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Oct 29, 2018

We simply attempt to be fearful when others are greedy and to be greedy only when others are fearful. – Buffett

Massive Selling Occurred in Early October But Is Abating

September and October have witnessed the largest selling of equities over the past couple of years. Of late, the selling has abated. Meanwhile, the selling has pushed mid-caps into a bear market alongside small caps. The Midcap 100 is down 25.2% from its peak in Jan ‘18, and down 22.9% YTD. The NSE Small cap 100 is down 40.0% from its peak, and 36.8% YTD. 88% of companies in the NSE are down at least 20% from their 52-week highs. Almost one third, or 31.9%, are down over 50%. Massive damage has been inflicted on equities.

As a consequence, valuations are coming back to reasonable levels. Almost half the companies in the NSE universe, 47.9%, now have a trailing P/E under 20x, while only 22.9% sport a P/E above 30x. Over a third of midcaps (36%) now have a P/E under 20x. One third of the NSE now sells at a PEG less than 1x versus their 3 year PAT growth rate, and 41% have a P/E less than their YOY PAT growth rate.

Quarterly Earnings Update

With 109 NSE 500 companies reporting to date, the numbers are impressive. Sales growth is currently trending at 25.3% yoy for the NSE 500, with 12.9% yoy operating profit growth, and PAT of 14.6% yoy, highlighting the impact of rising crude. Profit margins are at a healthy 11.3% net margin, with only Industrials showing weakness. It’s early, though, and generally the better earnings reports come through in the first third of the reporting season.

India Drives Amazon International Earnings

India’s strong earnings performance has highlighted the divergence in growth between India and developed economies. Despite a massive tax cut, U.S. companies have reported generally below expectation numbers. It’s particularly telling when Amazon blames its weak international sales on the Diwali schedule in India this year. With China in the doldrums, India is the growth engine for the world.

Massive Selling Happened in Early October, Net Volume is Stabilizing of Late

Massive Selling Happened in Early October, Net Volume is Stabilizing of Late

A Strong Start to Earnings Season with 14.6% PAT Growth and 25% Sales Growth…
…Led by Energy, Consumer Staples, Financials, Health Care and Real Estate

A Strong Start to Earnings Season with 14.6% PAT Growth and 25% Sales Growth

Global

With unilateral sanctions on Iran, a trade war with China, Fed rate hikes and central bank balance sheet contraction, the blame for a slowing global economy can be put squarely on developed world policies. Ironically, the predominance of worries are now related to developed markets. The U.S. yield curve came within 21 bps of inverting in the past month. While U.S. high yield isn’t indicating a rise in risk, global growth has clearly slowed. Leading economic data out of Germany, South Korea and China has slowed, and the global OECD leading indicator is also at stall speed. It’s not all bad news, however, as global PMIs for Manufacturing and Services remain in growth.

As usual, Brent remains in the thick of things. Recent news on disappointing profits of shale producers will only serve to give impetus to speculators on crude oil, which will be offset by global demand deceleration.

The U.S. is Staring At a Slowdown with Short Term Rates Rising and the Yield Curve Flattening…

The U.S. is Staring At a Slowdown with Short Term Rates Rising and the Yield Curve Flattening…

The Global OECD Leading Indicator Is Also Highlighting a Slow Down …

The Global OECD Leading Indicator Is Also Highlighting a Slow Down …

It’s Not All Bad News, Global Services & Manufacturing PMI Are Still in Expansion Zone, But Slowing…

It’s Not All Bad News, Global Services & Manufacturing PMI Are Still in Expansion Zone, But Slowing…

German Industrial Production Is Rolling Over into Negative Due to Slowing Auto Sales & Crude

German Industrial Production Is Rolling Over into Negative Due to Slowing Auto Sales & Crude

South Korean Exports Reflect the Slow Down in Technology Activity…

South Korean Exports Reflect the Slow Down in Technology Activity…

Brent’s Always Involved in a Global Slowdown and This Time is No Different…

Brent’s Always Involved in a Global Slowdown and This Time is No Different…

India

Short Rates Remain Stable Despite Recent Stresses

Unlike the corrections in 2013, 2011 and 2008, which witnessed a sharp rise in short rates, the 1 year T-bill yield has been remarkably benign in the face of the IL&FS default and NBFC crunch. The government’s and RBI’s reduced borrowing plan and swift actions to take over IL&FS and pump liquidity into the system were critical in preventing the situation from worsening.

Spreads Remain Stable Across G-Sec, Corporate Bonds, CDS, WACR and CBLO… But NBFC Rates Have Widened

As identified in the charts on the following page, spreads between corporate and G-sec, CDS pricing for State Bank and ICICI, the weighted average call money rates and CBLO rates have been stable, not demonstrating the spike in risk premium witnessed in previous credit freezes such as 2013. However, NBFC CP short term rates have widened by 50 bps, confirming rising stress in the NBFC space. More details from our Product team on credit risks later in this commentary.

India’s Corrections in 2013, 2010 and 2008 Witnessed a Sharp Rise in the 1 Year T-bill…
The Current Move in Short Rates Doesn’t Look Similar to 2008, 2010 or 2013…

India’s Corrections in 2013, 2010 and 2008 Witnessed a Sharp Rise in the 1 Year T-bill

The Yield Curve Remains Stable Although Corporate Bond Spreads Have Widened Slightly…

The Yield Curve Remains Stable Although Corporate Bond Spreads Have Widened Slightly…

While the 5 Year G-Sec Yield Spread Over T-Bills Widened During Sep ‘18…
…The Spread Has Contracted Meaningfully Of Late

While the 5 Year G-Sec Yield Spread Over T-Bills Widened During Sep ‘18

Rates Have Risen Uniformly Across the Rating Spectrum from Corporate A to AAA…
…But The Spike in A and AA Paper Witnessed in 2008 and 2013 Is Not Evident Today

Rates Have Risen Uniformly Across the Rating Spectrum from Corporate A to AAA

CDS Spreads on SBI and ICICI Remain Low, Suggesting No Concerns of a 2008 Type Scenario

CDS Spreads on SBI and ICICI Remain Low, Suggesting No Concerns of a 2008 Type Scenario

The CBLO overnight rate and WACR (Call Money Rate) Continue to Remain Stable Unlike 2008 and 2013 …

The CBLO overnight rate and WACR (Call Money Rate) Continue to Remain Stable Unlike 2008 and 2013

Meanwhile, Systemic Liquidity Remains Healthy and Credit Upgrades Continue to Outnumber Downgrades…

Meanwhile, Systemic Liquidity Remains Healthy and Credit Upgrades Continue to Outnumber Downgrades

Most Notably, NBFC CP Funding Costs Have Risen from 7.0% in Jan ‘18 to Above 8.25% …

Most Notably, NBFC CP Funding Costs Have Risen from 7.0% in Jan ‘18 to Above 8.25% …

Outlook

Equities

Valuations are at Fair Value and the News Is in the Price

Clearly the global data shows a slowdown. But EMs – and India – have been beaten to a pulp for the past 9 months now. The slowdown news is mostly in the price. Market cap to GDP is about 10% away from levels where it has bottomed in the past. Price to Dividend Yield is heading to levels that have previously seen bottoms in 2011, 2013 and 2015. Price to Dividend Yield isn’t subject to some of the distortions on earnings we have witnessed at the index level. Market cap to GDP is a powerful metric that suggests that we are reasonably valued.

NCLT Process Bearing Fruit

Given the war for Essar Steel between Arcelor and the counter bid by the Ruias, and other recent instances of strong bidding wars, the NCLT and the IBC will see extremely positive write-backs for most banks.

Market Cap to GDP Is Approaching Trough Valuation As Is Price / Dividend Yield

Market Cap to GDP Is Approaching Trough Valuation As Is Price / Dividend Yield

Pessimism and Blood on the Streets

Investing success requires a bit of contrarian thinking. Today, we are reaching the highest levels of fear and pessimism in over two years. Technical indicators are heavily oversold. Given the deep correction in mid and small caps, increasing exposure to mid-cap stocks gradually over coming months and considering reasonably priced large cap quality using a staggered approach, gradually increasing allocations, is a strategy that is likely to bear dividends over 2-3 years.

A Rotation into EM Is Increasingly Being Talked About by FIs

Today, the problems move back to developed markets, as the slowdown in economic data is mostly global. Emerging markets have taken it on the chin for the last nine months and done much of the hard work in implementing reforms. With the deceleration in data in the U.S., and rising rates that the consumer is ill-equipped to absorb, a rotation to EM looks possible. This may or may not happen, but EMs are increasingly being identified as relatively attractive, and this would be positive INR, positive FDI, positive CAD, positive equities and positive debt.

Gradually Rebalance to Strategic Asset Allocations

We recommend that investors that have seen their equity allocations trimmed due to the sell off, gradually rebalance portfolios towards strategic allocations over the coming months. Alternatively, increased systematic deployment to equities over 3-6 months is also likely to be a winning strategy.

Portfolio Insurance & Capital Protection

Using tactical strategies to protect capital is critical during these periods, as preservation of capital takes precedence over growth of capital. We have consistently advocated utilizing protective strategies to minimize downside risk in portfolios since last year.

Sectoral Preferences

With the slowdown in the global economy, private banks, domestic consumer staples, domestic healthcare remain our preferred sectoral over-weights. We continue to remain invested in top tier NBFCs, which have only given up their gains YTD while remaining wealth compounders over longer periods.

A reasonable narrative today is that the Indian economy will continue to grow, because of a young demographic that wants the good things in life and has the money to spend and willingness to borrow on credit to buy it.

Fixed Income

Two Key Decisions for Fixed Income Investors

The first is the amount of interest rate risk exposure an investor is willing to take in the portfolio. Rates have been rising for over a year now, and clearly duration or rate exposure, particularly given a long three-year holding period for tax benefits, has been an avoid for most investors.

The second decision is the amount of credit risk an investor is willing to accept. We would argue this is not a good time to have much of that either. Loss of NAV, or capital is undesirable for fixed income investors. So, it’s a time to be defensive on credit risk.

The Broader Credit Market Is Not Broadcasting Fear, But…

Except for the rise in NBFC lending rates, the bond market has remained remarkably stable over the past few weeks, despite news of IL&FS defaulting and rumours around real estate company defaults and NBFC HFC portfolios.

Our Product Team’s Research Suggests Risks Are Not Currently Being Reflected Due to Illiquidity

Our Product team put out a note on Friday last week that highlights the fact that much of the risk aversion that bond market participants are seeking is not currently reflected in the yield curve due to the illiquidity of underlying exposures.

Many of the papers are not traded frequently even in a normal secondary market. Trades lower down the credit curve are almost non-existent. Based on the Product Team’s research, we expect the widening of spreads to start reflecting on portfolios and NAVs as we move forward. Structurally, portfolio managers expect rates to be higher. Borrowing avenues are likely to narrow and borrowing costs for lower credit could escalate.

With valuations not reflective of realizable value, our product team believes risk exists that has not been accurately marked to market. Therefore, our recommendation continues to be a review of exposure to credit risk funds and a recommendation to shift to short duration and high-quality liquid paper, unless funds are in a 2-3 year holding period.

For funds that are outside of the 3-year holding period constraint, a move to short duration funds is recommended.

For funds still within the 2 – 3 year holding period, we continue to recommend Hold, as the impact of volatility is likely to be lower than the short-term capital gains tax impact. For funds less than 15 months, which have not accrued returns, a rebalance to short duration is recommended. Additional details are available in a note authored by the Products Team on last Friday.

PMIs in Manufacturing & Services Remain in Growth…

PMIs in Manufacturing & Services Remain in Growth…

Technical Strategy

The Nifty touched new low of 10004 for the decline on Friday to close at 2.66% at 10030 levels down by 2.66% for the week. After two weeks, holding above the rising support trend line connecting lows of 9825 and 7894; index has closed below it with long bearish candlestick formation on weekly chart. Now immediate support levels for the market are seen at 9952 levels which is March’18 low; and next level is seen at 9873 levels where 38.2% Fibonacci retracement of the rise from 6825 to 11760 levels. On the upside any bounce back towards 10350-10450 is likely to face resistance for the market. In Nifty options, Put have maximum open interest at 10000 suggesting as support level which is also psychological level for the market. India VIX continues to remain at elevated levels of 19.23 and consolidating. Expect volatility to remain in the market and further rise will continue to add pressure on the market.

Nifty Daily chart

Nifty Daily chart

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