Vijay Kumar Gaba

 The benchmark indices are scaling new highs every week for past seven weeks as least. The sharp recovery in markets, from deep correction in March, must have surprised most market participants. Many who panicked and sold off in summer are wondering whether it’s time to “Buy” again. Many who remained invested are wondering whether it’s time to ‘Sell”.

The broader question therefore seems to be, whether we are in a new bull market since April 2020, and the stock prices have a long way to travel north before any meaningful correction sets in; or it is a bear market rally that is normalizing the steep fall in March 2020 in the wake of total lockdown announced post outbreak of pandemic.

The last bull market started from August 2013 and lasted 5yrs till August 2018. In case we believe that it is new bull market that would mean that the bear market that started in August 2018 ended with panic bottom of March 2020.

However, if we believe that March 2020 panic fall was an aberration and the current sharp up move is just normalizing that aberration, and the regular bear market will play out after this normalizing cycle is completed in next couple of months. In this case we shall see markets stabilize around in 11500-12100 range and then decline gradually for some time. We had seen a similar situation in 2006-2009. In May 2006, markets corrected 25% in 3weeks as the first signs of subprime crisis emerged. But then markets rallied almost 100% (from lows of June 2006) in June 2006-January 2008 period; only to bottom around June 2006 levels in March 2009.

The moot point is how do we decide what state the stock market is in at present! The signals from the markets are indicating that regardless of the one way move in the market, the popular opinion is divided.

For example, the following are some signs indicate to a bull market:

(a)   Many IPOs since March 2020 have got tremendous response from investors.

(b)   Analysts are either ignoring bad news or finding positive angles in bad news . For example, consider the following:

·         One of the key argument for support of consumption related stock was the government support to the rural population. However, the news of PM-Kissan disbursement not happening (see here) was given a positive twist to imply that fiscal situation may not worsen after all.

·         M&M subsidiary SsangYong default on debt was given a positive twist to imply that M&M is sticking to its commitment of not investing more capital in loss making subsidiary.

·         Despite concerns over rising defaults on unsecured loans after the forbearance period ends, the valuations of many consumer focused NBFCs have breached the red lines. Analysts are supporting these valuations in the name of business consolidation, potential bank licenses etc.

·        S&P forecast of 7.7% contraction in India’s FY21 GDP was widely reported as “upgrade”.

 

(c)    All sellers are seen regretting almost immediately after the trade, as prices rise further before the payout is received.

(d)   Traders, investors and even fund managers are searching for stocks that have underperformed the peers, and betting new money on them in the name of “value”.

(e)    The social media timelines are overwhelmingly populated with success stories of popular traders and investors. The cautious investors are being guilt shamed by taunts of “I told you so”; and “I bought xyz in March 2020 and made return of $$$% in 9months”.

On the other hand, the following signs point to the possibility that it is a bear market rally that is normalizing the excesses of March 2020.

(a)   There is no particular theme or trend in the recent rally in stock prices. Stocks from diverse sectors like Bajaj Finance and Kotak Banks have become most expensive stocks perhaps globally, while ICICI Bank and HDFC Bank have lagged. Tata Steel has reached peak valuation while Hindalco has lagged. Tech Mahindra has ralled hard, while Infosys and TCS have lagged. Asian Paint has outperformed HUL massively. RIL has outperformed Bharti.

(b)   Domestic mutual funds have faced redemption in past couple of months. Domestic institutions have been net sellers so far this year, while foreign institutions have been net buyers.  However, there is no clear pattern in the flows, indicating tentativeness and lack of conviction. Overall net institutional flows have been marginal ($3.5bn) YTD.

(c)    Most of the rise in market has occurred due to valuation rating and not supported by earnings or forecast of earnings growth.

 

(d)   Last week the top gainer in NSE500 included some companies facing survival issues.

Personally, I am more inclined towards the second view (bear market rally). But I would leave it to readers to apply their own wisdom and decided their strategy.

 

 In a recent note, Matthew Hombach, Chief Rates Strategist of Morgan Stanley, wrote that Central Banks will inject another $2.8trn of liquidity in the global financial system in 2021. This would be the double the amount of highest liquidity injection in any year prior to 2020. This abundant liquidity, in Matthew’s view, will support the riskier investments at the expense of investments entailing lesser risk; implying weaker USD and US Treasuries and Stronger EM currencies and Equities. The caveat however is “if central banks signal a reduction in liquidity earlier than we expect, or our economists’ buoyant expectations aren’t met, risky assets could experience a wobble, a theme that might very well feature in our 2021 mid-year outlook”.

The conventional theory is that as the supply of transactional currency (money) rises, the price of money (interest rate) decreases. The lower interest rate results in lower cost of owning and carrying assets resulting in higher demand, and therefore higher price, for assets. Lower cost of money is also traditionally believed to increase the risk taking ability of the borrowers, resulting in higher demand for riskier assets, e.g., equities (over debt), emerging market assets (over developed market assets) etc. Lower cost of money is also seen to be catalyzing the flow of savings (surplus liquidity) from low yielding assets (e.g., USD, JPY, developed countries’ bonds etc.) to high yielding assets (e.g., emerging market currencies & bonds).

Also, as per conventional theory, the rise in supply of money which is not matched by rise in production of goods and services, inevitably results in rise in prices of goods and services (inflation).

However, the market trend seems to have strongly defied these conventional theories in past 10 years. Ever since the global central banks adopted the new normal monetary policies of abundant liquidity and near zero to negative interest rates, the demand and prices for developed market assets (USD, Developed market bonds and equities etc) have mostly outperformed the emerging markets and the prices of physical commodities have remained low, notwithstanding the small bump in recent months.

I think, the investment strategy needs to assimilate the trends in monetary policy, asset prices and inflation (of goods and services) in a holistic manner rather than drawing conclusion from the bits and pieces. The economic and financial research may better focus on the issue whether—

(a)   The excess (or additional) money printed in since the internet revolution started in late 1990s is to adjust the stock of money for rise in productivity, dematerialization, colossal rise in income and wealth inequalities and consequent changes in consumption, trading and investment patterns, changes in velocity of money etc.; or

(b)   The conventional theories are still valid and we are just protracting the inevitable, i.e., hyperinflation in prices of goods and service

Formulating an investment strategy for investors in India had never been as challenging as it appears today.

For past three decades, the secular growth narrative built on economic reforms, infrastructure development, demographics (large middle class, secular demand growth, accelerated urbanization, educated workforce, etc) and deeper and wider integration of Indian economy into the global economy, made the job of investment strategists easier. All policy failures, inadequacies in terms of physical and social infrastructure, political instability (especially mid 1990s), civil unrest, terrorist violence, geopolitical tensions, and market corrections due to these factors were accepted as “opportunities” to buy a secular long term growth story at a bargain price; and all such adventures were rewarded handsomely by quick reversal in mrket trends.

What you needed to be a successful investor in India, in my view, was the following–

(a)        Courage to take risk.

(b)        Deeper and wider to information.

(c)        Inertia to flow with the current.

(Contrarians who resisted the current and tried to swim against it were mostly annihilated, even though they were right about the unsustainability of the stock prices.)

(d)        Smartness to stay with the industry leaders, rather than spreading your capital too thin.

(e)        All stars favorably aligned in your horoscope.

Alternatively, the ability and resources to manipulate the markets would have also helped you, provided you were not too greedy and exited well in time.

It is pertinent to note that there is no evidence of Indian markets having a rally (or bust) based on their own investment theme in past three decades. Our market has just been passive participants in the global booms and busts (Commodities early 1990s; Financials mid 1990s; ITeS late 1990s; credit fueled construction mid 2000s; financials in mid 2010s, and digitalization of services and healthcare recently. Regardless, the mythology of Indian stock market is full of folklores about how the smart investors have identified the trends and businesses and made fortunes.

The things, however, do not appear to be that simple now. The “secular growth” narrative that drove the markets in past three decades is no longer unchallenged. There is an alternative narrative building. This counter narrative is based on the assumptions like the following:

(i)    India is failing in exploiting its demographic dividend.

(ii)   The pace of infrastructure building is lacking urgency and lags even many smaller emerging economies.

(iii)  The failure to maintain an adequate rate of investment has resulted in insufficient capacities to support the employment for rising youth population.

(iv)   The trend in quality of human capital has reversed due to failure of education and HRD policies.

(v)    A series of poorly planned reforms have diminished the popular appetite for any more radical reforms.

(vi)   The present government is not making sufficient efforts to build socio-political consensus for implementing key reforms to accelerate the growth.

(vii)  The potential growth trajectory of Indian economy has shifted downward to 6-7% and is grossly insufficient to support the rising aspirations of young demography.

The challenge of investment strategy is to find a balance between these narratives by neither getting overwhelmed by the negative narrative nor believing in the “secular growth” story of Indian economy blindly.

In next decade, either Indian equities will either have a theme of their own; or these shall lose the attention of global fund. In past couple of years a tendency to invest in global equities has emerged amongst Indian investors. This tendency may gain momentum in case the Indian economy fails to enhance its potential and realize such enhanced potential. Russia could be a relevant case in point to study in this context.

To support the positive narrative, the following excerpts from a recent Fidelity report could be useful.

“Throughout modern economic history, an expanding manufacturing sector has been essential to boosting employment and incomes. It’s a lesson that’s been driven home repeatedly, by the development of postwar Japan, the export boom in the Asian ‘tiger economies’ and most recently (and emphatically) China’s rise.

…..

India’s fixed asset investment has also lagged China’s and been on a declining trend in the past 10 years. In the 1990s, both countries had FAI at similar levels relative to GDP. Even though China has arguably spent too much on FAI in recent years, such investment is needed in the earlier stages of development and that’s where India missed the boat.

….

Today, India could be at an inflection point in the development of its manufacturing sector, as we think the government’s most recent package of reforms, known as Make in India 2.0, can be a game-changer if executed well.

The plan is to create 100 million manufacturing jobs and increase the manufacturing sector’s contribution to GDP to 25 per cent by 2025 from the current 16 per cent. It also features a doubling of infrastructure spending in the next five years versus the previous five years.

….

Overall, we expect an immediate contribution of around 0.5 percentage points of incremental GDP growth, and eventually the multiplier effects may lead to a contribution of about 2.5 percentage points.

…

Increased investment in infrastructure and manufacturing would also lead to productivity gains per capita. In absolute dollar terms of output per worker, India trails far behind other big developing markets like China and Brazil, not to mention the US or Europe.

With the increase in access to higher education, by 2030 India is expected to have a bigger tertiary-educated population than China. Meanwhile, urbanisation in India is forecast to increase from 35 per cent in 2020 to 43 per cent in 2035.

As a result, income levels in India are rising, as are the number of middle-class and high-income households. This will lead to a corresponding increase in consumer demand, which should translate into deeper penetration of sales of consumer items ranging from white goods to automobiles. Beyond consumer goods, other sectors that stand to gain from an acceleration in structural reforms include financials, industrials and healthcare.

The winners will be those firms that benefit firstly from structural growth, as penetration of their products and services increase in the country, and secondly, those that gain market share from weaker and less efficient players. For example, we expect this to include India’s private sector banks. Besides benefiting from structural growth, they will continue to gain market share from public sector banks due to their strong deposit franchises, conservative underwriting culture, well capitalised and strong balance sheets, and focus on technology.

The growing ranks of young affluent consumers means strong increases in housing demand, which translates into more mortgage business and other forms of consumer credit (not least, credit cards usage).

….

As a key emerging market and a proxy for global risk appetite, India took the full brunt of investor sell-offs when Covid-19 hit in early 2020. Going into 2021, while uncertainties remain, we expect the economy to continue its recovery path.

The recent rally has been narrow, focused on sectors such as healthcare, IT services and materials. Meanwhile valuations remain attractive across a number of areas including financials and industrials. As India’s economy gradually emerges from the Covid shock and corporate earnings start to improve, we think the long-term structural opportunities will again come into focus.”

 Before I say anything, I would like to make it clear that I use the terms “investor”, “trader” and “punter” in the context of equity investments, very judiciously.

To me an investor is a person who thoughtfully invests his money in a business to participate in the future growth of that business. A trader is person who is trying to optimize his return on capital by choosing from the best instruments available at any given point in time. It may be bond, fixed deposit, equity stock, gold, crypto currency, foreign exchange, other commodities etc. or a mix of these. Traders do not invest with the objective of “wealth creation”. Their focus is usually earning more than the risk free return while maintaining liquidity of his money. Punters buy financial assets or commodities just like lottery tickets. They get kicked by the prospects of hitting a jackpot someday and do not mind losing their entire capital in the process.

Here we are talking about investors only.

In summer of 2007, the global equity markets were doing great. Most global indices were close to their all-time levels. The global fund managers were exploring the world like Cristopher Columbus. Emerging Markets, BRICS, MENA, Frontier Markets etc were the hot themes. Everyone was deep in the money. Indian markets were no different. Then appeared first signs of sub-prime crisis and a sharp correction occurred in July 2007. However, the losses in correction were entirely recouped in no time and markets surged to their new highs by January 2008. The 14months after that were nothing less than a nightmare. The global equity indices saw cuts ranging from 35% to 75%.

The investors who had conviction in the strengths of the businesses they were invested in stayed the course and emerged winners. The punters lost their entire capital and much more. The traders also lost money.

In July 2007, at peak of the market, one investor invested in the stock of Mahindra and Mahindra Limited; the other investor invested in the stock of Reliance Industries; and a retired person invested in the Gilt Fund that invests in long duration government securities.

If they stayed invested in these instruments till today, the two investors in M&M and RIL stocks would be making about 9.25% CAGR (excluding dividends) on their investment; while the retired person would be making 9.5%.

A plain reading of previous two paragraphs may prompt the readers to jump to many conclusions. When I sent these two paragraphs to some of the readers for their comments, I got many responses. I find the following five responses as representative of the entire sample:

·         “Are you suggesting over a longer time frame, investment in gilt and stocks yield similar returns, but risk adjusted return are far superior in gilt.”

·         “If equities of front line companies have matched the return of Gilt, even after weathering two unprecedented crises (GFC, 2008-09 and Covid, 2020), then next decade perhaps equities will give phenomenal returns.”

·         “RIL gives you excitement’ but M&M is a steady performer.”

·         “If you are a long term investor, do not try to time the market. Over a longer period, returns would automatically get normalized.”

·         “Investment in reliance is like making a fixed deposit in SBI. You can never lose money.”

However, the responses could be very different, if I show the following chart to the respondents. This chart shows the relative performance of the stocks of M&M and RIL from July 2007 till date. The stock of M&M gave the entire return during first seven years (2007-2014) period. The current price of stock is almost same as it was in August 2014. The stock of RIL did not give any return for 9years (2007-2016). The price of the stock in December 2016 was almost the same as it was in July 2007.

A trader would immediately think, “December 2016 was the best time to sell M&M and buy RIL. This way one could have made the 2x the return of an investor.”

But an investor who is convinced about the business prospects of either M&M or RIL or both, the long intervening periods of no return are quite painful. The one who learns to manage this pain ultimately comes winner. The ones who succumb to this pain of non-performance, would sell RIL in 2016 and buy M&M, and end up as total losers.

If you want to fully assimilate the point I am trying to make here, then please talk to someone who had sold ITC and bought RIL in September this year, after getting no return in ITC for 5yrs.

 Inflation has been one of the central themes in global trading strategies in past one decade. During 2010-19, the central banks of developed countries (primarily US Federal Reserve, European Central Bank and Bank of Japan) struggled to build inflationary pressure in their respective economies, to attain a minimum level of inflation they considered necessary to motivate investments and sustainable growth. Incidentally, none of the Central Bank targeting higher inflation has so far been successful in their endeavor. Nonetheless, the sharp rise in global commodity prices in past few months has triggered a rush for “The inflation trade”.

 In Indian context, prices of all key commodities (metals, energy, food, cement, textile, and plastic etc), communication, healthcare and education, etc have seen strong inflation in past 6 months.

In its latest monetary policy statement, RBI admitted that “The outlook for inflation has turned adverse relative to expectations in the last two months”. The RBI expects the inflation to remain above its tolerance range for at least six months more. The policy statement reads, “Cost-push pressures continue to impinge on core inflation, which has remained sticky and could firm up as economic activity normalises and demand picks up. Taking into consideration all these factors, CPI inflation is projected at 6.8 per cent for Q3:2020-21, 5.8 per cent for Q4:2020-21; and 5.2 per cent to 4.6 per cent in H1:2021-22, with risks broadly balanced.”

The commodity sector has been one of the best performing sectors in the Indian stock markets in past 6 weeks. A number of brokerages have upgraded their outlook for steel, cement, gas, and chemical etc producers. Many have argued this to be a sustainable and durable trend and once in a decade opportunity to trade the inflation. For example, the brokerage firm Edelweiss expressed exuberance over steel prices and said, “Going ahead, we expect a blockbuster Q3FY21 with record margins in store. Furthermore, structural shortage of steel implies the rally in ferrous stocks has more legs despite their recent run-up. We remain positive on ferrous”.

I spoke with some steel and cement dealers, in Delhi, UP, MP and Bihar, in past two days. All of them appeared bewildered by the rise in prices. All of them cater to the small private construction segment, and none of them confirmed any sign of demand pick up in that segment. Being in trade for many decades, they were sure that demand is certainly one of the key factors driving the prices of steel and cement higher. They guessed, it could be a mix of supply chain disruptions, import restrictions, large inventory building by China and most importantly, the “understanding” between the domestic producers that could be driving the prices.

On the other side, Chinese Yuan has appreciated dramatically in past couple of months. This CNY appreciation has come along with first contraction in the Chinese consumer price index, since global financial crisis. At this point in time, it is tough to say how much of Chinese deflation is consequence of CNY appreciation, but it must certainly have some role. If the strength in CNY reflects the policy decision of Chinese authorities, we need to worry about deflation which China will be exporting rather than the inflation.

My take on the inflation trade, especially in Indian context, is as follows:

A large part of the global inflation in past 9 months could be the consequence of (i) supply disruption due to logistic constraints; (ii) inventory building by large consumers like China; and (iii) weakness in USD.

After reading and listening to views of various experts, I have concluded that that China might have built large inventories of all essential commodities (especially metals and energy) to hedge against (i) Trump victory and consequently intensifying trade war; (ii) longer lockdown due to pandemic Both these conditions have failed. Regardless of popular opinion, my view is that CNY strength is a Chinese gesture to US for ending trade dispute. If Biden reciprocates well to this gesture, inflation may not be a concern for next 10yrs at least.

I shall therefore avoid “The inflation trade” for now. However, if I see a sustainable pickup in demand next year, I shall be inclined to buy some domestic commodities like cement and chemicals (primarily import substitute).

 

UK has allowed the administration of vaccine for SARS-CoV-2 virus (commonly known as Covid-19) developed by Pfizer. Russia and Chinese authorities have also confirmed approval of separate vaccines. In India also couple of developers has expressed confidence that an effective vaccine will soon be available for Indian population.

This is certainly a matter of relief for the distressed mankind living in fear since outbreak of the pandemic. However, for the investors in stock markets wider availability of vaccine could be a matter of slight concern.

So far the investors in equity have had a decent run in 2020, regardless of the severe correction in the early days of the pandemic. In my view, a large part of the price gains in equity stocks could be attributed to the accommodative monetary policy adopted by the central bankers world over.

In past 9 months, a significant part of the cheap and abundant money may have actually flown to the financial assets (mostly equities) as (i) the requirement of money in real businesses have been less; and (ii) the interest rates have persisted at lower levels making it un-remunerative for investors to keep money in short term debt or deposits.

The rising certainty about vaccine availability and subsequent normalization of the accommodative monetary policies may rock the stock market party in 2021. It may be pertinent to recall the impact of taper tantrums on stock markets in 2013, when Fed started to wind up the QE used for supporting and stimulating the economy in the aftermath of global financial crisis in 2008-09.

In a 2017 study, Anusha Chari and others (National Bureau of Economic Research, Cambridge, see here), examined the impact of monetary policy surprises extracted around FOMC meetings on capital flows from the United States to a range of emerging markets. The study revealed “substantial heterogeneity in the monetary policy shock implications for flows versus asset prices, across asset classes, and during across the various policy periods.”, as per the study—

“The most robust finding is that the evolution in overall emerging market debt and equity positions between various policy sub-periods 14 Not reported but available from the authors. 33 appear to be largely driven by U.S. monetary policy induced valuation changes. In nearly every specification, the effect of monetary policy shocks on asset values is larger than that for physical capital flows.

Further, there is an order-of-magnitude difference between the effects of monetary policy on all types of emerging-market portfolio flows between pre-crisis conventional monetary policy period, the QE period and the subsequent tapering period. We detect some significant effects of monetary policy on flows and valuations during the period of unconventional monetary policy (QE). However, the effects are not consistent over all dependent variables. In contrast, during the period following the first mentioning of policy tapering, we uncover a consistent and large effect of monetary policy shocks on nearly all variables of interest.”

Normalization of global trade to pre pandemic levels may essentially obliterate the supply chain bottlenecks and ease commodity inflation. Remember, the pandemic has not caused any physical destruction, as is usually the case with a larger war. Therefore, normalization would not require any major reconstruction or rebuilding endeavor. The damage is mostly to the personal finances and small businesses. This will keep hurting the demand growth for few years and keep the need for additional capacity building low. The new capacities would all be built in healthcare and digital space, not much in the physical space.

In Indian context, in past six months, the yield curve has steepened the most in past two decades at least.

As per media reports, many private companies are able to raise 3month money at 3-3.3%, a rate lower than the policy reverse repo rate as well the corresponding bank fixed deposit rate. Obviously this is an anomalous situation and may not sustain for long.

There is little doubt in my mind that any further steepening of the curve could fuel Nifty to the realm of 15000 in no time. But I have serious doubts whether in a fast normalizing economy, as claimed by various government officials, economists and other experts, the short yields may continue to soften, or even sustain at the current level, especially when the inflation is seen bottoming at or above the RBI target rate.

Any sign of “withdrawal” might shock the brave traders, who are assuming unabated flow of cheap money. Beware!

 

 As per an old maxim, “beauty is in the eyes of the beholder”. This essentially implies that beauty or attractiveness of something (or someone) is mostly subjective. It is entirely possible that someone finds something beautiful, while at the same time someone else considers this thing to be ugly.

This maxim applies, mutatis mutandis, to equity investing also. A stock is found attractively values and prohibitively expensive by different market participants (analysts, fund managers, and investors) at the same time and price point; even though all of them may have access to the same set of data and information about the underlying company. The stock of ITC is a classic example of this dichotomy in the present day context. The stock is believed to be a top wealth creator and wealth destroyer at the same time by the different set of people.

I am sure no one would have any problem with this divergence in views about the future prospects of various businesses and companies. In fact this divergence in the views is what keeps the markets moving. Imagine a situation where there is no divergence in views about the future prospects and fair present value of the prospective earnings and growth of any company. There will be no trade in such stock as there would only be buyers or seller for that. The very purpose of stock markets will be defeated in that case. The more the divergence in views about companies and businesses, the better it is for the markets and market participants.

The real problem occurs when the market participants start looking at stocks from the eyes of “others” and begin to practice the greater fool theory. They start buying stocks of companies in which they have little conviction, believing that someone else will find “value” in this stock at a price higher than what have paid for it.

In past one month, I have observed numerous instances where brokerages and “market influencers” on social media are seen marketing stocks of bankrupt or loss making companies. Some brokerages have written sensational reports about “deep value” in public sector companies, which lay completely neglected three months selling at one half or one third the current market price (CMP).

Numerous equity analysts, fund managers and traders have written or spoken about the value in mid and small cap category stocks, suggesting how the current rally in this category of stocks may continue for next 2-3 years. Many these reports and interviews are totally silent on the fact that in almost all market and business cycles, a mostly different set of stocks perform well, and losers of previous cycles hardly perform well in subsequent market and business cycles.

I find the following, particularly relevant to highlight the point I am trying to make here:

 

I have no issues with these views or the people expressing these views. I just do not concur with these views. Given the current high momentum in the markets, I have two options either flow with the current to stay on the side lines and wait for the waters to calm. I am opting for the second alternative. My experience of past 30years guides me that I may not have to regret this decision 6 months later.

After hearing the finance minister (and Hindi translations of what she says by her Deputy) many times in past 7 months on the issue of stimulus for economic recovery, most market participants now appear disinclined to hear her anymore. I actually found many market participants wishing that the government actually does nothing and lest the economy recover on its own.

When the RBI governor comes out to brief media about the outcome of last Monetary Policy Committee’s (MPC) meet of the current financial year at 11:45Am today, most market participants shall be praying for a very “brief statement” and “No Action” by RBI. Not many would be expecting any further easing from the RBI, given the facts that—

(i)    Food inflation has remained rather sticky and non-food inflation has also started to rear its head higher;

(ii)   Liquidity in the system has surpassed the comfort level, leading to unsustainable fall in short term rates; and

(iii)  the real rate have now turned negative and are threatening to inflate a bubble in asset prices;

The questions before RBI/MPC therefore would be—

(a)   Maintain status quo;

(b)   Change the presently accommodative policy stance to neutral but refrain from doing anything; or

(c)    Change the policy stance and tighten the liquidity through market operations (Fx sale, short term bond sale etc) and/or policy action (CRR, SLR, MSF etc.).

Besides, one of the factors in the dismal export performance over past many months is out performance of INR over other emerging market peers. RBI might have to change its stable INR policy also sooner than later.

The market participants would obviously like to hear a “status quo” decision. Anything else may dampen the animal spirits driving the markets. Also, the market participants would not like the governor to speak for long (Governor Das is known for making long statements). The fear is that is speaks long, he will leave more material for (mis)interpretation.

A recent article published in Bloomberg Quint, summarized the present money market situation and quoted some money market participants as follows:

“The Reserve Bank of India may have cause to review its ultra-easy liquidity policy when it meets this week, as short-term corporate and government borrowing rates have remained below its policy benchmark rates for an extended period.

Yields on commercial paper have traded not only below the policy repo rate, the rate at which the RBI lends overnight funds to banks, but also below the reverse repo at which banks park funds with the central bank.”

“If this (surplus liquidity situation) continues, it would lead to a persistent mispricing in the commercial paper market as the existing yields are becoming unsustainable for investors. Even the policy rates are losing relevance due to the abundant liquidity scenario. So, there needs to be an immediate intervention from the RBI.” (Rajeev Radhakrishnan, Head - Fixed Income, SBI Mutual Fund)

“A quarter of the 274 companies that tapped the commercial paper market for borrowing funds via short-term bonds, with maturity below or equal to 90 days, raised funds below the reverse repo rate of 3.35% in November.”

“The mutual funds do not have access to interbank rates, as they cannot park their liquidity with the RBI in the reverse repo market like banks can, they don’t have a choice but to keep on buying these short-term commercial papers. Because of this, the rates have compressed so much that investors are buying CPs even below the RBI’s reverse repo rate.” (Parag Kothari, Associate Director, Trust Capital)

My personal view on RBI policy stance is that RBI may continue to take a pragmatic approach and change its policy stance to neutral and let INR weaken over next few months.

The excess liquidity may have already started to inflate financial asset prices beyond sustainable levels. If left unchecked, this would result in inflation of bubbles that invariably cause avoidable pain when they eventually burst.

The policy rates are already at level that is supportive of growth. Any further broader easing may not be warranted at this stage when the investment & consumption demand growth is not accelerating. Some targeted easing may however be considered to promote investment and exports in specific areas.

The fears of 2008-09 like market freeze shall materially abate in next few months and RBI may not need to augment the Fx reserve any further. It may actually consider selling some reserve accumulated over past 6 months to fund growth and higher borrowing needs of the government.

 

 

 I remind myself of this narration almost every market cycle. I think, it is the time to reiterate once again.

Have you ever been to vegetable market after 9:30PM? The market at 9:30PM is very different from the market at 5:30PM.

At 5:30PM, the market is less crowded. The produce being sold is good and fresh. The customer has larger variety to choose from. The customer is also at a liberty to choose the best from the available stock. The vendors are patient and polite, and willing to negotiate the prices. As the day progresses, the crowd increases. The best of the stuff is already sold. Prices begin to come down slowly. The vendors now become little impatient and less polite and mostly in "take it or leave it" mode.

By 9:30PM, most of the stuff is already sold, and only inferior quality residue is left. The vendors are in a hurry to wind up the shops and go back home. The prices are slashed. There is big discount on buying large quantities. Vendors are aggressive and very persuasive. Customers now are mostly bargain hunters, usually the small & mid-sized restaurant, caterers and food stall owners. They buy the residue at bargain price, cook it using enticing spices and oils, and serve it to the people who prefer to eat out instead of cooking themselves, charging much higher prices.

The cycle is repeated every day, without fail, without much change. No one tries to break the cycle; implying, all participants are mostly satisfied.

A very similar cycle is repeated in the stock markets.

In early cycle, good companies are under-owned and available at reasonable prices. Market is less volatile. No one is in a hurry. Smart investors go out shopping and accumulate all the good stuff.

Mid cycle, with all top class stuff already cornered by smart investors, traders and investors compete with each other to buy the average stuff at non-negotiable prices. Tempers and volatility run high.

End cycle, the smartest operators go for bargain hunting; strike deals with the vendors (mostly promoters and large owners) to buy the sub-standard stuff at bargain prices. Build a mouth-watering spicy story around it. Package it in attractive colours and sell it to the late comers and lethargic, at fancy prices.

The cycle is repeated every day, without fail, without much change. No one tries to break the cycle; implying, all participants are mostly satisfied.

If my message box is reflecting the market trend near correctly, we are in the end cycle phase of the current market cycle. I daily get very persuasively written research reports and messages projecting great returns from stocks which no one would have touched six months ago, even at one third of the present price.

The stories are so persuasive and the packaging so attractive that I am tempted to feel "it's different this time." But in my heart I know for sure, it is not!

In past one month, the set of businesses commonly referred to as “cyclical” in stock market jargon has outperformed remarkably. This one month outperformance has resulted in this set of stocks outperforming the benchmark Nifty on past 12 month performance basis also. Though, on three performance basis these stocks continue to lag substantially.

If I go by the media reports and the messages and report in my inbox, there is still “huge” value left to be realized in these set of stocks. The arguments are varied and quite persuasive.

·         A former CIO of a fund recently tweeted that “Deeply negative rates with excess liquidity getting cleared at zero rates is like cocaine to asset markets. We are in midst of a blow off top rally and if RBI does not mop this liquidity then stock prices in India could rise beyond imagination.

·         Another prominent fund manager, reputed for his stock picking skills, argues that so far the liquidity has gone into financial assets. From here on liquidity may move to real economy and fuel demand for infrastructure building and capacity creation. Components of cost like power, labor and interest rates are favorable for Indian businesses hence profitability should improve. There is strong case for investing in cyclicals which will benefit from capacity building in infrastructure and manufacturing.

·         The global brokerage firm Goldman Sachs (GS), in a recent report, highlighted that global Copper prices are now at highest level in past seven years. GS forecasts that “the world’s most important industrial metal was in the first leg of a bull market that could carry prices to record highs.” The report further emphasizes that-

“Against a backdrop of low inventories and net zero carbon pledges from countries including China, Japan and South Korea, Mr Snowdon believes significantly higher copper prices will be needed to incentivise new supply and balance the market.

We believe it highly probable that by the second half of 2022, copper will test the existing record highs set in 2011 [$10,162],” he said. “Higher prices should ultimately help defer peak supply and ease market tightness, but this first requires a sustained rally through 2021-22.”

·         A report by Motilal Oswal Securities highlights that Indian steel spreads have risen ~25% in 3QFY21 and are at a three-year high. Brokerage expects the spreads to stay strong on the back of a domestic demand recovery and higher regional prices.

It is further noted that Despite domestic iron ore prices rising to a five-year high, spot steel spreads are at a multi-year high due to higher steel prices and subdued coking coal prices. While iron ore prices from NMDC have increased by 30% YTD in FY21, imported coking coal prices have declined by ~35% YTD, keeping total raw material cost in check. As a result, domestic steel spreads are strong at INR33,000/t for flats (HRC) and INR30,000/t for longs (rebar).

·         Nirmal Bang Institutional Equities notes that Automobile sales continued its growth momentum in November’20 amid rise in preference for personal mobility on the back of good festive demand, upcoming wedding season, soft base due to overlapping of Diwali in November this year and continued positive sentiments in rural & semi urban markets. Barring 3Ws, all the segments reported YoY volume growth.

·         Emkay Global highlighted in a recent report that Chemical prices are firming up. The report mentions that In Nov’20, prices for key products such as Phenol, Benzene, Acrylonitrile, Butadiene, Toluene and Styrene jumped over 20% MoM in international markets. Rising container freight costs (~2x) on dedicated Asian routes due to a capacity crunch have pushed prices higher for certain chemicals. Freight costs within Asia are also likely to see an uptick in Dec’20 as carriers are prioritizing long-haul routes over shorter ones as a result of better economics. PVC prices have increased 10% MoM and are likely to swell further next month.

On the other side of the spectrum are people like Peter Chiappinelli of GMO, who are convinced that this liquidity fueled rally is about to end anytime now. In the latest GMO Asset Allocation letter, Peter emphatically advised his clients as follows:

“Currently, we are advising all our clients to invest as differently as they can from the conventional 60% stock/40% bond mix, just as we were advising them in 1999. Back then, we were forecasting a decade-long negative return for U.S. large cap equities. And that is exactly what happened. Today, the warning is actually more dire. U.S. stock valuations are at ridiculous levels against a backdrop of a global pandemic and global recession, and CAPE levels are well above 2007 levels, within shouting distance of the foreboding highs reached in October 1929. But it gets worse. U.S. Treasury bonds – typically a reliable counterweight to risky equities in a market sell-off – are the most expensive they’ve been in U.S. history, and very unlikely to provide the hedge that investors have relied upon. We believe the chances of a lost decade for a traditional asset mix are dangerously high.”

My personal view is that it’s 9:30PM in the stock markets. I believe that in post pandemic era, many of the traditional businesses may even not survive. Besides, in Indian context, the present capacity utilization levels may not warrant any significant capacity addition in next couple of years at least. The so called “Atam Nirbhar” capacity building trade may mostly be limited to soft commodities (like chemicals); electronics and defense production. Unlike 2003-10 infra capacity additions, it may not trigger any life changing opportunity for many engineering and capital goods companies.

The logistic constraints and paranoid inventory building by some economies may cease in next six months as vaccine is made available to more and more people. The Central Banks, especially RBI, may look at containing liquidity in 2021, before it can actually cause an inflationary havoc. The hyperinflation which many analysts, economists and fund managers are secretly praying for since QE1 in 2009 may actually not happen at all. I am also convinced from my own research that stress in unsecured credit segment has increased materially in past few months and banks will have to bear the brunt of this. I shall therefore let this trading opportunity in financials, commodities and cyclicals passé.

 The statistics for economic growth during 2QFY21; consumption, investment, exports and financial indicators etc. for the month of October were announced last week. The data has been received very enthusiastically. The general commentary is that the growth is “surprising”, and the recovery is much quicker and superior that previously estimated. The “buoyant” data and further encouraging news on vaccine development & launch kept the momentum in the stock market busy yesterday.

Since, most of the “surprised” reports are basing their arguments on the “Pre-Covid” and “Consensus Estimate” benchmarks; I find it pertinent to note the data with the usual year on year comparison.

1.    The production in eight core industries has contracted for eight consecutive months. In October 2020, the index of core industries fell by 2.5% compared to October 2020. It is important to note that in the base month October 2019, index had also contracted 5.5%.

While coal, fertiliser, cement and electricity recorded positive growth, crude oil, natural gas, refinery products and steel registered negative growth in the month of October 2020.

During April-October 2020, the index of core industries has now declined 13% as compared to a growth of 0.3% in the same period of the previous year.

2.    After witnessing an uptick in the overall export segment in the month of September, India's exports faltered back into the negative territory, contracting by 5.12% YoY in October.

The worrisome part however is that India has lagged its peers materially in exports growth in past many months. Comparative data of export growth on a three-month moving average basis showed that Vietnam, China and Taiwan have seen the strongest revival, followed by Bangladesh. India and Indonesia have lagged.

Vietnam saw exports rise by 12% on a three-month moving average basis. China and Taiwan have seen close to double-digit growth too. Bangladesh has seen 1.3% growth in exports on a three-month moving average basis. India’s export performance has been patchy, declining 3.9% on 3M moving average basis in October.

3.    India’s GDP contracted for second consecutive quarter on year on year basis. In 2QFY21 India’s GDP contracted 7.5% as compared to the same period in previous year. It is relevant to note that NSO has admitted data availability limitation and recognized a possibility of downward revisions to the GDP data for 2QFY21.

Nominal GDP contracted 4% on account of higher inflation in the quarter. Overall, H1FY21 GDP stands at -15.7%, worse than most of our peers.

 

I find the standalone growth statistics, independent of “pre-covid” and “consensus estimate” benchmarks, not very encouraging. Though one can certainly draw comfort from the fact that we may not deteriorate materially from the current level of economic activity. But we must recognize that the latest statistics implies two things:

1.    In best case, India’s GDP for FY22 may be just 3-4% higher than the GDP recorded in FY20. Ignoring the Covid-19 induced contraction, it would mean just 2-2.5% CAGR over two years. This anemic growth would be on the back of dismal and declining growth for past many years. The long term growth trend (5yr CAGR) would remain below 6% for next 3yr at least even if we consider the most buoyant of estimates. Given the dire employment situation and demographic compulsions of the country, this growth trajectory must raise at least one crease of worry on the forehead of even the eternal optimists.