What is our take on the Economy and the Financial Markets?
In our advisory note published on 1st Aug 2019, (NIFTY @ 11,000) we had upped Equity allocation in our portfolio to 65 – 70% range. Since then NIFTY has risen by 1,000 points to 12,000.
We think the risk rewards are more evenly poised now. While, the long-term growth picture for India is robust, there are significant near-term headwinds. As such, we do not expect Equity Markets to run away in a hurry.
We are taking this opportunity to bring down our Equity allocation to 50 to 55% level in view of factors outlined below:
- GDP growth in Q1 of FY-19-20, collapsed to 5%. Levels not seen for many years!
- Unfortunately, green shoots of recovery are still not visible in various economic indicators (IIP, Credit growth, corporate sales etc..,). As such this weakness may well continue for some more time.
- Our take is that while the Economy will recover, recovery will be gradual and is likely to be an U shaped one rather than V.
- This is because the Credit flow in the Economy, since ILFS collapse, has got completely choked and is not going to recover in a hurry.
- NBFC’s continue to struggle and face one of the severest liquidity crises
- In view of the above, we expect sub 5% growth in Q2 of the current Financial Year and closer to 4.25% growth in Q3.
- Our Equity markets not only face the slowing domestic economy but also risks emerging from global factors. We feel that US China trade war as well as BREXIT remains significant risks. At the same time USA markets are now in their 11th year of expansion and may stall anytime.
In this note we have looked at factors that have led to the growth slow down as well as evaluated whether Govt. has taken the steps that are necessary.
Further we have outlined the key themes that we are betting on in the Equity & the debt markets at the current juncture.
Why is GDP growing at a rate significantly lower than Potential?
Most economies around the world during the catch-up phase, have grown at 9 to 10% range not for a few years but for decades – Japan & Germany post second world war, South East Asian economies in the 1980’s, China since 1980 till recently. The list can go on.
India too has been growing at 6.5 to 7% range in recent times. It is in this context, that most observers have been completely taken by surprise by the sharp and protracted growth slowdown. The surprise has been greater, as we have just mandated a strong & stable Govt at the Center, which should have under the normal circumstances, significantly boosted the market sentiments.
That we are currently growing at 2.5% below potential, is a combined impact of many factors, some of which could have been avoided:
- Excessively tight monetary policy (Real rate exceeding 4.5%), while it brought down inflation, it has drastically slowed growth.
- Measures such as GST (though necessary) too has slowed the economy
- A strong commitment to fiscal deficit (3% level) has resulted in a very tight fiscal policy.
- Insolvency & Bankruptcy code along with implementation of Asset Quality Review/ Prompt Corrective Action mechanism too has drastically impacted credit flow in the system.
- Further the NBFC crisis (precipitated by ILFS default) has been the final nail in the coffin, that has completely choked credit flow in the system.
- Finally, subdued global markets have resulted in exports to slowdown.
What steps has the Govt taken to revive the Economy?
The issue of inadequate aggregate demand is being addressed by providing strong monetary/ fiscal stimulus. I will not be surprised if the deficit breaches 4% level this year. At the same time, there are several initiatives that have been taken for easing the liquidity crisis in NBFC sector.
On the structural front too, the Govt. has taken steps such as (1) Lowering of corporate Tax rate (2) Identifying sector specific issues including that of export slowdown (3) Personal Tax reform is in the offing too.
What additional steps should Govt take?
The need of the hour is to implement productivity enhancing reforms such as Land & Labor, as well as large scale Privatization of PSU’s.
At the same time, the country needs to build infrastructure at accelerated pace. This will not only stimulate demand but also lay foundation for far higher productivity. As most private players had burnt themselves in past, existing PPP framework needs to be completely overhauled.
Any positive development on these fronts will be important trigger for the market.
What are our Key Investment Themes Going forward?
Equity Related themes
- There is too much premium being paid for quality and hence we plan to avoid the MEGA Caps (FMCG, Private Banks etc.,)
- PSU – Most PSU stocks are trading at deep discounts (earnings Multiple of 10 to 12) and privatization may be a good trigger for their re-rating
- Pharma sector may significantly outperform (1) Quarterly profits have stopped declining (2) India business is doing well (3) Specialty segment in USA is starting to make headway (3) At the same time China generics formulation market is opening up
- Mid Caps – The mid cap index is still down over 20% since the peak achieved in Jan 2018. In view of the reasonable valuation, we see more value in this segment.
- Metals – US China trade war along with global slowdown has been a major challenge. We do see deep value emerging in many of the metal stocks
Fixed Income – Duration Play
We expect 10-year G Sec (new benchmark bond) to trade between 6.3 to 6.8%% for next 1 year
Fixed Income – Credit Play
- Govt Securities are trading at 6.5%.
- AAA papers (Tata Cap, LT Fin, M&M) are available between 8.3 to 9.0% yield
- AA+ papers (Muthoot, Mannapuram, Shriram Transport) trade between 11 to 12%
We believe that risk perception for anything less than AAA papers is at its peak. As the economy recovers, we expect the yield spreads to normalize. As such, we see value emerging in papers rated lower than AAA.
To the more sophisticated investors, we have started recommending Credit Risk Funds or even direct exposures in AA + Corporate papers.