Oct 1, 2018
The stock market is the story of cycles and of the human behaviour that is responsible for overreactions in both directions – Seth Klarman
IL&FS Spawns a Domestic Liquidity Crisis & Credit Crunch
NBFCs manage their operations using a concept referred to as asset liability management (ALM). A well managed NBFC endeavours to have the maturity of its assets match the maturity of its liabilities. Assets are loans such as infrastructure loans, personal loans, agricultural loans, consumer, housing with varying durations. Liabilities are borrowings from banks, commercial paper, mutual fund borrowings and bonds.
An ALM Mismatch
IL&FS has large loans in infrastructure with durations of up to 15 years. However, roughly 25,000 crores of liabilities is short term, or over 30%~, and the company was renewing the borrowing on a regular basis, while the majority of assets, over 80%~ are long dated. If a company cannot renew its debt, and the assets are not generating cash flows, you have a problem called an ALM mismatch and a liquidity crisis.
IL&FS has cash flow issues due to projects being stuck at different stages of completion, and claims pending with the government. As the company defaulted, the debt held by MFs and lenders had to be marked down, and panic began to spread through the system. Funds were forced to liquidate other securities – maybe for instance corporate bonds – creating a cascading effect, and a classic run on the system.
ILFS has assets, so it’s a liquidity and ALM mismatch issue. Talks are underway this weekend on recapitalization. As of this writing, key lenders have already agreed to step forward. Systemic impacts from IL&FS seem to be ringfenced. The statement by the LIC stating IL&FS would not be allowed to go under brought some stability to the market, as did the joint statement by regulators.
This is Not India’s Lehman Moment
It’s critical to note that there is no leverage on the book, unlike Lehman. There is an underlying value in the balance sheet and business. There are no egregious excesses. However, this comes on top of the rot that already sits on PSU books, with power loans now looking shaky. The government is clearly on the case, as is the RBI, with measures announced last week on reduced 70k crore of government borrowing and a relaxation on the liquidity coverage ratio.
Global Growth Has Decelerated in the Past Two Quarters…
…With All Regions Except India and the U.S. Slowing
While All Major Economies Sport PMIs Above 50 Signifying Growth…
… Growth Is Decelerating Everywhere, in the Eurozone, Possibly the U.S., EM, Japan, China and India…
…Notably, U.S. Services PMI is Now 52.9 and Germany Mfg is 53.7
President Trump’s Approval Ratings Decline Ahead of November Elections
One would have thought that the rip roaring economy would mean President Trump and the Republicans retaining the House was a fait accompli. Not so, if eight different recent polls are to be believed, each one showing a marked deterioration in the President’s approval ratings. The disapproval appears to be centered in the Midwest, in particular farmers and automobile manufacturers, which would imply dissatisfaction with Trump’s Trade War, and the large personal costs the President is imposing on voters that voted for him. With the Chinese likely to withhold trade negotiations until after November, Trump could be in for tougher times.
The Long Dollar, Long U.S., Short EM Trade Starts to Look Over Crowded
Two foreign factors contributed to EM weakness this year – strength in the U.S. economy and Fed liquidity withdrawal. President Trump’s tax cuts pulled growth forward, but fiscal stimulus of this nature is rarely sustainable and is temporary in terms of benefit. Mortgage rates have risen by over 100 bps to 4.66%, highest in the decade. Crude (WTI) has risen to $70+, real earnings growth is negative, and average hourly earnings are barely beating inflation. Traffic growth is slowing in the U.S., and the most recent Services PMI came in at 52.9, well below the previous levels of the mid 50s.
The Fed’s interest rate hikes and rising crude have worked to offset the gains provided by the tax cuts. The tech sector appears to be weakening, particularly Tesla and Facebook. The shale energy boom is being held back by infrastructure woes. Initial signs suggest growth is being impacted by rising rates and rising oil. This could mean some welcome respite on FI selling for EMs. It should, however, be noted that neither the yield curve nor the leading indicators are showing any signs of a turn as of yet.
It Should However Be Noted That the U.S. Leading Indicator Shows No Signs of a Rollover…
Trade Wars and Crude Oil Loom as Uncertainties
What’s left of the tax cut benefit after rising rates and rising crude will be further eroded by tariffs, which are a “tax on profits”. Collectively, rates, crude and tariffs are headwinds that have effectively eroded the gains pulled forward by the tax cut. Dollar strength has been driving EM weakness this year, and maybe, just maybe we are at the end of the Dollar strength rally. Should that hold, it will alleviate selling pressure on EMs.
Crude oil appears set to continue to rise, despite the President Trump’s efforts. We’ll see if a call over the weekend to the Saudis reigns in oil prices. The U.S. 10 year has risen to 3.10% as have short rates. Corporate debt to GDP in the U.S. is at the highest level in the past 50 years. Add in the impact of distorted supply chains, weaker global profits from EM and clearly there are cracks appearing in the U.S. growth narrative. With Europe, China and emerging markets all seem to be slowing as well, the global growth story now appears to have hit a speed breaker.
A Plethora of Risks Come to the Fore
NPAs, credit risk and contagion are front and center, and many NBFCs will fold, and MSMEs could experience difficulty in obtaining credit or rolling over credit. The message by regulators to single promoter led corporates has added to the uncertainty.
Trade wars, Fed tightening, liquidity withdrawal, a weakening currency are all a reality and while India could benefit in pockets, rising input costs and inefficiencies in sourcing and supply chain will be a drag on economic growth, and extract a toll on consumers. The INR has weakened dramatically this year, and policy response will determine further action. Should regulators not step forward on ring fencing the concerns around IL&FS, or additional skeletons emerge, a further bout of outflows is entirely likely.
Valuation is back in vogue. Domestic flows overwhelmed valuation the last couple of years but all new era thinking eventually reverts, and overshoots, the mean. Large caps selling at high P/E multiples were hammered last month.
Finally, there are worries that the global economy is slowing and on the domestic front, elections pose another worry. Further adding to uncertainty is the risk of a policy error.
If we’re writing about it, it’s already factored in the price. Earnings are likely to be good for Q2 as most of the serious damage was inflicted at the tail end of the quarter. Inflation is low, food inflation is likely to stay low with a strong kharif crop output expected this year, GDP growth is strong, the consumer balance sheet is strong with a high savings rate, and low indebtedness and the economy is growing. Fundamental growth drivers remain the best amongst large economies. India’s largest ace in the sleeve is that a large swath of the population is oblivious and unaffected by equity and global turmoil.
The Nifty 50 Does Not Reflect the Damage Done to the Broader Markets
In the Nifty 50, 10 stocks are down over 20% from the January 2018 peak. Meanwhile, 7 stocks are up 20%. While 29 stocks are down from the peak, an impressive 21 are up since the January peak. The top performers TCS, Reliance Industries, Bajaj Finance, Infosys, Tech Mahindra, Bajaj Finserv, Hindustan Unilever have saved the index. (table at the end of this note)
While the Nifty 50 has seen strong performance to the upside since the peak in Jan ’18, with 42% of stocks higher, the CNX has seen 80.6% of stocks lower, with 38% down 30%, and 56% down 20%.
81% of the CNX 500 Stocks Are Down from the Peak,
56% Are Down Over 20%,
And Half the Market Is Down at least 25%
Typically, Major Corrections Have Lasted Around a Year or a Bit Longer
The broader market peaked on Jan 29th, 2018. We are now in the 9th month of the correction, 244 days. Typically, cyclical corrections and the 2008 bear market have lasted between 359 and 449 days. It could be worse, as it was in 2000, but we think today’s economy and the late 1990s economy were very different; there are no discernible signs of a bubble and the domestic economy remains generally vibrant with a high savings rate.
The 2011 and 2015 Corrections Lasted 359 to 410 Days…
…We are At Day 244 and Down 6.9%
Yet Another Divergence Between Nifty 50 Reported Versus Bottom Up P/Es and Forward P/Es
While the reported index metrics are much higher, our analysis of the bottom up P/E shows that the bottom up trailing P/E for the Nifty 50 is now 22.6 and FY 19 P/E is 19.1. We’ve shared the numbers in the table. P/Es could be getting close to where markets have bottomed on cyclical corrections, but not cycle turns. Further, the Price/Cash Flow numbers look attractive. However, forward earnings remain unreliable and are likely to be ratcheted down should macro concerns continue to dominate.
While Reported P/Es are Much Higher…
Our bottom up analysis for Nifty P/E is now Trailing 22.6 and 19.1 for FY 19
Valuations for India Remain High, Relative to EMs but EM valuations are low relative to DM
Again, the reported index metrics are much higher with India valuations at the highest premium in a decade to EM valuations. However, EMs as a group are beaten down and EM valuations are attractive relative to developed markets.
Market Technicals are Deeply Oversold, But…
Technical metrics for the market are deeply oversold, at levels last witnessed in Dec 2016 (demonetisation low) and the bottom earlier this year in March (VIX low). Generally, these levels of extreme lead to counter trend bounces, within a cyclical correction. Markets, however, can continue to keep selling off even when technical indicators are deeply oversold.
We have been raising the issue of asset allocation, hedging, protection and rebalancing often since late last year, when euphoria and animal spirts were high. (see Déjà vu All Over Again, Aug 8, 2017, Return of the Dark Knight, Nov 13, 2017 and The Illusion of Attention, Jan 22, 2018 – available on our website).
Fear is palpable today. Each investor has a different threshold of pain tolerance, a different view of risk, a unique investment horizon and expected return. There are enough unknowns out there today – global and domestic – that forecasts are an exercise fraught with uncertainty. There are no blanket guidelines, except that volatility is the price to be paid for equity returns.
If volatility is worrisome, then the best strategy is to formulate a plan that gets the portfolio to an asset allocation that lets one sleep at night.
The market will always be a mechanism to transfer wealth from the impatient to the patient, from the fearful to the courageous, from the inexperienced to the experienced, from the small investor to the insider.
Strategy for Long Term Investors
For long term investors, let’s recognize that every bout of correction has always been followed by higher equity prices. Still, a review of portfolios– and risk tolerance – and putting in place a plan, considering capital protected strategies, hedging strategy or an asset allocation to debt is relevant. Mr. Buffett’s advice to be greedy when others are fearful is sound. For this class of investor, a plan to deploy regularly as we head to attractive entry points will deliver strong returns over a three year horizon.
Risk Averse Investors
For risk averse investors, it’s tough to make adjustments in the midst of a correction. Our advice remains the same as it was late last year. It’s usually not a good idea to sell when there is fear in the market. Some investors may have drifted far from their intrinsic asset allocation and risk preferences. Playing defense during times of heightened risk, is an option that should be considered, alongside a strategy for increasing risk exposure over the longer term. A detailed discussion with our wealth advisor may prevent a costly error that could impact the portfolio’s longer term return.
RBI Policy Meeting
A case was recently made by an economist that the spread between U.S. and India rates has shrunk to 4.5% from 8.25%, and raising rates would invite foreign inflows. We disagree, raising rates in a domestic liquidity freeze is counter-productive when the financial system is under stress. To design policy around global flows is a massive risk, particularly when the flows are really driven by factors outside domestic control, i.e., U.S. strength and Fed liquidity withdrawal. We hope the RBI will focus on the needs of the domestic market. FI flows will return when the economy demonstrates stability, growth and attractive investment opportunity. Raising rates will exact a toll on domestic consumers, businesses and banks, something we can ill afford at this juncture.
Bonds are attractive on a relative basis to equities by the widest margin in 10 years. With reduced borrowings, low inflation, gilts could rally, but there are too many moving parts to get a clear longer term indication. FMPs, ultra short duration and high quality corporate bonds remain our preferred exposures. We’d review portfolio holdings, and move away from low rated paper.
PMS Fund Update – Large Cap Fund Outperforming the Nifty and Multi Cap Down High Single Digits
Our large cap fund is up 2.9% YTD, and outperforming its benchmark the NSE 100 by 1.6%. Our multi cap fund is down 10.7% YTD, much of the loss accruing in the last month. The multi cap fund will be particularly attractive for additional capital deployment for a two, three year horizon.
Ensuring that the fundamental attractiveness of our holdings remains in place with visibility on earnings remains our primary focus. Earnings and price appreciation will follow. Capital protection should the selling continue will be our secondary focus. For investors that prefer unhedged portfolios, or hedged portfolios, please let your wealth advisor know.
Fourth straight week of negative close for the market and new low for the decline. The Nifty closed at 10930 levels down by 1.91% on weekly basis. Index is seeing lower tops lower bottoms sequence and formed long bearish candle for the week indicating selling pressure in the market. Nifty has broken rising support trend line connecting lows 9952, 10558 and trading below it. It has tested 10850 odd levels three times in last five sessions; also the 50% retracement of the rally from March’18 low of 9952 to August’18 high of 11760 comes at 10855 levels. Thus, indicating 10850 as critical level for the market. The 200 day moving average is at 10771 levels and 61.8% retracement of the of the rise (9952-11760) comes at 10640 which are next support levels. On the upside index needs cross 11150 odd levels for pullback rally to emerge in the market towards 11250 levels. India VIX measure of volatility has seen jump of 35% this month to 17 levels and for the week 9.4% rise. Thus, indicating market to remain under pressure and selling to further intensify on break below 10850 levels.
Nifty 50 Performance