Around end of March 2020, close on the heels of Covid-led lockdown, I turned bullish on equities, contrary to the widespread negative opinion on equities at that time. In the last ten months, I have presented my arguments many times. Markets have risen dramatically since then. It’s very likely that it may pause here for a while, after the sharp recovery we saw much to everyone’s surprise. This note though is to address what has become a raging question in some quarters – are equities in bubble zone and likely to go bust? I think not.
The anxiety over rates flaring up and inflation making a comeback seem somewhat premature. There are also reasons to believe that India is likely to do very well over next few years. India’s growth, more importantly investment growth, has the potential to return 13% next year and 7-8% thereafter. Here I elaborate on some of the fundamental tenets of my argument and some of the pressing questions emerging in this backdrop.
I also address some other FAQs from client on currency, commodities, numbers of budget and bonds. These are quick points. Most of them are covered extensively in our monthly notes and PPT. This is just to place simple answers to frequently asked questions at one place.
Is equity market in a bubble?
I have heard two chief arguments on this. One from macro traders, who I call them are from Inflation-istan and the other from routine bottom-up stock pickers or the ones I say are from PEstan. Here is a quick peek into both sides of arguments and my take on them:
Inflation-istan’s argument: The macro watchers know that almost all bear markets are produce of Central Bankers pricking the boom to avoid inflation. The argument is that such large amount of money creation (M2 growth of 20% in 2020), wealth effect due to increase in stock price, large fiscal deployment (10% of GDP as fiscal deficit) and QEs (8 trillion dollars of money printing at near zero rates by top 8 Central Banks) will result in inflation. But it’s important to understand that all the Quantitative Easing (QEs) in the world since the Global Financial Crisis (GFC) and tripling of S&P 500 couldn’t create inflation. In this crisis, a lot of personal savings are of rich not the poor, which will drive up asset prices not of burgers! Inflation in developed world is mostly about wage negotiating power and at 6%+ unemployment, that’s simply not there. What about prices of commodities? There is no great evidence that higher commodity prices drive up inflation. Oil moved from 10 to 100 in 2002 to 2007 but didn’t create any major inflation anywhere in the world. Some of the rise in inflation over past few quarters have been driven by high food prices due to supply chain disruptions. They are easing. So net net, this argument that inflation will prick this expansion is right but that it is round the corner is wrong. It’s a thing that we must take into account but is more likely to play out in 2023-24!
PEstan’s argument: These are valuation watchers who correctly argue that stocks are very expensive when you look at Price-to- Earnings (PEs) or Price-to-Book (PB). To substantiate their argument, they also show last year’s PE which of course appear obscenely high (right thing is to look at forward earnings). But it’s important to note that PEs aren’t independent of interest rates. A stock is nothing but a long bond. A 2% dividend yielding bond with close to 45–50-year duration. If real yield falls by 1%, the stock price should be 50% higher. Now where are the real yields? -1% in US. The same used to be 0.5% for last 5 years. During 2003-08 boom it was 2%. So, 1.5% movement in real yield (vs 2013-19) should mean the same cash flows will be 75% higher. But will there be same cash flows? Of course, some scarring will be there, and some businesses may never recover from the scars of the pandemic. But broad results show that it’s not much. Therefore, while stocks appear expensive, but at current level of bonds in the world, they aren’t bubbly. And if corporations sustain the productivity growth that they have shown over past 6 months, there is an argument to be made that they will get even more expensive.
So then when to exit equities?
My framework is to buy valuation and sell macro (I am not a bottom-up guy. More of a macro investor). So, until inflation really becomes a headache (that’s the key macro risk) and policy makers show tendency to tame it, we must stay invested. Remember that mild inflation isn’t a big worry for equities. It’s the hyper-one which hurts it (1970s kind for US, 2011-13 kind for India). I don’t know what the appropriate level of inflation (for equities) in India is, but it seems like 4-5% is a reasonable level. Our WPI in last 25 years has been near 4.5% and GDP Growth at 6.5%. CPI has been somewhat higher (Most due to Food prices. Do read this blogpost from our fund manager Pranay Sinha on why inflation isn’t such a big risk now). For US, Equities perform the best when inflation is close to 2% (last 10 year 1.5%). I have no reason to believe that it would be significantly higher than 2-2.5% over next 10 years. But if you begin to sight higher than 2-2.5% inflation in US and see FED wavering, I think that will be the time to take money off equities. I think it will happen in 2023.
How to think of India in the context of global stock macro?
India is like a growth stock to the world capital. In this super low-rate environment, a routine discounted cash flow (DCF) at low level of rates will throw higher Net Present Values (NPVs). Let’s say if the real yield is lower by 1% in the world, it will mean investors are ready to pay 50% more for same cash flows (because stocks duration is 40-50 years). It’s likely that Indian people will continue to sell stocks to Foreign Institutional Investors (FIIs). FIIs were less than 10% in early 2000 and their percentage share of Indian stocks rose to 20% in 5 years of bull market (2003-08). That number has stagnated there. I think over next decade, FII’s ownership will rise. Indians may not be able to participate in this rally because equity asset class will increasingly look lot more expensive to them (relative to other assets including bonds). But smart investors should remain o/w this asset class.
But Interest rates have gone up, will it hurt stocks?
Fact is large part of increase in rates is driven by ‘break even inflation rates’ in most of the world. Real rates have actually drifted down further over past few months. It’s the real rates which matter to equities, not the nominal ones (happy to share the equation if anyone wants it). I think real rates have drifted down by more than 1% across the world. Even in India, look at lending rates which have fallen by 1% whereas Consumer Price Index (CPI) has risen by 3% (over past 12 months). That means a large fall in real rates (that’s of past one year). It’s very likely that Indian inflation will be 4-5% over next 10 years = Indian bonds still deliver 1-2% real return. It’s very high in global context. This is also a reason why I think FIIs will return to Indian bonds, very soon.
Why am I not so bullish on Commodities now?
I have argued for reflation in commodities since April. But there are cracks in there. China is slowing. Its total financing has started to decelerate. Some sort of taper is underway there. This isn’t anything like 2008 where China did massive pump priming and that led to major demand boost for commodities. Remember, commodities prices are mostly driven by China demand. So keep a good watch on PBOC. As such, the last 10 months readjustment in commodities is coming to an end and unless PBOC (People's Bank of China) eases (liquidity) or China embarks on more fiscal easing, the path of least resistance in commodities could be stable or lower.
How about dollar?
Over past 50 years, Dollar has had three cycles. It peaked in mid 80s, early 2000 and then in 2014 or 15. Each time it peaked, some sort of crisis unravelled in EM. In 80s, it was about Latin American countries, in 90s, it was Asian economies and over last 5 years, it has slowed the world economy as such and paved way for crisis in countries like Turkey, Argentina etc.
I have been bearish dollar since March and have seen dollar depreciating substantially since then. But dollar is expensive even at these levels: US runs large Current Account Deficit (CAD) and Fed has been the most aggressive Central Banker in the world (along with the US Govt. being most aggressive in doling out stimulus cheques, therefore becoming a great exporter of its currency). This means the dollar weakness will stay for many years until the adjustment in US economy runs its course (Our assessment is Dollar is 15-20% expensive vs both CNY and OECD countries). This (dollar debasement) is an unwind of trade that has been on since GFC or 2012. But my view on INR remains neutral. RBI has been too aggressive in intervening both in forwards and spot. INR is also part of our industrial policy (a welcome change) now, so I expect it to stick at these levels for long time (though there is always a risk of appreciation if RBI choose to let it go). But in India, impossible trinity will kick in. We can’t have all three, fixed currency, free capital flows and independent rates. At least one will give in. I think the thing to give in is going to be short term rates in India (That’s why I think REPO rate hike is still a 2022 thing). They will stay depressed for very long.
Why did India growth not falter as much as many expected?
Our view since the beginning of the financial year has been that analysts are overestimating the extent of drawdown in the economy and we would de-grow by only 4-5%. Our current estimate is 6% contraction though I am still more bullish than that. Rising GST collection, NONG (Non-Oil/Non Gold) import growth, and credit growth, along with many other high frequency indicators suggest that our recovery is solid and it’s not just pent up demand that’s driving it. One question which often comes is why individuals and corporations aren’t in as much stress as was predicted by most? Why banks aren’t showing as much stress as was once anticipated by analysts? Here is my macro explanation: If we look into sectoral accounting of Private sector, Government and Rest of World then over past 1 year, the government dissaving increased by 5% (FD went up from 6% to 11%) the Rest of World dissaving increased by 2% vis-à-vis (current account movement from -1.5% to +1%). Together, it’s 7% of GDP excess surplus for private sector (individuals and corporates). This explains why corporations are deleveraging and households are not defaulting. We know from banks results in Sept (and some in Dec) that total Covid related restructuring would be only less than 2.5% of their book. The eventual credit cost due to Covid may turn out to be significantly less than that. This of course is a very different outcome for our financiers who are prone to major busts in the wake of such a big catastrophe. (That is what RBI FSI modelled, which ofcourse is a wrong prognosis)
Why Fiscal will remain stimulative despite lower fiscal deficit next year?
The expenditure as percentage of GDP is budgeted at 15%+ vs 12.25% in FY17-19. Next year Nominal GDP will be more than 14.5% as estimated. So, while activity resumes in the economy and most actors go back to consuming to pre-pandemic levels, government expenditure will still be 2% wider than pre-pandemic times. That’s why I think Indian government will remain stimulative even next year. This also remains risk to my stable inflation outlook.
What is the key risk to my view on growth?
I have argued for a glorious decade for India. I think stage is set for our country to deliver best ever growth over next decade (13% next year and 7-8% for rest of the decade). In year term, there are some risks. For Economy: Early or premature withdrawal by Central Bankers is the key risk to my argument for strong recovery in our country (and the world). Recovery is far from complete and authorities have to stay put with the support for 2021. For equities: I am a little worried on tax hikes. So far, only a 2-3 countries have discussed about Covid tax but given that Biden & his team (including Yellen) has hinted about tax increases one has to be somewhat careful. Once it is done in US, this will readily be accepted a wisdom by many. I think it will be a wrong thing to do, but it’s an entirely political call and we must watch out for it.
What should bond investors do?
I think Indian investors are getting a great deal in bonds. Bonds are likely to offer a reasonable real return (6% 10 year Gilt & 4-5% inflation over next 10 years). So, while it’s likely that RBI begins to withdraw accommodation, it’s already priced in markets. Our curves are relatively steeper than most G20 countries (both EM & DMs) and compensate really well. But in near term, there are far too many risks to bonds.
The borrowing numbers for this fiscal and the next are quite high for markets and path of least resistance is higher for bond yields. Unlike many other central banks, RBI hasn’t come forward to do large asset purchases. It worked fine last year but in the wake of sharp credit growth, it will be difficult to get buyers for long bonds. Therefore, in near term, there is a clear upside risk to bond yields. For long term investors, it won’t matter. So, my recommendation remains the same - Invest in short term funds (Corporate Bond or PSU or STPs) for 1 year+ horizon and for short term allocation, invest in liquid plus fund (Ultra Short Term, Money Manager, Low Duration). If you have 5-year money, put your money in Income funds.
The views and opinions expressed are those of Maneesh Dangi, CIO – Fixed Income and do not necessarily reflect the views of Aditya Birla Sun Life AMC Ltd (“ABSLAMC”) /Aditya Birla Sun Life Mutual Fund (“the Fund”). ABSLAMC/ the Fund is not guaranteeing/offering/communicating any indicative yield on investments. The document is solely for the information and understanding of intended recipients only. If you are not the intended recipient, you are hereby notified that any use, distribution, reproduction or any action taken or omitted to be taken in reliance upon the same is prohibited and may be unlawful. Further, the recipient shall not copy/circulate/reproduce/quote contents of this document, in part or in whole, or in any other manner whatsoever without prior and explicit approval of ABSLAMC.
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