Vijay Kumar Gaba

·         Growth: The year 2021-22 witnessed a sharp rise in level as well as in the growth of the majority of the important economic parameters like invested capital, input, output, GVA, net income, and net profit registered by the sector and even surpassed the pre-pandemic level in absolute value terms.

·         The main drivers of this growth in 2021-22 were industries like the Manufacture of Basic metal, Coke & Refined Petroleum Products, Pharmaceutical Products, Motor vehicles, Food Products and Chemical and Chemical products. These industries, taken together, contributed about 56% of the total GVA of the sector and showed GVA growth of 34.4% and output growth of 37.5% in comparison to 2020-21.

·         Employment: The estimated number of persons engaged in this sector in 2021-22 has exceeded the pre-pandemic level (that is 2018-19) by more than 9.35 lakh. The top five states employing the highest number of persons in manufacturing were Tamil Nadu, Gujarat, Maharashtra, Uttar Pradesh, and Haryana.

·         Wage Growth: Average emoluments also registered an increase with the average salary earned per employee in this sector had gone up by 1.7% in 2020-21 and by 8.3% in 2021-22 in comparison to the respective previous years.

·         Regional dispersion: The top five states, taken together, contributed about 53% of the total manufacturing GVA of the country in 2020-21 as well as in 2021-22. Gujarat remained at the top in 2020-21 and in the second position in 2021-22 while Maharashtra ranked first in 2021-22 and second in 2020-21. These two states were followed by Tamil Nadu, Karnataka, and Uttar Pradesh in both years.

·         Key produce: Food (16.35%), Non-metal minerals (11.87%), Textile (6.86%), Fabricated Metal (6.44%), Rubber and Plastic products (6.01%) were the top category of operational factories.

·         No. of factories: There was a total of 2,00,576 operational factories in India at the end of FY22. About 49400 or about one-fifth of the total factories were inoperational. About 51% of the total operational factories were in the top 5 states – Tamil Nadu (15.76%); Gujarat (11.63%), Maharashtra (10.16%), Uttar Pradesh (7.03%), and Andhra Pradesh (6.24%). Gujarat factories were the most capital-intensive (18.43% of total fixed capital).

·        
Debt: Manufacturing units had a total of Rs13971 billion loan outstanding at the end of FY22. The average interest cost of these loans was 11.7%.   

Self-reliance in the defense sector has been one of the major investment themes in the past three years. Besides dedicated public sector defense manufacturers, the stocks of many equipment and service providers to the Indian defense establishments have seen a sharp upmove. In the melee to own “defense stocks,” many investors have ignored the basic principles of investment and buying stocks of these companies at any price.

I had written a cautionary post about this many months ago (see here). The trend has only strengthened in the past six months. Stocks, even remotely associated with the defense sector, have seen hyperbolic moves. I feel the interest in the sector that was driven initially by optimism, may have crossed over the realm of exuberance.

 

In India, pro-establishment media and experts have mostly refrained from commenting on the interview; whereas the critics of the establishment have used this opportunity to emphasize that President Putin has answered many tough questions while Prime Minister Modi chooses not to answer media questions. I have not seen much discussion in Indian media on the assertions made by President Putin.

As a tiny fish in the pond, I am incapable of making any intelligent comments on matters of global or even national importance. Nonetheless, I found the following three things in the interview that interested me as a small investor.

·         “China's economy has become the first economy in the world in purchasing power parity; in terms of volume, it overtook the US a long time ago. The USA comes second, then India - one and a half billion people, and then Japan, with Russia in the fifth place.”

This is the only mention of India in this 2:17:19 hrs. interview. Indonesia got much more prominent mentions. China was repeatedly mentioned as a formidable global power. The recent trade trends are suggesting that near-shoring, friend-shoring, and China-proxy-shoring are emerging as more popular trends. Indonesia, Mexico, Vietnam, etc. are emerging as much stronger gainers of the China+1 strategy as compared to India.

·         President Putin made it clear, in no uncertain terms, that the era of global peace that prevailed particularly in the post-Cold War period is mostly over. We are entering an era of mutual mistrust; frequent disruptions; persistent and potent threats of a larger war; and redistribution of global power.

This implies that (i) defense spending will increase for most nations; (ii) given the current state of the stretched fiscal position of most developed nations, the collateral damage of higher defense spending will be humanitarian aid; (iii) Rising mistrust may also result in tightly closed borders, adversely impacting immigration; (iv) Volatility in markets will rise materially; and (v) USD will face persistent pressures.

It appears too early for India to claim self-reliance in defense production. It is also early to anticipate that India could become the fulcrum of any major global alliance in the next few years. This means we could face serious trade and foreign policy challenges soon. The recent performance of the government in this regard is not very inspiring.

·         President Putin hinted that Artificial Intelligence (AI) needs to be regulated and there must be a global understanding on this subject.

Failure to reach a wider understanding may pose a similar (if not greater) risk to the global peace and stability as the stockpile of nuclear weapons did in 20^th century. Misuse of AI could be devastating. The US and China are miles ahead of India in the development and deployment of AI in most areas, especially defense technology.

The implications for my investment strategy are as follows:

·         The sentiment of nationalism apart, for small investors like me it may not make much sense to place significant bets on the China+1 theme. To global investors markets like Indonesia and Mexico may offer better opportunities.

·         We should embrace higher volatility. The post global financial crisis (GFC) era of low volatility may be over in the next few quarters.

·         Overstretched fiscal positions and the specter of war may keep rates elevated for longer than presently anticipated, even if China accelerates the export of deflation. The cost of global capital could rise for Indian entrepreneurs.

·         It may not be a great idea to buy USD-denominated assets for small investors.

·         Defense production and AI will remain relevant themes for many years. But buying these at any price may not be a good idea. (more on this tomorrow. 

On the other side of the globe, the political debate in the US is also fast reaching the point where the most relevant question would be “Who will Donald trump defeat in the November presidential elections?”

The ever-forward-looking financial markets are not oblivious to these more likely political outcomes. It is therefore safe to assume that the current prices have factored in the election victories of Modi and Trump. Thus, from a political viewpoint, one should not anticipate a significant upside to the financial markets. An unexpected election outcome may though result in a material downside.

In the latest episode of Greed & Fear, Christopher Wood (of Jefferies), said about the US markets, “The stock market is priced for an idealized soft landing while the money markets are priced for a degree of monetary easing which only seems likely in the event of a recession. The fed fund futures are now discounting 144bps of rate cuts this year. On the US stock market, the Nasdaq 100 is now trading at 24.4x one-year forward earnings and the Russell 2000 is trading at 22.6x, compared with 19.6x for the S&P500, according to Bloomberg.”

The summer in the US is therefore going to be full of discontent. A soft landing (further earnings downgrades, slower consumption, and rising financial stress) may limit the upside in stocks while the Fed pushing the rate cut beyond May’24 may cause restlessness in the bond markets.

Back in India, the chances of any further re-rating of equities are getting slim.

·         Private consumption slowdown is now well accepted. The interim budget has made it clear that even public consumption is not likely to improve anytime soon.

·         The budgetary allocation for capital expenditure in the sunrise sectors Defense, Railways, Utilities, etc. has seen meager growth in FY25BE. The valuations of the stocks of these sectors may not see any further PER re-rating. The returns from here logically should be similar to the earnings growth in these businesses. Any disappointment in execution may however see a sharp sell-off.

·         Decelerating global growth shall keep export growth under check. The downward shift in growth trajectories of the US and China could also spill over to India through several transmission channels, such as trade in goods and services, commodity prices, and investment.

·         RBI has also made it clear that going forward it is not an all-blue-sky scenario for the Indian economy this summer. The risks to inflation and growth are at best balanced. The bond markets may not be fully pricing in the downside risks.

I do not want to sound like a party pooper. Nonetheless, I am happy to use this spring for repairing my roof, servicing my air-conditioner, and oiling my vehicle. Just in case, there is a cloud burst, sudden heat wave, or flood warnings needing immediate re-location.

Last Thursday, the finance minister presented an interim budget for the fiscal year 2024-25. The budget presentation had two part – (i) rhetorical and (ii) substantive.

The first part included a speech about the performance of the governments led by Prime Minister Narendra Modi for the past 10 years and promises for the next 23 years. The finance minister spoke about how in 2014 their government inherited an economy that was in shambles; and how they have pulled it out from a total mess and put it on the fast track to achieve the status of a developed nation by the year 2047; when we would celebrate 100 years of our independence from the colonial British rule. The finance minister also promised to implement a slew of development schemes over the next five years. She however refrained from listing any specifics or financial details.

The second part included (i) the accounts of the government for FY24; (ii) fiscal proposals for FY25, and (iii) a vote on account to meet the government’s expenses till a new government is formed and a full budget is approved by the parliament. This is the part that needs to be discussed and analyzed.

Fiscal prudence – achievement vs desirability

The finance minister presented that the fiscal deficit target for FY24 has been revised downward to 5.8% (Budget estimates (BE) 5.9%) and budgeted a fiscal deficit for FY25BE at 5.1% of GDP. She emphasized that the government is well on course to achieve the FRBMA target of a 4.5% fiscal deficit by FY26. The sharp improvement in the fiscal deficit has been received well by most. A tight balance is particularly commendable given the impending general elections. In my view, we need to ponder deeply over the following five points:

1.    At this stage of economic development, whether this degree of fiscal tightening is desirable? FY24RE shows that to meet the fiscal targets, the government has cut capex spending also. Is it appropriate to save on capital expenditure to meet fiscal targets? FY25BE growth in capex spend on key sectors is very moderate.

2.    FY25BE further confirms the trend of the past three years that the government is systematically cutting its consumption expenditure, subsidies, and social sector spending while allocating more for manufacturing and export incentives. Should investors assume that our economy is taking a left turn toward the Chinese model of growth (primarily manufacturing and infrastructure capacity building) from a largely consumption and social sector capacity building led growth?

3.    The budget does not explain why Rs one trillion, 50-year interest-free loan to states shall not be considered part of the fiscal deficit. For all practical purposes, it’s a drain on the center’s finances that will likely never be returned.

4.    Interest expense now constitutes 25% of the total government spending. There is no indication that this proportion will come down any time soon. On the contrary, with fiscal deficit staying at 4% of GDP or above for at least three more years, and greater reliance on high-cost small savings funding of deficit, it is likely that the proportion of interest in total expenditure may rise further. Under these circumstances, the sovereign rating of India may not see any upgrade anytime soon.

5.   With the current valuations of PSEs, disinvestment looks increasingly improbable. The government has not presented an alternative plan for fundraising so far.

…

The recently released Direct Tax Statistics by the Central Board of Direct Taxes (CBDT) shows that income taxpayers in India may not be a group of interest from a general election view point. For example, consider the following points evident from the said statistics:

No. of taxpayers: In AY23 only 8.91crore individuals paid some income tax (including TDS) in India. This is less than 10% of the total eligible voters in India. Though this year details have not been provided, from past year’s statistics it is clear that more than two thirds of these individuals have income less than Rs5.50 lacs, which is almost tax exempt. The population seeking income tax relief/incentive is about 2-3% of the voter base. This segment of the voters is also not particularly known for their commitment to voting.

Tax payer regional dispersion: During AY23, the government collected Rs8.26 trillion as corporate tax and Rs8.33 trillion as personal income tax. Four states (UP, Bihar, MP and West Bengal) which account for almost 40% of population accounted for only 7% of tax payment. Excluding NOIDA and Kolkata which may account for significant corporate tax, the personal income tax collections in these states would be of little relevance for elections.

Maharashtra with 9.5% population accounted for over 36.4% of tax collection. However, it would be interesting to see the picture excluding Greater Mumbai and Pune jurisdictions. Delhi accounted for 1.4% of population and 13.3% of tax collection.

The broader picture thus is that 50% tax collection happens from states having less than 10% population (that too mostly from 3 cities Delhi, Greater Mumbai and Pune) and 10% tax collection happens from states with over 40% population (including likely major contributions from NOIDA and Kolkata).

Direct Tax to GDP ratio highest: FY23 recorded a direct tax to GDP ratio of 6.11%, highest on record. Tax growth rate is consistently higher than the nominal GDP growth rate since FY17 (financial year 2015-16). FY22 witnessed the best tax buoyancy factor (tax growth to GDP growth) of 2.52 since FY03 (2.59).

Taxes growing faster than GDP: Between FY14 and FY23, direct tax collection has registered a growth of 11.2% CAGR, total tax collection has grown at 11.6% CAGR; whereas nominal GDP has grown at 10.2% CAGR only. Some part of higher tax collection could be attributed to enlargement of tax base; but the incidence of tax has also increased.

Trend to continue: The tax collection trends witnessed in the recent years are likely to persist in future also. There are about 66.3 crore PAN numbers allotted in India. Out of this presently only 8.91cr pay tax (including TDS) and 7.4cr people file income tax return. The administrative effort is to bring more PAN allottees to the tax net. The share of TDS in total tax collection has increased from 34.4% in FY14 to 41.5% in FY23. This shall also increase in future.

In short, if you are a taxpayer and hoping for any favor from the finance minister today, you might be disappointed.

In earlier times, diversification was a rather simple exercise. This usually involved allocating money to asset categories (equity, debt, commodity, real estate, etc.) that carried divergent risk profiles. During low inflation, easy money periods equities and real estate outperformed the debt; while in high inflation tighter money periods, bonds and commodities did better.

However, as the markets became more globalized, financialized, and dematerialized, the performance of various asset classes started to become more correlated. With more and more assets offering a similar risk profile diversification of portfolios started becoming a complex and complicated exercise.

In the past decade, we have seen sovereign bonds carrying more risk than equities; multiple geographies carrying the same risks; gold and silver not providing any hedge against monetary debasement; and bonds worth trillions of USD carrying a negative yield while the major central banks were printing unprecedented money.

In an attempt to resolve the complexity in diversification, further complications were added in the form of Art, Diamond, Luxury Yacht, digital token (NFT) and cryptocurrencies etc. Many of these lacked objective value parameters. Some of these were even depreciating assets. Some others did not have explicit legal sanction to trade freely.

In the past three years in particular, diversification tools like geographical diversification, debt-equity diversification, growth-value diversification, emerging-developed diversification; sovereign-private bond diversification; etc. did not always provide the desired results for the investors.

The reason is simple. Most assets, geographies, and economies have become much more correlated to each other. For diversification, it is critical that the assets in the portfolio are mostly uncorrelated. If the assets are reacting (or not reacting or that matter) in the same manner to a macroeconomic or geopolitical occurrence, their risk and return profile cannot be expected to be much different.

My recent interactions with multiple investors, money managers, and advisors indicate that the understanding of the concept of diversification as a risk management tool in Indian markets may be extremely poor. In the name of diversification, investors are being lured to invest in bonds that are riskier than equity; multiple mutual fund schemes holding a similar basket of stocks; and gold that has mostly been a currency and import duty hedge rather than inflation, interest rate or market risk (see here).

In the name of diversification, investors are many a time sold a variety of mutual fund schemes which not only are similar in risk profile, and sectoral exposure but contain the same securities.

To make my point clear, I would like to highlight the case of an investor XYZ. This investor claims to be very conservative with moderate return expectations. The advisors told him to have a “simple” and well-diversified portfolio. Out of Rs350, he was advised to invest Rs100 each in a Nifty50 ETF, BankNifty ETF and Nifty500 ETF and keep Rs50 cash for direct equity opportunities to optimize overall returns. This Rs50 was recently invested in HDFC Bank stock (considering it to be very safe and promising in terms of return.)

On the face of it, this appears a simple, safe, well-diversified portfolio. But a simple analysis would tell you that this is perhaps one of the riskiest portfolios one can construct under the current circumstances. This investor has effectively invested ~61% of his money in financial sector stocks, and worst, ~29% in just one stock, i.e., HDFC Bank. Regardless of the attractive valuation, recent underperformance, future prospects of a company, no risk manager can justify this type of asset allocation for a conservative investor with moderate return expectations.

(Note: HDFC Bank has a weightage of 13.5% in Nifty50; 29.4% in Bank Nifty and ~8.4% in Nifty500) 

Since my posts are mostly my personal views and observations, criticism does not affect me. I usually politely agree to disagree. I would thus avoid responding to criticism or the views to the contrary. Nonetheless, I may reemphasize my views as follows:

·         In the short-term (5-7 yrs) any business or investment strategy that assumes substantial decoupling of China from India’s trade specifically, and Western countries in general, may not be successful.

·         Presently, China+1 trade is confined to a few businesses (not sectors), where (i) China has explicitly implemented capacity shutdown, (ii) there are serious IPR violations or data security threats, (iii) Innovators have developed new markets and find it profitable to produce a part of overall production close to the new market, (iv) local government has offered meaningful incentives for building local capacities, and/or (v) a local partner has offered better terms/infrastructure as compared to the Chinese counterpart. All these situations are very normal business propositions and have little to do with geopolitics.

·         Increase in tariffs by the US post 2017 on the imports from China has reduced the US imports from China by ~5% (from 21.6% in 2017 to 16.3% in 2022). However, it has not changed the US dependence on China, as the new import partners have meaningfully increased their trade with China. (Read more)

·        In fact, China’s trade surplus with proxy countries (countries used by many countries to indirectly import from China) has increased meaningfully, implying some rerouting of trade. 

·         Insofar as geopolitics is concerned, it is important to note that China’s trade surplus with India and Western countries has not shown any meaningful change post Covid. Overall, China’s goods trade surplus has more than doubled since the pandemic, going from $400 billion a year to $900 billion (read more).

Also read China+1 ...rhetoric apart

https://www.investrekk.com/2024/01/china1-rhetoric-apart.html?m=1