Vijay Kumar Gaba

 For the stock markets, the 2023^rd year of Christ is beginning on a cautious note. The global narrative is swinging between an orderly decline to a precipitous crash. With the last man standing Haruhiko Kuroda (BoJ Governor) falling this week, it is clear that the “crusade” against inflation will continue in 2023 - and money will be expensive and tighter. This is most likely to reflect in slower economic activities, and aggressive trade and currency conflicts.

The developed markets that have thrived mostly on the steroids of cheap and easy money will show withdrawal symptoms which may include volatility, recession, protectionism, financial instability etc. The emerging markets largely dependent on exports to developed markets (commodity or merchandise) shall also suffer the collateral damage. However, the emerging market with strong domestic economies, stable fiscal conditions and stronger financial markets might find themselves in a position to take advantage of flight of capital from the developed and weaker emerging markets and lower commodity prices. India, arguably, is placed in the latter category of emerging markets.

It cannot be denied that a precipitous crash in the global markets will hurt the Indian market badly, just like it did during the market crashes of 2000, 2008-09 and 2020. However, in case of an orderly decline in the global economies and markets, India may stand out again in 2023, just like it did in 2022.

As of this morning, the risks to Indian markets are evenly balanced. Absence of bubble in any pocket of the market, low volatility, strong domestic flows, economic growth still close to past decade’s trend, and stable fiscal & financial conditions support the markets; while rising probability of a precipitous crash, a deeper recession than presently estimated and the geopolitical conditions taking a turn towards the worst, pose material threat to the markets.

The investors are therefore faced with high uncertainty in formulating an appropriate investment strategy. I would be extremely untruthful and dishonest to claim that my situation is any better than most of the investors. Nonetheless, after evaluating the entire situation I have shortlisted the following factors that would support my investment thesis for next 9-12 months and help me in navigating the turbulent waters.

1.    There are no signs of a bubble in the Indian equity market.

2.    The earnings growth is likely to stay positive for at least a couple of more years.

3.    Margins may bottom as inflation, rates and USDINR peak sometime during 2023.

4.    The leverage in Indian markets is substantially lower as compared to 2000 or 2008-09. The chances of a sustained crash are therefore much less this time.

5.    Despite the outperformance, foreign investors have not been enthusiastic about Indian equities in the past couple of years. The foreign ownership of Indian stocks is at a multiyear low. Besides, India's weight in MSCI EM has seen steady increase. The probability of an accelerated selling is therefore low.

6.    The valuations are not cheap though closer to the long term averages. Given the slower growth and higher bond yields, it is likely that Indian markets may witness some PE de-rating and trade below long term averages.

7.    The bull case for Indian equities as a whole is weak. The upside from the current levels is limited, given slowing growth momentum and higher rates; whereas a panic bottom could be deep.

8.    There are some pockets of the economy (and market) that are witnessing a sustainable transformation. These pockets offer once in a decade type opportunities. Some examples are Defence production; Biofuels; Real Estate; Manufacturing Modernization; Self-reliance in Intermediates’ Manufacturing; and Modern Retail. These pockets of growth have been well identified and analyzed, therefore, the risks are mostly known and the growth path well illuminated.

9.    Presently the opportunity cost of holding cash is minimal as liquid funds and short term fixed deposits are offering decent returns. There is no rush to go out and deploy cash in equities and other assets.

10.  The developed markets may hit the rock sometime in 2023, though a sustained recovery may elude them for a couple of more years at the least. The stronger emerging markets may find favor with the yield hunters in this scenario.

य: सर्वत्रानभिस्नेहस्तत्तत्प्राप्य शुभाशुभम्, नाभिनन्दति न द्वेष्टि तस्य प्रज्ञा प्रतिष्ठिता

One who remains unattached under all conditions, and is neither delighted by good fortune nor dejected by tribulation, he is a sage with perfect knowledge.

—Srimad Bhagawad Gita, Verse 57, Chapter 2

In the calendar year 2022, a multitude of battles were fought. These battles materially impacted the global markets and investors. Some of the important battles were —

(i)    Russia-Ukraine conflict that polarized the global strategic powers, threatening to unwind the post USSR globalization of trade and commerce;

(ii)   Central banks’ battle against the multi decade high inflation, that resulted from the colossal monetary easing and fiscal incentives to mitigate impact of the Covid pandemic, while keeping the economy from slipping into recession;

(iii)  China’s battle against Coronavirus, that kept significant part of the country under strict mobility restrictions;

(iv)   Businesses’ battle against logistic challenges, supply chain disruptions, and input cost inflation;

(v)    Global communities’ battle against the Mother Nature, as inclement weather conditions (drought and floods) impacted the life in almost all the continents;

(vi)   Governments’ battle against private currencies (crypto) threatening to replace the fiat currencies as preferred medium of exchange; and

(vii)  Investors’ battle with markets to protect their wealth.

It is likely that most of these battles will continue in the 2023^rd year of Christ as well. The outcome of these battles will eventually determine the direction of the global economy and markets in the next many years.

However, standing at the threshold of 2023, it appears less likely that we shall see any sustainable resolution to these conflicts in the next twelve months; though it cannot be completely ruled out. There would of course be some periods of ceasefire creating an impression that a conflict has been resolved, or is close to resolution. These impressions may drive the markets higher and make investors buoyant.

Nonetheless, a sustainable positive outcome from some of these conflicts will definitely be positive for the global economy and markets. It is therefore extremely important for the investors to maintain a equanimous stance. They should neither get swayed by the buoyancy created by temporary ceasefires in these battles, nor get panicked by the intermittent aggravation of these conflicts; while staying fully alert for a significant directional move in the market. They should at least avoid committing to a “bullish” or “bearish” stance early in the year.

I would like to quote two views, of reputable experts, to emphasize the despondency that is defining the global narrative presently:

Noriel Roubini

“Of course, debt can boost economic activity if borrowers invest in new capital (machinery, homes, public infrastructure) that yields returns higher than the cost of borrowing. But much borrowing goes simply to finance consumption spending above one’s income on a persistent basis – and that is a recipe for bankruptcy. Moreover, investments in “capital” can also be risky, whether the borrower is a household buying a home at an artificially inflated price, a corporation seeking to expand too quickly regardless of returns, or a government that is spending the money on “white elephants” (extravagant but useless infrastructure projects)….

…the global economy is being battered by persistent short- and medium-term negative supply shocks that are reducing growth and increasing prices and production costs. These include the pandemic’s disruptions to the supply of labor and goods; the impact of Russia’s war in Ukraine on commodity prices; China’s increasingly disastrous zero-COVID policy; and a dozen other medium-term shocks – from climate change to geopolitical developments – that will create additional stagflationary pressures.

Unlike in the 2008 financial crisis and the early months of COVID-19, simply bailing out private and public agents with loose macro policies would pour more gasoline on the inflationary fire. That means there will be a hard landing – a deep, protracted recession – on top of a severe financial crisis. As asset bubbles burst, debt-servicing ratios spike, and inflation-adjusted incomes fall across households, corporations, and governments, the economic crisis and the financial crash will feed on each other.”

(Read full article “The Unavoidable Crash” here)

Russell Napier

“This (inflation) is structural in nature, not cyclical. We are experiencing a fundamental shift in the inner workings of most Western economies. In the past four decades, we have become used to the idea that our economies are guided by free markets. But we are in the process of moving to a system where a large part of the allocation of resources is not left to markets anymore. Mind you, I’m not talking about a command economy or about Marxism, but about an economy where the government plays a significant role in the allocation of capital. The French would call this system «dirigiste». This is nothing new, as it was the system that prevailed from 1939 to 1979. We have just forgotten how it works, because most economists are trained in free market economics, not in history….

…the power to control the creation of money has moved from central banks to governments. By issuing state guarantees on bank credit during the Covid crisis, governments have effectively taken over the levers to control the creation of money…

…Out of all the new loans in Germany, 40% are guaranteed by the government. In France, it’s 70% of all new loans, and in Italy it’s over 100%, because they migrate old maturing credit to new, government-guaranteed schemes…. For the government, credit guarantees are like the magic money tree: the closest thing to free money. They don’t have to issue more government debt, they don’t need to raise taxes, they just issue credit guarantees to the commercial banks…

…Engineering a higher nominal GDP growth through a higher structural level of inflation is a proven way to get rid of high levels of debt. That’s exactly how many countries, including the US and the UK, got rid of their debt after World War II….

…We today have a disconnect between the hawkish rhetorics of central banks and the actions of governments. Monetary policy is trying to hit the brakes hard, while fiscal policy tries to mitigate the effects of rising prices through vast payouts.

(Read full interview here)

Outlook for 2023

Global macro environment: The present challenges in the macro environment may persist for the better part of 2023. The present monetary tightening cycle may pause in 1H2023, but persistent inflation may delay any easing to 2024. Higher rates may begin to reflect on the economic growth, as softening in employment, consumer demand, housing and other data accelerate. As things stand today, the central bankers shall be able to engineer a soft landing; however a material worsening of the geopolitical situation or an elongated La Nina condition may cause a faster deceleration in the economy. A stronger recovery in China and ceasefire in Ukraine with easing of NATO-Russia tension could be a positive surprise for the global economy.

Global markets: The current trend in the global equity markets may continue in 2023 also. The developed market equities and industrial commodities may remain under pressure and witness heightened volatility; the commodity dominated emerging markets may be highly volatile with a downward bias as commodity prices ease due to demand destruction; services and manufacturing led emerging markets may outperform. Metal and energy prices may continue to ease. Slower global growth may cause a strong rally in bonds and gold prices may end lower.

Indian macro environment: The momentum created by the post pandemic recovery is slowing down. The Indian economy is likely to grow less than 6% in 2023. A sharper global slowdown may actually bring real GDP growth closer to 5% in 2023. Though domestic food prices are expected to ease; a weaker USDINR might keep imported inflation, especially energy, higher. The current account may remain under pressure as export demand remains sluggish. Fiscal pressures may increase and it is less likely that the government is able to meet the FRBM targets for FY24. Worsening of Balance of Payment could pose a major risk, though at this point in time the probability of this appears low.

Indian markets: The benchmark Nifty may move in a larger range of 16500-20100. The risk reward at the present juncture is therefore fairly balanced. The Treasury bond yields may stay close to present level but the AAA-GSec spreads may widen as corporate borrowing costs rise. USDINR may weaken to the 83-85 range. 

Equities – A year of consolidation

The Indian equities consolidated the gains made during 2021 and are ending the year 2022 with marginal gains; unlike other major global markets which gave up most of the gains made during the year 2021. Considering the global economic, geopolitical and financial conditions this is a remarkable performance.

• The benchmark Nifty50 and Nifty Midcap 100 are ending the year with ~5% gain; though Nifty Small 100 has lost 2022YTD 11%. The market breadth has been marginally negative; and volumes below average.
• Nifty has now given positive returns in 9 out of the previous 10 years; with 2022 being the seventh consecutive year of positive return.
• Nifty averaged 17240 YTD2022, 8% higher than the average of previous year. This implies much better returns for the SIP investors.
• For long term buy and hold investors, five year rolling CAGR in 2022 is ~11.6%, which is close to 2016-2022 average. Five year absolute Nifty return in 2022 is ~73%, also close to 2016-2022 average.
• July 2022 was the best month of the year for markets. In July Nifty gained 8.7%; the aggregate return for the rest of 11 months is -3.7%.
• Smallcap stocks underperformed the benchmark Nifty for YTD2022; however on a 3yr basis, midcap and smallcap are still outperforming the benchmark materially. The newly introduced category of Multicap funds is the best performer YTD2022; while on 3, 5 and 10 yr basis smallcap funds are outperforming.
• Foreign investors have been net sellers in the Indian equities (secondary market) to the tune of Rs 1.46trn; while the domestic institutions were net buyers of Rs2.63trn; resulting in a net positive institutional flow of Rs1.17trn during YTD2022. Contrary to popular perception, the Nifty movement led the institutional flows and vice versa was not true.
• Sector wise, PSU banks (+71%) were clear leaders, outperforming all other sectors by large margin. Consumers, Auto, Energy and Metals were other notable outperformers. IT Services, Pharma and Realty have been notable underperformers YTD2022.
• Nifty Bank (+22%) has been a clear leader.
• Presently, technically Nifty is placed in neutral territory, close to 50 EDMA with RSI close to comfortable 44 and short term momentum indicators in buy zone.

Debt and Currency – USDINR weakens, yield curve higher and flatter

• USDINR (-6.1%) weakened YTD2022; while EURINR (+2.6%); JPYINR (+9.6%) were stronger.
• The Indian yield curve shifted sharply higher; though Indian bonds performed much better than their developed economy peers. RBI hiked the policy repo rate by 225bps during the year. However, the most notable feature of the Indian debt market was withdrawal of excess liquidity and consequent sharp rise in overnight and short term rates.

The Federal Open Market Committee (FOMC) of the US Federal Reserve (Fed) unanimously decided to hike the key bank rate by 50bps to 4.25%-4.5% target range, the highest since 2007. From near zero in the beginning of the year, this is perhaps the sharpest rise in rates in one calendar year.

In the customary post meeting press conference, the Fed chairman Jerome Powell emphasized on the commitment to rein inflation. He said, “we still have some ways to go” and “I wouldn’t see us considering rate cuts until the committee is confident that inflation is moving down to 2% in a sustained way,” indicating that rates will rise in 2023, though not at the same speed as 2022. The Fed chairman reiterated, “It is our judgment today that we are not at a sufficiently restrictive policy stance yet,” adding “We will stay the course until the job is done.”

The Fed Chairman had stated after the November FOMC meeting that the pace of tightening is less significant than the peak and the duration of rates at a high level. The Fed’s latest stance also emphasizes that the markets should brace for “higher for longer”.

The FOMC statement clearly indicated that they are aware that higher rates will impact the economy adversely. The projected unemployment rate for 2023 has been hiked to 4.6% from 3.7% in November 2022, as the economy is forecasted to grow at just 0.5% in 2023, at the same pace as 2022. The Chairman noted, “I wish there were completely painless way to restore price stability. There isn't, and this is the best we can do.”

It would be interesting to see if the Fed can actually deliver a soft landing of the economy as promised, without triggering a deeper recession, while attaining a milder inflation as per the target.

The Fed Chairman welcomed the recent lower inflation prints, but wants more substantial evidence to believe that the inflation is on a sustained downward path. He said, “the inflation data received so far in October and November show a welcome reduction in the pace of price increases, but it will take substantially more evidence to give confidence inflation is on a sustained downward path.” The Fed now expects the personal consumption expenditures price index, currently running at 6% - to cool to 3.1% in the final quarter of next year and to 2.5% by the end of 2024.

Belying the market expectations, the Fed Chairman clearly hinted that the rate hikes will continue in 2023 and the policymakers projected rates now indicate that we may end the next year around 5.1%, slightly higher than the previous projections. The dot plot now indicates a cut of 100bps from 5.1% in 2024.

 The latest policy statement and the aggressive stance of the Fed, is likely to anchor the inflationary expectations while resting the frequent speculations of an imminent “peak” followed by immediate easing of rates.

The equity markets were disappointed as most participants were expecting a “peak” below5% and a cut in 2023 itself. The stock ended lower after a volatile session. The bond markets were however not too bothered and yields ended marginally lower after the Fed statement.

The global markets behaviour in the year 2022 would remain subject matter of analysis for many decades. Almost all markets – equity, bonds, commodities, crypto, housing, arts etc. - have shown a classical pattern in the current year, despite several unconventional factors impacting the global economy.

If we observe from the averages the behaviour of commodity markets in particular has been very archetypal in a market still enduring a war, inclement weather and supply chain dislocations. S&P Goldman Sachs Commodities Index, has gained ~17% YTD 2022.

Evidently, the first half of 2022 saw a sharp surge in commodity prices led by energy and food prices, ostensibly due to the Russia-Ukraine conflict and severe drought in many parts of the world. However, easing of post Covid logistic constraints and monetary tightening by most central bankers led to an improvement in supplies; demand destruction and unwinding of speculative positions; resulting in lower commodity prices.

 

However, if we analyze the internals of commodities markets we find huge variation in price performances of various commodities within the same category. For example-

·         Energy: crude oil is literally unchanged for the year; Ethanol, Naptha, Propane etc. have lost 15% to 35% for the year; whereas Coal (+147%) and Natural Gas (+84%) recorded huge gains. Wind Energy and Solar Energy prices are down over 10% YTD2022; whereas electricity prices in European nations are higher by 37% (UK) ti 105% (France).

·         Precious metals: Gold is unchanged for the year; while silver(+5%), platinum (+10%), and Titanium (+27%) are ending the year with decent gains.

·         Other metals: Steel (-59%), Tin (-39%), and Copper (-11%) are major losers in the metal universe. Aluminum, Lead, Zinc are also ending the year with some losses; whereas Lithium (+157%), Bitumen (+20%) and Nickel (+46%) have bucked the trend. LME Index fell ~6% YTD2022.

·         Chemicals: PVC (-28%), Soda Ash (-13%), DAP (-13%), Urea (-41%), were some major losers during the year. Polypropylene and Polyethylene etc. are mostly unchanged for the year.

·         Agriculture produce: Coffee (-33%), Cotton (-25%), Rubber (-20%), Palm Oil (-20%), Wheat (-9%), etc. are ending the year with strong losses; Sugar, Cocoa, Tea are little changed; while Rice (+20%), Soy (+17%), Corn (+10%) are some notable gainers. US Lumber prices are lower YTD2022 by over 60%.

As of this morning, the uncertainty in the commodity markets appears much higher than the equities. The following uncertainties, for example, could continue to impact commodities markets in 2023 also:

·         Covid situation in China and growth trajectory post opening. A sharper recovery than presently estimated may again lead to a strong rally in many commodities.

·         A ceasefire in Russia-Ukraine conflict with easing of sanctions on Russia could impact energy and food markets materially.

·         A deeper recession triggered by persistent monetary tightening could result in sharper demand destruction and further inventory unwinding, resulting in further cuts in commodity prices. On the other hand a softer slow down followed by a guided recovery (monetary easing) could result in accelerated inventory rebuilding and sharper price inflation.

·         Extension of La Nina conditions beyond 1Q2023, as presently estimated, could further worsen food supply leading to sharp inflation in prices.

·         Further deterioration in international relations and persistent Sino-US trade war could accelerate central bank demand for gold.

If you can look into the seeds of time, And say which grain will grow, and which will not, Speak. (Shakespeare, Banquo -Scene III, Act I, Macbeth)

The past three years have seen an intense war between the forces of “Greed” and “Fear” in the financial markets. Both the forces have won some battles and lost some. Though the benchmark indices close to their all-time high levels might give an illusion of decisive victory of for the forces of “Greed”; but the negative market breadth, poor volumes, declining participation of the domestic institutions, net selling by the foreign institutions and underperformance of the broader markets in the past one year indicate that the forces of “Fear” have not yielded much ground.

The period 2020-2023 has seen some localized bubbles in the markets, e.g., new age businesses (ecommerce, digital payments, gaming etc.), healthcare (Covid spending) and metals (supply shortages); which have been duly normalized without much damage to the overall market structure. For the 3yr period, the NIFTY IT is still yielding an absolute return of 93%; Nifty Metal is up 166% and Nifty Pharma is up 60%.

There have been two major drawdowns in the benchmark Nifty. The first one was the panic fall due to the outbreak of Pandemic (33% fall during February 2020 to March 2020), which was fully recovered in the next 8 months by November 2020. The second drawdown was due to the geopolitical tensions in Europe (16% fall during January 2022 to June 2022), which was fully recovered quickly in the next five months by November 2022.

For the period of three years, the broader markets are still sharply outperforming the benchmark Nifty. The Nifty Midacp100 is higher by 95% and Nifty Smallcap 100 is higher by 79% as compared to the Nifty50 which has gained 55% in the past 3 years. However this ought not be construed as a decisive victory of the forces of Greed. The anecdotal evidence suggests that numerous new investors who entered the market (or increased their participation materially) in late 2020, may have materially underperformed the benchmark indices; even losing their capital in many cases. Unmindful leverage, excessive trading, ill-advised exposure to poor quality businesses and/or new age businesses at unsustainable price levels may have caused them to underperform or lose capital.

Sharp decline in the value of cryptocurrencies in the past couple of years, almost no return in gold and very poor return in the debt has also impacted the investors’ sentiments in the past one year particularly.

Standing at the threshold of the New Year 2023, both the forces appear tired and looking for fresh supplies. The forces of fear are anticipating a full blown global recession and sharp decline in the global risk appetite; whereas the forces of Greed are looking for a managed slow down followed by a full recovery.

In the context of India, the forces of fear are expecting a full blown balance of payment crisis, higher fiscal deficit, de rating of PE multiples due to failed earnings recovery, and abortion of nascent capex cycle. On the other hand, the forces of Greed are relying on continued government support to capex, strong flows on economic outperformance and stable financial system, peaking of inflation and rate cycle, lower energy prices, fair valuations, and earnings surprises to support their cause. It will be interesting to see how the battle evolves. 

 The Reserve Bank of India made its last policy statement of 2022 on Wednesday, 07 December 2022. The next policy statement of the RBI is scheduled in February 2023.

 The Reserve Bank of India (RBI) shall announce the latest monetary policy stance of its Monetary Policy Committee (MPC). While the market narrative is focusing on the decision regarding change in the policy rates, I believe the decision “to hike or not to hike” may not be the primary point of deliberations over the past two days.

In the past seven months since May 2022, RBI has hiked the key policy repo rate by 190bps. The benchmark bond yields or lending rates have not risen in tandem to the policy rates. Only the call money rates and bank deposit rates have seen a corresponding rise. This could mostly be a function of sharp rise in credit growth (now above 18%) at a time when RBI had reversed its accommodative stance and withdrawn over INR12trn of surplus liquidity from the market

The benchmark 10yr treasury yields have fallen 25bps in the past six months. However, 3-6months bond yields have seen sharp rise of 135bps and 112bps respectively.

 

The hike in repo rate has been only partly transmitted to the markets in terms of lending rates. The base rate of banks has risen from 7.25%-8.8% (in the week ending 06 May 2022) to 8.10% - 8.80% (in the week ending 02 December 2022). MCLR of banks has changed from 6.50% - 7.00% to 7.05% - 8.05% during this period. Savings bank rates (Nil change) and small savings rates have hardly moved in this period. However, the bank deposit rates have grown much faster from 5.00-5.6% to 6.1% - 7.25% during this period.

The call money rates have risen from an average of 3% to 5% during this period.

From the above it appears that it is the withdrawal of accommodation (liquidity) that may have impacted the money market rather

The monetary tightening in the past seven months does not appear to have material impact on the price level, which continues to remain elevated, led by energy and food. Of course, the monetary policy measures usually impact the prices with some time lag and we may see the prices correcting going forward.

However, what may worry MPC is that the growth is already showing signs of slowing. Negative real rates on deposits are hurting savings. There is not much evidence of rising rates destroying consumption so far, but we may see it going forward. The global commodities appear to have bottomed and a China reopening is seen as a trigger for rise in commodity prices, despite slowing global growth. The rising external vulnerabilities might keep USDINR under pressure, keeping imported inflation high. Obviously, MPC cannot ignore the actions of the Fed and the narrowing gap between India and US risk free yields.

Besides, MPC must have given a roadmap to the government to bring inflation within its tolerance band of 4-6% last month. The statement today might echo the commitments made in the letter written to the government last month.

So, MPC would have deliberated how to find equilibrium between liquidity, inflation, growth, external stability (Fx reserve, flows, USDINR, export competitiveness), financial stability and also political expediency.

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.)