Nov 16, 2016
“Give me control of a nation’s money and I care not who makes the laws.” – Amschel Rothschild
The demonetisation scheme caught the markets by surprise. The only comparable we can think of in analysing this event is a natural disaster analogy, a temporary but painful contraction in economic activity. First order reactions are invariably negative. When viewed from a larger perspective, however, these usually end up being barely identifiable blips in the longer term picture. For example:
Short Term Effects of Demonetisation
Longer Term Effects
A Much Needed Recapitalization of Public and Select Private Sector Banks Is a Strong Positive
Viewed from a perspective of assisting the banking system, this move is a masterstroke. Banks are being flooded with deposits and a consequent decline in NPAs as a percentage of assets gives stressed public banks a lifeline to work on diligently and efficiently addressing their bad loans.
Secondly, banks are benefitting from widening spreads and stand positioned to experience greater transaction velocity in coming months. We would expect a greater willingness on transmission of rate policy and multiplier effects on an incremental Rs. 2-3 lakh cr. base money. It’s not all positive. Fears exist about the impacts from the LAP and micro finance segments.
Additional Rate Cuts Coming
RBI policy is likely to be aggressively accommodative given the shock that the economy has just experienced. We’re looking for at least 50 bps in coming months.
Strengthening Fiscal Situation & Pro Growth Budget
Indian markets have experienced sell-offs similar to the one we’re witnessing every few months for the past few years. These have historically turned out to be good opportunities to deploy capital for investors with a medium term outlook.
We’ve been suggesting index returns would be muted for some time now, and that call has been accurate, albeit helped in large part by unforeseen events. We recommended investors consider hedging portfolios and take protective measures in early September (see “Global Turmoil & High Valuations“, Sep 12, 2016).
Attractive Valuations Now Available in Many Quality Stocks
While the market continues to be expensive at 21 times trailing earnings. Many stellar, quality stocks have seen 20%+ corrections and are now selling at reasonable valuations. Our fair value model is approaching levels that have historically led to attractive forward equity returns.
Greater Flows into Equities Longer Term, Bonds Shorter Term
A significant increase in flows is likely headed to financial assets away from real estate and cash. Bonds will gain in the shorter term, but we expect over the longer term, flows are headed to equities. While Gold benefitted temporarily, we believe the opportunity to use physical Gold as a warehouse of black money is likely on its last legs.
We’ve been calling for declining interest rates since late July (see “The Gambler’s Fallacy“, August 01, 2016) and recommending investors add tactical exposure to duration since July. The demonetisation could lead to structural change in the debt markets, with a potential substantial reduction in the fiscal deficit, pending clarity on the treatment of the extinguished notes by the RBI on its balance sheet as a windfall profit or a liability reduction with a matching asset offset.
Further, the spread between corporate bonds and G-secs has widened and we recommend exposure to income funds. Our call on the direction of interest rates heading lower stays unchanged.
Latest reported CPI figures came in at 4.2% YoY for Oct-16 vs. 4.4% in Sep-16, indicating continuing cooling of inflation. This was primarily driven by easing of food prices on the back of favourable monsoons this year, thus opening the way to further rate cuts and reduced inflationary expectations.
GDP Growth & Earnings
After a slow rate of GDP growth for the next couple of quarters, the subsequent two years could see a sharp revival in growth. Inflation could fall sharply alongside declining rates and accommodative policy.
We believe it will get far tougher to use cash transactions to purchase Gold. With that in mind, our view on Gold remains negative and we maintain our underweight Gold.
We expect transaction velocity to decline and rising stress in the sector. We believe the sector will be targeted with further reforms beyond the benami property announcement. We would avoid the sector.
Massive tax cuts are likely to lead to surplus wealth in the U.S., a portion of which will eventually find its way back to emerging markets.
Copper has exploded on high volume, and that’s indicative of a pickup in global economic growth prospects. The U.S. 10 year has sold off sharply, with rates rising, again an outcome we perceive as indicative of a rising demand environment.
Copper Prices Are a Leading Indicator of Future Economic Growth
A rotation out of U.S. Treasury Bonds Is Indicative of Improving Global Prospects
Our favoured sectors remain private banks, pharma, energy, capital markets, auto ancillaries, NBFCs, ex micro and LAP, we are evaluating IT anew, and PSU banks as a tactical trade.