House under Renovation!

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Aditya Khemani, Fund Manager, Motilal Oswal AMC

The biggest question investors have today is where we are in the economic cycle. Before I try to answer that let us go back into short term history to have a better clarity on the same. We all know the strengths of India in terms of demographic dividend we talk of by virtue of half the population being less than 27 years of age hence providing a long runway for growth. This has led to Indian equity markets being the darling of foreign investors who now own 21% of the listed universe in India. But this demographics doesn’t make India immune to the cyclical downturns any economic goes through. And when things look bad everyone starts doubting the growth potential of India but the maximum wealth is made at those junctures only. Only difference is optimists see the glass half full and the pessimists see the glass half empty and it is for an individual to decide which side of the table he wants to be.

Let me be more objective now. Till start of 2018 everything seemed good as the economy was doing fine and markets were rocking. But then we saw the Brent crude oil price move up from USD 60/barrel to USD 85/barrel and as you all know India imports 85% of its oil requirement and hence whenever price moves up it impacts India’s macro adversely. Roughly every one USD per barrel of oil is a higher import bill of USD 1 bln. So with this uptick one saw the INR depreciate from 62 to 74 per dollar and in order to meet the USD demand for higher imports, RBI had to infuse around USD 25 bln into the system and when it does that it has to pull out similar amount of INR from the system. And this was the start of the liquidity problem we all talk of today. But the bigger problem was when IL&FS default happened in September, 2018 and thereafter the series of corporate defaults have continued. And this has led to an atmosphere of risk aversion where people are scared giving money to everyone. Hence money is chasing only the top rated NBFC, corporates, etc. Free flow of liquidity in the economy is akin to the free flow of blood in our body. So just like free flow of blood is essential to the performance of every organ in our body, free flow of liquidity in the economy is essential to the different parts of the economy doing well and hence the economy in aggregate doing well. So we have seen the real estate sector, MSME sector, weaker NBFC, weaker corporates being in problem where no one wants to lend to them. And this liquidity problem is turning into an insolvency event for some corporates. And hence there is fear in the system to lend to these people. Overall the weak macro over the last 18 months is leading to slowdown one is seeing in the micro data points over the last 6 months as there is always a lead and lag in terms of macro impact on micro data points.

That was the backdrop so what next? As I write this I know sentiment has been weak last 6 months but if we think objectively there have been some improvements in the macro data points which will lead to improvement in the micro data points with a lag (maybe in 6 months). We have seen global growth decelerate with 2019 global GDP growth forecasted to grow by around 2.9% versus 3.6% in CY18. Infact 2018 was the best year for global GDP growth since 2008-09. And when this happens you see commodity prices especially crude oil price come down. Hence one has seen Brent crude oil correct back to around USD 60 per barrel and most of the metal prices also correct by 15-20%. So what led to the start of macro deterioration is turning to be the driver for macro improvement also. So we have seen our currency be one of the best performing currency, our forex reserves have again gone up, Current Account Deficit fears have come down, etc. Plus we have also seen the monsoons be very good this year which will lead to some uptick in the rural part of our economy which has been under some stress. Plus we have seen the RBI cut repo rates by around 1.35% since February 2019 but the lending rates have been cut by around 0.35-0.40% only as deposits re-price with a lag hence one could see around 1% lending rate cuts by the banking system over the next 12 months.  More importantly investors had started doubting the urgency on part of the Government to revive the economy. But the recent corporate tax rate cut along with the other measures they have announced is a clear signal to different stake holders of the new found clear sense of urgency within the Government quarters and the pro- growth stance. And equity markets like growth and hence we are seeing some improvement in the sentiment across.  We are in the last stage of the corporate India cleanup which will set the base for the next upcycle in the economy. So the combination of these factors is leading to macro improvement which will feed into micro improvement in maybe a couple of quarters. There are obvious challenges too but in case one goes into history one will see there have been challenges at most times and I said at the start it is for one to decide whether he wants to be an optimist or a pessimist. Yes one needs to see the risk appetite improve but that will happen with time as it is like no bad news is good news. So I am sure over the next 3-6 months one will see things normalize as data points show some improvement. Also data suffers from a year on year (YoY) phenomena and because things have been weak for the last 12 months we will start seeing improvement in YoY numbers due to favourable base effect and investors will read it as sequential improvement which will then feed into next level of growth. So, for example we might see auto monthly numbers not look as bad going ahead. Some of the challenges we should be cognizant of are the limited fiscal space of the Government to revive the economy, real estate sector revival, private sector leverage, risk aversion, etc.  So yes timing the market is difficult and there could be volatility but over the next couple of quarters one will see gradual improvement in the economy which will set the base for equity markets performance. So Indian equity markets is at an interesting inflexion point and should create wealth in the years to come. And one should not get fooled by seeing the Nifty index levels that they have missed the bus as bigger wealth will get created when economy improves and the markets become broad based as opposed to the polarisation we are seeing now with most investors chasing the same pockets of growth now. The BSE Midcap index is still down around 20% from the top and the BSE Small Index is down around 35% from the top. And within the Nifty too, very few stocks have contributed to the upsurge. So I feel it’s an interesting time for the investors to put on the seat belts and ride the cycle over the next 3-4 years.

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