It’s lot to do with low cost abundant liquidity and improved macroeconomic sentiment – benefits to few top line companies while most stocks lag behind….
The recovery momentum in developed & emerging markets indices since post-Covid March 2020 lows is amazing and most didn’t expect upside break of pre-Covid all-time high of February 2020. What’s most surprising is the retention of upside bullish momentum despite being in untrodden territory, holding on to “buy on dips” appetite by pushing the base higher in “2 steps up & 1 step down” mode, establishing sustainable uptrend journey. It’s for sure that fears of the past is put behind to keep the present in optimism from the confidence on the future. Companies that are comfortable in capital & cash with absorbing capacity and those in health care, pharmaceuticals & essential services sector got benefited, while most others got badly hit. What could be the triggers to set up the trend for the future on those that gained the most and those that lost significant value?
Is the worst behind on output contraction and unemployment? How far could Central Banks stay on expansion of monetary stimulus? Is it easy to stay on course of extended fiscal stimulus? How to expand investment-consumption dynamics for recovery of lost economic value between start of 2020 to end of 2021? Need to find answers to these questions.
It’s mixed expectations on GDP growth for Q4/2020 and H2/2020. There’s comfort that contraction of Q2-Q3/2020 is behind and into expansion mode from Q4. But, this is high dependent on revert to “business as usual” economic activities, pushing impact of Covid & lockdown behind and brining the vaccine into reality. At this stage, there exists conflict in preference between life & livelihood with most suffering from lockdown impact, pushing Governments into dilemma of choosing between the two. It’s worse on Emerging & developing economies where the fiscal bandwidth gets squeezed beyond tolerance. All combined, while there’s better comfort on worst of 2020 is behind, there emerges risk of uncertainty on achieving top-line capacity of end 2019 by end 2021.
Most Central Banks in their pursuit to support growth and to arrest deceleration in output expansion took extraordinary monetary measures pushing policy rates to as low as it could, lead by G7 Central Banks keeping short term borrowing rates around zero to negative. This was followed by balance sheet expansion through asset purchases and infusion of liquidity into system. The combination of abundant liquidity at low interest rates provided the relief for significant upside to financial markets and establishing turnaround on capacity & employment. It turned good for Emerging markets supported by higher inflows from (fair-weather) Foreign Portfolio Investments. It’s so far so good. What Next? Central Banks ultra-dovish monetary policy stance is understandable when risk on headline inflation is low from demand-push and supply-squeeze factors, and what if when system gets into business-as-usual consumption mode making higher demand for investments and credit? So, it’s safe to assume that the best of monetary policy stance of most Central Banks are behind with transition into pause-mode till end of 2021 with shift to balanced stance between growth-inflation in 2022 before start of tightening monetary stance, both on policy rates & liquidity in 2023. Risk to this outlook is from extended Covid impact on the global economy, pushing the need for shift of FED Fund rate from above zero interest rate phase to negative interest rate policy regime. This outcome will set up gloom & doom in 2021 diluting the low cost liquidity impact on financial markets. The Indian context is different – RBI walked the extra mile despite in headwind dynamics from elevated inflation and fiscal deficit – headline inflation above MPC tolerance zone of 2-6% and fiscal deficit above FRBM tolerance range of 2-3.5%. So, the above-said risk factor will have the worst impact on the Indian economy & financial markets if the turnaround gets delayed, notwithstanding the hope from “make for India” (less dependent on imports) and “make in India” (for higher exports) themes.
The extraordinary fiscal stimulus support from the Government of developed economies did emerge to limit damage on the global economy and livelihood through balance sheet expansion of Central Banks from asset purchases & currency printing, thus expanding M3 money supply to arrest deceleration in consumption at the expense of compromise in fiscal prudence. What if Covid-impact turn from bad to worse beyond 2020 through 2021? Can Governments of developed & emerging economies turn loose on fiscal position against lower base of GDP? This risk factor can’t be ignored at this stage, hence good to be cautious when in hope of growth expansion for full recovery of 2020 contraction.
Given the limited bandwidth of Treasuries and Central Banks, what would support to achieve optimum capacity utilisation from higher consumption and what could lead to accelerated spending? The initial push need to be obviously from public sector push on investments & consumption. Governments need to invest and spend more on economic & social infrastructure, revive real estate sector and put monies in the hands of have-not’s who are either un or under employed with struggle to make both ends meet. It’s tough task for Governments to achieve this outside fiscal deficit, and need innovative & out of the box solutions to make it work. There’s absolutely lack of clarity on how it will be achieved.
Indian context is high dependent on Banking sector stability and appetite for credit risk
Banking sector reforms are under way – consolidation from M&A transactions, higher promoter holding for private banks at 26-40% and allowing large & well-run NBFCs with clean compliance & governance track record for conversion as a Universal Bank. It’s good that RBI has addressed the (post-Covid) issue of capitalisation of private banks when valuation of most banks crashed below 50% of all-time high. It’s prudent to provide the first option to promoters rather than going elsewhere when risk capital is scarce. So, increase of 15% cap to 26% is in order and more to regulated & well diversified entities upto 40%. This expectation was covered in 12th September banking sector report as trigger for value re-rating of (second-line) private sector banks outside of Big4 (HDFC/ICICI/Axis/KMB) and have seen 60-75% rally since then. The resolution around old generation private banks has begun with DBS-LVB reconstruction (writing off Tier 1 & 2 liabilities) and it’s possible that NBFCs aspiring for Universal Banking license will be pushed to achieve consolidation and to bring old generation private banks into mainstream that are now small with regional focus. While consolidation among old & new generation private banks will go smooth, it’s important to infuse life into public sector banks, that are already down at 12. Lots have been said about recapitalisation of public sector banks and woes around compliance & governance and productivity & profitability. It’s job half done if early resolution is not achieved given the combined PSU banks market share of over 50%.
RBI is made to shoulder management of huge government borrowing without market disruptions and to ensure adequate flow of credit to systemic sensitive borrowers. While Government has extended credit underwriting support, RBI provides cost efficient liquidity through TLTROs. This support can’t remain for long and Banks need to perform the role of financial intermediation to the satisfaction of (borrower) stakeholders and to be catalyst for output expansion and employment generation. Having addressed the way forward from adequate capital infusion, banks should now gear up to resolve issues around productivity & profitability and compliance & governance. Given that time is of essence, need to be prepared to fund economic capacity expansion in 2021 and into FY22 & beyond.
What’s the impact on macroeconomic fundamentals and financial markets?
The top-line stocks have gained the most from fiscal & monetary support of Governments and Central Banks, while mid & small cap stocks are significantly below 52 week & all-time high. Large cap stocks have derived the benefit from liquidity for easy entry & exit. The phase since end of Q1/2020 is more of short term (liquidity driven) rather than long term buy for hold (economic value) play. It’s important to be watchful on upgrade in economic value (of stocks) and dilution of liquidity & rate advantage for medium to long term investment philosophy. At this stage, achieving stability at all-time high will be from hope of extended liquidity support through 2021 and with optimism that GDP growth of 2022 shall be established above top-line of end 2019. What about emergence of conflicts between elevated fiscal deficit and sticky elevated headline inflation? No clarity at this stage to this make or break event risk, hence leave it aside for now, marking this as big risk factor in play.
US bourses have lead from the front with all equity indices comfortably settled at all-time high preparing for great landing for 2020 despite existence of risk from Covid pandemic. India is not far behind thanks to accelerating FPI inflows – Nifty comfortably over 2019 close & pre-Covid 2020 high and Bank Nifty in catch-up mode moving towards 2019 close. What Next bias is mixed between consolidation above pre-Covid February 2020 high or extended rally in 2021 before push-back for stability above 2019 close. What’s the upside target and the reversal point? Need to mark one step at a time, watch Twitter handle for direction. For now, buy on dips is the way to go!
It’s been fantastic return for 2020 in US Treasuries and AAA/AA assets and Emerging markets & India not far behind. It’s extraordinary & one-off, hence not to expect similar kind of return in 2021 & beyond despite in extended rate-pause mode. Even a rate cut in 2021 will be seen as negative building higher credit risk, hence it’s safe to assume that best of value appreciation in debt/fixed income assets is behind, and at best could be carry-trade play in 2021 – funding long term bonds from short term borrowing, being extra cautious on mark to market NAV. This outlook would emerge as headwinds to other asset classes.
USD Index lost over 10% in 2020 from 103 to 91.50 followed by recovery failure below 95. The outlook for rest of 2020 & into 2021 is mixed between 88.50-93.50 and 90-95 with most play expected to be at 91-92.50. EUR/USD upside break at 1.1650-1.1850 building steam towards 1.20-1.2150 was the script but see no cues to set focus beyond 1.1650-1.2150. USD/JPY got pushed down from over 110 to below 103.50-105, but don’t see cues as yet for extended weakness below 100-101.50 and into sideways mode at 100/101.50-105/106.50
Despite USD weakness, soft interest rates and uncertain macroeconomic outlook, Gold failure from over $2000 into $1750-1850 and unable to retain safe-haven appetite is good for big picture comfort on financial assets, while Brent Crude recovery momentum at $35-50 is in order from shift of economic capacity from contraction to expansion. Will it lead to shift of tolerance range from $35-50 to $45-70? If yes, India need to be prepared for managing direct impact on exchange rate and indirectly on fiscal deficit and interest rate. It’s good to keep this in mind for investment decision.
Conclusion: No luxury for complacency and limited room for optimism, hence being cautious and neutral is the way to go…
Despite 2020 being an extraordinary year inflicting heavy damage on the global economy, financial markets have done well across asset classes. There’s no guarantee for repeat performance in 2021 when the economy is in crossroads. The first target for comfort is from hope of achieving end 2019 top line GDP by end of 2021, visibility of which will get clear by early 2021. Till then, financial markets will ride an extended uptrend with high probability of losing steam around end of Q1/2021 preparing for value adjustment – whether it’s up or down is the unknown devil or the joker in the pack!
Good luck for rest of 2020…
Moses Harding
