A Primer To Navigating Global Economic Crosswinds in the Year Ahead
The Federal Reserve kept the target range for the federal funds rate at its 22-year high of 5.25%-5.5% for a third consecutive time in December and indicated 75 basis points cuts in 2024. Their stance reflects policymakers' dual focus on returning inflation to the 2% target while avoiding excessive monetary tightening. Policymakers emphasized that the extent of any additional policy tightening would consider the cumulative impact of previous interest rate hikes, the time lags associated with how monetary policy influences economic activity and inflation, and developments in both the economy and financial markets.
Market Dynamics and Interest Rates
The above sums up the state of mind of global central bankers, and markets have started pricing in no hikes going forward in the US at least. Economic data also strikes the same semblance with inflation falling across the board for all major economies. In the US, the CPI has fallen from a high of close to 9% to 3.10% in the Nov 23 reading, while for the Eurozone, it has fallen from a high of 10.50% to 2.40%. Other economic data, including Non-farm Payrolls, ISM manufacturing, has been at best mixed. Hence, the above points out stable growth numbers to falling inflation. However, Debt/GDP numbers for major economies hover around the highs like for the US; it's around 129%, Japan 263%, France 112%, UK 97%. Even central bank balance sheets continue to remain high, though some decline is being seen as they shrink their balance sheets, which has grown steeply during the pandemic.
Sense which can be made out of the above moving parts is that as rates adjust to new hope of no further rate hikes, UST is already down to 4.20% from a high of 5.01% seen in Oct 2023; the market can go into a range-bound volatile zone for the next few months as key economic data will determine the strength of momentum in inflation and growth numbers. The best estimate can be that only in the second half of FY 25, one should expect some rate cuts as central banks would want to be sure of their past actions leading to a degree of confidence that they have inflation under control, as Brent and Food price always remain in a different trajectory, defying economic numbers, while uncertain geopolitical environment now is the new normal.
India's Economic Landscape
Back home, India's GDP for the second quarter expanded by 7.60% after reporting expansion of 7.80% in the first quarter of FY 24. RBI, in its latest monetary policy statement, increased its FY 24 GDP projection to 7% from 6.50% earlier. Even if we grow at this rate on a sustained basis, we will become the third-largest economy soon, but to grow beyond 6.50%, we would require higher exports and investment growth, but this has to be in the background of slowing global trade and tensed geopolitical environment.
Equity Markets and Investment Strategies
Markets have been buoyant with Nifty again making a new high and crossed the 21000 marks. The way new demat accounts are being opened seems to suggest there's a fear of losing out amongst investors, and everyone wants to jump on the bandwagon regardless of valuations. Almost all bigger institutions have been raising India's growth forecasts recently, along with recommending an increase in India's weightage in global allocations. Recent state election results further cheered the markets as it reinforces the expectation of continuation of central leadership and thus economic policies. However, long domestic equity has become a crowded trade; hence, would be careful to mindlessly go long on equities at this juncture. Against Nifty return of 15-17% in the last one year, one's stock portfolio, if tilted towards mid-caps, can easily be touching 35-40% returns, but kya karein dill mange more. You name the sector - 40-60% return is normal, whether Cement, Engineering /Capital Goods, Auto /Auto Ancillary, Metals and Minerals, or Hospitality, but still the domestic and external flows keep on chasing the market; of course, some sectors underperformed like Retail, Pharma and healthcare, Information technology, consumer durables, FMCG, Chemicals, and fertilizers. One has got to choose his strategy going forward, whether be a growth investor or a value investor; my sense is that if you are a patient investor, you will get growth stocks cheap in a downturn and value stocks still cheap in a bull run, with their dividends providing a cushion when the market falls.
Derivative Trading Trends
Interestingly, recent reports suggest trading in futures and options is 400 times bigger than the underlying cash market turnover, and there is a 500% jump since 2019 in the number of options and future traders. Could be due to the attraction of quick money, but what I understand is that most traders use this as speculation and based on their assumptions of the market - sell near-term strikes where the uncertainty premium is slightly higher and hope the market doesn't move, and they pocket the premium till the next expiry begins. No wonder SEBI study says that 90% of F&O traders are losing money. Do keep in mind this activity requires a large number of margins to earn absolute money, assuming one has agility to dodge the market movement and has the ability to run based on margin strength. Nothing wrong with the above, but what if the market moves 6-7% as a gap up or gap down?
Government Bond Market and RBI Policies
The government bond market remains range-bound in the 7.20-7.40 range on the 10-year in spite of a large fall in UST. The market, however, remains positioned on expectations of large inflows due to index inclusion in the next calendar year. With oil also cooling off, there's no trigger for the market to build any pessimistic scenario though the base effect and recent rise in vegetable prices will make next couple of CPI prints higher. So, all in all, seems a longer status quo from RBI and range-bound Bond market which will wait for a news or data flow to breach the 7.20% barrier to reach 7.10% on 10-year yield. Only risk stems from the government announcing many freebies recently which will put pressure on govt finances and delay the fall in Fiscal deficit as projected.
Currency and External Factors
The surprise factor has been INR, which has remained stable to weak in spite of the fall in Dollar Index but could be attributed to year-end USD outflows and oil import demand. Do not see reading much into INR's behavior and remains a short Dollar trade in case it is around 83.50 levels unless driven by some fundamental change. We are also very comfortable from a current account perspective given the strength in services and transfers flows which will keep BOP relatively calm. However, traders should not get misled by low vols on INR as it seems RBI is holding it in a narrow range, and thus trade short straddle and strangle with a stop loss as vols are very low.
Regulatory Changes and Banking Sector
RBI recently increased risk weightages for Banks and NBFC's exposure to unsecured personal loans and credit cards. As per S&P, these measures will impact tier 1 capital of banks by 60 bps. Borrowing costs for lower-rated NBFC's will surely go up by 25-50 bps depending on the credit profile. This loan category has been growing by 26% approx. over the past one year. These loans along with consumer durables represent 9.80% of the total loans in the banking system as of Sept 22, 2023. NBC's credit, on the other hand, has increased from 8.60% of GDP in 2013 to 12.30% in 2022 while over 40% of their funding was through bank borrowing.
Investment Opportunities in Fixed Income
NBFC's have been also funding their balance sheets through Securitization Direct Assignments and Co-lending so it's been a win-win for both NBFC's and Banks. The new accounting norms, however, don't allow NBC's to completely de-recognize the asset; however, the overall gearing number is what investors should look at as long as liability mix is diversified. Credit Research has become complicated for these companies with new nomenclature like Managed Assets, Adjusted gearing, etc. The gearing numbers need to reflect the adjustment to net worth with regards to net stage 3 numbers along with net SR's, restructured book, and non-performing investments to assess the overall risk on the balance sheet and the potential leverage.
However, we are at the cusp of a revolution in financial inclusion as reflected by an increase in the gross loan portfolio of MFI's by 24.30% YoY to 3.60 Lakh crores as of Jun 30, 23, due to strong demand in rural markets as per CRIF High Mark. Care ratings expect the gross NPA ratio of microfinance cos to fall to 2% by Mar 2024 due to higher collection efficiency. MFI industry is currently dominated by non-bank lenders with a market share of 40.40%, followed by banks at 32.50%, and small finance banks at 17.20.
Conclusion: Navigating Uncertainties
With Equity markets and Gold remaining an evergreen Asset class, Gsec could emerge as an attractive asset class given the expectation of a fall in interest rates but 3–5 year Corporate Bonds in AA to A- category also look very attractive given the credit strength of NBFC's in MFI, Gold Loans, Vehicle Financing, MSME credit, etc., including Small Finance Banks. However, the entire thesis is known and expected and hence a crowded trade across the asset classes; hence, investors need to be cautious on the unknowns and tread the market carefully with a lot of research and patience.
(This article first appeared in Livemint.)
