Vijay Kumar Gaba

Some notes on the current state of the Indian economy.

Monsoon ‘abnormal’ so far

The monsoon season this year has been quite erratic so far. Statistically, during the period from 1^st June to 22^nd August the country has received 9% more than the normal rainfall. However, the temporal and spatial distribution of rainfall has been quite abnormal so far.

·         252 (36%) of the 703 districts in the country have witnessed ‘excess’ (20% to 59% above normal) to ‘large excess’ (60% or more above normal) of rains.

·         236 (34%) districts have received ‘normal’ (upto 19% above or below normal) rains.

·         215 (30%) districts have received ‘deficient’ (60% to 59% below normal) to ‘large deficient’ (more than 60% below normal) rains.

·         More importantly, the granaries of India – UP, Bihar, Jharkhand, West Bengal have been mostly deficient to large deficient. In UP, 66 out of 75 districts have been deficient to large deficient. In Bihar 35 out of 38 districts have received deficient to large deficient rainfall.

The agriculture activities have been affected in large part of the country due to erratic, large excess and deficient rainfall. However, the water storage levels in most reservoirs are now good and soil moisture is also better, which augurs well for the Rabi crop. Thus, despite a below par Kharif crop and poor summer vegetable crop; we may see decent overall agriculture growth in FY23. However, the rural demand in this festival season may be not buoyant. The rural credit may also face renewed stress in some pockets.

Infrastructure orders ‘strong’

NHAI reportedly awarded 6,306km of orders in FY22 – vs 4,788/3,211km in FY21/20, exceeding its target of 5000km. Other government departments and state governments are also accelerating the pace of infra order awarding, especially in roads, irrigation, metro, water and mining. It is expected that the order momentum may sustain in FY23 as well. Reportedly, more than Rs1trn of tenders have been issued in July 2022 alone. Roads, water, and railways continue to be the major contributors for the same.

Among sectors, roads, railways, water and irrigation, and power equipment (Solar EPC) saw strong inflows in April-July 2022. Growth in railways was driven by large wagon orders. Growth in power equipment was driven by solar EPC orders.

Considering the ‘above estimate’ performance of most infrastructure developers, it is evident that the execution may also be improving. It is reasonable to expect that the infrastructure activity may finally be taking off to an acceleration phase.

Inflation expectations ‘anchored’

Reported CPI for July 2022 was at 6.71%, at five month low level. Though, it remained above the RBI upper tolerance band of 6% for 7^th consecutive month. The core inflation-excluding food and fuel segments- came in at 6.04% in July compared to 6.22% in June. Thus a slowdown in inflation rate was primarily driven by food, transportation and communication.

The RBI Governor commented yesterday that “inflation is getting increasingly anchored; has moderated from the peak. Bond yields at the long end are reflecting the anchoring of inflation. Softening of crude and commodity prices is also supportive. Inflation has peaked and is expected to moderate.”

As per the brokerage firm JM Financials, “India’s inflation trajectory is trending downwards while core inflation should be range bound (5.9% - 6.4%) throughout the upcoming festive season before easing meaningfully. But the risk of percolation of high WPI inflation to retail inflation would keep CPI elevated, currently the wedge remains as high as 8.2% and even if July WPI print eases by 50bps, the wedge would still be 8%. Although global supply chains may show early signs of easing, geopolitical issues are far from over and any further escalation would negatively impact crude price and INR. We see Q2FY23 CPI inflation at 6.9% vs RBIs 7.1%, easing inflation would entail a policy action addressing more towards defending
INR than suppressing demand, hence Sep’22 MPC meet should see shallow rate hikes (30bps).”

Borrowing cost and deposit rates rising

As per rating firm CARE Ratings, “Credit offtake had shown an improving trend in the latter half of FY22, which has continued in the first four months of FY23. RBI has been working on reducing the liquidity surplus in the banking system which has been consistently reducing and is currently around the Rs 2 lakh crore mark from Rs 7 lakh crore at the beginning of 2022.”

Weighted average lending rate (WALR) for all banks has risen post RBI hiking the policy rates. Expectations of further policy rate hikes are also prompting certain banks to proactively raise rates. Deposits rates have also witnessed some hikes; though the rise in deposit rates, has been slower than the increase in lending rates.

From various recurring events that generate significant anticipation and anxiety amongst market participants, the speech of the US Federal Reserve chairman at Jackson Hole annual symposium is the most popular one. This year the speech is scheduled to be delivered on 26^th August. Since, the markets are again filled with anticipation and anxiety. I find it pertinent to highlight a few things about the event and its likely consequences.

Jackson Hole is Davos in Wyoming

Later this week the Fed Chairman Jerome Powell is scheduled to make a speech in a symposium held in Jackson Hole valley (Wyoming, USA). This annual symposium, sponsored by the Federal Reserve of Kansas City, has been held since 1978; and in Jackson Hole since 1981. The symposium is usually held in the month of August, just ahead of the pre scheduled US Federal Reserve Open Market Committee (FOMC) meeting in September.

Many prominent central bankers, finance ministers, reputable academicians and market participants take part in this symposium to discuss the currently important issues facing the global economy. In the distant past, some reputable economists, like James Tobin (Tobin Rule) and John Taylor (Taylor Rule), have presented their path breaking papers at the symposium.

It is customary for the US Fed representative (Usually the Chairman or a senior official) to present their thoughts on the topic selected for that year’s symposium. The topic for the 2022 symposium is “Reassessing Constraints on the Economy and Policy”.

There have been a couple of instances (Paul Walker 1982 and Greenspan 1989) where the US Fed representatives dropped some hints about the imminent policy changes in the ensuing FOMC meetings. But those hints were incidental and not by design. Otherwise, there has been no instance where the thoughts of the US Fed representatives have actually digressed from the given topic for the symposium. Nonetheless, various experts have been regularly conducting a post-mortem of their speeches to find mentions of the words and terms which they can use to market their own views in the garb of the Fed’s hints.

In fact in the past two decades, no path breaking paper has been presented at the symposium and Fed chairman speeches have been noted for all the wrong reasons; most notable being the Bernanke dismissal of sub-prime crisis (2007); and Greenspan’s advocacy for expansionary policies (2005), which was heavily criticised by Raghuram Rajan in 2005 and rest of the world in 2008.

It would therefore be not completely wrong to say that the Jackson Hole event is now mostly irrelevant for the financial markets. A harsher criticism would be to state that Jackson Hole is on the path to become the American version of annual outing of worlds’ elite held by an NGO (World Economic Forum) in Europe’s Davos.

For records, at the last year Jackson Hole symposium, the Fed Chairman did not say or hint anything that had not been said at previous FOMC meetings, Congressional testimonies and various public speeches. The focus was on the topic of the symposium (“Macroeconomic Policy in an Uneven Economy”) rather than the monetary policy of the US Federal Reserve. In fact, to highlight the role of monetary policy in the current macroeconomic environment, Chairman Powell had mentioned that “The period from 1950 through the early 1980s provides two important lessons for managing the risks and uncertainties we face today. The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation. Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times.” (Speech of Fed Chairman Powell at 2021 Jackson Hole Symposium)

Do not rush to fill your buckets

In case an investor is feeling a rush to act in anticipation of what the Chairman Powell might (or might not) say at Jackson Hole this Friday, I would like to narrate the following to him/her:

If a geologist tells you, “the Himalayan Glaciers are melting fast and there will be no water in the Ganges in the year 2050”; what would be your instant reaction? Will you—

·         Rush to store water in buckets?

·         Begin to explore places which are not dependent on the Himalayan Rivers for their water needs, for relocation in next few years?

·         Commit yourself to the environment conservation by adopting 3R (Reduce, Reuse and Recycle) as part of your life so that the green house emission is reduced, global warming is reversed and the geologists are proven wrong?

·         Dismiss the information provided by the Geologist as fait accompli and get on with your routine life?

I may say with confidence that various people will react differently to this information, but none will rush to store water in buckets, and a very large majority will dismiss the information as fait accompli.

I believe that the finance and economics experts prophesying various policy changes are no different than the Geologist forecasting the end of the Himalayan glaciers; and the investors’ collective reaction to their prophecies is also no different. A large majority of investors dismiss the experts’ views and perhaps no one takes material investment decisions based on these prophecies. Nonetheless, these prophecies do create an environment of great anticipation with usual jitteriness and eagerness in the near term. One mistake most of the investor make in this environment of jitteriness and eagerness to do something, is to not ask themselves—

(a)   What is the situation that is being sought to change?

(b)   How the change would impact the businesses underlying their portfolio of investments?

(c)    How the action they are contemplating to take will protect them from the perceived adverse impact of the change in the status quo?

For example, if Quantitative Tightening (QT) is prompting you to take an action on your portfolio – look at the following US Money Supply chart (M2) chart and decide how long will it take for the US Money Supply to reach pre QE1 level.

Notwithstanding the official position about the state of economy in the US, the market is building an elevated probability of a recession (or a recession like, if I may say so) situation in 2023. The short term (1-2yr) bond yields are now higher than the benchmark 10yr yields in a number of developed economies, including US, UK, Canada, Sweden, and emerging economies like Brazil, Mexico, Hong Kong, Turkey, Pakistan etc.

Historically, the yield curve inversion has been a harbinger of recession in the majority of instances. For example, in the case of the US, the yield curve inversion has been followed by a recession in all of the past seven instances.

In this context, it is important to note that the US Federal Reserve (Fed) and European Central Bank (ECB) have unambiguously stated that they are willing to accept a measured slowdown in the economy to achieve the goal of price control. The Monetary Policy Committee (MPC) of the Reserve Bank of India (RBI) also stated categorically that for now price control is the primary objective and not economic growth. This implies that RBI is also willing to accept a calibrated slowdown in the economy to meet the end of price stability.

As it appears from the commentary of global central bankers, renowned economists and widely acclaimed market experts, the process of monetary correction may be a protracted one; and hence the global economy may not return to the desired trajectory of growth anytime soon. The situation for the stronger emerging markets like India may however be different. These economies could find their own course and avoid recession. Nonetheless, the impact of the slower (or negative) global growth would be felt and remain a key obstacle to high growth.

In particular, if our growth plans have accorded high priority to (a) exports to developed countries and (b) reliance on manufacturing growth due to global businesses preferring Indian facilities over China or Germany (China+1 or Europe+1); then probably we our policy makers would need to rework the strategy for the interim period.

So far, we have not heard any credible plan from our policy makers to mitigate the impact of impending recession-like slowdown in our major trade partner economies. In such an environment, RBI’s 4.5% real GDP growth projection for 2HFY23 might prove to be marginally optimistic and growing 7% in FY24 would be a big challenge. The markets need to take cognizance of this, in my view.

After almost a decade the Indian financial sector seems to be out of troubled waters. Almost all significant banks are beyond solvency concerns and set to progress in the path of growth. The asset quality has shown steady improvement for most banks despite Covid disruptions. The loan growth has improved from historic lows seen in the past few years. Earning growth is strongly aided by healthy recovery from the bad accounts.

Moreover, the loan books of most tier 1 and Tier 2 banks are tested for stress and provisions are adequate to meet most foreseen adversities. These institutions have come a long way from the first announcement of Dirty Dozen (the largest 12 non performing accounts) in the summer of 2017. Eight of the notified 12 accounts have been resolved with more than 50% recovery. Resolution is under progress for two accounts and the other two are under liquidation. As of the end of FY22, no major potential stressed account has been reported that can materially alter the current status of any bank. The credit cost from hereon will mostly be under control with some defaults in the normal course of business.

The best part is that the rather stringent provisioning and disclosure norms have significantly enhanced the credibility of the books of banks. The capital adequacy is positive for aggressive lending. Obviously the outlook for Indian banks is bright and buoyant.

Most of the non-bank lenders (NBFCs) are also back on the path of steady growth. The asset liability mismatch (ALM) and asset quality concerns have been mostly addressed by almost all meaningful NBFCs. Many weaker players have been eliminated from the market. For the survivors, the business is brisk and profitable.

Obviously, for the investors in the financial sector better times lie ahead, even if the consensus overweight on the financial sector might slow down the trajectory of gains a little.

Notwithstanding the air of optimism all around, the sky may not be all blue and bright. There are scattered clouds that do not look menacing as of this morning; but certainly warrant a watch.

I shall be in particular watching some conglomerates that are growing too fast (both organically and inorganically) and are considerably leveraged. In some cases the leverage appears supported by the balance sheet that might have been engineered to look healthy but not necessarily backed by tangible assets. The cash generation is poor; thus the servicing capability could be severely impaired if the things do not go as per the plan, raising the spectre of dirty dozen all over again.

The number of systemically important (too big to fail) financial institutions is also growing steadily. The regulator (RBI) is keeping a closer vigil on these institutions. Additional regulatory provisions have also been prescribed for these. Nonetheless, in case of a global contagion like dotcom (2001-2001) or global financial crisis (2008-2009) the probability of a “big tree collapsing” in India is now certainly not zero.

From the business viewpoint, I hope that while aiming to achieve global size and economies of scale, the Indian managements would have learned key lessons from the decline of global conglomerates like General Electric and General Motors and demise of Lehman and Merrill Lynch etc.

 The latest episode of global inflation is impacting peoples’ lives in multiple ways, especially in developed countries where the present generation of citizens has not experienced this kind of rise in the cost of living; borrowing cost and challenges in accessing consumer credit. It is of course a significant challenge for the young investors and professional money managers who have been raised in an environment of profligate fiscal policies; abundance of liquidity; near zero cost of borrowing; persistent struggle to mitigate the deflationary pressures and unchallenged US supremacy over global markets and geopolitics. For them all the assumptions that underlined their investment strategies might be falling apart; just like the Dreamliner Titanic.

This episode of inflation and consequent monetary tightening would indubitably prove to be an important life lesson for the young investors and money managers; and go a long way in defining the future investment strategies and market directions.

Besides, there are some other noticeable side effects of the inflationary pressures on the global socio-economic milieu. For example consider the following:

There are several reports indicating that harassed by the rising cost of living and high rentals, many youngsters may be returning to live with their parents; several more may have delayed the decision to leave the parental homes; yet some other who were living alone are moving in with their partners and friends to save on rental and other costs (for example see here). It may be too early to conclude anything, but if this trend sustains we might find it catalyzing some interesting changes in the demographic profiles of many countries; housing market; immigration policies etc.

There is enough anecdotal evidence available to indicate that employees demand higher wages to manage the rising cost of living; but they seldom agree to wage cuts during the deflationary phase. The businesses therefore usually engage in workforce realignment to optimize their wage bill. The senior employees whose actual contribution is stagnating but wages are rising, are invariably replaced by younger employees which cost much less simply due to their lesser vintage. Inflation thus causes higher unemployment in middle and upper tier employees, who are either forced out of the labor market or accept new jobs at much lower wages. The governments however do not have this luxury of letting senior people go. They usually meet the goal by imposing a moratorium on fresh hiring and rationalizing non-wage costs, e.g., travel.

The products’ prices usually do not move in direct proportion to the raw material prices. During raw material inflation the margins of most companies shrink, unless they enjoy significant demand elasticity for their respective products and are able to pass on the entire raw material inflation on to their customers. However, during the raw material price deflation phase, a majority of companies do not pass on the benefit to their customers. This is the phase when most companies, that have survived the inflationary period, see their margins expanding.

As the rate of inflation declines, the prices of consumer goods do not necessarily fall. They just stop rising at a faster rate. Thus, if the wages of households have not risen in line with the rise in the cost of living, the hit to their consumption and/or savings could become structural.

Financial repression is one of the worst impacts of inflation. The savers lose real income while the borrowers get money at much lower real cost. Post inflation this situation is rarely reversed. Neutral real rate is usually the best case in a deflationary period. Positive real rates are not seen to last for any meaningful period.

To control inflation, a variety of fiscal and monetary policies are used by the governments and central banks. Higher interest rates, lower liquidity, higher tariffs to curb demand, subsidies to the poor to augment their income are some of the popular tools used to mitigate inflation and its impact. However, in case of deflation the use of fiscal policies is not very popular; even though in some cases incentives are offered to encourage demand. Withdrawing fiscal subsidies and incentives in the post inflation period however proves to be a serious political challenge. Thus, while the monetary expansion could be moderated in a relatively shorter span of time, the fiscal corrections could take much longer.

 The NITI Aayog recently published “India Innovation Index 2021” report, which presents “an in-depth analysis of the state of innovation in the Indian economy”. The India Innovation Index 2021 presents state-wise rankings based on the innovation landscape and performance of the country’s states and union territories. The latest framework of the index has been mapped from the Global Innovation Index, published annually by WIPO (World Intellectual Property Organization).

The report earnestly recognizes that human capital is the source of innovative ideas, knowledge, and practices. It notes that high innovation capabilities need heavy investment in human capital development at all levels to develop skills beyond technical knowledge, e.g., imaginative thinking, devising methods to tackle complex issues and keeping pace with the times.

The report emphasizes “the practice of promoting innovation at the grassroots is necessary to fully utilise the potential of the indigenous knowledge bases by engaging the local communities in the process.11 The exercise is of greater significance in a country like India where a considerable share of the population is engaged in the informal sectors. To monitor and promote grassroots innovation, the Government of India in 2000 established the National Innovation Foundation (NIF) as an autonomous body of the Department of Science and Technology. The foundation aims to drive innovation at the grassroots through documentation, protection of Intellectual Property Rights (IPR) and commercialising innovation and innovative techniques devised by unaided small-scale innovators. The institution was able to file 114 patents in the year 2019-20.”

R&D has played a significant role in the growth of developed countries. The countries that have high per capita R&D expenditure tend to have higher per capita GDP as well.

Innovation in India

In India, R&D investment has been relatively low. In the past few years, R&D investment in the country has declined from 0.8% of the GDP in 2008–09 to 0.7% in 2017-18. This is lower than the other BRICS nations—Brazil spends about 1.2%, Russia about 1.1%, China just above 2%, and South Africa around 0.8%, with the world average being about 1.8%. On the other hand, developed countries like the United States, Sweden, and Switzerland spend about 2.9%, 3.2% and 3.4%. Among all nations, Israel spends the most, 4.5%, of its GDP on R&D.

Dismal private participation in R&D

Besides very low R&D spends, another challenge in India is lack of private participation in the innovation process. About 60% of all R&D spend is incurred by the government against USA 10%, UK 6%, and Israel 1.5%. A major chunk of India’s R&D expenditure is thus on defense and space research; whereas healthcare and manufacturing account for ~13% of public sector R&D spending.

Huge regional disparities

The ability to innovate is dependent on the quality of human capital. It rests on the opportunities in terms of research and development. Lower spending on R&D, and less innovative opportunities may lead people to move from one region to another region - state/ country for better opportunity.

Overall Global Innovation Score for India is a dismal 14.56. Besides, there exist huge regional disparities within the country. Most of the R&D effort in India is concentrated in few states and cities. Some clusters in NCR, Karnataka, Tamil Nadu Maharashtra, Telengana and Gujarat account for a large proportion of overall innovation effort in the country.

Suggestion for improving the innovation rank of India

The report makes the following suggestions for improving the global innovation score of India to aid faster economic growth and development.

1.    GERD needs considerable improvement and should touch at least 2%, which would play an instrumental role in India achieving the goal of a 5 trillion economy and further influence its innovative footprint across the globe.

2.    The role of the private sector in research and development needs to pick up pace.

3.    The expenditure on human capital has been unable to create that knowledge base in the country, which could be due to the intricate reasons of bureaucracy, administration, outreach, etc. It is observed that innovation is skewed against the manufacturing sector. This requires inexorable efforts to overcome challenges and make the best use possible.

4.    India has been able to provide a conducive environment for businesses to thrive, in terms of a business environment, safety, and a legal environment, but we have not been able to support the same in terms of investment and knowledge workers. We need to harness the energy and potential of youth to augment knowledge workforce.

5.    We need to sincerely fill the gap between industry demand and what we produce through our education system.

6.    India needs to undertake efforts in creative goods and services, which have been ignored for a long time.

7.    In India, intangible assets like patents and trademarks filing process are complex and face procedural delays. We need to streamline this.

8.    Our states and Union Territories need to break silos and start working in tandem, as no state/UT can thrive alone endlessly without taking care of its peers.

About two months ago, I received a late night call from one of my close acquaintances. The man was in a tearing hurry. Almost gasping for breath, he informed me that the stock market in India is going to crash and the benchmark Nifty is certain to fall to at least 12500 levels. He had learned from some very credible sources that the markets world over are going to crash soon; and India may actually go the Sri Lanka way. “Crude prices will top US$140/bbl soon and USDINR will collapse to 85”, he sounded extremely confident. Half asleep, I did not know how to react to his claims instantaneously. To buy some time to react, I pleaded “could we discuss this in the morning, please!”.

When I called him in the afternoon, the next day, he had already liquidated half of his portfolio. He sounded quite relieved and exuded the confidence of a victor. I had no contact with him, till he called again yesterday evening. This time, he wanted to know “Could Nifty make a new high in the next 3-4months?” I again had no instant answer to his earnest inquisition. I am sure that the question was mostly rhetorical; since he sounded quite convinced about this proposition of market scaling new highs soon. I think he will deploy his cash in a day or two.

I am not sure, if this one isolated instance is indicative of a larger market trend, viz., the greed dominating the fears”. But from my experience of over three decades, I can certainly tell that this person definitely has a lot of people accompanying him “in” and “out” of markets at frequent intervals.

Many of these proudly claim themselves to be “seasoned investors”, who have the ability to read the pulse of the market and foresee the future trends well in time. They alternatively use “macroeconomic factors”; “technical charts”, “political developments”, “geopolitical events” and “valuation” arguments to camouflage their “greed and fear”.

One morning they would swear by valuations and economic fundamentals; and on other days they sound like experts and loyal followers of the Elliott Wave and Japanese Candle and Sticks. One day, they feel confident listening to the “mother of all bull market” narrative of Rakesh Jhunjhunwala and “fastest growing economy” claims of the finance minister, while the very next day they need tranquilizer to sleep because some Nancy Pelosi is boarding a flight to Taiwan. They confidently forecasted, in February 2022, the end of Ukraine within one week and beginning of WWIII.

What actually surprises me the most is that despite their frequent mood swings and mostly intuitive actions in the market, they are not only able to beat the benchmark indices consistently, but also outperform some of the most seasoned fund managers and long only investors; though they may not be earning to their full potential, meaning their actual return may be lower than what they could have made otherwise. This consistent outperformance lends them confidence and belief that their strategy and methods are the best way of “investing” in stocks.

I would never concur with them, even though I could never earn more than them from my investments. The question that arises from this is – if I cannot beat them, should I join them? My answer is an emphatic “No”. Because - I always sleep peacefully. I do not bother to call anyone at midnight to ask what is happening in the markets. I do not give a damn even if President Biden is also flying with Speaker Pelosi to Taiwan and PM Modi is flying to Tibet to meet the Dalai Lama. And I certainly do not care if Wave C of 3 is opening or it is an extended 2 Complex.

 The monsoon this year is progressing well. At midpoint of the season, about 70% of 703 districts in the country have received normal to excess rains; and only 5% districts are witnessing a large deficiency. With the dark monsoon clouds hovering over most parts of the country, the skies in markets appear bright and sunny.

The stock markets and bonds have mostly recouped the losses made in the past four months. USDINR is also trading at two months low. Economic indicators are no longer worsening – inflation is high but stable; tax collections are strong; fiscal deficit is under control; core sector growth is recovering; bank credit to industry is picking up; leading indicators like vehicle sales (especially commercial vehicles), freight carried; port & railway traffic are all showing signs of stabilization and recovery. Current accounts are a cause of concern. However, positive FPI flows in July and recent correction in global crude oil prices are providing at least some comfort; which is reflected in INR appreciation also.

The market narratives have also changed remarkably in the past couple of weeks. The phrase “Hyperinflation” has almost vanished from the market discussions. Recession, Peak rates, Peak USD, Peak crude prices, wider adoption of Bitcoin, equity market bottom etc. are now increasingly finding mention in the market commentaries. For example—

CITI Global Commodities Research recently, inter alia, noted “Most analyses of oil markets emphasize the consequences on prices of further supply disruptions. In this report we focus on the potential consequences of an increasingly likely recession. In a recession scenario with rising unemployment, household and corporate bankruptcies, commodities would chase a falling cost curve as costs deflate and margins turn negative to drive supply curtailments.”. It further noted that “It looks as though for this year and into 2023 Russian crude oil exports may remain robust, even if refined product exports may fall. Therefore, further global oil demand weakness should spell higher inventories and weaken oil prices. Yet, the distortionary impacts of Europe boycotting increasing volumes of Russian oil should continue to be headwinds for global oil prices. In a recession scenario, we would see oil prices falling to $65/bbl by year end and potentially to $45/bbl by end-2023, absent intervention by OPEC+ and a decline in short-cycle oil investment.”

Jefferies, in the latest edition of its signature report Greed & Fear '' noted that “There is no doubt that financial markets, in the midst of the silly season, have been in an awful hurry to price in the peak of inflation and the end of Fed tightening. Fed tightening expectations peaked in mid-June at 4% in early 2023 while the money markets are now discounting 50bp of easing next year after the federal funds rate peaks at an assumed 3.25-3.5% in December, or 100bp above the current level following the 75bp hike yesterday to 2.25-2.5%”.

Lazard Asset Management believes that “Despite lingering headwinds, like fallout from regulatory crackdowns and zero-COVID policy aftershocks, China’s growth trajectory is still likely to show a recovery in the second half of 2022, and opportunities may be ripe for the picking in this vast market”. It also noted in a recent report that “Emerging markets fundamentals are in a relatively solid position overall especially as higher commodity prices have improved the terms of trade for commodity-exporting countries. As such, the current account and fiscal balances for many countries have improved while debt valuations have grown significantly more attractive’ – clearly a sign of preference for a “risk on” trade.

Bank of America Research in a recent report, estimated that the US 10yr benchmark bond yields could reach 2% in less than a year.

Particularly, in the Indian context, the market participants seem quite relaxed after the recent market run up and correction in crude oil prices. Recently released World Economic Outlook by the IMF mentioned the resilience of the Indian economy, expecting it to grow ~8% in 2022 and ~6.4% in 2023 despite a widespread global slowdown. As per Emkay Research, H2FY23 may reveal India’s ‘true’ growth trajectory, based on: a slew of reforms in recent years, improving EoDB, thrust on domestic mfg., rising capacity utilization; marginal base-effect from Omicron should be a bonus.” Though the brokerage firm finds food and energy inflation a key challenge for the Indian economy, it notes that the underlying drivers of globalized inflation are cooling, overall easing the inflationary pressures. It accordingly believes that margin pressures on the commodity consumers are beginning to ease and shall reflect in 2HFY23 numbers.

Brokerage firm Edelweiss believes that “US Recession Fears Overplayed - Recessionary models show a low probability of the US undergoing recession. After a dismal H1 of the year, H2 has a better probable payoff. The U.S & European Market are likely to consolidate in the later half of the year and likely to underperform other world equity markets. Emerging markets seem to have limited downside as compared to developed markets.”

 The US Federal Reserve has comforted the global markets with assurance of maintaining strong intent to control prices while not being unnecessarily disruptive in terms of monetary tightening. The markets are apparently reading a 0.9% contraction in the US economy in 2Q2022, as sufficient ground for the Fed to be mindful of the likely disruptive impact of the future hikes; given that the US economy is technically in recession after having contracted for two consecutive quarters in 2022.

The marked slowdown in the economic activities in Europe and China; and easing of the global logistic bottlenecks has noticeably moderated the inflationary expectations, as reflected in the yield curves across the globe. The fears of 1930s type hyperinflation appear to have subsided, at least for now. The equity valuations are gradually adjusting to “above zero” and “neutral” interest rate regimes. The recognition of “positive rates” however is still missing from the popular narrative and hence remains a key risk.

The wider acceptance of the ground realities in respect of the Russia-Ukraine conflict is making it relatively easier to find amicable supply chain solutions. Gradually, the global community is beginning to accept that (i) the conflict may persist for longer than previously anticipated; (ii) stricter economic sanctions on Russia may not yields the desired results and in fact could produce material unintended consequences; and (iii) isolating Russia could provide significant impetus to the ideas of “de-globalization” and “polarization” of the world; raising the specter of multiple and larger geopolitical conflicts, and undermining the global consensus on important issue like climate change, poverty alleviation and denuclearization.

Two factors that can impede the process of returning to normalcy (yet a New Normal), in my view, are –

(1)   Compromise on the climate control targets, further aggravating the already erratic weather conditions across the globe.

The food shortages (and consequent food inflation) could worsen materially leading to reversal of advancements made towards poverty and starvation alleviation in the past three decades in particular. There could be widespread civic unrest; production and supply chain disruptions; and rise in loss of human lives due to hunger, violence and inclement weather.

(2)   Dominance of leftist ideology in global politics hampering creation of new capacities and perpetuating inflation.

As I had mentioned in one of my earlier posts (The Challenges of economic policy), a large number of countries are opting for left of center parties/leaders to govern them. Moreover, to counter the egalitarian agenda of left of center parties, even the right of center parties like conservatives in UK, BJP in India, LDP in Japan and Yemina in Israel are increasingly resorting to socialist agenda to retain power. Obviously, the top priority of governments across the world is immediate relief to the poor rather than growth. It is therefore more likely that the tighter monetary and fiscal conditions will continue to challenge the growth ecosystem in near future. The new capacity building may continue to lag; resulting in more frequent bouts of high inflation, as compared to the past two decades and hence larger volatility in financial stability and macroeconomic environment.

 The struggle between Newton's law of gravity and global markets is perennial. Many times it appears that the markets are defying the laws of gravity and breaking out of their orbit. However, in the end, it is the law of gravity that has always won. Notwithstanding the distance covered away from the “fair value zone”, and the time spent in the away zone, the asset prices invariably tend to return to the fair value zone. In the common market parlance these digressions and eventual return to normalcy is described by the phrases like Overbought, Oversold, Overvaluation, Undervaluation, Mean Reversion, etc.

It is important to note that a long time spent away from the fair value zone could be very deceptive for investors. Sometimes it gives an illusion that the fair value zone for the subject asset may have already shifted higher or lower and the current price is actually closer to the fair value zone. The investors lacking in discipline and/or conviction may fall for this deception and buy/sell the asset in the “away zone”. Two classic examples of this phenomenon are the stock price of ITC Limited and IRCTC Limited during 2019-2021.

In the past one year, all asset prices that were trying to defy gravity, without having necessary escape velocity, are crashing back to their respective ground positions. Now since the asset prices are correcting downward, trampling the traders and investors coming in their way, the questions to ponder are:

(a)   When would the asset prices hit the rock;

(b)   Whether the rock will be soft or a hard one; meaning whether the prices will jump higher immediately after hitting the rock or they will get stuck there at the bottom, till the next high tide comes to their rescue;

(c)    Which assets are fragile enough to crash and get destroyed when these hit the rock;

(d)   Which assets are flexible enough not to get damaged by hitting the rock and bounce back faster.

History could be a good guide in analyzing these points and finding appropriate answers. However, 2008-2009 may not be a good reference point in this context, in my view. The crisis began to hurt global asset prices from early 2008 as the economic growth, fuelled by a decade of exceptionally loose credit, started to fizzle out and financial leverage became unsustainable.

The process of adjustment and correction was interrupted by innovative and audacious monetary policies of large central bankers. Surprised and enthused by the "whatever it takes" approach of central bankers, traders and investors made large bets on a faster economic revival. Consequently, many asset prices in fact scaled higher peaks than seen during the bull market of 2005-2007.

As it turned out that the comfort was false. The central bankers did manage to restore stability in the financial system; but the economic recovery remained feeble and unbalanced. The global lockdown in the wake of Covid pandemic has completely exposed the fault lines of the global economy and markets. Consequently, the asset prices are now rationalizing to factor in the prospects of even slower economic recovery and further rise in global imbalances.

The process is expected to be protracted and painful. Nothing will be achieved in a year or two.

The good news, in my view, is that India is decoupling from the global pain, as the painful economic corrections implemented in the post global financial crisis era are now beginning to yield results. In fact, as one of the worst sufferers of unfavourable terms of trade, India could be a major gainer as the global imbalances get adjusted to more fair terms of trade.

I am certainly not expecting any exceptional return from the Indian equities over the next couple of years. However, it is apparent that Indian equities can give normal returns for a much longer period than their peers.

 Hikes another 75bps

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) hiked the federal fund rate by 75bps yesterday to the range of 2.25% - 2.50%. This is the second 75bps hike in two months. In the post meeting press interaction the Fed chairman Jerome Powell outrightly rejected the speculations that the US economy is in recession. The FOMC members are of the opinion that the strong labor market allows the US economy to tolerate rapid monetary tightening.

For the first time since February 2020, the FOMC statement did not mention Covid or coronavirus.

…leaves the door open for further data dependent hikes

Reiterating the commitment to achieve the 2% inflation target, Powell also indicated that while another unusually large increase could be appropriate at our next meeting, the FOMC would set policy on a meeting-by-meeting basis rather than offer explicit guidance on the size of their next rate move, as he has done recently; thus, leaving the future course of the FOMC action wide open.

As per the Bloomberg estimates, the market consensus is now gathering around two more 50bps hikes in September and December FOMC meetings, with the fed fund rate peeking around 3.4%, lower than the previously estimated 3.8%.

The US economy is estimated to have grown at a tepid 0.4% (QoQ, annualized) rate in 2Q2022 after recording a negative growth in 1Q2022, technically avoiding a recession. The US officially acknowledges a recession if the economy logs a negative growth for two consecutive quarters.

Markets react positively to FOMC – stock rally, yields and USD tumble

The markets took comfort from the growth outlook and Powell’s statement on future rates being data dependent. The market participants appear to have concluded that the FOMC may reach the end of the tightening cycle by the end of 2022, triggering a “risk on” rally in the markets.

·         Battered tech stocks surged strongly with the benchmark Nasdaq rising 4.06%, the largest one day gain since November 2020. The broader index S&P500 gained 2.62%.

·         US Dollar Index lost 0.66%.

·         2yr SU Treasury yields fell 10bps; while 10yr benchmark yields were down 5bps at 2.78%.

…but deeper yield curve inversion signals recession as consensus

The US yield curve is now inverted the most in two decades, highlighting that the markets strongly believe a recession is around the corner. The 2yr yields are now over 30bps lower than the benchmark 10yr yields – clearly indicating that the market sees higher risk of recession than the Fed. The deeper yield curve inversion is seen to imply that Fed may actually return to the path of easing as early as 2023.

Click here to see a nice compilation of analysts’ reactions to the FOMC statement.

The Nifty Metal Index has gained over 10% in the past one month; outperforming the benchmark Nifty50 (+4.5%) by 2x. Six out of the total fifteen Index components have gained over 10%, with Hindalco (+16%) being the top gainer amongst the metal producers.

In this period, the Bloomberg Commodity Index is down by ~2%; LME aluminum futures are down ~2.5%; LME copper futures are down ~9.5%; Brent Crude prices are down ~11%; NYMEX gold futures are down ~5.5% and China Steel Bar prices are down ~10%.

Also, in the past one month, the benchmark US 10yr Treasury Bond yields are down 9% from 3.13% to 2.78%; and the US Dollar Index (DXY) is up by 1.9%.

I find the divergence between performance of metal stocks and global trends a little intriguing. The global commodity prices, bond yields and US Dollar movement etc. are all pointing to a significant slowdown (if not recession) in demand. The outlook for the domestic demand in India is also not enthusiastic in the near term. The 1QFY23 results have indicated pressure on margins; attracting earnings downgrades.

In my view, the investors holding metal stocks in their portfolios need to analyze the following three scenarios:

1.    The ~33% correction in Nifty Metal Index during April – June 2022 quarter is an overreaction to the slowdown concerns and imposition of export duty on some steel products. The market is now rationalizing the excessive correction.

2.    The slowdown/recession concerns may be overblown, especially in the context of Indian producers of industrial and base metals. The demand for metals will remain strong in India, even if global slowdown extends to 2023 due to monetary tightening and war. The government may withdraw the export duty and even provide additional protection from cheap imports to help the domestic producers. The producers with significant global operations like Tata Steel and Hindalco will manage to recover their volumes and margins in a couple of quarters if the economic slowdown is managed well.

3.    The global commodities, especially the base and industrial metals, have not seen any significant capacity addition since the global financial crisis. During the lockdown in the wake of Covid pandemic, the inventories have been utilized. For most metals, the inventories are at historic low levels. The monetary tightening by the global central bankers is making inventory carrying cost expensive and hence discouraging inventory restocking. The global bond markets and inflation forecasts are indicating that the monetary tightening cycle may end sooner than later; and the central bankers like the US Federal Reserve may actually embark on a path of monetary easing as early as 1Q2023. In that case, we may see a sharp surge in commodity prices in 2023-2024 as the demand-supply gap tightens further.

As a strategy, I usually avoid commodity stocks in my portfolio due their cyclicality, volatility and unpredictability of their earnings and consistent need for capacity building. However, I am inclined to believe more in the third scenario playing out over the next 3-5yrs. I would therefore be on the lookout for some metal producers that have decent operating leverage (unutilized capacity); unlevered balance sheet; offering decent valuations. As of this morning, I found nothing that fits my criteria.

 In the next couple of days, the market participants world over will be focused on the FOMC statement on Fed rates, inflation & growth outlook and guidance for the monetary policy direction in the near term (next 3-6months). The “active” market participants in India, in particular, would be staying awake till late midnight on Wednesday to hear what Fed Chairman Jerome Powell has to say.

The fact that Thursday happens to be the monthly derivative settlement for July contracts, makes the Fed decision, and likely reaction in our markets on Thursday morning, even more pertinent for the derivative traders in India.

Besides the derivative traders, the currency traders; bond traders and corporate treasury managers who need to actively manage their Fx exposure, would also staying awake to see how the US Dollar, EUR and US Treasuries behaves post the FOMC statement and try to assess how Indian bonds and INR may react in near term.

Our markets may however be relieved to a great deal if the RBI makes an unscheduled rate decision on Wednesday morning itself, just like it did on 4 May 2022, preempting the pressure on Indian bonds and INR post FOMC decision. For records, in his recent statement, the RBI governor has already spoken about the inevitability of further rate hikes. It would be better if it is done tomorrow rather than a week later (04 August 2022) when the MPC of RBI is scheduled to make a statement on monetary policy.

The European Central Bank (ECB), for example, hiked 50bps last week – their first hike in 11 years- to preempt further slide in the Euro. ECB hiked despite signs of accelerated slowdown in growth and rising fiscal pressures on peripheral Europe.

Since the FOMC decision would be known in less than two days, I do not find any need to speculate on the likely outcome and the market reaction to that outcome. Nonetheless, it would be appropriate to say that the market is pregnant with the hope of a unambiguous ‘pause’ signal from the Fed and consequent weakness in USD and a rather dovish MPC. The chances of disappointment are therefore marginally higher than the chances of positive surprise, in my view.

What should be the strategy of an investor under these circumstances?

In my view, the first thing an investor should do is to have a good dinner on Wednesday; go to bed early and not watch the markets, including business newspapers & TV channels and investing handles on social media, on Thursday.

Second, investors should focus on performance of the companies in their respective portfolio, rather than bothering too much about the general impact of global macro developments. They should assess the ability of the companies in their portfolio to manage the impact of rate and currency volatility on their respective businesses. The history indicates that better managed companies in India have managed this volatility very well without letting it materially impact their performance beyond a couple of quarters in the worst case.

Third, if the change in global rate and currency outlook materially alters the investment argument for a company in their portfolio, they should place a “sell” order for it today itself.

The debate over whether “equity investing” is an art or science is never ending. There are arguments on both sides, but none of these appear strong enough to settle the debate. Almost all episodes of this debate usually end with the compromising statement - “Equity investment is both an art and a science.”

The application of quantitative research and financial models does give it a scientific color. But use of quantitative methods and financial models is highly influenced by the personal preferences, experience, estimates and prejudices of the user. Invariably, the forecasts of fundamental analysts vary based on what parameters they have used in forming their respective opinions. For example, a 50bps difference in weighted average cost of capital (WACC) used by two analysts could give dramatically different assessments for the fair value of a stock. As someone pointed out, fundamental analysis of equity stocks is like navigating a car. While all the cars are designed scientifically, the drivers have distinct styles of driving and the results – time to travel a defined distance, safety of the passengers and vehicle, fuel mileage obtained from the vehicle etc. – largely depend on the style and experience of the driver.

The “art” side of equity investing is even more complicated. Most investors view a particular stock from the vista point they are standing at that particular point in time. Their decision to buy or sell stock depends on their financial, psychological, and social condition at that particular point in time. The decision (and therefore view on a stock) can change dramatically if they move to a different vista point, i.e., their financial, psychological and/or social change.

For example, an investor who invested in a portfolio of stocks 10yrs ago for children's college fees, he/she will sell the portfolio as soon as the children get admission in college, irrespective of the future outlook of these stocks.

Parallel to the debate of ‘science” vs ‘arts”, a lot of mythical investment strategies are also commonly discussed and marketed. The investors, analysts and money managers use terms like “value vs growth”; “cyclical vs defensive”; “large cap vs midcap”; “financials vs technology”, which are mostly mythical and have no scientific basis.

·         Most large IT Services companies count BFSI as their primary customer segment. Most large financial firms are reporting spend on technology as their primary capex. How could possibly the investment in these two sectors be alternative.

·         Auto, Energy, and Banks sector equities have given positive returns over the past 3yr, 1yr and YTD2022 horizon. This period saw one of the most pervasive socio-economic disruption globally and triggered a global recession. Whereas, media, pharma and IT services are the sector that are down on 1yr and YTD2022 basis, though IT and Pharma sectors have given strong returns over the past 3yrs. The question is how would define what is cyclical and what is secular or defensive in this scenario.

·         Midcaps have outperformed Nifty over past 1yr and 3yr timeframe. So what is the relevance of largecap vs midcap debate?

The point I am trying to make is that the investors must avoid these mostly redundant and mythological distinctions and debates and focus on their investment objectives and strategy to achieve those objectives.

Last night I got a call from a friend who had been staying in London for the past 3years. He wanted to know what type of air-conditioner is better – window or split type. He sounded quite hassled as he was figuring out how the air conditioner would be installed in his rented apartment; what kind of permissions would be required; whether he can get a skilled technician to install an air conditioner; and how much would be the operational cost (electricity bill) for using an air-conditioner in London. I am sure he was overreacting to an ordinary situation, because the situation is dramatically asymmetrical to his perception of life in London.