Market Outlook – June 2020

Elon Musk’s SpaceX created history by launching astronauts into the space for the first time ever from a commercially made spacecraft. This at a time when the world is still struggling with the virus lends out some hope, that we should not write off human ingenuity. It also underscores the importance of innovation and technology as key drivers for success in today’s era when some are seeing the crisis as an opportunity while most others fall by the wayside. It is no surprise then that big tech and biotech continue to drive the US stocks rally. Yet a continuation of the rally should not be taken for granted given the rising civil unrest in the US, the growing global clamour for protectionism and perhaps a potential second wave of the virus. And nor should be the dominance of big tech.

The deflationary environment of the past decade marked by low growth, low inflation and low rates has driven polarization of the stock market into select few winners globally. A structural break into a reflationary environment can reverse this. With a rapidly rising unemployed population and an ever-increasing number of zombie companies, this is all but vital. A regulatory backlash cannot be ruled out to correct this. More simply, aggressive fiscal measures complemented with accommodative monetary policy can help revive inflation globally, provided economies reopen enough to allow multipliers to work. That however is contingent on the progress of the pandemic with further waves of the virus staying the key risk.

The deflationary pulse has also led to continued underperformance of emerging markets, in line with the trend of the past decade. In a crisis, the challenges get aggravated as EMs cannot afford the same fiscal profligacy as their developed peers nor can their central banks explicitly monetize the fiscal deficits. Run on the currency and hyperinflation often result from deficits and direct monetizations perceived as incredible and unsustainable. History is full of such instances. EM performance bottoming out too will depend on return of reflationary forces with dollar weakness and commodities strength being the two key trends to watch out for. The recent rally in EM equities has indeed been fuelled by a pullback in the US dollar even as the sustainability of this pullback remains to be seen.

Indian market had been an under-performer within the EM complex in this crisis. Even though an environment of dollar strength and commodity weakness is usually associated with its relative outperformance given low dollar debt, high FX reserves and net imports of commodities. Yet, the still rising number of Covid cases, concerns on financial sector and lesser fiscal support all contributed to this weak performance. This, when we were already in a prolonged slowdown as underscored by the recent GDP print. The technical aspect of high weightage of Financials in the index also weighed on relative performance. However, recent signs of the economy opening up have led to a sharp rally for Indian equities helping reverse some of the underperformance.

The government announced a slew of stimulus and reform measures in a bid to seize the crisis as an opportunity and fight for a position of strength in the changed world order. Overall, it prioritized structural supply side reform over near-term demand boost. Reforms in the farm sector were encouraging and should help address the two key challenges of price discovery and value addition. Also encouraging was the intent for reforms around factors of production- land, labour, capital, and enterprise. However much more needs to be done on this front, especially on the last one – enterprise.

Corporate profits as a proportion of GDP have been dwindling for almost a decade now. Large profit pools are necessary to fund investments leading to employment and income generation. At a time when innovation and technology are key differentiators, these profit pools are critical to fund R&D. Aspiration to play a prominent role in the global supply chain requires pro-business policies that incentivise creating organizations of size and scale that can compete in the global marketplace.

The PM also talked about the government’s focus on laws. Judicial, administrative, and regulatory reforms are needed to align the machinery to this growth aspiration; accountability and efficiency must go hand in hand without compromising one for the other. We must leverage data and technology to accelerate our transformation. The thrust on uplifting the masses must continue as strong social capital is vital to fulfil our aspirations as a nation. The current migrant crisis needs to be carefully handled. Rehabilitating them is important, and so is keeping the rural economy insulated from Covid, as it has remained amongst the only bright spots so far.

Another thrust of the stimulus announcement was to revive the credit engine through credit guarantee support to MSMEs and to some extent NBFCs. This should help better transmission and allow money multiplier to kick in. Similarly, the focus on NREGA is welcome given its high multiplier impact. We believe this is one of the most productive ways of boosting aggregate demand and should be significantly scaled up. In the same vein, allowing additional borrowing by states with conditionality attached on reforms is in the spirit of cooperative federalism and makes immense sense given the higher multiplier of state spends.

Yet the gravity of the slowdown may force the government to spend more to revive demand. If additional borrowings are accompanied by a credible medium-term plan to revive growth, emphasis on structural supply side reforms, and a roadmap on fiscal consolidation, it may not be taken negatively by rating agencies. On the other hand, lack of growth will anyway deteriorate the debt profile through sheer interest burden. The recent downgrade by Moody’s is a quick reminder of this very dynamic. In any case, capital flows into India historically have been driven by growth prospects rather than ratings.

The RBI will need to undertake calibrated monetization of additional borrowings. On its part, it has been aggressive on rates, liquidity, and transmission. Yet the current yield curve is one of the steepest in India’s history. Given the sharp jump in quantum of bond supply (both G-sec and SDL), the market would be keenly watching the actions of central bank in creating additional demand avenues including OMOs. Additionally, further relaxations may be needed for greater flexibility to lenders on one-time restructuring. Hasten to add, while this is the crying need of the hour, we must keep an eye on hard-earned gains on the credit culture across all segments. It is our collective responsibility.

We have been maintaining a relatively high duration in fixed income funds. While structural view remains unchanged, we will take advantage of tactical opportunities as we expect bond market to be in a consolidation mode for the time being. Credit spreads are elevated, but they also reflect the economic uncertainty and constraints in the financial system and therefore we stay selective.

On equities, we are anxiously excited as we scout for winners amidst this chaos. With a deadly mix of issues ranging from a pandemic, country-wide migrant crisis, locust attacks, cyclones, earthquakes, border tensions with neighbours, a ratings downgrade, all coming together, India’s resolve is being tested. Adding to the macro issues, disruption is becoming a norm be it around consumer behaviour, technology, policy, geopolitics, supply chains, and so on. The response can be either to hope for normalcy to return or to seek opportunity in this apparent chaos. Firms that take the latter approach are likely to survive and thrive.

Winners will be the firms that stand ready to rethink and reimagine their business processes. Agility and nimbleness will matter more than size. Innovation and R&D will create a lasting competitive advantage and not the scale of physical assets. Planning will help, but more important will be creating strong feedback loops to prepare for unknown-unknowns. Risk management should evolve to account for black swans and also newer risk areas such as cybersecurity. Scouting for talent will be important, as will be re-skilling and holistic well-being of employees amidst the new Work regime. Treating all stakeholders fairly amidst the crisis will be vital in building trust, which in turn will help create long-term value.

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