Looking through the smokescreen

Economic package: no silver bullets

The Indian government and central bank have actioned a 21 trillion Indian rupees (INR) economic package so far. The package is principally aimed at providing relief and paving the way for structural reforms amid the COVID-19 pandemic.

The fiscal announcements are aimed at supporting agriculture, farmers, migrant workers, micro, small and medium enterprises (MSMEs), microfinance institutions (MFIs), non-banking financial companies (NBFCs), increased public employment outlay, state government outlay and supporting infrastructure. This will be achieved largely through measures like liquidity support, interest subvention and policy changes. However, the support falls short of financial market and business expectations. This seems to have been largely due to insufficient provisions to stimulate demand, support businesses and so growth.

Will they lend, spend and invest?

While record levels of liquidity are available now in the economy, the key factor remains the demand for and supply of credit. The latter has been deficient for the most vulnerable segments of the economy since late 2018. In that time, NBFCs and mutual funds de-risked their loan portfolios, but banks have not stepped in to compensate for the void created.

Credit demand appears low with many business operations ceasing, increasing unemployment and low earnings and income visibility. While the Reserve Bank of India (RBI) has helped, using some direct intervention and providing credit support to banks and financial agencies, the size of and appetite for these measures remains limited.

Consumer spending on discretionary items is unlikely to return to levels seen before the pandemic soon. The same should be the case with investments in anything beyond “quality” businesses or deposits.

While RBI has cut interest and reverse repo rates, and savings and deposits rates have also fallen, lower rates alone may not be enough in dissuading lenders and savers from parking cash (rather than lending or investing).

Kicked cans and accidents

Debt moratoriums, forbearances, deferrals, subsidies; credit enhancements, support and guarantees; extensions of terms, enhanced lending limits, relaxed compliance regimes and payment deadlines; respite on recognition norms for stressed assets; and abeyance on credit rating downgrades or bankruptcy proceedings are all critical in mothballing the economy. But, these initiatives juxtapose allaying immediate fears with increased concerns around more “cans kicked down the road”.

Increased restructuring and NPAs are a given, and that is precisely what markets are factoring in at the moment (albeit not fully yet). But, who will pick these “kicked cans” and will the initiatives ultimately create major unintended negative consequences? While investors are running very light on credit exposures, any major accidents may jeopardise any, critical, revival in risk sentiments.

Bankruptcy risks and distressed debt

The Indian quarantine period is likely to increase the economic stress on many sectors, such as infrastructure, real estate, automobile, NBFCs, travel and tourism and even consumer discretionary.

Businesses and real asset-backed loans in operations that are viable (as opposed to solvent) will hopefully attract much investor interest at, steep, discounts to the replacement cost. In the case of consumer loans, the increased risk premiums available over the significantly lower cost of funds should hopefully reduce the “haircuts” needed to compensate for the risk of higher delinquencies.

The lenders are expected to take big haircuts, but the government may need to assume the biggest chunk of distressed debt. This may be achieved through risk capital or directly taking the hits in the form of loan waivers, public banks’ recapitalisations or buying papers directly from the primary and secondary markets. The timing and materiality of these operations would be more important though, while the debate around potential conflicts of interest, or “moral hazards”, could be a headwind.

Kick-starting the economy

The focus of the markets seems to be shifting from tracking COVID-19 statistics to re-opening the economy and a potential pick-up in supply and demand. India’s federal set-up could complicate the start-up process. Government plans on when and where to restart the economy depends on the intentions, resources available and the political will of state administrations. Improving supply chains across sectors will also require strong cooperation across states and international borders.

Positive news around the science of a vaccine is likely to help risk assets. However, the discovery of a vaccine may take many months to produce sufficient quantities and administer them across the country.

Focus on quality

We believe that “quality businesses”, with relatively strong balance sheets, are best placed to prosper from the economic resumption. As their order books increase, they may be able to aid business confidence by acting as a backstop for their vendors and supply chain. Quality businesses may gain market share and over time, pricing power. With a high premium placed on such businesses, we recommend actively managing portfolios rather than doing so passively.

Opportunities in the “new normal”

The opportunities around global supply chain diversification, especially against the incumbent Asian peers, is increasingly being recognised. Self-reliant India, vocal for local, local to global, made in India and other similar themes, may continue to dominate the government’s reforms agenda. While the reforms announced last month were focused on agriculture and farm sectors, especially in strengthening India’s position in the herbal and health superfoods industry and in supporting MSMEs, all quality businesses that fall into these themes may benefit in future.

Carefully calibrated protectionism, price controls, to prevent profiteering, and tax rates may remain risks for some, but opportunities for others.

While consumer staples businesses should be the first one to revive, other sectors, such as technology, healthcare and pharmaceuticals, should grow wider and deeper. They should maintain the pace and ingenuity set during the current crisis. Furthermore, the value in these sectors may lie across all sizes of business, both in the public and private markets. The real estate sector may undergo a strategic shift in both offices and residential.

Real returns and risk premiums

In the last six years, Indian average consumer price inflation was around 4.5%, compared with around10% for the six years prior to that period. Key factors of inflation in India, such as fuel and food, remain muted. Also, in a world flush with liquidity and increasingly starved of positive real rates, inflationary pressures are low, with the greater risk seemingly from disinflation or falling prices.

Real returns of 200 basis points (bps) or more from top-quality, short-term corporate debt seems attractive. Similarly, another 300-500bps risk premium from diversified actively managed equities usually appeals to many investors. However, volatility will likely be high for some time for risk assets.

Diversification remains key

In fixed income, we retain our tactical preference for select high-quality and liquid assets up to five years in maturity. While the RBI is likely to be able to manage the increased supply of gilts, the market focus shall be on the manner in which the Indian central bank manages term and credit spreads.

In equities, in the absence of short-term positive triggers, caution seems to be the watchword. We are still cautious on financials, due to expected elevated levels of NPA’s over next two quarters. We are more constructive on defensive sectors, like technology, pharmaceuticals and consumer staples.

Having cash available to invest may prove handy come the second-quarter earnings season that starts in July. Building opportunistic positions in the mid and small-cap segment may be worthwhile, as well as in select plays across manufacturers of two-wheelers, metals and cement, best delivered through actively managed portfolios.

Portfolio diversification remains key in current volatile market conditions with allocations to gold and private assets, especially in capturing the emerging trends in the “new normal”.

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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