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The Great Disconnect

Sep 7, 2020

In each of our commentary over the last five months, at the cost of sounding like a broken record, we have written about the global disconnect between the real economy and equity markets. The US leads this gulf. It’s hard to reconcile staggering facts such as US government debt is expected to exceed the size of its economy this year and S&P 500 delivered 9% return in August and 21% for the past year. Fed now owns almost a third of all bonds backed by home loans in the US. A harsh sounding but accurate articulation of the situation we read was “Markets are trading on a perverse combination of Fed life support and rabid speculative mania”.

US Federal Debt as % of GDP


Global Macro

In a somewhat anticipated move, the US Fed chair, Jerome Powell, announced formal reorientation of Fed policy from rigid inflation targeting to average inflation targeting allowing the Fed more wriggle room. Effectively, markets now stand assured that Fed will hold off hikes even if inflation spikes beyond 2% temporarily and hence, rates will stay lower for longer (consensus is until 2023). Meanwhile, Europe is facing its second wave of Covid cases. However, governments and the populace are resisting lockdowns in the current wave.

Even as economies have opened up, economic data remains grim – Australia after 27 years is now in a technical recession. In reaction to this, governments around the world have been stacking up debt to fight the pandemic driven slowdown.


Equity markets, on the other hand, continue to shrug just about all such news on its way up. The tidal wave of liquidity is so strong that bets against US stocks are at lowest levels sees since 2004. Big tech continues its dominance with Apple’s market cap surpassing that of the entire Russel 2000 (US small cap index of 2000 companies).


In fact, global market cap has now inched beyond USD 91 trillion which equals to 105% of global GDP and yet our technical analysts continue to believe that the US markets have more steam left.

Global Market Cap to GDP Ratio


Indian equity indices too have shrugged off the worst GDP print since India started publishing quarterly figures in 1996 and posted about 3% gains for the month. India is on its way to its first annual contraction in GDP in last 40 years. With a lockdown that was more stringent and longer than most, our GDP contraction was amongst the worst in the globe.

April-June 2020 GDP Growth


While India’s manufacturing PMI for August was in expansion zone, services PMI contracted for the fourth consecutive month. The patchy economic recovery is also reflected in the GST collections with July 2020 collections coming in at 86% of July 2019 numbers. Sporadic lockdown across states impacted movement of good and by extension GST collections adversely.


The rally past month has been broad based with midcap and small cap participation. Midcaps and small caps have sharply underperformed large cap since early 2018. In fact, the divergence between midcap/smallcap and large cap performance had become quiet stark by March 2020. Yet we saw broad based correction in March 2020. There were concern that midcaps and smallcaps would face greater pain in the current economic dislocation. However, we are now seeing increased interest in mid and small cap names. We noted that lately calls by our trading desk have more midcap names than large cap names – an indicator that the momentum has strength.


Portfolio Actions

As highlighted above equity momentum has strength. However, we believe earnings growth will be the key driver over the longer term. Both our in-house strategies are focussed on earnings growth. In the quarter gone by the weighted average earnings growth for both the portfolios was much higher than the benchmarks and we believe the same trend will continue in ensuing quarters. While, both our strategies outperformed their respective benchmarks in the month of August, on absolute basis, our multicap strategy – Sanctum Indian Titans did better given the broader market rally even after factoring in the hedging cost.

Akin to wearing a life jacket while rafting, in Sanctum Smart Solutions, our in-house momentum-based strategy, we bought inexpensive hedges while increasing risk exposure by buying more midcaps and increasing sectoral concentration. We will look to hedge intermittently through to November when volatility around US elections may increase. Similarly, in Sanctum Indian Titans, we hedged about 15% of the portfolio in August and continue to remain hedged to similar extent in September as well.


Technical Commentary

The Nifty continues to make higher highs and higher lows for the current rally which started from the March low of 7,511. However, the pace of rise has moderated and closely tracks the rising support trend line from March lows. Every dip is getting bought into.

11,800 is a key resistance level, a breakout above it would suggest that the rally could continue towards 12,000 and then towards 12,250 levels. On the downside 11,325 (21-day exponential moving average) is the immediate support. A break below this could suggest correction in the market. 11,110 and then 10,880-10,800 zone (200 day moving average) are key supports after 11,325.


India VIX has been declining since March and is currently at 21 level, a six-month low. We saw a sharp spike in VIX in late August, which is expected at lower levels. However, if VIX rises above 25-28 level we could see selling pressure in the market.

While overall the market trend remains positive, caution needs to be maintain going forward.

As highlighted above US markets remain in positive trend. S&P 500 has hit new all-time high. The next key levels for S&P 500 are 3,610 and 3,780. Nasdaq is also setting new highs; it has significantly outperformed the broader markets. US dollar is in a downward trend against major currencies including the INR. Crude is range bound with a positive bias. Gold has seen some correction lately, however it managed to hold above USD 1,900/oz levels which is a key support level. USD 2,025/oz is a key resistance for gold.

Fixed Income

The monetary policy statement released earlier this month held rates steady, it was fairly dovish, and it acknowledged an uneven economic recovery. In our monetary policy note dated August 6, 2020 we had stated that we don’t see much steam left in the bond rally. In fact, bonds sold off towards the end of the month as the minutes of the MPC meeting indicated that there are inflation concerns. The sell-off was met with prompt intervention by the RBI, which announced OMOs and enhanced HTM (‘Hold to maturity’ portfolio) limits. Real interest rates (interest rates minus inflation) is close to zero, with prevailing inflation concerns there appears to be limited room for further fall in bond yields unless the RBI surprises by adopting unorthodox measures.


India Inc has delivered better than expected results for the quarter due to cost cutting measures and quick wins on improving productivity. But valuations continue to run ahead and price in a lot of optimism. If one were to look at markets unidimensionally, taking gains off the table would make sense. But our multi-factor model ensures that we look at markets from different angles. Technical indicators continue to show momentum and hence we continue to stay invested in equities.

As highlighted earlier, in our portfolios we are partially hedged using put options. We believe, volatility around US elections may increase as we approach November. Investors that are concerned about the volatility in equity markets can look at hedging using out of the money put options. Current costs are fairly low, if volatility does increase the cost of hedging will also shoot up. Hence, hedging now rather than waiting is a better strategy in our view.

In fixed income our pursuit of opportunities, well balanced for risk, continues. The 6-8 year bucket looks tactically appealing (only for risk-aware investors) but this is best addressed through direct bonds than mutual funds, in our view. Our asset allocation portfolios traditionally have used only debt funds as route to market but upon careful consideration we find that REITs/INVITs could add value on a risk adjusted basis. We have therefore, added meaningful allocations to these, in each of our three model portfolios.

We are bracing ourselves for volatility in the fixed income segment. We expect a rather large government borrowing program coming our way. There are also concerns around inflation, globally. India is unlikely to be insulated from these. But we are not pressing the alarm bell yet.

Our early call on gold and our timely calls on fixed income have ensured that we have some cushion in our asset allocation portfolios. We are therefore not changing any weights yet, but we did rebalance our portfolios out of turn last week instead of waiting for the quarter to end as gold and equities have seen sharp move up in the last few months.

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