CIO SPEAK

The June’20 quarter ended up being the best for US equities in over 20 years. For India, this was the best quarter in 11 years, since June 2009. The rise has been as swift and unusual as was the crash. The Nifty has surged over 35% from March lows even as the number of Covid-19 cases in the country have jumped from 500 to over 6 lacs during the period. Valuations were near GFC (2008) troughs in late March and investor positioning was reflecting extreme pessimism. At the same time, economic data globally suggests continued pick-up from Mar-April levels. This has partly been a function of economies reopening and partly owing to the unprecedented policy support that has come through globally on both monetary and fiscal fronts. Optimism on a vaccine is high too with several competing candidates.

The unprecedented liquidity has directly helped financial markets as well. While equities have done well, safe havens such as Gold and US treasuries stay well bid too indicating the prominent role liquidity has played in lifting all boats. Within equities, the rally has been broadening with small caps participating as well. Another interesting feature of this rally has been the so called “Robinhood” effect, wherein the participation by retail investors has substantially increased through low cost online brokers. Bouts of volatility are likely as the divergence between markets fundamentals and macro fundamentals gets addressed with the latter catching up albeit much gradually. US M2 growth is already at a multi-decade high. The Fed has stayed dovish with respect to forward guidance. Expansionary fiscal policy is here to stay as we believe governments globally will resort to Keynesian economics to create low end jobs through infrastructure spending in the wake of rising inequality and social pressures.

The combination of unprecedented monetary and fiscal stimulus globally should prove reflationary on the other side of the crisis. Markets believe that the worst on the economy is behind. However, the zigzag on the health crisis will likely continue in the near term. Continued rise in number of cases in India and in other countries including the US is concerning. While this may not result in widespread lockdowns anymore, it could slow down the reopening process and delay the return to normalcy. The second order impact of delayed normalcy on creditworthiness of stressed borrowers and hence health of the financial system is a key risk. Additionally, there are long-term changes that the crisis will bring about around consumer behaviour, technology, healthcare, policy, geopolitics, supply chains, and so on. These disruptions will shape the course of the economy over the next few years.

It is becoming pretty evident that the current crisis has only accelerated the shift towards a multi-polar world, challenging the unquestioned hegemony of the West. As global powers race for dominance and new coalitions emerge, EMs like India should enjoy increased bargaining power in the new world order if we play our cards right. While we command a strategic location on the globe, India is particularly well placed to leverage its position for two more reasons: one, its 1.3 billion population makes it a large market and two, the same population also serves as a rich source for big data.

In a world where AI and related technologies disrupt traditional sources of competitive advantage and are likely to be vital in the race for global dominance, we must leverage our advantage on data to the fullest. High mobile and data penetration, NPCI and a robust payment infrastructure, widespread coverage of Aadhaar cards, initiatives such as Health Stack, etc point to India’s preparedness on the digital side even as we must aspire to execute much better. In addition, with a democratic set-up, rule of law, and IP protection, India offers trust and transparency. Building strength on technology may take time, but data surely is a strength and through right execution we can forge ahead.

The right policy mix is critical. We need to create a robust ecosystem to nurture entrepreneurs. Start-ups in India have been funded by VCs or PEs that have largely relied on foreign money, as domestic investors have stayed away. We now boast of foreign exchange reserves in excess of US $500 billion. Time may have come to think about our own sovereign fund to fund innovation and provide the much-needed risk capital. Similarly, we need to incentivize the domestic pool of savings into such ventures. We also need to create right incentives for Indian talent abroad to return and help in powering our digital transformation. Moments like these lead to extra ordinary changes. SARS proved to be an inflection in Alibaba’s journey in China. Covid-19 is a similar inflection point in our journey, and we must make the most of it.

The Covid-19 crisis is likely to accelerate deglobalization and localization in manufacturing, and at the same time lead to increased globalization on services. Both are trends that India is well placed to capitalize on. On manufacturing, we need to go with full might, through policy, capital and infrastructure support, to help industries that we want to prioritize as we make in India, and for India. We have become competitive on corporate tax rate. We have created success stories in Autos, Pharma, and Light industrials. We are now doing the same in Chemicals and Electronics. However, we still have external dependencies in both that need to be addressed and localized to the extent possible. Bringing down the cost of factors of production, a focus on innovation and a business-friendly environment are critical to realize our true potential.

In contrast to the deglobalization narrative, services could actually witness more globalization owing to the Covid disruption. The west has many Indian doctors, professors, and tech professionals. Earlier they had to physically relocate after obtaining a Visa. Today with increased virtualization, they can be more easily employed without the need of physical movement. More and more firms are adopting Work from Anywhere. What stops a teacher in India to impart education to kids in the US through a virtual classroom or a doctor to administer telemedicine to a patient anywhere. The whole offshoring theme that has helped services exports from India in sectors such as IT can go a notch higher as a result. This has the potential to create millions of services jobs as virtual workplaces allow greater global person-to-person connect.

In the near term, however, we still need to see through the challenges on both the health aspects of the virus spread as well as the economic slump. With FY21 GDP likely to look like FY19 GDP, debt profile is bound to worsen. To grow our way out is the only way to go even as that means fiscal expansion in the near term. Monetary policy has stayed accommodative and real rates are negative. Interestingly, continued monetary accommodation and low real rates could revive demand for real assets. Price correction along with low rates can do the trick for the real estate sector, which in turn has the potential to pull the economy out of its slump.

On fixed income, even as there is some more room for yields to fall, the juiciest period for government bonds is likely behind. While the curve stays very steep, continued fiscal pressures provide resistance. Credit spreads have shrunk but remain high due to economic uncertainty and risk aversion. FPIs have been heavy sellers in Indian debt markets. This makes India’s inclusion in global indices critical, failing which RBI will have to absorb a large part of the supply. Further, policy rates may not have much room to fall as risks to medium term inflation are weighed against the near-term disinflationary impact of the crisis. Forces such as rising protectionism and tariffs, supply disruptions owing to Covid, geopolitics, and supply chain reorientations, rising labour cost due to reverse migration and a continued surge in global M2 growth have the potential to revive inflationary pressures as and when demand returns.

On equities, we stay bottom-up. Black or grey swans have happened with striking regularity, starting with the dotcom crash at the turn of the century, the ghastly 9/11 terrorist attacks, a once in decades global financial crisis, the sovereign debt crisis in Europe, EM crisis after the taper tantrum, Brexit, a decade plus of persistent deflation eventually culminating in negative crude oil prices, demonetization, and of course the once-in-a-century pandemic in Covid-19, all in a span of 20 years. This underscores the need for robust risk management as being integral to investment process, and at the same time highlights the need to pick companies and managements that can navigate the unknown-unknowns that have occurred all too frequently.

This is a momentous point in our journey. Inflection points such as these have the potential to make or break nations, institutions, and organizations. The winners of the future can look very different from the winners of the past. In the near term, risks around a potential second (or rather continued first) wave and consequent delayed return to economic normalcy amidst heightened investor optimism may continue to bring bouts of volatility. The best way forward is to identify these winners and stay invested through the chaos.

Navneet Munot
CIO – SBI Funds Management Private Limited