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Even with a sharp sell-off on the last day, equity markets had another month of strong gains in August. The gains were broad based as small caps led with over 10% rise. Right noises on global policy have reinforced our view that a combination of fiscal and monetary accommodation will help reflate the global economy, beating the deflation of the past decade. Corporate India’s performance has been better than expected with significant cost control. While part of this may come back with revenue, some of it could be permanent. Innovation and technology may lead to lasting cost advantages and productivity gains. Buoyant capital markets have been well-utilized by banks to shore up their balance sheets. Strong balance sheets, robust cost control and lower taxes augur well for reversion in corporate profitability over the medium term. However, just as things didn’t turn out as bad as markets had feared during March lows, we do not think we are quite in the clear yet as the market move back to near pre-Covid highs might suggest.
Globally, policy support has been the single most important driver for all asset markets in our view and positive news on that front continued. At the annual Jackson Hole symposium, Fed Chair Powell indeed reset Fed’s monetary policy goal to average inflation targeting as widely anticipated. This means that after a period of undershoot of the Fed’s 2% target, it will allow inflation to run ahead of the target as a make-up strategy. He also talked about making maximum employment a broad-based and inclusive goal, focussed on low and moderate-income communities. Overall, this implies that policy rates will stay low for longer, allowing inflation and labour markets to run hot to compensate for the inflation undershoot of the past few years. This only strengthens our reflation thesis, even as we continue to believe that fiscal policy will have a much more important role to play in bringing about a broad-based growth revival in the wake of rising inequality globally.
Incrementally, however, it looks unlikely that there can be continued good news on policy front to support the near vertical market rise. We may have seen a peak on policy optimism for the time being. If anything, US presidential elections are a looming uncertainty. Recent reports suggest Trump is closing on to Biden even as the latter is still a favourite albeit by a thinner margin. Democratic sweep would have allowed for more expansionary and redistributive fiscal policy and hence greater reflationary pulse. Yet another related risk is that if election results are too close, they may be challenged, leading to a period of uncertainty and policy paralysis. At a juncture when lot hinges on fiscal policy, and when geopolitics is quite fragile, this is a risk markets seem to be ignoring thus far.
Back home, RBI faces a tough choice between preventing rupee appreciation, keeping lid on long-end yields and fighting inflation amidst surging inflows. However, the RBI’s intent to support the economy even in the wake of rising inflation is comforting. It continues to be aggressive with Operation Twist which allows it to signal to the market that it will indeed do ‘whatever it takes’ to keep bond yields from rising, while staying liquidity neutral. On the other hand, it has increased the SLR holding limit for banks to 22% of NDTL from the current 19.5%. This will allow more absorption capacity of government bonds as continued operation twist allays fears on mark-to-market losses.
For yields to stay down sustainably, inflation trajectory going forward will be important. Globally too the way inflation pans out in the near term will have important ramifications. As economies gradually reopen, supply may take time to return in the wake of supply chain disruptions. Also, while policy response has been aggressive to support small businesses, there is bound to be some creative destruction which will take out capacity from the economy. These supply side challenges may lead to an inflation uptick. Even as this should be short lived as supply side ramps up, high inflation prints amidst recovering but low growth may not be the best data mix for markets in the interim.
While the recent RBI actions have led to considerable easing of long end rates, on an overall basis India’s yield curve has steepened somewhat over the past few weeks. Some steepening is being witnessed in the US as well. If this continues amidst surging inflation expectations, it may work against equities at the margin. Equities are long duration assets and even some surge in longer end yields impact valuations. Eventually we believe policymakers will step in to put a lid on yields, especially in the western world where debt-to-GDP ratios are already at multi-decade highs. To support the economy and address the widespread economic inequality, fiscal policy will have to remain expansive adding to debt burden. The way out would therefore be to inflate the debt away: keep nominal yield low, real rates
negative and let the currency depreciate. Even as surge in long end yields may prove temporary, this may provide a reason for the heightened equity optimism to subside in the interim. Alternatively, and somewhat perversely, weak economic data and equity market correction may act as triggers for yields to fall again.
For India, the economic reopening has been slower and there are signs of plateauing of activity. The recent GDP print was weaker than expectations. The weakness in state capex is worrisome given that states contribute to two-thirds of government capex and the multiplier impact of capex spends can hardly be paralleled. The weak print also emphasises the need for a demand boost even as fiscal capacity is constrained and the government continues prioritising structural reforms. Even as things normalise, this may well end up being a K-shaped recovery, where parts of the economy recover, some face cyclical challenges, and some others face permanent challenges. Internals of macro numbers on growth and inflation will matter more as aggregates may not reveal the true picture. Policy will have to ensure convergence to address the challenges on inequality at corporate and individual levels. And yet at some level, policy may only help to an extent in what is largely a medical problem and when on the disease front, we still appear to be struggling. While policy so far has underwritten the near-term downturn and helped address tail risks, there are limits to what it can achieve at least till we have a medical solution.
The impact on consumer and corporate behaviour for example is difficult to predict clearly at this point. Savings appear to have gone up recently as evidenced in our current account surplus, which suggests that private sector is saving more than the government sector’s deficit or dissaving. Yet MF equity inflows have plunged. Some of these savings may have directly gone into stocks as evident from the rise of Robinhood investors, not just in India but world over. Indeed, some measures of retail sentiment are now indicating euphoria. These retail traders will likely exacerbate market volatility in the event of a correction. With real rates staying negative, savings may also find their way away from financial assets into physical assets. This may not be all bad news as it may provide the much-needed fillip to real estate sector, the sector that has the potential to bring the economy out of its current glut. Builders do not have the capacity to continue holding on to inventory. Some price correction, low rates and genuine pent-up demand can turn things around for the sector. Within equities too, we believe a return of inflation should turn the tide in favour of asset owners.
Overall, there is no denying that the current crisis has necessitated the right policy change that helps reflate the global economy. Corporate sector in India looks in good health to capitalize. After ten years of underperformance by equities versus bonds, a revival in corporate profits should turn the tide over the next few years. Yet in the near term, the rally overlooks meaningful challenges we face in the interim. After the recent surge both in equities as well as bond yields, valuation attractiveness has shrunk, with yield spread back to historical medians. While polarization is just reversing in favour of small and midcaps and that space stays attractive, it is unlikely that these stocks will continue rising in the wake of a near term market pullback. For fixed income investors, inflation remains the key monitorable in the near term. A steep yield curve and the RBI’s strong intent to keep a lid on yields may provide tactical opportunities. Credit spreads for quality paper have contracted to pre-Covid levels and one needs to be very selective in that space too.
We are living in an environment with radical uncertainty. The uncertainty should keep financial market volatility high. And this volatility in turn will provide opportunities for patient long term investors.
CIO – SBI Funds Management Private Limited September 1, 2020
(Mutual funds’ investments are subject to market risks, read all scheme related documents carefully.)