By Vinayak Basu from Deloitte.

Summary:

  • Long Equities short currency is the safest way for global investors to put money into India.
  • Favour big names with low debt and large amount of free cash flow.
  • Demographic trends in India point to increased domestic participation in equities over the next decade.

Views are my own and do not reflect those of my current employer

A virologist would have shorted risk assets in February 2020 and made a lot of money. The same virologist would have probably stayed short into June and lost much of his gains to a liquidity induced juggernaut courtesy Messrs Powell et al. Unless we have a massive solvency crisis or some other 2020 equivalent of a Lehmann moment, we are likely past the lows in risk assets whose performance in the second half of 2020 is likely to be largely driven by liquidity and/or changes in the COVID-19 serious hospitalisation/death rate – Markets don’t seem to care about number of positive tests anymore – its quickly becoming clear that the virus is not as deadly as first feared.

The Indian economy is expected to contract by -6.4% in FY21 (down from 4.2% in FY20) according to Care Ratings. The country went into full lockdown on March 24th and the -6.4% figure is probably towards the higher end of most consensus estimates given that domestic consumption which makes up over 50% of India’s GDP was down almost 70% between March and June.

Wholesale prices are down 3.1% YoY mostly driven largely by reductions in the cost of fuel and power. India’s fiscal deficit widened to Rs. 4.66 trillion (4.59% of FY20 GDP) with government receipts down 69% to Rs. 0.45 trillion. India posted a $600 million current account surplus in Q1 2020 driven primarily by lower trade deficit (down from 2.1% of GDP to 0.9% of GDP). Manufacturing contracted for the third straight month albeit at a slower pace Manufacturing PMI up from 30.8 in May to 47.2 (expected 37.5) in June (PMI below 50 implies a contraction in manufacturing relative to the previous month). Broad money supply (M3) is up 23% from June 2018.

Between June 2018 and June 2020, Indian Debt has outperformed Indian equities which in turn have largely outperformed wider EM equities – and this trend is likely to continue into the second half of 2020. In the last three months, the MSCI India Index has beaten the MSCI EM Index by around 5%. During this period, the benchmark Nifty 50 rose 35.2% from its March lows and now sits 13.5% below its January highs.

Indian equities look expensive now with the Nifty 50 trading at roughly 28x trailing earnings and 20x FY21 earnings which is more than both the 2-year average (27x trailing) and the 5-year average (25x trailing). One thing to note is that consensus estimates of FY21 and FY22 earnings don’t discount either a second wave of the virus or a mass solvency crisis. Either of these could spark a Feb-March like sell-off.

A strong Anti-China rhetoric is likely to dominate US foreign policy in the 2020s regardless of who wins the election this year. Earlier this month, the Democrat controlled house followed the Republican controlled senate in passing sanctions against companies that supported China’s new National Security Law in Hong Kong. In May, the White House stopped the Federal Retirement Thrift Investment Board from investing in Chinese companies. The FRTIB, which manages close to $594 billion through its Thrift Savings Plan, was criticised by President Trump, who promptly sent nominations to Congress to replace three of FRTIBs five board members. Fund managers should probably start (if they haven’t already) prepping for a world where the asset allocation choice set is explicitly decided by congress.

India is particularly attractive to investors looking to diversify away from China – the 30-day average daily net flows has turned positive for the first time since February 20th and stands at $93 million per day at the end of June. The first half of 2020 also saw a record Rs. 400 billion ($5.3 billion) of domestic flows into equities as mutual funds rebalanced away from government debt and into equities. Within equities, Investors are likely to favour growth (read Tech) over value if you must buy one Indian company, buy Reliance – it is effectively a monopoly. The current BJP government wants to get growth back on track and it is willing to ignore issues related to antitrust to meet this goal. Big tech, facing an increasing number of regulatory challenges in Europe/North America, probably sees India in the same way as the East India Company saw the country in the 17th century – a market that guarantees them a future stream of monopoly profits.

The gamification of investing via platforms such as Robinhood that allow fractional ownership, options and margin trading could cause a massive inflow into Indian equities in the next 5 years. Domestic Indian investors opened 830405 new Demat accounts in June 2020 (up from 552512 new accounts in May) and this trend is likely to continue and could go parabolic with the right catalyst – I won’t be surprised if Reliance launches a Trading and Investment app in the next 5 years. Yields are likely to go lower and Generation Jio is likely to pile into equities.

Between 2018 and 2020, high real yields and a relatively stable currency vis-à-vis wider EM caused global investors to pour into Indian Government Debt. This saw Indian Debt comfortably outperform wider EM debt. The 10-year benchmark currently has a nominal yield of 5.8% (down from 6.5% at the start of the year).

The curve is very steep (the spread between the 10 year and the 2 year is 160bps – up from 32bps in June 2018) and with the government borrowing record amounts to fund its $265 billion pandemic relief package expect the RBI to announce further Open Market operations in 2020Q3.

The BJP Government’s 2019 Corporate Tax cuts and low rates in most of DM gave a boost to the already profitable INR carry trade but with Indian rates now at record lows (RBI set the benchmark rate to 4%), going forward, the currency and Indian risk assets are likely to move in tandem.

Historically, the narrative around the rupee has been largely centred around oil prices and the India’s twin deficit problem but a decade of falling commodity prices (largely driven by US Shale and exacerbated by a pandemic induced shutdown) and the surprisingly strong (for now) ‘Make in India’ campaign has caused a sort of regime shift in the rupee-oil correlation.

A move back to the old regime combined with a $60 or higher oil price could spell trouble for investors who have gone ‘All In’ on India – mid to long term investors in India should probably hedge some of their equity/debt risk by shorting the rupee.

 

Technical Glossary:

  • Nominal Yield: Real Yield adjusted for inflation.
  • FX Carry Trade: Currency trading strategy that seeks to exploit differences in interest rates between two currencies to make money.
  • Demat Account: A Demat (or dematerialised account) is used by Indian investors to hold financial securities.
  • Fiscal Balance: Government Receipts (i.e. revenues of the government primarily through taxation) – Government Expenditure

 

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