Vijay Kumar Gaba

Fear, paranoia and resilience prevails in 1HFY22

The financial year FY22 started with the country reeling under the impact of an intense second wave of Covid-19 pandemic. The images of citizens struggling for life saving drugs and Oxygen, overcrowded cremation grounds and corpses of the victims of pandemic floating in the Ganges were imprinted on peoples’ consciousness. For once, disease, death, and desperation dominated the popular narrative.

The life seemed still with everyone becoming fearful and paranoid. It felt that spirituality and austerity would dominate the behavior of common man for many months to come. The government went into overdrive to build health infrastructure, provide assistance to helpless citizens and planned, what would eventually become, the biggest public vaccination drive ever in history of mankind. The austerity and fiscal discipline did not appear to be anywhere in the list of top priorities.

The macro economic data for 1QFY22 however presented a slightly different picture. Private consumption was the largest contributor to the growth and government had refrained from spending much.

The 1QFY22 growth came in better than most had anticipated as the sporadic lockdowns did not affect the economic activity. The recovery in 2QFY22 appears to be much better than estimates, with many indicators reaching pre pandemic levels. The growth estimates for FY22 have been accordingly revised upwards by most agencies.

…did not impact financial markets

The financial markets also did not reflect the sentiments peddled in the popular narrative. Despite, the government incentives to promote local manufacturing; acceleration in award of contracts for large infrastructure projects; the government support and incentives for MSME credit; significant expansion in digital banking ecosystem; revival in real estate market, etc. the credit demand growth is persisting at multi decade low levels.

The stock market has witnessed heightened activity, with benchmark indices gaining close to 20% in 1HFY22 on the back of much higher participation from the household investors. Mid and small cap stocks dominated the activity, indicating the strong dominance of the sentiment of greed over the sentiment of fear.

The market rally has been rather intriguing, given that environment for equities has not been very supportive from conventional wisdom viewpoint.

The following factors, which have bothered the equity markets historically, have been conspicuous by their exalted presence.

·         The energy prices (Achilles heel of the Indian economy) have climbed sharply higher. The second round impact of the energy inflation have also become visible in higher costs of production and freight.

·         Food inflation has persisted at elevated levels. In fact, headline inflation has persisted above the RBI comfort zone for many months, terminating any chance of further monetary easing by RBI. The debate now circles around the tightening schedule of RBI.

·         The vulnerabilities of the Chinese financial system have been exposed with one of the largest real estate developer defaulting on its debt obligations.

·         The central bankers of developed countries gave clear signals that the monetary easing has peaked and their next step would most likely be the monetary tightening.

·         RBI has shown tolerance for higher yields and slightly weaker INR.

·         Institutional investors have remained on the fringes for most part of the 1HFY22.

·         The cold war like condition between US and China has intensified further. Polarization of global trade majors is also increasing

·         Geopolitical situation at northern borders remains alarming, with no resolution in sight for Sino-Indian standoff at LAC and increasing influence of China and Pakistan in Afghanistan.

·         The strong leader of Germany lost elections to the left alliance, reinforcing the trend of the left leaning socialists gaining power in most of the large countries, the environment for free trade and globalization continues to worsen.

·         The weather has been extremely erratic world over. Unusual weather pattern were seen across continents. Unusual snow fall and drought in Latin America; Drought, extreme heat and wild fires in North America; floods in Europe, China and Indian sub-continent caused extensive damage to crops and supply chain disruptions. The prices of industrial raw materials and food increased materially world over.

·         The corporate earnings have been stronger than the estimates in 1QFY22, but the valuations in many pockets are seen prohibitively high. The valuations in commodity sectors like metals and chemicals etc. seem to discounting the current inflationary trends to the eternity.

Money in pocket may not reconcile with profits shown in SM timelines

Regardless of the presence of the supposedly adverse factors, the equity markets have remained quite resilient so far.

However, in past couple of weeks the volatility in markets has increased significantly. While various commentators and observers have attributed the rise in volatility to one or more of the above listed factors; it is pertinent to note that these factors have been present, and widely acknowledged for past many months. It would therefore not be justifiable to attribute the market volatility and jitteriness to these factors alone.

The anecdotal evidence indicates that in view of the above listed factors, the participation in equity markets in past six months has been rather tentative and lacking in strong conviction.

Most investors appear to be actively trading, frequently booking small gains/losses. Thus, even though the benchmark indices have shown strong gains in 1HFY22, not many personal portfolios may be showing the matching gains.

Now, as the market commentary turns to “cautious optimism”, “fairly priced”, “Long term Story in tact” from “abundant opportunities”, “recovery trade”, “TINA for India” etc., the unconvinced investors/traders lacking in conviction are turning even more nervous.

Of course greed is still the dominating factor and not many market participants are taking money off the table; they are even quicker in booking profit and losses.

Sector shopping in search of quick gains is also gaining higher momentum leading to faster sector rotations, giving an illusion of abundant trading opportunities. Obviously, the money in pocket is not reconciling with the money being made on social media timelines.

Money made on Twitter wall is exponentially higher than what broker’s statement is depicting and that is making the investors/traders both nervous and greedier for now. So expect, the current state of volatility and low returns to continue for few more months at least.

Economy fast recovering to pre pandemic levels

As per the consensus estimates, Indian economy shall recover to pre pandemic level latest by the middle of FY23; in what is popularly called a “V” shape recovery.

The growth thereafter is expected to be more moderate. The normalized long term growth trajectory may however not reach 6%+ level (seen in pre pandemic period) till FY27 at least.

Corporate earnings - 2QFY22e growth to be moderate as base effect withers

Nifty 4QFY21 and 1QFY22 EPS growth was the strongest in more than two decades. Poor base effect and strong pent up demand were the primary causes attributed to such sterling corporate performance.

However, these factors are seen tapering from 2QFY22 onwards, and the cost pressures are rising. We may see revenue growth as well as margins moderating this quarter.

…though the long term earnings trajectory earning to remains robust

Regardless of the moderate 2QFY22 earnings growth, the long term earnings growth (Rolling 5yr CAGR) trajectory is expected to remain strong for FY23 and later years.

Markets – Greed dominates the Fear

During 1HFY22 the market performance was dominated by the cyclical sectors like Real Estate, Metals, Energy and Infra. IT Services was the only non-cyclical sector that continued with its good performance from 2HFY21. Financials and Auto were the major underperformers.

Given their underperformance for much of the past 3-4years, sectors like Realty and Metals were significantly under-owned, it is therefore likely that most investment portfolios might have underperformed the benchmark indices.

 

FII remained net seller while DII were small net buyers in 1HFY22

During 1HFY22 over Rs59716cr were raised through 26 IPOs. This compares with Rs54576cr raised through 33 IPOs in the entire FY21. However, an analysis by the brokerage firm MOFSL highlighted that almost 52 per cent of IPO investors sold shares on the listing day. This clearly indicates towards lack of conviction amongst investors, including institutional investors, in the new businesses. Most IPO investors appear taking this as a trading opportunity to make some additional money from the funds lying in the savings account earning a pittance.

India outperformed the peers by wide margin

During 1HFY22 the Indian equities outperformed the major global market by wide margins. Nifty gained close to 20%, whereas the second best Index S&P500 of USA gained 10%. Amongst peers Brazil was the worst performing market with a loss of 7%.

Market outlook and strategy

As of this morning, there is great deal of uncertainty as to the shape of the global order that would emerge in next couple of years. It is highly unlikely that we would get much clarity over next 6-12months. To the contrary, it is more likely that the conditions become even more uncertain and unclear.

Insofar as India is concerned, I continue to feel that 2HFY22 may just be a continuation of 1HFY22, with some added complexities and challenges. The country may continue to witness protests and unrest. The consolidation of businesses may continue to progress, with most small and medium sized businesses facing existential challenge. Disintermediation and digitization may also continue to gather more pace.

The normal curve for the economy may continue to shift slightly lower, as we recover from the shock of pandemic. A large part of the population may continue to struggle with stagflationary conditions, with nil to negative change in real wages and consistent rise in cost of living. Geopolitical rhetoric may also remain at elevated levels.

Market Outlook – 2HFY22

The outlook for markets in the near term is mostly negative.

Macroeconomic environment - Neutral

Global markets and flows - Negative

Technical positioning – Negative

Corporate earnings and valuations - Negative

Return profile and prospects for alternative assets like gold, real estate, fixed income etc. - Negative

Greed and fear equilibrium - Negative

Perception about the policy environment - Positive

Outlook for Indian markets

In view of the positioning of the above seven key factors, my outlook for the Indian equity market in 2HFY22 is as follows:

(a)   Nifty 50 may form a short term peak in next couple of months. The process of forming the top has already started. In case the market follows the trajectory of 2HFY08, we may see the top around 18700-18900 level, followed by a sharp correction. However, if Nifty follows the pattern of 1HFY07, we may see top around 18200-18300 followed by a sharp 20% correction and a sustained rally thereafter.

(b)   The outlook is positive for IT, Insurance, large Realty, healthcare, agri input, and consumer staples, negative for commodities, and neutral for other sectors.

(c)    Benchmark bond yields may average below 6.5% for 2HFY22. INR may average close to 74 in 2HFY22.

(f)    Residential real estate prices may show a divergent trend in various geographies, but may generally remain strong. Commercial and retail real estate may also continue to see recovery.

Key risks to be monitored for the market in 2HFY22

1.    Relapse of pandemic leading to a fresh round of mobility restrictions. (Less likely)

2.    Significant worsening of Sino-US trade relations.

3.    Material tightening in trade, technology, and/or climate regulations in India and globally.

4.    Hike in effective taxation rate to augment revenue.

5.    Material escalation on northern borders.

6.    Prolonged civil unrest.

7.    Stagflation engulfing the entire economy, as inflation stays elevated and growth fails to meet the expectations.

8.    Premature monetary tightening.

Investment - Strategy

Asset allocation

2HFY22 may be a difficult period for investors, in terms of high volatility, poor expected returns from diversified portfolios and poor return from long bond portfolios as yield firm up. In view of this, I shall continue to maintain higher flexibility of my portfolio; keeping 30% of my portfolio as floating, while maintaining a broader UW stance of equity and debt.

Large floating allocation implies that I shall continue to trade actively in equity. 30% of portfolio would be used for active trading in equities and debt instruments.

My target return for overall financial asset portfolio for 2021 continues to be ~7.5%.

Equity Strategy

I would continue to focus on a mix of large and midcap stocks. The core criteria will be old economy cyclicals which are cheaper from historical and contemporary perspective, have decent market share, are changing business model to suit the new conditions, and would benefit from economic recovery.

I would target 6-7% annualized price appreciation from my equity portfolio.

Miscellaneous

I have assumed a relatively stable INR (Average around INR74/USD) and slightly higher short term rates in investment decisions. Any change in these assumptions may lead to change in strategy midway.

I would have preferred to invest in Bitcoin, but I am not considering it in my investment strategy due to inconvenience and unease of investing.

Factor that may require urgent change in strategy

·         Material rise in inflation

·         Material change in lending rates

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

“The crisis of today is the joke of tomorrow” — H. G. Wells (English Author, 1866-1946)

As of this morning, a number of regional economies appear struggling with some sort of crisis. The factors causing these crises are varied; and in many cases even trivial. Collectively, these regional crises appear to be clouding the global economic recovery; and threatening a protracted phase of stagflation (negative or very poor real growth).

In particular, the sharp rise in global energy prices is a matter of serious concern for all. The prices of natural gas and coal are now at decade high. Crude oil prices are also at 5yr high and forecasted to move further in view of expected harsh winter. Consequently, the electricity prices and transportation (shipping and freight) costs have also risen sharply. The sharp inflation in energy prices is becoming a global crisis and being seen as a major threat to the global economy recovery.

From a plain reading of the events across the globe, inter alia, the following factors appear to be catalysing some sort of crisis, impacting the global economic recovery from the Covid-19 pandemic.

1.    Supply chain disruptions caused by labour displacement due to the pandemic; underinvestment in capacity building in past one year; uneven recovery across sectors and geographies; etc.

2.    High tide of pandemic stimulus ebbing.

3.    Erratic weather patterns across the world adversely impacting the crops.

4.    Hard geopolitical and trade related positioning between groups led by China and the USA.

5.    Precipitous shift in the business models towards ESG and digital, leading to significant change in demand and supply patterns for carbon and decarbonized products; material shift towards renewable energy and electric mobility, etc.

6.    Rising fragility of global financial system, with burgeoning debt both at the sovereign as well as household levels.

7.    Hardening nationalist positioning constricting free movement of labour and capital (e.g., Brexit).

The following are some of the instances that reflect the changing business conditions, demand supply patterns and the crises emanating from these.

US – Business consolidation and uncertainties hurting the supply chain

"Sorry. No French Fries with any order. We have no potatoes", a board at the Burger King in Florida read this week.

The shortage of trucks and driver is choking the supply chain across US. As per the industry sources, “Truck drivers that would transport cargo on flatbed trucks are being recruited away by Walmart and Amazon to exclusively pull box trailers or shipping containers. Large items like steel piles and premade concrete pieces either can't fit or can't be loaded into containers or box trailers. Vendors tell me demand is as high as 40:1, meaning for every available flatbed truck there are up to 40 waiting customers. The roads around the NYC metro area are as clogged with truck traffic as ever, but we're facing longer waits and higher prices to haul non-containerized cargo.”

One of the largest shipping ports in USA (San Pedro, LA) reported that some 60 container cargo ships idling at the entrance of the port complex last week. With an increase of 30.3% in cargo volume as compared to the same period in 2020, the congestion at ports is showing no signs of easing.

As per WSJ reports - The armada of cargo ships is due to surging volumes and unpredictability in global supply chains caused by the Covid-19 pandemic, and exacerbated by shippers pulling holiday-season imports forward to avoid delays later. The congestion at ports is one of a number of global bottlenecks as ports juggle strong consumer demand and shortages of workers and equipment caused by pandemic-related health and safety measures. These challenges have been  leading to significant delays and additional logistics costs.

UK gasoline crisis – Brexit may have a role to play

As the country heads into what could be a harsh winter, the US energy prices are soaring. In past nine months, the prices of natural gas in UK have risen over 250%. Though multiple factors could be attributed to the precipitous rise in energy prices and consequent second round inflation, logistic issues are cited as one of the principle reasons.

The complexity of the situation forced Paul Scully, the U.K.'s minister for small businesses to comment, “We know this is going to be a challenge and that's why we don't underestimate the situation that we all find ourselves in.”

The government officials and the prime minister himself have maintained that there is no shortage of the fuel in the country. It is the shortage of the drivers that is causing supply chain disruptions for fuel and food. The government is even contemplating to call the army to help bridging the supply chain gaps.

While there is no official word on labour shortages, it is estimated that labour supply may have got choked due to Brexit; travel restrictions due to Covid19; and less number of labour participating due to Covid19. The chief economist of KPMG speaking to media estimated that labour shortages may take 6 more months to fully resolve.

Andrew Goodwin, chief U.K. economist at Oxford Economics, told CNBC – “Households have got this big stockpile of savings to spend, but that will be starting to ebb away a bit simply because the bad news we're having on things like inflation. I suspect, we're going to end up in a situation where the reality is a little bit disappointing to what we were expecting say three months ago. And that's simply because of these issues with supply shortages, both in terms of sort of constraining output and also just eating into consumers' purchasing power."

Though the US economy is expected to reach pre Covid level by 3Q2021, demand pull is not something that is being cited frequently as one of the primary reasons for inflation spike. It is mostly the supply chain disruption.

Another popular view is that “It’s outrageous to suggest the current UK energy situation is the result of a rapid transition away from fossil fuels. It is primarily a gas crisis, fuelled by the nation’s slow transition to lower carbon sources. The origins of the crisis are complex, and date back many years.”

“Gas prices in Europe are at record highs, but the European Union’s internal energy market – of which the UK is no longer part – allows member states to trade with each other in a way that balances prices out.

This means EU countries can’t always take full advantage of very low energy prices, but at the same time means they’re protected from very high prices.

The UK, as an independent country outside the internal EU market, can take better advantage of low energy prices. But at times like these, when energy prices are very high, it left highly exposed to price shocks.” (Prof Aimee Ambrose, Sheffield Hallam University)

China’s decarbonization plan – Beijing Winter Olympics in play?

In the last week of September, the production line of a solder company in Kunshan was silent. In previous years, the factory was busy, stocking up for the National Day holiday. However, due to strict local power restrictions, they have temporarily had to suspended production. “All companies are going to stop production,” one manager explained, “When the policy first came out, it was thought that it wouldn’t affect processing companies. But since September 27, it requires all companies to stop production.”

Steel, non-ferrous metals, chemicals, textiles, and other energy-consuming industries are all affected. Unlike the previous round of flexible measures, which aimed to reduce energy consumption by 10%-30%, the current power control policy is more stringent. Now, local authorities are implementing an “open 2, stop 5” measure; companies will only be allowed to operate for two days a week. Most will have to reduce their production by 90% or shut down completely.

China aims to keep power consumption under control with carbon neutrality targets in mind. In August, the central government issued the “Barometer of 2021 Half-Year Regional Energy Consumption Intensity & Total Amount” – also known as the energy consumption “double control” plan. Under this plan, provinces must manage “total energy consumption” as well as “energy use intensity” while meeting their five-year targets.  (International Tin Association)

Some observers suspect that this plan is primarily aimed at ensuring blue skies during winter Olympics in Beijing; while other believe that it is part of the long term plan to decarbonize the Chinese economy.

The impact of “double action plan” is that Global consumers are already facing shortages of smartphones and other goods ahead of Christmas. The Global Times reported that “Multiple semiconductor suppliers for Tesla, Apple and Intel including ESON, Unimicron and ASE groups, which have manufactured plants in the Chinese mainland, recently announced they will suspend their factories’ operations to follow local electricity use policies.”

Brazil agriculture – snow and drought cause havoc

Brazil faced an unusual cold weather with froth killing the crop, followed by one of the severest drought in many decades. Brazil is also one of the worst affected countries due to Covid-19 pandemic in terms of the fatalities.

The New York Times reported, “Crops have shriveled up under searing heat. Immense water reservoirs, which generate the bulk of Brazil’s electricity, are growing alarmingly shallow. And the world’s largest waterfall system, Iguaçu Falls, has been reduced from a torrent to a trickle.”

Several states in the country are facing the worst drought in at least 90 years. The crisis has led to higher electricity prices, the threat of water rationing and a disruption of crop growing cycles. Agriculture, an economic engine of the nation — which relies heavily on hydropower — is now at risk.

Experts said the arid landscape, which coincided with a rise in illegal deforestation over the past months in the Amazon rainforest, could lead to a devastating fire season. Enforcement of environmental regulations is weak in the rainforest, and fire season traditionally begins in July.”

Before the worst drought in a century, Brazilians were surprised by unusual snow fall in July. At least 40 cities in the Rio Grande do Sul reported thick ice, while 33 others witnessed heavy snowfall reaching up to a meter high in some places, according to several reports. For most of the Brazilian population it was their first snow experience. The snow materially damaged sugar, citrus, and coffee farms.

“We’re left with a perfect storm,” said Liana Anderson, a biologist who studies fire management at Brazil’s National Center for Monitoring and Early Warning of Natural Disasters. “The scenario we’re in will make it very hard to keep fires under control.”

Brazil, is the world’s biggest exporter of coffee, sugar and orange juice. Poor Brazilian crop means that the global coffee and sugar prices have shot up sharply.

Conclusion

These are only some of the instances of regional crisis that are having global impact. The prices of food and energy are rising across countries. The productions lines are working at sub optimal capacities due to input shortages. The policy makers are hoping that these crises are all transitory and would ease in next few months (mostly on their own) as the pandemic related curbs are eased and bottlenecks are removed. However, in the interim severe damage could be caused to many small and medium sized business and households.

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

Future market price target is usually the least important and most subjective component of an equity research report. The household investors must not act solely based on the “price target” flashed on their TV screens or social media timelines. They must spare sometime to go through the details and get hold of all the strings attached before taking any investing decision.

In a T20 cricket match, a statistical algorithm predicted that chances of Team “A” winning are 79%. The result was flashed on TV screens and a viewer promptly bet a dinner for two on Team “A” victory, with his friend. 

Two overs later, a rookie Team “B” bowler claimed a hat trick and the statistical predictor was now showing chances of Team “B” winning as 83% (from 21% earlier).

The general elections concluded just 3 hours ago. The TV screens were flashing results of exit polls showing Party “A” sweeping the elections with 65% of seats. The ticker on TV however did not show the disclaimer, which said that a 1.2% swing could change the results in favor of Party “B”.

A viewer who had a bet with his wife (a supporter of Party “B”) one year of dishing if the Party “B” wins majority, rued his reliance on TV breaking news for the full one year,

A prominent global brokerage house (XYZ) released a research report for ABC Ltd, giving a 12month price target of Rs400 (against the current market price of Rs210). The TV channels, social media timelines and newspaper headlines flashed “XYZ forecasts 90% gain for ABC Ltd”. Hundreds of investors rushed to buy the stock of ABC Ltd, without caring to read the research report. The report actually built multiple scenarios and highlighted multiple risks. Rs400 target, i2 months hence, was based on a completely blue sky scenario, with no risk playing out. It also assumed that the collective wisdom of market will get influenced by the analyst’s unconventional pricing method for the company.

As it happened – the sky came out to be clouded; some risk factors mentioned in the report also played out and market did not care to agree with the unconventional pricing method of the analyst. The stock price plunged to Rs75 a year later. Most investors booked losses; cursed the analyst and alleged him to be in cahoots with the unscrupulous market operators and corrupt company management.

Indifference to details may be one of the most unfortunate parts of the entire investment process of household investors (commonly referred to as the retail investors). In their eagerness and greed to make money faster than others, these investors usually act on headlines without actually caring to go into the details. It is also seen that the reliance on “Research Reports” by the household investors is mostly misplaced. Most of them only care to read the “price target”, without going into the analysts’ rationale for such target; or caring about detailed analysis of the business of the company. For household investors, it is critical to understand the types of equity research reports and their components.

Types of equity research reports

Equity research reports are prepared for a variety of purpose. The constitution of the report usually differs according to its purpose. For example -

The most common equity research reports are the Sell Side Initiation and Maintenance reports. These are reports prepared by research analysts employed by various brokerages for the purposes of marketing their investment ideas to the clients. The initiation report is the first report on a company by a particular analyst. This report usually contains a detailed quantitative and qualitative analysis of the company. After the initiation report is released, the analyst then releases periodic maintenance reports to update the original data for the new developments like quarterly results; corporate actions, and policy changes etc.

Second popular types of reports are “deal reports”. These reports are prepared by the investment banking research analysts to market the proposed equity issue of the underlying company to the institutional investors. These reports usually have an inherent bias in favor of the underlying company.

Third type of popular reports is “buy side equity research” reports. These reports are usually prepared by the research analysts of the investing entities (e.g., mutual funds, private equity funds etc.) for their internal use purposes. These reports usually are influenced by the guiding principles and investment strategy of the investing entity; and hence may not be relevant to all classes of investors.

The focus, content and emphasis of various types of reports are different based on their objective. Household investors cannot exclusively rely on these reports, made available to them on social media, blogs or friends in right places, for their investment decisions.

Components of a Research Report

The components of an equity research report would depend on its objective and target audience. The basic components of the most popular a “Sell Side Equity Initiation Research Report” would usually consist of following-

·         Description of the Company – Historical background, business, facilities, capacities, promoters, key management, etc.

·         Analysis of the business – Products, applications of products, competitive landscape, demand-supply dynamics, emerging trends, technological advantages, etc.

·         Analysis of finances – Historical trends in capital structure, cost of capital, capital allocation efficiency, leverage sustainability, solvency, advantages (or otherwise) relative to competition etc.

·         Analysis of profitability – Historical trends in margins, growth, return on equity, sustainability of margins etc.

·         Future Projections – Profitability, Growth, Solvency, Sustainability Competition etc. over next 2-4years.

·         Risk factors – Risks to the business, finances, profitability and forecasts

·         Actionable – Buy, Sell, Hold, Accumulate, Reduce etc.

·         Price target – Expected market price of the stock on a given future date.

There are many sources for the details provided in the research reports, e.g., – (i) Factual data available from historical records; (ii) Published research by professional research organizations and Institutions like CRISIL, CMIE, NSSO, RBI, IMF, etc.; (iii) Management presentations and company reports; (iv) Market research by the analyst himself; and ((iv) Analysts’ estimates., etc.

The suggested action (buy, sell etc.) is based on the estimated relative performance; implying that the stock of that particular company is likely to do better (or worse or in line) than competition and/or benchmark indices. In many cases, the actionable is actually not based on the estimated absolute performance of the stock price.

Future market price target is usually the least important and most subjective component of an equity research report. This piece of data in a report is heavily influenced by the analysts’ subjective perception of the business, growth, profitability, and the method of valuation used to derive such target. It is therefore common to have vastly different price targets given by different analysts at the same time, for the same stock

It is akin to a TV commentator forecasting a team’s score in a 50 over match at the beginning of the inning based on the weather conditions, grass on the pitch, and performance of key batsmen & bowlers in previous five innings, etc. Even though their analysis and forecast are based on their experience and available information, their forecasts about the total score seldom come true.

The household investors therefore must not act solely based on the “price target” flashed on their TV screens or social media timelines. They must spare sometime to go through the details and get hold of all the strings attached before taking any investing decision.

In its latest meeting the US Federal Reserve Open Market Committee (FOMC) reiterated its position stated in the last meeting. The Committee maintained status quo on the Fed rate (Repo Rate) and its asset (bond) buying program (US$120bn/month). The limit for single counterparty under reverse repo has been raised to US$160bn from the present US$80bn, allowing the banks to park more money with the Federal Reserve.

The Committee reiterated its stance of last meeting, stating that “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted”; implying that the FOMC decision on QE continues to be data driven, and the present reading of data guides a gradual unwinding of the monetary stimulus introduced to mitigate the impact of Covid-19 pandemic.

“While no decisions were made, participants generally viewed that so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate”, the Fed Chairman said in a post meeting conference.

The Chairman also informed that the Committee feels that the Fed is closer to passing the test of “substantial further progress” on employment and inflation. Accordingly, more members now see the first rate hike happening in 2022. It is pertinent to note that in June, when FOMC members last released their economic projections, a slight majority of members had projected rate increase into 2023.

The markets have obviously read what it wanted to in the Fed statement. The bullish response to the Fed statement implies that market is giving more credence to the “slower growth” forecast than the “higher inflation” expectation. The market move post Fed statement implies that the confidence in “November Taper” is much lower given the slowing growth and uncertainties in Chinese markets. Even if the tapering begins in November, the pace may slower than anticipated. Also, the data for the “lift” (rate hike) may not adequate as of now and much more evidence may be required before a concrete lift decision could be taken.

Despite the headline inflation running much higher than the fed target of 2%, FOMC did not appear concerned about price situation. The Chairman repeatedly stressed in his interaction with the press that “he expects price pressures to subside as supply chain factors, goods shortages and unusually high levels of demand return to pre-pandemic levels’; thus reiterating his “transitory” stance on inflation.

Many analysts have related the Fed decision to postpone the question of Tapering to the November meeting, to the debt ceiling fracas in US. “The Fed never makes major changes to policy when there are major unresolved issues in Washington,” said Danielle DiMartino Booth, chief executive of Quill Intelligence. “Between the debt ceiling, budget resolution and potential for a government shutdown, there are plenty of political reasons for the Fed to not change policy.”

In my view, Fed would refrain from taking any decision till the (i) concerns over Covid-19 variants subside materially; (ii) political fracas in US ends amicably; (iii) dust created by Evergrande settles down and (iv) “transitory” nature of inflation is denied. November Taper, if at all happens, would be slow (may be US$10bn/month) and protracted. The rate hike decision is still in the realm of speculation.

Whether we like it or not, China is a key factor in India’s policy making function. The China factor materially influences our economic policies, foreign policy, and defense policy. This may be true to a material extent for US, Japan and Korea policy making functions also.

Inarguably, the Chinese economy has been one of the key driving forces for the global economy in past three decades. Chinese have labored hard for over five decades, since beginning of cultural revolution in 1966, to emerge as a potent global force. In past three decades they have subsidized the global economy by providing cheap labor and capital; and funded a large part of the US and EU fiscal deficits since early 2000s. The Chinese support was a key factor in keeping the global market afloat during the global financial crisis. It would not be entirely wrong to say that China also helped the developed economies in protecting “their environment” by letting them relocate most of their polluting industries to China.

In the process, China perhaps digressed a little too further from its core ideology of Marxism. The selective capitalism allowed many “depravities of the West” to permeate the Chinese system, e.g., rampant corruption, flagrant inequalities and conspicuous consumerism. “Growth at any cost”, has perhaps costed too much to the Chinese society and the system. There have been reports of growing dissent amongst citizens for a variety of reasons. The citizens exposed to the global economy and society naturally desired more freedom (especially of expression) tat was denied. The demographic control policies (one child, immigration to cities etc.) also created imbalances and dissent.

In past few years, the Chinese government has sought to change the course of its polices to address some of these issue. For example, -

First, China sought to move into higher orbit by asking to be treated at par with developed countries. They claimed global acceptability for their currency; bigger role in the multilateral institutions like World Bank; dominant role in global trade and commerce through “Belt and Road” and other Initiatives; bigger role in global geopolitics etc. Besides, China has also made substantial strategic investments in Asia, Africa, Latin America and European continents to garner wider support.

USA, that has been dominating the world since the collapse of USSR, obviously did not like the idea and an overt trade war ensued.

Second, China cracked down massively on its polluting industries by shutting huge capacities. This impacted the global supply chains and forced the global corporation to seek alternative supply sources. (India has been one of the major beneficiaries)

Third, to correct its growing demographic imbalances, China abolished its one child policy and allowed upto 3 children per family.

Fourth, Chinese authorities made a paradigm shift in policy towards businesses; and took punitive/restrictive actions against likes of Internet major Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo, and numerous private tuition entities to signal the change in the direction of of winds in China.

Fifth, it prescribed strict financial prudence norms for its real estate sector to ensure that there is no hard landing of the economy. Many prominent developers failed to meet these norms and were forced to take corrective action.

Sixth, and most important, the premier Xi Jinping, proposed a new economic policy framework (“New Development Concept”), comprising of three key concepts –

(i)    “Dual circulation economy,” which seeks to reduce China’s future dependency on export-driven growth, and instead have Chinese domestic consumer demand become the principal growth driver;

(ii)   “Common Prosperity,” which emphasizes income redistribution away from China’s billionaire class to low- and middle-income earners;

(iii)  New “industrial policy,” led by a revamped state-owned sector, giving top priority to new technology platforms as the drivers of the 21st century global economy, including semi-conductors, artificial intelligence, quantum computing, and new forms of advanced manufacturing.

The changes obviously would have far reaching impact on China, as well as the global economy. There are many popular view prevalent about the nature and extent of this impact. One popular view is that like Japan in 1980-1990, China will allow systematic undisruptive dismantling of the froth that has developed in its economy (soft landing). The other view is that 2020-2030 will be the decade of socio-economic revolution in China, as against the decade of cultural revolution (socio-political) during 1966-1976.

In my view, China is working on a new model in which the core ideology of Marxism (uncorrupted and equal society) shall become a guiding force; communist party will remain fully in control of markets; and China becomes a great global power. Arguably, it will involve significant geopolitical and trade conflict. Signs iof which are clearly visible to us in China Sea, Afghanistan, and Ladakh.

It remains to be seen how far Xi Jinping would be successful in implementing this new design. Nonetheless, the actions so far speak of the full commitment to the new policy framework. It is in this background that we need to assess the recent developments in China and global markets.

Evergrande – scarecrow or black swan?

One of the basic law of physics is that the higher an object is propelled into the atmosphere, the faster it returns to the earth; unless the propeller lends enough velocity to the object to help it transcend beyond the gravitational orbit of the Earth.

This principle of physics can be applied to the businesses also. A business that is propelled higher using the fuel of debt, risks crashing down to the ground zero, if the business model is not strong enough to take the business out of the debt spiral and place it in the orbit of sustainability. However, in cases where the fuel itself is contaminated (unsustainable debt); the fuel tank (management) is leaking, or the velocity is inadequate (unsustainable business model), the chances of business crash landing increase manifold.

In past one decade, we have seen many examples of this phenomenon in India. The businesses that grew remarkably in the decade of 2000s with the help of easily available credit, but had leaking tanks (unscrupulous management,) contaminated fuel (unsustainable debt) and/or inadequate velocity (poor business models) came crashing down in the decade of 2010s. JPA Group, Suzlon, ADAG, DHFL, Yes Bank, SREI, Bhushan Steel, are only few example. Globally, Lehman Brothers, which crash-landed in 2008, has become epitome of this phenomenon.

Chines real estate sector – symbol of malaise

The Chinese real estate development sector has been under scrutiny for more than a decade now. The sector has been at the core of phenomenal growth of Chinese economy in general and the financial sector in particular for past two decades. The real estate sector development apparently contributes more than one fourth of GDP of China and constituted over three fourth of the Chinese household wealth.

Nonetheless, numerous fables of ghost towns, unsustainable debt, window dressing of lenders’ books have been very popular in the past decade or so. Most bankers, investors and money managers have been worrying about this; though not many might have taken steps to reduce their exposure to Chinese enterprises materially. Perhaps, they were too confident that the Chinese authorities would not let any large business fail, lest it may deter the global investors from investing in Chinese businesses.

The things however have begun to change dramatically since past one year, with the Chinese authorities making a paradigm shift in its policy towards businesses. Though, the punitive/restrictive actions of Chinese authorities against likes of Internet major Alibaba, food delivery leader Meituan, ride hailing app Didi, popular micro blogging app Weibo, and numerous private tuition entities have been signaling the change in the direction of of winds in China, the scare of failure of real estate major Evergrande has drawn greater attention of the entire global markets towards the developments in China.

Evergrande in that sense has become the symbol of malaise prevalent in China, just like Lehman symbolized the malaise in US financial sector during the global financial sector.

For an Indian investors, it is pertinent to understand the Evergrande episode independent of the price action of the past week in the stock markets. Remember, panic is more likely to mislead than guide to a safe haven.

What is Evergrande?

Evergrande, a Guangzhou based real estate developer founded in 1996, is one of the largest real estate developer in China. As per the website of the group, it owns more than 1300 real estate projects (about 780 under construction) in close to 300 Chinese cities; has interest in many other businesses, including sports, media, electric mobility etc.

Evergrande, with over US$300bn in assets (close to 2% of Chinese GDP) is also one of the world’s highest indebted developers with more than US$300bn in dues to lenders and operating creditors. Out of this about US$129mn in interest was due for payment this week and US$850mn of principal repayments are due in next 3months.

Reportedly, the Chinese government has chalked out a bail out for Evergrande. In the arrangement, Evergrande may be virtually nationalized. This should provide some immediate relief to the markets, but it is not important in a larger context. This arrangement just kicks the can a little further to allow soft landing.

What’s the problem?

The rating agency Fitch recently downgraded a host of Chinese developers, including Evergrande; and warned about a “probable default” by the troubled developer. This warning has sent shock waves across the markets, as it was feared that a default by Evergrande may impact the entire real estate development and financial sectors in China directly; and commodities and consumer sectors indirectly.

It is estimated that a crash in real estate sector may hurt lot of homebuyers who have made substantial part payments, and thus impact their financial status materially. It is also estimated that material slowdown in real estate sector, may slow down overall Chinese economy materially, leading to substantially lowered demand for industrial commodities like steel and copper. This may have serious repercussions for global commodities markets; and also impact the consumption demand for things like iPhones in China.

The stocks and bonds of Evergrande and other major real estate developers like SIMIC crashed by 35% to 80%. While the Chinese homebuyers might lose money, if Evergrande projects are not completed in time or are abandoned completely; the global investors who had invested in stocks and bonds of Chinese developers have already lost substantial money. In that sense, the global investors are equally part of this problem.

In fact, the current problem may be more intense for the global investors who are over leveraged in the Chinese high yield bonds and have large unhedged exposure to Chinese real estate developers and their lenders, than for the Chinese enterprise and Chinese authorities themselves.

What caused the problem?

Prima facie, managing US$1bn of Evergrande’s payments due in near term, was never a material problem for Chinese government, which virtually owns the entire banking system and has huge surplus in reserves. After all, Indian government with almost one sixth GDP of China, and much smaller banking sector, could manage much larger problems (IL&FS and Yes Bank) with relative ease.

The problem in fact lies in the changing policy paradigm in China.

To implement far reaching reforms in the delinquent real estate sector, the Chinese government outlined three parameters to be followed by all the developers, viz., (i) The liabilities of any developer must not exceed 70% of its asset value (L/A < 70%); (ii) the net debt of developers must not exceed its net worth (net leverage < 100%); and (iii) all developers must have cash which is more than their short term debt (cash to ST debt > 1).

Apparently, the objective of stipulating these conditions was to preempt a systemic crisis that could potentially drag the entire financial system into a deep crisis. Last year a large number of entities failed the test.

The bigger problem was however identified in the business model followed by the developers like Evergrande. They apparently bid for land at very high prices. The local authorities were obviously very happy with these bids as it augmented their revenue substantially. The higher land prices were then passed on to the home buyers with inflated property prices.

This made bankers happy as they could lend more to homebuyers due to higher notional value of the collateral property; but resulted in substantially higher household debt and unaffordable home prices.

The household savings thus got diverted to inflated housing sector rather than the capital starved high technology sector which had to increasingly rely on the foreign capital. It also impacted the private consumption, frustrating the government efforts to make Chinese economy domestic consumption driven from the presently export driven.

To correct all these issues, Chinese authorities took a series of measures, including curbs on VC investment in real estate, and checking the corrupt practices in real estate sector.

Consequently, the real estate developers saddled with unsustainable debt and inflated assets are feeling the pressure. But it is important to note that it is not the real estate alone, but the entire high yielding Chinese debt that is feeling the pain. Also Evergrande may have become face of the problem, but it is certainly not the only one in problem. Many other like it, e.g., SIMIC, Fantasia, Suna, etc are also in trouble.

What are the implications?

A series of defaults in Chinese real estate sector could potentially have multidimensional implications. For example

(a)   It could lead to serious wealth erosion for the Chinese home buyers. To mitigate some of this impact, the Chinese authorities are resorting to transferring the assets of troubled real estate developers to the lenders, who shall get it completed and sell to the home buyers. A variant of this model is being tried in India also with assets of JP Associates, Amarpali, Supertech etc.

As stated earlier, beleaguered Evergrande Group has apparently negotiated a settlement with the lenders for a short tern respite. Besides, the Chinese authorities are ensuring adequate liquidity in the market to stem repeat of post Lehman market freeze and global contagion.

(b)   The bond and stock prices of troubled developers have already seen severe losses. The global investors holding these securities have already weathered the loss. However, it is hard to believe that after having experienced Lehman collapse, these investors had not hedged their risk.

(c)    The developments in Chinese real estate market could lead to material slowdown in the Chinese economy, and therefore the global economy, threatening the fragile recovery from the pandemic. The demand for commodities could collapse leading to sharp correction in prices.

It is pertinent to note that the signs of slowdown in global economy were already emerging  three months ago, with World Bank, ADB, IMF etc downgrading their growth estimates. China had anticipated slowdown in demand for commodity prices and accordingly started liquidating its strategic reserves of steel and copper. The commodity prices mostly peaked three months back. Most central bankers have recognized this trend, terming the commodity inflation as transitory; and refrained from acting on elevated price conditions.

Further, a slower Chinese demand may actually ease pressure on the global logistics and supply chain bottlenecks, thus providing a short term relief to the struggling industries worldwide.

Implications for Indian investors

The Indian investors must see the current developments in Chinese economy and markets as continuation of the trend that started with Trump-Xi trade war. This will only accelerate the move towards China+1 policy of global businesses; which is widely expected to of great benefit for Indian businesses.

In the near term we may see minor outflows from Indian markets, as the global investors with significant exposure to Chinese developers seek to rebalance their portfolios due to losses and redemption pressure. However, in mid to long term this could actually result in higher allocation (China+1) to India by investors also.

The Evergrande episode is expected to refrain the Central Bankers from rushing into monetary tightening; while PoBC continues to ease liquidity. This has obviously alleviated some of the near term concerns of the markets.

The most visible impact for Indian investors would however be the likely easing of inflationary pressures, providing some easing room for RBI.

It is less likely that the Chinese investors would seek to withdraw material investments from India, under the current circumstances, especially when the rules regarding fresh investment from China require much greater scrutiny.

However, beyond the immediate events, we need to keep a close watch on the developments of wider import occurring in China.

Evergrande – scarecrow or black swan?

In media, the Evergrande episode has been termed as sighting of the proverbial Black Swan, a rare event that may disturb the status quo materially.

Black Swan events are, by definition, completely unexpected events of large magnitude and consequences and usually mark a watershed in the history.

No surprises that the prospects of a default, and its perceived potential repercussions sent the global markets into tailspin earlier this week. Traders anticipating a repeat of Lehman moment in Evergrande default, rushed to close their positions. It was feared that failure of Evergrande will have a strong spiral impact on the global financial system and markets. It may result in collapse of China property development market, leading to sharp fall in property prices and erosion of collateral value for banks. The collateral damage will also be felt in metal markets, as China property developers have been a key drivers for the metal demand.

But it is pertinent to note that China real sector, its importance, challenges, problems and threats have all been analysed threadbare in past one decade. There is nothing that is not known to global investors and analysts. It is only the lure of high yield and confidence in Chinese authorities (they would not let it fail) that keeps the investors’ interest alive in this market. China and all its enterprise face close scrutiny of the global community, despite scant availability and low reliability of the information. To be honest very few investors and analysts would not expect the available information to be mostly manipulated. Everyone therefore is always on their guards in relation to anything connected with China. Therefore, Sighting a Black Swan in Chinese context itself is a Black Swan event.

I would therefore like to believe that Evergrande is a scarecrow that has been shown to the global investing community as a warning of the risk of investing in high yield bonds by over leveraging.

It is also a harbinger of the things that are likely to come over next few years. A decade of readjustments in China may require many adjustments in most corners of the world.

Despite the risks inherent in equity share ownership, the traumatic shocks of 1992, 2000, 2008 and 2020, equity remains a popular investment option among both individual and institutional investors. In fact, after the global financial crisis of 2008-09, the riskier equity (startups and pre revenue) has become even more popular with the investors who have been chasing yields on one hand and had access to cheap money on the other hand.

After the market crash due to outbreak of pandemic, the inflows into global equity funds have surged exponentially. The net flows in 2021 YTD alone exceed the net flows during previous two decades (2001-2020).

Anecdotal evidence suggests that one of the main reasons behind this unshakable popularity is the possibility of scoring “big”. It is this chance of multiplying the money in short term, which has attracted hordes of investors to the stock market.

Nonetheless, there is no dearth of people who are scared of the word ‘equity investing’.  Some of them have lost their entire savings in stock market, and the others, considering it another form of gambling, did never invest in shares.

Where do you stand in this picture?

·         Is it true that the investment option, which has statistically given highest returns in all economic conditions, did never work for you?  If yes, did you try to examine the reasons for this?

·         Even if you made fabulous gains in the stock market, could you attribute these to careful planning, or was it a fluke?

·         Do you consider investing in stocks an art and a science, or just a ‘roll of dice’?