Between the devil and the deep blue sea

As we progress through the pandemic, the number of confirmed cases in India keeps hitting new peaks, partly due to better rate of testing. India now finds itself at the third top place worldwide for COVID-19 infections, according to John Hopkins University. The recovery rate though remains high and mortality rate is relatively low.

Turning to gross domestic product (GDP) growth prospects, while April-June quarter should see one of its sharpest contractions, for the full year 2020, GDP is likely to recover somewhat, but still contract. High-frequency economic data suggests that activity is picking up. However, the initial pace of recovery, supported by pent-up demand, seems to be plateauing as the distribution of growing COVID-19 cases switches among urban districts.

Lockdowns, containment and restriction measures persist at the regional level, especially in key urban centres. While the situation in some of the earlier peak-infected cities are easing, with economic activity picking up, some key urban centres and states are seeing renewed lockdowns. Also, newer cities have started peaking.

Gradual recovery

A stronger recovery seems to be occurring in the rural economy and this pick-up in rural demand is the biggest mitigating factor. A factor aided by the government’s focus on policy support for the area, a good monsoon, record sowing of crops and faster unlocking in the rural regions. This should mitigate, but not fully offset, the ongoing economic damage caused by the COVID-19 crisis.

Therefore, we expect the recovery path to be very gradual and definitely not a relatively quick, V-shaped one. Overall, the potential impact of the health crisis and a potential vaccine solution on the economy may be overplayed in the short term. In turn, this lends itself more to being expressed through market volatility rather than having a real impact on corporate profitability.

Low credit risk appetite

Beyond the pandemic, the key issue facing the economy remains around a possible credit crisis. The general credit risk aversion was evident before the current crisis (especially since the Infrastructure Leasing & Financial Services (IL&FS) default in late 2018).

Loan moratoriums make it difficult to evaluate the impact (although moratorium levels are coming down sharply). Unlike some developed markets, the Reserve Bank of India has limited policy space, including targeted-longer term refinancing operations (TLTRO’s), to support credit markets.

Banks, non-banks, mutual funds and retail investors continue to be risk averse to credit. How lenders manage their balance sheets through the looming credit risk and bounce back may have a significant bearing on the recovery path in the country.

Debt moratorium risks

While visibility may remain low over the coming months, with risks increasing as debt moratoriums finish, it is important to start deciphering this more closely. The potential downside surprise to expectations from public sector banks seems to be unlikely to change in the short term. Especially considering their apparent dependence on fiscal recapitalisation and some structural reforms in their governance and management.

While non-banks have been starved of their competitive funding sources since the IL&FS crisis, a lot is being generalised around the state of this important segment. Stretched wholesale lending exists in the housing finance companies and the non-banking finance companies sectors. However, there are enough players in the non-banks segment with stronger balance sheets and access to cheaper funding. Lastly, “quality” private sector banks have been shoring up their capital base and will have the opportunity to fill in the gaps. These banks are expected to pick up market share as growth visibility resumes, especially in consumer credit.

More fundamentally, low credit penetration and a good credit culture in India, especially in the consumer segment, should remain big tailwinds in surprising the markets positively in the medium term. In line with our expectations of a very gradual economic recovery, we would play this contrarian call very gradually and more tactically.

Liquidity driving valuations and temptations

Inflation is expected to remain elusive, rates seem set to be lower for longer and liquidity looks likely to remain plentiful. As such, “The Great Polarisation” in favour of quality, safety and liquidity, that we have advocated since early 2019, continues to chase valuations to increasingly unattractive levels. This is true across equities, debt as well as gold.

Temptations are running high across asset classes:

• In Indian equities: temptation to be in mid and small caps and/or in value/cyclicals versus large caps and larger mid-caps quality stocks (due to uncomfortable valuations)
• In debt: temptation to be in longer duration or lower credits versus shorter duration, high-quality and liquid bonds (worrying looking valuations and unattractive yields).

Investors should be careful around “value” traps and liquidity traps (risk of not being able to liquidate positions), keep strict tactical risk budgets and ideally deploy such budgets through active managers.

Diversification

We continue to advise maintaining a well-diversified and actively managed portfolio across:

• Quality Indian equities (with overweights on IT, telecoms, consumer staples, consumer durables and insurance)
• Global equities (with a bias towards US equities)
• Gold (also providing an Indian currency hedge to the portfolio)
• High grade corporate bonds in the 1-5 year maturity bucket
• Less correlated private assets (particularly healthcare, consumer and technology sectors.

Staggering the investments and re-balancing may help smooth the ride for those who cannot bear particularly volatile returns.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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