Sep 19, 2024
• US Fed actions continue to be in focus for global markets.
• US Jobs data is being revised downwards, and US bankruptcy filings have increased.
• India’s economic growth remains resilient and increase in capacity utilisation suggests that private
capex should also pick up soon.
• We are gradually underweighting equities and prefer large caps over mid and small caps.
All Eyes on Fed
Expectations around US Fed actions continued to be front and centre last month. Earlier in the month, one of the Fed presidents stated that the stage was set for policy easing as unemployment numbers had deteriorated. Later, at Jackson Hole, Chair Powell also conveyed a similar message about potential rate cuts in September. In response, the US 2-year bond rallied (34 bps in a month), and the yield curve notably un-inverted for the first time since mid-2022.
US bond market pricing in rate cuts
Source: Bloomberg, Sanctum Wealth
We have been sceptical about the strength of US growth over the past year. Jobs data for the 12 months preceding March 2024 has been revised down by over 800,000 jobs, effectively lowering monthly growth from about 242,000 to approximately 174,000 jobs. Another indicator of this is the pace of bankruptcies, which we have addressed previously. Lower interest rates had protected 'zombie' companies for a long time, but their vulnerabilities became apparent as rates rose, which is now reflected in the increase in bankruptcies.
US bankruptcy filings have increased
Source: S&P Global Market Intelligence; Data complied as of 2 nd Sept 2024
While this is an essential and healthy cleanup of the system, other vulnerabilities are surfacing. A small business survey shows a sharp dip in confidence. A comment from Citigroup noted that they are observing Investment Strategy 18 September 2024 a shift in spending on credit cards from discretionary items to essentials in recent days. All this data validates our scepticism. Ironically, as the market's clamour for rate cuts cooled, the case for rate cuts grew stronger. The length of time between the last rate hike and a rate cut has been longer only once before, which raises the question of whether the Fed is too late. We believe that a rate cut in July might have helped.
Months between last Fed hike and first cut
Source: Federal Reserve
It is not just the US but the world at large that is slowing down. The Markit global manufacturing PMI indicates further contraction in global activity. The index slipped to an 8-month low of 49.5 in August 2024, down from 49.7 in July 2024. Of the 32 countries surveyed, 18 reported deteriorating conditions.
Data from China has been mixed. While retail sales picked up slightly, home prices and industrial production have declined. Chinese equity markets are now closer to January 2019 levels, with over USD 6 trillion in market capitalization wiped out since their peak in 2021. Equity markets had recovered sharply after the government clamped down hard on short sales and quantitative trades. However, as these policies failed to address fundamental issues, the markets sold off again.
Chinese equities have underperformed since 2021 peak
Source: Bloomberg, Sanctum
Data rebased to 100 as of 31 st July 2020
India Update
India's GDP growth for Q1 FY25 was lower at 6.7% compared to expectations of 7.2%, drawing attention. However, Gross Value Added (GVA) remains resilient, at 6.8% in Q1 vs 6.3% in the previous quarter, suggesting that the difference may stem from taxes and/or subsidies.
India’s growth has been resilient
Source: Bloomberg, Sanctum Wealth
The government, with its largest capex outlay in recent years, has been a key driver of economic growth in India. However, around election time, that spending slowed down, which is reflected in the GDP numbers. Manufacturing growth decreased to 7% from 8.9% in the previous quarter. With capacity utilization exceeding 76%, the highest levels since June 2013, there is a possibility of increased private sector capex.
India manufacturing sector capacity utilisation
Source: Bloomberg, Sanctum Wealth
Sequential softness notwithstanding, it is worth noting that India and Vietnam are the only two countries with manufacturing PMIs in the expansion zone. Consumption has bounced back, supported by rural demand, which is showing signs of improvement as reflected in two-wheeler sales, tractor sales, and lower demand for MNREGA jobs. We have been positive on rural demand for the last couple of months and have incorporated this theme into our direct equity investments as well as our selection of managed products.
Domestic CPI inflation moderated significantly below the 4% mark, but this easing was mainly due to the favourable base effect. Continued higher vegetable prices in the near term remain a concern, but if the recent drop in crude prices is sustained, it would help bring overall inflation down worldwide.
Election-bound states are ramping up welfare spending as elections approach. The Haryana government announced several welfare schemes, including providing LPG cylinders at subsidized rates, fortified milk for school-going girls, and increased loan amounts for self-employment. Maharashtra introduced the 'Ladki Bahin Yojana,' despite warnings of fiscal profligacy from the central government. States have been received higher transfers from the centre, and judicious spending is important to maintain growth momentum.
India Markets
The Nifty 50 reached lifetime highs in August but still underperformed compared to global markets. On a calendar year basis, however, it continues to be an outperformer. We previously mentioned that we expect sector rotation in the Indian markets, and that appears to be playing out. In August alone, healthcare and technology stocks delivered healthy returns of 7% and 5%, respectively. Market favourites of the past year, PSUs, corrected by about 6%. Capital goods fared somewhat better than PSUs, losing about 3%. We expect this rotation to continue over the next few months as participants trade relative value.
Source: Bloomberg, Sanctum Wealth
The above returns are price returns
We have been exercising caution in the midcap and small-cap segments. Both midcap and small-cap indices are trading at a significant premium to long-term averages. While these segments have been growing faster, we believe these high valuations are not justified, even when factoring in higher growth. Furthermore, growth expectations are moderating, putting additional pressure on valuations.
Mid and small caps relatively expensive
Source: Bloomberg, Sanctum Wealth
We acknowledge the upside risk due to liquidity in the short term, and therefore our call may be somewhat early. However, if valuations were to mean-revert—which they always do—the potential drawdown from here could be significant. Therefore, we continue to stand by our view of reducing exposure to small-cap and mid-cap stocks.
While large-cap valuations are also not inexpensive, there is relative value in large caps. Anecdotally, our conversations with various managers suggest that they, too, are gradually paring back their exposure to small- and mid-cap stocks in favour of large caps.
Outlook
Equities: We are beginning to gradually underweight equities. We prefer large caps and have reduced our exposure to mid and small caps. This decision considers the cushion we have built over the past four years, during which we were overweight in midcaps.
Fixed Income: Considering the resilience of the Indian economy, we expect to see a shallow rate-cut cycle. However, debt inflows could drive yields lower, and therefore our duration call remains intact.
Debt inflows into India have been strong
Source: NSDL Monitor, CY2024YTD: Up to August 2024
Gold: We were affected by the fall in domestic gold prices due to the unanticipated cut in customs duty on gold. However, prices have since recovered. We remain optimistic about gold based on both fundamentals and geopolitical uncertainties.