimal and hence, the evolution of AXSB and ICICI is most admirable in this regard. Loan mix change trends in 1HFY24 have been directionally similar.

AXSB and INBK have the most improved liability profile over the past 12 months, achieved without resorting to premium SA rates

IDFCB, INBK and AXSB have seen the greatest improvement in share of LCR retail deposits over 12 months, amounting to 858, 652 and 529 bps, respectively. IDFCB, however, has depended on premium SA rates to achieve this. KMB, IDFCB and AXSB have CASA ratios of 48.3%, 46.4% and 44.4% but, again, KMB and IDFCB have achieved the same using premium SA rates.

AXSB and BOB are the largecap banks with the most improved fee income traction over the past 12 months

The fee income to assets for AXSB and BOB has risen 21bps and 7 bps, respectively, over 12 months. The rise has also been healthy for IDFCB, CSB and RBL at 31 bps, 29 bps and 21 bps, respectively. However, IDFCB and RBL are achieving this basis a sub-optimal dependence on small-ticket unsecured lending.

Gas utilities: Cautious outlook (Kotak Securities)

Gas consumption at record highs, growth now to trickle: Indian gas consumption is up sharp 15% yoy to ~185 mmscmd in FY2024TD. Apart from the increased HPHT gas production, LNG imports have been markedly higher. After multi-year declines, gas offtake by the power sector picked up due to seasonal factors. New fertilizer capacity also fully ramped up. With lower prices, oil to gas switch demand also recovered. But growth will likely trickle now. CGDs segment growth has considerably slowed, and fertilizer may not need much additional LNG. We remain cautious on gas utilities with SELL on PLNG and REDUCE on GAIL, IGL and MGL.

Gas consumption up strongly in FY2024: Several stars have aligned to push Indian gas usage to record highs this year. KG-D6 production has ramped up to ~30 mmscmd. Most of new fertilizer capacity that has been gradually commissioning is also fully operational now. After five years of decline, gas offtake by the power sector recovered temporarily due to seasonal factors. Also, with much lower LNG prices (versus past two years), oil-to-gas arbitrage demand recovered in refining and other industries.

CGD demand growth has considerably slowed: While gas volumes are up strongly in FY2024, we note that from 2012 levels (previous KG-D6 production peak), gas consumption has grown at below 1% CAGR. With policy focus, priority gas allocation and low APM prices, over 2012-22 CGDs’ gas demand was up 2.2X (8% CAGR), whereas growth was weak for most other key demand segments. With rising APM shortfall and higher APM prices (new formula did not bring much relief), CGD’s pricing advantage has withered and growth has considerably slowed (~3% CAGR over FY2022-24E).

Medium-term volume outlook weak; LT outlook even weaker: In our view, with new APM price formula and rising shortfall, CGDs’ gas cost will keep rising. Despite several new CGDs starting operations, CGDs’ demand growth will be weak. For other consuming segments, outlook is weaker.

In power sector, APM gas allocation keeps declining. Also, at current APM/LNG prices, gas-based generation has limited offtake in merit-order dispatch regime. Volumes will likely remain weak, unless there is policy support (such as for offsetting impact of renewable power intermittency issues).

In fertilizer, no new gas-based fertilizer capacity is planned. Rather with policy focus now on green hydrogen, there will be mandates soon to switch to green hydrogen usage, with entire fertilizer capacity moving to green H2 over LT.

For other segments, gas usage will continue to be dependent on price arbitrage of liquid fuels versus gas. With not much incremental domestic gas, and relatively tighter global LNG markets, we believe the pace of switch to gas will remain slow. Also, similar to fertilizer, there will be rising policy focus to switch to green H2 usage instead of gas in the longer term.

Remain cautious on gas names: Gas consumption in FY2024 has been higher versus our earlier estimates. However, with CGD sector demand growth considerably slower, the growth outlook remains weak. We remain cautions on gas utilities.

Chart for the day

Thought for the day

“Blessed is the man, who having nothing to say, abstains from giving wordy evidence of the fact.”

——George Eliot (English Author, 1819-1880)

Word for the day

da capo (adv)

Repeated from the beginning (used as a musical direction).

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The Publisher of this note does not offer any portfolio management, brokerage, money management, equity research, or investment advisory services of any kind. Please take advice from a qualified and registered investment advisor before making any investment decision.

Material from these reports may be copied freely, without any need for permission from the Publishers. This is however subject to copyright consideration of the contents of third parties.

Please refer to the attached PDF for the full report and important disclosures

Economy: Momentum continues (Phillips Capital)

IBC Resolution Timelines Continue to Lengthen for Creditors (INDIA Ratings)

HH Fin savings fall: Appearances can deceive (IIFL Securities)

IT Services: Budgets ain’t budging (JM Financial)

Banking: A closer look at credit costs and other aspects (Yes Securities)

Banks whose normalized credit cost run rate most exceeds or matches

Banks whose normalized credit cost run rate most lags FY24E consensus

Banks with the largest proportion of loan book impacted by the new RBI

While NIM may see lesser volatility going forward, there are multiple moving parts to monitor in this regard

AXSB and INBK have the most improved liability profile over the past 12 months, achieved without resorting to premium SA rates

AXSB and BOB are the largecap banks with the most improved fee income traction over the past 12 months

Gas utilities: Cautious outlook (Kotak Securities)

Thursday, November 30, 2023

Conquering the guilt and normalizing

Last year, the former Japanese prime minister Shinzo Abe was assassinated while he was addressing a public meeting. This is perhaps the first of its kind of act of violence since assassination of Inejirō Asanuma, the then Chairman of the Japan Socialist Party, in 1960. The visuals of Abe’s assassination may have shattered the image of Japan, most people would be carrying in their mind, viz., the image of most courteous people showing remarkable patience and calmness in their public behavior.

The post WW2 generation had only witnessed Japanese people who were extra polite, patient, courteous, and cooperative. These Japanese were very different from the pre-WW2 Japanese, who took pride in their martial and imperialistic traditions. Political assassinations were commonplace. The Japanese Army was considered one of the most brutal forces. The imperialist Japanese occupied parts of Russia, China, and Korea; plundered their wealth, and enslaved their women. The 1945 nuclear attack on Nagasaki and Hiroshima perhaps overwhelmed the Japanese society, burdening it with the guilt of being one of the main characters in the two disastrous world wars and losing its pride to the allied forces led by the US and Russia.

In fact, this is not only in Japan. After decimation of the manifest fascist forces (e.g., Germany, Japan and Italy) and imperialistic forces like Great Britain and Austro-Hungarian empire post WWII, the world has been a rather peaceful place as compared to the preceding 2000yrs. The conflicts post WWII have mostly been contained. Even during the height of the cold war between NATO and Warsaw Pact countries, and shenanigans of star-wars, there had never been a threat of escalation to the scale of a larger World War.

However, if we correlate some of the events and trends in the past couple of years, the picture that would emerge is not very comforting. For example, consider the following events and trends:

· Assassination of Shinzo Abe.

· Numerous acts of violence across USA and Europe, apparently perpetrated by random people who are not radicalized.

· Blatant violation of international laws by Russia in invading Ukraine, and botched attempts of NATO allies to internationalize the issue (contrary to the containment during earlier Crimea invasion).

· Internationalization of recent hostilities between Israel and Hamas.

· China is aggressively threatening its neighbors’ territorial and economic integrity.

· USA handing over Afghanistan to Taliban.

· Hyper nationalist right aligned leaders/parties winning elections in Italy, Argentina, Netherlands; while hardline leftists won elections (re-elections) in many jurisdictions, e.g., Germany, France, Australia, Chile, Mexico, Bolvia, Brazil, Peru, Honduras, and Columbia, etc. Both the Chinese premier Xi Jinping and Russian premier Vladimir Putin are firmly entrenched in respective offices for as long as they wish, and actively working to polarize the world.

· Reliance of population on governments for meeting basic needs rising exponentially along with the rise in the financial and fiscal vulnerabilities across the globe.

· Frequency of mass public protests rising in various jurisdictions.

· Tendency of governments to overregulate and over govern increasing across jurisdictions.

Besides, the commodity producing emerging economies which felt that they have been at the mercy of the financialized western world due to overwhelming dominance of USD on global trade, have been grouping (expansion of BRICS, BRI of China, etc.) to be in a position to command terms of trade.

I get a sense that the world is now in the last phase of erasing the guilt of the two world wars. In the next two decades, the real threat humanity faces is the threat of the human race returning to its normal self – unabashedly intolerant, violent, greedy, imperialist, as they were mostly in the pre-WW2 era, ending the era of prolonged peace since 1945.

The recent Russia-Ukraine and Israel-Palestine episodes have already demonstrated that territorial occupation is becoming acceptable, just like 19^th century. It is common to hear about imminent alteration of status quo in Taiwan and Pakistan occupied Kashmir. Blatant defense of merciless killing of innocent children and women in Gaza, acceptance of suppression of women by Taliban in Afghanistan, and killing of Uighur Muslims in China indicate the change in global thinking. Regrouping of Arabs with Russia and China alliance against the interest of the western world is also a pointer to the potential shape global order might be taking in next couple of decades.

Where does India stand in this transition of global order and what small investors like me should be doing under these circumstances?

Will share my thoughts on this in the coming weeks.

Wednesday, November 29, 2023

To buy gold or not?

The first tranche of Sovereign Gold Bonds (SGB 2015-I), issued in November 2015 are maturing tomorrow (30 November 2023). The final redemption price of the bond has been fixed at Rs6132 per SGB unit. SGB carries a coupon rate of 2.5% p.a, payable at six-month intervals. The investors in SGB (2015-I) have thus earned a 12.7% CAGR on their investment.

To put this return in context, the Nifty50 index has grown at 12.4% CAGR in this period. An average Large-cap mutual fund has yielded ~13.75% CAGR; an average Small-cap fund has yielded ~23% CAGR and an average Gilt fund has yielded ~7.25% CAGR over the past eight-year period.

Of course, the return of equity and gold are not comparable as equities carry much higher risk and entail significantly large volatility. The risk profile of SGB and a normal gold ETF is different since SGB bears a coupon of 2.5% p.a., has no management fee, and carries an implicit sovereign guarantee. It may be considered better than holding physical gold as it is offered in dematerialized form and thus has no holding cost or theft risk; though there is a potential roll-over risk. Besides, if held till maturity, the return on SGB is exempt from capital gains tax, unlike Gold ETF and physical gold which are subject to usual capital gain tax.

The household investors who shall receive the redemption amount in a day or two therefore face two questions —

(i) Whether they should maintain their allocation to gold, reduce the allocation, or increase the allocation under the current circumstances?

(ii) Whether they should wait for the next issuance of SGB and redeploy the redemption proceeds in such bonds (last SGB issue happened in September 2023 @Rs5923)?

I would like the household investors to consider the following data points in answering these two questions:

· A significant part of return on gold is due to the depreciation in the INR as compared to USD. Adjusted for USDINR variation, SGB (2015-I) return would be ~10.3% as compared to the present 12.7%. A weaker USD, as widely expected, could negatively impact the SGB returns in future.

· The current USD gold price is almost the same as it was in July 2020. In this period Indian gold prices have risen ~20%. Adjusted for USDINR changes and hike in custom duties, the Indian gold prices have hardly changed since then. So, investment in gold has been more of a currency and duty arbitrage than anything else. Remember, the last three years have seen pandemic, massive monetary dilution, unprecedented fiscal profligacy, four-decade high inflation in the developed economies, worst geopolitical crisis in Iraq war, huge gold buying by central banks – all catalyst for a super bull market in gold, if we analyze from a historical perspective.

· At the current price, SGB issued in August 2020 are yielding ~5.5% CAGR only, less than an average gilt fund. Considering that interest rates might have peaked, return in gilt funds could improve further in the coming years.

· Bitcoin, which is gaining popularity as an alternative asset, has massively outperformed gold in the past eight years, three years and one-year timeframes. It is widely forecasted to continue to outperform the yellow metal in future also.

Friday, November 24, 2023

Some notable research snippets of the week

Global Economics Intelligence executive summary, October 2023 (McKinsey & Co)

The global outlook is unchanged despite weaker readings in trade, consumer confidence, and business activity. Still-elevated inflation and interest rates are acting as headwinds to economic growth.

According to the International Monetary Fund’s (IMF) October World Economic Outlook, global growth is forecast to slow from 3.5% in 2022 to 3.0% in 2023 and 2.9% in 2024 (Exhibit 1). This is similar to April’s report, which forecasted global growth of 2.8% in 2023 and 3.0% in 2024. Furthermore, the October report states that, although the likelihood of a hard landing has decreased over the past six months, China’s property sector crisis could deepen. Near-term inflation expectations have increased and, in turn, could contribute to the persistence of core inflation pressures. Furthermore, more than half of low-income developing countries are in or at high risk of debt distress. The Conference Board shows that US real GDP increased by 4.9% in the third quarter. In the eurozone, third-quarter economic growth was weaker than expected, with GDP falling by 0.1% quarter-over-quarter (for a 0.1% year-over-year rise). In the emerging economies, China’s GDP growth in the third quarter slowed to 4.9% year-over-year (compared with 6.3% in the second quarter), reflecting the fading influence of the base effect. During this time, GDP expanded by 5.2%.

There are mixed signals from global trade. Exports rose for Russia and the United States but fell for Brazil, China, and the eurozone; imports increased for Brazil, Russia, and the United States but fell for China. In China, cross-border trade continued to decline in the third quarter, with a year-over-year drop of –10.2% (–6.0% in the second quarter), exports dropped by –10.8% in the third quarter (compared with a –5.4% decline in the second quarter). Imports decreased by –9.4% (–7.0% in the second quarter). In addition, the Container Throughput Index increased to 129.6 points in August, compared with the previous month (128.0 points revised). European throughput fell, while Chinese ports continued to strengthen.

Overall consumer confidence declined, primarily due to elevated interest rates. Notably, households in Brazil are the exception because they remain more inclined to spend than save. On this point, consumer confidence in Brazil increased to 97.0, the highest reading since February 2014. By contrast, confidence deteriorated in the eurozone, dropping 17.8 after recovering from last year’s historic low. The United Kingdom also saw steep decline. There, the cost-of-living crisis, a slowing jobs market, and the uncertainties posed by the conflict in the Middle East are contributing to a growing unease in consumer sentiment. The view is a bit more nuanced in India. The sales growth for September was 9% year-over-year, which suggests that consumer sentiment remains optimistic, despite economic uncertainties.

The manufacturing sector has been in contraction for 13 consecutive months. In the eurozone, purchasing managers’ index (PMI) numbers for manufacturing remain in contraction primarily because of declining demand.

Similarly, momentum in services is weakening, with most countries experiencing either stagnation or contraction (only India and Russia are exceptions). In the United States, the services PMI decreased to 50.1 (50.5 in August).

Q2FY24 Review: In-line earnings despite topline miss (Elara Capital)

Earnings growth continue to be fueled by domestic cyclicals

Aggregate topline performance of Elara coverage universe (235 stocks) disappointed, up just 3.6% YoY, falling short by 2.6% versus our expectations. Earnings growth of 65.8%, however, was in-line, led by Energy. Ex-Financials EBITDA margin stood at 17%, expanding 609bps YoY and 10bps sequentially.

A 6.3x profit surge for Energy, led by oil marketing companies (OMCs), spiked earnings of Elara coverage universe by 66% for Q2FY24. Excluding Energy, earnings growth was healthy at ~32%, primarily led by domestic cyclicals sectors such as Auto and BFSI.

Earnings for Auto, ex-Tata Motors, grew 57.4%, led by a combination of better product mix, lower commodity costs and operating leverage.

Earnings growth for BFSI was broadly in line, owing to steady loan growth and robust asset quality even as margins compressed further.

Elara Cement universe reported double-digit YoY volume growth for the second quarter. A YoY uptick in realization and a YoY drop in operating cost (due to normalization of fuel cost post the spike during the Russian-Ukraine war) sharply improved YoY margin.

Beat-to-miss ratio improved to 1.1x in Q2

Within Elara coverage universe, 36% of the companies saw earnings beat (actual results exceeded estimate by >5%), while 32% of the companies saw an earnings miss. The beat-to-miss ratio improved marginally from 1x in Q1 to 1.1x. This uptick was primarily driven by Banks, Industrials and Metals that outperformed expectations.

Diving deeper, large-cap companies demonstrated stronger resilience, with a beat-to-miss ratio of 1.5x. Mid-caps also fared better with a ratio of 1.4x. But small-caps underperformed with a beat-to-miss ratio of 0.8x.

Earnings see upgrades but breadth low

We raise FY24E earnings expectations for Elara coverage universe by 3.3%. Commodity-oriented sectors saw the highest earnings upgrade of 9.1%, but the breadth of revision remained concentrated in Energy and Cement. Industrials and Real Estate were the other notable sectors to see healthy earnings upgrades, while Metals and IT were the main laggards, with 60% and 36% of the companies seeing earnings downgrade.

We increase our earnings growth expectations for FY24E by 3.3ppt to 35.7% and for FY25E by 2.8ppt to 11.9%.

Twenty-two companies have seen ratings upgrade post Q2 results, of which six are large-caps. Seventeen have seen ratings downgrade. Within large-caps, Tata Motors, Ambuja Cements, Bharat Petroleum, ONGC, Cholamandalam Investment and Larsen & Toubro have seen a ratings upgrade, while SBI Cards and Payment Services and Tata Power have seen a ratings downgrade, in Q2.

Quant Research: Mean-reversion and momentum – a dynamic duo (Kotak Securities)

There are two major driving forces in financial markets: mean reversion and trend. We have written at length about momentum portfolios. In this note, we look at how to create mean-reversion portfolios. We try to strip the stock-specific return component from the total returns of the stock and run the mean-reversion strategy on it. We divide our universe into different clusters and create a long-short portfolio that picks stocks from each cluster.

Mean reversion and momentum

Mean reversion and momentum are the two major driving forces in financial markets. Mean reversion is the tendency of recent winners to underperform and recent losers to outperform. On the other hand, momentum is the tendency of the winners to continue to outperform, while the losers continue to underperform. We have written in detail about momentum in the past (Strength in Diversity). In this note, we use similar principles to create a mean-reversion portfolio.

Focusing on stock-specific returns help

While constructing a mean-reversion here, we use stock-specific returns only. The key idea is that returns that are not affected by the key market themes (e.g., re-opening after Covid-19 lockdowns, some sectors catching a tailwind, ‘value’ stocks having a strong recovery) are more likely to revert. To strip out the stock-specific returns, we use a technique called Principal Component Analysis (PCA). PCA is a statistical method used to reduce the dimensionality of data by identifying the most significant patterns and relationships among variables.

It achieves this by transforming the original variables into a new set of uncorrelated variables called principal components. This process aids in identifying the key factors driving variability and facilitates a more straightforward analysis of the underlying structure within the data. We also divide the universe in clusters and pick the best-performing stock from each cluster in the short portfolio and the worst-performing stock in the long portfolio. The portfolios are weighted in the inverse of the stock volatility, giving higher weight to lower-volatility stocks. While constructing the long-short portfolio, we short 0.8 units of the short portfolio for a 1-unit long.

Long-short mean-reversion portfolio delivers consistent returns

The long-short mean-reversion portfolio delivers close to 12% annualized returns with a volatility of 12%. These returns are uncorrelated to the market. In addition, there has been only one calendar year where the returns of the long-short mean-reversion portfolio have been negative. The long-mean reversion portfolio outperforms the index significantly, delivering 18.2% annualized returns, compared to 10.2% annualized for the Nifty-50 index. When we combined the optimized momentum long-short portfolio as described in Strength in Diversity with the mean-reversion long-short portfolio, the combined portfolio delivers ~12% annualized returns at 7.5% volatility.

Logistics: Continuous optimism in sight (ICICI Securities)

Q2FY24 was a mixed bag. Key points: 1) Rail companies trumped surface express companies. 2) Volume growth across companies. 3) Street raises TPs for BlueDart Express (BDE), CONCOR and Gateway Distriparks (GDI), but slashes for Mahindra Logistics (MLL) and VRL Logistics (VRL). 4) Street lowers EBITDA estimates for all companies. 5) Post- results, stock reaction was best for CONCOR but subdued for MLL and VRL. We believe that earnings for most of the companies in this space could improve in Q3FY24 with the quarter being dotted with festivities. Additionally, we will keep an eye on the EXIM trade imbalance.

A mixed big

Performance of the companies under our coverage was mixed with rail companies having a distinct edge over surface express ones. Key points: 1) Shipments/volumes increased across all the companies, especially, BDE (up 13.6% YoY), VRL (up 8.4% YoY) and CONCOR (up 7.6% YoY). 2) Profitability improved for all the companies under coverage, except MLL and VRL. 3) In the case of ICDs/CFSs, weakness in EXIM volume (overall) and EXIM imbalance remain key concerns, though the demand scenario is improving.

Overall, we saw both profit margins and volume inching up across the companies (predominantly for CONCOR and BDE) though VRL’s performance was subdued, mainly due to delayed festive seasons. The companies across the spectrum retained their volume guidance for FY24 and expect Q3FY24 to be better owing to the festive season.

Street’s post-earnings moves

Post-Q2FY24 earnings, while Street has trimmed FY24 EBITDA estimates for most of the companies, especially MLL (12.4%), FY25 EBITDA estimates have been broadly retained, except for MLL (slashed by 8%). Similarly, TPs (largely based on FY25E performance) have been cut by 6-7% for TCIE and MLL, but, raised by 6% for CONCOR. In our view, street’s raised multiples for CONCOR and BDE are possibly due to better growth outlook; albeit reduced slightly TCIE‘s case.

Our post-earnings stance

We are now more positive on the industry as margins have seemingly troughed for most of the companies under coverage and volume growth will likely remain healthy. Except notably for CONCOR (up 8.6%), factoring in the sharp upswing in its domestic business.

NBFCs: Customer acquisition driving growth; asset quality healthy (ICICI Securities)

New customer acquisition has gathered pace post covid and, more specifically, it has accelerated during the past six months. This is reflected in 6mn unique borrower addition between Dec’22 and May’23, implying a monthly run-rate of 1.2mn customers’ vs 0.7mn between Mar’22 and Dec’22. As a result, bulk of incremental AUM growth during the past one year was driven by new customer acquisition and flattish average ticket size. AUM grew 18% since Mar’22, of which growth driven by new borrower stood at 16% and the rest 1% was contributed by an increase in the outstanding per borrower. Notably, underlying asset quality trend continues to be robust as reflected in PAR 30-90 DPD bucket at system level of 1% as of May’23.

New customer acquisition gathers pace

Incremental growth in industry has been largely driven by accelerated new customer acquisition since Mar’22. MFI industry has witnessed robust 18% AUM growth between Mar’22 and May’23, of which 16% growth was driven by new customer acquisition. As a result, outstanding per borrower broadly remained flat at ~INR 50,000 between Mar’22 and May’23. During covid phase (Mar’20-22), AUM grew 11% and was entirely driven by higher ticket size as reflected in outstanding per borrower increasing to INR 50,000 by Mar’22 from INR 40,000 in Mar’20, implying an increase of 12% between Mar’20-22.

New customer acquisition run-rate increased to 1.2mn per month between Dec’22 and May’23 from 0.7mn per month during Mar-Dec’22. Unique borrower base at industry level increased to 70mn by May’23 vs 58mn in Mar’22 and 59mn in Mar’20. Net borrower base between Mar’22 and Sep’23 has grown by highest 23% for Fusion, followed by 13% for CA Grameen and 10% for Spandana.

Underlying asset quality trend continues to be robust as reflected in

collections (ex arrears, including NPA) at ~97-98% ...

Collection efficiency remained robust in FY23 and sustained in Q2FY24. Broadly, collection (ex arrears but including NPAs) remained at around 97%-98% with collections for CA Grameen at 98.7%, Spandana at 97.7%, Utkarsh at 97%, Fusion at 95.5% and Bandhan at 94%. Robust collections also led to PAR 1+portfolio (ex Bandhan) settling at average 3% with 1.3% for CA Grameen, 2.6% for Ujjivan, 3.2% for Satin, 3.4% for Spandana and 6% for Utkarsh.

...except Punjab and Haryana

While collection efficiency remained robust across states, industry data suggests Punjab and Haryana are facing some challenges as reflected in PAR >30 increasing to 6.6% by Jun’23 from 6.3% in Mar’23 for Punjab and 5% from 4% for Haryana. PAR >30 for rest of the states has either improved or remained flat QoQ between Mar’23 andJun’23.

Our view

Cleaner balance sheet, negligible stressed asset pool as of Jun’23 and revised MFI regulations (removal of pricing cap and mandatory comprehensive bureau report) would continue to act as strong industry tailwinds going ahead.

Chemicals: 2H to be better than 1H – Unanimous guidance (Centrum)

Q2 was a disappointing quarter all across the chemicals segment however agrochemicals results were a mixed bag. Severely impacted by demand weakness in exports markets coupled with pricing pressure, chemical companies reported their weakest performance in past several quarters. China dumping slowed down, however inventory destocking still continued in global market impacting the exports performance. Agrochemicals, reported mixed performance and were impacted by dry spell in August. Fluorochemicals too suffered from export demand weakness coupled with pricing pressure. ECU decline continued in Chlor-Alkali segment with average ECU at ~Rs26,000/ MT. In Q2, on 2^nd August, domestic Soda Ash prices were revised downwards by ~6% to Rs29,800/ MT (Tata Chemicals). Soda Ash prices averaged at ~Rs30,400/ MT while demand was impacted due to increasing imports particularly from Russia, US, and Turkey. For chemicals sector some pain from exports market may prevail in Q3FY24E due to lean inventories by global companies. However, generally managements unanimously guided 2HFY24E to be better than 1H.

Management comments on operating environment

RM environment – High cost inventories are largely exhausted during 1H and now the low cost RM shall start reflecting in financial performance. China dumping has slowed down, however, volatility due to volatile crude prices still remains.

Energy/ power/ coal costs – Power/ coal costs have again started moving up which were on a downward trend since past few quarters. Utilities cost has thus started going up slowly. Both domestic and international logistics costs have been normalised.

Exports – Exports remained under pressure in Q2 as the global inventory destocking continued. However, the destocking in chemicals is now approaching the end and normalised demand shall start in near future. Agrochemicals still faces inventory challenges and is likely to remain under check at least for the next couple of quarters.

CRAMS/ CSM/ Fluorochemicals – Fluorochemicals demand in exports market suffered in Q2 and prices also remained under check. CRAMS/ CSM other than fluorochemicals reported mixed performance.

Agrochem – Erratic rainfall and dry spell in August impacted demand for agrochemicals during the Kharif season. Pricing pressure due to lower generics prices globally too impacted overall performance. Some agrochemical companies witnessed good demand for their products with leaner channel inventories while others suffered from higher channel inventories coupled with pricing pressure in certain generic molecules.

Operating performance of Chemical companies in Q2FY24

Total 38 (excl. Tata Chemicals) – Gross margins (GMs) contracted 128bps QoQ and 54bps YoY signifying some pricing pressure despite lowering RM cost inflation. EBITDA margins contracted 25bps QoQ primarily impacted by GM pressure. Despite YoY contraction in GMs, EBITDA margins expanded 61bps YoY signifying benefits from lower opex including lower energy, power, fuel, and logistics costs

Large 17 (excl. Tata Chemicals) – Gross margins contracted 103bps QoQ and 173bps YoY while EBITDA margins contracted 45bps QoQ and expanded marginally by 6bps YoY

Mid-size 14 – Gross margins contacted 14bps QoQ while expanded 75bps YoY (benefit from YoY RM cost deflation). Lower operating costs led to EBITDA margin expansion by 101bps QoQ and 171bps YoY

Small 7 – Gross margins expanded 117bps QoQ while contracted 229bps YoY, EBITDA margins expanded 68bps QoQ while contracted 221bps YoY

Operating performance of Agrochemical companies in Q2FY24

Total 10 (excl. UPL) – Gross margins expanded 318bps QoQ while contracted 76bps YoY while EBITDA margins contracted 71bps QoQ and marginal 6bps YoY

Financial performance in Q2FY24

Total 39 chemical companies – Revenues declined 9.3% YoY impacted by demand challenges and pricing pressure, however remained flattish QoQ. EBITDA declined significantly by 20.4% YoY led by operating deleverage. Sequentially too EBITDA declined 6.5% impacted by demand issues particularly in exports market. PAT plummeted 30.3% YoY while 6.2% QoQ

Steel: India imported highest steel in Oct’23 in one year (Centrum)

The steel price in domestic market was able to hold its ground while China was facing demand slowdown leading to fall in prices. This resulted a premium of >10% compared to landed cost of imports from China and South Korea. Due to huge profitable arbitrage, buyers preferred imported steel over domestic and hence total steel imports in October 2023 stood highest at 0.73mt in last one year. Currently, the difference has closed down to just 1.7% over landed cost of imports.

Steel production in China has declined for the fifth month in a row; below 80mt mark first time in 2023 In October 2023, Chinese steel companies scaled back their steel production by 3.7% MoM/1.8% YoY, reaching a total output of 79.09 million tons. China steel production is consistently reducing highs of 95.7mt in March-2023. Steel production in the country fell majorly due to soaring iron ore and coking coal costs along with dampness in demand from real estate sector.

International iron ore price shoots up despite demand weakness in China; China iron ore inventory at 7 years low Iron ore price has been above USD100/t throughout CY2023. Further, despite bleak demand outlook owing to stress in housing, it has surged to 8 month high and is up by 10% MoM. The primary reason is due to falling demand, the supply chain stayed away to build inventory while steel production remain steady and is up 2.5% YoY YTD resulted into iron ore inventory touched 7 year low to 105mt in mid-November. Along with series of stimulus efforts and recent announcement of selling 1 trillion yuan bonds for infrastructure projects boosted demand recovery prospects and supported sharp surge in iron ore prices. Concerns over disruption in supply due to possible strike in BHP Australia has also played its role. However, uncertainty on demand recovery, steel production cuts and any steps taken by government to curb spike in prices could add bearish risk for the iron ore market.

ArcelorMittal expects Europe steel consumption to turn negative in CY23 ArcellorMittal expects Europe’s apparent steel consumption to further degrade in Q4CY23 and can end in negative growth territory for 2023. The steel consumption is expected to be below bottom end of its forecast between 0.5% decline and 1.5% growth due to weak demand and construction activity. Although, global ex China apparent steel consumption is expected to remain on positive front of 1-2% in 2023.

Thursday, November 23, 2023

Is a bull market forming in commodities?

I have been tracking the news flow and experts’ opinions regarding the developments in global commodities markets for the past couple of years. Of course, I am a novice in matters of global economics, trade, and finance; but the commodities markets are particularly something I could never understand.

From my elementary understanding of economics and human behavior, I understand that aging demography, deeper & wider penetration of dematerialization & digitalization in human lives, rising awareness about climate change, and deteriorating growth potential of the developed economies, and perhaps China also, definitely do not augur well for the commodities’ demand in the long term (10-15yrs). However, the opinion of experts is overwhelmingly in favor of a bull market in commodities in the short term (2-5yrs).

The key arguments presented by experts in favor of a bull market in commodities could be summarized as follows:

(a) Energy prices have corrected back to the pre-covid period. European power prices, US gas prices, natural gas prices, coal prices, and crude oil prices are back to more “normal” levels. The latest inventory, consumption, and production forecasts for 2024 and 2025 are indicating further easing in energy prices over the next couple of years. Energy being one of the major costs in the production of commodities, lower energy costs and adequate supply is a bullish argument for commodities.

(b) Focus on the use of clean energy, particularly for mobility and electricity production, is changing the demand mix for metals. The demand for metals like copper, aluminum, lithium etc. is rising much faster than the supply. The stockpiles are diminishing fast.

(c) Commodity producers, mostly emerging economies, are getting stronger in global strategic balance. The expansion of BRICS to include more commodity producers in the emerging market alliance is just one instance. These economies are now in a much better position in determining the terms of trade, which are dominated by the financialized developed world in the extant global order.

(d) The geopolitical conditions are worsening. Presently, two fronts (Palestine and Ukraine) are witnessing open war. The fear is that more fronts could open in the next couple of years as the political stands are hardening and no one is showing signs of backing out. Wars have been traditionally bullish arguments for commodities as demand for war equipment and reconstruction work need more metals and building materials.

(e) There is not much consensus on this point, but a strong view is that USD as a global currency may have peaked and could potentially see a steady decline over the next many years. The share of global trade invoiced in USD terms and USD reserves of global central bankers have witnessed a consistent decline in recent years. Moreover, the cross-border flow of funds from the US has witnessed a sharp rise in 2023. Unsustainable US public debt has led to a downgrade of the US sovereign rating outlook. Besides, the trade conflict with China has led to a conspicuous shift of technological advantage from the US to China. These trends may consolidate the position of commodity-producing emerging economies enabling them to seek favorable terms of trade.

(f) Bloomberg Commodity Index is presently at the same level it was in November 1995.

I have avoided investment in commodity producers for a few years now. I think more study of trends in the commodities market, and a review of investment strategy is due.

Wednesday, November 22, 2023

Are financial services getting commoditized

Have you recently received calls, emails, and/or text messages from banks and NBFCs offering a variety of products and services? If the name of the institution making the offer is removed, would you be able to differentiate which call, email, or message came from which institution? Do they all not look and sound the same?

· They all offer credit cards with attractive cashback offers, discounts, access to airport lounges, flexible limits, and purchase protection.

· A few years ago, Yes Bank started offering higher rates on saving accounts (with conditions). Many other banks like RBL, AU, Kotak, IDFC First etc. followed suit.

· There is not much to differentiate between SME, Housing, and personal loan offerings of various banks and NBFCs.

· Most banks have made retail/consumer business a priority and announced a strategy to increase the portion of retail credit in their overall credit slate.

· They offer tech-driven solutions, claiming their platform to be the best in class; though there is not much to differentiate in the tech platforms of the top 15 banks, which account for about two-third of the total credit market.

This was not the case three decades ago, when the process of privatization of banks and liberalization of NBFCs started. The new-age banks came out with materially differentiated offerings.

ICICI Bank and IDBI Bank, due to their origins, were specialists in project finance. Kotak Bank, having graduated from a leasing NBFC, was considered a specialist in equipment financing. HDFC Bank was a pioneer in capital market business, corporate salary accounts etc., and housing finance. The large public sector banks were specialists in social and priority sector financing as well as funding of large infrastructure and industrial projects with long gestation and payback periods. Small PSU Banks would focus on consumer finance and personal loans. Foreign banks like CITI, Standard Chartered, HSBC etc. serviced large corporates, mostly with foreign trade linkages, MNCs, and HNIs. Private Banking (and credit card) was mostly a domain of foreign banks with CITI having a majority share. Now all banks offer all services. The share of foreign banks has gradually reduced.

Points to ponder over for investors are (i) When the financial and banking services become commoditized, Is there a case for a sharp valuation differential in banks and NBFCs? and (ii) Is there a strong case for the cyclical and commoditized Indian financial sector to trade at a significant premium to its global peers, especially the ones that are much larger and better capitalized?

Some may argue, these doubts are too premature and should be put to rest for at least another decade. I see some merit in this argument insofar as the valuation of Indian financials relative to the global peers is concerned. The Indian financial system and financial services may continue to grow at a much faster rate as a significant part of the population is still underpenetrated and underserved, and the segment of the population that lives from paycheck to paycheck and relies heavily on rolling credit is growing fast. However, insofar as the valuation differential of the top 15 banks is concerned, the question might need to be examined much earlier.