Backdrop – Year of Corona
Time magazine came up with a cover showing 2020 with a big red cross across it and calling it the worst year ever. Some of the other descriptions of the year include wrought with pain, maddeningly mundane, debilitating and total helplessness. However, it is ending on a good note with rapid vaccine introduction literally injecting lots of confidence.
2021- Confluence of Favourable Factors
Combination of global and economic factors are providing India with a great opportunity to put itself in a fast sustainable growth model. Indian response will determine the future trajectory.
Strategic Geopolitical Reset
Many countries have realized that national security, economic security and health security are all intertwined and therefore the global supply chains cannot be just structured for efficiencies and profitability, but have to be diversified and self-reliance is increasingly important.
China has grown rapidly but is also perceived as an expansionist and has built up a wolf warrior reputation. Overcoming China’s expansionism is an objective irrespective of whichever USA administration is in power. Biden’s incoming National Security Advisor Jake Sullivan stated in the context of China that if you continue to abuse the system, there will be consequences.
Additionally, from an economic perspective, it is in the strategic interest of the western world that India emerges more rapidly as a source of not even greater demand but greater supply too, thus reducing excessive dependence on China. India’s market economy and responsible governance makes it a safe partner when it comes to contract designing and manufacturing.
Dr Jaishankar states in his book ‘The India Way’ that most impressive growth stories of the last 150 years have all been with the participation of the West. It is true of Japan in 1950s, South Korea in 1960s, ASEAN in 1970s and China in 1980s. These countries absorbed technologies and built their own competencies. India has the same opportunity now with its big domestic market and favourable demographics.
Vaccine distribution will be a key factor in facilitating reopening of the economy. Serum Institute of India expects to have 10 crore doses ready by January 15, 2021 and from March onwards, is likely to produce 10 crore doses every month. India is expected to have 30 crore people vaccinated by July 2021.
The world is awash with liquidity, with Federal Reserve and central banks including RBI reducing interest rates and injecting tremendous amounts of liquidity. Additionally, an unprecedented U.S. peacetime fiscal deficit, combined with aggressive monetary stimulus is putting pressure on the dollar, which has weakened considerably with USD index falling to 89.8 from the levels of 103.8 in March 2020. Indian Rupee which was at 76.5/USD is now close to 73. These factors have generally favoured emerging market economies as they attract more capital seeking higher returns without the risk of depreciating currency. Some analysts also see this as starting of a decadal shift to the emerging markets.
Cost of capital has declined substantially in India– good corporates were borrowing at 12%, now the rate has declined to 7%. These are likely to remain low. Besides, oil prices are low and that is good for the Indian economy.
Finance Minister Nirmala Sitharaman said in an interview this month that she wouldn’t let worries about a fiscal deficit stop her from spending more. “There is a need, and a clear need, for me to spend the money,” Sitharaman said. The federal government’s budget gap will probably widen to 8% of GDP this year since the government’s priority now is to have a sustained economic growth. And the federal budget on Feb. 1, 2021 is likely to demonstrate this intent clearly.
India is making efforts to take advantage of global supply chain diversification. PLI (production linked incentive) scheme aims to give companies incentives on incremental sales from products manufactured in domestic units. The scheme invites foreign companies to set up units in India, however, it also aims to encourage local companies to set up or expand existing manufacturing units. It has targeted 10 key industries including electronics, pharmaceuticals, ACC battery, Solar panels, Automobiles and auto components.
Earlier, the government had introduced a favourable tax regime for new manufacturing companies. The Taxation Laws (Amendment) Ordinance, 2019 passed on 20 September 2019 inserted Section 115BAB offering a low tax rate of 15% (plus surcharge and cess) to new manufacturing companies.
RBI is likely to keep an accommodative monetary policy for some time and will tolerate even higher inflation. Repo rate is currently at 4 %, it was at 5.15% in Feb 2020. 10-year bond yields are hovering around 5.8%. Lower interest rates help the economy, for example home loan rates are now available at very attractive levels.
In India, digitisation is gathering pace and the pandemic has accelerated the adoption of digital technology. This trend will have lots of impact with good productivity enhancement and benefits in many important sectors including education and health. Reliance along with Google will be manufacturing low cost smartphones and 5G services should also be introduced in the not too distant future. The vision is high speed internet connection available for every gram panchayat, easy access to common services centre within their locality and safe & secure cyber space in the country.
Big crisis like Covid forces major reforms. While developed economies have spent lots of money for coming out of the crisis, developing economies which did not have money are pushing reforms –India is relaxing labour laws and rules that have protected farmers from the market forces for decades.
With the confluence of all the factors stated above, India seems to be at the cusp of a multi-year economic growth cycle. India may record its fastest GDP growth in history, maybe 11-12% next year. This will of course be a bounce back because of the low base effect caused by Covid deceleration. More importantly, probability of it being sustainable is high. One important indicator is that India has proved far more resilient despite small fiscal stimulus which means the long term scars will be shallower. Additionally, as more people get vaccinated, services including tourism, travel and restaurants are likely to come back. Importantly, gross capital formation has remained at 29% in spite of Covid. A reasonable incremental capital-output ratio of 4 can yield close to 7.5% annual growth, but implementation efficiency will determine the actual growth rate.
With a sustained economic growth, there is a high probability of a sustained rise in Indian equity indices. Interestingly, the markets already are at an all-time high and the natural question is that where do we go from these levels. In reality, during the last 3 years, the markets have risen very little. 2018 was a negative year for Indian equities while 2019 was slightly positive, 2020 saw a great rise but preceded by a great fall, thus last 3-year Indian equity returns are close to only 5 % annualized.
Another question is about the current high valuations. However, if we look at India 10-year bond yields those are hovering around 5.9% and the low yields are here to stay. Additionally, there are expectations of a broad based strong earnings momentum during FY22 and FY23. Future earnings growth and low cost of capital can still support a further rise.
With the global stock of negative-yielding debt near $18 trillion, the hunt for higher returns will continue to favour emerging markets over developed peers. A recent survey of global fund managers showed that higher-yielding currencies and bonds, such as those in Mexico, Brazil and India, were favoured.
My overall view of the equity markets is that the ride could continue though with occasional bumps. As the last quarter of CY 2020 showed, the recovery could be quite broad based with high quality stocks of different market caps and multiple sectors expected to participate.
Risk factors – what may trigger profit preservation
Firstly, the world has changed and there is no easy globalization. For China and ASEAN countries earlier, it was much easier to access global markets and technology. Now many countries are warier and cautious.
Commodity cycle will eventually pick up. For example, in the last couple of weeks, Brent oil prices have moved up to USD 52/bbl. Prices below USD 60 are fine for the Indian economy, but beyond that could be an impediment for growth.
Inflation is creeping up and it is difficult to forecast how it will fare in the future. If inflationary pressures develop, it can lead to RBI not being able to pursue an accommodative monetary policy.
Market is discounting that Covid will soon be contained because of vaccines and any setbacks in that direction could be a negative factor. There have been mutant strains, especially in UK. Vaccine distribution is also a major logistical exercise and there could be unexpected problems.
Additionally, the market is forecasting a full-fledged recovery in a short frame of mind, and if that does not happen, it can lead to a correction. For example, it is yet to be established whether the pickup in demand for autos is a pent up demand or genuine long term demand which can be sustained.
Implementing reforms in India is not easy and Indian government is facing significant resistance against farmer and labour reforms. Additionally, there have been problems in land acquisition and privatizing power distribution. It is possible that India can miss out on demographic dividend – it currently has a labour participation of 43% as compared to 60% of so called miracle successful economies.
The first step as always is appropriate asset allocation which is dependent on individual goals and the market view. Each portfolio should have a hierarchy of liquidity, safety and yield enhancing. Money with less than 1-year horizon should be in liquid funds, 1-2 years in short term debt funds and 2-4 in hybrid or balanced schemes. Given our bullish view, long term money with a horizon of more than 4 years should be invested in equity schemes.
Equity scheme selection should closely express our view of a broad based recovery accompanied by corrections. The selection should be such where it participates and generates alpha but at the same time should not fall drastically in a correction because of any risk factor becoming prominent.
First selection parameter will be to evaluate schemes on the basis of alpha (returns higher than the benchmark) generation in a consistent manner over different time periods. Second will be low risk ratios so that in the event of a correction, movement of the whole portfolio should not be volatile. Third will be their actual stock composition- these schemes should have a good mix of large cap and mid cap stocks of leading companies in their respective sectors.
Moreover, in scheme selection for the current scenario, we have to adopt a barbell approach which is essentially riding in 2 boats. There has been a major sector rotation in the current up move where leadership has swiftly moved from one sector to another. Barbell is a combination of both defensive and cyclical sectors. Defensives include information technology(IT), pharmaceuticals and consumer staples. Indian IT companies in the present set up are not merely defensives but seem to be riding a new growth wave because of a strong global trend of migrating to cloud and this trend can last for a few years. Cyclicals will include financials including private banks and insurance, consumer durables, industrials and energy stocks.
Overall, there is tremendous opportunity for the Indian economy to grow and indications are that Indian equity can come back to its winning ways. Investors can do well by selecting appropriate and relatively stable schemes to express this multi-year, multi- cap and multi-sectoral view.