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Dec 9, 2020

Global Macro and Equities

As Covid19 vaccine inches closer to reality for millions of people, it feels like normalcy is back in the line of sight. One may argue that globally cases are still rising, but lower fatalities in the current wave is a respite.

We are seeing signs of a return to normalcy in economic activity as well. Global industrial output recovered further, and economic surprises stayed positive. MSCI All Country World Index earnings revision remained positive and the expectations are for earnings to grow at 24% in 2021 after a contraction of 17%-19% expected in 2020.

The positive sentiment was echoed by global equity markets with all 40 markets gaining in November and delivering the second-best month in 25 years. Commodities joined the cheer with the GS Commodity index running up 13% in the month. Precious metals, however, retreated as portfolios get geared for growth over safety.

However, there is a flip side to all this cheer. Globally, services continue to struggle, and localized lockdowns / self-imposed mobility restrictions are on the rise. Of the top 30 global cities with most depressed traffic congestion , 20 are in the U.S. – the largest consumer of the world. All this indicates that the recovery is still fragile.

With the rally in equity markets, we believe the market continues to be ahead of fundamentals and valuations continue to stay rich.

Notwithstanding all the court cases, as the Biden team prepares for transition, nominations for key positions are being announced. Notably, Janet Yellen for U.S. Treasury secretary. A labour economist, criticized for holding rates too low for too long during her tenure as chair of the Fed Reserve, is known for social programs and liberal monetary stance. Her appointment is also an indicator of the Biden camp’s keenness on bringing down unemployment – one of the key issues plaguing the U.S. economy.

Covid-19 and policy response to it around the globe has deepened inequality which could have a damaging effect in the long run.

Domestic Macro and Markets

In line with the globe, domestic economic indicators too are normalising. Q2FY21 GDP growth contracted less than expected at 7.5%. To put things in context, at end of November, 49 economies had declared GDP for the same period and the average decline is 12.4%.

Agriculture, manufacturing, utilities delivered growth whereas expectedly, hotels, transport, financial services and real estate contracted. At a time where fiscal stimulus is absent, a sharp contraction in government spending at 22% came as a big surprise.

The RBI in its monetary policy held rates steady as expected and guided for the accommodative stance to continue into the next financial year. In the recent past liquidity glut has caused short term rates to crash below the reverse repo rates (i.e. Non-banks are lending to borrowers for the short term at rates lower than what banks ‘lend’ to the RBI). Therefore, market participants were expecting some mechanism to be announced that would absorb some of this liquidity and put a floor to short term rates. However, the policy statement was ambiguous on this account and merely mentioned the use of all possible tools.

Quarterly Asset Pair Allocation Update

As most of the quarterly macro data releases came through and the corporate earnings season concluded we ran our proprietary asset pair model that serves as a guide for tactical asset allocation adjustments. The score for equities has moved higher, while the score for gold has moved lower. Therefore, we cut our 5% overweight on gold to 2.5% and add the 2.5% to midcap equities across profiles.

Equities VS Bonds

Earnings and Macro improving, though valuations quite expensive

Industrial production turned positive in Sept 2020

PMIs have witnessed strong growth

Normalising economic activity and market share consolidation is visible in better than expected corporate earnings for the quarter ended September 2020. For the past quarter, 37 out of 50 nifty companies reported a positive revenue growth on a year over year basis. Cost controls have helped EBITDA margins (ex-Financials) expand 310 bp YoY to 19.8%. Notably, BFSI share in Nifty profit pool has now increased to 26%.

A combination of a low base, revival, lower NPA provision and return to profitability of some firms has resulted in sharp earnings upgrade. Sectors such as telecom, metals, auto and banks are likely to see a rise in profitability after many quarters of muted profits or losses. Several management commentaries too are upbeat. We are seeing these earnings upgrades, after 23 quarters of consensus earnings downgrade!

Sharp upward revision in earnings

More positive earnings surprise than negative

We are cognizant that a sustained uptick in commodity prices may actually put some pressure on the margins. But several sector leaders are consolidating market share and a demand revival leading to improving top-line may mitigate some of the pain from margin pressure.

A global reflation/risk-on trade and MSCI rebalancing led record quantum of foreign inflows into Indian equities. However, this has been offset to some extent by the sustained selling from domestic institutional investors (DIIs) this fiscal year.

Foreign Investors net buyers, DIIs net sellers

Equities expensive relative to bonds

Equities have rallied hard since the March 2020 lows. And with new all-time highs over the last few weeks, technical momentum is in favour of equities. (More on this later in the technical commentary section). However, this has made equities expensive across measures – trailing PE, forward PE, PB and market cap to GDP. See valuations table in the earlier part of the commentary

As is true for most global equity markets, Indian equities too are richly priced even after factoring in recovery in macroeconomic data and earnings. While liquidity and momentum favour equities, we have to weigh in the risks as well. We are therefore increasing our position only marginally.

November witnessed huge style and sector rotation globally as well as domestically. We expect this trend to continue over the next few months.

Large Cap Vs. Midcap

Midcaps neutral

Markets through 2019 were polarized and the trend continued through the early months of 2020 as well. However, the rally has broad-based itself in the past few months. 182 of BSE-200 constituents gained in November 2020, with 116 stocks posting month-on-month gains in excess of 10%. This makes both the segments i.e. large-cap and midcap indices richly priced. However, there is sharper earnings upgrade in the midcap segment. There are several smaller sectors, wherein the sector leaders are consolidating their market share e.g. appliances, pipes, sanitaryware, etc. Some of them even clocked all-time high margins in the past quarter. Such sector leaders offer relatively better investment opportunities. We are therefore adding 2.5% weight to midcaps and bringing the overall midcap weight to close to neutral.

Large caps are expensive

Midcaps equally expensive

Sharper earnings upgrade for Midcaps

Fixed Income

Corporate Bonds VS Government Securities

Corporate spreads have plummeted, but government borrowing remains a risk

After the dislocation in March 2020, corporate bonds have been rallying and consequently spreads have compressed sharply. There are very little spreads left especially in the good quality AAA/AA papers. Lower rated, mispriced papers have also largely aligned. The upgrade to downgrade ratio however remains unfavourable. Therefore, credit opportunities continue to be of interest only to a small discerning class of investors.

Very little corporate spreads across the curve

However, downgrades outpace upgrades

On the other hand, elevated government borrowing is a major risk for government bonds. Despite government assurances that they will not exceed the borrowing target (revised in May 2020), the fiscal math doesn’t add up. While GST collections crossed INR 1 lakh crore in October and November, overall revenue collections are behind the target. As mentioned above, the government spends have sharply contracted. However, in the absence of cash transfer and direct stimulus, a pro-growth stance needs the support of government spending. Else the government risks a slower recovery. Markets have therefore been expecting higher borrowing either from state governments if not central government. Either way, an increased supply of government bonds is expected. The RBI would have to step in to absorb a big part of the supply if they desire to flatten the yield curve.

Government borrowing likely to increase

Short-term VS Long-term bonds

Term spreads attractive, but duration call has its own risks

With limited corporate spreads, one might be tempted to look at duration. In our view, that call has its own risks. As highlighted above elevated government borrowing is a major risk. Additionally, consumer (CPI) inflation has now exceeded RBI’s upper target of 6% in 10 out of the last 11 months. The RBI has maintained that inflation persists due to supply chain issues and should normalise over the next few months. But with commodities and food prices rising, we believe, the RBI has limited head-room available to ease rates further.

Inflation exceeding RBI’s target range

Term spreads are attractive

Currently, there is an attractive carry in the 6-9-year bucket but should be played only tactically. We remain neutral between short-term and long-term bonds.

Gold VS Cash

Still overweight Gold, but to a lesser extent

Loose monetary policy (U.S. money supply M1 had its biggest monthly jump in November), fiscal intervention, the expectation of USD weakness and a huge supply of negative-yielding bonds continue to be supportive of gold.

On the other hand, as global reflation takes hold, safe-haven assets don’t offer as much value. Also, with Joe Biden as the President-elect of U.S., expectation is that the geopolitical rhetoric would reduce even as Joe’s U.S. continues to negotiate with China on trade.

Monetary easing here to stay

Gold ETF holdings have declined

Thus, the overall score is still in favour of gold, but to a lesser extent than earlier.


Weak dollar, fundamentals suggest INR strength

After a bounce in September and October, the dollar index has remained sideways. Given the loose monetary policy in the US, the dollar is expected to remain weak relative to other currencies. This could bode well for emerging market currencies like the INR. Other fundamental factors are also in favour of the INR. Crude oil prices continue to remain low. With OPEC countries not being able to come to an agreement on the supply cut, crude could remain at low levels going forward as well. This is positive for India’s current account deficit and balance of payments as crude is India’s largest import.

Lower crude oil prices positive for the INR

Dollar weakness to support the INR

The RBI has also used dollar weakness to build up India’s FX reserves, which have touched new all-time highs. Strong FX reserves will allow the RBI to intervene in the market in case the INR faces bouts of volatility. Foreign inflows into equities and foreign direct investments have also supported the INR.

FX reserves at an all-time high

While technical momentum in favour of the INR has moderated, fundamentals support the INR. Hence, our asset pair scores are in favour of the INR vs. the USD.

Summary of Our Asset Model

Portfolio Strategy Commentary and Actions

While the growth in earnings at index level may not look that appealing, there are always companies growing faster than the index that investors can bet on in order to generate alpha. While managing our in-house strategies, our endeavour has always been to invest in businesses with above-average growth potential. Whether it is through companies operating in high growth industries or through gain in market share from peers or both, the bottom line is to identify companies with superior and sustainable earnings growth along with high return on capital. This is very evident from the growth reported by our portfolio companies over the past several quarters.

Sanctum Indian Olympians Vs Nifty

Operating Profit growth

Sanctum Indian Titans Vs Nifty

Revenue Growth

Operating Profit growth

Strong earnings growth in our portfolio companies has supported the outperformance in our in-house strategies over longer time horizons. Both Sanctum Indian Olympians and Sanctum Indian Titans have outperformed their respective benchmarks over the 1 and 2 year time horizon. We believe, superior portfolio earnings growth relative to the benchmark will continue to support the performance going forward as well.

In Sanctum Smart Solutions, financials were key contributors led by Bajaj Finance. Other standout performers in the portfolio were Info Edge, Divi’s Lab, HDFC Life and Tata Steel. Our weights in consumer discretionary and speciality chemicals also contributed positively. However, the underperformance of Reliance, pharma and IT hurt the performance. Also, to avoid any event risk around US elections, we had hedged the portfolios in November. As markets reacted positively to Biden’s win, the hedge cost the portfolio some performance.

Coming to portfolio actions, markets ran up sharply in November and appeared ripe for some profit-taking. Since addition to Sanctum Indian Olympians just about a month ago, MRF has rallied more than 30%. We believe markets are now pricing in growth expectations materially higher than what we believe the company is likely to achieve. Hence, we decided to take money off the table. We may re-invest in this company in future if we find justified valuations. In Sanctum Indian Titans, we have not made any significant portfolio change.

Technical Commentary

After being largely sideways for a couple of months, markets rallied hard in November with Nifty gaining 11.4%. The rally was led by the index heavy weight – banks. Bank Nifty was up by almost 24%.

The Nifty continues to hit new highs as dips continue to get bought into. The next resistance is about 3% away, a break of which could suggest a move toward 14,580.

After consolidating between 18.35-25 levels, India VIX closed at 18.0, a new low. Thus, with volatility and uncertainty easing further gains are likely. Broader market indices BSE – Midcap and Smallcap have picked up momentum in the last four weeks and have been outperforming the Nifty. Both indices have decent room for growth before the next resistance level.

Bank Nifty and Nifty IT are close to key levels. If Bank Nifty can sustain above 30,200, it could move towards 32,613 (8% above current levels). Similarly. Nifty IT is also close to its all-time high of 22,619. A break above could support a rally toward 23,929 (6.6% above current levels).

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