Seeking refuge in uncertain times

The outlook for the COVID-19 pandemic, containment measures, economy and effectiveness of the monetary and fiscal stimuli remains unclear. As we pass through this dark period, bumpiness in financial markets is likely to be unsettling.

The lows seen in risk assets in March look unlikely to be revisited again in coming months, unless the pandemic worsens significantly or the demand destruction it is causing exceeds our estimations. On the other hand, the potential upside also seems to be capped in the very near term, barring “The Great Polarisation” in favour of “quality”.

Positioning

The worsening outlook prompted us to move to being neutral on equities in April, from our previous overweight call. However, we maintained an underweight on cash and ultra-short-term debt to fund the overweight stance on Indian debt. We continue to think of gold and private assets as important diversifiers in portfolios.

Even during particularly volatile times, history shows that staying invested usually pays off and that missing just a few of the strongest daily price gains may impact long-term performance considerably.

India macroeconomic backdrop

The outlook for the country’s gross domestic product (GDP) growth seem to have worsened, given the extension of the quarantine period, along with effects on the mining, agriculture, manufacturing and utility sectors seemingly being higher than we expected.

Furthermore, the recovery to be weaker than we had forecast, given deteriorating global prospects and the rising risk of COVID-19 outbreaks leading to shutdowns at the local level.

The new normal

Monetary policy headroom is available to smoothen the effects of transition on the economy through this painful period. Relief packages and government measures aimed at stimulating growth will also help. Whether they will be sufficient will depend on the ultimate size of the challenge that lies ahead.

In time, the baton will once again be passed to the resilient, high-quality, private businesses to muster a gradual recovery, along with the country’s favourable demographic profile and consumption.

There are some tentative signs of the opportunities emerging to position portfolios for the “new normal” beyond the crisis. These include Indian companies likely to benefit from global supply chain displacements and increased interest in participating in the country’s consumer growth story. Deals such as Facebook-Reliance or the role that Indian pharmaceuticals and technology sectors may play in the new normal.

Indian equities

First-quarter earnings announcements are likely to be disregarded by many market participants, especially with many companies continuing to withdraw their near-term guidance. Instead, the market will, over time, look to earnings growth reported for June, as an indicator for 2020 prospects, and on expectations for 2021 and beyond.

Further, consensus downgrades to company earnings for forecasts for the 12 months to 31 March 2021 forecasts seem likely, which we think will be mostly flat. On the other hand, FY2022 earnings growth may rebound strongly. Earnings in some pockets of market, like financial services, might take longer to recover, given potential elevated credit costs in 2022, if bad loans spike significantly next year.

Volatility and investor flows

Equities recovered somewhat in March and again in late April despite muted investor flows into the asset class, both from Indian and non-Indian institutional investors. However, we see risks that valuations reflect an overly optimistic view on prospects and may be particularly susceptible to disappointments in this low visibility environment.

Volatility, measured by the “fear index” known as the VIX, which had shot up to especially elevated levels in March, cooled off last month but remains high by historical standards. It may take some time before volatility stabilises at more typical levels.

Attractive valuations

Valuations look relatively attractive on an historical basis. Furthermore, the premium that Indian stocks enjoyed over emerging market peers earlier in the year has largely evaporated in the last month. However, the unprecedented nature of the pandemic and the supply and demand shocks created, makes calculating valuation metrics far more difficult, if not impossible.

Valuations for cement producers, as a domestic cyclical play, seem attractive after recent sharp correction in stock prices. Discretionary consumption, such as auto, will take more time to recover as consumers delay their discretionary spend amid uncertainties related to job security or income growth and lenders reduce unsecured consumer lending as credit cost rises.

Focus on quality

We believe investors should remain focused on “quality” names. We define quality as large-caps and largish mid-caps companies with stable earnings growth visibility, ability to efficiently deploy capital, relatively low financial leverage and dynamic and transparent management credentials.

As the economy reopens, these businesses should continue to gain market share and improve operating margins, pricing power and lower their cost of capital. And with lower corporate tax rates, quality businesses should be able to demonstrate resilience in dealing with a changing economic landscape.

Indian debt

The Reserve Bank of India (RBI) continues to take measures to support the economy and financial system. This includes liquidity measures and rate cuts as well as unconventional tools such as Targeted Long-Term Repo Operations (TLTRO) – especially targeted at vulnerable sectors of the economy. The central bank is providing much additional finance to banks and some public financial institutions to support them in lending to small and medium-scale industries with high levels of employment.

The RBI continues to relax regulations regarding asset recognition for banks and non-banking financial companies. This includes asking banks to increase provisioning by 10% of assets that are under a repayment stands still and disallowing some banks from paying dividends in order to conserve capital.

We expect the RBI monetary policy committee to cut repo rates by another 80-90 basis points to bring the rate to around 3.50%. Further measures from the central bank may include special open market operations, TLTROs and other non-conventional steps designed to support the economy and growth. We feel that the measures may particularly benefit gilts and high-quality corporate bonds and the yields on these issuers may compress.

Whatever it takes

In light of a greater probability of higher fiscal slippages, debt up to five years’ maturity is likely to attract more interest from participants than the longer end of the curve. Some relief on the supply of debt, by the government directly placing issuances with the RBI, cannot be ruled out considering the central bank’s desire to do “whatever it takes”.

Credit risk

The biggest risk in debt markets continues to be of worsening credit contagion leading to rising solvency risks, rating downgrades, credit spreads widening and/or liquidity drying up.  We have not lost sight of the credit stress in the system even before the current crisis, since the Infrastructure Leasing & Financial Services default in late 2018. Once this period of elevated debt forbearances, moratoriums, bridge financing and court orders restricting rating downgrades is over, the market will be staring at these “cans that have been kicked down the road”.

While credit costs for lower-rated entities may reduce with the RBI’s latest moves, we may see banks remaining generally averse to increasing exposure to lower credits in these uncertain times.

The government may also step in to either provide credit support to banks or provide capital to form a special purpose vehicle that may take leverage to lend to the lower-rated issuers, especially in the vulnerable segment. However, with the latest rout across debt mutual funds, especially funds carrying lower-rated papers, the demand gap is significant to bridge.

Hence, we continue to find “safe and quality” names in debt issuers attractive, a segment of the market that should continue to enjoy increased supply (liquidity) and a lower cost of capital.

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