In this latest edition of the newsletter. we have covered details on the following:
- SEBI's new margin rules, effective from Sept 1, 2020, effective on the cash markets for buy as well as sell transaction.
- The charm of sectoral and thematic and its effects on a well-diversified portfolio.
- What are RBI’s OMO operations?
- Details on the Honourable Supreme Court’s decision to grant a timespan of 10 years to pay the statutory dues to the government.
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Market Commentary – Kites fly but come down
COVID related data suggests the following key observations
The world is currently seeing a recovery of 74% on the total cases so far, while India has seen a recovery of 81%.
India contributed to 17.5% of the total cases, however, it accounts for 12.58% of the active cases and also accounts for 19.24% of the recovered cases.
Compared to the global mortality rate of 3.5%, India's mortality rate is low at 1.6%
The exponential growth factor seems to be over now as the new cases are consistently near the 30-day moving average which indicates a linear trend
Last few days, the active cases have started to see a dip as the recovery rate started to exceed fresh cases
Key implications for the economy
1. Full recovery is possible when there is an effective vaccine treatment.
2. Localised virus outbreaks cannot be ruled out which means the economy will find it difficult to work at 100% employment.
3. Markets reflect much higher optimism than ground reflection.
4. The improvement in the economy from now on until the vaccine roll-out, is likely to slow.
While 2nd Quarter is likely to show much lower degrowth compared to the first quarter, simply because of the less widespread and the overall lesser days in lockdown, Q3 is very likely to not follow that improving trend. Q3 is characterised by the festive season peculiarities where the overall effects of long drawn holidays are countered by the overall increase in personal consumption due to the festive season continuing till December end. Q3 is the second biggest GDP contributor. The early trend shows that this year’s festive spend will face a COVID induced dampener and this is likely to affect the recent pick up in the rural economy which has been a sentiment changer in the last few months.
US Equity Markets – too soon too fast, entering volatility
Volatility is likely to remain high for most of the remaining part of the year as markets realise that the actual time to full recovery from COVID versus the optimistic expected time is still inconclusive despite hopes ever so increasing for a vaccine. US election results and the days preceding the actual outcome will continue to create uncertainty.
This will likely bring in short term corrections. Besides, the current rally has continued for a long time from the time of the March lows and therefore, a high probability that markets may take a breather.
The US Fed’s monetary support remains intact with renewed guidance that incorporates a framework to allow inflation to overshoot its 2% level threshold. A cheaper US Dollar would mean lesser export of inflation to Emerging Markets thus adding support to the latter’s interest rates remaining low. It is the fiscal support that the Fed must worry about.
Before the pandemic, initial jobless claims were running at about 212,000 a week, with continuing claims at 1.7 million. Weekly figures on unemployment claims showed the labour market remains deeply damaged by the Covid-19 crisis. Initial jobless claims in regular state programs were unchanged at 884,000 in the week ended Sept. 5, well above the 850,000 that Bloomberg consensus had expected. The high levels of jobless claims, both initial and continuing, point to the uncertain nature of the recovery.
The supplemental weekly jobless-benefit payments under the Lost Wages Assistance program which provides an extra $300/week from the federal government to was capped at 6 weeks from the start of August. The end of the extra payments is likely to impact consumer spending in the current situation where the labour market despite improvement continues to remain much worse than the pre-pandemic levels, while the stimulus package extension as well remains undecided.
The next round of fiscal stimulus for the US Economy currently looks uncertain as the Democrats and Republicans have not come to an agreement in the latest Senate vote with the Democrats asking for a much bigger stimulus at 2.2 trillion while the Republicans proposing a much-reduced USD 500-700 billion for the next round of fiscal stimulus. The agreement to renew fiscal support is imperative else the household incomes will be under pressure in the remaining months of 2020.
According to a Bloomberg report on data gathered by US Federal Agencies including the likes of US Census Bureau, at the end of August, 130 million out of nearly 250 million Americans said they avoided eating at restaurants and about 21 million people had resumed dining out.
As of August, 70% of respondents said that they were making fewer trips to stores now than they were making before the pandemic. The group of the youngest adults aged 18 to 24 had 68% saying that they were shopping less.
As per the US Census Household Pulse data till August end, 29% replied that they have cancelled their plans of pursuing post-secondary education during this fall. Nearly 50% of those who cancelled said they had concerns about contracting Covid-19, or fears having the illness. 42% of the group which cancelled their higher studies said they couldn’t pay for educational expenses due to changes in income from the pandemic.
As per the same survey, more than 100 million Americans reported “feeling down, depressed or hopeless over the past week”, with those between 18 and 29 and the people who’d lost jobs/living alone being the ones most likely to express those feelings.
The kite of good hope - Be mindful of the gap that exists between reality and hope
Most estimates say that we will be at 0% GDP year on year quarterly GDP growth by the 4th Quarter of FY21 and that news will be confirmed by May 31st next year. Assuming a combination happens where we have finally conquered the fear of the virus and we reach normal GDP levels, it justifies a nifty level of 12500, a 1000-point move from here. This implies that you really do not gain much by purchasing heavily into Indian Equities from here on till then.
For an 8% gain that can be justified on the basis of numbers and growth %’s, at some time in not so distant future, we can be sure that the road ahead will have diversions and some U-turns as well before we reach 12500 levels by May 31st based on a rationale mind expectation. Nobody can rule out how market forces play out, it can even be argued that markets should reach 14000 because markets may discount the good growth in 2022 and so move ahead to 14000 levels in the year 2021.
So be it, the chances of making gains continue with the investor as he continues to be a buyer over the entire period although in a spread-out manner. Not all flying objects are a kite and not all flying objects are a plane. A plane flies because there is fuel (internal energy), while a kite flies higher because of wind (external energy) and the support of the thread length.
Markets can behave like a plane when there is a strong case of fundamentals justifying the flight, as good as saying that the economy is travelling in the plane and not standing on the ground. On the other side, markets can behave like a kite flying high while the actual economy may remain rooted on the terrace from where the kite is being controlled (or rather not controlled).
There is a limit to the heights the kite can fly and that depends on the amount of thread (optimism) on the reel. At some point in time, the kite must come down to lower levels if the not ground level (correction).
Current Nifty Constituents Dupont Model
We did a proprietary Dupont analysis for current Nifty companies and based on future capacity utilisation (Sales/Assets ratio), Profit margins and Leverage, assumed to not increase because of low capacity utilisation, we foresee a 27-30% increase in earnings. This can go higher by another 4-5% double annualised due to inflation without further higher waterfall effect as capacity utilisation is low. That gives an overall 35% earnings growth over FY20 earnings. On a PE basis, we are currently at 19.35 thereabout FY22 earnings. This looks expensive 2 years ahead from now.
Historical Nifty Values
Price to book values is not volatile compared to PE ratios. The former has a bigger denominator base which tends to fluctuate lesser due to the lower contribution of 1-year earnings, in other words, the asset value tends to hold to their value even if earnings in a year go down to nil as well. The return on equity which is the price to book divided by price to earnings is at a low of 10% while the current book value is 3547. Assuming a median ROE of 16.5% on the current book value of 3547, we should be getting an EPS of 586 post which we apply a median payout ratio of 27%, when we add the residual to the current book value, we get 3975. At the median P/B of 3.5, we get a value of 13900 Levels by 2022. This is a future value calculation for the Nifty in 2022 around May.
There is a story linking the weakening of the US Dollar to the Emerging Markets turning attractive for fund inflows. However, the MSCI India Index which with its 86 index constituents covering 86% of the Indian Equity universe, shows a Trailing Twelve Months PE of 26.05 and a forward PE of 22.66 indicating an expected growth of 15% in the next 1 year. The MSCI Emerging Markets Index shows a corresponding PE of 18.2 and 14.88 indicating an expected growth of 22.5% over the same 12 months. The latter has a dividend yield which is almost double and a price to book ratio which is 60% of the India Index.
Short term bearish, long term bullish
While the visibility on the longer-term fundamentals have improved greatly due to reforms and strengthening in the details of the reforms, the time till complete recovery from COVID and its fear will determine the length of the short-term bearishness. We have started seeing more sectors turning attractive compared to pre-COVID levels especially the pharma and IT. Capacity utilisation is at more than 10 years low and this means sales recovery without the need for immediate CAPEX through further debt raising.
Interest costs cyclically likelier to reduce and operating leverage would generate higher earnings. Overall, net profit margins which were showing signs of increase before the COVID breakout is likely to sustain the new trend in the period post-recovery. Mid-caps and Small-caps are likelier to benefit from the rising share of the organised sector compared to the informal sector in every industry, with lower bargaining power for labour post the recent migrant crisis and the closing of many SME’s. Many of the SME’s will continue to see problems to raise cash in the times of struggle to manage working capital and lack of credit from banks as banks continue to be wary of lending to the cash crunched SME’s.
Stay invested, keep investing but slower, steadier! Be on power saver mode and carry the charger.
To summarise, the present market situation is laced with the optimism of things happening faster and markets as well as moving faster in anticipation and optimism. Normally these are the perfect times when volatility comes uninvited and spoils the party where hope was only waiting to meet reality.
Clients already well allocated should ideally reduce the purchase of equities and balance it with investments in other assets that are less correlated. At some point, they should also decide to cut back equity in the form of exposure reduction to reduce the effect of volatility on their portfolios. This will ensure the redeployment of money at lower levels. For new clients, it is better to stagger the investments with a horizon of 1 year which would ensure that they can invest till next September by which most of the uncertainties of the present would be overcome.
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The writer of this Market commentary is Chief Investment Officer, Satish Anand. He can be contacted for queries and clarifications on firstname.lastname@example.org