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Silver Lining

Jul 8, 2022

In 1913 when the U.S. Federal Reserve Board came into existence, containing inflation and limiting economic swings were its key mandates. Ironically, today the Fed has been the primary source of inflation, and the U.S. is likely already into a technical recession. The Atlanta Fed has cut its GDP forecast to -2.1%

Gears of conversation have changed yet again towards estimating the depth of the recession and breadth of its damage. Hypotheses around the U.S. heading into a deflationary environment have also emerged. Europe is also facing headwinds intensified by its energy dependence. Christine Lagarde, ECB Chair, has already warned of a severe risk of abrupt (read disorderly) fall in asset prices.

China’s property woes continue as Shimao, the 6th largest real estate issuer, defaulted last week. While three of the five most prominent real estate issuers already defaulted earlier, and this one wasn’t unexpected, it shows that the path to recovery will likely be slow.

Even with all the negative news flow, there is optimism amongst investors and analysts.

S&P 500 strategist estimates for the end of 2022

Equity funds attract money during 2022 bear market in departure from past routs

The optimism is probably an indicator that the worst isn’t behind us.

In a massive about-turn, the fed futures are now pricing a 75 bps rate cut in 2023! This action by the Fed might appear somewhat dichotomous considering inflation is still high. But inflation is, in fact, a lagging indicator; it peaks during or even after a recession and bottoms well after the recession is over. Since 1980, inflation has bottomed an average of 14 quarters after the recession was over. One wonders whether we are closer to peak inflation as a globe. Commodities are cooling off, bringing some relief to countries such as India that are net importers and where the economy is growing (albeit at a slower than expected pace).

Changes in prices since March 2022

The U.S. investment-grade credit shows signs of stress as spreads (additional yield investors demand for taking an additional risk over government securities) have widened to 150 bps. Beyond this level, yields usually tend to move to distress levels.

The other badly hit asset class is cryptocurrency. Bitcoin has lost over 70% in value and quite rapidly at that. It was considered a hedging tool against equities but hasn’t proven so. The excessive volatility forces institutions to reconsider their positions, further exacerbating the fall. The ecosystem is facing its brunt, as captured in the timeline below.

Sharp decline in Bitcoin

India Update

Amidst all the gloom, observers awaited the Indian fiscal deficit print release with some trepidation, and a lower-than-expected number of 6.7% came as a relief. Revenues are buoyant, although there is a slippage in divestment, and expenditure is higher than expected.

The government also imposed a windfall tax on the export of petrol, diesel and aviation turbine fuel. The move is likely to yield the government Rs 7000 crores.

Indian equities sold off by about 4.7% during the month. The outflows in the current calendar have exceeded the outflows during the GFC. The strong domestic flow continues to counter this brutal outflow, and FDI flows are also robust.

Despite the gloom, India is faring well on several parameters. Advance tax collections in Q1 have seen a healthy 46% YoY growth, and GST collections remain robust. Composite PMI has been trending up in the last few months. Q4 earnings have been decent, considering the challenging operating environment. Despite the one-offs of the Oil & Gas sector and price correction in Metals, earning expectations for FY23E remain positive. Moreover, earnings in the FY24E could witness upgrades from declining input costs, given that corporates are taking calibrated price hikes keeping demand in sight.

The economy is also well positioned on corporate leverage, as bank NPAs are at a multi-year low, leverage is at a multi-year low, and credit growth is picking up after the COVID blip. Despite record outflow from FPIs in the Indian market, we have seen record FDI inflows in the manufacturing sector, indicating the long-term potential of India as an investment destination.

Since the beginning of the year, we have written almost every month that we believe in the India story and that what we face are near term headwinds.

In his book “A Wealth of Common Sense, ” Ben Carlson has a worthy quote on better decision-making in such times.

“Over decade-long time horizons, your investment performance will mainly be derived from how you handle corrections, bear markets and market crashes. During every single bear market, there will be times when you wonder how much lower the market can go. The economic news will be terrible. Other investors around you will be depressed. Pessimism becomes pervasive.”

We believe that headwinds could intensify and colour the long-term outlook of many, but when we look at management commentaries and valuations, we see opportunity.

Domestic equity valuations have corrected

Therefore, we are adding to equity exposure in small steps of 50 bps over the next three months. If the correction unexpectedly deepens, we will add further.

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