Mar 19, 2018
The stock market is the story of cycles and of the human behavior that is responsible for overreactions in both directions. – Seth Klarman
A few problems dog the markets that led markets to shrug off good economic data last week. One, domestic PSU related woes, and myriad follow on impacts. Two, relentless FI selling that is offsetting domestic flows. Three, trade war rhetoric and global policy uncertainty, and finally, valuations remain uncomfortably high.
FI Selling Has Been Offsetting Domestic Buying…
Foreign investors remain sellers of Indian equities. FI selling began in earnest late last year, and has acted as an offset to domestic inflows. Surprisingly, FIs are net buyers in March to the tune of INR 6,200 Cr, while DIs have pulled back to a minimal net INR 307 Cr. The entire FI purchase occurred the day the Industrial Production and inflation data was announced.
That foreign investors have turned sellers isn’t a surprise. As early as August 2017 last year, we wrote: “To summarize, valuations are at extremes, and the market technicals are weak. But strong volume is driving the move. Sentiment is reaching frothy levels. The IPO market is classically overheated. It is an opportune time to trim allocations back to in-line with long term strategic asset allocation weights.” (Deja Vu All Over Again, Aug 8, 2017).
Since then, we’ve regularly recommended portfolio rebalancing, strategy review, asset allocation to strategic and tactical strategies such as capital protection and hedging.
Foreign Selling Has Offset Domestic Buying Over the Past Few Months
PSU Losses Have Become An Albatross Around the Market’s Neck…
An Albatross Around Our Neck
The PNB scam exacerbated worries around the PSU complex. The PSU problem has become an albatross around not just investors necks but the economy as well. Not only are PSUs creating a fear and uncertainty overhang, they are reporting huge losses, which are leading to muted earnings growth at the index level. Slowed earnings growth leaves our markets expensive on valuations, and finally, the bailout affects the government’s fiscal math, leading to a rise in the cost of capital. The PSU problem has to be addressed at its core and bold decisions need to be undertaken.
The Trade War Remains Rhetoric for Now
We do not think the trade war will escalate; that is the only logical conclusion one can make at this point. Clearly, however, fears of duties and penalties remain a negative for exporters. A domestic focused portfolio is clearly preferable.
Outlook
Fixed Income – Our Relative Valuation Model Favors Bonds
The relative valuation model has a strong track record as is evident from the chart. It is signaling bonds are relatively attractively priced versus equities, from a yield perspective. Historically, the spread has reached levels that have been a good indicator of forward returns. However, the model does not factor a three-year holding period, that most investors must contend with. We continue to favour corporate credit and FMPs.
Equities
On January 22nd, a week prior to the top, we acknowledged these risks: “The valuation on the Nifty is currently 27.4 times trailing…the spread differential on bonds versus equities is close to a sell signal on equities, although historically early… and the market’s technicals deteriorated this past week.” We further added that “There will be corrections along the way. Risk averse investors would do well to carefully review their asset allocations, rebalance accordingly and consider tactical and protective strategies.” (The Illusion of Attention, Jan 22nd).
Our Relative Valuation Model Favors Bonds Over Equities
On January 25th, 2018, we bought puts for our Sanctum Titans and Sanctum Olympians portfolios two days prior to the market peak. However, it is the nature and psychology of markets that it is quite difficult to implement these choices.
Current View
Moving to the present, the manner in which good economic data was shrugged away last week makes it evident that it remains a time for defense. Our expectation is that FIs will remain sellers until valuations move to more reasonable levels. When FI selling stops is anyone’s guess. Our asset allocation models are tilted towards debt over equities.
Index Returns Versus Stock Selection
We wrote in September that “forward expected returns on equities at the index level look muted when compared with history.” (Asset Allocation Quarterly, Sep 4th, 2017). We continue to hold on to that view. The counter point to macro is micro. We note in our portfolios, that the average return on stocks purchased since August is 24.6%. The names were mid caps. Meanwhile, the quality large caps we own have suffered. Motherson Sumi and Hindustan Petroleum are cases in point. Our point is that well selected stocks with earnings growth at reasonable valuations offer the best opportunity for return going forward.
Large Versus Mid Cap
With FIs selling primarily larger caps, and large caps sporting lower earnings growth, as well as higher international exposure, we’re hard-pressed to recommend a wholesale shift to large caps. More than large versus mid, it is individual level valuations that will determine returns.
To summarize, FI selling, trade war rhetoric, PSU woes and valuations are overwhelming good economic data. The PSU banking sector has become an albatross around the economy. With this backdrop, the market will likely converge to fair value, whether via earnings growth, or multiple contraction. We reiterate our advice of the past few months. Yet again, we suggest asset rebalancing, rotation into debt, capital protection and hedging. Investors would do well to recognize that defense is sometimes the best form of offense.
Quarterly Asset Allocation Pairs Update
Broadly, asset class outlook preference tilts neutral between equity and bonds.
The Model Favors Corporate Bonds, Shorter Term, Equities, Mid Caps, USD and Cash
Equities Vs. Bonds
Underlying fundamentals remain solid across all fronts for equities
Commercial credit growth has recovered fairly strongly an indication that corporates’ appetite for increasing loan uptake remains strong. Further heartening is the fact that trailing 12m central government expenditure growth has also shown a sustained pick-up in what should act as a strong impetus for the economy and an added feather in BJP’s arguably recently jaded cap (reference, recent U.P./Bihar by-elections, the Gujarat elections etc.).
The IIP is also showing signs of continued uptrend over past few months, with consumer durables also contributing strongly in Jan-18 (after last 12 months contractions). CPI has also cooled off in Feb-18 at 4.44% vs. 5.07% in Jan-18 which was primarily driven by a softening in Food and Fuels.
However, the price for the fundamentals has been seeing uncertainty after the last bull run in CY17
Recent spikes in volatility has led to increased uncertainty in formation of any upswing in the markets. Large caps have shown slightly more resistance to the volatility though overall markets remain slightly nervous. On the fixed income side, hardening yields have elevated the term premium though the recent cool down in inflation (Core CPI remaining stubbornly high though) has contributed to a moderate softening in yields, thus slightly favouring fixed income over equities.
Globally as well, EMBI spreads have been on the wane recently, suggesting a shift in capital into riskier emerging markets. While the spiking in U.S. 10y confirms this, India 10y has not shown any materialistic signs of cooling off. This implies that globally, India has likely lost its forte investment position chiefly on account of the stellar bull run in CY17, the exchanges’ protectionism in sharing data overseas among others and hence, much of the global inflows into emerging markets has likely skipped over India towards other developing nations. Resilient India 10y yields can also be seen in conjunction with the significant increase in average 3m cumulative debt outflows.
Large Cap Vs. Mid Cap
Large caps severely undervalued vs. Mid caps
Large cap attractiveness vs. mid caps on trailing basis has increased significantly over the past three months. Surprisingly, the large cap NIFTY50 index has remained more resilient in terms of price levels over the same last three months than its mid cap peer indices.
Large Caps Trade At a Valuation Discount to Mid-Caps
Earnings projections strongly favour mid-caps – though expectation have been tempered
Our last quarterly asset allocation update highlighted improving earnings growth expectations in the preceding three months, with mid-caps outpacing large caps. The current season though paints a slightly different picture in the sense that while mid cap growth estimates still far outstrip those of large caps, analysts have somewhat tempered their growth expectations with 3 year forward CAGR for mid-caps moderating to 39% from 43% a quarter ago and large caps also simmering down to 16% from 18% earlier.
Slowing expectations of forward bottom-line growth across the board
Corporate Bonds Vs. G-Secs
Hardening G-Sec yields has compressed spreads vs. AAA
Spreads between AAA bonds and G-Secs have narrowed to 56bps as of Feb-18, below the long-term average of 103 driven primarily by reflection of the inflation expectations and fiscal deficit in G-Secs. However, post the Feb-18 CPI readings, some moderation in spread compression should be witnessed. The credit upgrade/downgrade ratio has remained broadly at 1.2x over the last 2 years indicating consistent upgrades of corporates which net-net, paints a brighter picture for corporate bonds.
Supply dynamics conducive for corporate bonds
Further, supply of corporate bonds remains below last 2-year average levels auguring well for them vs. a likely supply glut of G-Secs on account of the ballooning fiscal deficit, likely farm loan waivers etc. An improving liquidity in corporate bonds vs. G-Secs also bodes well for the former as their liquidity risk premiums should come down.
Bonds – Short Vs. Long
1/10 Spreads Favour the Long End
Spreads on the 1/10, and the 5/10 have widened above long-term averages, suggesting that the long end of the curve looks attractive.
Dynamic Bond Funds have gradually started increasing duration
Kotak and ICICI have sharply increased their duration exposure in Feb-18 after cutting in Jan-18, indicating a slightly favourable stance towards the long end.
While Latest CPI readings have eased tensions in Long term bonds, still early to shift stance
The latest Feb-18 CPI reading has relieved hardness in long yields and the dwindling systemic liquidity is likely to exert downward pressure on short term yields as banks no longer have a surplus for lending out. In a nutshell, the elevated Government borrowings should likely weigh down yet on long term yields which corroborates our continued stance on favouring the short end.
Gold – Remain Underweight
Negative Indicators for Gold Valuations
As in our last quarterly update, gold bullishness continues to trend lower and has curbed the asset’s price. Gold remains overvalued vs. oil with the long-term average relationship implies a gold price of $857 per troy ounce vs. CMP of $1,323. The gold/oil ratio is one of the more stable relative valuation measures for gold and has been in downward correction mode over the last couple of months, confirming the predictive relevance of this indicator.
Volatility in the U.S. has spiked on valuation fears and tariff wars. This has prompted asset flows into the traditional “safe-haven” assets like gold away from “riskier” assets such as equities.
No Material Demand
ETF Gold holdings have continued falling in last few months, while at the same time speculative net contracts positions in the yellow metal have risen offsetting some of the holdings losses. Net-net, this remains an overhang for the yellow metal with prices expected to gain firm support should underlying non-speculative long positions prevail.
USD Versus INR – Neutral
Macro parameters favourable for the INR
While FII and FDI net inflow run-rates have YTD been fairly weak, in the long run these should likely bounce back. Additionally, lower EMBI spreads imply a risk-on attitude of flows away from USD into EM debt further with possible support for the INR (yet to be seen).
Other valuation factors such as increase in India’s FX reserves, import cover and a declining trend in overvaluation levels in REER (thus arresting the pace of overvaluation decline) should support INR strength.
Technical Outlook
Equity markets begin last week on a strong footing but bears took control of the market on Friday amid fears of global trade war concerns and worries over no-confidence motion moved by Telugu Desam Party against NDA government. The Nifty closed the week at 10195 levels down by 0.31%, but 2.7% off the high of the week. Now 10450 odd level has emerged as the resistance area for the market as index was unable to sustain above it and seeing reversal from there. Also, the 21 day exponential moving average is acting as reversal zone for the market. In Nifty options, strike price 10400 and 10500 call options have highest open interest which is likely to cap the upside. On the downside index has immediate support at 10180-10141 levels where 200 day moving average and recent swing low respectively are seen. Breaking below this next support for the market is at psychological level of 10000 and then 9738 levels. On the upside, index needs sustain above 10450 levels on closing basis to see rally towards 10640 levels which is key level for the market.
Nifty Daily chart
