Vijay Kumar Gaba

Every day the stock markets in India (and other parts of the world also) are cheering the "positive data" and rising towards the previous highs. In my view, it may be a case of total cognitive dissonance. The market participants are selectively choosing the data that gives them hope of better days ahead; completely ignoring plethora of evidence indicating that economy is tottering on a long and winding road entering the dark woods with only scattered sunlight and no end in sight. Many experts have highlighted this case of dissonance between equity markets and economy, questioning optimism of investors and corporate managements. For example—

• The incumbent RBI governor Shaktikanta Das recently highlighted that "There is so much liquidity in the system, in the global economy, that's why the stock market is very buoyant and it is definitely disconnected with the real economy. There will definitely be a correction but we can't say when."

The minutes of the Monetary Policy Committee's last meeting also highlighting the regulators' concerns about the specter of stagflation, clouding the visibility of further rate cuts and also bringing on table the probability of change in RBI's accommodative stance over systemic liquidity.

• The former RBI governor (2008-2013) who sailed the Indian economy through the rough waters of global financial crisis also reportedly termed the recent positive macroeconomic as mere mechanical rebound, highlighting that India's short- and medium-term growth prospects continue to remain grim and the government should not read too much into the economic activity coming back from the depressed base of lockdown.

He categorically told PTI in an interview that "I don't believe we should read too much into the green shoots that you refer to. What we've been seeing is just a mechanical rebound from the depressed base of the lockdown; it will be misleading to see it as a signal of a durable recovery."

• The brokerage firm Kotak Securities highlighted in a recent research note that "certain high-frequency indicators show some level of stagnation—(1) diesel sales declined 19.3% in July 2020 versus 15.4% in June 2020; diesel volumes are a good indicator of freight movement and general economic activity, (2) daily e-way bills in August 2020 are 18% yoy lower versus 10% yoy lower in July 2020) and (3) electricity demand is still marginally lower in August 2020 than previous period level after being higher in the month of July 2020.

• As per a recent research note of Edelweiss Securities, "PMIs have moved up from all-time lows. However, this leading indicator is stalling now, showing the effect of state-level lockdowns and absence of demand stimulating fiscal support While market is cheering the denominator managed positive data, a number of experts are questioning the validity of green shoots."

• As per the brokerage firm, Nomura Securities, "medium-term outlook of lower inflation and the growth challenge remains largely unchanged – we estimate GDP growth to average -5.0% y-o-y in 2020 – falling to -15.2% y-o-y in Q2 2020 and recovering to a still-subdued -5.6% in Q3, -2.8% in Q4 and -1.4% in Q1 2021."

  Numerous other economists and strategists have also highlighted that growth trajectory may remain poor for longer. Surprisingly, the corporate leaders are not echoing this sentiment and are showing agreement with the political view of an imminent recovery! Either they are scared of speaking the truth or the experts are totally out of synch with reality. As Shakespeare said, "There are many events in the womb of time which will be delivered." I do not mind waiting for the labor pains to get over and the child be delivered. Till then, I shall stay cautious and conservative on my asset allocation (see here)

Continuing from yesterday (see Preparing for chaos - 3)

In April, I had shared my thoughts about the investment strategy for post COVID-19 world (see here). The strategy was based on the assessment of situation based on the information available till then. Though the strategy has worked out very well so far, I must admit that luck might have played some part in this.

The present circumstances indicate that the socio-economic, geopolitical and political repercussions of the COVID-19 pandemic would be much deeper and wider; and would be felt over a much longer period than earlier anicipated.

I continue to believe that

1.    The current crisis is unprecedented in the sense that it has seriously impacted the liquidity, solvency and viability of a large number of businesses, all at the same time. The number of businesses going out of business before this crisis ends would therefore be much larger than the crises faced by global economy in past 75 years since the end of WWII.

2.    The only way out of this crisis is to inflate a colossal bubble in asset prices, which is equally unprecedented.

I believe that the foundation of next big global bull market will be laid in next 12 months. Like every time before, the next bull market will be much bigger than the previous one. We shall see a large bubble building in the market that will change many things in the real economy as well; much like the internet bubble of 1990s reshaped the global economy forever.

3.    The new trade and strategic blocks will emerge to provide leadership to the world. The world may de-globalize, localize and re-globalize at the same time. Collective leaderships and many smaller common markets like EU having deeper cooperation may emerge. Digital international highways may become more common than the traditional physical movement of people. The assets and currencies may get further dematerialized. The international travel protocols may change to include medical tests as a prerequisite for all international travel.

4.    People rather than material will become the focus of policy formulation. The demographic trends may see dramatic shifts over next 2-3 decades. It could be either through liberal but orderly immigration or incentives to procreate more in developed nations.

5.    The global wealth and income inequality may increase to alarming levels. The number of poor (below poverty line) may rise disproportionately across the world, especially in emerging countries. This could potentially trigger a fresh wave of communism across the world fueled by increasingly isolated China and Russia.

I further believe that the present view of European and Japanese resurrection may not come true in true sense, as adverse demography will keep hindering their ambitions.

In Indian context, I believe that we may just follow the global trends and not create a trend of our own. I do not see any significant acceleration in growth trajectory normalized for poor base effect of FY21. Indian economy may struggle to avoid getting trapped in whirlpool of stagflation and may just avoid that. The interest rate may not fall as much as anticipated earlier, but may still remain low. Consumption may sustain, as the agriculture sector that employs maximum workers in the country, may continue to do better, especially in terms of investment and fiscal spending.

As an investor therefore I shall avoid committing strongly to any specific sector or asset class for next couple of years. I will continue with my "Buy and Hold with regular rebalancing" strategy for selected stocks.

Asset allocation

I shall be reducing my equity allocation to neutral (60%) from overweight (70%) in next one month. I may also consider bringing it further down to underweight (50%) in 3QFY21. Accordingly debt (30%) and cash allocations (10%) shall also be brought to neutral position.

Continuing from yesterday (see Preparing for chaos -2)

As I said earlier, the world will be a materially different place in five year from now. However, notwithstanding the technological advances and development of advanced forecasting techniques, it may not be accurately predict the contours of the global order in 2025. The learnings from great depression may only inform us that changes will be dramatic. However, these may not guide us about the nature and direction of the changes, because the present circumstances are very different from 1930s.

Given that I am a tiny investor, and my concerns are mostly limited to the local Indian assets, I would like to only assess

(a)   Where India stands in this melee?

(b)   What changes are required in my investment strategy to mitigate the impact of transformative changes that may take place in next 5 years?

I hear lot about a Industrial revolution in India. The government has spoken about many ideas like "Make in India", "Make for India", "Make for World", "Self Reliant India" to emphasize on the need to focus on growth of manufacturing sector in India. In past few months some incentives have been announced to promote manufacturing of mobile handsets. There are proposal to implement similar production linked incentives for chemicals also. Besides, many tariff and non tariff measures have been announced to protect and promote Indian manufacturers of tyres; power tillers; chemicals; arms, ammunition & equipments used by defense forces; etc.

Somehow, I am not able to see how these measures will make Indian economy more competitive globally. The policy on defense production for example is incongruent with the objective. Import restrictions on TV and Mobile sets would be inefficient for consumers and revenue both. The better course would have been to subsidize domestic production for three years to afford domestic producers an opportunity to become globally competitive without impacting the consumers.

I therefore feel that we may not see a significant shift in the growth trajectory for manufacturing and IPR based industries in next few years at least. The growth pattern seen in past one decade will continue, with industries like pharmaceutical, Chemical and Automobile etc further improving their scale and competitiveness quotient.

I am also not feeling any excitement about India becoming a spare tyre to the global industries seeking some safety for the eventuality of China getting punctured. The assumption that the world will be able to ignore China for long and learn to live without it forever seems preposterous to me. I shall therefore be extremely cautious on businesses that are building capacities just on this basis.

Also, given the poor employment elasticity of modern manufacturing, I do not approve of investment in manufacturing just to improve create more jobs.

I am therefore of the view that India is struggling to find a way out this chaos and there is no indication that we are moving in right direction as yet. I shall therefore maintain a cautious stance on my investment strategy for next 3-5 years.

...to continue tomorrow

Continuing from yesterday (See Preparing for chaos)

I believe that severity of any geopolitical event, financial crisis, economic event, natural calamity, industrial disaster, technological evolution, pandemic, etc. must be assessed in terms of its impact on the human lives. Any event that severely impacts the asset prices but its impact on human lives is limited to a small segment of people does not qualify to be a called a global crisis in my view.

I put the financial crisis of 2008-09 in this category. The impact of that crisis was largely limited to financial markets and investors. It had almost no implications for the human life per se. It actually impacted more populated developing economies positively as the unprecedented amount of liquidity manufactured in developed markets found its way to emerging market assets enhancing the wealth effect in there.

Similarly, the events like 9/11 attacks in New York city, 26/11 attacks in Mumbai city, Nuclear accidents in Chernobyl & Fukushima, Tsunami in southern India, massive earthquake in Nepal, numerous cyclones in USA etc all were massive events, especially in terms of their economic impact - but their impact on human lives was mostly limited. These events therefore do not qualify to be global crisis, and usually do not have transformative impact on the global order - markets, businesses, protocols, systems, geopolitics etc.

The events like two World Wars, the great depression of 1930s, outbreak of Spanish Flu etc on the other hand have material impact on human lives world over leading to material changes in the global order.

In my view, the outbreak of COVID-19 pandemic qualifies to be a global crisis that will have transformative impact on the global order. Treating this event as a usual socio-economic event would be a grave mistake, in my view.

I believe that the world will be a materially different place in five year from now. However, notwithstanding the technological advances and development of advanced forecasting techniques, it may not be accurately predict the contours of the global order in 2025. The learnings from great depression may only inform us that changes will be dramatic. However, these may not guide us about the nature and direction of the changes, because the present circumstances are very different from 1930s. For example-

• The war expenditure and reconstruction activities post WWII helped to a great extent in bringing the economies back on the path of growth. The destruction in present case would only be in asset prices and moral of the people. The world is struggling with excess capacities in most areas, including the basic needs of food, energy, and housing.

• The great depression occurred when the benefits of industrial revolution were still accruing. In post WWII numerous new inventions were made to make substantial productivity gains. The benefits of the scientific and technology advances were afforded to a larger proportion of the society. The growth in that sense was democratic and egalitarian. In past 20yrs, the focus of scientific research and technology development is mostly on increasing the speed of execution and reducing the size of products. The growth is aimed at widening the already wide disparities.

• The economics in 1930s was mostly physical. People, money, material, information etc all travelled physically from one place to the other. Presently, the world is totally dematerialized.

Notwithstanding the unpredictability of the situation, investors are obliged to foresee the future and orient their portfolios to align with the emerging scenarios.

...to continue

The undeniable fact is that FY21 could see most pervasive contraction in global economy in post war era. The economic impact of novel coronavirus led lockdown is deep and wide, engulfing most economies, most sectors and most people. The impact may not be evenly spread as services sector have suffered more due to restrictions on mobility; and consequently the developed economies with larger share of services in their economy have also suffered more. The economies based on commodity exports have also suffered extensive damage due to lower demand and logistic challenges. The economies based on agriculture may be the least impacted as demand and supply chain for food have been least impacted due to pandemic.

If we consider the impact of pandemic from socio-economic distress view point, the poorest countries perhaps would end up suffering the most. Poor health infrastructure, cut in global development aid, sharp cut in remittances, fall in exports, etc have hit the poorest the most.

The economists world over are intensely debating whether the economic recession of FY21 would eventually evolve into a global economic depression, a phenomenon not experienced in post war era; or it will remain a deep recession.

It may be pertinent to note that -

"A recession is a significant decline in economic activity spread across the economy, lasting more than a few months, normally visible in real GDP, real income, employment, industrial production, and wholesale-retail sales. A recession begins just after the economy reaches a peak of activity and ends as the economy reaches its trough. Between trough and peak, the economy is in an expansion. Expansion is the normal state of the economy; most recessions are brief and they have been rare in recent decades." In US, the official definition of US is decline in real GDP for two consecutive quarters.

The term depression has not been defined clearly in economics literature. In the common parlance the term is used to describe a period of prolonged and severe economic recession. As per famous economics writer Gregory Mankiw, "the most famous economic downturn in the U.S.’s (as well as the world’s) economic history was the Great Depression, often described as starting in 1929 and lasting at least through the 1930s and into the early 1940s, a period that actually includes two severe economic downturns. Using the NBER business cycle dates, the first downturn of the Great Depression started in August 1929 and lasted 43 months, until March 1933, far longer than any other twentieth century contraction. The economy then expanded for 21 months, from March 1933 until May 1937, before suffering another downturn: from May 1937 until June 1938, a period of 13 months, the economy again contracted."

Obviously, there may be no active expert in the world, who has firsthand experience of handling an economic depression. If the current downturn does evolve into a global depression, it may be as chaotic as it was in the 1930s, simply because it will be a new phenomenon for everyone.

In Indian context, FY21 would likely be the first year of negative GDP growth in past 40 years. In fact since independence, there have only been four instances of negative GDP growth in India - FY58 (-1.2%); FY66 (-3.7%); FY74 (-0.3%) and FY80 (-5.2%). Most experts who have any firsthand experience of handling a recession either as a policy maker, regulator, banker, bureaucrat or politician may have retired or expired. Very few like Dr. Manmohan Singh, who have firsthand experience of handling multiple economic recessions are presently available in the country. Their views, suggestion and advice must be taken seriously by the government of the day.

I am a total novice insofar as the macroeconomics principles are concerned. Nonetheless, I will be happy to share my thoughts on this issue in later posts; particularly as I see them impacting my investment strategy.

The brokerage firm, Sanford C. Bernstein in a recent report highlighted some noteworthy points. The firm evaluated whether the recent sharp fall in economic growth would mark the end of the slow growth cycle triggered by the global financial crisis a decade ago; and beginning of a sustained high growth cycle leading to a multiyear bull market in Indian equities.

The issue is relevant from many points. But as an investor, I find it more pertinent in view of the current market sentiment. The huge divergence between the macroeconomic data and equity markets has disturbed even seasoned investors. The common investors on the other hand are swinging wildly between the opposite polls of greed and fear. Each one percent rise in equity prices ignites the greed and slight fall in prices imposes the fear. Obviously, swaying by these extreme emotions, not many investors/traders are able to maintain their composure and losing money. The rising volatility in the prices of precious metals is making the situation worse, as many investors are getting avoidably distracted by this.

The cited report highlights that the previous strong macro cycle in India was during FY04-10; after making a low in FY01-03 period.

The present macroeconomic conditions resemble the lows of FY01-03 in many aspects. The socio-economic redundancies caused by the radical reforms initiated in 1991-1995 period led to massive buildup in bank non-performing assets and unemployment. The asset prices were also collapsing. The people rejected the extant political regime and lack of an alternative led to 3 general elections in 3years (1996-1999). To make the matter worse we had consecutive poor monsoons in 1999-2002, leading the rural economy in a poor state.

The capacities build post 1991 and a second set of radical reforms during 1991-2003, finally started yielding results from 2004. Strict fiscal discipline, controlled inflation, falling interest rates, rise in household savings, and rising exports helped the economy to revive. The global recovery leading to resurgence in services exports was a key factor in the economic recovery as it created unprecedented wealth effect in the Indian middle class. Demand for automobile, housing, commercial real estate etc had an immense positive impact due to developments in IT sector, construction of highways and SEZs.

The commitment to reform was very high. The government did not hesitate in divesting number of monopolies like coal, power, oil & gas, civil aviation, mobile telephoney, roads, ports, airports, etc. The best part was the execution of reforms. Many PSUs were disinvested, with ministers not hesitating a bit on potential corruption allegations. MNREGA cemented these macro reforms by transmitting the benefits to the bottom of the pyramid.

The cited report, rightly highlights that the execution on reforms by the current regime is not inspiring. "With lower returns, limited access to resources, private sector is not keen to participate in Infra and the easier Infra catch-up build is already behind. Smart cities, mass transport systems are new scripts, but execution is weak and volatile. Inability to scale-up manufacturing and focus of Indian companies on traditional products makes it difficult for exports to scale-up meaningfully."

Moreover, the household savings are declining structurally and leverage rising. The geopolitical considerations mean that the subsidies from China, in the form of cheaper imports may also be not available. The exports which supported the previous up cycle in Indian economy and markets are not likely to see any quantum jump in short to midterm. Import substitution is a tricky business and impacts the competitiveness of Indian businesses in the short term.

The report concludes that "the new scripts are interesting, can help create some jobs, but are not game changers – we expect a rebound in macro in 2HFY21/ FY22 but currently see less room for a multiyear bull macro cycle."

I mostly agree with the prognosis.

The 1QFY21 results announced so far have been mostly better than average estimate of various analysts. About two third of the companies in Nifty 50 universe have declared their results so far. Out of these about 10% companies have missed the analysts on EBIDTA front; while 60% have surpassed the estimated with decent margins. This has obviously comforted the investors. Nifty sales has declined 28% (yoy) while EBIDTA decline is marginal at 1%. This highlights that most companies have managed their cost very well. The empirical evidence suggests that cost savings are mostly sticky with most of the Indian companies. This certainly augurs well for the future profitability of companies.

The good news however ends here. On macroeconomic side, the incremental data is indicating that the economic recovery might be stalling after small recovery in May and June. Many economists and strategists have underlined this phenomenon in their recent reports. For example, note the following:

"Phase 2 of unlocking India commenced from July 1, which offered more relaxations and left it to State governments to decide the extent of unlocking. Our data shows July did not witness much incremental improvement and the pace of recovery has hit a plateau. Our Activity Index shows that in July the economy operated at 79.6% of capacity, which existed in February (pre-COVID). One reason apart from the Monsoon and intermittent lockdowns that could be moderating the pace of normalization could be the resurgence of cases in rural India. (emphasis supplied)" - Elara Capital

"Our in-house Economic Activity Index (EAI) for India’s real GVA (called EAI-GVA) contracted 7.0% YoY in Jun’20 – its fourth successive decline – which implies that economic activity shrank 18.7% YoY in 1QFY21. Industrial activities contracted sharply by a fifth (compared to 33% fall in May’20), while the services sector shrank only 3.6% YoY (supported by massive fiscal spending) in Jun’20. Farm activities grew 10.4% YoY – the highest pace in nine years.  EAI-GDP index (our in-house measure of official GDP) also contracted 4.8% YoY in Jun'20, following 19.7% decline an month ago and implying a decline of 18.4% YoY in 1QFY21. Very strong fiscal spending growth of 49% YoY supported EAI-GDP, without which the decline was 7.5% in Jun’20. Private consumption spending contracted 9% YoY and investments declined 30% YoY in Jun’20. Excluding government spending, EAI-GDP contracted 20% YoY in 1QFY21.  Overall, our estimates suggest that real GDP may have contracted 18-20% YoY in 1QFY21, in line with our forecasts. We expect another decline of 2-3% YoY in 2QFY21, before real GDP posts growth in 3QFY21." - Motilal Oswal Securities