By: Navneet Munot, CFA, CIO, SBI Mutual Fund and Director IAIP
2016 began on a note of increased volatility and stress across global market. Equity markets fell, spreads on high-yield bonds widened and commodities tanked further.
The US Fed kept interest rates unchanged in its January meet and said it was “closely monitoring” global developments, but maintained an otherwise upbeat view of the US economy. While, the Bank of Japan pushed interest rates into negative territory (lenders pay!) and European Central Bank signaled more easing.
The current downtrend in market is being compared with 2008 and reasonably so. Historically, whenever we see equity market (MSCI world) fall of more than 10%, the period has coincided with an economic recession. While the world economy has some structural challenges and there is a tail risk that current financial market stress can have reflexive impact on the fundamentals themselves, our view is that it is far from heading into another recession. The improving labor market in developed markets, strength in European manufacturing activity (as indicated by their PMI) and strength in US consumer balance sheet indicate sufficient muscle power to keep the growth at current levels.
Globally, markets have become strongly linked to crude oil in the recent months. Even for the Indian market, which diverged from crude oil movements last year, saw renewed correlation with crude oil prices over last few months. Our expectation is that most of global commodities are close to bottom and stability returning in the commodities market will go a long way in reversing the market sentiment.
China was the main driving force behind the rising commodity prices over last decade, its fixed-asset investment growing at an average of 25% from 2003 to 2011. The high investment growth was led by property investment and related heavy industries, the biggest drivers of demand for commodities. The last decade’s commodities boom has led to a big supply response. The substitutes for oil saw huge investment ranging right from shale gas in US to nuclear energy in Japan and to increased LNG and renewable energy supply world over. The fall in oil prices led OPEC countries to breach its production limits and Non-OPEC producers like Iran and Russia to pump more supply in the market. In fact, China itself added large capacities in many of the commodities, including coal, steel and aluminum. Owing to these confluences of events, while global demand for commodities is still growing, it has not been able to match the pace of supply expansion.
The first phase of meaningful fall in commodities (which began since mid 2014, catalyzed by slowing Chinese growth) was cheered by the market as it works well for many segments of a global economy. Reduced commodity costs help margins to expand and as some of that cost advantage gets passed on to the buyers, it benefits consumer spending. But the continued fall in commodity prices raised concerns on earnings of the energy related companies and the fiscal damage being wrought upon energy producing nations. The collapse in oil prices has prompted many sovereign wealth funds to liquidate their financial assets, putting further pressure on markets. We are presently in this second phase of capitulation. In the long run, however, the fall in commodities has set a stage for transfer of wealth from commodity producers to global consumers and will have a positive impact on overall world economy.
On the domestic front, the fundamentals of the Indian economy are relatively better than that of most other emerging market economies. But these better macros are yet to translate into better micros. A broad based earnings recovery is yet to take shape. Some of the hard hitting measures taken to improve the macro have affected India’s micro. For instance, fiscal consolidation by way of curbing revenue spending (low MSP hike, reduced subsidies) has led to a fall in rural income. While contained inflation is a boon for overall economy, it has caused nominal growth to slip below the cost of borrowing, thus hurting the debt dynamics for the private sector. A low nominal growth also hits corporates’ ability to improve their revenues. Other factors like two successive years of bad monsoon (hence low rural income and demand) and weak global demand has also led to persistent capacity under-utilization. And lastly, stress in corporate balance sheet which in turn impacted bank balance sheet are some of the reasons affecting corporate profitability.
Increased government spending and further policy reforms, likelihood of a better monsoon (after two successive years of deficiency) leading to a revival in rural spending and implementation of seventh central pay commission will lead to an overall recovery in demand situation. Urban consumption is already showing signs of recovery. With all this, corporate profitability could improve by 12-15% over the next couple of years given a low starting point. Over the long-term, gradual acceleration in GDP growth amidst controlled inflation would likely lay the foundation for a more stable and longer duration expansion cycle for India.
Time and again, price movement has shown that markets find reasons to rationalize levels if valuations run ahead of earnings. The current correction in the equity markets might just be that reversion to rational levels.
In this sense, the near term challenges offer good opportunities for investors to enter equity market and build the portfolio from a long-term perspective. In last one year, Domestic fund inflow has counterbalanced the FII outflow and we believe this trend to gain momentum. Indian households are vastly underinvested in equity market. The increased diversion of household savings into equity and debt market over time will help to markedly reduce the impact of global developments on India through the capital channels.
In its latest policy meet held on February 2nd, RBI left the Repo rate and CRR unchanged at 6.75% and 4.00% respectively. Despite the central bank reiterating its accommodative stance, India’s bond yields have moved upward in past few months. While hardening of bond yields across the emerging markets have played a part, the supply pressure in the domestic market has also intensified. State borrowing has jumped significantly in this fiscal and is likely to be further complicated by the recent Uday scheme (Ujwal Discom Assurance Yojana) announcement by the government, aimed at the revival of debt-laden power distribution companies. On the demand side also, though the banking sector has remained the major buyer for government bonds, such demand is declining with lagging deposit growth. The appetite of FIIs and mutual funds has also reduced. Given the unfavourable demand-supply dynamics, market will be keenly watching the forthcoming union budget and the consequent borrowing numbers. While our medium term view remains positive, we have reduced duration in bond funds by switching to front-end of the curve (5-7 year segment) that looks attractive from a valuation perspective.