Thought for the day
"Choose silence of all virtues, for by it you hear
other men's imperfections, and conceal your own."
—George Bernard Shaw (Irish, 1856-1950)
Word for the day
Pinguid (adj)
Fat, Oily
Malice towards none
One SI and one constable of UP Police, managed to misguide
the entire cavalcade of the PM.
#Surgical Strike 2.0
#National Security
First random thought this morning
The Constitution of India has been amended 101times till now. The
changes made so far include some fundamental amendments like adding the words
Secular and Socialist to the preamble of the Constitution. But whenever someone
expresses the need for review of the Constitution, political parties, especially
Congress, start making all sort of noises.
UK does not have a specific constitution. US Constitution, having
only 7 articles, came into effect in 1789 and has seen only 27th amendments so
far. The fact that we have the lengthiest Constitution in the world that has
been amended 101times in 70year, only highlights that some things are wrong and
need review. For example, the Constituent assembly might possible not have
fathomed that our democracy will become feudal & dynastic, succumbing to
blatant cronyism. That some of most renowned journalist would like to see state
CMs being chosen based on their caste. That our judiciary will be accused of
deciding criminal cases based on caste and religion of the accused.
Outlook and Strategy for 2018
I am not sure how relevant it is to define the outlook for stock
market with a calendar year perspective. Even more redundant seems the task of
actually defining a strategy to suit such outlook and implement it in
terms of actual trades.
I strongly believe that like any other business, the business of
investing should also be managed on "going concern" basis, rather
than breaking it into calendar years and quarters. The market outlook and
strategy should therefore be defined ad infinitum. The review and changes in it
should correspond to the changes in the underlying assumptions and business
environment rather than change in calendars and diaries.
Nonetheless, since it is a practice, and I am a compliant citizen,
I must follow it. So here are my two cents on the market outlook for 2018.
Market Outlook
In my view, the stock market outlook in India, in the short term
of one year, is a function of the following factors:
(1) Macroeconomic environment.
(2) Global markets and flows
(3) Technical positioning.
(4) Corporate earnings and valuations
(5) Return profile and prospects for alternative
assets like gold, real estate, fixed income tec.
(6) Greed and fear equilibrium
(7) Perception about the political establishment
1. Macroeconomic environment
My outlook for the likely macroeconomic environment in 2018 is as
follows:
(a) Inflation: The consumer inflation
may continue to remain above the RBI target of 4% for most part of the year.
The core inflation may rise on the back of higher raw material prices and
wages. Imported inflation shall remain elevated as global commodity prices
remain strong.
(b) Fiscal Deficit: The government may
persist with FRBM targets compromising with public investment and consumption.
Expect the present trend of delay in payment of subsidies, tax refunds and
contractors' payment to continue in 2018 as well. The systemic liquidity may
thus remain constrained most part of 2018.
(c) Rates: Expect benchmark yields
to average above 7% for the year. RBI may hold policy rates during 1H2018, but
if inflationary pressures persist a hike could be considered. Deposit rates may
firm up further as systemic liquidity remains tight.
(d) Current Account: Expect current
account to worsen on the back of rise in energy import and sluggish export
growth.
(e) Savings: Household saving may
grow at slower pace as real wage growth remains poor. Corporate savings though
may be higher due to continued deleveraging and rise in free cash flows.
(f) Investment: The government
investment expenditure may see some slow down due to fiscal constraints and
higher allocation to social sector ahead of elections. Private capex may see
recovery in some sectors as like consumption and commodities. Poor capacity
utilization may however keep overall investment growth under check.
(g) Exchange Rate: USDINR may
remain stable as higher yields continue to support inflows. Funding BoP should
not be a problem at all.
(h) Growth: Expect higher rates to hit
real GDP growth in first half. In 2H2018, we may see growth recovering to 7.25%
as GST benefits begin to kick in.
To sum up, the domestic macroeconomic
factors may not be supportive of stock market in 2018. Especially, rise in
rates and inflation expectation may hurt growth and delay the recovery in
investment cycle.
The only significant positive could
possibly be the reversal of NPA cycle. As the resolution process gathers pace
and government provided fresh capital (as promised), we may see the pressure on
bank's balance sheets easing considerably. This would however be subject to
keeping control on the fresh areas of slippage, especially personal and farm
loans.
2. Global markets and flows
There is not much divergence in the analysts' and economists'
views about the global macroeconomic outlook for 2018. However, the divergence
is conspicuous in the investors' and fund managers' outlook for global markets
in 2018.
The near consensus view on global macroeconomic conditions can be
summed as follows:
(a) As the fiscal and other drags created by the
global financial crisis (GFC) fade away and normalization process accelerates
further, the US economy may continue to deliver robust growth. Though the
growth may peak around 2.5% much below the pre-GFC normal level of 4%.
(b) The Japanese economy has finally returned to
steady growth after a prolonged slump. GDP growth has stayed at about 1% for
three consecutive years since 2015. The growth may remain close to this level
for next couple of years.
(c) The growth in Eurozone may remain firmly on
the recovery path, even when ECB begins to taper from January 2018. The zone
may however see higher political volatility.
(d) The export based economies of Asia may extend the
stronger growth seen in past couple of quarters, well into 2018. China may
continue to defy the call for a hard landing and grow close to 7%.
(e) 2018 see acceleration in the process of
normalization of unconventional monetary policies adopted in the aftermath of
GFC. The net QE may drop to almost zero by the end of the year. US Fed may hike
3times in 2018, but other central banks in developed world are not seen hiking
in 2018. Asia may see further tightening of rates with China and Korea taking
the lead. The bond returns are therefore likely to be muted in 2018.
(f) As the US Tax reforms get implemented, lot
of money parked outside by US corporations may fly back to US. This may see USD
strengthening, mostly at the expense of emerging currencies.
(g) While the general consensus favors equities
in the developed markets, the opinion is divided on EM equities.
In my view, the global markets are
likely to see higher volatility, as they adjust to normalized monetary policies
and muted returns. Rising rates and inflation shall obliterate chances of any
significant positive surprise on growth. Contracting liquidity shall challenge
the flows to EMs and other risk assets. Overall, save for a nasty geo-political
surprise, the global factors appear neutral to marginally negative for India.
3. Technical Positioning
In pure technical terms, I see Indian
markets in the last leg of the bull phase that started from summer of 2013. The
correction from here will be sharp and deep. While it is difficult to forecast
how much more it can go up, before the correction sets in, it is easier to
forecast the contours of the down cycle, that is as follows:.
Strictly in technical terms, Nifty has definitely completed the up
move that started from 28 August 2013 from low of 5285 (intraday low 5118) a
few months ago. Any move beyond 10114 is a bear market rally.
Base case for 2018
Nifty should bottom around 8470 in next 13months, i.e., a 50%
correction of the rally from 6825, the low of March 2016.
Probable scenario for 2018
Nifty may correct 38 to 50% of the up move (5285 to 10114) in next
13months. Which means, the downmove may bottom between 8280-7700 Nifty level by
January 2019.
Worst case scenario
The worst case scenario could be that Nifty corrects the entire
gains made since March 2016 low of 6825.
The 100%+ gain in benchmark indices since August 2013, when the
macro improvement cycle began, is mostly a function of PE re-rating; for
corporate earnings have shown little growth. Moreover, whatever improvement in
earnings is seen, it could be mostly attributed to cost savings (especially
financing cost and raw material advantage). There is little evidence of
improvement in pricing power or significantly higher productivity of capital.
The macro improvement cycle is almost over. Financing cost and raw
material prices are showing a distinct upward incline.
In my view, the PE re-rating cycle is mostly over. Any improvement in equity returns from this point onward will have to be driven entirely by earnings growth.
In my view, the PE re-rating cycle is mostly over. Any improvement in equity returns from this point onward will have to be driven entirely by earnings growth.
The corporate fundamentals would need to show material improvement
over next 9-12 months to sustain the present valuation levels.
The current implied earnings growth over FY19-FY20 is well over
20%. If we consider the historical perspective, in a rising rate, rising
inflation, scenario the earnings growth of over 20% has not been sustainable.
Even if we can manage this kind of earnings growth (not my base case) due to
very low base (almost no growth for over 3yrs now), FY20 could be a challenge.
I therefore expect a PE
de-rating in 2018. Financials, materials, consumption, small cap themes that
have materially outperformed the market may suffer the most.
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5. Alternative return profile
Real estate: Real estate prices have bottomed in most
geographies in the country. In some southern cities there are early signs of
recovery in prices. Though 2018 may be early to forecast a full blown recovery
in real estate sector, the fear of hike in rates and cost inflation may prompt
some buying.
Gold: Post demonetization and GST, physical gold
demand has been subdued. Most gold ETF have returned nominal gains during 2017.
Though conventionally, rising inflationary expectations and firming rates have
a positive correlation with gold prices, this time around this correlation
seems weakening. Amidst the battle between new age cryptocurrencies and
conventional currencies, gold is also struggling hard to maintain its crown of
glory. Though some strategists are strongly recommending as the only safe haven
in 2018, in my view, it may not be so.
Fixed income: It is reasonable to expect fix income
returns to exceed 6-8% return most analysts are expecting from benchmark equity
indices.
Overall, in my view, the return profile
of alternatives is still positive for equities. However, if due to government
incentives, better regulations and other factors, real estate prices recover,
this could be a major negative equity flows.
6. Greed and fear index
Historically, one of the most successful, though intuitive
indicator of greed overtaking the fear in market is outperformance of small cap
stocks over large cap stocks. On this parameter market is ripe for a major
correction. Implied volatility index is another generally accepted indicator of
fear.
In past an outperformance level of 25-35%, in a given period has
marked the cycle peak for the market. The correction thereafter have been
sharp, painful and very broad based. In one year post peaking, the broader
market corrected much more sharply as compared the benchmark indices.
In last instance the outperformance
peaked in January 2008 and broader markets corrected over 80% in the following
one year as compared to ~60% for the benchmark indices.
The current situation is
far worse than the previous instance. The small cap index has outperformed the
benchmark by over 3x.
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Moreover, the fear index
(India Vix or Implied volatility index) has been stubbornly low during past
three years.
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7. Perception about the political
establishment
The change in the central government in 2014 created a very strong
positive perception about the political stability, intent and vision in the
country. There was near unanimity amongst market participants that the
political establishment shall be supportive of the market.
In past one year, the market's perception about politics has
gotten somewhat divided. The market's nervousness around UP and then Gujarat
elections clearly suggest that the market may no longer be 100% confident of
the Modi victory in 2019. Moreover, the common perception is that any setback
to Modi government shall reflect in negative market performance.
Given that in next 17months a large number of states and India
will go to elections, the market may remain nervous in 2018.
The political perception therefore, in
my view, remains a negative factor for the market in 2018.
In view of the positioning of the above seven key factors, my
outlook for the market in 2018 is as follows:
(a) The market may witness higher volatility during
2018.
(b) The returns from Indian equity may be very low or
negative.
(c) Small and midcap may underperform the
benchmark.
(d) Financials, consumer non-discretionary, and capex
themes may suffer more than others. Global commodities will show a mixed trend
with industrial metals doing much better than bulks and precious metals.
(e) Exporters (especially to US) may outperform.
(f) Bond yields may tough a high of 7.80%, and
average above 7% for the year.
(g) Real estate prices may stabilize in most
geographies and continue to recover in select geographies.
Investment strategy
Asset allocation
I continue to maintain a strategic 65% equity and 35% debt asset
allocation. However, since I expect a fall in both equity and bond prices, I
will keep 25-30% of equity allocation as tactical cash in my portfolio, which
shall be deployed as and when the anticipated correction in the prices
materializes. I would avoid gold.
My target return for overall financial asset portfolio for 2018
would be ~8.5%.
Debt investment
I would like to largely confine my debt investments to accrual
products only; strictly avoiding search for capital gains in my debt portfolio.
However, I may consider debt funds with long duration if benchmark
yields rise over 8.25% due to some global event.
I would avoid undue credit risk in my debt portfolio to make few
bps additional return. Though I would not like to be paranoid about the credit
risk and not waste my time looking for risk where none exists.
I would target 7% post tax return on my debt portfolio.
Equity investment strategy
I would mostly focus on large cap stocks, with strong balance
sheets and superior return ratios.
(a) Target 10% price appreciation and 1% dividend
yield from my equity portfolio;
(b) Overweight on global pharma and IT. Prefer niche
IT players rather than generic service providers;
(c) Overweight housing ancillaries, ex HFCs.
(d) Underweight consumer staples.
(e) Underweight on financials, especially NBFCs.
May consider select PSBs that may benefit from recapitalization and NPA
resolution.
(f) Overweight high income discretionary
consumption;
Equity trading strategy
(a) I shall avoid frequent trading in 2018 and focus
on building a portfolio for the following 2-3yrs perspective at least.
(d) I would actively look for shorting opportunities
in financial and richly valued consumption space.
Miscellaneous
(a) I would not consider precious metals for financial
asset allocation.
(b) I assume a relatively stronger USD, stable EUR and
weaker CNY in investment decisions. Therefore I would be discreet in choosing
exporters and foreign currency borrowers for investments.
What will change my view?
1. Full blown recession in US.
2. Surprise recovery in Europe and Japan.
3. Hard landing in China.
4. Sharp earnings recovery in India led by
higher investment demand
5. INR breaking and sustaining over 70/USD.
6. A full blown war in the Korean peninsula.
It is critical to note that short selling and derivative trading
involves materially higher risk. These require much higher level of technical
expertise and knowledge and therefore not suitable for all investors/traders.
The readers should seek expert advice before making any investment or taking a
trading call.
