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The Great Leveller

Mar 2, 2020

“The oldest and strongest emotion of mankind is fear, and the oldest and strongest kind of fear is the fear of the unkown”

Not ironically, the quote is by a horror fiction writer. And the past week

of equity markets may well have been scripted by someone like that. The newly identified coronavirus Covid19, that Bill Gates called ‘once in a century kind of pathogen’ evoked fear of the unknown in economists, investors and medical fraternity alike. Global equity markets sold off sharply as infection cases spread to Italy and escalated quickly thereafter. The pace of the selloff was brutal – the US S&P 500 index corrected 10% in just six days from an all-time high of 3393, the fastest 10% correction in its history. What liquidity giveth, liquidity taketh.

Performance of Key Global Indices

Performance of Key Global Indices

MSCI ACWI is now officially in a correction phase. Indian equities though, fared better relative to its Asian as well as key global markets. It’s relevant to point out that the Shanghai exchange has banned short selling, thereby shoring up the Shanghai Composite Index as well as those where it has a higher weight such as MSCI Asia-pacific and MSCI EM Index.

At the time of writing this piece, according to reported data, the number of new Covid19 cases outside of China, is for the first time, higher than in China. If an economy as large as China – 16% of global GDP- is at a near standstill for over a month, the global growth is bound to be impacted although the extent of disruption is hard to estimate. Initial revisions shave off 10-30 bps of global GDP growth for 2020, but one should expect more revisions to the number as more data flows. Also, while much is talked about the supply chain disruption due to the virus, we think there would be a material demand impact as well.

The response to Covid19 will naturally be a key determinant of the pace of growth recovery. As of now, it appears that the Chinese economy is more likely to have a sputter start than a kick start. The migrant workforce may not want to return to the factories when the perceived risk of infection / quarantine remains high. PBoC has taken some measures in terms of a 10 bps rate cut and liquidity infusion, but the economy will need a lot more support. Considering their narrow monetary latitude, PBoC will have to pull a rabbit out of the hat.

Performance of Key Global Indices

The Fed, on the other hand, has currently ruled out any pre-emptive rate cuts to protect the US economy from the anticipated supply shock. However, the market has already begun pricing in a rate cut on March 18, 2020. It is noteworthy that since Allan Greenspan was the Fed Chair (1987), the Fed has never defied market expectations as long as there is 60%-70% chance of a rate cut being priced in by the market. If that were to hold true this time as well, effectively, the rate cuts are likely to come through (currently at least two cuts this year are being fully priced in). Perhaps, as a reaction if not pre-emptively.

Closer home, we had begun the month on a reasonably optimistic note. It seemed like the worst of the macro cycle was getting behind us with improved print on IIP, PMI, Auto sales etc. The noise around weak business traction reducing incrementally. The budget didn’t have much for the immediate term but continued with reform push that should prove to be growth accretive in the long term. We were approaching the results season with some trepidation since in the previous several quarters disappointment had dominated the mood. The results were largely in line with market expectations (more details on this later). However, the adverse economic impact of Covid19 has put a dent to the optimism.

As per an economic vulnerability scorecard 1 , India is ranked 20 out of 26 countries implying low vulnerability to spillover effects from China. Dependence on Chinese imports centers primarily only around electronics manufacturing and pharmaceuticals and these may be impacted. On the other hand, oil prices moving down sharply (down 12.3% in Feb 2020) helps our economy. Our conclusion is that India although not insulated, could be a lot less affected than a lot of its global counterparts. Hence, only a dent in our optimism – achhe din got postponed.

Assessing impact granularly is a herculean task and also unlikely to be anywhere close to accurate. Hence, we rely on anecdotal evidence which suggests that a lot of companies have inventory to tide over until late March. If imports are significantly impeded beyond March, then pain could percolate in the following months. But it is pertinent to take stock of where we are, going into this. As mentioned in the opening paragraph above, in the recently concluded result season, the results were in line with expectations. One must be circumspect that the growth expectations were fairly muted. Markets were hoping for lower provisions by banks and some boosters from debt recovery to land at a respectable earnings number. The hypothesis indeed played out.

Performance of Key Global Indices

Softer raw material prices helped improve operating profits despite lukewarm topline growth. We expect this to continue in the next couple of quarters too as global raw material prices have been correcting further. BFSI and Consumer drove the earnings, while Metals dragged the aggregates. Prior to the covid19 outbreak, earnings recovery was expected to be faster off a low base in key sectors.

1 Nomura Anchor Report, Feb 17 2020.

Performance of Key Global Indices

Until the coronavirus scare, the market consensus was of a 24% growth in Nifty but now these numbers will need some heavy handed revisions.

Our portfolio management strategies continue to deliver alpha through this tough environment. We had raised some cash in all the three strategies as precautionary measure. We will redeploy the same as the on-ground situation gets clearer or valuations correct sharply.

On the portfolio construct, Indian Titans currently has 61% large cap and 32% mid & small cap while the balance 7% is in cash, while in Indian Olympians as well we are currently holding 7% cash in the portfolio.

Performance of Key Global Indices

Performance of Key Global Indices

Performance of Key Global Indices

Seamless credit flow in an economy is an essential tool for growth. Post the IL&FS debacle the confidence in the credit market has been very fragile. To aid credit flow, the RBI followed up its use of unconventional measure (viz Operation Twist) with LTRO. This means that the RBI will make cheap credit available to banks for one to three years. Combined with ample liquidity and encouragement/nudge by the government we see banks appetite to lend gradually improving. This could eventually help the credit market return to some sort of normalization.

Technical Trends

The Nifty was down by 7.28% for the week and for the month of February down by 6.36% to close at 11,202 levels. Broader market indices BSE Midcap and BSE Smallcap were down by 5.57% and 6.54% for month respectively.

The Nifty has been in decline mode since it touched all-time high of 12,430 in January this year. Last week index broke key support levels; post budget low of 11,614 with a gap and 200 day moving average. Thus, indicating medium term trend is also down. Now immediate support is seen at 11,000 odd levels where rising support trend line connecting low of 10,004 and 10,670 comes on weekly chart. Below 11,000 levels next support zone 10,780-10,637 where August-September 2019 lows are seen.

On weekly chart, Nifty sequence of higher tops and higher bottoms is yet to be broken. Thus, 10,637 will be critical on level on the downside. On the upside Friday’s falling gap area of 11,384-11,536 will the resistance zone. For sustained uptrend to emerge Nifty needs to start trading above 11,650 levels on sustainable basis.

In Nifty March series monthly options, maximum open interest for Puts is seen at strike 11,800 followed by 11,700; while in Call options maximum open interest is at strike price 12,000 followed by 11,800. Significant call writing was seen strike price 11,500 suggesting as resistance level for the market. India VIX measure of volatility has seen major spike as coronavirus fears griped the market. It closed at 23.23 levels, up by 70% for the week. VIX has seen fresh breakout above 17-18, thus expect volatile swing in the market going forward also.

Performance of Key Global Indices

Outlook

Equities: We have been running neutral weights on our equity portfolios in light of weak macro and fundamentals but strong technical trends and liquidity. Pre-outbreak we were deliberating increasing our equity weights considering fundamentals have stabilized and there was evidence of the macro cycle bottoming out. With the news flow around covid19 some of these bases are impacted temporarily but additionally technical trends of the market have weakened. Rather than choosing to underweight equities, we are choosing to buy the dips and add to companies with robust fundamentals.

Fixed Income: Improving macro fundamentals and RBI’s persistent focus on rates transmission nudged us to evaluate credit opportunities. Also, since the flow of money into these opportunities is more like a trickle yet, we see more debt covenants favoring the lender. This is a big change from late 2017 when lot of money chased credit opportunities and credit structures were covenant lite. Prior to the covid19 outbreak we were of the opinion that the AAA curve was almost juiced out. But with global central banks likely to cut rates in an attempt to support growth, we are reviewing our stance. We now think there could be some more steam in the higher rated credit curve and hence shift to higher yield opportunities could be calibrated and gradual.

Gold: While we do believe that key central banks will support growth through looser monetary policy, we also note that the ammunition in their arsenal has been gradually reducing since the GFC (Global Financial Crisis). If the covid19 outcomes are harsher than expected, gold will have a significant melt up. With so much uncertainty surrounding us, it seems like a clear bet to overweight. The technical trends also seem to favour the decision. We are following suit in our model portfolios. We are trading in short term debt/liquid for further overweight in gold.

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