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Deepak's Memos

Wealth Letter March 2021: The Month of Crazy

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[Edited excerpt from Deepak’s March memo to Capitalmind PMS clients]

The Indian budget revealed one big thing: the government is going to borrow a lot more money. From a 7 lakh crore of planned borrowing last year, we’ll see over 12 lakh crores borrowed in the coming year. Add to that the woe of inflation, and interest rates in the bond market – better known as “yields” – have risen sharply. The government used to borrow at 5.8% and now it’s borrowing at 6.2% or more.

This has also seen echoes elsewhere in the world. When Joe Biden was sworn in, in January, yields in the US were less than 1%. Now they have moved to 1.5%. Everywhere, people are paying a little more to borrow.

How does this impact stocks? In the beginning, it didn’t seem to. After all, what’s a little rise, you might think. 1.5% is what it was before Corona in the US. Even in India, the yields are just about where they were before the RBI cut rates. 

Note: RBI cutting rates doesn’t necessarily mean the market will demand lower rates. The market – with the pricing in the 10-year bonds – thinks about how the RBI is likely to react going forward. That’s why right now the system sees short-term borrowing (less than 90 days) at about 3.3% while longer-term borrowing has gone to 6%+. For corporates, rates are even higher. 

Stocks eventually will be impacted. They did see a bit of a fall, with the Nifty falling about 6%, and the US Nasdaq falling about 11%. This is the fear that rates will go up and that liquidity will be reduced by the central banks. 

Why? Because if people see inflation as a problem, or government borrowing going too high, there will be a point at which interest rates will have to rise. But inflation is not because of money printing – that’s been happening for ages. Inflation’s because investors think that people will actually get to spend that money, demand will go up and prices will go up. This is visible in prices of other “things” – like crude oil prices, copper prices and so on. 

In effect, the market is spooked that there is going to be an actual recovery and that the price of everything will go up. This could well be true, of course. Prices can rise sharply. Interest rates can continue to go up. So much that not just the Indian government but also that of the US, Japan and Europe pay higher interest rates on their debt. This would render everyone bankrupt almost instantly because they can’t afford to pay – they’re far more leveraged than India is. The entire world collapsing in a heap is not useful as a bet, though prediction of doomsday is the third oldest profession in the world. It doesn’t happen, but not for the lack of trying. 

Putting doomsday predictions aside, what else is likely?  Copper and Crude which are up a lot, are traded assets, and prices can easily go up for speculation as much as for real demand. In crude, you have an unnaturally cold situation in Texas, and US oil production has fallen 40% as wells has to be shut for lack of power (the irony!) and for the freezing weather. Finally, crude oil wells seem to start strangely fast when prices cross the $65 barrier – and indeed, crude prices were at $80+ three years ago, when new supply came in so strong that oil crashed to the 40s – a year before Corona hit us. 

(For India the problem is that our government raised fuel taxes so much that we feel the pinch largely due to the increased tax. But again, they’re not blind to it, so there are some expectations of a cut in prices soon)

Copper prices are usually a harbinger of inflationary expectations, and while prices are high, they’ve been higher over a decade ago. A decade of money printing hasn’t hit the most useful industrial commodity, until now – will it sustain? We’ll have to wait and see.

For India, the clear problem remains in fuel prices, not in much else. 

We expect the following things to happen:

  • Crude prices are likely to cool down post-April, barring any wars or natural disasters. 
  • If in the interim, interest rates (market yields) rise too fast, we expect central bankers to act yet again. This may happen only if the market crashes hard because now, stock prices falling is a political problem more than an economic one.
  • Stock markets will see much higher volatility simply because of the uncertainty. More so in India where the central bank isn’t as communicative as in the west.

In simple English: By the end of 2021, bond yields in India and abroad are likely to be lower than today. So we keep our government securities positions as they are, for now. Adverse news will mean we will take action, of course. 

Looking at the listed non-financial data in the country, it appears that:

  • Revenues for December 2020 quarter are flat, year on year
  • But profits are up more than 30% on aggregate. This is quite big.
  • We believe this might have a temporary element of lower travel and marketing expenses due to the lockdowns. 
  • Industrial credit has been flat for nearly 6 years now – and even retail credit exposure to housing and credit cards is flattening out. Overall credit growth remains at 6% and hasn’t seen a bump up.

The point: This is not a very enthusiastic recovery from an economic standpoint. It’s like saying if you only eat twice a week, you’re going to have more money saved. Sure, cutting down on eating makes you healthier when you’re fat. But at some point, you might be cutting out on the nutrition required to keep the engine going – and the economy, we fear, is seeing some of that. In the form of increased profits, but no credit growth or industrial capex. 

Having said that, the total profit pool for all listed corporates in India is about Rs. 500,000 cr. added up. This is half of what Apple holds in cash, worldwide. The next 10 years should see this profit pool grow substantially from here, just as India gains relative size compared to the west. 

A quick note about some of the portfolio action we’ve seen:

  • We’ve added a stock exchange to our multicap portfolio, which is slowly shaping to be oriented towards disruption, innovation and digital. Exchanges are where the future of most financial assets will be, and the number of accounts crossing 5 cr. means that more volumes will flow on them. With recent issues in the NSE causing an alarming shutdown, we expect SEBI to require more volumes to flow to the BSE just to balance it out. And of course, as debt markets move toward exchange trading, the BSE’s larger market share in debt will help.
  • On the index portfolio we’ve added some midcap exposure, but we’ll probably stop at 10%. Index positions remain at about 67% India, 33% US. 
  • Momentum has been doing well in the last few months, even as the broader market goes flat, and is recovering its mojo after a relatively tough few months.

How can we not say something about Bitcoin

The big mover so far has been Bitcoin and we expect some action on that by the government in this month. There might not be an outright ban, but it’s quite likely there will be restrictions on trading or owning the cryptocurrency. It’s a strange beast, that. Because it is unlikely to ever succeed as a currency by itself – it can only be an asset, measured (to great happiness) in another, more accepted currency. Put another way, if you measured your income in bitcoin, you have had the biggest loss in income ever. And you won’t like that, so you’ll measure it in rupees/dollars instead. If most of the things you paid for were listed in bitcoin, they’d have to be marked lower and lower in price every month, otherwise, they become unaffordable. Asset, not currency, will be the way to go. Maybe they’ll change the name to crypto-assets instead.

Sadly, we can’t invest in it (SEBI Rules) so our interest, however regretful, will be as a spectator. 

The rest of the year will have to be spent looking for data points where either central bank policy will reverse or governments will find better ways to finance themselves. Regardless, the next ten years should continue to see a large benefit of financialization and of greater productivity. We just have to ride the volatility over.

Cheerfully,

Deepak


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