May 29, 2017
While it is to be admitted that a man may for a time make money by chance on Wall Street, I assert that the tenure of men who depend solely on luck is only for a season… And the ones who depend solely on Luck to pull them through are the Lambs; and it is on these Lambs that Lions thrive and fatten.
– Adam Smith, The Money Game
Fear emerged last week, as it is prone to do during periods of exuberance, to test investor resolve. The one thing that hasn’t changed much in the past two thousand years is human nature. Our recent experiences have an inordinate impact on our expectations of the future. Memories of recent sell-offs were triggered and fear was tangible mid-week. Investors were selling mid-caps and small caps like there’s no tomorrow.
The easiest way to ensure you’re a lion and not a lamb, in our opinion, is to take a longer view and independent thought, not letting market action dictate our response. So we start by focusing on the critical question: has anything changed?
Equities
Earnings over the last fortnight have been strong
This earnings season has been heartening. Notwithstanding the NPA issue, sectors remain comfortably placed. Looking at CNX 500 companies that have reported over the last fortnight, we see healthy top-line trends emerging post demonetisation, with operating margin efficiencies yet to kick in.
CNX 500 Delivering Healthy Top Line & Profit Growth
Source: ACE, Bloomberg
Additionally, these companies have also surprised on the bottom line. This is especially comforting given that this recent batch of company reports has been much stronger in terms of beating estimates than the first wave of Q4FY17 reports. This bucks the trend we’ve seen over the past few quarters of reports weakening during the second phase of earnings season. Over the last fortnight 59% have met or exceeded expectations versus the initial number at 47%.
The Recent Batch of Earnings Reports Has Been Stronger Than Expected
Source: ACE, Bloomberg
While earnings move markets, we also recognize that backward-looking data doesn’t always provide a leading indicator to upcoming turns in the economy. So, it’s an opportune time to revisit the larger picture.
Three Years of the BJP
The bigger picture is that India has a government relatively free from scandal and focused on creating wealth via corporate and market friendly reforms. The BJP has succeeded in spreading its message of hope and economic development, giving rise to an aspirational populace with confident expectations for the future.
Another key factor underpinning the India story is the government’s successful focus in bringing down inflation, leading to a declining cost of capital and transmission of reduced borrowing rates to consumers and corporates. In the process, the BJP has successfully brought about a deepening of the capital markets, particularly equities and in the coming quarters we expect in real estate.
India today is in one of the strongest fiscal positions of the past few decades. The government has demonstrated its commitment to a fair and healthy real estate market. With reforms and initiatives such as Affordable Housing for All, targeting 50 million new low cost homes over the next five years, RERA, infrastructure status to affordable real estate, and the Pradhan Mantri Awas Yojana, it’s clear the government recognizes the positive multiplier effects and wealth creation of a healthy real estate market.
With a 250 bps reduction in mortgage rates and a 10% CAGR growth in consumer incomes, the affordability gap is narrowing. Finally, the government recognized early on that infrastructure and mobility of goods, services and consumers was critical for growth. To this end, the Sagarmala, integrated development of waterways, road, rail and air, extending aviation to smaller towns, creating frameworks for PPP, GST and a strong budget allocation to infrastructure are some key initiatives we would highlight.
The key takeaway is that, India is now amongst the most attractive investment opportunities globally.
NPAs Are Rising Alarmingly for PSU Banking Sector
What remains a concern, though, is the sticky NPA issue. The RBI NPA ordinance was a step in the right direction in terms of empowering banks via an implicit immunity assurance; however, at the end of the day, successful execution of the resolution remains to be seen.
The data yet again demonstrate the PSU/Private bank divide. PSU banks glazed over operational due diligence processes in their quest to expand their loan book growth. The net result is that Gross NPA levels are now rising dramatically. Meanwhile, private banks have ensured a tighter credit culture and have maintained asset quality reporting only 2.1% GNPA levels in FY15. We’ve yet to purchase a PSU bank in our portfolio.
However, we would note that SBI has maintained a better balance between loan growth and asset quality as was seen in their latest standalone reported Q4FY17 performance. The private banks appear to be the best placed of the lot; however, here too we would note that the performance has been widely divergent. For every HDFC Bank and IndusInd Bank, there’s been an Axis Bank and ICICI Bank.
Gross NPA Divergences Are Hitting Private Sector Banks
Per the recent RBI mandate, banks in their annual reports need to disclose their non-performing assets and RBI’s own independent assessment of the same.
Underreporting by Banks: Gross NPA Divergences
Source: Company data
Yes Bank has reported the highest divergence in FY16 asset quality at 0.76% vs. RBI’s independent view of 5.0%. PSU Banks are yet to publish their annual reports at the time of this writing and we think tracking of the degree of underreporting by these banks could have a potential sector-wide drag. The banking space warrants an active analysis on a stock by stock basis.
Reliance Communication Downgrade
Slightly alarmingly, as if on cue from the Chinese debt downgrade, there have been a couple of corporate credit rating downgrades domestically as well, the most prominent being the ICRA and CARE fresh downgrades of Reliance Communication with Moody’s having already downgraded earlier citing competitive pressure in the Telecom industry (reaffirmed by RBI as well).
CARE in its report said the downgrade was the result of Mukesh Ambani owned Reliance Jio’s impact on the operational risk profile of RCOM. CARE has given the rating of ‘Credit Watch with Developing Implications’ to the company. While the company has issued statements claiming payment of half yearly interest on the bond in question and assured future payments, the current downgrade reiterates our negative stance on the Telecom sector and competitive pressures are likely to continue to weigh on cash flows.
Global
Globally, concerns have surfaced rapidly. Impeachment worries in the U.S., a shocking credit downgrade by a rating agency on China and Indo-Pakistan tensions stoked investor fears.
Impeachment Highly Unlikely in the U.S.
Breaking these down, we think a Trump impeachment is highly unlikely. The process for impeaching a President starts with a vote in the House and requires a simple majority. The case then moves to the Senate, where a two-thirds vote is required to convict the commander-in-chief. Should this even proceed, it will be long drawn out as Republicans control both Houses. Should the unforeseeable indeed happen, Vice President Mike Pence would come to power.
Secondly, the track record on rating agency warnings is questionable at best. Finally, in our 25 year experience of watching markets, war has invariably been a boon to markets, post the requisite shakeout. We’re nowhere near such a situation today anyways. Market participants concurred, and interpreted these effects as transitory as the week progressed.
Subprime 2.0: No immediate concerns
Fearmongers have started talking about Subprime 2.0 – the burgeoning outstanding auto-loans – so let’s look at the data. Subprime 2.0 seems worse than Subprime 1.0 in terms of verifying income. Reports indicate that two leading lenders (Santander Consumer USA Holdings and AmeriCredit) verified income on only a fraction of their borrowers. Further, 40% of borrowers have FICO credit scores between 501 and 550, a range that is considered deep subprime. Total outstanding auto-loans are ~$1.0 trillion and have risen steeply in the last few years.
Motor Vehicle Loans Owned & Securitized Outstanding
Source: Bloomberg
To put things in perspective though, such worries seem premature as the 2008 housing bubble reached a peak debt level of $14.5 trillion in mid-2008, corresponding to a debt/GDP ratio of roughly 1 times. In contrast, the auto-loan/GDP ratio currently is ~0.06x.
The Volatility Index (VIX) Has Taken Data In Stride & Back to Historic Lows
Source: Bloomberg
Brazil: A likely issue of concern
JBS SA, the country’s largest meat packing firm has come forth and declared (per Brazilian newspaper O Globo) that they are paying a witness to corruption to remain silent in ongoing investigations whether the Government was accepting bribes from companies and illegally helping them. JBS have brought forth this taped proof as part of a plea bargain in the hope to seek a leniency deal after admitting to prosecutors.
Brazil’s stock market plunged more than 10% immediately after opening (Thursday, 18-May-17). Brazil’s currency, the real, also tanked more than 9% against the dollar, its worst day since the global financial crisis in 2008.
We think the impact of the news will remain limited to companies that have LatAm exposure.
India-Pakistan Rivalry
The mounting tension between India and Pakistan, following the beheading of two Indian soldiers by a Pakistani border team on the LoC (Line of Control), has cast a shadow over ties between the two countries. Troops have been massing on both sides of the shared border.
Further, the $50 billion China-Pakistan Economic Corridor (CPEC) traversing through certain Indian owned territories could create “geo-political tension” in the region by igniting further tensions between India and Pakistan. Many experts opine that profits alone do not drive China’s business with Pakistan in the CPEC; rather, the strategic intent is to encircle India. China has repeatedly dismissed such concerns and maintains it to be a purely commercial infrastructure within its “One Belt, One Road” pan-Asia project.
China
Independently, China was downgraded by Moody’s Investor Services to A1 from Aa3 for the first time in nearly 30 years, with the expectation that the financial strength of the economy would erode in coming years as growth slows and debt continues to rise (Moody’s estimates 40% Government debt-to-GDP by 2018 from a current 20%).
The ratings downgrade could translate to higher borrowing costs for the government, its institutions and state-owned enterprises, particularly in the offshore market. This could push Chinese companies to borrow even more money from domestic banks, further increasing the risks.
We’d note, though, that China’s credit rating still remains investment grade and Moody’s in fact upgraded the outlook from negative to stable citing balanced risks.
Fixed Income
Wide Dispersion in Interest Rate Forecasts
In trying to ascertain the future direction of interest rates, that too over a 3 year holding horizon, our expectations are that the economy is in the middle innings of an upcycle. One would normally expect rates to head higher at some point in coming quarters. However, the call isn’t cut and dry.
First, the reduced borrowing requirements of the government as laid out in the budget reduces supply of G-Sec bonds and will thereby exert downward pressure on G-Sec rates. Benign inflation trends are pushing for a declining inflation premium in bond pricing. Were FIIs to determine that the exchange rate is likely to convert to a positive return contributor, foreign flows could make their way back into the bond market. Rising tax collections and continuing fiscal discipline are likely to further add to downward pressure on rates. Finally, RBI policy is fairly loose currently as it still has INR 3.5 lakh crores of liquidity sloshing around in the system which has contributed to bank lending rates declining.
In light of the various cross-currents, we just don’t see an edge in making a typical rate forecast for a rise in rates at some point in the coming quarters. Rather, we think the opportunity lies in the steepened curve structure. The yield curve today is steep enough to provide opportunity and adequate protection against a rate hike cycle that one may potentially occur in coming quarters. Corporate bond funds look attractive as the upgrade cycle on the back of improving economic fundamentals leaves enough cushion for adverse rate hikes. For conservative investors, we strongly suggest avoiding duration and avoiding a risk of capital loss, and stay invested in accrual bonds and select actively managed AT-1 bond managers.
Outlook
The brief sell-off in domestic markets looks to have been a ripe time for fresh deployment of capital. Earnings are continuing to deliver and with the robust performance domestically, we see no reason to review our forecast to remain invested in the equity markets.
Technical Strategy
The Nifty50 rallied in the last couple of days to touch a high of 9605 on Friday and settled at 9595 levels. While the index witnessed a brief correction last week, mid and small cap stocks were hit hard. The current rally has been led by large cap stocks which have propelled the index to new highs. The move has kept the higher top higher bottom formation intact, reaffirming the uptrend in the Nifty.
The swift rally in the index has given a fresh uptick on our momentum indicator, suggesting market is likely to head higher. Both Foreign and Domestic institutional inflows have been positive pushing the index higher. Now, the next level for the market is seen at 9760 and then 10,040 levels.
On the derivatives front, the Nifty options Put/Call ratio recently touched a multi-year high of 1.41, but now retreated closer to a neutral level of one and is currently at 1.10 which is supportive for the market. INDIA VIX too saw a spike recently, but again touched a new low maintaining the negative correlation with the index. On downside, 9400-9350 is the immediate support zone for the market and critical support point at 9100 levels.
