Mar 5, 2018
“I’d love to have a trade war with China.…If we did no business with China, frankly, we will save a lot of money.” – Donald Trump
In a volte-face, last year’s euphoria and optimism seems to have been replaced by skepticism and caution. Key concerns have come to the fore, including rising interest rates and the deteriorating state of the public sector banking system domestically. Globally, liquidity withdrawal, Fed rate hikes and trade war rhetoric loom over markets.
Since late August, we have had a call for a recovery in the economy, while noting emerging risks related to valuation, crude oil, rising rates and leverage. The recovery is clearly coming through, but the risks continue to mount as well.
The Good News: The Domestic Economy Is Picking Up
Across a whole host of indicators such as credit, industry, consumer, trade and fiscal (chart on page 3), the data clearly demonstrates a pickup in the domestic economy. Earnings are up. Further, the government is stepping up their spending, possibly building a head of steam heading into an important election cycle.
Rising Rates, RBI Tightening and Economic Turns
Equities can continue to rise in a gradually rising rates environment; however, our limited dataset suggests that a move above 8% could be an area where the economy starts to face headwinds. There are additional markers, however, which lead us to the opinion that it’s early to be worried about rates or a cycle turn. For one, RBI rate increases have preceded every major correction in the past two decades.
Domestic Market Peaks Over the Past 18 Years…
…Have Historically Been Preceded By an RBI Tightening Cycle
Rates Traditionally Rise With Recovering Economies (2004 & 2009)…
…This Time Around the Move Is Being Arguably Driven By Fiscal Concerns
Traditionally A Rise in Short Term Yields Is a Precursor to Equity Sell Offs (2000, 2006, 2007, 2011)…
…Again, Short Term Yields Remain Stable
The Domestic Yield Curve Is Steepening, Which Can Be Interpreted as a Healthy Sign…
The Domestic Economy Is Recovering Nicely…
Indian Equities: Financialization Delivered a Growing 1.95 Lakh Cr ($31.1b) Since 2015…
…While Cumulative Foreign Flows Are Volatile, at a Much Lower 1 Lakh Cr ($16.2b)
Two, the peak in equities generally occurs at a significant lag to the first rate hike, ranging from at least a few quarters to more than a year. On this metric, it’s clearly early to be worrying about market peaks.
Rates traditionally rise with a recovering economy. This time around, the rise can be attributed to concerns around government borrowing. However, the concern over rising rates is mitigated by strong earnings growth, the gradual nature of the rise in rates, a steepening yield curve and stable short term yields.
The Foreign Investor’s Influence in Domestic Markets
Should volatility re-appear, a sense of our market’s exposure to global flows will provide insight into potential exposure. During the period of massive Fed balance sheet expansion from 2013 to early 2015, foreign institutional inflows into India were a cumulative 2.25 lakh crores. Clearly, not all of this was liquidity related to Fed balance sheet expansion. Since January 2015, cumulative FI flows have been growing at a far slower pace, a cumulative inflow of 84,000 crores. In comparison, domestic flows have measured 1.9 lakh crores since the beginning of 2015. In other words, domestic investors have pumped in twice the flows as foreign investors since Jan 2015.
The sell-offs experienced in 2011, 2013 and 2015 were painful in magnitude and severity. The data support the fact that the current sell-off, and the sell-off during demonetization could have been more painful had it not been for the support of domestic flows. Secondly, the data in the chart demonstrate that the domestic investor pumping money into equities was the driver behind the 2017 rally.
While there will be cyclical ebbs and flows in domestic investment into financial assets, the secular trend towards financialization is just getting started. Our markets are deeper today and could recover quicker, but we appear to remain highly correlated with global markets.
EPFO to Step In With Additional Capacity to Buy Government Bonds
A news release that hasn’t received much coverage last week is the government’s decision to let EPFO increase allocations to sovereign paper while reducing the minimum purchase requirement for corporate bonds to 20% from 35%. The EPFO is India’s largest domestic buyer of debt, with over 10 lakh crore under management, and 2.4 lakh crore in additional annual contributions from 50 million subscribers every year.
The larger limits for government bonds will allow the EPFO to invest more in government and state bonds. The Centre is slated to borrow 4.07 lakh crore from the market in 2018-19, and 3.7 lakh crore of state borrowings. This should help alleviate the pressure on government bond yields.
Globally, the U.S. Economic Cycle Is Further Along with an Aggressive Fed on a Rate Hike Cycle…
The Fed has been embarked on a rate hike cycle having raised rates three times in the past year. However, an extenuating factor is the extremely low absolute level of the Fed Funds rate compared to prior cycles. Further, the yield curve remains benign for now, and compared to prior cycles, it would appear that the Fed has additional leg room to raise rates.
A Rise in the Fed Funds Rate Invariably Leads to Recessions in the U.S.…
We would note, however, that Fed rate hikes – reliably, eventually and invariably – lead to recessions, with the caveat that there is a fair amount of lead time between hikes and eventual recessions, as the chart demonstrates.
Equally important to note is that this isn’t a normal cycle. It is quite likely that the markets will deliver a strong response to the Powell Fed as rates continue to move higher, and that is an underpin to our thesis that this year is likely to see volatility.
The Fed’s Balance Sheet Reduction Will Pick Up Pace in Coming Months…
The Fed’s balance sheet is down by $127b since it’s peak in Jan 2015. But as the second chart below demonstrates, it’s got a long way to go. What’s clear is that rates are likely headed higher in the U.S., and the balance sheet reduction is likely to pick up pace, just as the Trump administration moves forward with fiscally irresponsible tax cuts and possibly, a trade war.
Trade Wars a Risky Gambit by Trump
Markets sold off and then recovered on news of Trump’s intention to levy massive import duties on steel and aluminum imports. This could be a negotiating gambit, akin to pushing his real estate bankers to the brink before negotiating a great deal. If Mr. Trump is serious, and does in fact sign the bill, that will likely unleash trade sanctions and retaliations, and could have serious inflationary implications for the global economy.
Reassurance for Investors in the Assembly Elections in the Northeast
With two more north-eastern states in its kitty, the BJP is transforming into a national party, and demonstrating its expertise in election campaigning. The results have come against the backdrop of tepid performance in the Gujarat elections, and allay concerns around re-election uncertainty.
The rising complexity in the global economy can make an investor’s head spin. As long as earnings growth and economic growth is robust, markets are likely to act favorably. We’d also note the recent pickup in central government spending. However, the risks are rising as well.
From a portfolio management perspective, our preference remains earnings growth at reasonable valuations in strong sectors. We welcome large cap exposure if accompanied with growth and reasonable valuations. We remain cap agnostic between mid and large caps, favoring a balanced mix. We are far clearer about preferring domestic focused themes.
On evidence of a deceleration in the economic data, or earnings, we’d be inclined to re-consider our cap preferences. After a strong year last year, cautious optimism remains a prudent course of action. Our view remains unchanged, favoring bottom up growth at reasonable valuations for long term investors, and capital protection, hedge strategies, long short strategies for investors with concerns around capital loss.
The Spread Between Equity Yields & Bond Yields is Now Almost 4%…
…Suggesting An Opportune Time to Rotate Allocations to Fixed Income
Incremental clarity on the EPFO stepping forward is a welcome development. Yields are now at levels that are attractive for investors to consider locking in attractive rates. The relative yield of bonds is now significantly more attractive than the yield offered by equities, at the index level.
As we’ve consistently maintained, the macro picture is worse today for equities, but incrementally attractive for fixed income. Our preference in fixed income remains corporate credit and FMPs, with ultra short for risk averse investors.
The Nifty closed the week down by 0.3% at 10458 levels. Index retested 10300 levels and witnessed bounce back to 10600 odd levels. But market failed to sustain above 10600 levels as selling pressure is seen at higher levels. Now index is trading broadly in a range of 10300 to 10640 levels. Upside in the market will only be seen once index starts to trade above 10640 levels on tradable basis. Then pull back can be seen towards 10740 levels which fill the falling gap area. In Nifty options significant open interest is seen in 10700 and 10800 strike price calls suggesting this is likely to cap any gains on the upside. On the downside index has support at 10300-10275 levels, breaking below this, index can see decline towards 10100-10050 levels where 200 day moving average is seen and previous swing’s low supports are seen. Below this, next support level is seen at 9900 levels.