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Cutting through the Noise

Oct 5, 2020

Covid continues to dominate headlines and mind space for most of us albeit in different ways. India continues to tread towards full unlocking, and we may have bent the curve. The US is also reporting fewer fatalities, although the focus is now on the convalescing the President and the first lady. Europe despite being firmly in the grip of a second wave, has a much lower fatality rates this time around. Lockdowns are more exception than the rule in Europe implying people are learning to live with the virus.

Europe ex UK covid new daily cases and deaths

Covid response is turning out to be a key factor in the US electoral politics with Biden gaining further lead over President Trump in opinion polls post the first presidential elections. With President Trump being forced into isolation the campaign trail that was otherwise running hot, will lose precious momentum in these crucial ‘slog overs’.

In India, a significant event in the past month was the agriculture reform bill being passed. This reform will allow farmers to freely transact and in the long term allow for a more efficient price discovery. However, states need to support execution for ensuring success of the bill.

Global equities had a volatile month with the Nasdaq correcting almost 10% from its September 2nd peak. A megacap like Apple witnessed dramatic moves of ~30% run up since Aug beginning to the September 2nd highs and then a sharp 18% correction post that.

Notable, Nikkei 500 surpassed its previous Dec 1989 peak in the past month – that’s after a whopping 31 years. It reminds us of the perils in blindly believing that equities at any price is justified, if the horizon is long and that long range GDP and corporate earnings growth has no substitute.

Last week the RBI released the government borrowing calendar for the second half of this fiscal year. The government decided to stick with its revised target of INR 12 lakh crores for this year as against market expectation of a much higher government borrowing plan. However, 10-year government bond yield hardly reacted suggesting that market doesn’t seem to believe in the fiscal maths. GST collections have been much lower than target, there is little room to cut government expenditure and there could be need for further fiscal stimulus to support economic dislocation due to the pandemic. Hence, it is unclear how the fiscal gap is going to be bridged. A slightly higher, but a cleared borrowing plan would have helped reduce market uncertainty, in our view.

Quarterly Asset Pair Allocation Update

Towards the end of every quarter we run our asset pair model which provides us with valuable inputs that help formulate our investment strategy. This methodology helps us focus on multiple factors and data points rather than getting lost in the noise that is amplified these days. Our asset pair methodology did not suggest much change this time around. We are neutral on most asset pairs and continue to think that INR and Gold could do well compared to USD and cash respectively.

Equities Vs. Bonds

Macro data improving, though valuations expensive

Since the sharp fall in March 2020, equities have rebounded handsomely. In fact, parts of the Indian equity market have almost fully recovered losses for this calendar year. This move up has coincided with cut in earnings, hence valuations have become expensive. Even though bond prices have also rallied over the last few months, resulting in very low bond yields, equity valuations relative to bonds are much higher.

Valuations supportive of bonds

Equity valuations have shot up

On the other hand, while macroeconomic data remains weak at an absolute level, the trend is improving. This could be one of the reasons driving equity prices higher. Additionally, corporate earnings for quarter ended June 2020 delivered positive surprises with higher than expected EBITDA margins leading to better than expected earnings. We will be watching for follow-through of this trend when the earnings for quarter ended September 2020 are announced in the coming few weeks.

PMI’s have witness sharp rebound

Earnings revision have turned positive

After strong technical momentum in August, equity momentum has moderated over the last one month with equity prices now consolidating around current levels. Also, domestic institutional investors have turned net sellers over the last couple of months even as foreign investors remain net buyers.

Overall, improving macroeconomic data and positive earnings surprise is getting offset by elevated valuations. Technical indicators and flows are also neutral. Hence, we continue to remain neutral between equity vs bond asset pair.

Large Cap Vs. Midcaps

Not much to choose

Given the economic dislocation due to the pandemic, the broad consensus was larger companies would be better equipped to strive and consolidate in current environment. This to some extent has reflected in corporate earnings for last quarter. We have seen higher earnings downgrade for midcaps compared to large caps thus far. However, in terms of price performance midcaps have done slightly better than large cap at an index level. Some of the better run midcaps and small caps have in fact significantly outperformed large caps this year. Hence, in terms of trailing price to earnings midcaps are expensive compared to large caps.

Midcap earnings downgrade outpaces large caps

However, analyst expect greater bounce back in earnings for midcap relative to large caps over year or so. Hence, in terms of 12month forward PE, midcaps are slightly better off compared to large caps. Also, as highlighted in our last investment strategy note, we have seen more midcap trading ideas by our trading desk in last few months. This indicates that technical momentum is also relatively in favour of midcaps.

Nifty valuations higher than historic avg.

Midcap forward PE slightly better off

With no clear indication in favour of either of the asset class, we are moving neutral on midcaps compared to a marginal large cap bias earlier.

Corporate Bonds vs Government Securities

Limited corporate spreads but increased government borrowing a dampener

As we have already articulated in our various commentaries, corporate bond yields have plummeted over the last few months. There is hardly any spread between corporate bonds and government securities currently. While spreads remain elevated for corporate bonds rated below AA, risks are also elevated for that segment. Corporate downgrades continue to outpace upgrades by a huge margin.

Corporate spreads have plummeted

Downgrades outpace upgrades

While borrowing calendar announced by the government last week did not indicate higher than target borrowing, as highlighted above market doesn’t seem to believe in the fiscal maths. GST collections undershot government expectation last fiscal year itself. To add to that economic activity has been muted in first half of this fiscal year. Hence, GST collections have missed target by a huge margin thus far and are expected to track lower. Additionally, government expenses are unlikely to decline in current times given the medical and other associated cost of the pandemic. It is unclear how the government will fund this gap. Muted credit growth and hence limited avenues to lend suggest banks have some room to absorb higher supply of bonds. Also, the RBI has been doing OMOs. However, it might not be enough to fully absorb higher government bond supply even if the government is able to sick to its borrowing plan.

Government borrowing to be closely watched

Lower credit growth to support some demand

Short-Term vs Long-Term

Term spreads attractive, but duration call still risky

Consumer (CPI) inflation has been exceeding RBI’s upper target band of 6% for a few months now. Higher food prices have been a key driver of CPI inflation. With easing of lockdown, supply side constraints are likely to ease which could support lower food prices in the future. Additionally, good monsoon and moderate rise in MSP could also support lower food inflation. However, as highlighted by the RBI in its last monetary policy, inflation outlook is quite uncertain. This could constraint RBI’s ability to reduce interest rates further.

Terms spreads attractive

Inflation higher than RBI’s target range

The yield curve has steeped now. There is significant difference between the yields offered by short-term bonds and long-term bonds (term spreads). However, increased government borrowing and limited room available with the RBI to cut rates any further could be risks to a duration call. A duration call, in our view, at best could be a short-term tactical call for risk-aware clients. Thus, we are neutral between short-term and long-term bonds.


Macro, technical momentum supportive of the INR

The INR has strengthened relative to the dollar this calendar year. Our asset pair methodology suggests that INR strength could continue going forward as well. The macroeconomic data is supportive of the INR. Crude oil makes up a large portion of India’s imports. While they have recovered from recent lows, crude oil prices continue to remain low. This has kept India’s current account deficit in check and balance of payment in positive territory. Additionally, FDI inflows have more than offset FII outflows from Indian debt market. The RBI has also added to FX reserves during recent INR strength. All these factors are supportive of the INR.

India’s FX reserves have increased significantly

Lower crude prices supportive of the INR

Momentum is also supportive of the INR. Notwithstanding the recent bounce back, dollar index (DXY Index) has been weak this calendar year. Technical indicators suggest dollar index weakness and INR strength could continue going forward as well.

Gold vs Cash

Most factors still in favour of Gold

After a stellar year or so, gold saw some profit booking last month. Many wondered if the gold run was getting over. To the contrary, our asset pair score moved further in favour of gold last month. While gold valuations relative to other commodities has increased, a weaker dollar has helped gold. Most global central banks have indicated that “lower for longer” continues to be the theme for them. Increasing expectations of US yields veering below zero should support gold prices. Although the demand for physical gold has been weak, demand by ETFs, speculators has been quite strong.

USD weakness supportive of Gold

Rising ETF holding has supported Gold

As we know, gold acts as a hedge when equity volatility is elevated, hence, increased equity volatility has also supported gold this year. With global equity rally, volatility had begun to decline. But last month as global markets oscillated between gains and losses equity volatility picked up again. As we head into US election, we expected volatility to be on the higher side. Geopolitics is another factor influencing gold prices. China’s increased political friction with the US, HK, Taiwan has now toned down in the past few days but the risks continue to lurk in the background.

Hence gold can act as a protection in a client portfolio. Thus, we continue to remain overweight gold in our portfolios.

Elevated equity volatility positive for Gold

INR Gold moving higher

Summary of Our Asset Model

Portfolio Strategy Commentary and Actions

We have often repeated that market is running ahead on anticipation of economic recovery and on the back of global liquidity unleased by central banks and governments across the world. Hence even at the cost of being repetitive, we want to reiterate that we remain cautiously optimistic in managing our portfolios. The forthcoming earnings result as well as the festive season will be key events to watch out for, in setting the expectations right for demand environment in the economy and way forward.

In Sanctum Indian Olympians, while we have deployed some cash during the month, the portfolio construction still remains counter cyclical. Most of the businesses we own are the ones with market leadership, lean balance sheet with superior quality management and the ones which have the wherewithal to tide through this crisis and emerge stronger. Hence, we believe this will be the portfolio which will sail through the current storm despite downward revisions in India’s growth forecasts.

In Sanctum Indian Titans, we have a choice to hedge the portfolio to safeguard the investors from any potential capital erosion. We have, therefore, been intermittently hedging the portfolio partially in the last three months. As we await the outcomes of the earnings season, festive season and US elections we have partially hedged our portfolio for October as well.

Further, as we move to a neutral view of midcaps we added Nocil. It passes our quality filters and is also attractively valued. Nocil is a market leader in rubber chemicals with 45% market share in India (rest of the demand mostly met through imports from China). It also has strong presence in export markets, generating one third of its revenue. With increasing cost of production in China and rising anti-China sentiments, Nocil should benefit from the uptick in demand. It has a debt-free balance sheet and generates healthy return ratios.

We also continue our hedges in Sanctum Smart Solutions as the market warrants caution. Even though hedges incurred some losses for us last month, we added December puts to provide protection against the major event in November, US presidential election.

Technical Commentary

After 5 months of rally, Nifty saw some consolidation last month. We are now seeing lower highs and lower lows on daily chart of Nifty. Even though Nifty bounced back from its 200-day moving average last week, it has moved below 21-day exponential which was acting as support during the rally. Nifty has a negative bias in the short term as indicated by long bearish candles. The recent low of 10,790 is now a key support. 10,790 marks 200DMA, 23.6% Fibonacci retracement and pervious swing low. 10,158, 38.2% Fibonacci retracement of the entire rally from March lows, is the next support if there is a break below 10,790. On the upside, 11,800 need to be broken for a fresh uptrend to emerge. 12,250 would be key resistance if 11,800 is broken. Also Bank Nifty needs to show strength for any sustainable uptrend to emerge. India VIX seems to have stabilized around 24-19 levels over the last one month, however we expect it to rise as we head into US elections next month.

Broader market indices BSE Midcap and Smallcap have both hit key resistance levels on long term chart. Smallcap index has been in a range of 15,450 and 14,100. A break below 14,100 could suggest a decline towards 12835-12780 levels. While a break above15,450 needs could suggest a rally towards 17,100 levels. Midcap index has resistance at 15,380 which needs to be broken for rally towards 17,000 levels. On the downside, a break below13,900 could lead a decline towards 12,950.

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