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Divergence in Reality

Jun 3, 2020

Global reopening, a ray of hope

“Finally!” is the emotion that springs to our minds as large part of the globe shifts gears from managing through a lockdown to re-emergence. Notwithstanding personal fears, just having the option of mobility is a big trigger for the hope of normalcy. But one look at the accompanying chart tells us that some are treading a tricky path.

As an aside, adoption of the Sweden model has been much debated in media circles of India, but it is interesting to note that the country has a mobility rate of -93% which implies that people have exercised caution.

Greater mobility also means ability to resume economic activity and by extension resumption of income for millions of people. It is only now that we will begin to understand the quantum of damage wreaked by the pandemic.

At the same time fears of a second wave are also gaining voice, fairly so. What gives everyone hope is news of vaccine trials progressing. Pfizer CEO has even gone on record saying that they could have one ready as early as October 2020.

In India the curve isn’t flattening yet. We are also staring at another wave of increase in infections. With migrant workers heading home in hordes, rural India, that had been largely unscathed until now, is likely to have new emerging hotspots. Medical facilities in these areas are fairly limited and managing the crisis could have serious challenges. These migrants are a sizeable part of the labour force in cities and hence any restrictions on their mobility would adversely impact sectors that employ them.

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The Atmanirbhar package

The PM, in a nationwide broadcast, announcement the much-anticipated economic package. None were expecting the quantum to be as large as 20 lakh crores. Hence, given the size, almost every industry segment expected some benefit from it. But as the fine print came through, the package became a victim of its own hype. We acknowledge that as the lockdown extends and government revenues fall off the cliff, extending fiscal support without upending the balance gets tougher. But we believe, there was room for more especially given the circumstances.

The measures are closer to ‘life support’ than stimulus. Making credit lines available to MSMEs being arguably the most important measure in the package. (See note dated May 13, 2020). We have been consistently writing about the need to support MSMEs. They are vital to employment generation and are currently going through stress. While we do believe we are entering a new era of formalization and consolidation, it is important to note that larger corporations, as efficient allocators of capital, tend to focus on technology rather than employ people to attain scale.

The Rs. 45,000 crore partial credit guarantee for NBFCs and MFI is being routed through PSU Banks. Constrained by limited risk appetite, the scheme in its implementation may only be marginally effective. We hope these are speedily implemented and there is adequate operational ease in availing them.

Monetary Policy

The special economic package was followed soon by an out-of-turn Monetary policy. Unlike the one on March 27, 2020, this wasn’t triggered by any stress, and hence advancing the timeline surprised many. The policy announced a 40bps repo rate cut to 4%, lowest in the past two decades. The accompanying commentary was sombre, acknowledging GDP contraction as a reality and also committing to take further steps, if necessary, to support growth. (See note dated May 22, 2020)

Results and a blank crystal ball

Typically, we look forward to the result season. The equity team spends considerable time dissecting corporate performance and gleaning insights. Whilst we continue to track result data, we also know it is no longer the most relevant lens to build expectations for forthcoming quarters. However, data highlights that even before covid, India Inc wasn’t expected to deliver very strong earnings growth.

Q4 FY2019-20 was dominated by managing supply chains as China had been under lockdown since late January 2020 while lockdown in various states in India was implemented since March 20, 2020. Of the Nifty500, only 180 companies have declared results thus far and the earnings at an aggregate have contracted by 80 bps and the Nifty earnings have contracted 30 bps. Also, most managements have refrained from giving a number guidance as there are far too many unknowns at this point.

Rural oriented businesses though appear to be more optimistic than the others. This could be attributed to a good Rabi harvest and Kharif sowing. The locust attack and its potential damage still needs to be assessed.

Financial services have the largest weight in the mainstream indices and amongst them lending companies (Private Banks, NBFCs) were considered secular growth stories. Those with larger retail lending books were coveted due to its lower NPAs. The disruption of economic activity and announcement of moratorium however, have soured the story. Provisioning is being bumped up and there is uncertainty around NPAs. Though the extent of loans under moratorium varies from across banks. Also, some of them have been prudent enough to make higher provisions in the last quarter itself.

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This percolating to the equity prices and credit spreads as well

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Equities:

“Sell in May and go away” they say. Turned out to be almost true. Most of the month saw equity markets in a downward drift. In the last few days, however, markets recovered sharply to end about -2.8% down. Broader market indices BSE Midcap and Smallcap outperformed Nifty50, losing 1.4% and 1.9% respectively for the month. The fall further accentuated our underperformance relative to US markets. Nifty has now underperformed S&P 500 by a whopping 29% in the past year. We have been advocating international diversification as a part of strategic allocation for a long time now. Various factors converge in favour of it – lower correlation to Indian equities, greater number of HNIs now have lifestyle exposure to various parts of the world and in the near term, greater room for economic stimulus by developed countries and therefore arguably better resilience.

Our arguments in favour of geographical diversification are often countered with questions around valuation specifically around FANGMAN (Facebook, Amazon, Netflix, Google, Microsoft, Apple, Nvidia) since they have already delivered a sterling return in the past. These constitute close to 48% of the Nasdaq Index.

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Contribution to Returns: Earnings Growth vs. Multiple Expansion
(Absolute numbers for the period 2015-2019)

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We ought to caveat that due distinction needs to be made between tactical and strategic allocation in the international funds. Once the risk appetite returns and flows are directed to other pockets of the globe and these funds may take a breather / underperform. But as a part of strategic allocation, a steady build up is warranted.

Technical Trends

On the monthly chart, Nifty has formed a dragonfly doji candle reversal pattern i.e. markets declined initially during the month and then saw buying at lower level such that the market could recover its losses and hence recover most of it losses. Also, after March low of 7,511, Nifty has been forming higher lows for last couple of months indicating buying coming at higher levels. Thus, market can move higher if it manages to take out the April month high of 9,889. If the Nifty crosses and sustains above the level of 9,889, it can move higher towards 10,440 levels. However, if it is unable to move above 9,889 then we expect selling to emerge at higher levels and markets could consolidate in wide range of 9,900-8,800. On downside, immediate support is seen at 9,350 and then at 9,150. But major critical level for the market is 8,800, if it breaks below this once can expect resumption of downtrend to take place.

In Nifty June monthly expiry options, maximum open interest for Puts options is currently seen at a strike price of 9,000 followed by 8,500. While for Call options maximum open interest is seen at 10,000 followed by 9,500. Strike price of 9,500 and 9,600 has seen significant build-up of open interest thus suggesting these levels are likely to act as resistance zone for the market. Whereas on the downside 9,000 level could act as a support. India VIX has been range-bound between 45 and 33 odd levels for last one month. It drifted lower and closed at 30.2 level. Staying below 33 level will be supportive for the market while any rise in VIX will cap the upside and keep the market range bound.

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Portfolio Actions

In our in-house portfolio strategies, Sanctum Indian Olympians and Sanctum Indian Titans, we have been defensive since the beginning of the COVID-19 crisis. We have been maintaining cash levels in our portfolios since Feb 2020, which are currently at high single digit levels. We had also bought puts in Sanctum Indian Titans and may buy again in June if we see reason to enhance caution.

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Fixed Income:

Post the monetary policy announcement, yields predictably rallied. The liquidity sloshing around is driving yields on short end lower, with overnight rates intermittently below the repo rates. Liquid fund returns are therefore headed lower and investors may actively look for other alternatives. We have been maintaining that weaker balance sheets will find it tougher to raise funds and therefore bear higher cost of capital for some time to come.

However, in the AA & AA- category there are companies that are unlikely to get significantly impacted even in these times. (For example: Well managed gold loan companies. Since they are in possession of the collateral and gold values have been going up, NPAs are not expected to escalate significantly.) Yet the credit spreads of these companies have widened creating a mis-pricing opportunity. These are low hanging fruit for agile investors. As mixed news flow continue, we could see more of such opportunities coming our way.

Conclusion:

Global markets, fuelled by liquidity, have chugged higher in stark divergence to economic reality. The Fed disclosed that they have bought into some junk bond ETFs and that could improve sentiment further. Central banks around the world continue to announce stimulus packages in an attempt to revive consumption and trade. China has been out of lockdown for nearly two months now. While industrial production has seen some recovery (y-o-y), retail sales are showing a degrowth. With so many job losses, discretionary spending recovery is expected to be slow.

The geopolitical risks also need to be considered. At the time of writing this China has ordered major state-run firms to pause some US agriculture goods purchases as Beijing evaluates tensions with the US over Hong Kong. The escalating tension between the two powers threatens to put the recently inked trade agreement at risk. The world will be watching this closely as US heads into elections.

We have been underweight equities since the April 2020 rally. The dichotomy makes it harder to decide allocations. At such times typically, our multi-factor model approach helps. We take into consideration not only fundamentals but also other factors such as liquidity and technical trends. But even after considering these, we are fence sitters currently. Even at the risk of some temporary underperformance we want to wait and watch. But hopefully not too long.

In fixed income, we have been recommending select corporate bond funds consistently for the past few months. Earlier our preferred category was banking & PSU funds. AAA rated PSU bonds have attracted huge flows as our flight-to-safety hypothesis played out and the spreads have now narrowed sharply. We think the compression story in this case has fully played out and now the opportunity is limited to rate cuts.

There is greater opportunity in the AAA non-PSU or bonds of Private companies. Strong HFC, NBFC names are available at an attractive spread over PSU Bonds. We therefore reiterate our conviction in the recommended corporate bond funds.

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