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Hopium! - Alpha Edge, July 2020

Nifty Index had a strong month with ~7.5% and the best quarter in 11 years, since June 2009. The rise has been as swift and steep as was the crash. The Nifty has surged over 35% from March lows even as the number of Covid-19 cases in the country have jumped from 500 to over 6 lacs during the period. Probably the fastest crash and recovery on record globally.

Indian equity market valuations have again reached a disconcerting level of 28.30 x as we speak. It seems to be supported by a narrative of falling yields in India and globally. However, the real reason for the rise is unprecedented liquidity. That has directly helped financial markets to price in an anticipated V-shaped economic recovery and / or discounting too far into the future – FY22. Over the last two decades we have seen consensus estimates underpricing growth only once, in 2005-2006. Every year before and after, the analysts estimates of Nifty EPS have mostly overstated and have been needlessly optimistic, creating ‘Hopium’ – hope induced by opium.

Globally, all Central banks have continued their expansionary stance. China has shown a very strong recovery. The economic activity and mobility data in the US, UK and Europe has improved in the last two months, but is flattening now indicating the recovery might be a more of a bumpy ride than a smooth one.

On the Domestic front, good recovery in 2 wheeler sales, GST collection of 90% of pre Covid levels are positive indicators. But the Nifty earnings have de-grown by ~23% YoY and Nifty Mid Cap Index has reported a loss at an aggregate level in Q4 FY20. The weakness in corporate earnings in the March quarter, when the impact of the lockdown was insignificant, clearly indicates the sluggishness in the economy even before the Pandemic.

FY21 Nifty earnings growth consensus estimates have already been downgraded to -10%, with a recovery expected in FY22. The reasons for the earnings downgrade has been subdued consumer demand, low capacity utilisation, and a stressed financial sector with likely NPA pressure after extension in the moratorium period is over. With valuations looking expensive again, we believe that the equity markets may remain range-bound and upside is likely to be capped from current levels. We do continue with our cash call of 50% and are closely keeping a tab on the ongoing developments. Were there to be evidence of sustainable earnings recovery and fair valuations or both, we look forward to becoming fully invested.

On the Fixed Income Front, RBI has been aggressive through its bond purchase program and has led to a contraction in Credit spreads within high quality (AAA and PSU) bonds. But the spreads remain high for bonds rated AA and below attributable to economic uncertainty and risk aversion.

We believe that there is some more room left for yields to fall, however, the juiciest period for government bonds seems likely behind. While the curve stays very steep, continued fiscal pressures provide resistance. Hence we believe that exposure to debt markets should be taken through short term funds for 1-2 years investment period and Banking and PSU debt funds for more than 2 year investment period. Credit spreads are elevated, but they also reflect the economic uncertainty and constraints in the financial system. Hence we continue to avoid credit risk even if the spreads are higher.

While structural view remains unchanged, we will take the advantage of tactical opportunities as and when possible.

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Unlock 1.0! - Alpha Edge, June 2020

India has completed two months of the nationwide lockdown, meant to curb the spread of the novel coronavirus pandemic. So far, essential services, some industries, railways, and more recently, domestic aviation was allowed to resume.

Further, the Government has announced its “Unlock 1.0” plan to open religious places, offices, shopping malls, restaurants, and hotels from June 8 in non-containment zones across the country. It will be a good start to begin with as the economic activities came to a grinding halt amid the lockdown period.

The Indian government has issued clear guidelines required to be followed for each type of establishment. A failure to follow these social distancing guidelines can increase the risk of a rise in containment zones as economic activity resumes delaying further recovery.

On the global front, Global GDP growth estimates for CY20 continue to be downgraded further due to the pandemic. However, the slowdown in incremental cases, progress towards medical solutions, and re-opening of economies have been some positives. Central banks also expected to further expand their balance sheets. However, the Civil unrest in US and flaring of US-China tension are new risks.

On the local front, India is playing catch-up with global markets ignoring the ongoing pandemic, the country-wide migrant crisis, cyclones, earthquakes, locust attacks, border tensions with neighbours and a ratings downgrade.

We believe that the near term upside is expected to be limited due to the continuing earnings downgrades amidst the COVID-19 uncertainty, poor consumer demand, low corporate earnings growth, and a stressed financial sector with likely NPA pressure after extension in the moratorium period. Hence, we do continue with our cash call and are closely keeping a tab on the ongoing developments.

On the debt front, the RBI has been aggressive in policy response so far whether it may be rates, liquidity, and transmission. Yet it has only met with partial success in achieving the desired outcomes. Given the sharp jump in the quantum of bond supply (both G-sec and State Development Loans), the absence of any announcements for managing the supply such as Open Market Operations(OMOs) or any other similar measures will lead to steepening of the yield curve.

Hence we believe that exposure to debt markets should be taken through short term funds for 1-2 years investment period and Banking and PSU debt funds for more than 2 year investment period.

While structural view remains unchanged, we will take the advantage of tactical opportunities as and when possible.

Credit spreads are elevated, but they also reflect the economic uncertainty and distress in the financial system. Hence we continue to avoid credit risk even if the spreads are higher.

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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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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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Play it by ear! - Alpha Edge, January 2020

Wish you and your family a happy new year. Hope you had a great time welcoming it.

2019 was a year of ‘divergence’ in many ways. While the economy decelerated considerably, equity markets did well even though corporate earnings fell short.

Further, even within equities, we saw a strong polarisation, with a preference for a few large corporate houses, whereas, broader markets didn’t do well. A similar trend of polarisation was witnessed in the debt space as well, as quality was preferred over anything which was non-AAA post the ILFS crisis.

It had been like a Bull market for Large Caps and Quality names but a bear market for the broader market. Ample liquidity and a dearth of investment opportunities were the key reasons for this selective risk-on behaviour. Sound Balance sheets and better earnings /cash flow visibility was rewarded handsomely.

In contrast to 2019, 2020 seems to be a year with a lot of promise for the broader market especially mid & small caps. However, a few key events such as the Union Budget, Earnings season (impact of Corporate tax cut), US- China trade truce agreement, Brexit and a build-up of US general election will have a major role to determine the further market direction. Hence we believe we must ‘Play it by ear’ in 2020, with heightened alertness.

The recent run-up has been very strong, taking the valuations closer to +2 standard deviation mark. With valuations once again hovering near its peak, we may see profit booking soon. 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.

On the Fixed income front, yields are likely to trade within a range as conflicting forces are at play. On the positive side, factors such as moderation of global growth, easing stance of major global central banks, slowing domestic economic activities, RBI’s Accommodative stance, attractive term premium over repo rate and moderating credit growth favour lower yields.

On the negative side, possible increase in the fiscal deficit due to corporate tax rate cuts, excess SLR (Statutory Liquidity Ratio) investments within the banking system, Higher food inflation, etc. might impact yields adversely. However, we believe that most of the aforesaid factors are largely priced in and scope of significant move on either side from here on seems limited.

With a lesser scope of a significant move in yields on either side, any exposure to debt markets should be taken through short term to medium term debt funds with a high-quality portfolio.

Gold has seen a significant run up as highlighted last year. Financial and geopolitical uncertainty combined with low interest rates globally will likely continue supporting gold investment demand. Therefore, we believe that the appeal of Gold is likely to remain elevated at least in the first half of 2020. Historically, dollar weakness is associated with commodity strength. Hence, we are closely watching the dollar movement in anticipation of a breakout in the commodity index. 

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