We look at returns of various asset classes such as equity, debt, gold, crude oil and the Indian rupee in our latest monthly market summary.
We use data for these charts from Investing.com
Most major equity markets globally faced a steep correction in the month of October. While the S&P500 and the Sensex outperformed their developed and emerging market peers, they still recorded a correction of 5-7 per cent in the month.
Indian bond yields spiked sharply in early October to roughly 8.20 but then fell over the course of the month to 7.82. The concerns over defaults on the systemically important IL&FS initially created an overhang on the market. This was amplified by concerns over oil prices spiking, the FED raising interest rates and the currency depreciating sharply. Post the MPC meet and post the government taking steps to change the board of IL&FS, there seems to be some calming of sentiment in the market.
Gold moved up in the month and closed above the 1200 dollars per ounce. If the commodity moves strongly away from the 1200-1400 range, it would give a better indication of the long term trend.
Oil corrected sharply in October. From a value of 86, it fell to to just over 74 dollars per barrel at the end of the month. Because of our large dependance on oil imports, it is important to keep an eye on this figure as it can have a destabilising effect on our macros.
The Rupee seemed to stabilise against most major currencies in October.
Interesting commentary from across the web in the last few weeks:
MIB: Howard Marks, Oaktree Capital – The Big Picture
Confessions of an equity analyst – Value Research
The impact of NBFCs on fund flow to the economy? – Bloomberg Quint
The $80 Trillion world economy in one chart – Visual Capitalist
The next recession – The Economist
The future of healthcare – The Economist
Beware of market timing rules of thumb – Insecurity Analysis
The land challenge underlying India’s farm crisis – Livemint
Amazon’s private label business – CNN
The NBFC scare isn’t over yet – Bloomberg Quint
Warnings mount for leveraged-loan market – FT Alphaville
Decoding the NBFC bailout – Capitalmind
23 charts and maps that show the world is getting much, much better – Vox
A lost decade of dollar cost averaging – A Wealth of Common Sense
Oil’s rally isn’t over yet – Bloomberg Quint
Moral investments aren’t outperforming – FT Alphaville
Slowing US momentum- The Reformed Broker
What happens when interest rates rise? – Morgan Housel
Haste Makes Waste – Morgan Housel
The electric future will start on two wheels – Bloomberg
Credit Risk Funds pose a problem – INR Bonds
Investing is Hard – YouTube
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2018 has seen tightening in financial markets across the globe. This is having divergent effects on growth for different economies. This trend is in sharp contrast to to the synchronised recovery and easy liquidity conditions we were seeing in 2016 and 2017.
The US economy continues to have strong momentum. The FED has gradually removed accommodation and has raised rates every year since 2015. As a result, the term spread has started to narrow and yield curve has started to flatten. The BIS has captured this in its latest quarterly review in the following chart:
The “flight to safety” effect has kept long term yields low in the US. It has also probably contributed, along with escalating trade tensions, to the rally of the US dollar. This has put further pressure on emerging market economies. India is not alone in that a number of such economies have been experiencing portfolio outflows with policy or political uncertainty compounding market stress and currency depreciation.
From the BIS:
The long and unprecedented run of 16 consecutive months of net inflows to EME investment funds was cut short in May (Graph 4, centre panel). The slowdown had actually started in February for hard currency bond funds, and then extended to equity and local currency bonds as the US dollar appreciation accelerated in late April. This in turn reduced the returns on those assets for dollar-based investors. Unusually large EME carry trade returns fell precipitously as from April, dropping in August below the low levels of November 2016 (Graph 4, centre panel).
A number of these emerging economies benefitted from loose monetary policy of the developed economies over the last decade. Now that the liquidity is being withdrawn, the economies that have not addressed structural issues are feeling the most pain.
Even in more developed European economies, corporates started to see higher borrowing rates because of euro area sovereign financial stresses resurfacing.
The expectation is that global liquidity and credit conditions will continue to tighten, especially in the USA. A flat yield curve generally portends a recession. With other markets already showing signs of losing momentum, what does it mean if even US growth starts cooling off?
How does a balance of payment problem affect demand in the economy? Neelkanth Mishra of Credit Suisse puts it in an elegant way in an interview with Ira Dugal.
To paraphrase, if you think of it like a household budget: suppose a family has a consumption expenditure of Rs. 120 and an income of Rs. 100. The difference of Rs. 20, which would need to be borrowed from someone, would be the equivalent of the current account deficit. If, say oil prices go up, the consumption basket then becomes Rs. 140 and you would have to borrow more. Quite often it is the case that no one will be willing to lend the family more and therefore their consumption has to be brought back down to Rs. 120. This is the demand adjustment that the economy will have to face.
Neelkanth commented that the demand adjustment may be nearly 2 per cent of GDP and this could be the reason for the current panic in the currency. The balance of payments adjustment also puts a question mark on medium term growth rates. He estimated that even seven per cent growth rate is not sustainable. This is because our energy import bill is at an all-time high even though oil prices are at half the levels seen in the prior peak.
The entire interview is worth a watch:
Other discussion points from the conversation:
The RBI Annual Report generally has a lot of interesting charts and data that give good insights into the state of the economy. In this second post, we cover five charts that we found quite informative from the latest report.
A measure of a country’s export performance is to track its share of world sports over time. According to the RBI report, India’s share of world exports have grown by about 2.5 times between the year 2000 and 2017. When we look at relative increases in particular goods, we see that India’s relative comparative advantage (RCA) “eroded considerably” in the pearls and precious stones segment but has seen some improvement in textiles. The chart above shows the RCA for the top 5 exports from India and an RCA value greater than 1 indicates a comparative advantage.
We can see from the chart above that we have a large and growing trade deficit with China. Possibly a large contributing factor is the import of smartphone and other electronic goods. On the other hand we have a trade surplus with the US and this is probably why we hear rhetoric from Donald Trump about India having unfair terms of trade with America.
From the report:
Non-oil non-gold imports accounted for 65.1 per cent of total import growth on a weighted contribution basis as a part of domestic demand spilled into imports (Box II.6.3). Electronic goods, pearls and precious stones, coal, chemicals, machinery and iron and steel together contributed more than half of the growth in this segment (Chart II.6.4)
With import growth largely outpacing that of exports throughout the year, the merchandise trade deficit expanded to a five-year high. Since 2011- 12, the trade deficit has averaged 7.3 per cent of GDP, making it pivotal in the overall balance of payments.
From the report:
The number of cases on frauds reported by banks were generally hovering at around 4500 in the last 10 years before their increase to 5835 in 2017-18 (Chart VI.1a). Similarly, the amount involved in frauds was increasing gradually, followed by a significant increase in 2017-18 to Rs. 410 billion (Chart VI.1b). The quantum jump in the amount involved in frauds during 2017-18 was on account of a large value fraud committed in gems and jewellery sector, mainly affecting one public sector bank (PSB).
From the report:
During 2017-18, PSBs accounted for 92.9 per cent of the amount involved in frauds of more than Rs. 0.1 million, as reported to the Reserve Bank while the private sector banks accounted for 6 per cent. As regards cumulative amount involved in frauds till March 31, 2018, PSBs accounted for around 85 per cent, while the private sector banks accounted for a little over 10 per cent. At the system level, frauds in loans, by amount, accounted for more than 75 per cent of frauds involving amounts of Rs. 0.1 million and above while frauds in deposit accounts were at just over 3 per cent (Chart VI.2). Within the loan category of frauds, PSBs accounted for a major share (87 per cent) followed by the private sector banks (11 per cent). The share of PSBs in frauds relating to ‘off-balance sheet items’ such as Letter of Credit (LCs), LoU, and Letter of Acceptance was even higher at 96 per cent. New private sector banks accounted for more than 20 per cent of the frauds related to ‘cash/cheques/clearing’ and ‘foreign exchange transactions’. New private sector and foreign banks accounted for 36 per cent each of all cyber frauds reported in debit, credit and ATM cards, among others. Out of the seven classifications of frauds in alignment with the Indian Penal Code, ‘cheating and forgery’ was the major component followed by ‘misappropriation and criminal breach of trust’. In ‘cheating and forgery’ cases, the most common modus operandi was multiple mortgage and forged documents. Mumbai (Greater Mumbai), Kolkata and Delhi were the top three cities in reporting of bank frauds through ‘cheating and forgery’. In respect of staff involvement in frauds, banks reported that it was prominent in the categories ‘cash’ and ‘deposits’, which had a much smaller share in the overall number of fraud incidents and the amount involved.
We take a look at equity valuations and find that they have moved into even more expensive territory.
We use data from the NSE website starting from when it is available in January 1999 to look at the P/E Ratio, P/B ratio and the dividend yield of the index and compare it to past history.
In the chart above, the red areas highlight when the PE ratio is significantly higher than normal implying that markets are expensive and future returns are likely to be lower than in the past. On the other hand, green areas show when the PE ratio is significantly lower than normal implying that markets are cheap and returns from equities should be higher than average.
On 9th October 2018, the Nifty PE Ratio was at 24.9 which is more than one standard deviation from the historical average of approximately 19. Market valuations have corrected from the value of 28.1 seen in August, but continue to remain expensive territory from an earnings point of view.
Similar to the PE chart above, red areas in the PB chart denote times when markets are expensive whereas green areas show when markets are cheap relative to history.
The price to book ratio of the Nifty has moved down to 3.3 and is just below the long term average of 3.5. On the basis of book value, markets are trading in the normal range. The difference between valuation indicators in the PE and PB could be due to cyclically suppressed earnings. Part of this could be due to low capacity utilisation and part of this could be attributed to structural NPA issues with public sector banks that are depressing earnings. Therefore, even though the price is expensive on the basis of current earnings, it could be that an increase in utilisation levels or a normalisation of the NPA situation could give a bump to earnings in the future and normalise the PE.
The dividend yield chart denotes value in a manner that is opposite to the PE and PB charts above. When the dividend yield is higher than normal, it means that markets are cheap. Similarly when the dividend yield is lower than normal, it is a sign that markets are expensive. The dividend yield is around the same levels in the last quarter, at 1.3 per cent. This is still close to the long term average of 1.5 per cent.
Interesting commentary from across the web in the last few weeks:
How high is EM corporate debt? – Advisor Perspectives
Global cost of housing – Bloomberg Quint
The framework of the MPC – Bloomberg Quint
The bond market in a rising rate scenario – A Wealth of Common Sense
The performance of PMS in this market – Bloomberg Quint
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Over the last few quarters, growth in the Indian economy has been quite robust. The MPC, in its latest policy statement, talked about how growth “surged to a nine-quarter high of 8.2 per cent in Q1:2018-19, extending the sequential acceleration to four successive quarters”. But the macro environment has now changed substantially, throwing a cloud over the outlook going forward.
First, export growth may not be as supportive as people expect. The world experienced a phase of synchronised recovery between 2016 and 2017. Unfortunately India did not fully participate in this growth story due to domestic policy changes including the GST and demonetisation. The issues related to those events are behind us. But now, there is significant divergence now in the growth of major economies. The EU and Japan have started to slow in 2018 whilst the US continues its momentum. Incremental data also points to a slowdown in China which could have a knock on effect on other ASEAN countries. The global rhetoric on tariffs and trade wars are unlikely to help either. Even though the recent fall in currency should give a boost to exports, we do not have a conducive global environment to take the most advantage of it.
Second, on the domestic front, rising oil prices and the depreciation of the currency are likely to have an effect on growth and inflation. The monetary policy report has some guidance in this matter. According to Manas Chakravarty in the Mint:
The MPR also provides some clues and numbers about how underlying factors affect inflation and growth. For instance, it says that a 10% increase in the international price of a barrel of oil for the Indian crude basket is expected to reduce growth by 15 basis points (bps) and push up headline inflation by 20 bps. The price level also matters—the same percentage increase at a higher price point increases the impact on inflation. For example, an increase from $100 a barrel to $110 a barrel could pull up inflation by around 22 bps. Perhaps more importantly in these times, RBI estimates that for every $1 increase in the price of a barrel of crude, India’s current account deficit could widen by $0.8 billion.
How will changes in the exchange rate affect inflation? Says the MPR: “Assuming a depreciation of the Indian rupee by around 5% relative to the baseline, inflation could increase by around 20 bps, while the likely boost to net exports could push up growth by around 15 bps.” On the other hand, an appreciation of the INR by 5% could soften growth by 15 bps in FY19 and lower inflation by 20 bps
The monetary policy statement had taken average price of the crude oil basket to be $80 and a dollar rate of 72.50, both levels which have already been taken out.
Third, the tight liquidity and credit scenario will also mean NBFCs will be unable to lend very aggressively. The public sector banks are awash with the NPA mess and would be unwilling to lend more and therefore the growth in credit would largely fall to private sector banks. Unfortunately, while these banks would pick up some of the slack, they would not be able to offer the same products and terms as the more aggressive NBFCs. Hence credit growth and therefore demand will likely moderate.
Finally, capital flows have been drying up, with net FPI turning negative both in the equity and debt segment. Additionally, GST revenues have been lower than projected and the government is struggling to meet its fiscal deficit targets. This means that we are staring at a balance of payments problem which would prove to be a dampener on aggregate demand and hence growth.
All in all, this points to an environment which is not conductive to growth going forward.
A few notes from the MPC statement and press conference today.
But first, a quick recap of the previous August policy and guidance:
In the August meeting, the MPC was of the view that domestic growth momentum was strong and that the output gap was closing. However rising trade protectionism, geo-political tensions and elevated oil prices posed risks to near term and long-term global growth prospects. Additionally, the MPC was of the view that uncertainty around inflation needed to be monitored even after accounting for MSP hikes and elevated crude prices. Keeping these factors in mind, the MPC increased the repo rate by 25 basis points to 6.5 per cent and kept their stance as neutral.
What has happened since the last policy decision:
The last inflation print came in at 3.69 per cent which is below the target inflation of 4 per cent and lower than the MPC’s own target of 4.8 per cent. However between the policies, oil has moved from roughly 70 dollars per barrel to over 85 dollars a barrel. The rupee has also depreciated substantially to over 73 rupees to the dollar. both of these factors could create substantial upside risks to the inflation outlook going forward. In addition, bond yields have moved up sharply and liquidity in the credit markets have tightened with issuances drying up.
Notes from the latest policy statement and press conference:
The policy statement kept the repo rate unchanged but changed its stance to one of calibrated tightening. The RBI governor mentioned that the outlook was overcast with downside risks to global growth and trade. This is due to various factors including country specific emerging market events that have a spill over effect on portfolio flows, global tapering of quantitative easing as well as a normalisation of the monetary policy stance and continuing tariff wars affecting global trade.
Domestically, there is a sequential acceleration of GDP growth, with manufacturing and agriculture in particular doing well. However, the services sector performance has been mixed. Consequently, the GDP print of Q1:2018-19 was significantly higher than that projected in the August resolution.
Inflation outcomes were actually below projections. This was driven by expectations that food inflation would to remain benign. The crude oil rally however would pose upside risks.
In terms of fund flows, FPIs have been net sellers in both equity and debt, whilst net FDI has been positive. Additionally, Rupee depreciation has been moderate compared to its emerging market peers. The RBI governor mentioned that real effective returns on currency has been about 5 per cent.
The MPC noted that global headwinds in the form of escalating trade tensions, volatile and rising oil prices, and tightening of global financial conditions posed substantial risks to the growth and inflation outlook. It is therefore imperative to further strengthen domestic macroeconomic fundamentals.
Urjit Patel mentioned that this could be done in the following way:
The RBI also had a short note on the current crisis in NBFCs. They mentioned that the RBI, SEBI and the government were monitoring the situation closely. They mentioned that the Asset liability mismatch from NBFC’s due to over-reliance on CP for lower marginal cost of funds. And that a better model would be to rely on equity funding to better match liabilities.
Finally, Urjit Patel mentioned that assumptions on exchange rate and slippage in fiscal deficit were already baked into inflation projections. The MPC has already raised rates twice this year and a change in stance means that rate cut is off the table. Now the two options would be either rate hike or neutral.
Interview of Jeff Bezos at the Economic Club of Washington
Some of my key takeaways: