Jun 11, 2018
“It is a capital mistake to theorize before one has data. Insensibly one begins to twist facts to suit theories, instead of theories to suit facts” – Arthur Conan Doyle, Sherlock Holmes
The Recent Market Sell-off
Last week had many market participants shaking their heads in bewilderment on the nature of the sell-off. The index (Nifty 50) held its ground and stays within striking distance of all-time highs, while 931 out of 1305 stocks – or 71% of all stocks – in the broader market are down over 20% from their recent highs.
Key global reasons for the sell-off are the foreign institutional selling as a result of a stronger dollar, the Fed’s aggressive balance sheet reduction, and rapid acceleration in U.S. treasury issuances which are withdrawing liquidity from emerging markets. Domestic reasons were the SEBI mandated reclassification of funds which has led to large cap funds unloading mid and small caps, and the additional surveillance measures (ASM) which reined in rampant speculation and leverage in the names on the list. We could add a final factor, which is media reports of sub-par profit growth at an aggregate level. What’s critical to note, however, is that none of the factors listed are related to the domestic economy’s fundamentals.
A Comparison of the Current Cycle Indicators With Prior Cycles
Valuations and Peaks
We compare current indicators with indicator values at prior stock market peaks. As is clear from the data below, valuations today are amongst the highest ever. Alongside peak valuations, we would normally expect to see peak earnings, as was the case in 2007 and 2010. However, earnings remain depressed. Even eliminating PSU loss making companies leaves us with 13% earnings growth, nowhere near the peak 20%+ EPS growth we witnessed in 2007.
RBI Policy Remains Benign…
We compare the number of rate hikes and quantum of interest rate increases across rate hike cycles back to 2007. The 2008 Great Recession was accompanied by 9 RBI repo rate hikes, and the 2011 correction was accompanied by 13 rate hikes. In both cases, raising interest rates by a collective 300 bps+ led to severe corrections. The RBI continued to hike rates well into the recession in 2008. Today, an elongated rate hike cycle is not in the cards.
Today’s Peak Valuations Are Not Accompanied by Peak Earnings Growth…
Today’s RBI Monetary Policy Remains Benign and Neutral…
…Versus 9 Hikes in 2007 and 13 Hikes in 2010
10 Year G-Sec Yields Are At Levels Where Prior Peaks Occurred…
But Massive Domestic Flows Are What Possibly Makes This Cycle Different…
…Overwhelming FI Flows Since 2015
Crude Oil Is Manageable at Current Levels Versus Prior Peaks at $88 – $103…
…and the CPI Is a Far Cry from Days of Double Digit Inflation
PMI Manufacturing and Services Are Mired in Sluggish Growth…
But Bank Credit Is Strong…
…IIP Is Suggestive of Sluggish Growth
While Passenger and Commercial Vehicles Sales Are Soaring…
Current Government Spending & Capital Formation Is Strong …
But Petroleum Consumption Is Sluggish…
Ten Year Yields Remain at Levels Similar to Past Market Peaks
While absolute levels of G-sec yields have stayed consistently around the 8.0% level, we were a bit surprised to note that yields continued to rise in each cyclical top post the equities peak. Unlike traditional equity bond relationships, bonds have peaked post equities in recent corrections. Today, there is limited confirmation that bonds have peaked yet.
Yet Again, We Find Foreign Institutional Flows Steadily Declining in Importance
FIs sold INR 65,000 crores in 2007 and their selling was less severe at INR 28,000 crores in 2015 and 2016. Recent data suggests FIs flows this year have moderated considerably. In comparison, domestic investors have pumped INR 250,000 crores into equities since 2015, in a consistent manner, or 4 times the FI flows, and the pickup in DI buying since 2015 versus the prior cycles is a significant recent development.
Crude and Inflation Remain Manageable
Brent crude hit $88 – $93 during the 2007 and 2010 market peaks, and $104 at the top in 2013. Clearly, crude has been a non-factor in recent times. With shale supply, rising U.S. production, and OPEC making noises about increasing supply, combined with a decline in demand out of China and India, it looks unlikely that crude will hit $90 this time around.
Manufacturing and Services Are Showing Average Growth Only
We had many high growth quarters in the 2000s, and late 2010 as well. With PMIs barely staying in growth, the economy is nowhere near over-heating.
India’s Economy Remains Generally Healthy
While a case can be made for a garden variety cyclical correction, and arguably we’ve had that already, there is nothing to suggest an over-exuberant, over-heated economy today that is similar to 2007 or 2010. We’re a long way away from double digit inflation. 2007, 2010 and 2013 were hit by crude and valuations, while 2010 and 2013 saw the double whammy of a crude oil price shock and runaway double-digit inflation, with food and vegetable inflation getting up as high as 16%.
The economy remains healthy, particularly on government spending and consumption, with hopeful signs that private investment is coming forward. Inflation today is half the rate it was at prior cycle peaks. Crude is much lower than levels that led to past market peaks. There is no evidence that the economy is over-heating; rather, sluggish growth is the appropriate metaphor.
Auto, credit and consumption sectors remain strong, and rural looks to be recovering steadily. What explains the strength in credit, spending, and auto sales? Simply, we think credit and demographics. The majority of India’s population is in its peak spending years.
Elections and Markets
The current worry du jour is elections. Yes, no one wants to revisit the high inflation days of old. However, significant wealth has been created across all rolling 5 and 10-year periods. We continue to remain in a structural reform and demographics driven bull market. The recovery is sluggish, choppy, but remains a recovery nonetheless, and recent momentum in earnings and sales is a positive sign.
The risk to our forecast is an aggressive central bank policy, with regular rate hikes that would reliably kill the nascent recovery.
Given the recent weakness in data, the RBI had a difficult choice between favoring the nascent recovery, or targeting inflation and reducing vulnerability to EM outflows. The RBI chose the latter, despite projecting CPI inflation in the range of 4.7-5.1% for the first half of FY19, and declining to 4.4% in H2. It was a non-consensus decision, particularly in light of a contracting Services PMI and other recent data that showed a slightly weaker trend. The decision to move to neutral was important and a welcome announcement for markets.
Core CPI rose to 5.3%, suggesting that there has been some evidence of rising inflationary pressure, possibly driven by rising crude and commodities. The PMI report also highlighted rising input cost pressures. With the rate hike, and CPI projections within the glide path at 4.8-4.9%, the RBI moved to a neutral bias. Wage growth remains muted, and there are limited labor cost pressures. Rather, respondents have highlighted rising worries about job prospects. The recent trend in crude is lower as well.
Upside risks clearly remain. The 10-year hit the 8% mark last week, and the rise in borrowing costs for the government will further impede the fiscal math. Currency depreciation and capital losses in bond holdings coupled with the rise in global yields, also led to FPI outflows. The lack of interest from foreign institutions means yet another buyer of debt has backed away from debt investments. With a backend loaded financing schedule, a fair bit of uncertainty remains in the bond markets on the financing requirements of the government.
The RBI also decided to hike the Liquidity Coverage Ratio (LCR) carve-out from the Statutory Liquidity Ratio (SLR). RBI highlighted that scheduled commercial banks have to reach the minimum Liquidity Coverage Ratio (LCR) of 100% by January 1, 2019. This means banks can hold a lesser amount of G-Secs, which will reduce the demand for G-secs. It will improve the liquidity in the system and will pull down interest rates on CDs that are used for short term holdings.
The spread between the repo rate and T-bill has been signifying the short-term market is pricing in more rate hikes. Bond yields continue to make gradual new highs. While the bond market is factoring in one to two additional rate hikes, a 75 bps hike in borrowing costs, alongside high crude oil prices at the pump, will meaningfully dent disposable income.
Central bank forecasts have been unpredictable and volatile of late. We continue to favor corporate credit – accrual funds – over duration and prefer short end over long on a risk reward basis.
After the gap down opening on Friday Nifty managed to recover its losses to close flat for the day at 10768 levels. On weekly basis it managed to eke out gains of 0.7%. For the fifth session in last couple of weeks index has been facing resistance around 10770 levels and unable to hold above it. Nifty is seeing buying coming on declines, but on upside lacking strength to clear overhead resistance. Sustaining above 10770 levels on tradable basis expect Nifty to rally towards 10860 where the falling resistance trend line connecting highs of 11172 and 10929 is seen. Above that next level is seen at 10929 levels which is the May month high. On the downside immediate support is seen at 10690 levels, breaking below which, we expect market to test 10550 levels. Below this level next support is at 10420 odd levels which is now crucial level for the market. India VIX measure of volatility has seen decline of 6.4% for the week to 12.69 levels has been supportive for the market.