Treading a cautious path

We cut equity this week.

Global macros and policy decisions have an impact on equities. This movement of funds and transfer of risks have an impact on equity prices, moving them higher or lower.

The IMF in its latest World Economic Outlook report forecasted a less severe contraction of 4.4% in global GDP for FY 2020. While this less severe situation reflects the picture in developed economies and (in particular) China, the outlook for emerging economies was below average — our economic outlook points to a more uncertain path to normalcy.

The stimulus is still keeping uncertainty at bay.

The US injected about $2 trillion into the economy in March through direct cash payments to individuals, supporting household incomes as the unemployment rate reached a record of 15%.

However, unemployment benefits expired in July and other sources — interest rate cuts, asset purchases — have largely been exhausted. A (new) stimulus package through Congress is essential for a recovery in the near term — this seems likely post elections in November, but its magnitude will depend on election results.

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Uncertainty has topped prior election levels.

It’s not just the US; Brexit issues remain unresolved between the UK and the EU.

On the other hand, it looks likely that we might have a vaccine in 2021. However, an average person might have to wait until 2022 to get it.

Even the RBI has limited leeway to exercise stimulus measures.

Latest data across indicators point to a flattening recovery and a spike in inflation — this makes it difficult for the RBI to follow easing monetary measures.

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A double whammy.

Flattening recovery

India’s factory output in August contracted by 8%. While this is better than ~11% contraction in July, the recovery trend is losing momentum. The core-sector saw a broader contraction in August compared to July. Even the consumer non-durable categories, which showed positive growth in June and July has slipped back to contraction territory again.

Inflation uptick

Last month inflation spiked to 7.34%, higher than RBI’s expectations of 6.88% — driven by a 20.7% rise in vegetable prices. A sharp increase in food prices at a time when employment and wages down mean that households will find it difficult to spend on non-food items, which is negative for aggregate demand.

A fall in job-seekers

While there is a gradual improvement in unemployment rates, major support has been from fewer job-seekers — several individuals are not seeking active work and have left the workforce.

Labour reform and farm bills are expected to have a medium-term impact — we don’t see much progress in the near term.

Despite this, financial markets have run-up — the divergence (against real markets) just got bigger.

Fund flows drive markets; domestic institutions, foreign investors, and retail are the three major participants. Since May, both foreign institutions and retail investors have been net buyers. However, domestic institutions turned sellers since July and foreign institutions turned sellers in September for the first time since April, ahead of US Elections.

Institutional players were net sellers of equities last month.

Central banks globally have been channelising flows to their respective economies since March — interest rates are at record lows and are likely to remain the same until 2023.

For a large number of investors, equities are the only option. Hence, a larger percentage of investors’ surplus is getting channelised to equities. This stimulus money also flows into emerging markets (like India) through foreign portfolios (of individual investors) — a stimulus-induced flow of ₹35,000-crore in May and June.

With no stimulus yet, the tap could close soon.

Compared to developed markets, there are only a few stocks in India with the capacity to absorb such inflows — this leads to higher prices and creates a price momentum which in-turn attracts more investors chasing these stocks. The steep recovery has been more concentrated — only a few companies that are perceived to be more resilient and sustainable businesses have seen uptick — but has pulled the index to new valuation highs.

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Did we recover that fast?

Valuations are high, but unreal if you consider global and domestic uncertainties.

Allocation changes

We stopped equity flows this week — no changes to debt and gold inflows. We will use the extra cash for optionality — to enter if the market corrects. We are watching this space closely, and we will keep you apprised when we start equity flows again.