Vijay Kumar Gaba

·         They all offer credit cards with attractive cashback offers, discounts, access to airport lounges, flexible limits, and purchase protection.

·         A few years ago, Yes Bank started offering higher rates on saving accounts (with conditions). Many other banks like RBL, AU, Kotak, IDFC First etc. followed suit.

·         There is not much to differentiate between SME, Housing, and personal loan offerings of various banks and NBFCs.

·         Most banks have made retail/consumer business a priority and announced a strategy to increase the portion of retail credit in their overall credit slate.

·         They offer tech-driven solutions, claiming their platform to be the best in class; though there is not much to differentiate in the tech platforms of the top 15 banks, which account for about two-third of the total credit market.

This was not the case three decades ago, when the process of privatization of banks and liberalization of NBFCs started. The new-age banks came out with materially differentiated offerings.

ICICI Bank and IDBI Bank, due to their origins, were specialists in project finance. Kotak Bank, having graduated from a leasing NBFC, was considered a specialist in equipment financing. HDFC Bank was a pioneer in capital market business, corporate salary accounts etc., and housing finance. The large public sector banks were specialists in social and priority sector financing as well as funding of large infrastructure and industrial projects with long gestation and payback periods. Small PSU Banks would focus on consumer finance and personal loans. Foreign banks like CITI, Standard Chartered, HSBC etc. serviced large corporates, mostly with foreign trade linkages, MNCs, and HNIs. Private Banking (and credit card) was mostly a domain of foreign banks with CITI having a majority share. Now all banks offer all services. The share of foreign banks has gradually reduced.

Points to ponder over for investors are (i) When the financial and banking services become commoditized, Is there a case for a sharp valuation differential in banks and NBFCs? and (ii) Is there a strong case for the cyclical and commoditized Indian financial sector to trade at a significant premium to its global peers, especially the ones that are much larger and better capitalized?

Some may argue, these doubts are too premature and should be put to rest for at least another decade. I see some merit in this argument insofar as the valuation of Indian financials relative to the global peers is concerned. The Indian financial system and financial services may continue to grow at a much faster rate as a significant part of the population is still underpenetrated and underserved, and the segment of the population that lives from paycheck to paycheck and relies heavily on rolling credit is growing fast. However, insofar as the valuation differential of the top 15 banks is concerned, the question might need to be examined much earlier.

The air quality of Delhi and surrounding areas deteriorates to the severely poor category, requiring several restrictions, including school shutdowns, mobility restrictions, construction ban, etc. Pollution has become a serious impediment to the health, life, and productivity of the local population. Besides, since this is the peak tourist arrival season for North India, it also negatively impacts the local economy.

Every year, governments and administrations pretend to take serious note of the problem and promise to take effective steps to control the air quality. However, the problem is worsening every year.

In my view, air pollution is a major issue that requires a mission scale effort to handle. Random and ad hoc measures that are usually taken every year have minimal effect on the air quality level. In many cases, like the ban on diesel vehicles and power generators, these prove to be counterproductive. I suggest the following 10 measures that may be taken as part of the long-term sustainable solution for the air pollution problem in the Delhi NCR area.

1.    Develop a 2 km wide ring forest encircling the NCR area. Forest may have dense trees like banyan, need, peepul, and amaltas on govt land and fruit trees like Mango, Jamun, etc. on the farmland falling on the way. Farmers may be provided an adequate subsidy to undertake these fruit plantations on their farmland.

2.    The entire Aravali hill range must be declared a protected land. All illegal mining in the area must be punished severely. Intensive reforestation activity must be taken on the hill range.

3.    All households must take a pledge to not use personal vehicles at least 2 days in a week, unless there is a medical emergency.

4.    All civil work contractors must be required to ensure that no dust is scattered around or flies from their work projects.

5.    All roads must be made pothole free to avoid traffic slowdown.

6.    All encroachments on public roads, including unauthorized parking that slows down the traffic, must be immediately removed with severe penalties for any recurrence.

7.    Govt may allow the removal of crop stubble using MNREGA workers till a viable tech is available to dispose of crop residue from farms to minimize burning of crop residue.

8.    Airports in NCR may be expanded to ensure there is no air traffic jam over NCR skies during peak hours.

9.    Large industries with material emissions may be systematically relocated away from NCR.

10. Empty grounds may be developed as city forests. The horticulture department may identify institutional, commercial & residential areas where threes could be planted and partner with the owners to plant and maintain trees.

On the other side, rural markets are reporting a noticeable slowdown in demand. Most companies catering to the rural sector, like farm chemicals, farm equipment, consumer staples, building materials, etc., have commented in their presentations about the slower rural demand.

The Reserve Bank of India, several commercial banks, and other lenders have highlighted rising stress in personal loans, credit card outstandings, and micro-lending. Two wheelers and entry-level cars are also not quite reporting encouraging numbers. There are reports about common households downtrading in staples, personal care, home care, and textile spending.

These trends are, in fact, not recent. Many reports and commentaries have highlighted the acceleration in the “K” shaped trend in economic growth in the past decade or so, especially after the demonetization. Moreover, these trends are not India-specific either. It is well documented that several emerging economies and some large economies like the US, are also witnessing a sharp rise in income and wealth inequalities.

In my view, whatever the statistics might suggest, what we are doing is definitely not progress. Several businesses doing well; their stock prices rising; and more and more middle-class households trying to capture a small piece of the growth of these businesses is inarguably a good omen for the country. But in no way it can camouflage the broader picture, i.e., the risk of India failing to become a middle-class country as the growth becomes even more unsustainable.

Without elaborating further, this morning I want to share three experiences I had over the last week. These experiences highlight that we may be treading on the wrong path of economic progress; the administrative machinery recognizes the problems but is mostly clueless/incompetent in suggesting a course correction; and the people are fast losing their empathy and sensitivities towards fellow citizens and becoming ominously self-focused.

1.    I was sitting in a friend’s office, interacting with a few field executives in his company. Fifteen minutes into the discussions, a young field executive (39yrs of age) indicated some breathlessness and asked for a glass of water. However, before someone could bring water he fell from his chair and collapsed. He was immediately taken to a near by private hospital, where the doctors on emergency duty refused to examine him, declaring him dead on arrival. This apparently healthy man has two young daughters (8yr and 11yrs old) and a non-working wife. He was earning a salary of fifty thousand, but had almost no savings. His life is also not insured.

This instance is not rare. There have been several such instances of young people dying suddenly. It raises serious questions on the health consciousness of our society – poor life style, preventive care and emergency help; social security of the workers in unorganized and SME sector; insensitiveness and incompetence of the hospital staff, etc.

2.    A friend (56yrs) felt unease in the chest while working in his office in NOIDA. He rushed to a reputed hospital in South Delhi, where he was examined and advised a procedure involving the insertion of two stents in his heart arteries, immediately. The problem was that there was no room available in the hospital. The entire hospital was fully occupied. He was operated, on and, kept in the ICU for three days. On checking I discovered that most of the NCR hospitals are currently operating at near full capacity. Respiratory complications, dengue, and waterborne diseases like typhoid, and heart and kidney diseases are afflicting young and old alike.

So, it is not only diabetes and cancer that is a matter of concern for the Indian population. The heart, lungs, liver, and kidneys - all vital organs are getting weak. Overall immunity and stamina of a common Indian youth may not be optimal. As a country, we may idolize Virat Kohli, but only a handful of us can claim to be striving for a fitness regime like him.

3.    Having traveled to various hospitals in NCR for two days, when the average AQI level was more than 500, I am feeling severe itching in my eyes and my throat is almost choked. Obviously, millions like me are suffering like this. The government has shut down schools, and imposed restrictions on driving vehicles and construction activities. Productivity is taking a massive hit. I am told that conditions in Mumbai are also not much better.

I strongly believe that the statistics we claim to be indicating progress are mostly meaningless. It is not progress. It is simply regression.

In the US, the financial system was on the verge of collapse. Several banks, insurers, and other financial institutions were reporting massive write-downs on their subprime Collateralized Borrowing and Lending Obligations (CBLO). The cost of protecting debt (Credit Default Swaps) was rising sharply. The US administration and Federal Reserve were mostly in denial, at least in their public posturing; even though the Fed had started to cut the benchmark fund rates from September 2007.

Signs of a sovereign debt crisis had started emerging in peripheral Europe. In countries like Portugal, Iceland, Greece, and Spain (popularly called PIGS) treasury default swaps had spiked to indicate imminent default.

The financial markets in the developed world had started correcting sharply. Both equity and bond prices had fallen. The emerging markets were however doing relatively better. The investment strategists at the large global banks were coining terms like BRIC (Brazil, Russia, India, China) and Frontier Markets (including Pakistan, Bangladesh, Bahrain, etc.) to distract investors from the crisis in the developed markets and peripheral Europe. Many of these markets like India and Pakistan had become the best-performing global markets in the October 2007-January 2008 period. Bangladesh and Sri Lanka had also done extremely well.

Despite the financial system in the developed markets collapsing and talks of bail-out gaining currency, a section of the market started forecasting hyperinflation, matched only by the inflation preceding the great depression in the 1930s. The resource-rich Latin America was becoming the hot investment theme. Numerous Latin America and Natural Resource funds were launched to collect billions of dollars in fresh investment worldwide.

This was the time when a renowned commodity guru, Jim Roger forecasted an unprecedented commodity super-cycle. I had an opportunity to meet him in person in the spring of 2008 when he was speaking at the prelaunch event of the Natural Resource Fund by an Indian fund house in Mumbai. In a brief 15-minute interaction, I found his knowledge of economics, global finance, and strategic affairs quite ordinary. He appeared to be a smart trader who would sense opportunity in commodities markets and rotate his positions swiftly.

Nevertheless, all the assumptions of global experts and gurus were demolished in the next 12 months. BRIC and Frontier markets performed the worst. Commodity markets went into a long (almost a decade) bearish phase. Investors who relied on these experts lost money, despite the financial stability returning to most troubled countries. Smarter investors who ignored these experts and invested in Greek and Italian bonds at 60c to a dollar raked in the mullah.

I find that the global markets are in the same position as they were in 2007-2008. Experts in their wisdom are making a variety of forecasts.

For example, numerous experts are forecasting the trajectory of Fed rates in 2024 and 2025; even though there is no empirical evidence of any correlation between Fed decisions and experts’ forecasts.

One renowned global strategist has reportedly forecasted a 25% correction in Indian equities if the incumbent regime loses power in the 2024 general elections. Disregarding the fact that there is no empirical evidence of any correlation between political regime and stock market performance in India.

Similarly, there are forecasts of Bitcoin topping US$1,00,000/per coin; gold outperforming financial assets; and Japanese equities doing better than Europe and the US.

There is an intense debate over the US economy skirting (no recession), slithering (soft landing) or collapsing (hard landing) into a recession. The debate on the end game for mountains of debt developed markets have accumulated over the past 15 years, more particularly in the past three years is also intense.

For a tiny investor like me, the situation is very tough. After reading zillions of pages of research, I discovered almost no one (analysts, economists, strategists, government officials, central bankers, et. al.) has any clue about how the situation is evolving. Everyone seems to be arguing from their biases and experiences; and praying to god that their prophesies come true so that they can tell the world “I told ya so”.

The Fed chairman is no exception to this. As you would hear from him tonight, he has literally no control over prices, growth, geopolitical situation, and markets. Regardless, there is an entire industry that will try to establish a correlation between what the Fed says and what happens in the market thereafter.

I have therefore decided to read research reports only for some useful data points and indications towards future trends. I shall avoid the forecasts, conclusions and recommendations, till I find strong evidence of clarity emerging.

The economic performance of the US has been below par in the past decade. The handling of the pandemic has been highly questionable. Both monetary and fiscal policies have not yielded the stated objectives of price stability (inflation has been persistently high and rates have become growth restrictive) and financial stability (many regional banks have failed, delinquencies are rising and capital adequacy & reserves of banks have deteriorated, particularly in the past couple of years). Fiscal profligacy has benefited the rich much more than the poor.

The efforts to restrict the benefits of advanced technological innovations flowing to China through tariff and non-tariff means have mostly failed. In fact, these efforts have led to a greater focus on China to successfully develop indigenous technology, forge new alliances, and diversify its market and vendors. The Sino-Arab technoscientific alliance is one prominent example.

The exit of the US forces from Afghanistan and the installation of the Taliban government; failure to prevent Russian invasion in Ukraine and protracted (21st months) conflict there; continued ISIS aggression in Syria and alienation of Turkey; virtual failure to reign Iran’s nuclear ambitions; and now escalation of hostilities between Israel and Palestine are only some recent examples of the strategic failures of the US.

To make things worse, the demography of the US started to worsen. In 2022, the US population grew a meager 0.4% and is estimated to shrink in 2023. Whereas the number of homeless and jobless may be rising.

Consistent deterioration in the quality of political leadership; sharp rise in income and wealth inequalities leading to a conspicuous rise in domestic unrest and violence; unmindful fiscal profligacy; the emergence of an alliance of nations having quasi, pseudo, and non-democratic regimes led by key adversaries China, Russia & Iran and including key allies like Saudi Arabia is seriously undermining the US supremacy.

The education and skill standards of the average US youth are deteriorating fast, raising the reliance on immigrant workers for jobs requiring high skills. The political rhetoric, even from the likes of Vivek Ramaswamy who himself comes from a family of immigrants, further explains the goal incongruence in the US policy.

In my view, it might be a matter of years, not decades, when the fabled “US Consumer” diminishes. The average American household becomes spendthrift; the social security system collapses and fiscal profligacy is forced to reverse the course. An entire global ecosystem that is based mostly on the indulgent US consumer could potentially come down crashing. Also, while most money managers and businesses in India are talking about the “China+1” opportunity, I have not heard anyone talking about “China is number 1” in new technologies including 7G, 8G, AI, smart chips etc.

As an investor, I would like to build these probabilities into my strategy. I am keen to filter my investments for the US consumer and technology dependence.

I note that the debate is intensifying, widening, and deepening. Moreover, it is becoming more balanced with many conventional money managers, regulators, bankers, and administrators coming in support of digital currencies as an alternative to fiat currencies.

A few days ago, Larry Fink, the Chief Executive Officer of BlackRock, one of the most influential financial firms globally, commented in a TV interview that under the current circumstances “Crypto will play a role as flight to quality”. He was reported to have said, “Bitcoin is a hedge against the devaluation of your currency”. This comment is in total contrast to his comments in 2017 when he had emphatically condemned the idea of cryptocurrencies, saying “Crypto is an index of money laundering”.

Last month, a leading German Bank (Bank) reportedly entered into a partnership with Swiss trading firm Taurus to offer custody services for institutional clients' cryptocurrencies and tokenized assets. In 2018, Deutsche Bank's chief investment strategist Ulrich Stephan criticized crypto for being "too volatile and not regulated enough." Standard Chartered (A leading British Bank) also made a bold forecast predicting that “Bitcoin prices will climb to $100,000 by the end of 2024.”

Earlier this summer, Hong Kong’s Securities and Future Commission proposed guidelines to enable Chinese users to invest in Bitcoin and some other large-cap cryptocurrencies on registered platforms. This is in total contrast to the stance of the mainland Chinese authorities.

In the meantime, several smaller African and Latin American countries, like the Central African Republic, Uganda, Zimbabwe, El Salvadore, Paraguay, Venezuela, etc. have continued to adopt cryptocurrencies in their monetary system, some even declaring bitcoin as legal tender. Last year, even Ukraine created a ministry of digital transformation with an aim to become one of the foremost authorities on crypto. (see here)  Cryptocurrencies are now legal in many countries/regions like the EU, US, Mexico, Brazil, Israel, etc.

There are speculations that the ardent crypto hater Warren Buffet may also be having a slight change of heart in recent months. In an apparent change of traditional policy, Berkshire Hathway has invested as much as US$600 in two fintech firms - PayTM of India and StoneCo of Brazil. This has led to market speculation that the firm may change its long-held stance on digital assets including crypto.

India’s regulatory thought process on crypto has also travelled a long way in the past five years. The Reserve Bank of India started with a blanket ban on the sale or purchase of cryptocurrency for entities regulated by RBI (all scheduled commercial banks and NBFCs) in 2018. The RBI governor “equated crypto trading with gambling”. The ban was declared untenable by the Supreme Court. Presently, the legal position on dealings in crypto in India is ambiguous. It is neither explicitly unlawful nor a regulated asset. However, last week RBI governor reiterated his stance on the cryptocurrency ban, saying there has been no change in the central bank’s position.

No surprise that Bitcoin has weathered all the pessimism and sharply outperformed gold and equities in the past five years. Since October 2018, Bitcoin has gained over 400%, as compared to ~63% for gold (in USD terms) and ~47% for S&P500.

Some of the noteworthy events weathered by the market include - hawkish commentary from central bankers (including the RBI and the US Fed); downgrade of global growth estimates; poor growth guidance by IT services companies; a truly ominous escalation of hostilities between Israel and Palestine; erratic monsoon season and consequently elevated food inflation & cloudy outlook for the rural demand leading to a sharp rise in global crude oil prices; opinion polls indicating some setback for the ruling BJP in the forthcoming state assembly elections; etc.

The bond yields in developed countries have risen to levels not seen in the past two decades. The US benchmark (10yr G sec) bond yields are presently close to 5% - a rise of over 700% in the past three years. Similarly, The Japanese and German benchmark (10yr G sec) bond yields have also seen a similar rise in the past three years. Conventional wisdom indicates that such sharp spurts in the bond yields invariably lead to the unwinding of leveraged positions of global investors, mostly resulting in a sharp correction in emerging market asset prices, especially risk assets like equity.

Notably, the emerging markets in general have underperformed the developed markets in the past year. However, the Indian equities appear to have performed mostly in line with the developed markets.

Besides, the broader markets in India have actually done exceedingly well in the past three years; with Smallcap and midcap indices sharply outperforming the benchmark indices. This trend has continued in recent weeks.

In fact, some global brokerages like Morgan Stanely and CLSA have upgraded Indian equities to “overweight” recommendation in their suggested portfolios. It is expected that these upgrades might stem, or even reverse, the net selling position of the foreign portfolio investors in the Indian equities.

In the given situation, a common investor in India may be faced with the following doubts:

(a)   The financial conditions in many of the developed markets, especially the US, are deteriorating fast. If we evaluate the present conditions in the US markets, a sharp correction in asset prices (equity, bonds, and real estate) looks imminent. Chinese and European markets also look jittery. Under these circumstances, would Indian equities continue to do better or these also fall in line with the global peer?

It is pertinent to note that in 2H2007, the Indian economy and markets were also in a position of relative strength and had sharply outperformed. However, in 2008-09 we not only collapsed but also underperformed our global peers.

(b)   The return on alternative assets like fixed coupon-bearing securities, precious metals, and cryptocurrencies now looks promising on a risk-adjusted basis. Would this lead to diminished flows in equities?

(c)   Historically, positive real rates have resulted in the accelerated unwinding of the leveraged USD and JPY positions (popularly known as carry trade) globally. Would we see indiscriminate selling in India along with other high-yield (mostly emerging) markets, like all previous instances of such unwinding?

(d)   Notwithstanding the improving breadth of earnings growth, it appears that the reported earnings may not match the market estimates of 18-24% earnings growth for FY24-26. Would this result in some PE contraction (price-led easing or through time elapse) of the Indian equities?

(e)   If the Indian equities prices do fall, how much fall could be expected, and how long will this correction last?

My views on these issues, as of this morning are as follows. Please note that the situation is evolving very fast. It is more probable that my views will keep changing to suit the conditions as they evolve.

1.    The Indian equities may correct 10% to 15% and not collapse (25% or more). 2023 is different from 2008 since the leverage at the corporate level and financial market level is significantly lower now as compared to 2008 and rates in India may peak at a much lower level as compared to 2008 (repo rate 9%).

However, the breadth of the fall could be severe. Many more stocks could see a fall of over 25% than the number of stocks falling less than 10%. It is therefore prudent to focus on the quality of the portfolio rather than gain potential.

2.    On a 12-month horizon fixed coupon bearing securities could offer matching risk-adjusted returns to equities. However, beyond 12-months equities will continue to outperform alternative assets.

3.    Unwinding of carry trade appears to be already in progress. In September and October, we have seen close to US$3bn net selling in the Indian equities. This may continue and even accelerate, causing deeper daily moves in the market.

4.    I believe that a 10% correction in Nifty50 followed by a one-year time correction would make valuations reasonable.

5.    In my view, in the worst case Nifty could possibly correct to 16880 level. However, the most likely scenario would be a fall to the 17895-18170 range followed by a consolidation phase of 6-8 months. Thus, a fall below 17895 would be an attractive buying opportunity, in my view. 

WPI in Contraction for the Sixth Month; core inflation higher (Centrum)

WPI inflation witnessed a yet another contraction in the month of September and registered a deflation of 0.26% YoY, down from -0.52% in August. The print came in slightly lower than the estimates as the general consensus was around -0.5%. This was the 6^th month where we have seen a contraction. All the segments witnessed a deflation in prices, except for the Primary Articles. However, on a monthly basis primary articles contracted while Fuel & Power and Manufactured products saw rise in prices.

Core inflation rose in September

India’s WPI based inflation witnessed a further contraction in August. The persistent moderation in WPI since May-22 has been mainly because of constant decline in mostly all the major sub-indices. Although at a slower pace than previous month, this month’s fall in the wholesale prices can be mainly attributed to all the sub-indices except for the primary articles, as food prices (although slowing down) remains in the positive. The deflation in Fuel prices have slowed down as international crude prices have again started to pick up. We expect food prices to cool down in the coming months, all while fuel prices may turn out to put pressure on the headline WPI figures. The core prices remained in deflation for the 7^th consecutive month as it fell by 1.4% compared to 2.2% in the month of August.

September’s report clearly shows that the inflationary pressure caused by high food prices have eased down considerably - which clearly indicates a good sign for the market. However, production cut done by Saudi Arabia and Russia could hurt the prices further on the upside. Clearly, the tightness forced by the RBI has started to show, as both core CPI and WPI are on a downtrend, which eliminates the volatile fluctuations of food and energy prices. This report came after the CPI recorded a print of 5.02% for the month of September, which took a detour from the 7.44% it had hit in the month of July.

Narrowed trade deficit a transient respite (Systematix)

India’s trade deficit narrowed in Jul’23 on the back of a sharper decline in imports than exports. But it reflects slowing demand and global trade. As trade was the biggest driver for post-pandemic recovery, the receding global bounties are having a wider impact on the domestic economy, particularly the employment-intensive services sector. While RBI has the buffer in the form of forex assets, the spillovers of external sector vulnerabilities can manifest into volatile currency and rate markets.

Overall trade reflective of slowing global and domestic demand: At the segregated level, the oil trade has been contracting since Mar’23 by 20% (YoY) on average. Non-oil & and non-gold/silver trade has also contracted by 5.9% (YoY) on average since Dec’23. This is reflective of simultaneously slowing global trade and domestic demand.

Contracting services trade has a larger bearing: With the current declining trend of the overall trade since its peak in early 2022, it is going to have a multi-layer cascading impact on the formal sector. Overall services trade and its components, which remain a significant source of formal and informal employment, have started exhibiting signs of moderation or contraction.

India strategy: Global headwinds to test domestic resilience (AXIS Capital)

Indian equities should be able to offset some of the downward pressure emerging from the downward adjustment in valuation of global financial assets due to the sharp rise in risk-free rates (UST yields). Not only are inflows into domestic MFs likely to be resilient, EPS growth and revisions are both supportive of time correction. With a cyclical upturn in capital formation supporting the structural improvements in labour and productivity growth, the domestic economy should also be able to offset some of the headwinds from the ongoing global slowdown. A sharp US recession, though, can drive a spike in risk premia and also intensify growth headwinds for the economy.

Structural drivers likely to drive 7% growth annually

We believe India can grow at ~7% annually, with 1% growth in labor input supplementing 2%-plus growth in total factor productivity. We expect strong TFP growth to continue (2.4% CAGR in the five years pre-Covid), on (1) the state continuing to cede space to the private sector (the latter generally uses labour and capital better); (2) improving macro (roads, highways, airports, ports) and micro (last-mile access to energy, piped water, internet and financial services) infrastructure; (3) formalization of retail and construction; (4) net services exports; and (5) state capacity improving.

Improving capital formation to provide cyclical boost, offset headwinds

The pre-Covid growth slowdown was due to a fall in growth of capital formation (bad-loan clean-up and a real-estate downcycle). This is now changing: dwelling construction is picking up, and leverage on corporate balance sheets and lenders has likely bottomed out. These should offset the several cyclical headwinds faced by the economy.

The first is limited fiscal space and a falling fiscal deficit ratio. Second, even with a pause on repo rate hikes, financial conditions can continue to tighten as loans roll over. Third, as the global economic slowdown is already hurting growth in goods and services, a likely US recession next year can intensify pressure in some of the export-driven sectors.

Real-estate cycle turning after a decade-long downturn: No sub-continental sized economy like India can grow rapidly without strength in dwelling construction. Despite 2.4% annual growth in household formation (Exhibit 28:), a houses-to-households ratio of 0.97 in 2019, 4% annual growth in the size of houses (the floor space per person in India is ~100 sq ft, vs 550 in China and 700 in the US, Exhibit 29:), and rising quality of construction, the value of dwelling construction in India barely grew over 2012-21.

Time correction for now: lower global P/Es, and steady EPS growth

The US Treasury (UST) yields have risen 2 pp, and are likely to remain elevated, in our view. With Nifty earnings yield spread over UST yields at record lows, P/E can remain under pressure despite the USD 30-35bn of unintended flows into domestic equity MFs.

P/E premium to world is already elevated at 30%. Markets may time-correct as Nifty earnings are in much better shape than in the past decade: (1) for-the-year EPS seeing upgrades vs sharp 10-25% cuts in the prior decade; and (2) double-digit growth FY24-26E vs 4% CAGR 2011-20. In our 30-stock model portfolio, we are overweight financials, autos, utilities, cement, and real-estate, and underweight IT, industrials, and metals.

US bond yields may remain elevated (MOFSL)

During the past three months, the benchmark 10-year US treasury yield has surged toward 4.75%, about 100bp higher than the mid-Jul’23 level. Notably, the rise in the yield is not limited only to the longer end, but it is seen across the curve and more at the shorter end, as the spread between the 3-month yield and the 10-year yield has actually narrowed from -1.5pp in mid-Jul’23 (and 4-decade low of -1.89pp in early Jun’23) to -0.9pp in Oct’23, last seen in early 2023. (All data used here is as of 16th Oct’23).

If the cost of funds increases sharply and continuously, it is usually believed to hurt borrowers. Nevertheless, since a bulk (~90%) of household loans are fixed-term, higher rates have not pinched customers in the US. Because of this, the burden of higher interest rates will be borne by the lenders, due to the higher cost of roll-over and/or refinancing the loans. On top of this, the financial institutions also see a drop in the value of their securities portfolios due to higher interest rates.

Moreover, although higher rates may not affect existing customers, they are likely to affect new demand badly, hurting home prices. This, if happens, will have the potential to broaden and sharpen the economic slowdown. However, mortgage/non-mortgage loans continue to grow decently, which shows that consumers are not worried so far.

None of these troublesome implications, thus, have played out so far. Our expectation of a serious US slowdown by mid-2023 did not materialize, and even the soft landing theory has been elusive. The US economy remains strong, supported by the drawdown in savings by US consumers, which is in contrast to most other rich nations.

However, this is unlikely to continue for a long period, especially if bond yields stay so elevated. Only ~8% of the market participants expect a rate hike on 1st Nov’23, down from 33% a month ago, and 29% expect it in Dec’23 (up from 2.3% a month ago). It means that the majority of participants would be surprised if the US Federal Reserve delivers another rate hike, like they projected in their Sep’23 policy meeting.

We believe that even if the Fed does not hike rates in the next meeting, it cannot afford to loosen its stance. If so, bond yields will remain elevated, and the longer they stay high, the higher the risk of an economic slowdown is. Accordingly, we push our expectation of a US economic slowdown into 1HCY24.

Unrealized losses of the financial institutions have surged

If the cost of funds increases sharply and continuously, it is usually believed to hurt borrowers. Nevertheless, since a bulk (~90%) of household loans are fixed-term, higher rates have not pinched customers. Because of this, the burden of higher interest rates will be borne by lenders, due to the higher cost of roll-over and/or refinancing the loans. On top of this, financial institutions also see a drop in the value of their securities portfolios due to higher interest rates.

According to the Federal Deposit Insurance Corporation (FDIC), the unrealized losses on investment securities of all the FDIC-insured institutions in the US have amounted to close to or more than USD500b during the past five quarters. Since the Fed started hiking interest rates in Mar’22, unrealized gains have disappeared (from USD29.4b in 3QCY21) and large losses (totaling USD558b in 2QCY23) have emerged. The unrealized losses are divided in the ratio of 45:55 between available-for-sale (AFS) and held-to-maturity (HTM) securities portfolios.

We are not suggesting that all these losses will be realized. However, it is probable that some institutions may be forced to unwind their positions unwillingly, making it economically very difficult for them to survive. Overall, it may not bring down the entire financial sector, but it definitely holds the potential to send chills. Of course, timely intervention by an extremely active US Fed could change the course.

Steel demand to grow slower than expected (Centrum)

World steel association in its October 2023 outlook revised steel demand growth estimate to 1.8% in 2023 and reach 1,814.5mt downgrading from 2.3% YoY earlier. As steel using key sectors like infrastructure and construction witnessing impact of high inflation and high interest rate leading to slowdown in both investment as well as consumption. However, recovery in auto production continued in 2023, helped by order backlog and easing of bottlenecks resulting high growth for most regions. For CY24, world steel demand is expected to show 1.9% YoY growth led by demand improvement in World ex China.

China - The real estate sector have shown state of weakness as key indicators like land sales, housing sales and new construction starts continued to fall in 2023. However, government infrastructure spending stood as major driver for steel demand. As a result, steel demand is expected to rebound by 2% YoY at 939mt in CY23 after fall of 3.5% in CY22. The various measures undertaken by the government should lead to stabilisation in property sector. Hence, under this assumption, the steel demand for CY24 is expected to sustain at CY23 level.

India - India remains bright spot in the global steel industry benefiting from surge in construction and infrastructure sector driven by government spending as well as recovery in private investment. After growing by 9% in CY22, demand is expected to show healthy growth of 8.6% in CY23 and 7.7% in CY24.

US - Despite the resilience of the US economy to steep interest hikes, steel using sectors are feeling demand slowing down. Particularly, residential construction is affected, which is expected to contract in 2023 and 2024. Manufacturing has been also slowing, but the automotive sector is expected to continue its post-pandemic recovery. The lagged effect of tight monetary policy points to downside risk for 2024. After a fall of 2.6% in 2022, steel demand is expected to decline by 1.1% in 2023 and then grow by 1.6% in 2024.

European Union and UK - In CY23, EU economy stood stronger than expected to able to manage energy crisis arising from the Russia-Ukraine war. The high interest rates and energy costs had heavy effect on manufacturing activities. Though, recovery in automotive sector continued. The steel demand after a fall of 7.8% in 2022, is expected to fall by 5.1% in 2023. Although in CY24, demand is expected to see rebound as impact of current adversaries likely to cool off.

View & Outlook: Developing nations to spearhead global steel demand

Overall, worsening economic outlook due to influence of monetary tightening that hurt consumption and investment alike. The construction sector has been negatively affected by the high interest rates and high-cost environment, especially the residential sector. Falling housing sales have led to financial troubles for major Chinese real estate developers, generating concerns about the health of the economy. For CY2024, auto sector growth likely to decelerate, China to remain uncertain depending on the policy direction to tackle economic difficulties, regional conflicts such as Russia-Ukraine, Israel-Palestine and elsewhere further add to downside risk. Steel demand dynamics in emerging and developing economies continue to diverge, with developing nations excluding China remaining resilient to global headwinds. After falling by 0.6% in 2022, steel demand in emerging and developing economies excluding China will show growth of 4.1% in 2023 and 4.8% in 2024.

India metals - Earnings to be a mixed bag (Systematix)

India’s steel production and demand remained strong for a seasonally slow quarter. Domestic crude steel production increased by 15% YoY during July-August 2023 while other major economies witnessed a decline over the same period. Various economic indicators also signal strong demand from the infrastructure, building and construction, and automotive sectors, a trend likely to gain momentum in 2HFY24. Prices of major base metals fell during 2QFY24, with zinc/aluminium recording a decline of 25.7%/8.6% YoY and 4.5%/5.2% QoQ. Lead and copper prices were relatively resilient at USD 2,170/t (+9.8%/+2.5% YoY/QoQ) and USD 8,356/t (+7.9%/-1.5% YoY/QoQ), respectively. Silver/gold prices slid lower by 2.5%/2.7% QoQ but remained higher by 22.6%/13.3% on a YoY basis, respectively.

Primary steel producers under our coverage (JSW Steel, SAIL, and Tata Steel) are estimated to report a 3%/1% YoY/QoQ drop in 2QFY24 revenue due to lower steel prices and seasonal factors. However, despite seasonality, the EBITDA margin is likely to remain stable driven by higher volumes and lower raw material costs.

Strong domestic demand is likely to keep the earnings buoyant for JSW Steel and Tata Steel, partially offsetting the impact of lower sales volume estimated at their respective international operations. We estimate strong sales and EBITDA recovery for SAIL driven by 13%/5% YoY/QoQ growth in 2QFY24 reported production.

Mining companies MOIL, NMDC, and Coal India are likely to report a YoY EBITDA growth of 28% driven by strong operational performance. APL Apollo Tubes (APAT) and Surya Roshni (SYR) are estimated to report EBITDA growth of 29% and 19% YoY, respectively, driven by high-margin value-added product portfolio and higher volumes partially offsetting lower steel prices. For our non-ferrous coverage (Hindustan Zinc, Vedanta, and NALCO), we estimate a YoY/QoQ drop of 21%/3% in EBITDA reflecting the movement in base metal prices. Overall, we estimate 2QFY24 EBITDA of our metals and mining universe to increase by 13% YoY but decline by 5% QoQ. We currently have BUY on SAIL, TATA, JSTL, MOIL, NALCO, SYR, NMDC, COAL, and VEDL, and HOLD on APAT, and HZL.

Strong domestic demand: India reported a 17% YoY growth in monthly crude steel production in August 2023, and remains one of the few countries globally to consistently record growth in steel production. India’s September 2023 manufacturing PMI came in at 57.5, above the neutral level of 50 for the 27^th consecutive month, indicating strong order intake and sustaining demand.

The latest Index of Industrial Production (IIP) data for manufacturing activity in basic metals also indicated a strong demand scenario, as it increased to 215 in August 2023 vs 207.7 in July 2023 (2011 as the base year). Strong demand, increasing volumes, and lower raw material costs are likely to outweigh the impact of lower steel prices and help key ferrous companies maintain EBITDA margins during the quarter. We believe, earnings have already witnessed a significant pullback in 1QFY24 as key metal prices normalised from the record levels breached during the same period last year and, going forward, higher volume-enabled operating leverage will ensure margin sustenance while higher demand keeps prices in check.

Rising exports disaffirm overcapacity risk in China; will likely keep steel prices

rangebound

Steel demand from the property sector in China, largest steel producing country, remained subdued during the quarter slashing hopes of a faster economic recovery. However, expected steel production cuts have not materialized as well due to an offsetting demand from the infrastructure and manufacturing sectors. China’s PMI data showed expansion in September 2023, after recording a contraction in manufacturing activity for two consecutive months. Lack of domestic demand from the property sector has also led to a rise in steel exports from China. During April-July 2023, China produced 364.6mt of crude steel, a marginal increase of 0.36% from last year. Over the same period, exports of finished steel to India increased by 27% and 58% YoY in value and volume terms, respectively. We believe, China is likely to take milder production cuts for the rest of the year due to concerns over economic growth that would keep exports high and inventories at a comfortable level thus providing downside support to steel prices.