Oct 14, 2019
“We want to elevate the world’s consciousness” – Adam Neumann, WeWork
Being an equity investor is akin to being the ‘house’ in Vegas. The house eventually wins. We maintain a positive view on equities, neutral on gold, and underweight duration on bonds.
The House Always Wins….
It’s almost become fashionable to be pessimistic these days. Pessimism on equities, the credit crisis, the economy. However, the factors that guide our market outlook, such as central bank action, fiscal policy, monetary policy, rate action, indicators of stress in the credit markets and corporate earnings are all indicating a positive outlook driven by gradually improving fundamentals. Titans of industry are positive, and we’re comfortable aligning our views with these gentlemen that have been massive wealth creators. Further fiscal reforms lie ahead, this time on the consumption front, if media rumours are to be believed.
Owning quality growth equities is akin to being the house in Vegas. The house, eventually, and always, wins.
Those that Ignore the Lessons of History…
A knowledge of history is also our crutch. When America was setting up its factories in Japan in the 1960s, Japanese workers produced shoddy work, were notoriously tardy, and there were large cultural landmines to be navigated. By the late 1970s, the Japanese had progressed to dominating the world in cars and electronics, but their labor costs were rising. American manufacturers switched to Taiwan and Korea. Yet again, dirty factories, shoddy work, unscrupulous owners were the norm, until capitalism drove efficiency, profits and a better way of life.
Next came China, sometime in the early 1980s, offering nothing but cheap, hard-working labor. The rest is history. That incidentally, makes one ask the question, why not India? To those that complain about shoddy Indian manufacturing, the lessons of history give us a path forward. Let’s also recognise that India’s domestic economy today is meaningfully large. Apple, Walmart, Uniqlo, Ikea, Haier, Huawei, Xiaomi, OnePlus, Kia, MG Hector are heralding a tectonic shift, admittedly glacial in nature, could be underway.
The Global Fear Mongerers and the Recency Effect
On the subject of pessimism, a cottage industry of bloggers in the U.S. has made good money from web traffic and google adsense, scaring the wits out of investors since 2009, hyping up bad news and building crash scenarios that have Americans heading to the hills with canned food and guns. The Fed’s QE programs of this decade have created an embedded expectation of a massive crash ahead in the international investment psyche. We think it’s classic “recency syndrome”. We question the logic that a massive crash lies ahead of us.
A Low Amplitude Expansion Argues for a Low Amplitude Fall
The U.S. is in a slow, low amplitude recovery, with minimal population growth, and limited productivity improvements. It’s starting to look a lot like Japan. What if the business cycle is, in fact, dead as Mr. Jhunjhunwala posited? If the up amplitude is 1.5% to 2.5%, what are the odds of system failure on the downside? The Fed has launched QE lite. We see no compelling reason to bet on a collapse of the global economy.
The bears argue that U.S. debt levels have skyrocketed. That’s true at the government level. However, the U.S. consumer has deleveraged. Low growth, QE, and low interest rates appear to be here to stay.
WeWork – the Emperor with No Clothes On
God descended amongst the ranks of the Silicon Valley elite, with flowing hair and an objective to “elevate the world’s consciousness”. Venture capital was already tightening. If sanity has descended on Silicon Valley, it’s because the public markets have pushed back. Valuation could matter going forward. Post WeWork, only the bravest are likely to venture into the endless loss-making unicorn. The stock market has re-asserted itself as the eventual arbiter of value.
Global Trade Has Plummeted Since Q3 2018 but the Baltic Dry Index Suggests a Bottom
Global trade has plummeted into negative territory in recent months, as much a function of the U.S. China trade war, as it is a function of the global slowdown in manufacturing and automobile sales. The Baltic Dry Index led the contraction lower and is now suggesting a bottom may have been made in global trade. The recent positive news on a truncated U.S. China trade deal, stimulus announcements by the ECB and the Fed could be the reasons that the global economy may be stabilizing.
Global PMI data remains Positive, China stabilising, but OECD Leading Indicators Remain in Slowdown
Separately, global PMI data suggest that services activity remains healthy enough to offset the contraction evidenced in manufacturing. China appears to be stabilizing and while leading indicators are slowing, the slowdown appears gradual in nature.
Domestic Slowdown is Sharp in Pockets, But Credit and Consumer Goods Remain in Growth Mode…
Sentiment measured by the RBI survey of business assessment has plummeted to a five year low. Automobile and tractor sales continue to be mired in a recession. However, domestic passenger air traffic appears to have bottomed and is rising modestly. Credit remains healthy, with personal loans and credit cards tracking strongly. Consumer goods – durable and non-durable – are growing steadily in single digits.
Services Trade Remains Robust
Reflecting the slowdown in goods production, exports and imports for merchandise are both in negative territory with imports in a severe fall. Services, particularly exports are rising steadily and services imports accelerating higher.
Direct Taxes are Tracking Higher by 9.9%, While Indirect Taxes Present a Challenge
Income tax collections are up 13.6%. Corporate taxes are likely to fall in coming quarters. GST collection remains marginally positive. The government could let the fiscal slip or will balance the budget via stake sales and lower cost overseas borrowings.
Creative Destruction Underway
Domestically, we believe the rot in the system is being cleansed. Market forces are punishing leveraged businesses. Creative destruction will unleash healthier models in short order.
Our Case for a Recovery
Our fundamental case for a recovery in the economy is driven by our view that the credit crisis is in the final phase of resolution. Stressed company shares are getting battered daily. However, in the broader market, short rates continue to decline, liquidity is in surplus, NBFC spreads have compressed and rates are gradually declining.
Separately, the quantitative easing announcement by the Fed, the rate cuts by the RBI, the tick up in commodity metal prices, compression in domestic spreads, and the decline and bottom in bond yields are all positive signs that the economy has likely bottomed and the process of recovery is beginning. Incidentally, public sector bank credit is up 9% yoy and PSU banks are taking the lead on rate transmission.
We remain positive on equities, despite pervasive negativity and a sharp slowdown in global and domestic economic activity. We remain focused on large caps. Value is beginning to emerge selectively in mid caps. Stock selection remains the key to alpha. As discussed last month, active managers, particularly pms managers, including our strategies, are delivering meaningful outperformance.
The bond markets are signalling an approaching bottom alongside the factors mentioned above. In the event, duration becomes untenable, while credit becomes attractive for aggressive investors, particularly on a staggered entry basis.
We continue to favour corporate bonds, PSU and banking bond funds, with low duration exposure. Long short strategies make sense as complements to debt, and as debt plus. Credit risk is worth an exposure for aggressive investors, driven by our view that the worst will be over this quarter and the economy will revive in coming months.
Fixed income, like equities, is shaping up to be as much a sectoral call as it is a manager call. With wide dispersion across managers, getting both calls right will be the key to alpha.
We are neutral weight Gold.
Bond Markets Signalling a Bottoming Economy
It was a week of respite for the market after the correction from high of 11,695 to low of 11,090. The Nifty closed higher by 1.17% at 11,305 levels on weekly basis. Broader market indices underperformed benchmark with BSE Midcap gaining 0.49% and Smallcap down 0.29% for the week. Nifty has taken support in the region of 11,150-11,060 where previous consolidation highs and 61.8% retracement of the rally 10,670-11,695 are seen. Index has also managed to close above 200 day moving average. Now immediate level is seen at 11,400 where falling resistance trend line connecting highs of recent correction comes. Nifty needs to cross and sustain above 11,400 levels for market to rally towards 11,650-11,700 zone. On the downside 11,150-11,060 is the critical support zone for the market now. Breaking below 11,060 fresh selling pressure will be seen in the market towards 10,800. In Nifty October monthly expiry options, maximum open interest for Put is seen at strike price 11,000 followed by 11,200; while for Call maximum open interest is seen at 11,500 and 12,000. Nifty Put-Call option distribution data is suggesting is support at 11,000 levels and resistance at 11,500 levels. India VIX declined by 2.5% to close at 17.14 level for the week. The recent rise in VIX got capped at 18 odd level which has been acting as resistance for last couple of weeks, but it needs to move below 16 for market to see sustainable up move. However above moving 18, will lead to lower levels in market.
Nifty Weekly Chart