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Revenge Spending

Jul 7, 2021

Global Market Update

We have had another quarter of global recovery, teemed with optimism and consumer confidence. ‘Revenge spending’ is moving from being a hypothesis to reality for a larger part of the globe. China was one of the first to open up and we saw the revenge spending trend there last year. All of this confidence is also reflected in the IMF’s growth estimates revision yet again after two rounds of increases in October 2020 and January this year. Economies with lower vaccination pace will lag of course.

Global corporate profit estimates are above the pre-pandemic levels and continue to see upgrades albeit at a slower pace.

The upbeat sentiment is reflective in the march ahead of most key indices

The upbeat sentiment was checked by the change in the dot plot of the US Fed which maps out policymakers’ expectations for where the interest rates could be headed in the future. The current dot plots suggest that interest rates hike could start as early as 2023. While the Fed chair Jerome Powell downplayed the change in dot plots by saying that the Fed is nowhere close to even discussing interest rate hike, as we have been highlighting in our commentaries a sooner than expected action by the US Fed and global central banks is a risk to be watched.

China, an important economic force, however, is now reigning in credit sharply with borrowing by state-owned enterprises dropped to the lowest in the study’s roughly 10-year history. Forecasts for 6-month borrowing project a further drop. Lower credit coupled with rising covid cases has led to a drop in the Services and manufacturing activity.

Chinese PMI data indicates a drop in economic activity

Back home too, our PMI indicators dropped, expectedly though to 41.2 in June vs 46.4 in May 21. Employment fell for the 7th consecutive month. But a reopening will lead to a rebound in these numbers.

India’s Services PMI declines

Quarterly Asset Pair Review

The Sanctum Asset Pair Model is a proprietary asset allocation model that highlights a favourable asset for investment between multiple asset pairs. We do this exercise quarterly and the output is deliberated by our Investment Committee to arrive at final scores that guide us with our tactical asset allocation. With earnings results behind us, we did this exercise last month. Most score remains broadly unchanged. In major changes, the USD vs INR pair and the Gold vs Cash pair scores moved to neutral from positive INR and marginally positive Cash, respectively.

Equities Vs. Bonds

Earning momentum continues even as valuations expensive

Indian corporates recorded yet another quarter of strong earnings which were ahead of street estimates. Nifty revenue (ex-financials) grew by ~15%yoy for the quarter ended March 2021 and net profit grew ~85% yoy (on a low base). The net profit was ~8% ahead of street estimates. This has led to sharp upgrades in EPS estimates. The consensus now expects ~30% CAGR growth in EPS over the next two years. The outperformance in earnings has been led by sectors like Oil & Gas and Metals that have benefitted from the rise in commodity prices.

Sharp EPS revisions across indices

More beats than misses

Most macro indicators show a sharp recovery primarily due to a low base and less strict lockdown in April/ May 2021 vs last year. PMI data which is not impacted by the base effect highlights some moderation in economic activity, India manufacturing PMI fell to 48.1 in June 2021, the first contraction since July last year. However, with the second wave of covid behind us, an increase in the pace of vaccination and businesses adapting to the new normal (renewed restrictions with every surge in cases), economic activity should pick up in the coming months which could be positive for equities.

PMIs moderate

Other macro indicators impacted by low base

Strong earnings growth has supported equity rally- Nifty has moved up by close to 10% since the start of the earnings season. Hence, earnings upgrades have been matched to some extent by the up move in prices. Hence equity valuations remain expensive.

Equity valuations expensive

Overall, we believe, if earnings momentum continues and inflation risks (as highlighted in June 2021 investment commentary) do not materialise, equity prices could remain supported despite elevated valuations.

Large Cap Vs. Midcap

Marginally positive Midcaps

As highlighted above earnings momentum has been strong over the past few quarters. The midcap index has seen much sharper earnings upgrades than large caps. Analysts expect this momentum to continue in coming quarter two with the midcap index expected to deliver higher 3-year CAGR EPS growth than the large cap index.

Significant EPS upgrades seen by both large caps and midcaps indices

Strong earnings growth in midcaps has been followed by a sharper move in midcap prices. Hence on the valuation front, both largecap and midcaps are almost equally expensive.

However, given the sharper rally in midcaps, technical momentum is in favour of midcaps.

Large caps are expensive

Midcaps equally expensive

Since we are positive equities and within that positive midcaps we have added some weight to Midcaps in Enhancement and Generation profiles (Midcap weight in Shield is capped at 5%) by taking out some weight from debt. Even within large caps, we have added allocation to Nifty Next 50, which has higher exposure to smaller large caps, by reducing weight in Sanctum Indian Olympians which is mandated to invest in market leaders.

Fixed Income

Corporate Bonds Vs. Government Securities

Neutral, Credit spreads low but credit environment favourable

Credit spreads between AAA and G-Sec bonds continue to remain low with select opportunities available across the yield curve. However, the credit environment has improved. Credit upgrades have outnumbered downgrades and many ratings have been reaffirmed over the last couple of quarters. Additionally, the government could overshoot fiscal deficit with GST collections likely to miss expectations amid economic disruption due to the second wave.

Very little corporate spreads across the curve

Upgrade to downgrade ratio has bottomed out

Government borrowing could overshoot expectations

Overall, we are neutral between corporate bonds and G-sec.

Short-term Vs. Long-term bonds

A barbell strategy

The bond yield curve remains steep. Hence the term spread (difference between long-term and short-term yields) is attractive. With short-term bonds offering such low yields, one might be tempted to take a duration call. However, the macro environment doesn’t support taking high duration calls. As we have highlighted before we are at the bottom of the rate cycle and hence as interest rates rise longer duration papers will see higher capital losses. Additionally, government borrowing could exceed budgeted numbers leading to future pressure on yields. The overall asset pair score also underpins our view. The scores are in favour of short-term bonds.

Global bond yields have risen

Term spreads are attractive


Investors are looking for safety and stability when investing in debt. Hence given the expectation of capital losses in duration we continue to suggest keeping a large part of your debt investments in low duration, ultra-short papers that get repriced quickly and minimize capital losses as and when yields rise. Investors could maximize yield on the portfolio by investing part of the money in mispriced good quality AA/A rated papers, carefully selected high yielding debt and alternative assets like INVITs.

In our model portfolios, across profiles, we are reducing exposure to corporate debt funds which have net YTMs in the range of 5-6% and adding to INVITs which could deliver pre-tax yields in the range of 9-10%.

Gold Vs. Cash

Neutral, though gold can act as an inflation hedge

We highlighted how inflation is a key risk to watch out for given the sharp rise in US inflation in April and May. India also recorded a spike in CPI inflation in May. While the Fed and the RBI have played down fears of quicker than anticipated action by them, if inflation remains sticky, it will test their resolve. As we know gold tends to act as an inflation hedge. We saw that play out in May when gold rallied post the April US CPI inflation numbers. A sharp rise in inflation could hurt debt and if followed with lower growth even equity returns. Hence, some allocation to gold could help provide a hedge against inflation risk.

However, a decline in speculative position and reduced equity volatility is negative gold. Thus, tactically we are neutral gold.

Speculative position on a declining trend

Reduced volatility negative for gold

USD Vs. INR

Neutral

US dollar weakness has supported the INR this year. It has also allowed RBI to increase its FX reserves during this period. These FX reserves will allow the RBI to intervene in case of elevated INR volatility. However, a rise in commodity prices, particularly crude is a key risk to the Indian current account deficit and the INR. Global inflows have also moderated. Hence, we are neutral between the pair.

Rebound in crude prices a concern for the INR

Dollar weakness has supported the INR

Summary of Our Asset Model

Technical Commentary

The Nifty has been range bound, consolidating its gains between 15,450-15,900 levels for the last four weeks. As seen in the chart, Nifty is trading close to the support line of the long-term rising trend channel. While Nifty has moved below the channel now, the trend remains positive till it holds above 15,400 levels. On the upside, a move above 15,900 could suggest that the trend could continue towards 16,250 and then towards 16,500. On the downside, a break below 15,400 could lead to a test of 15,000 support levels.

BSE Smallcap has given breakout above its all-time high of 25,276 and we expect the uptrend to continue towards 26,392 and then 27,000 levels, while support is seen at 24,740 levels.

Globally, Nasdaq has given a breakout after consolidating in the range of 13,400 to 14,200 for four months. The next key resistance level is seen at 14,840.

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