THE BIG UNDERPERFORMANCE

Over the last few days I was thinking of what to write on. The most interesting thing that I found when I was writing the last piece were the very interesting formations that I saw in the charts of the troubled European countries which was similar to the chart formations in the year 2004 before the time when a two year up move in global equity markets fructified. Over the last 3-4 weeks those formations have become even more prominent and it seems that we should see those moves actually take place strongly. The often talked about big rotation from bonds to equities which has been more talk than action till date might actually fructify during this time frame too. I think that the main reason why that shift was not happening till date had to do with two main reasons

- Lack of clarity in the recovery cycle of major developed economies

- The fact that due to unconventional monetary policy tools bond yields were being held down to unsustainable levels. However since bond yields kept on falling even as equities recovered there was no real incentive for investors to shift from bonds into equities. However as bond yields have spiked over last couple of months we have seen the first signs of the so called “Great Rotation” actually take place. Moreover the US economy seems to be moving on a self sustaining recovery cycle despite the Fiscal drag. As the housing and equity markets improve in that country we will again see the wealth affect come up and support the recovery cycle. The risks will obviously remain related to the eventual cut in government expenditure in order to reduce the fiscal deficit and the direction that the move takes.

Similarly there have been positive undertones coming from the UK, Japan and the Euro zone too, although the news has been mixed but improving to a great extent. The bigger concerns have come up in the developing markets where the talk of Fed Tapering has led to a huge speculative trade taking place against the currencies of countries that have high CAD’s or borrowed heavily in the international bond markets over the last few years. Whereas it is true that the CAD problems are real, it is also true that they have been known for a long time and it is not that there is going to be a huge reduction in global liquidity over the next 2-3 years at least. Given the economic data coming out of the US it is very clear that Tapering is going to start. However it is also true that at the rate of $ 85 billion per month i.e. $ one trillion per year cannot really continue. Interest rates are going to remain low in most developed markets for the foreseeable future and liquidity is likely to be ample. As such the current CAD scare is likely to be temporary, however over the long term unless CAD comes under control we will keep on seeing such a crisis after every few quarters. In the Indian context we have seen a huge underperformance on both global markets and also relative to mostly correlated EM’s over the last few weeks. The reasons are two fold

-Contradictory signals from the RBI are making people concerned that they have lost the plot. After failing to bring inflation under control despite ultra tight policies now they seem helpless as far as the currency goes. Their current moves on tightening liquidity again are a retrograde one.

-The government is in the election mode and seems to be only bothered about dole out politics as well as taking steps which can help them politically in the next elections. As such crucial decisions related to reviving the investment cycle just remain on paper. Most people have started believing that there will be hardly any move from the government except vote gathering moves from here on. The big positive has been the way the monsoons have panned out and thus indicate a record Kharif crop as well as prospects of a bumper Rabi crop. This should be positive for food inflation unless and until the government continues to hoard foodgrains which are ultimately eaten by rats or contaminated. The other big support for the economy this year should be strong government spending followed by election related spending. As such economic growth should be relatively sustained at the 5.5% level overall.

The other factor that should help us near term is that most correlated currencies like the Brazilian Real, SA Rand, and Turkish Lira etc are showing signs of reversal and as such the pressure on the INR should ease off in the near term. Results and the MarketsOverall the results season has been decent with good results from the Technology and Pharmaceutical sectors. Private sector banks have held on, however PSU banks have seen significant balance sheet stress. With no Capital Expenditure in the economy the Infra sector has been under stress both due to subdued turnover and high interest costs. Telecom has come back strongly and the performance is also reflected in their stock price moves over the last six months. The sector should see continuous improvements going forward.

Overall the current scenario reminds me of the year 2002 when valuations were very cheap. FMCG and Pharmaceutical stocks were trading at very high valuations and there seemed to be no imminent economic recovery. However that was a good time to invest. Stocks in most sectors are now trading much below intrinsic levels and the last few days especially have seen a panic sell off in the broader markets. Moreover like I mentioned earlier the global markets are also looking well placed to move up further. Under the circumstances India could continue to be an underperformer but still move up. We have also seen some FII brokerages turning underweight on India which is a contrarian signal for low downside potential.
As such there does not seem to be a case for a huge up move, however valuations ex of FMCG, Pharma, IT are extremely cheap. Ultimately it is buying cheap and selling high that makes money and there is no reason why the same will not happen over the next one year. MID CAP discount over large caps is also at a record high creating good opportunities in that part of the market too.