Vijay Kumar Gaba

The Indian economy has grown 9.7% (yoy) in 1HFY23, as compared to 13.7% growth recorded in 1HFY22. Given the consensus growth forecast for FY23 is around 7%, the implied growth rate for 2HFY23 is close to 4% (yoy).

Further the forecast for FY24 are veering around 6.2% (ranging from 6% to 6.4%), given the rising global slowdown hitting exports further; lagged impact of monetary tightening likely hitting in 1HFY24; investments slowing down on poor demand growth visibility and persisting high inflation further hitting domestic savings.

It is therefore likely that the Indian economy might grow less than 5% for the next four quarters. This will be the period that may see a very high decibel drama in the global theatre. The current trends indicate that the monetary tightening by the US Fed and other global central bankers has already started to impact the demand and employment. The consumer demand, housing starts, and high paying jobs are showing a distinct downward trend. Similar trends are also visible across Europe. Easing bond yields, despite likelihood of further hikes and tightening by the central bankers, at least till 1Q2023, is clearly indicating a notable slowdown in the global economy in 2023.

The long term growth trend (5yr CAGR) continues to remain below par.

2QFY23 GDP data had some trends that should worry markets. For example—

• Industry sector growth contracted by 0.8%, mainly led by decline in manufacturing activity (-4.3%).
• Government consumption contracted 4.4%, while private consumption was also lower YoY as well as sequentially.
• Exports continued to slow for the seventh consecutive quarter. 2QFY23 export growth of 11.5% was the lowest post pandemic. Net export is likely to come under further stress given the looming global slowdown, which would likely dent global demand further.
• Services growth (9.3%) was also lower YoY (Q2FY22-10.2%) and sequentially (1QFY23-17.6%), mainly dragged by community and defence services.
• Subsidy disbursement was poor, while tax collections were strong, resulting in lower GVA growth of 5.6%.
• The Gross Domestic Savings (GDS) at 26.2% of GDP in 1HFY23 is the lowest in two decades.
• The April-October 2022 fiscal deficit is reported at 45.6% of FY23BE. This materially higher as compared to 36.3% in the similar period of FY22. This number read with higher tax collection, lower government consumption, lower subsidy distribution and sharp rise in government investment implies that 2HFY23 could see slower government capex.

Besides the economic data, the market fundamentals are also indicating headwinds for markets in the next few months. For example—

• The present spread between 10yr US Treasury yields and 10yr GOI Treasury Yield is ~3.4%, which is lowest since the global financial crisis (2009). Given the negative BoP forecast for FY23, the USDINR may continue to be under pressure, further narrowing theoretical arbitrage for foreign USD investors. The foreign portfolio flows could be impacted if this spread sustains or narrows further.
• NSE500 EBITDA Margins at 15.7% during 2QFY23 were the lowest in ten quarters. Thus despite 29% yoy growth in sales, NSE500 PAT declined ~3%.
• Net FPI selling in YTDFY23 has declined to ~US$3bn; but the domestic flows are showing some signs of tiring. With domestic savings declining and household finances under pressure, the domestic flows may likely be moderate in the next few months at least.
• Nifty is trading at ~10% premium to its long term average one year forward PE multiple. Since, the current estimates of EPS are elevated and likely to be downgraded further, this premium could actually be higher.

I shall continue to remain cautious and not get swayed by the recent up move in the markets. I believe that the market shall provide much better entry points in the next few months. Insofar as my current portfolio is concerned, I am maintaining my standard asset allocation for now (see here). However, I would like to raise some tactical cash if the markets rally further from the current levels.

In the past couple of years China+1 has been one of the most popular buzzwords used in the Indian market context. The term is popularly used to refer to a business strategy of diversifying ‘reliance’ from China to other jurisdictions. The reliance on China in this context could be for manufacturing of products; sourcing of key raw materials; customer base for products and services; and/or investments.

In the past couple of decades, since the China was admitted in WTO, a large number of global businesses, particularly from developed countries, have significantly increased their reliance on China, to take advantage of liberal government policies towards business, lower cost structure (wages, tariffs & taxation); relaxed emission norms; easy & cheaper access to finance and raw material, and massive local consumer base etc.

They offshored their manufacturing facilities to China; outsourced manufacturing to Chinese producers; developed China as a key market for their products; raised funds from Chinese lenders and investors; collaborated with Chinese research organizations to develop new products and technologies and used China as a hub for their global supply chains.

As the chart below shows, in two decades, China has replaced the USA as the top trading partner of the most countries in the world. However, due to factors like the Sino-US trade war that started in 2016, implementation of stricter emission norms by China, hike in domestic wages and zero Covid policy of China, many businesses and governments have felt a need to reduce their overreliance on China. Many emerging economies, including India, are competing to attract these businesses to their respective countries.

Many market participants have identified China+1 as a major opportunity for the business, and therefore, investors in India.

I find it worth examining what is a realistic size this opportunity. More on this later…

I had a chance to meet a small group of seasoned market participants yesterday. The group included a couple of brokers, some investors, a banker and a few analysts and advisors. After exchanging pleasantries and going through the mundanity of “kya lagta hai?” (what’s happening in the market?), the discussion veered around “what could go wrong to make Nifty fall 20% from the present level”.

 The benchmark indices in India are now trading at their highest ever levels. In fact, in the past one year, India (+9.6%) has been one of the best performing equity markets in the world, in line with the emerging market peers like Brazil (+8%), Russia (+9%), and Indonesia (+7.5%) etc. Only a few emerging markets like Venezuela (+107%), Argentina (108%), and Egypt (+15%) have done much better.

For many Indian investors these statistics could be meaningless. To some it may actually be annoying as the performance of their individual portfolio may not be reflecting the benchmark performance. Regardless, largely the equity market returns have been reasonable, considering the challenging environment. It is therefore a moment to celebrate.

Once the celebrations are over, it would be appropriate to ask ourselves “whether at ~18700, Nifty is adequately taking into account all the factors that may impact the corporate performance, risk appetite, liquidity and financial stability in 2023?” In particularly, I would like to assess the risk-reward equation of my portfolio especially in light of the factors like the following:

Stress on discretionary spending

In the recent months several companies have rationalized (or announced the plans) their workforce. A significant number of highly paid workers are facing prospects of job loss. Anecdotal evidence suggests that the uncertainty created by a 2% workforce rationalization could temporarily impact the discretionary consumption plans of at least another 48% employees who retain their jobs.

Reportedly, IT hiring from the top colleges in India are likely to witness a 50% fall in 2023 (see here). We might see similar trends in other sectors also as most management have guided for a moderate growth in next few quarters.

My recent visits to several rural areas indicated that discretionary consumption in farmer households has already been impacted by poor income in the 2022 Kharif season. As per reports La Nina (excess rains) conditions that impacted crops for the past four seasons, are likely to persist through Rabi season, while the 2023 Kharif season might witness El Nino (drought like) conditions. (See here)

Erosion in wealth effect

On the last count India had more than 115 million crypto investors (see here). About two fifth of these investors were below the age of 30, thus having a strong risk appetite. These investors had seen sharp gains in their crypto in 2020-21m but apparently they are now sitting on material losses in their portfolio.

A significant number of new listings, especially from tech enabled businesses, are trading at material losses to their immediate post listing prices. These businesses typically have a material part of their employee compensation in the form of ESOPs. Many employees who had seen substantial MTM gains in their ESOP values have witnessed material drawdowns in their portfolio values. A few of them might be facing double whammy of material MTM losses and tax liability.

A number of small and midcap stocks that jumped sharply higher in 2020-21 have corrected significantly in 2022.

Obviously, the wealth effect created by the euphoric movement in stock and crypto prices has subsided to some extent. This submission of wealth effect shall also reflect on risk appetite, consumption pattern and investment behaviour of the concerned investors.

Tightening fiscal conditions

Lot of market participants are betting on continued fiscal support to infrastructure & defence spending, and incentives like PLI etc.

It is pertinent to note that the forthcoming budget would be the last full budget before the general elections to be held in 2024. It is likely the government chooses to increase the social sector funding at the expense of capital expenditure next year. The disinvestment program might also be slowed down to avoid adverse publicity for the government. Imposition of additional tax(es) or hike in capital gains tax could also be considered. All these events could impact the investors’ sentiment.

Rising external vulnerabilities

The external sector has been weak for a few quarters now. The trade deficit in October 2022 widened to a worrisome US$26.91bn. Exports dropped ~17% in October 2022 on slower global demand; while imports were still higher by ~6%.

Notwithstanding the efforts of the government to improve trade account by import substitution and export promotion; the exports have grown at a slow 4.3% CAGR in the past three years; whereas the imports have registered 14.3% CAGR in the same period, resulting in larger trade deficit. The external situation thus remains tenuous.

It is pertinent to note that the World Trade Organization (WTO) has projected a sharp slowdown in world trade growth in 2023. (see here) Obviously, the pressure on balance of payment will remain elevated in 2023.

Cash on sidelines may protect the downside

Overnight (liquid) funds are now yielding a return of ~5% p.a. Bank deposits are offering 5.5-6% return. Under the present circumstances, at ~18700, the upside appears limited to 8-10% while the downside could be much more than 10%. Obviously, the risk-reward equation is not favorably placed at this point in time, and the opportunity cost of holding cash is not bad. This could keep a lot of money waiting at the sidelines.

Higher cost of carry and margins have also resulted in lesser leveraged positions in the market. 

The cash on the sidelines and lower leverage may keep the downside somewhat protected.

What is most wonderful?

Yaksha asked Yudhishthira “what is most wonderful?”

Yudhishthira answered – “Every day numerous living entities are dying and going to the abode of Yama. Yet one thinks/believes one will live forever (Immortal). What can be more wonderful than this?”

As the spring was paving way for summers in 2020, the entire country was locked down to prevent the spread of Covid-19 pandemic. A few weeks into the lockdown, the skies became blue; peacocks started dancing on city roads; mountains were visible from long distances; roads were empty; air was serene; a pleasant quietness had replaced the annoying cacophony; many misogynists and patriarchs were helping their wives in household chores; many tech illiterates were quickly leaning to use smart devices for communication, shopping & entertainment; the sentiments of frugality, minimalism, spirituality, & patriotism, etc. overpowered vanity, presumptuousness, pretense, selfishness etc.; and new births and deaths were accepted with equanimity.

As the autumn approached, some relaxations were allowed but austere weddings (50 guests) replaced big fat weddings (1000-3000 guests). Professionals continued to work from remote locations. Many of whom had moved back to their peaceful home towns, far away from bustling metros.

Two years later, the skies are no longer blue; peacocks have retreated to their hideouts; roads are as choked as before March 2020; air quality is severely poor; misogynists are no longer helping their wives; big fat weddings are back; spirituality and frugality have been overwhelmed by vanity, revenge tourism, revenge shopping etc.; professionals have left their old parents behind for a miserable life in metros; births are being celebrated and deaths are being mourned.

Everyone had seen the advantages of driving less, loving more, being spiritual & frugal, and being equanimous; but still no citizen are seen vowing – no driving personal vehicle for at least two days a week; no big fat wedding; less vanity, presumptuousness, pretense; respect for women etc.

The worst part is that no politician, policymaker, judge or administrator has advocated enforcement of these “virtues” for the sake of future generations.

What could be more wonderful than this?

Accountability

A household hired a new domestic worker. The worker promised to work hard and more efficiently than all the previous workers that had worked for the household. Few months later his neighbors pointed out to the household that the new worker is not true to his promise and may be indulging in some acts of corruption also. But instead of seeking accountability from his worker to whom he was paying a decent salary, the household started quarreling with the neighbor. The neighbors failed to appreciate how could this household pay the worker decently; tolerate all his inefficiencies, mistakes, laxity and insolence; and also aggressively attack the neighbors who dared point out the worker’s mistakes to the household.

Nothing could be more unfortunate for a democracy, if the people who enthusiastically and hopefully supported a particular party and/or a leader, stop seeking accountability from them; and to make the matter worse begin to violently put down anyone else who dares to ask questions from such a party and/or leader.

(This narration mostly explains the present mood of a majority of the voters in Gujarat, besides some other states.)

 The minutes of the last meeting of the Federal Open Market Committee (FOMC) of the US Federal Reserve System (Fed), held in November 2022, were released a couple of days ago. The meeting was a joint meeting of the FOMC and the Board of Governors of the Fed, hence the number of participants were much larger than a usual FOMC meeting.

After the release of the minutes, the popular media narrative has been that the Fed officials and most participants are concerned about the likely adverse impact rate increases could have on financial stability and the economy; hence, we could “soon” see the Fed scaling down the pace of rate increases. The markets have obviously drawn a sense of comfort from this narrative and decided to move higher.

The minutes make some points that I found worth noting. From a plain reading of the minutes, I find that the participants were generally—

(a)   Surprised by the resilience of the job market;

(b)   Concerned about the persistence of the inflation and assessed the risk on the upside;

(c)    Comfortable with the broad economic conditions which are presently indicating slower growth but no risk of recession;

(d)   Comfortable with the anchored inflationary expectations;

(e)    Confident that the monetary tightening will reflect on inflation and other economic conditions with a time lag;

(f)    Inclined to keep the monetary policy “restrictive” for long;

(g)    Focused on the final Fed rate that would be adequately restrictive, rather than the rate hiked per meeting; and

(h)   Mindful of the market expectations and behaviour about the monetary policy direction and trajectory.

The media narrative of a slower pace of hikes (50bps in December meeting), seems to be driven by the following five mentions in the FOMC minutes:

1.    The minutes noted that “Most respondents to the Open Market Desk’s surveys viewed a 50 basis point increase in the target range for the federal funds rate at the December meeting as the most likely outcome.”

2.    “A number of participants observed that, as monetary policy approached a stance that was sufficiently restrictive to achieve the Committee’s goals, it would become appropriate to slow the pace of increase in the target range for the federal funds rate. In addition, a substantial majority of participants judged that a slowing in the pace of increase would likely soon be appropriate. A slower pace in these circumstances would better allow the Committee to assess progress toward its goals of maximum employment and price stability. The uncertain lags and magnitudes associated with the effects of monetary policy actions on economic activity and inflation were among the reasons cited regarding why such an assessment was important.”

3.    “A few participants commented that slowing the pace of increase could reduce the risk of instability in the financial system.”

4.    “Some participants observed that there had been an increase in the risk that the cumulative policy restraint would exceed what was required to bring inflation back to 2 percent. Several participants commented that continued rapid policy tightening increased the risk of instability or dislocations in the financial system.”

5.    “There was wide agreement that heightened uncertainty regarding the outlooks for both inflation and real activity underscored the importance of taking into account the cumulative tightening of monetary policy, the lags with which monetary policy affected economic activity and inflation, and economic and financial developments.”

Interestingly, the media narrative generally ignored the following noting, that indicate lack of consensus on slowing the pace of hikes:

A.    “A few other participants noted that, before slowing the pace of policy rate increases, it could be advantageous to wait until the stance of policy was more clearly in restrictive territory and there were more concrete signs that inflation pressures were receding significantly.”

B.    “With monetary policy approaching a sufficiently restrictive stance, participants emphasized that the level to which the Committee ultimately raised the target range for the federal funds rate, and the evolution of the policy stance thereafter, had become more important considerations for achieving the Committee’s goals than the pace of further increases in the target range. Participants agreed that communicating this distinction to the public was important in order to reinforce the Committee’s strong commitment to returning inflation to the 2 percent objective.”

C.    “Members agreed that, in assessing the appropriate stance of monetary policy, they would continue to monitor the implications of incoming information for the economic outlook. They would be prepared to adjust the stance of monetary policy as appropriate if risks emerged that could impede the attainment of the Committee’s goals. Members agreed that their assessments will take into account a wide range of information, including readings on public health, labor market conditions, inflation pressures and inflation expectations, and financial and international developments.”

D.    “Russia’s war against Ukraine is causing tremendous human and economic hardship. The war and related events are creating additional upward pressure on inflation and are weighing on global economic activity. The Committee is highly attentive to inflation risks.”

In my view, the chances are high that the Fed may slow the pace of hikes from the December meeting; but the end rate may be higher than previously estimated. We may have decisively shifted to “higher for longer” from “lower for longer” rate scenario.

More on FOMC minutes next week.

The latest edition of the FIFA World Cup, arguably the most popular sporting event in the world, is currently being played in Qatar - a tiny Islamic monarchy in Middle East Asia. With a population of 2.9 million, Qatar is hosting approximately 2 million guests, denying them freedom of alcohol, narcotics and sex, considered three major components of FIFA events, besides football. Moreover, the schedule of FIFA World Cup was changed for the first time to November-December from the usual June-July; apparently to suit the weather conditions in Qatar, which is unusually hot during summer months.

It is intriguing for most why Qatar was chosen to host this event. Initially there were allegations of bribery and use of unfair means by Qatar authorities; but these were found baseless after a two year long investigation. However, if we consider the trend, the selection of Qatar to host the event might not look inexplicable after all. The three preceding editions of the FIFA World cup were held in South Africa (2010), Brazil (2014) and Russia (2018) – all emerging economies. The 2026 edition is scheduled to be hosted jointly by the US, Canada and Mexico. For the 2030 edition, most bids are jointly given by two or more countries involving at least one emerging economy, e.g., Uruguay-Argentina-Paraguay-Chile; Spain-Portugal-Ukraine; Saudi Arab-Egypt-Greece, etc.

Notably, the preceding three editions of the FIFA World Cup were hosted by the members of BRICS block. It is expected that the other two members (India and China) may also get to host the prestigious event in the next decade. Also, the number of participating countries has been increased to 48, to include more small countries.

Byju’s, the Indian Edtech company is one of the co-sponsors of FIFA World Cup 2022. Also, Lionel Messi, currently one of the most popular football players in the world, is also global brand ambassador for one of the initiatives of Byju’s. Notwithstanding the fact that India is not amongst the 48 teams participating in the event; it is estimated that more than 30000 football fans from India will be attending the event. Besides, many of the 75000 Indians staying in Qatar would also be attending matches there.

Obviously, FIFA has sensed where the economic balance of the global economy is tilting. It probably has the best sense of the purchasing power of people. It is moving to the places where demographics is improving in terms of younger soccer fans with better purchasing power; and moving away from the places where population is growing older and rising income and wealth inequalities are shrinking the target audience base for the game. FIFA also seems to prefer venues with easier VISA rules and comparatively decisive (authoritative) governments that can make commitments faster.

Of course, FIFA’s sense of global economy could be challenged; but there are multiple other signs suggesting that the balance of global economy is moving away from the nations that have dominated the global economy in the past centuries that saw colonization, industrial revolution and world wars moving the balance westward.

So, when Reliance group chairman Mukesh Ambani claims that the Indian economy will grow to $40trn by 2047, he may be mostly correct about the future trend; even if the number is an enthusiastic exaggeration. 

 The toughest job in the present day environment is risk management. Of course, it has never been an easy job; but when we consider the proportion of moving parts, fragility of systems, disregard for conventions, total lack of mutual trust and disillusionment with the status quo, managing risk appears the toughest job. I can now appreciate the risk managers’ plight during the first half of 20^th century; when similar conditions were prevailing.

To illustrate my point, let me highlight the following instances which may not appear ominous to a common man, but could give cold sweat to risk managers.

• Interest rates have risen in most parts of the world in the past one year. In many cases the rise in rates has been rather steep, especially the developed economies. Most of these economies were struggling with deflation pressures for the better part of the past two decades. Obviously the rates were low (close to zero and negative in many cases). Many businesses were built assuming this to be a lasting phenomenon; or at least many investors valued businesses assuming this to be a lasting phenomenon. The pandemic however annulled this assumption. It now appears that we shall not have near zero rates for longer, even if inflationary pressures ease in the next couple of years. A large number of the businesses built on “lower for longer” assumptions are facing existential risk.

How would a risk manager handle this risk? If an investor changes the assumption of “lower for longer”, the basic case for investment in such ventures may collapse. An exodus that may thus result would only result in immediate collapse of such a venture. If the management guides change in assumptions about finance cost, cash losses and poor visibility of fresh capital, the valuations will collapse anyways.

·         The news flow in the past few days includes the following headlines:

1. “Iran fires missiles at Kurdish militias in eastern Iraq” (see here). This was to follow up 73 ballistic missiles fired by Iran in September 2022 (see here).
2. “Texas to send military armored personnel carriers to the border to escalate enforcement. The move comes days after Texas Gov. Greg Abbott invoked an 'invasion' clause to step up border enforcement.” This is part of the border reinforcement in the past 2 decades in which billions of dollars have been spent. State funding for border security has grown from $110 million in 2008-2009 to nearly $3 billion for the 2022-2023 budget cycle. (see here)
3. “Ukraine nuclear plant shelled, U.N. warns: 'You're playing with fire!” (see here)
4. “South hits back as North Korea fires most missiles in a day.” (see here)

Besides, news flow on Sino-Indian border tensions and China’s aggressive posturing on Taiwan has been consistent. A risk manager who is aware of the energy crisis of the 1970s; has been struggling to manage the fall outs of Russian invasion of Ukraine; and is aware of hardliners winning elections in Italy, Israel, Brazil etc. would find it hard to ignore these geopolitical threats.

• “Mumbai sees temperature dip, IMD issues cold wave warning for parts of Maharashtra.” (see here) This could be a worrying signal for risk managers worrying about inflation; supply of grapes, onions, pomegranates; public health etc.

Besides, in the mountains it started snowing earlier this year. Late rains have ensured late sowing for Rabi crops. If winter sets in early and nascent crops are hit by frost, we may have poor Rabi yield.

• I recently met with a company which earns substantial revenue from UN tenders. The management highlighted the substantial cut in funding of the UN as a key risk to their operations. They did not mind discussing the probability of the UN becoming redundant or even getting dissolved in the next 10-12 years.

The point I am trying to make is that in the present times investors should better avoid overconfidence in any investment idea. The black swans could emerge in flocks from nowhere. It is therefore a good idea to keep portfolios well diversified and liquid. Exposure to exotic, unproven, experimental, innovative, expensively valued businesses must be kept to bare minimum – ideally not more than what you could easily afford to write down fully.

 The former NITI Aayog Vice Chairman, Arvind Panagariya claimed that India may record a real GDP growth rate of 8% in FY23. However, there are not many who would agree with him. The Reserve Bank of India has projected a growth rate of 7% for FY23, in their latest forecast. Most professional forecasters have much lower forecast for the growth in the next few quarters. The average of professional forecasters’ projected growth of the Indian economy for 2023, as per Bloomberg, is close to 6%. In their latest forecast, Goldman Sachs Group projected the Indian economy to grow at 6.9% in calendar year 2022 and 5.9% in 2023. Morgan Stanley Research expects the Indian economy to grow at 6.8% in 2022 and 6.2%in 2023. Fidelity International expects the Indian economy to grow between 5.5 to 7% in 2023.

Recent economic data has been giving mixed signals about the economy. While the domestic sector is showing resilience, the external sector continues to remain a concern.

Weak external sector

The external sector has been weak for a few quarters now. The trade deficit in October 2022 widened to a worrisome US$26.91bn. Exports dropped ~17% in October 2022 on slower global demand; while imports were still higher by ~6%.

Notwithstanding the efforts of the government to improve trade account by import substitution and export promotion; the exports have grown at a slow 4.3% CAGR in the past three years; whereas the imports have registered 14.3% CAGR in the same period, resulting in larger trade deficit. The external situation thus remains tenuous.

…offset by resilient domestic sector

In the domestic sector however there are some signs of stability. GST collections have been strong; credit growth has started to pick-up; manufacturing and services PMIs are indicating expansion and inflation is showing signs of peaking.

As per the Nirmal Bang Institutional Research, “incremental flow of credit to the commercial sector in 1HFY23 is at a multi-year high when compared to the recent past.” A recent report by the brokerage highlights that Incremental credit flow from banks, while being led by retail credit, is now becoming more broad-based, with services (mainly NBFCs), industry (particularly MSMEs) and agriculture also contributing.

As per the rating agency CARE Ratings, the quality of debt being raised and outstanding in India has been improving consistently. The proprietary CareEdge Debt Quality index (CDQI) of CARE ratings is now at almost 7 year high. As per the latest release, CDQI inched up further to 92.74 in October 2022 as compared to a level of 92.70 in September 2022 on account of increase in higher rated debt and upgrades in the investment grade rating categories.

The commentary of most corporate management indicates that rural demand is a matter of concern for now. A good rabi crop could address some of this concern; but overall the growth prospects remain modest. The Indian economy certainly does not face any prospect of recession or even a sharp slowdown; but we may not see any meaningful acceleration also in the next couple of years. The external shocks may create large volatility in the markets and provide good entry points for the money waiting on the sidelines; otherwise we are in a boring market for the next many months.

The latest earnings season (2QFY23) ended, leaving the markets with “glass half full or glass empty” feelings. The aggregate results were mostly in line with the already moderated expectations; though granular details indicate a wide divergence within sectors. Overall, the management commentary sounded optimistic about easing raw material, logistic and wage cost pressures; though the companies did not sound particularly sanguine about the demand environment, especially the rural demand and export demand.

The earnings for 2QFY23 were also mostly driven by financials; while IT, FMCG and Pharma also put up a good show. Oil & Gas, capital goods, consumer durables, telecom, automobiles and cement were notable underperformers. Post the results, FY23 Nifty EPS estimates have seen marginal changes, while FY24e earnings estimates have been moderated further. The long term (5yr CAGR) earnings trajectory is now flattening after a sharp growth witnessed during FY19-FY22. This flattening of long term earnings trajectory may jeopardize any chance of a PE re-rating of Indian markets, in my view.

 Thirty seven years ago, on 22^nd September of 1985, the representatives from the now defunct G-5 met at Plaza Hotel, New York to discuss one of the most remarkable currency manipulation plans. On that afternoon, the US, France, Germany, UK, and Japan signed the Plaza Accord to weaken the US dollar to help the US reduce its burgeoning trade deficit.

As part of the accord, the US agreed to cut its fiscal deficit materially; while Germany and Japan consented to boost their domestic demand by cutting taxes. All parties agreed to actively “manage” their currency markets to “correct” their current account imbalances.

In backdrop to the Plaza Accord, the US Dollar had appreciated about 48% during 1980-1985, primarily induced by the sharp hikes in the policy rates by the US Federal Reserve, led by the Paul Volcker; pressurizing the US manufacturing by making (i) imports from Japan and Germany more competitive and (ii) exports to other countries less competitive. This was the time when US manufacturing giants like IBM and Caterpillar were facing severe stress and lobbying the US Congress for relief.

The US Dollar (USD) depreciated over 25% against Japanese Yen (JPY) and German Mark (DEM) in the two years following the Plaza Accord. The plan worked with limited success but not without material collateral damage. The US-Japan trade sustained as Japanese automobile and Electronic products continued to overwhelm the US consumers. US-Germany trade imbalance corrected materially. A stronger JPY however resulted in severe deflationary conditions in the Japanese economy, resulting in the famous “lost decade”.

Paul Volcker retirement from US Federal Reserve and appointment of Alan Greenspan was heralded by Black Monday, 19^th October 1987. The stock markets crashed the world over and the limitation of the Plaza Accord stood exposed. The era of “Greenspan Put” that started in 1987 has continued till recently, with few short interspersed breaks; though the nomenclatures are now more generic like “Fed Put”, “ECB Put”, “BoJ Put” etc.

The current situation in the US is no different from the early 1980s. Inflation is persistently high. Rates are rising. The USD is strengthening. The trade deficit is now with China, instead of Germany and Japan then. The growth has slowed down materially. But the stock market implied volatility is impudently low. The only plausible explanation for this in my view is that the markets have strong belief in the central bankers’ put. The markets appeared assured by the reckless support extended by the central bankers post Lehman Collapse and in the wake of Covid pandemic. The belief that a “black Monday will not be repeated” is too strong at this point in time.

In this context, the latest presentation of Fidelity International on “2023 Investment Outlook” makes an interesting reading. Outlining one of the three key themes for 2023, the presentation, inter alia, highlights the following:

·         Interest rate differentials have driven the dollar ever higher, creating headwinds for countries dependent on trade, with large external debt burdens, and/or maintaining a currency peg. Vulnerability is highest among emerging markets.

·         We see chances for a Plaza 2.0 type global accord on controlling the dollar as low in the absence of a full-blown currency crisis. In the meantime, central banks including the BOJ and HKMA must ramp up efforts to defend currencies.

 In my view, we have entered a phase in world history where the politico-economic ideologies, e.g., free market, socialism, communism etc., have lost their theoretical context. In a significantly large number of countries the ruling parties and their leaders are not particular about adhering to their core ideologies. The voter base of the parties also appears to be divided on the basis of current issues rather than the core ideologies.

 The benchmark Nifty 50 index has given almost no return in the past 12 months. Nifty Smallcap 100 Index is down over 13% and Nifty Midcap 100 index is down about 2.5% over the same period. Adjusted for dividends and inflation, the real returns would be worse. On a comparable basis, the benchmark S&P 500 index of US yielded a negative return of ~15%; Stoxx500 of benchmark index for Euro Area returned negative 12% and Hang Seng, benchmark for Hong Kong market, returned a negative yield of ~30% over the same period.

This is a popular set of statistics that is used by market participants like advisors, portfolio managers, and wealth managers etc., to advance arguments in support of their past performance and future prospects of investments made now.

Investors use this set of statistics in a variety of ways. For example—

·         Investors following a relative return strategy may find comfort in the fact that their portfolios have performed better than the benchmark indices, though they have lost money or earned a negative return on their investments.

·         Investors who are invested for a long term, may argue that Nifty 50 3yr CAGR is still 15.5%, which is a decent real return of over 10% p.a., accounting for inflation and dividends.

·         Some investors may draw comfort from relative outperformance of Indian benchmark indices, as compared to the global peers; even though their own portfolios have yielded negative returns.

In my view, however, this could be a serious mistake most of the investors might be making. The relative return argument (or “strategy” if you prefer to use this jargon) serves no purpose for those investors who are depending on their portfolio of financial investments to meet key goals of their life, e.g., financial freedom and retirement planning etc. To the contrary, this argument could actually lead them to a false sense of security and comfort; whereas their primary objective of investment might be getting defeated.

The investors whose investment objective involves any one or more of the following ought to prefer an absolute return strategy, instead of a relative return argument. For their investment objective would invariably involve a defined cash flow over a definite period of time.

1.         Retirement planning – regular income to supplement the loss of salary/wages.

2.         Goal based investment, e.g., buying a house, children education expense.

3.         Financial freedom - assured minimum income to allow

Such investors should ignore the noise and resist excitement in their investment endeavors. Their investment strategy must focus on making a reasonable rate of absolute return over the “defined” period of time. Beating the benchmark index should be the least of their concerns.

However, the investors whose investment objective is primarily wealth preservation and/or reasonable growth; and regular cash flows from investment are not required to sustain (or improve) their lifestyle may accept a relative return argument; for historically the benchmark indices have been able to yield decent positive real return. These investors can afford to bear intermittent volatility since they do not need regular cash flows or lump sum redemptions at defined intervals.

 If I must choose one word to define the current global situation, it will indubitably be “tumultuous”. There is commotion, agitation, emotional outbursts, upheaval, chaos, distraughtness, indecision and haphazardness in almost all spheres of life – be it economics, finance, governance, politics, or geopolitics. As the trust deficit deepens and widens further, the leaderships are dissipating fast.

USA and UK which have provided political leadership to the world in most of the past hundred years, no longer enjoy wide acceptability. In fact both the countries are struggling to manage even their own internal conflicts. The trends elsewhere also suggest that people are choosing perceptibly stronger and decisive leaders to lead in these tough times. Some examples are Brazil, Israel, Sweden, Italy, and China.

Geopolitically, the hegemony of NATO is facing serious challenges from the new alliance of Russia, China, and North Korea, who have not shown much respect for the extant global order. The largest energy supplier to the world, OPEC also appears inclined to move away from the present system of petrodollars and dominance of western developed economies.

Despite the pandemic; severely inclement weather conditions prevailing for the past couple of years over the most parts of the world (especially the developed world) and extremely painful energy crisis in Europe; the global leaders gathered in Sharm-el-Sheikh (Egypt) for COP27 conference are least likely to come to an equitable and effective agreement over climate change.

The global markets are in turmoil. The illusion of stability created by central bankers of developed economies post the global financial crisis is fading fast. Most of the money printed by the central bankers to keep the wheel of markets moving has been used to fuel prices of financial assets and boost bank reserves. Very little went into building new productive capacities. The unscrupulous politicians were happy to unleash a regime of blunderous fiscal profligacy using the abundant and cheap money.

The deceptive wealth effect created by artificially inflated asset prices, especially financial assets, has been crushed by the shortages of food, energy, and workers unwilling to work etc. The business models built on “dreams” are crashing down. The stock prices manipulated through leveraged buybacks using zero interest borrowings are correcting to their realistic valuations. The gullible investors who ran ahead of time and mistook crypto (a medium of exchange) for valuable assets are also facing a reality check. They are also realizing that all NFTs may not be as valuable as a work of Picasso.

As things stand today, we may soon find ourselves standing at the same crossroad where we stood in autumn of 2008. The markets may implode. The inflated asset prices may burst. The headlines might again be dominated by scary jargon like PIGS. Many Lehman-like castles may come crashing down. Globalization may take several steps back, before a new world order emerges.

Many may find these thoughts unnecessarily provocative and scandalous. There could be strong arguments in favor of India as an oasis of stability and growth amidst all this global chaos. But I am not a great admirer of Ms. TINA. I shall not live under any illusion of the Indian economy and markets escaping a global Tsunami; though I am confident that India shall survive it and soon get back on her feet. The key however is to “survive”.

Also read…Stay cautious

Yesterday some media reports indicated that according to an internal assessment by the finance ministry “India balance of payment (BoP) is likely to slip into a $45-50 billion deficit in the current fiscal year.” (see here) This is obviously not good news for the INR exchange rate. Nonetheless, USDINR has rallied to its best level in almost two months, in the past two days.

It is pertinent to note that India’s current account has remained mostly negative since the global financial crisis (2008), with a brief period of surplus during Covid-19 pandemic. India’s current account deficit was $23.9 billion in the quarter ended June 2022, the worst since the last quarter of 2012. India had witnessed a serious current account crisis in 2013 that required the RBI and government to initiate some drastic measures like reducing limits under LRS. Of course, the present situation is not as dire as 2013, since we have a much stronger Fx reserve position now as compared to 2013. Nonetheless a close watch is warranted on the foreign flows, both portfolio and capital account. In the first nine months of the calendar year 2022, RBI has drained over US$100bn from the Fx reserves. The RBI has specified that this reduction in Fx reserve is due to two factors – (i) valuation adjustment (fall in value of non-INR denominated bonds and fall the relative value of Non-USD currencies in the Fx reserve); and (ii) intervention in Fx market to support INR exchange rate.

Various analysts have estimated that over 50% of drawdown in the reserves could be attributable to the valuation adjustment and the rest to the RBI’s forex market intervention.

As of this morning, there are little indications to suggest that this trend of fall in reserves, either due to valuation adjustment or market operations, may not continue for at least next 6-7 months; given the forecasts of a deeper recession in Europe (more fall in the value of EUR, GBP, CHF and European treasuries); persistent weakness in JPY; and slowdown in the US economy. Poor export growth and thinner FPI/FDI flows might keep India’s current account and Balance of payment under pressure.

The private sector capex is showing no sign of a significant pickup. Most of the capex so far seems related to maintenance, upgrades, debottlenecking etc. The outlook for exports is also not very encouraging.

The government has frontloaded capex, especially in roads, defense and railways. 2HFY23 might witness some slowdown in government capex as the fiscal position tightens (1HFY23 fiscal deficit has been higher due to front loaded capex despite buoyant tax collections).

Overall, we may have some strong macro headwinds for markets in 2023. Investors need to remain watchful and not get carried away by the recent recovery in benchmark indices.