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Sunday, September 20th, 2020

Market Outlook - August 2020

- Navneet Munot - 

July was characterized by a flattening of economic activity as the continuous improvement off April lows appears to have plateaued.Thistrendisalsovisibleinothermajoreconomies,especiallytheUS.Fading-offofpent-updemand,continued surgeinvirusinfections,andcautiousconsumersandbusinessesareprobablyleadingtothis.Delayedreturntonormalcy hasbeenourkeyworryintherecentpast.YetthemarketswereanythingbutworriedwiththeNifty surgingover7.5%in July. The ongoing results season pointed to corporate pain even as cost control and lower moratorium books for banks cameassilverlining.Marketshavetakencomfortthatthebreadthofearningsdowngradeshasclimaxed,andsomestocks are seeing upgrades incrementally.


Theprimaryfactorbehindtheriseinallassetsrangingfromequitiestobondstopreciousmetalshasbeenarecordsurge in global money supply growth. The US is leading the charge with a mid-20s growth, the highest on record since 1960. Unlike the initial rounds of QE post the 2008 crisis, when liquidity largely went into strengthening bank balance sheets, credit guarantees and fiscal stimulus have ensured broad money expansion now. While India has been much more constrained fiscally, it is still seeing a surge in money supply largely due to the balance of payment situation. Current account surplus alongwithimprovingcapitalflowshaveledtomassiveaccretioninthecentralbank’sforeignexchangeassets.Asaresult, theRBI’sbalancesheethasexpandedto27%ofGDP,notmateriallylowerthantheroughly33%fortheUSFed.M3growth in India is over 12% now, much ahead of the negative nominal GDPgrowth.

 

In a normal situation, the surge in money supply would have gone into inflating the economy. However, given that economiesarenotfullyopenyet,moneyvelocityhascollapsed,andalargepartisfindingitswayintoassetpriceinflation. Thisisleadingtothedisconnectbetweenrealeconomyandfinancialmarkets.Yetatsomelevel,reflexivitymayhelp,and financial market performance can potentially positively impact the real economy. Equity raises have risen meaningfully forexample,ashave debtraises.Thishashelpedlimitthedamagedespiteoneofthesharpestdropsineconomic growth. Bankruptcies have been prevented and financial stability has been ensured, thanks to the abundant liquidity.

 

However, the magnitude of benefit to the real economy will depend on the virus situation and the extent to which the economyisopenbothofficiallybutmoreimportantlyintermsofactualpeoplebehaviour.Afiscalstimuluswillhelpbetter channelize the money supply into the economy too, but even the timing of that may depend on the successful control of the virus.Stimulusinapartiallyopeneconomymay notcreatetherightimpact.Thatthevirushasnowreachedthesofar lesseraffectedareas,likeTier2and3cities,is worrying.At some level,thegovernmentcanonlyhelpcurbthevirustoan extent. Eventually it must become a people’s movement where citizens, communities and businesses play a larger role. Private sector’s pursuit for profit cannot be without keeping employees, along with other stakeholders, in mind. Healthcare and reskilling should become central to business leaders agenda.

 

Evenifthesurgeinbroadmoneysucceedsininflatingtheeconomyeventually,historicallysuchepisodeshavequicklyled tooverheating.Theshortcyclesofcapitalflowdrivenboomandbust inIndiaarealltoofamiliartous.Wemustmakethis expansion more sustained through adequate capacity creation for enhanced absorption of this capital. The supply side measures undertaken by the government in the crisis so far are in the right direction. Atma Nirbhar Bharat and associated policy changes should focus on creating industries of scale. We should take this opportunity to reimagine our financial sector-reformingpublicsectorbanks,development corporatebondmarkets,securitization market,alternative funding mechanisms like AIFs and building developmental institutions to name a few. Infrastructure creation, judicial, regulatory, and administrative reforms, and using technology to power our transformation is critical. And so is structural reform on issues of education, healthcare, and reskilling. The global environment is evolving in a way that we increasingly look like being at the right place, at the right time. We must not squander this opportunity.

 

Yet in the near term, liquidity has led to markets significantly outpacing the economic improvement. Heightened retail activity indicates a degree of frenzy and lends markets vulnerable. Valuations on price-to-earnings (P/E) multiples appear stretchedtoo.However,inpastepisodesofstretchedvaluationssuchas2007-08,corporateprofitstoGDPwereatmulti- year highs while they are at multi-decade lows now. Therefore, peak multiples were being applied to peak earnings then versus high multiples on trough earnings now. The other difference is that global interest rates are near zero now versus sayover4%onUS10yearyieldsthen.Thenarrativeonvaluationsgloballyhaschangedfromlookingat P/Estolookingat


equity risk premiums (ERPs) in the context of low yields. The related asset price inflation has been a key consequence of the unconventional monetary policy (UMP) pursued by global central banks over the past decade.

 

The other unintended consequence of UMP has been an increase in unproductive deadweight in the economy globally. Zeroratesandquantitativeeasingeasilyleadtocapitalmisallocation.Companiesthatareunproductiveand,inmostcases, insolvent and should have otherwise wound down are continuing to operate thanks to the easy availability of low-cost credit,leadingtotheriseofso-calledZombiefirms.TheseZombiesandcorrespondingunproductivecapacityputpressure on the pricing power of other sound firms in the industry. Similarly, while these firms optically lower unemployment by employing labour, wages stay anaemic given low productivity. This is one reason why fall in unemployment in the US in the past decade was not accompanied by commensurate wage inflation. Thus, the problems of disinflation and low productivity that the central banks have been fighting in the first place gets accentuated.

 

Combinationoflowwagegrowthandassetpriceinflationleadstoincreaseininequality.Bymanymeasuresglobalincome disparity is at multi-decade highs. We continue to believe that monetary policy globally has hit its limit and fiscal policy will have to do the heavy lifting hereon. Some version of universal basic income and creating blue collared jobs through increasedinfraspends,pushingupaggregatedemandshouldeventuallybereflationary.USPresidentialElectionsareonly threemonthsaway.Ademocraticsweepwillincreasethelikelihoodofredistributivepoliciessuchasincreaseinminimum wages, higher taxes on the rich and higher fiscal spends.

 

The EU too announced a large recovery fund which was unprecedented and points to greater fiscal cohesion between member nations. Having done a relatively better job on controlling the virus and with greater monetary-fiscal coordination, EU could well turn out to be a dark horse in the new multi-polar world dominated by US-China headlines! TheEurohasalreadysurgedpostthefiscaldealannouncement.Ontheotherhand,prospectsofbettergrowthelsewhere andcontinuedmonetaryaccommodationinthewakeofsurgingCoronaviruscasesintheUShaveledtosharpdepreciation in the dollar. Dollar weakness has historically been good for Emerging Markets and commodities and can strengthen the reflationary effects of the unprecedented monetary and fiscal stimulus globally.

 

For India, the immediate priority is to control the virus. We must revive demand through decisive fiscal measures. While we look to rationalize expenditure and boost revenue through formalization, growth acceleration remains central to improving our government debt profile.Should Debtratioscontinuetoturnugly,wemayrunoutoffirepowertocounter the next shock. A credible boost to growth is the only way out. Additionally, versus continued moratorium extension, a one-timerestructuringistheneedofthehour.Hastentoadd,wemustkeepaneyeonhard-earnedgainsoncreditculture. While creative destruction is essential, sound firms must be saved. With profits as proportion of GDP dwindling, creating sustainedeconomicgrowthwillrequirelargeprofitpoolsaswell.Foritistheseprofitpoolsthatwillhelpfundinnovation, investment,andemploymenttosustaintheeconomy,whilecreatingscaletocompeteinthe globalmarketplace.This Will also be important as the social welfare agenda needs resources too. At a time when governments are assuming larger roles in the West, the policy prescription for India may just be the opposite.

 

Ondebt,whilethejuiciestperiodforgovernmentbondsisbehind,therestillisroomfortermpremiumstocontract.Credit spreads for better rated corporates have shrunk and there is room for better transmission once uncertainty fades. On equities, while mean reversion in corporate profits is key to equity market performance in the medium term, liquidity rules supreme in the near term. Yet risks like retail frenzy, plateauing economic activity, and a potential fiscal cliff in the USanduncertaintyaroundPresidentialelectionsarereal.Westaybottomup-theunprecedentedcrisiswillhaveprofound impact on the complexion of winners and losers of tomorrow and identifying them early amidst this chaos will be the biggest driver of alpha.

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About the Author
Navneet Munot
Author & Consultant
 
Navneet Munot, CIO, SBI Mutual Fund
 
Disclaimer : The views expressed by the author in this feature are entirely her / his own and do not necessarily reflect the views of INVC NEWS.

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