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Event Update

Mar 9, 2020

Global equity markets including India, have taken further deep cuts today as a confluence of factors play out – Crude oil price war, spread of coronavirus and domestically the Yes Bank cookie crumbling. As we write this note, US S&P 500 is cooling at a circuit breaker down 7% today and down 17% from its all-time high just 13 days ago. Nifty lost almost 5% today, down 15% from its all-time high on Jan 14, 2020. We look at the key issues behind this mayhem.

Price Wars Trigger A Freefall In Crude Prices

Crude oil prices fell a steep 25% today as Saudi Arabia triggered a price war after Russia refused to accept further steep cuts proposed by the OPEC. At one point in the day oil prices had corrected by more than 30%, steepest fall since 1991 Gulf War.

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Earlier this month OPEC was negotiating additional production cuts for the remainder of the year. This was to counter the declining price amid concerns that crude oil demand could be adversely impacted as global growth slowed. This would have ostensibly limited the decline in oil prices. But in response to Russia’s refusal to cut production, Saudi declared a ramp up in its own production as well as sharp price cuts. This price action now puts pressure on Russia as well as other oil producing nations to either follow suit and match prices or lose out on market share.

Currently, USA is the largest producer of Oil. Sharply lower prices will impact several leveraged, high cost producers. With lower profitability, these may find rolling over debt difficult thereby potentially triggering bankruptcies. There may be respite though, since China needs to buy substantial volumes of US crude under the recent trade truce agreement.

At a time where globally inflation stubbornly remains below the targeted 2%, lower oil prices will only push this lower. With Central Bankers operating with very limited ammunition, global reflation trade seems to drift further away.

India, as the third largest importer of oil, will be a beneficiary of lower oil prices. Last fiscal India spent USD 112 bn on oil imports. Each dollar saved on an annualized basis reduces our import bill by Rs 10,700 crores. If these gains are passed on by the government, it could meaningfully benefit Oil Marketing Companies and other sectors that are heavily dependent on crude and crude derivatives. Alternatively, if the government increases duties and retains the windfall gains, it may enhance the much needed fiscal headroom. With reduced inflationary pressure, the RBI has more room to deliver further rate cuts.

Coronavirus (Covid19) Continues to Spread

The Coronavirus infections continue to spread with the total number of confirmed cases crossing 1,00,000 with close to 90+ countries reporting at least one confirmed case.

Until Feb 20, 2020, Italy had only 3 reported cases of the virus infection. Soon after, a cluster of cases were detected and municipalities comprising 55,000 people were locked down. The number escalated to 5,800+ by March 07, 2020 and the government announced a lockdown that has over a quarter of its population quarantined. That is roughly 1.6 crore people not participating in economic activity in any major way. The delay in reaction has exacerbated the risk of escalation in number of cases. Further, US, a much larger country and the consumption engine of the world, appears starkly under prepared to contain the spread. This is spooking markets world over and equities have been selling off.

As highlighted in our investment strategy note “The Great Leveller” – dated 2nd March 2020 – fully assessing the impact of coronavirus on the economy is a herculean task. However, global supply chain, trade and tourism is likely to be significantly impacted in a world which is as globalised and connected as ours. We expect a supply as well as a demand shock as outcome of this event.

Yes Bank Cookie Crumbles

The bank has been under stress for over 18 months and has been looking to raise capital for nearly a year. Even potential investors as indicated by the bank did not appear to have credibility. In the meanwhile, non-performing loans increased substantially and stressed assets were pegged at roughly Rs 80,000 crores as of September 30, 2019.

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The bank postponed its December quarter results. The extent of stressed asset is set to erode the bank’s entire net worth of Rs 25,000 crores and further require a bail out. The RBI issued a moratorium curtailing withdrawal by depositors to Rs 50,000 per day for a month. In an attempt to resolve the situation, the RBI has also superseded the board of the bank, appointed an administrator and issued a draft reconstruction scheme whereby SBI will infuse capital of Rs 2,450 crores into the bank for 49% ownership. The hope is this should enable the bank to find other investors. However, it remains to be seen how the situation unfolds once the moratorium is lifted and the December quarter results are released.

While the situation appears grim, one should not lose sight of the fact that failure of a bank as large as Yes bank could have unleashed another wave of risk aversion and possible contagion risk in an already fragile credit market. RBI may have just averted another crisis.

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Outlook

Impact of the coronavirus isn’t known but India could be lot less impacted than other parts of the world. The oil crash also helps us more than it hurts us. Yes Bank is another crisis averted, almost. We may not achieve our GDP growth targets if the overall situation doesn’t improve. But even at a lower growth, we may look better than most of the world. However, macro-economic fundamentals alone don’t move markets. There is the question of liquidity and sentiment. In times like this, these two factors influence more than fundamentals. If there is a global risk-off trade, FIIs will take money off the table. We are already seeing this in outflows from Indian equities as well as bonds in the last few days. Domestic investors however, continue to pump in money, including Rs 16,993 crores in February 2020. Overall sentiment remains weak and large cuts such as today’s will only exacerbate the situation. Volatility will continue to be high and as they say, fasten your seatbelts!

Final words, revisit your asset allocation. The action one takes in these markets are the true reflection of one’s risk appetite. This experience should guide the actions at peak of the next cycle. Because there will be one.

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