Apr 17, 2017
Valuation & Growth
“Over the last few decades, investors timeframes have shrunk. They’ve become obsessed with quarterly returns. In fact, technology now enables them to become distracted by returns on a daily basis, and even minute by minute. Thus one way to gain advantage is by ignoring the “noise” created by the manic swings of others and focusing on the things that matter in the long term.
– Howard Marks,
The Truth About Investing
Markets continue to climb the wall of worry on growth and valuations. Repentant FIIs that sold low during demonetisation are buying high today, in volume. Meanwhile, the invigorated domestic investor seems to have acted far wiser during recent times and is reaping decent rewards. The lack of alternative investment opportunities, globally and domestically, excess liquidity sloshing through the world economy, and toned down expectations for a massive U.S. tax cut and fiscal stimulus, are additional factors driving investors into equities.
As Howard Marks states so eloquently, one way to gain advantage is by ignoring the noise and focusing on the long term. On this front, there is enough to look forward to with India.
Significant Rate Transmission of 90 bps~ Occurred During Demonetisation…
…Rates Have Come Down 115 bps Since Last Year…
…Benefits Will Start Accruing to Earnings April 2017 Onwards
The Only Charts That Matter Right Now…
…FI & DI Flows into Equity Are Driving Markets Higher
Rate Transmission Benefits Are Under Appreciated and Could Lead to Upside Surprises
The MCLR declined substantially during and post demonetisation, to the tune of roughly 115 bps since August of last year. The bulk of the move occurred in Nov and Dec-16. Since transmission benefits generally take six to nine months to come through, the impact will be visible starting Q2 CY17 and this gives us reason to remain positive on the prospects for earnings growth.
We expect the benefits could be tangible for corporates, and mildly additive to disposable income for consumers. All manner of projects and return calculations are impacted positively when the cost of capital is lowered.
Our expectation remains that the economy stabilised in the second half of Q1 CY17, so even if results disappoint somewhat due to a tepid January, we would be prone to providing the benefit of the doubt to markets.
Earnings Revisions Trending Strongly in Mid Caps and Upwards for Nifty
Further lending comfort is that blended forward earnings revisions for mid caps are showing strength, up 27% over the last 9m, while for the Nifty is up +8%. We would note as usual that the picture is muted for the Nifty as it is impacted by large losses in a handful of companies.
As a result of the strong performance by mid caps in the previous quarter, the gap in valuations on the far more reliable trailing P/E basis has also shrunk.
Finally, from a global investor perspective, India’s premium relative to developed markets is at the low end of the historical range, a further reason why the rotation to markets such as India is likely to continue.
The Pace of Mid Cap Earnings Revisions Are Far Stronger Than the Nifty
The Valuation Premium on Midcaps Has Shrunk Relative to NIFTY
MSCI Indian Premium over DM Remains at Low End of Historical Ranges
Inflation Should Remain Manageable
Despite being flagged a number of times by the RBI as a key concern, we think the deflation in the prices of pulses and vegetables as well as the appreciation in the Rupee will act as offsets against the recent rise in Crude. With import inflation subdued, the Indian Crude basket attractively priced, a strong Rupee and strong trends in domestic production, we think inflation is likely to stay within the glide path of the RBI in the near term.
A Strengthening Rupee Alongside Benign Crude Prices Should Keep Import Inflation in Check
A Dichotomy in Some Macro Data
Unfortunately, a similar level of cheer is not visible in the macro data, with IIP contracting 1.2% to a four month low in Feb-17. The one area of optimism is the upward trend we are noticing in the PMI data, for manufacturing and services and we would hope for the momentum to continue as corporates are now starting to feel more confident.
Manufacturing & Services Momentum Trending to Recovery…
India Manufacturing PMI at a 5 Month High
Strong Pickup in India’s Trade Activity
Maintaining a healthy uptrend, India’s trade exports growth rose to the highest at ~28% YoY since Oct-11. The global economic recovery is now supportive, with the Global Manufacturing PMI at 53.0 in Mar-17 a 69-month high. What led to the higher momentum in the reading was the sharp increase in engineering goods which bodes well for capital goods exporters. Higher petroleum prices continue to impart an upward push to petroleum products which were the other contributor.
Uptick in Indian Exports and Imports on Improving Global Trade
An Alternative View on Dismal Credit Growth
There has been much talk about woeful commercial credit growth, which is down to 4% YoY. However, MSME and consumer credit growth are running closer to GDP growth, at above 8%. What appears to be happening is that credit growth has stalled at the large corporate level but is far more dynamic at the grass roots level. This would explain the dichotomy between the growth experienced by private banks and NBFCs versus growth in the commercial credit data series.
While Commercial Credit Growth Is Woeful at 4% YoY…
April to Dec NBFC Credit Growth Is On Trend…
…And Personal Loans and Loans to Services and Agriculture Remain Healthy
The 10 Year Appears to Have Made a Bottom Late Last Year & a Trend Change Appears to Be Forming
Since the massive unwind in positions when the RBI moved to neutral, the 10 Year has been firmly range-bound between ~6.6%-6.9%. With WPI rising alarmingly, a view forming that the next move by the RBI is likely to be a rate hike than a rate cut, the spread between wholesale inflation and the ten year close to multi year lows, the spread between the U.S. and India’s 10 year benchmarks falling below historical average levels, and a large front end loaded government borrowing program on the cards in the first half of the year, we see limited impetus for a further move lower in interest rates.
Finally, the move in the 90 Day T-Bill is also supportive of improving fundamentals for the economy, and yet another indicator that rates are likely to stay range bound or have an upward bias from these levels.
Our view then is that we think rates are likely to stay range bound in the near term. However, with an expected pickup in economic growth in the coming quarters, the pickup in trade, increased government stimulus spending, increased consumer spending from the 7th Pay Commission, transmission benefits etc, we think rates would have a slight upward bias were growth momentum to accelerate in coming quarters.
With that perspective, playing for yield in the longer end of the curve carries the risk of duration exposure and related capital loss. We continue to prefer accrual funds with corporate bond portfolios and without G-sec exposure. Secondly, we advise select AT-1 bonds, actively managed, where the opportunity for upgrades is likely and investments are managed with an 18-24 month horizon.
The 10 Year Has Bounced Strongly From the Lows in December…
…Alongside an Alarming Rise in WPI Inflation
As a Result, the Spread between G-sec & WPI is perilously close to going negative at 0.32%…
…Indicating a Negative Real Rate
The India US Spread Is 4.5%, Below the Average Spread of 5.11%…
The Rise in the 90 Day T-Bill Is Also Indicative of an Improving Economy…
Finally, the Spread Between Corporates & G-Sec’s Remains Wide at the Long End…
…So Duration Exposure Is a Critical Offset That Must Be Factored
Gold Breaks Out To a 5 Month High
We have been consistently underweight the yellow metal and benefitted from the underweight call. However, the Republican’s penchant for war, the uncertainty in North Korea and Syria, and the pickup in inflation would be the two reasons we would attribute to the recent spike in the price of Gold. To wit, Gold pierced the 200-day moving average, and is up 11.88% in dollar terms. Finally, the French election remains tight and Le Pen has a chance.
Given the lack of an income stream, and vulnerability to capital loss, it is difficult to be bullish on the yellow metal as there is still a lack of clarity about escalating tensions and the French election and the outcome of the Euro zone. So, we remain comfortable staying invested in yield generating assets, with a small allocation to Gold of roughly 5% in our wealth profiles.
Gold Has Made News Highs in Local & U.S Currency…
…Our Preference Remains for Yield Generating Assets
Trump Re-kindles the Republican Penchant for Belligerence
The recent pickup in tensions in the Middle East and North Korea reminded us of the penchant the Republicans have for war, whether it be Bush I, Bush II or Trump.
During the US election campaign, candidate Trump inspired hope that although his administration would carry a big stick, it would be less belligerent. Those hopes are dashed, as things have escalated to nuclear threats out of North Korea, which is particularly worrisome. Donald Trump’s order of US air strikes on Syria provided investors with a sobering taste of what the coming four years could look like.
Guns, Oil and Spending
The Second World War, Vietnam and Iraq wars were all fought with increased spending, financed by borrowed money and violent oil spikes. The base case scenario then to be watchful for, is to eye events related to Korea, Iran and Syria, as well as bigger budgets, low interest rates and central bank balance sheet expansion.
Tax Plan Scrapped
Finally, President Trump promised in early Feb-17 that he would unveil a “phenomenal” tax plan within two to three weeks. Well, it was scrapped last week, because as AP reports it is back to the drawing board. In doing so, the president agenda of fiscal stimulus, tax breaks and growth seems to have been delayed indefinitely, and may not come until early 2018 if not later.
India In the Top Emerging Markets Performers
With a 16.6% return during the quarter, India was number two amongst emerging markets, only slightly trailing Mexico’s 17.0% return. Equally impressively, India was amongst the top performers for the one year period, with a 19.2% return, matching the performance of most key emerging markets, while outperforming the MSCI Emerging Markets index return of 14.5% and MSCI World’s return of 12.5%.
India Is Among the Top Performers for the Quarter and 1 Year Periods…
Watch on Earnings & Inflation
With the accelerated pace of remonetisation, discretionary consumer spending held back by demonetisation is expected to pick up and will gather momentum over the quarters ahead. The recovery will be aided by the reduction in banks’ lending rates. Further clarity will emerge on earnings announcements this month.
We have listed reasons for our continued optimism on equities and positioning on bonds and gold. We expect markets to continue to climb the wall of worry, and a correction can certainly not be ruled out, particularly given the global backdrop. However, we see nothing on the macro or fundamental front that gives cause for concern as of this writing. Valuations do remain high, but not as much so when adjusted for lower borrowing costs and inflation. P/E expansion has played out in large part, so earnings are likely to determine forward returns in large measure.
Dispersion in stock returns is likely to continue to be wide, as has been the case for many quarters now. Stock selection and active management will play key roles in return generation.
The Nifty closed the week at 9151 levels down by half percent for the week. Index is facing resistance above 9250 levels and seen some profit booking coming in in last few days. But broadly on longer term charts index continues to consolidate at higher levels and more importantly above its breakout level of previous high which is positive for the market. In Nifty options, 9300 strike price Call option has the highest open interest for call options followed by 9200, suggesting as the immediate resistance for the market on the upside. Thus suggesting above 9250 levels on tradable basis index may see rally towards 9500 odd levels.
On the downside 9000 strike price Put has the highest open interest suggesting as the base for the market. Also previous pivotal swing low is seen around 9000 levels indicating as important support level for the market. The Nifty options Put/Call ratio is at 1.09 and still off its recent high levels of 1.23 odd when correction were seen in the market on last two occasions. Thus suggesting there is still room on the upside. INDIA VIX measure of volatility continues to be at multi year lows and any sharp spike in the volatility will be a cause of concern for the market.