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Implications of a weaker currency

Sep 3, 2018

Should Investors Just Buy the Top Performing Large Caps and Be Done?

Before we get to the Rupee, we’d like to briefly share some thoughts on recent market performance. There was a time as recently as a year back, when investors required a 4-5% outperformance by an active manager over the Nifty 50 as a pre-requisite for considering a fund. How the tables have turned. After years of underperformance, an awakening of business titans Reliance, TCS, Unilever et al, which for years had remained dormant, and legitimate earnings delivery have led to the Nifty decimating most active managers.

Year to date, only four stocks – Tata Consultancy, Reliance Industries, Infosys, and Hindustan Unilever – have contributed over 100% of the Nifty 50s return. Most investors know the details and we’ll skip them. So why not just buy the top 10 or 15 quality large caps and be done? That’s a rational thought, one that we’re guessing has occurred to investors.

Does A Buy and Hold Large Caps Strategy Outperform?

To answer this question, we start by noting that, TCS stayed range bound at 1400 for over 3 years while most of the market roared higher. Reliance Industries languished around 500 for years before beginning its explosive move. Similarly, Hindustan Unilever and Infosys languished for years. Pharma was a can’t miss sector. One could have bought Sun Pharma to hold, and watched the holding plummet from 1140 to 440. Buying the highest quality large caps would have delivered decent returns, but not market trouncing returns. Back of the envelope calculations have large caps returning 17.5%, even excluding Sun Pharma, versus 16.0% for the index. Or you could have bought the Nifty midcap 50, and made 24.2% over the period, albeit with gut wrenching volatility. Yet again, a diversified portfolio of large and mid delivers the optimal risk adjusted return.

Even The World’s Most Successful Investor Under-performs the S&P 500 40.3% of the Time

Large Cap Performance Is Only a Recent Phenomenon…
…A Large Cap Portfolio Would Have Barely Beaten the Nifty 50 Over 5 Years…
…While Significantly Underperforming a Diversified Portfolio By 7-8% Annually

Active Managers Underperformance

Some investors will be quick to write off active managers for underperformance – we’d term it short terminism – and eager to switch to the new hot fund. Here, we bring in the Oracle of Omaha’s track record. It turns out the world’s richest and most successful investor has underperformed the S&P 500 40.3% of the time, when comparing daily six month rolling returns versus the index. No manager will outperform the index all the time; however, manager skill will be increasingly critical as we move forward and dispersion of returns is likely to remain wide.

As an aside, it’s interesting to note that Mr. Buffett’s performance skyrocketed during the crashes in 2000 and 2007. Clearly he lives up to his rule #1, Don’t Lose Money. Looking at the chart, we’d guess he was hedged, in cash, or defensives heading into those sell-offs and actively timing the market top.

Implications of a Clear Breakout by the Rupee

While the GDP print of 8.2% will grab headlines, it’s a rearview number. What’s more important in our view is that the Rupee has made a clear break out to an all time low versus the dollar and is one of the worse performing currencies this year. The follow up questions are: 1) How have equities performed during periods of a depreciating Rupee, and 2) what sectors outperform and underperform during these periods?

Mid and Small Caps Look Particularly Vulnerable in Depreciating Currency Scenarios

We looked at the three episodes in 2012, 2013, and 2014 where the Rupee was depreciating. The Nifty 50, and large caps, managed reasonably well, exiting each episode with a less than 10% loss or small gains (see table below). Mid caps had significant and painful sell offs in 2011 and 2013, but attractive gains in 2014. While definitive statements can’t be made because each cycle is different, clearly this suggests caution with respect to mid and small cap exposure until currency depreciation stabilizes.

Sectoral Preferences Clearly Favor IT, FMCG, Pharma and Reliance Industries (Energy)

IT and Pharma clearly benefit from a depreciating Rupee. FMCG benefits due to the inelasticity of demand for fast moving goods, and ability of most FMCG companies to pass on price rises. Year to date, these are in fact the sectors that are outperforming, along with Energy. With respect to Energy’s surprising outperformance, one need look no further than Reliance’s 60% weight in the index.

A Clear Breakout by the Rupee

A Clear Breakout by the Rupee

Markets Have Not Done Too Badly During Periods of Depreciation…
…But It’s Minor Selloffs & Not a Bloodbath for Large Caps, and Mixed for Mid & Small

Markets Have Not Done Too Badly During Periods of Depreciation

Pharma, IT and FMCG Are Clear Beneficiaries of a Weaker Rupee…
…While Metals, PSU and Realty Are Consistent Underperformers

Pharma, IT and FMCG Are Clear Beneficiaries of a Weaker Rupee

Looking at Year to Date Performance, IT, FMCG, Private Banks and Energy Are Top Performers…
…While Media, PSU, Metals and Real Estate Have Underperformed…

Looking at Year to Date Performance, IT, FMCG, Private Banks and Energy Are Top Performers

Year to Date, Large Caps Continue to Dominate Returns…
…While Midcaps Have Shown Signs of Recovery Over the Past Month

Year to Date, Large Caps Continue to Dominate Returns

Outlook

We were early proponents of structural benefits from reforms coming through at a lag. The thesis seems to be playing out. We’ve also been bullish on equities for a few months now, after being bearish late last year into early this year. With a 1000 point rally in the Nifty 50, it’s a good time to reassess where things stand.

Macro Concerns Loom, Particularly Around the Fed and Crude

Global and macro concerns are worth monitoring; in particular, the depreciating currency and the potential for a rise in crude. EM outflows, Fed balance sheet contraction, Fed rate hikes remain headwinds. Demand for crude remains strong, alongside production declines in Iran and Venezuela, and Permean basin woes on water and infrastructure, as well as late cycle global commodity dynamics.

Weak Currency Policy a Concern

Recent data suggesting the RBI stayed on the sidelines while the Rupee depreciated suggests that a strategy of maintaining export competitiveness vis a viz other emerging markets could impact domestic growth prospects. Not only does a weaker currency decimate FI returns, it creates a vicious cycle of further selling and dissuades FIs from investing in India, while importing inflation. A double whammy of crude and currency can be a worrisome combination. Already, however, we are witnessing the highest ever diesel prices. Financial debt has recently risen in domestic consumer balance sheets, and the potential to further weaken domestic disposable income remains. Should crude rise or the currency weaken further, consumer disposable income will get impacted by rising EMIs, fuel prices, inflation and rate hikes.

Good earnings this quarter have already raised expectations for the current quarter and beyond. The key to all this may be whether strong domestic flows are structural in nature or taper off at some point. As long as domestic flows remain strong, it’s entirely possible that we get through the currency weakness and crude risks. However, should crude or the currency worsen further, the RBI will likely be forced to raise rates later this year.

Market Technicals Weak

Technically, market breadth has been narrowing, but flows remain robust. Should the twin concerns on crude or currency worse, we’ll implement hedges. Investors should follow a similar strategy, and continue to review investment portfolios, with a willingness to lock in profits and pare equity allocations should either of these concerns worsen.

Fixed Income

We Remain Wary of Global Outflows, Rising Global Inflation, Rising Domestic Inflation

The rationale outlined for equities percolates to Fixed Income as well. Should crude rise from these levels, or the currency weaken further, the RBI will have to raise rates further.

FI Debt Investors Likely Remain Sellers

Nothing dissuades an EM foreign investor like a falling currency, that wipes out local currency returns. This alongside balance sheet contraction, trade wars and rising rates, will likely have FIs stay on the sidelines.

Liabilities of state governments have risen in double-digits since 2012-13 and a large supply of SDLs has led to a hardening of yields. The spread between state government loans and central government bond has increased from 38 basis points in 2014-15 to 59 basis points in 2017-18.

Recognizing rising state borrowings, and the government’s aggressive spend recently, the bond market has bounced back to levels above 7.95 on concerns around fiscal consolidation, inflation and rising rates. Higher borrowings from the Centre and states also threaten to crowd out corporate borrowers from the market. The hardening of yields feeds into inflation through input costs, further increasing yield levels, thereby creating a vicious cycle.

We recommend ultra short and low duration corporate bond funds.

Technical Outlook

The Nifty touched new all-time high of 11760 last week and finally settled at 11680.5 levels. Index saw some profit booking coming from higher levels, but managed to hold above the rising support trend line connecting lows of 10558, 10946 and 11340 levels. Nifty has formed longed legged doji candlestick pattern after some decline suggesting indecisiveness in the market and the short term decline may be over. Thus, holding above 11640 levels expect the rally to continue in the market initially towards 11845 levels. Considering breakout above previous its all-time high of 11172, index can continue towards 12000 levels. On the downside immediate support is seen at 11640 levels, breaking below which market can see profit booking towards 11500 levels. In Nifty options, 11600 has highest open interest followed by 11500 and Put writing good addition was seen 11500 to 11700 suggesting supports are shifting higher. For Call options, 11800 has highest open interest followed by 12000 and considerable amount of Call writing was seen 11700 to 12000 suggesting resistance at higher levels. Thus, market could see range bound action if it fails to take out 11760 levels on the upside.

Nifty Daily Chart

Nifty Daily Chart

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