Vijay Kumar Gaba

Tuesday, June 23, 2020

2020 Mid Year Review - Global Events that defined 1H2020

The first half of the year 2020 has been perhaps the most eventful six months in the past one decade, not only from the financial market perspective but from socially, economically and .geo politically also. Some of the key events of past six months which could have material long term impact on global socio-economic and geo political order could be listed as follows:

The WHO declared COVID-19 outbreak as a pandemic. Over eight millions people across the world are infected and over 4,62,000 deaths have been reported till yesterday. Many countries enforced partial to total lockdown of all economic activities resulting in one of the deepest recession the global economy has faced in past 100years. The global economy is expected to contract by 4-6% in 2020. The central Bankers across the world announce massive monetary easing to mitigate the economic impact of the pandemic and engineer a economic revival.

India has so far reported over 4,18,000 confirmed cases and over 13,700 deaths have been reported. The Indian economy is expected to shrink 4-6% this year in line with the global economy.

US in an unprecedented move suspends financial to the World Health Organization (WHO), alleging irregularities in handling of the COVID-19 pandemic and connivance with Chinese authorities in supressing the facts about the spread of COVID-19.

Over one million protestors took part in the New Year march in Hong Kong. This was perhaps the largest public protest against the Chinese authority, and prompted the Chinese regime to implement new security laws in Hong Kong, virtually ending its autonomy from the mainland China. Later UK Prime Minister said that they will amend UK citizenship laws to permit citizenship
Death of George Flyod, leads to one of the largest public protest and riots in US since Martin Luthar King (Jr) led civil rights movement. The protests were organized across the world in against the racist bias in US & police brutality and in solidarity with the ethnic Indian American community.
The United Kingdom and Gibraltar formally withdrew from the European Union culminating the process which started with a referendum in June 2016.
The disagreement surface in the oil cartel (OPEC+Russia) leading to massive crash in global crude prices. The WTI Crude oil future settle at minus $37.63 in April expiry as the buyers failed to take delivery due to shortage of storage space.
The Saudi Arab led coalition declares unilateral ceasefire in millitary action against forces Houthi forces in Yemen to end the five year old war.
A US drone strike at Baghdad International Airport killed a senior Iranian general and Iraqi paramilitary leader. In apparent retaliation Iran launched ballistic missiles at two Iraqi military bases hosting American soldiers, injuring many personnel. A misdirected missile shot by Iranian forces, struck a Ukrainian civilian aircraft, killing all 176 people on board. Iran also deployed its first military satellite in the space.
After a long standoff in Doklam in 2017 (in which no casualties were reported), another serious engagement took place between Indian and Chinese forces on LAC in Ladakh. Many casualties and serious injuries have been reported from both the sides. This has brought the Sino-Indian relationship to a new low since 1975, and threatens to change the geo-politics and economics of the South Asian region for ever.

The stocks markets have noted all these events with sharp volatile moves, but decided to ignore and move forward.....to continue tomorrow

Friday, June 19, 2020

Investors Beware - 4

In past few days there has been heightened activity in stocks of the companies which are perceived to be beneficiaries of the "war" (trade or military) with China. My fellow small investors are lapping stocks making defence equipments, telecom equipments and missiles, as if there is going to be an attack on China tonight. The stock prices of many such stocks have risen by 10-25% this week. The stock price of a public sector power equipment manufacturer gained on the assumption that the government might ban Chinese competitors and the order book of this company may swell. Some pharma, chemical and agro chemical companies also witnessed action based on assumption of trade restrictions with China. The businesses dependent on imports from China witnessed selling pressure, while the businesses considered to be the alternative to the Chinese impost saw extra buying interest.

I would like to request my fellow investors to exercise some extra caution and restraint while jumping in buy the "beneficiaries" of the "war" with China. They must at least take note of the following points, before making any investment decision based on this impulse.

(a) A war, small or prolonged, with China will have disastrous impact on both Indian and Chinese economy. By extension it will also impact the global economy. The war with China will not be limited to stones and iron rods, as the recent reported skirmishes have been. It will be fought on ground, in air, in the ocean and most importantly in the cyberspace. Pakistan for sure would like to engage Indian forces in the western and northern sectors to distract Indian forces in order to help its ally China. Moreover, given that China is finding itself cornered due the suspicions over its role in spread of COVID-19 across the world, and has been mustering allies who can support it on the global platforms, there are chances that the conflict may expand beyond Sino-India borders.

The point to note is that a war, even if it lasts less than a week, could have disastrous economic impact in terms of disruptions and costs (economic and human). Higher taxation, higher inflation and higher rates would be the most natural consequences. If the assumption is 'war" then the investors would be better off buying USD with all their money rather than buying mid and small cap companies which may or may not survive a 5 day war.

(b) Accept it or not, as of today China is an integral part of India's economy. Millions of small businesses, traders, retailers, and footpath vendors depend overwhelmingly on the Chinese imports for their livelihood. Without a credible rehabilitation scheme for millions of these people dependent on trade with China, the "Boycott China" campaign in not going to be successful in any measure. If you want to fully assimilate what I am saying, take a round of you local market and see for yourself.

(c) A large number of large businesses are dependent on the imports from China to carry out their manufacturing activities. They import critical raw materials, engineering products, plant & machinery and spare parts for their plant & machinery from China. Sourcing all these from alternative sources may either not be feasible or may be materially expensive.

(d) A large number of large businesses have a big market for their final products in China. Finding alternative markets may be difficult for these businesses.

(e) A significant number of global companies are looking to shift their operations from China. The governments of emerging markets like India are willing to go out of their way to attract these companies to their shores. Some of these companies may finally land up in India. This will be both threat and opportunity for Indian businesses. Some businesses may face enhanced competitive pressure from these global companies which relocate to India from China, while others may gain from becoming part of a larger global supply chain. Betting on who will gain and who will lose from this shift in global supply chain is a difficult task even for most of the sophisticated investors.

(f) Chinese investors have invested, directly or indirectly, in a large number of Indian businesses. Many startups rely heavily on Chinese funds or technical support for their businesses. Many plants and infrastructure projects have been or are being built by Chinese companies. Their completion and maintenance could be severely impacted if the trade relations with China worsen due to war. The Indian promoters may lose heavily if this were to happen.

I am certainly not against the goals of self reliance and import substitution. But these things cannot be achieved over night and without tremendous pain. A long term strategy and willingness to bear the pain is what is needed to attain these goals. Rhetorical nationalism and mindless jingoism may lead to devastating consequences. In my view it will take 10-15years of meticulous planning, diplomacy and execution for us to meaningfully reduce "Made in China" from our day to day life. Doing a BTST (Buy Today Sell Tomorrow) trade on this theme can only bring losses. So at best it is avoidable.

Also note that the transition from a agro economy to industrial economy is a slow and excruciating process. Expecting quick results may lead to avoidable disappointment. Remember:

(a) Most of the claimed "Demand" in India is still "Need". The "capacity to pay" that is quintessential to "Demand" is still low.

(b) The "Democracy" is both the strength and weakness of India in economic context. Unlike China, it is not an easy order here to override sustainability concerns and regional aspirations for faster economic growth. Socio-political consideration would continue to take precedence over pure economic concerns.

(c) The "Demography" is a still a raw strength. Without substantial investment in "gender equality" and "skill development" this resource cannot be exploited fully.

Thursday, June 18, 2020

Investors Beware - 3

The financial sector has massively underperformed the broader markets in past three months. A number of experts have called for increasing exposure to this sector in view of this underperformance. They have argued that valuations are now discounting the worst in terms of COVID-19 related delinquencies and the economic activity shall normalize in next 2-3 quarters. The consensus amongst experts is veering towards outperformance of the sector in next 12-15 months. It appears that many non institutional investors are in agreement with the experts' opinion and have increased their exposure to the banks and NBFCs, especially the low priced ones.

I would like these investors take note of the following data points while increasing their exposure to the financial sector in India.

(a) The capacity utilization of Indian enterprises peaked at 83% in 2011 and has ranged between 70-75% since then. It declined to below 70% in 2QFY20, much before the COVID-19 induced lockdown took place. The business sentiment is at multi year low, indicating that businesses do not see any sustainable rise in capacity utilization and need for capacity addition in short term.

Consequently, the project announcement has declined in past five years, from 17% of GDP in 1QFY16 to about 5% of GDP in past 4 quarters. The project completion rate has also declined materially.

This does not augur well for credit growth in the short term. Any growth in credit demand will come from mostly from consumption and working capital requirement. The quality of credit shall therefore remain under pressure, and ALM issues will persist.

(b) Consumer confidence is at lowest since 2013, and the employment outlook has worsened materially. This shall keep the fastest growing credit category (personal loans) under check as the borrowers' credit profile deteriorates.

(c) The liquidity in the system is surplus, and it is likely to remain so in the short term. The call money rates are now closer to reverse repo rate, rendering overnight market competing with RBI.

Besides, the bond yields are now below bank lending rates, even though the benchmark G-Sec yields are well above the policy repo rate. This shall pressurize banks to liquidate some of their excess SLR portfolios and lend aggressively in the market. The pressure on return ratio may increase while the credit quality remains under pressure.

(d) MF as source of corporate funding (especially working capital and promoter equity) has come under pressure due to a spate of defaults in past one year. This could bring some short term financing business back to banks. But the events of moratorium in case of Yes Bank and PMC Bank have left scare in the memories of depositors. They are increasingly veering towards larger banks, especially large PSBs. The cost of funds for smaller private banks may therefore rise in the short term.

(e) The mutual funds and banks are wary of lending to non AAA rated borrowers, especially NBFCs. The cost of funds and availability of growth capital may remain a major constraints for these NBFCs, at a time when the delinquencies are expected to rise once the loan moratorium ends in August.

Personally, I would exercise little extra caution in making fresh investment in any financial stock. For asset allocation discipline, I shall stick to top 4 banks and top 4 NBFCs.