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Long Haul to recovery! - Alpha Edge, May 2020

The month of April has been thus far the worst since the pandemic has started but has turned out to be one of the best for the stock markets. Markets saw a sharp and swift bounce back due to the unprecedented liquidity available. It has neglected the damage this pandemic and the ongoing lockdowns have brought to the global economies, corporates, and consumers.

Our Prime Minister has announced an impressive stimulus package ‘Aatmanirbhar Bharat Abhiyan’ to give our economy the much needed impetus. But unlike the most relief packages announced globally, Rs.20 lakh crore is not entirely in new spending and includes Rs.1.7 lakh crore package the government had announced in March as well as the steps taken by the Reserve Bank of India (RBI) such as liquidity enhancing measures and interest rate cuts.

The reforms and the package are definitely a positive step, but we believe the benefits of the same will be enjoyed in the long term. The need of the hour is to boost consumption demand and the fiscal part of the package is a mixed bag in that direction.

The demand and supply disruptions have been significant and is highlighted by the lead indicators such as weak Oil prices and declining Baltic dry Index (indicator to assess global economic activity). With the incremental active cases increasing day by day and the exodus of migrant workers to their native place surely make the case stronger for a longer W/U shape recovery and hence we believe that though the market has run up from its March lows, we see a Long Haul to recovery for global economies, corporate earnings, and consumer demand.

Hence, we had utilised the bounce-back rally, as an opportunity to take a 50% cash call from a) equity allocations within our model portfolios and b) Direct equity strategies, the same was published in our communication via “ Flash: Partial Exit from Equities : up to 50% “and the tweet shared on 30th April. The backdrop was the certainty of near-zero earnings growth for FY21, current high valuations - both on PE multiples and the Yield Gap models (attractiveness of Equity Vs Debt) amongst others which did not justify allocations to 100% equity with any degree of confidence. Going ahead, as the fundamentals improve or valuations become truly cheaper, we will re-evaluate the current cash call and update you proactively.

On the Global front, the GDP growth was not only negative for the US and Europe but was way below expectations. Without any clarity on the end of the lockdown period in the US and Europe, the global GDP forecasts may lower further.

On the Fixed Income front, RBI on its part has been aggressive in policy response so far. Yet it has only met with partial success in achieving the desired outcomes. The yield curve has continued to steepen and corporate spreads stay elevated. As a result, 2yr AAA credit spreads (yield difference between 2yr government Bond yields and 2Yr AAA bonds) still hover at ~220 bps as 2yr government Bond yields have touched 4.3% and most of 3Y AAA PSU bonds still at 6.4-6.5%.

Investors should welcome this spread retracement as yet another opportunity to allocate to quality fixed income and duration plays. Hence, we believe that exposure to debt markets should be taken through short term funds for 1-2 year investment period and Banking and PSU debt funds for more than 2 year investment period. The corporate earnings are expected to be subdued amid the lockdown period and its aftermath. Hence we continue to avoid credit risk even if the spreads are higher.

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Flash - Partial Exit from Equities : upto 50%

In our monthly newsletter ‘Alpha Edge’ released on the 13th of April, we had outlined our strategy of taking a cash call in the range of 30%-50% once the Nifty crosses the 9500 levels and comes closer to the ~50% retracement of the fall witnessed from the onset of the pandemic. 


Our observations:

(i). With the rally from March 2020 lows of Nifty 7500, the markets have rallied nearly 30%. The current valuations levels are at 22+ which do not seem to be pricing the earning deceleration ahead and look over valued. 2020 is clearly likely to be a year of flat to negative earnings growth. As the extent of such de-growth in earnings becomes visible, markets will keep adjusting lower, reflecting the incremental reality of economic downtrend. This process of adjustment could continue till an extreme where the index PE valuations possibly reach sub 15 levels, an area that typically marked the end of past bear markets. At such points markets tend to look forward rather than backward and a recovery in markets ahead of the economy begins once again. We are not there yet.

(ii). For instance, markets bottomed out at sub 15 PE multiples, towards the end of the bear markets of 2000-2002 and 2008 where prevailing growth was comfortable unlike the 2016 to 2019 period. The adjustment patterns and trends could repeat, as the world economy comes to a grinding halt with only a slow or gradual recovery likely owing to the severe unpredictability of how the health crisis will resolve and when full-fledged economic activity can resume. The structural dislocations that are unfolding currently will result in both demand and supply shocks alternatively and may take time to stabilise in a few quarters from now.

(iii). To summarise...with the prospects of near zero earnings growth for FY21, current high valuations - both on PE multiples and the Yield Gap models (attractiveness of equity Vs Debt), do not justify allocations to 100% equity with any degree of confidence.

Hence, further to our communication via Alpha Edge- April 2020 and the tweet shared yesterday by our founder, we would like to initiate a 50% partial exit from equities as per your risk profile (Nifty 50 at 9850).

As fundamentals improve or valuations become truly cheaper, we will re-evaluate the current cash call and update you proactively.

The cash call is being applied to equity allocations across all our model portfolios and the same will be available in our newsletter on our blog shortly. 

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The Great Reset! - Alpha Edge, April 2020

Hope all of you are safe. The corona virus outbreak is likely to force a great reset of every assumption of human life and the equations amongst them - economic, financial and philosophical. 

To begin with...we owe you an apology. Our market timing models did indicate an approaching possibility of correction which we shared with you vide our notes in Jan-March 2020. The underpinning of an impending correction was similar to those that prompted us to take a 30% cash call in 2015 March and Jan 2018. As we expected this round of correction to start from a higher Nifty level than at the time of communication, we had stopped at cautioning but not actioning. We deeply apologise for missing this particular opportunity to safeguard your portfolios.

Why did we miss by a whisker? Of the four factors that help us in our tactical asset allocations viz - earnings momentum, valuations, persistency and fund flows, we couldn’t anticipate the volte-face of FII fund-flows that abruptly halted, turned and bolted from the markets. The speed of FIIs and their algos that now run 70% of the world’s trading volumes is something we will learn to factor in due-course.

We have seen unprecedented level of volatility in global capital markets at the end of the FY 2020. In India, Nifty 50 was down by 23.2% MoM whereas Nifty Mid cap and Small cap bleed by 30.3% and 36.7% respectively.

Internationally, the US is all guns blazing through its 150 bps rate cut within a month and announcement of $ 2.3 trillion fiscal stimulus package to provide stability to economic activities during this period and ensure that the eventual recovery is as vigorous as possible. Once it is apparent that the global economy is headed for a severe downturn or recession, markets see the bulk of selling during the same periods when the Fed ramps up its policy response.

But as policy response globally achieves a critical mass and market valuations begin to reflect the new harsh reality of lost earnings, markets begin to form a bottom. During the 2008 crisis as well, particularly during Sept–Oct 2008, the market fell very sharply even in the face of a determined and coordinated global policy response. But, eventually, as the stimulus started to have an effect and market valuations became cheap, markets bottomed out.

In India, markets are reacting as much to the lockdown and its economic fallout as to the pandemic itself, with billions of people are being locked down in their homes.

A study on non-pharmaceutical interventions (NPI) such as lockdowns during the 1918 Flu pandemic across the US found that cities (such as San Francisco and Pittsburgh) that adopted lockdowns earlier and for longer not only had lower mortality, but also grew faster than others in the medium term. India therefore may have done the right thing by imposing a country wide lockdown earlier on but many head of states believe the period of lockdown need a further extension to ‘flatten the curve’ of incremental positive cases.

This has led to economic consequences such as supply and demand shock. Lock downs have not only bogged down the distribution of intermediate or final goods but have also changed the consumer preferences restricting it to basic essentials and the trend may continue in the near future. We believe that even post the lockdown, markets will have to navigate the pain of the crisis and its aftermath. Many industries will take longer to get back to normal production and distribution capacities, due to the exodus of migrant workers to their native places during the lock down.

With the country’s economic growth already on decline, the pandemic and the imposed lockdown will have a further impact on the economic activity and corporate earnings. The current TTM PE valuations at 20.5x on 9th April are still meandering near last 20 yr average of 20.2x and with near to medium term earnings visibility at risk, any extension to lockdown will call for further de-rating in valuations albeit the available liquidity due to quantitative easing.

With the ongoing rally, If Nifty reaches 9,500 levels which is the 50% retracement of the entire fall, we are likely to take a cash call of 30% to 50% proportionately across all equity investments.

For new allocations/surpluses, considering the extra-ordinary situation, asset allocation should reflect at least 2 years of liquidity requirements. For incremental investments in equities, we believe Nifty levels of 7,500 and below make equity investments very attractive on PE (@ -1 standard deviation) as well as yield gap (Earning yield – bond yield) basis.

We believe that sectors such as Pharma, FMCG and IT will be favoured over other sectors. Whereas, Industrial goods, Real Estate, Auto and auto ancilliary, Hotel and Hospitality will be less favourable due to the current lockdowns and change in consumer behavior hereon.

We would be closely monitoring the pandemic, corporate earnings, valuations and volatility in the equity markets for re-entry, if we experience stability/favourable conditions in any of the above factors.

For Fixed Income, Despite the policy intervention of RBI on 27th March, the yields across the curve continue to be at elevated levels due to recent state government borrowings of Rs. 1,60,000 Crores. Further, risk aversion and flight to liquidity have been prime reasons for investors to stay away from corporate bonds. This is in anticipation of continued lockdown and minimal economic activity in the near term. The 6 months to 3 year space on the yield curve looks very attractive with limited volatility.

Hence, we believe that exposure to the debt markets should be taken through short term funds for 1-2 years investment period and Banking & PSU debt funds for more than 2 years investment period. The corporate earnings are expected to be subdued amid the lockdown period and for the next couple of quarters. Hence, we continue to avoid credit risk even if the spreads are higher.

Stay Safe, Stay Healthy

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Coronage! - Alpha Edge, March 2020

Is the significant fall of the 10 Year US G-sec to an all-time low of 0.34 bps and crude oil collapsing to $ 30 signaling to a US/Global recession? What seemed to be a normal correction due to the Coronavirus scare has been accelerating with the contagion effect across interest rates, currencies and all asset classes. Historically, we have seen that central bank policy actions have been able to halt the market downfall. However, the recent market fall, post the US fed cut seems to signal probable loss of control of Central banks. We shall await for a next leg of policy action and the market reaction thereafter to assess a structural shift in the direction of markets.

In February, equity markets have been on free fall with Nifty 50, Nifty Midcap 100 and Nifty Small cap 100 index falling 6.4%, 6.8% and 8.8% respectively. Markets all over the world have turned ‘risk-off’, as investors struggle with the economic ‘Coronage’ that is happening. With the advent of the novel virus spreading over to new territories with each passing day, global economic and corporate earnings forecasts are being revised sharply downwards.

On the global front, as an emergency response to any economic fallout from the epidemic, the Fed has announced a 50 bps rate cut on 3rd March. If the impact of the virus is not contained, central banks world over may follow suit. With the US elections not far away, a tax cut is also expected from the Trump government if the impact of the Coronavirus aggravates. Our allocation to Gold for many portfolios since 2016 has started to pay-off. The time may not be far away when we see US rates at near Zero and Gold crossing its previous highs and reach 2500 USD.

On the domestic front, the juggernaut has been hit hard, though with a delay. With the global interlinkages increasing and getting more substantial, we have no choice but to adapt to outside shocks affecting us. The current virus epidemic is yet another shock that will at a minimum have a temporary impact if managed well. And at a maximum, we tread into the unknown.

Certain industries such as auto manufacturing, and auto component industry may see tough times as raw materials inventory depletes in the next couple of months. On the other hand, due to the disruption in production of the chemical industry in China, Indian specialty and agrochemical players with global export footprints may benefit from a hike in international prices. Cool off in commodity prices will help improve margins for Industrial manufacturers, but the adverse impact of the virus on global demand might offset the benefit.

Markets may continue to experience volatility in the near term in such uncertain times.  Historically, whenever US Fed had to cut rates out of turn, i.e, inter-meeting, the year went on to be mostly turbulent. As we have highlighted earlier, this may provide mid & small caps better entry points than their larger counterparts for medium to long term investments, short term pain notwithstanding.

On the fixed-income front, the bonds have rallied, partially influenced by global softening of bond yields. Benchmark 10-year bond yield is at 6.18%, partially helped by the recent fall of US Treasury 10-year yield to 0.34% post a 50 bps Fed rate cut. RBI's stance on policy rate action remains accommodative, but action depends on the easing of inflation.

With less expectation from duration funds and credit space still being a cause of worry, any exposure to debt markets should be taken through short term to medium term debt funds with a non-negotiable high-quality portfolio.

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1-All! - Alpha Edge, February 2020

On the onset of 2020, the equity markets have finally seen a broad-based rally as Small caps significantly outperformed large caps with the Nifty Small Cap 100 rising 6.71% for the month versus a 1.7% fall in the Nifty. Similarly, Nifty Mid Cap 100 rose 5.31% outperforming the Nifty by 7.01%. This is in line with our view of the past few months that the extreme polarization that the market had witnessed in favour of selective large caps should continue to reverse as a revival in economic activity and corporate profits materializes going ahead.

On the global front, it was an eventful month. It started with geopolitical tension between the US and Iran, then a respite through the US-China trade deal and Brexit but ended with Corona Virus.

On the domestic front, the Union Budget, RBI policy were key events. The Union Budget continued with its focus on infrastructure, Agri and rural economy, social welfare, simplification on taxes but reviving consumption demand seemed to be the key agenda.

However, few expectations were not addressed in this Budget. Expectations were high on the removal of LTCG and measures to revive the real estate sector given its employment generation potential and the multiplier impact it has on the economy.

RBI in its bi-monthly policy kept the rates unchanged but has announced several measures to boost credit growth. They had tried to address the liquidity concerns in the system through Long Term Repo Operations (LTRO). Further, to boost consumption demand, the RBI also removed a mandatory requirement of CRR of 4% for every new loan extended to retail loans for automobiles, residential housing and loans to MSMEs. These measures make the environment highly conducive for increased liquidity and credit growth. Though the Union Budget fell short on expectations, RBI’s ‘Policy measures’ was a very good move. We believe that the eventful month was a ‘1-All’ for the Indian economy.

Q3 FY20 earnings so far are in line with expectations. Earnings growth has likely bottomed out and Nifty earnings growth expected to increase from 13% in FY20 to 23% in FY21 as per market consensus. Sectors such as Auto, Telecom, Corporate Banks, and Pharma which had seen a cyclical downturn have shown early signs of a recovery.

We believe that the yield will stay in a narrow range due to the increase in fiscal deficit and on the other hand, the central bank’s efforts on LTRO and policy measures to improve liquidity and credit growth. With less expectation from duration space and credit space still being a cause of worry, any exposure to debt markets should be taken through short term to medium term debt funds with a high-quality portfolio.

On the equities front, with valuations once again hovering near its peak and if Corona Virus is not contained then there could be risk-off from equity markets in the near term. We believe that any declines hereon shall be seen as opportunities to invest for better returns in the next 2-3 years.

As we have highlighted earlier, we continue to believe that mid and small cap provide relatively better entry points than their larger counterparts for medium to long term investments.

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