Will the emerging market crisis eventually touch the Indian Shores or has India’s macro come a long way from fragile five days of 2013?

The crisis is deepening in emerging markets. The crack is widening far beyond the obvious names like Pakistan and Nepal. When a celebrated economy in the not-too-distant past is at the door-steps of IMF, one can understand the extent of crisis in the emerging markets. What was once extolled as a miracle economy, Bangladesh could now be bordering on an IMF bail-out?  Such is the scorching heat across emerging markets. In such a scary situation, one can’t help, but start digging deeper for any hidden macros risks in India. Could the consensus view of a relatively stable macro for India be clouded by few serious misgivings? Or, has India’s macro really come of age from those fragile days of 2013? Let us dive in and explore.

Emerging market crisis follows a very familiar pattern. In times of high liquidity cycle (while Fed is easing), money supply is abundant and it reaches far-away shores to seduce the usual EM suspects to go for an over-drive on consumption-driven growth with borrowed capital. In a playbook style, falling dollar index, rising local currency, cheaper imports, lower interest rates etc. all play together to fuel local consumption. In times of abundant liquidity, currency valuations get distorted to artificially high level so as to hide the underlying twin deficit problems (Current account and fiscal) that usually the case for most of the emerging markets which import much more than what they export. When the music stops, which usually does when Fed starts the tightening, the reverse dynamics of rising dollar index, falling local currency, surging interest rates etc. pushes up the hidden vulnerabilities to the surface. In these times, markets start looking closely at some of the metrics like dollar debt to GDP, current account deficit, level of forex reserves, upcoming dollar debt payments etc. with a microscope. If market smells a rat in any of those metrics, it beats down the currency in a vicious cycle to bring the country down to the brink of bankruptcy. This usually happens in a self-fulfilling feedback loop fashion with a falling currency triggering outflows which in turn fuels further fall in currency that in turn aggravates the already aggrieved twin deficits, inflation etc.

So, the key thing is the confidence of investors in the macro metrics. If it is broken, it triggers a vicious cycle as explained above. The confidence comes from various factors that include level of forex reserves, credibility of central bank in handling inflation, dollar debt to GDP, short-term debt payments, manageable current account etc.

Where does India stand on these?

Level of forex reserves are reasonably high at over eleven months of imports (even after its recent depletion in defending the Rupee). Similarly, India’s dollar debt is at a manageable level of around 19%+ of GDP, far lower than many Asian peers. India’s central bank enjoys high credibility in tackling inflation risks. These are positives for India. But there is one sticky spot for India. That is, India’s historical vulnerability from high current account deficit (CAD) that suddenly shoots up during such crisis times, esp. when crude goes beyond 100$ level amid weakening Rupee (as 80% of India’s energy requirements are imported). This has always been a potential landmine for India, esp. during Fed tightening cycle. Will this time be different?

To answer this, let us go back and look at the key difference between 2013 and now in terms of CAD vulnerability. Not to forget that India was clubbed as one of the countries in Fragile Five in 2013. The key macro difference between 2013 and now, comes from the differing trajectory of growth between crude and the software exports. Software exports in dollar terms have more than doubled in this period while crude imports in dollar terms have stagnated or marginally declined (even at this elevated level). Looking at the data points, software exports have surged from 70Bn dollars (appx) level in FY14 to 178Bn (as per Nasscom) dollars now (FY22) whereas energy imports (including LNG) have declined from 140Bn dollars level in FY14 to 130Bn dollars in FY22. This has brought in a huge comfort in easing our macro vulnerability from Oil risks. Today, software exports income covers more than the total oil bill by a factor of 1.3 times (even at this elevated oil price of 100$+) from a precarious situation in FY14 when oil bill was 2X of software exports income. This comfort is only going to increase multifold with the projection of over 300Bn dollar+ annual exports by 2025 as per Nasscom projections, given the huge super digitization cycle globally. Also, bear in mind how oil import as a share of total imports has come down from 30% level in FY14 to 21% level now (FY22). It doesn’t stop here. India’s focus under the current political leadership on renewables, ethanol blending, CNG infrastructure, potential leadership in green hydrogen, sourcing oil at discount from Russia etc. will further strengthen India’s macro architecture. Needless to say that India has come a long way in its macro stability esp. in its external financing and CAD management.   

In our view, this development will single-handedly change the contours of India’s macro risk profile. This change is the most under-debated and least understood across investment community. Add to this the Indian companies’ and banks’ rising credit profile on the back of huge cleanup of corporate and bank balance sheets. With NPA cycle behind, risk of potential accidents in the financial sector receding (such as ILFS in the 2018 tightening cycle), India’s macro seems to be among the few shining spots for global investors. This is probably the reason why India witnessed investments of near 34Bn dollars in the PE-VC (28% growth YOY) space in the Ist half of calendar year when FIIs were busy pulling out over 25Bn dollars from the equity markets. This emerging comfort on macro stability, progressive policy environment, Rupee’s relative strength and positive long-term growth prospects etc. probably could be the reasons for the rising confidence from domestic investment community and for the huge resilience Indian markets have demonstrated during the current crisis. Next few months will tell us whether this prognosis is right or wrong. Interesting times to watch out for!

This article of mine was published in the online edition of Economic Times (07/08/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/will-the-emerging-market-crisis-eventually-touch-dalal-street/articleshow/93408910.cms

Will US Fed walk the talk on the stimulus exit?

If the news that the Fed has an ambitious plan for monetary tightening hasn’t reached you yet, you must be in a dwindling minority. Blueprint for a massive monetary exit has been out for a while now. It will be on a scale that world had not witnessed any time in the past. It has been set on a double R i.e. rate hikes and reduction in balance sheet size. If you are like me and wondering, is there a third R so that we can make it a nice sounding acronym of triple R (of course, no connection with the blockbuster flick RRR), yes, there is one which the Fed would like to desperately avoid in this game of tightening, that is, Recession.  What keeps the Fed awake late night is this, how to execute the first two “R”s rigorously without having to deal with the third R? Or will the worry of third R push the Fed to abandon its tightening plans half way? Let us dive in. 

Looking at the genesis of this inflation battle, there is a lot of merit in what some of the experts are echoing on Fed being far behind the curve on its fight against inflation. Unfortunately, Fed had seriously under-estimated the risk of how far the inflation will go. Initially, Fed assumed inflation will be transitory and it will come under control once the lock-down is behind. That assumption went completely awry because of Ukraine conflict and renewed Omicron related lock-down in China. Now, Fed has to make up its lost time by going for a lot more aggressive steps on its tightening to shore up its inflation-fighting credentials. One should expect an aggressive tightening now with an accelerated interest rate hikes and balance sheet shrinking. Beyond the already discounted aggressive rate-hikes, on balance sheet shrinking, in July-Aug, they are likely to start with $25Bn per month and accelerate to $90Bn+ monthly unwinding from second half. The plan is to complete the full run-down by end of 2023. That is a massive 1.7tn dollars of liquidity reduction.

Given the scale of this exit, there will be repercussions both to the asset prices and to the consumer demand. It is not going to be easy for Fed to run the full course. On slightest of the excuses, it might slow down or even reverse its course. Even if the Fed wants to go the full course, the political establishment may not have the will to face the consequences. Looking at the past cycles, one can see the familiar pattern of shorter down-cycles and longer up-cycles. There is a reason why down-cycles are shorter. One doesn’t need to look beyond Fed’s PUT (unconditional back-stop from Fed whenever markets go through trouble) for finding the reason. No sooner than the demand starts contracting because of Fed’s medicine, political pressure starts building up on Fed for easing up to start another round of stimulus. This has been the playbook in the past cycles. It is unlikely to be different this time too, though long-term solution lies in allowing the patient to go through the full medication to completely purge the excesses. Fed has been postponing this D-day for long. What will make the Fed to go for the final kill is a known unknown and should be left for a discussion for another day. For now, it is unlikely that the Fed will go the Paul Volcker way of hard landing. For the uninitiated, Paul Volcker was the Fed Chair in 1979 who took the inflation battle head-on and managed to vanquish it, though not without putting the US economy into a painful recession.  

Turning to inflation now, there seems to be some cooling off on the whole-sale prices. Freight prices are down on easing container shortages (except for crude containers). Supply chain issues no longer hit the headlines. Chip and fertilizer prices are down. So is palm oil price. There is a sort of crash in metal and commodity prices, but for crude. These lower prices will impact the WPI very quickly and then   transmit to consumer prices with a lag effect. To that extent, the worst is probably behind for the inflation, unless we have new surprises in store.

In all likelihood, with the worst is behind on inflation, Fed is most likely to use the incremental softening in inflation as an excuse to go slow on tightening by becoming less hawkish down the line. There is a good chance that Fed might opt to go with this politically palatable path, thereby postponing the eventual hard-blow to sometime in future. Where does it take us? If history is any guidance, we will see more of a zig-zag movement in rate-hikes/tightening rather than a full-hearted Paul Volcker like playbook. This would mean soft-landing without hard exit from stimulus. For equity markets, that would mean a shorter down-cycle and faster rebound. Though this could be the most likely outcome, no one can be sure about anything in the short-term as things are so volatile and uncertain on the inflation front. Given this, the best way to navigate this uncertainty is through a disciplined process of investing and asset allocation.        

Happy Value Investing!!!

Valuation of IT Stocks: Tactical Retreat or Irreversible Ramp-down?

Markets are magnifying machines. On the way up, it is all about what can go right as they magnify the greener pastures. On the way down, projection of pitfalls takes the primacy, as the magnification shifts to the murky side. Nature of the beast is such that it can never take a realistic or objective view. It swings between over-shooting and under-shooting. Since markets are born with the magnifying lens, it is investor’s job to wear the contra gear to keep off from the market’s fallacy.

One sector that is at the receiving end of this manic behavior is the IT sector. After two years of one-way run, stocks in this sector are getting brutally punished in the current downturn. Looking at the data points, in this calendar year, YTD, IT index is down by near 26%. In comparison, the Sensex is down only by 7.6%. In month of May (MTD) alone, the IT index is down by over 11%. If the fall at index level is 26%, one would fret to imagine the slump at the stock levels, esp. at the mid-cap end. In the pecking order of falling-from-grace, the one standing tall in this inglorious list is LTI (L&T Infotech) with a fall of over 47.8% followed by Mindtree at a touching distance. Even larger names like Wipro and TechM are not far away with a fall near 40% (all above data points as on 25th May).

One wonders, what has happened to all that sound-bites about super-digitization cycle, secular cloud transformation etc. that drove the valuations in this sector to stratospheric level in the last 2 years. Has anything materially changed or is it only a change of lens? Why is there a sudden rush among brokers to downgrade IT stocks? It started with JP Morgan and Nomura. Now, no brokerage wants to be left behind on this new down-grade rush. What explains this?

In our view, it is more of a valuation-reset than of any material change in growth projections or sector prospects. It is more of a narrative- following-price-action than the other way. As it happens always in the markets, price-action leads and then the narrative follows. Ironically, though the brokerages downgraded their target prices, none of them has downgraded their growth forecast for FY23. Even for FY24, they are less certain about the slowdown in tech spending. Downgrades are fast coming on fears of further price erosion.

So the next question to ask is, what triggered such a sharp price-action in the IT index relative to the Sensex and Nifty? For that, one needs to look at what is happening to NASDAQ stocks, because they are the lead indicators for the sentiment in the tech space. Taking that argument, probably, the rout in NASDAQ stocks explains the deadly derating that we are witnessing in Indian IT stocks. It was a common knowledge that the NASDAQ stocks were in a bubble zone and Fed action came as a much needed blow to prick it. As is to be expected, the meltdown in the NASDAQ had a massive rub-off effect on tech stocks globally. Indian IT stocks which were way off in valuations from their historical averages, had to bear much of the brunt from NASDAQ effect. Even after this sharp correction, the valuation in this sector is still far off from their historical levels and is yet to come to a fair valuation levels, esp. in the mid-cap IT space.

Having said that, none of the medium to long-term drivers for growth in IT space have gone away. Enterprises’ willingness to spend on digital and cloud transformation will continue to feed into above average earnings growth for the sector. But the growth in earnings is unlikely to translate into valuation growth as much of the stocks are still trading well above their historical averages. So in essence, nothing much would happen on the valuation front and the story going forward will be more of earnings catching up with the expensive valuation than anything else. That is the best-case scenario one can hope for IT stocks. To conclude, is it time for time correction for tech stocks? Only time will tell. Watch out for interesting times!

This article of mine was published in the online edition of Economic Times (05/06/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/valuation-of-it-stocks-tactical-retreat-or-irreversible-ramp-down/articleshow/92018927.cms

When can FIIs return? Fed’s previous tightening cycle drops some clues

Taper is behind, but tightening is ahead. That is a subtle one-liner that captures what to expect from Fed going forward. On taper, US Fed stuck to its schedule. It began the program in early Jan and quickly finished it by winding down new bond purchases to zero by end of March’22. Now it is onto the next, rate-hikes and balance sheet shrinking. With monetary tightening in terms of balance-sheet reduction, expected to begin by Jul-Aug, it will not be out of place to peep into what happened in the previous stimulus cycle to get a sense of what lies ahead. Looking back, in the earlier Fed stimulus cycle (post Global Financial Crisis), though taper started in 2013, it wasn’t until late 2017 that the Fed really started taking serious steps to shrink its balance sheet. For the uninitiated, taper refers to winding down the size of the fresh bond purchases while balance sheet reduction refers to allowing those earlier purchased bonds to mature without repurchases. As is well known, the later has a much bigger impact on the market as the excess stimulus liquidity is pulled out of the markets by allowing the bonds to mature without repurchases. That’s how Fed scales down its balance sheet size after every stimulus cycle.

This time too, Fed has an ambitious plan to arm down its pandemic stimulus by planning to shrink its balance sheet by a sizable scale in the coming months. As per some estimates, it may, in all likelihood, start with 25Bn dollars a month from Jul-Aug, slowly accelerate to 95Bn and end the entire unwinding by 2023 December. If that happens, one is talking about taking out over 1.7tn+ dollars of liquidity out of the system in 18/19 months beginning July/Aug. To put that in perspective, it will be nearly thrice the amount that was pulled out in the previous cycle in 2018/19 i.e. about 660Bn dollars were pulled out as part of balance sheet reduction program from Feb’2018 and Aug’ 2019. 

By any scale, this is a massive unwinding. The world had not witnessed such a large-scale winding-down any time in the past. Of course, relative to what was pumped during pandemic (near 5 trillion dollars from April’20 to Mar’22), the scale of unwinding may not seem sensational. Given that the Fed’s balance sheet expanded from 4 trillion to near 9 trillion dollars in this period, a gradual reduction over the extended period is probably the best outcome one could hope for. Yet, markets are naturally worried whether FIIs will ever come back to emerging markets in this period when Fed is busy pruning its balance sheet. Given this huge overhang of liquidity challenge for the foreseeable time, it may seem realistic to assume that FIIs are unlikely to return any time soon, esp. after their massive exodus from India since Oct’21. For the record, they have pulled out over 23 billion dollars (net sales) since then.

It is precisely here, where a peep into the past liquidity cycle could throw some interesting insights into how FIIs behaved in a similar situation. Let us go back and look at the period between Jan’18 and Aug’19. In this period, Fed reduced its balance sheet by over 660bn dollars, by pulling out an average of 30bn dollars every month (exact amount varied from low of 16bn to as high as 61bn in different months). It helps further to split this period into two to understand how FIIs behavior changed over the time of the unwinding. In the initial part, as the Fed unwinding started, FIIs started pulling out in Feb’18 and accelerated their pace during the mid-year to reach the peak sometime in Oct-Nov’18. FIIs pulled out over 6.5bn dollars in this period. But, what happened post that was more interesting. Until this period, Fed’s unwinding was about 30Bn dollars per month, which it later increased it to 38Bn dollars per month from Jan’19 until Aug’19. Ironically, after the increased quantum of monthly unwinding from Fed, FII flows reversed into inflows and there was a massive net inflows of over 13bn dollars in the period between Jan’19 and Aug’19. Not to forget that in this period, over 300bn dollars was pulled out by Fed to reduce its balance sheet. So, what does one conclude from this?  Is there a co-relation between Fed’s unwinding and FII flows?  Of course, there is co-relation in the initial period, but not long after. More importantly, what is more interesting is that the inflows in the later part were twice the money that left in the initial part. Having said this, it is also important to keep in mind that no two cycles will be same. While the broad pattern may be similar, exact point at which the tide will change for FII flows could be difficult to predict. But what is more important to understand is that the FII money will come back much sooner than Fed’s timeline for unwinding. Not only it will be sooner, but it will be much larger than what went out. This is one reason why some seasoned investors are expecting a melt-up (bull- run) for Indian markets next year (2023). From this perspective, the current weakness, which is likely to continue for few months on account of Fed’s rate-hike and balance-sheet-shrinking overhang, is a great opportunity for long-term investors to lap up their positions, esp. on those sporadic panic days which will come often for a while.

Happy Value Investing!!!

This article of mine was published in the online edition of Economic Times (03/05/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/when-can-fiis-return-feds-previous-tightening-cycle-drops-some-clues/articleshow/91284603.cms

Indian market’s resilience amid FII’s ferocious exit: Should you rejoice or worry?

There seems to be no let-up in FII sell off in Indian markets. Daily sale numbers have been over a billion dollars for a while. This calendar year alone (Jan to March), the tally has trumped the trillion (Rs) mark by a wide margin. FIIs have pulled out over 20 billion dollars (net sales) since Oct last year. That is a staggering number. To put this in context, during March 2020 fall on the pandemic break-out, it was much less than 10 billion dollars. Going back, even during the global financial crisis in 2008, the numbers did not cross 15Bn dollars. What is happening now is more than an exit. Past sell-offs very much pale in comparison. It is an exodus on an elevated scale. Such an elevated exodus should have hit the investors extremely hard, if one goes by the nasty fall (both during GFC in 2008 and in March 2020) in earlier such occasions with much less FII sell-off? Not so. Investors, though bruised this time, not completely knocked out. Sensex and Nifty seem to have survived the FIIs scare with marginal losses. Year to date, they are down by a little over 1.5% in this calendar year, but not by a lot. Same is the case with broader markets with small and mid-cap indices scraping through the scare without a serious scar. They are down by 5.63% and 4.73% respectively. All these numbers are as on 25th March. 

The level of resilience that the Indian markets have exhibited, has seriously surprised even the most seasoned investors. Some of them are genuinely perplexed. If someone had told them in the beginning of the year that oil is going to be flirting with 130$ level amid a raging war in Ukraine and FIIs would be pulling out en-masse from emerging markets on Fed’s tightening and taper cycle, they would have expected Rupee and stocks to have got massively ravaged big time in India. But here we are now with Rupee barely budging and stocks surviving with slim losses.

There are two ways to look at this resilience. One view is that the domestic investors (both retail (through growing SIP book) and institutions who are playing a significant role in this resilience) are sold on India’s medium to long-term prospects. For them, the market is signaling a surge in economic and earning upcycle in the coming years. They expect the corporate growth and profit cycle to surprise significantly on reform-centric policy stability, China+1 trigger, super digitization upcycle, PLI based manufacturing scale-up etc. These investors belong to the most bullish camp. On the other side, the bearish investors believe that this resilience may give away to a much bigger fall if the domestic investors give up their support at some point on relentless FII selling amid growing fears that the commodity inflation may slowly seep into a structural stagflation. As per them, it is better to wait on the sidelines. Only time will tell which way the wind will blow.  

Here is where it is critical that the investors take the historical perspective. Else, one will get frozen into inaction clouded by the short-term uncertainties. It is important to remember that no macro risks in the past had a lasting impact beyond few quarters. If one goes back and look at the past macro challenges in the previous cycles, every macro event has been a clear buying opportunity in hindsight. Even in the worst global financial crisis of 2008, where everything was crumbling down like nine pins, the event did not last beyond three quarters for the markets.

The entire FII selling saga can be looked at from another view as well. That is, what would happen to the markets when much of the FII exit money comes back, which it usually does when normalcy returns? Even if half the money (10Bn dollars) comes back in a hurry, one can imagine

where that might take the markets to, esp. when both local and global investors are on the same buying side. Because of such various diverse views, markets seem to be in consolidation mode at the moment. Investors based on their investing horizon, should capitalize on this consolidation to build a structurally strong portfolio on bottom-up basis to reap exceptional returns over time. More so because markets seem to have more or less discounted the taper cycle and interest rate hikes from Fed. What is still not discounted is how far the risks from geo-politics can go. Can it become a wider conflict or will it get contained? What happens on that front will determine how markets will trend in the short-term. Needless to say that we are in interesting times.

Happy Value Investing!!!

This article of mine was published in the online edition of Economic Times (03/03/2022). Glad to share the link:https://economictimes.indiatimes.com/markets/stocks/news/niftys-resilience-amid-ferocious-exit-by-fiis-should-you-rejoice-or-worry/articleshow/90622388.cms

Is RBI’s repo rate losing its relevance?

In usual times, RBI sets the tone for interest rates through its benchmark repo and reverse repo rates. Market then takes the cues from these rates to decide its course on the yield curve. That is a typical text-book style functioning of bond markets. But there are times when market takes the mantle from RBI to set the direction for the interest rates. Currently we seem to be in one such times with RBI falling well behind the curve.

Since the time RBI reduced the repo rate by over 120bps during the period of Feb-May 2020, repo rate has stayed put at 4%. Same is the case with reverse repo with its rate ruling at 3.35%. But, of late, bond markets have refused to buy-into this stability. Looking at the ten year Gsec yield, it hardly paints a stable picture that RBI is projecting through its repo rates. Since last October, it has sharply moved up by over 100bps reflecting market’s staunch refusal to fall in line with the RBI’s accommodative stance. In fact, the yield went all the way up to near 7% immediately after the presentation of budget, before cooling off to the current level of 6.75%+ (as on 24th Feb) level on a surprising (and adventurous to many) dovish stance of RBI in its latest policy announcement post the budget.

There is a justifiable reason why markets are refusing to toe the RBI line. Besides inflation scare, latest budget has also added to the market’s ire on the borrowings. Here is how it stacks up.

From the equity market’s point of view, this budget has been a success, esp. if one goes by the stock market’s response in the days following the budget. It has lapped it up with all cheers, because of the budget’s focus on capex and growth. There is nothing in the budget fine print to upset the equity markets. Given the capex and growth push, the economy facing stocks in the broader space will do very well in the coming months. In effect, the budget is going to push further the economic momentum which the country is already witnessing on account of turn in capex, property, credit and export cycles. But if one looks at from the bond market’s point of view, the picture is not all that rosy.

If at all if there is any risk from this budget, it is likely to come from the bond market. During the budget presentation, there is one number which the bond markets weigh anxiously is the Govt’s borrowing level. This time, the large borrowing number in the budget (Rs 11.51tn net borrowings) for this year came as an unpleasant surprise to the bond markets. Bond markets were not prepared for this huge increase (from Rs 9.67tn last year). Also, the bond markets were expecting some kind of tax benefits to FPIs so as to expedite the inclusion in global indices. There was no such tax concession announced in the budget. Now that there is going to be delay in bond inclusion, market is expecting this large borrowing to put pressure on 10 year Gsec. On that expectation, the yield spiked by over 30 bps (in the days following the budget), only to cool off to a much lower level post the RBI’s dovish policy announcement.

Will this cool-off be temporary? Should one be alarmed by this large borrowings? One should certainly be worried if the packed-up borrowing calendar pushes up the ten year Gsec yield in a dis-orderly fashion. But, given the ultra-conservative nominal growth projections in the budget, this risk is unlikely to play out. In our view, Govt. will have a lot of headroom to manage the fiscal space, because of the extra-ordinary cushion in the budget numbers. Look at the nominal growth as per Budget. It has assumed about 11.5%. But this is an extremely conservative number. If one takes the economic survey as the cue, the real GDP growth as per the survey is likely to be 8.5% for FY23. If one adds the most likely inflation number, one will get a much higher number for nominal GDP growth. As a result, the Govt. in all likelihood, will have a lot more flexibility to alter the borrowing plans as the year unfolds, if the bond yields moves in a dis-orderly fashion. Even in the current year (FY22), Govt. had originally estimated to borrow around 9.67tn, against which the revised estimates are likely to be only 8.75tn. While the Govt. will have a lot of leeway in the managing the borrowing calendar as cited above, new geo-political risks such as Russia-Ukraine situation could play a spoil sport. If this conflict plays out for an extended time, it will have the potential to upset the inflation/interest rate dynamics for India from pressure points that are fed through elevated oil and commodity prices.

In summary, in the context of these evolving risks, it is rather surprising that RBI chose to keep the accommodative stance with super dovish tone in its latest policy pronouncements. Only time will tell whether RBI has been wise in its move or audaciously adventurous in its accommodative stance. Interesting times to watch out for!

This article of mine was published in the online edition of Economic Times (26/02/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/wise-or-adventurous-how-to-read-rbi-policy-action-amid-evolving-geopolitical-risk/articleshow/89845949.cms?from=mdr

Spoilt for Choice?

What taper couldn’t do, geo-politics seems to have managed it. Markets are on a free fall and stocks are on fire sale, thanks to Putin’s adventures. How long and how far this correction will last is anyone’s guess. If history is any guide, going by previous war situations, stocks should bottom out quickly and start recovering in weeks, if not in days. Of course, this assumes that there is no escalation beyond the limited war that is currently on. Given the extent of deep cuts in much of the stock prices, the earlier predicament of buy-on-dip sentiment is likely to shift to sell-on-rallies for now. This would mean that the markets are likely to be under pressure for a while and the momentum may take some time to come back, though gradual recovery is not ruled out.

What is interesting to notice in this correction is the diverging degree of damage inflicted between growth (read expensive) and value stocks. The damage in growth stocks has been much worse than that of value stocks. Probably this is reflective of the emerging shift in underlying trend towards value in the coming environment of broader economic recovery amid tighter liquidity and monetary tightening.

But what is even more fascinating for India is, just when there is a visible turn in the economic momentum, one is faced with problem of plenty. With the increasing number of stocks hitting new lows (esp. in small and mid-caps), one is really spoilt for choices in this manic market. With the capex, property, credit and export cycles turning, the economic momentum has never been stronger for India. From the economic momentum point of view, this sharp correction has come at an opportune time for investors. As someone wise said, “All past corrections look like an Opportunity, while all present and future corrections look like a Risk”. If this is not an opportunity, what else will be? It is time to invest and add to the portfolio positions, not to time the bottom!

Happy Value Investing!!

Will EV story be as electrifying as the market makes out to be?

In the short term, markets are all about stories. They make the markets exciting. Stories put the stock prices on steroid. Who would have thought a mature sector like technology would see a tectonic shift in valuation on market’s successful spinning of super-digitization story. So is the case for new-age start-ups where stories are spun on the next super-apps. But the interesting thing is, stories cut both ways. It is not only on “hope” on which they are built. When they are built on “fear”, that is when, it gets more interesting for investors, esp. the ones who are focused on value.   

Let us take the story of EV with a specific example. On one end of the spectrum, you have a core business (diesel engines for commercial three-wheelers) that is on a sunset with the prospects of slow death. At the moment, over 95% of the operating profits come from this failing core business. That has not stopped its stock price to move up by over 2X over last six months. What did the magic? It is from a successful spinning of EV story to the dying core business. It doesn’t matter that the e-two-wheelers they have launched will take decades to reach scale and profitability. All that it matters is the “hope” that there is a big business out there in the future, however long and far it could be. That is a powerful hope-story in the working. No prize for guessing name of this company.

Now, let us turn to the other end of the spectrum. Here, you have a solid core business (engine lubricants) that is throwing free-cash flow year-after-year with a reasonable growth prospects. The business is a high-quality branded business with high return metrics. But there is a fear in the market that if EV becomes an electrifying story, then it might lose all its relevance. It is another matter that it will continue to grow for decades (and throw free-cash-flows) even if the most optimistic projections playout for EV adoption. But, fortunately or unfortunately, for the markets, “fear” is a good story compared to a decade-long free-cash-flows. It is not hard to guess that the stock price of this company has been languishing with no takers even at a steeply discounted valuation. That is a ferocious fear-story in the working.

Now, here is an interesting question. What if, there comes a new twist to the tale that has the potential to stall (or slow) the EV revolution? That will be a boon for the investors who took to high allocation in opportunities where fear-gauge was feverishly high on EV adoption. Surging lithium prices on global shortages have precisely come as a surprising new twist to the whole EV tale. Lithium prices are up by over 185% in the last six months (40% in the last month alone). Prices of Cobalt and Nickel which go in the battery cells have also been precarious on supply issues. Since these components constitute close to 50% of the cost of cells, sharp increase in prices of these raw materials, as some estimates suggest, has the potential to increase the final battery costs by over 40%+. Since cost of battery forms near 50% of the final EV product, it is fair to assume that the new-age EV players will soon have to contend with the difficult decision of either increasing the prices by over 20%+ or absorbing the hit.

Irrespective of how the EV players will handle this difficult situation, one thing is fairly clear. With the change in cost dynamics now, the timeline for mainstream adoption is going to be pushed farther away from the earlier estimates (which itself was for 2030). Anticipating these supply challenges for lithium to continue, some of the big entrants in the new energy game are throwing their muscles behind the alternates like sodium-ion. Reliance’s recent acquisition of Faradion for USD 135Mn is a case in point.

Sodium-ion is at the cusp of a commercial breakthrough. And Faradion — a company based in the UK, holds 21 patent families on cell materials, cell infrastructure and transportation. Reliance will also invest an additional USD 35Mn to expedite its commercialization agenda.

All these are not going to be good news for current stream of EV “hope-story” bulls as the mainstream EV adoption is not going to be anytime soon. More so for India, given the insurmountable challenges like charging infrastructure, inadequate local battery manufacturing eco-system etc. Of course, while adoption could be faster in the case of three-wheelers and to some extent in two-wheelers, even there, one still foresees challenges because of the change in cost dynamics on surging lithium and associated materials like cobalt and nickel (Ola electric’s ongoing struggle to get its supply chain in shape is well documented)

As this story evolves, it may be time for value investors to screen those stocks that are badly hit by elevated EV fear for value opportunities that have the potential for a major re-rating. Lot could be found in autos, auto-ancillaries, battery makers (lead) and lubricant brands etc. Watch out for interesting times.

Happy Value Investing!!

This article of mine was published in the online edition of Economic Times (29/01/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/will-ev-story-be-as-electrifying-as-the-market-makes-out-to-be/articleshow/89218266.cms?from=mdr

Markets’ mysterious divergence: Expensive at an aggregate level, but attractive at select sectors level?

Pockets of Deep Undervaluation?

Way back in August in year 2020, RBI sounded a note of caution for the markets. It was unusual for the central bank Governor to predict corrections in the markets, that too in the very early stage of the market cycle. But that was what he did, when he said in an interview that there is a disconnect between the stock market and the real economy and a correction will be witnessed. Sensex was trading at around 38K when he made that intriguing comment. Of course, he underestimated the power of global liquidity and the strength of resilience of Indian economy. Driven by these two dynamics, Sensex went on to scale the senior citizen mark (60K+) by Oct’21, surprising both the mint and the main streets alike. Though it has given up some of the gains in the ongoing correction, Sensex is still trading at over 50% higher from the level when RBI did the shout-out on correction.

Now, with central banks across the globe in accelerated tightening mode, the debate on markets’ valuation has come to the fore once again. Fed is now talking about aggressive tapering (winding down the quantum of monthly bond-buying program by 30Bn dollars instead of the earlier plan of 15Bn) and accelerated interest rate hikes (three hikes in 2022 against an earlier plan of one hike). Given these aggressive tightening plans, at the current level markets couldn’t be more expensive on historical terms, esp. with benchmarks trading at 21 times on one year forward. While no one can argue on that, are benchmarks the be-all and end-all, esp. when benchmarks can hide more than what they reveal? Benchmarks are good at reflecting valuations at the aggregate level, not necessarily at the discrete individual sector or stock level. Here is the case in point. In the last six months, while Sensex has surged, certain stocks in select sectors like pharma, auto, and financials to name few, have been slaughtered mercilessly. Some of them are down by over 50% in the last six months and are trading very close to the valuations of early 2020. Such is the disconnect between benchmark and the select ones in the broader space. So, painting the entire market with the same brush of over-valuation may hardly hold water. There are still deep pockets of under-valuation in select space in the broader markets which savvy investors can look at for salivating returns in the coming months and quarters. In general, markets favor bottom-up stock pickers in mid-part of bull cycle precisely for this reason.

Of course, there are reasons why certain sectors have seen step-motherly treatments. Lack of short-term earnings visibility is one of the key reasons for the pressure on stock prices in those sectors. If there are no structural challenges in the sector, then, it is question of time before earnings visibility returns to those sectors that suffer from cyclical challenges for the stocks to get back its shine in the markets. Take for example, in the case of pharma, multiple headwinds like soft prescription sales on Covid, delay in FDA approval for new filings on account of soft lockdowns, pricing pressure on inventory destocking, surge in input-prices on supply-chain issues etc. have all come together as a perfect storm to conspire a deadly slowdown in generics sales in US markets. As a result, Indian pharma companies which have a concentrated revenue share in US generics have been particularly hit on revenues and profitability for the next few quarters. As to be expected, markets with its obsession with next quarter earnings, have de-rated such stocks by over 50%+ to extremely attractive levels. One is spoilt for choices in this space with some of them offering substantial margin-of-safety from their inherent long-term intrinsic value.

Similarly, auto is another space for cherry-picking, given the short-term challenges in the chip supply. With markets in no mood to wait for eventual pick-up in credit-cycle, banks and non-bank lenders have been relegated to least wanted remnants. This is in spite of some of these lenders regaining their balance sheet and capital strength on improving asset quality and write-off issues. Like this, one can look at sectors like media, entertainment etc. where ad-cycle turn (over time of course) will bring the market interest to such ignored space.   

To summarize, as portfolio managers, we are as kicked now to find the next under-valued opportunity in this mid-cycle of the bull market as in the early stage last year, given the ample opportunities which market is willing to provide, because of its manic obsession with the short-term numbers. Rather, to put it succinctly, market is still meaningfully meaty for mindful stock pickers in spite of its stellar run since last year.

Wish all our readers a very Happy New Year!!

This article of mine was published in the online edition of Economic Times (04/01/2022). Glad to share the link: https://economictimes.indiatimes.com/markets/stocks/news/mysterious-divergence-of-stock-market-sensex-looks-expensive-but-certain-sectors-turn-attractive/articleshow/88688448.cms?from=mdr

Why have surging FII outflows not rattled the Rupee?

Rupee’s remarkable resilience amid rising dollar index is at odds with its historical trend.

There is an unwritten rule in financial markets. It goes like this, “Give an inch, they will take a mile”. Even a tiny wobble in the leading index can wreak havoc in the smaller ones that track it. Small movements in the larger benchmarks get magnified in marginal ones. This magnification rule drives almost every aspect of financial markets, with no exception. One doesn’t need a dashing move in Dow Jones for Russel index to rocket (Russel is a US small-cap index for the uninitiated). Inching up of Dow can get you a mile of Russel. Same is the case with our own Sensex and Nifty. Our small-cap index sizzles even for a not-so-sizable shift in Sensex. Taking these cues further to currency markets, it should come as no surprise that emerging market (EM) currencies would dance to the tunes of dollar index with wild swings. Remember the mayhem in Rupee during the summer of 2013 when dollar index inched up during the taper tantrum.

Given this history, it is natural that any negative cues (rising) in dollar index is watched with trepidation by EM central banks. But the recent trends have defied these norms, esp. in Rupee. Looking at the last two months data, with dollar index rising from 94 to 96 level (as on 26th Nov’21), one would have expected a magnified fall in Rupee as happened on earlier such occasions. But far from it, Rupee has barely budged in the last two months. In fact, it has marginally moved up from 75.12 to 74.80 level (as on 26th Nov). Does this signal a new strength for India’s currency? Or, presence of some tactical factors that are keeping the Rupee strong temporarily. Let us find out.

When dollar index firms up, predictable things happen. Carry trade reverses anticipating a further rise in dollar. As a consequence, EMs see large FII outflows. Since such out-flows happen in a disorderly fashion, it leads to sharp fall in their currencies. This time too, in the last two months, FIIs have pulled the plug with large outflows from secondary market.  Estimates indicate that FII equity outflows have been huge, in the range of 6Bn dollars since early Oct. When such large outflows occur in short period, it hits the financial markets very hard (both equity and currency markets). The reason, it had not shaken the Rupee this time, is because of large counter-flows in the primary (IPO) market. Oct-Nov was the busiest season for IPO here with Paytm, Policybazaar and Nykaa raising near Rs 30,000Cr. In this Calendar year alone, India has raised near Rs 1.00tn (appx15Bn dollars) from the primary market. This is an all-time high for any single year. The earlier high was Rs 67,000Cr in 2017.  These large flows into the primary market coupled with the huge forex reserves of 640Bn dollars (which RBI could use to stem the fall in Rupee) made the trick this time to spare Rupee from nasty fall.

But the larger question is how long Rupee can avoid the damage from the incessant outflows from the secondary market. More so when the Indian currency is relatively over-valued on REER basis (Real Effective Exchange Rate). To quote independent research firm QuantEco, “We estimate that the Rupee’s relative out-performance in Nov will lead to 9.4 -9.9% over-valuation on REER basis, the strongest level in nearly four years”. Further, with the IPO market expected to cool-off post the Paytm’s disastrous debut, it is reasonable to expect that Rupee will come under pressure sooner than later. More so with the renewed scare on new Covid variant that is engulfing the financial markets. Of course, given the large forex reserves with RBI, the damage, even if it happens, is unlikely to be as scary as 2013. Current forex reserves can cover over 15 months of imports. Such a large import cover gives a huge cushion to RBI to take any steps to stem any steep fall in Rupee.  

With this new variant Omicron, the whole carry trade saga could take a new twist as well. For some reasons, if the risks of economic disruptions (lockdowns) come to the fore because of this new variant, it might force Fed to go slow on tapering and also to put off the time for eventual rate tightening cycle. This, if happens, will weaken the dollar index and the US treasury yield. This, as a consequence, will set off a new carry trade cycle, which in turn will boost larger flows into EMs.  At this point of time, one is not clear which way the wind will blow. But, whichever way it blows, it is unlikely to cripple the Indian currency in any crucial manner.

Interesting times to watch out for!!