Investing in Testing times
“Be fearful when others are greedy, and greedy when others are fearful”Warren Buffett
Today, it is evident this is easy to preach and difficult to practice. Corona Virus has turned out to be the trigger that has posed serious question mark on continuation of the 11-year old bull market
2008 and the longest Bull market.
In 2008 markets had seen similar panic and had fallen dramatically. The reasons were the sub-prime crisis and collapse of the important financial institutions.
After the subprime crisis, governments and central banks were forced to act. Synchronized policy actions from central banks across the world led to recovery in markets. Policy makers have since played a role of “Pro-active Doctors”. if they see even some hint of illness, they act fast and swiftly to avoid any spread of infection. But, these “Doctors” are having limited medicines at their disposal. When US Fed first said that they will withdraw the liquidity in the system, global markets collapsed (Taper Tantrum).
We have seen the pendulum swing away from globalization and a rise in nationalism. This is seen in the election of nationalist leaders and evidenced by Brexit and US-China Trade war. Whenever such swings threatened to derail the markets, but the “Pro-active Doctors” and their medicines (Massive liquidity, easy and market supporting monetary policies) made sure that markets not just remained on track, but zoomed faster.
Period from 2003-08 is described “Mother of all bull markets”. The indices zoomed 5x in 5 years. After the subprime crisis in US, Indian markets also fell in line with Global peers. Indian government and central banks also swung into action and markets recovered within a years’ time. But our macroeconomic situation deteriorated. India was one of the fragile five economies in 2012-13. Since 2013, we saw a decent rally especially in Mid & Small cap segment till January 2018. The valuation excesses in Mid & Small cap segments led to crumbling of the prices. Many structural changes like Demonetization, GST, MF recategorization, Insolvency & Bankruptcy Code, RERA, IL&FS and NBFC crisis led to large erosion in Mid & Small cap segment. In 2019, we saw a polarization in Indian Markets with only a handful of stocks gaining massively, leading Sensex and Nifty to new highs. This was in line with the trends in the global markets. Nasdaq was the leader of the bull run. Even there, a polarization in favor of the Faang stocks was apparent. Most of the global markets were following this lead.
Risk of the Unknown
Like a black swan, the outbreak of the COVID -19 virus has jolted all the global economy. The markets have crashed. The speed of the decline has surprised everyone. This is not a financial event. Nor is it a “normal” occurrence. The incubation period of 2 weeks makes it very difficult to distinguish those who are affected. We describe fast rising trends in other fields by the phrase “becoming viral”. Now we have experienced what it means in real life. The exponential rate of growth, geographical spread, lack of proven treatment and lead time for developing and testing vaccines mean that the markets are dealing with an unknown risk. They are trying to factor in this through substantially increased risk premium and hence, there has been a stampede for the exit door. Governments across the globe have preferred to lock down economic activity and close their borders to stop the spread. This may appear like an overreaction, but it is important to try and arrest the spread. If there is exponential spread, the healthcare capacities will fall severely short.
Flattening A Pandemic’s Curve
These steps also lead to a shutdown of businesses. Demand destruction followed by supply disruption could mean wiping out the growth for 2 calendar quarters and pushing the global economy into recession.
This could also hurt leveraged businesses. Airlines, hotels, travel and logistics companies will face the brunt. An oil price war between Saudi Arabia and Russia at the same time could push Oil & Energy companies into financial distress. This can extend to their lenders and some financial companies may run into difficulties.
Seeing increasing impact of corona virus on global economic activity, global central banks and governments have sprung into action with various policy measure. They are trying to avoid the impact of stock price erosion on businesses. Special lines of credit will also be opened up for ailing sectors. As the credit ratings of some of the borrowers get downgraded, the spread between sovereign and corporate debt yield would widen. This can create further harm.
|Country||Quantum of Rate cut||New Policy Rate||Previous Policy Rate|
|Hong Kong||50 bps||1.50%||2%|
- China, Hong Kong, South Korea, Malaysia have announced fiscal stimulus measures.
- Bank of Japan stepped in to buy ETFs worth $940mn
- ECB President Christine Lagarde pledged readiness to take appropriate and targeted measures to address risks due to the coronavirus outbreak.
- G7 nations reaffirmed their commitment to adopt all appropriate policy steps to protect the world economy from downside risks posed by the coronavirus.
- IMF announced $50 billion package for low-income and emerging market countries to help combat the impact of the corona virus epidemic
- President Trump announced financial package – paid sick leave, aid to struggling industries like airlines, and potentially eliminating payroll taxes for businesses for the rest of the year
Some comforting facts amid falling markets
The price to book value is 2.3x, which is at the lower end of spectrum. The worst readings were seen in 1998 and 2002, which were 1.9x. This tells us that prices are cheap. The prospective 1- and 3-year returns have been attractive, whenever we have seen prices drop to these levels.
Price to Book Value: One of the lowest levels in 11 years
The sentiment in the markets is lower than the sub-prime crisis in 2008 and also that in the crashes of 1998 and 2004. It is the speed of fall that has damaged the sentiment beyond limits.
Equity Vs. Bond yield 28 February 20
Bond yields have collapsed in March 2020 and earnings yield has gone up. We would need to adjust the prospective earnings estimates for FY21. The slowdown due to demand destruction and supply disruption would pull the earnings lower. Earlier EPS growth expectations in excess of 20% would be moderated to 15%.
Equity earnings yield is inverse of the Nifty P/E ratio—and indicates what equities yield as an asset class. Typically, when bond yield (minus) equity earnings yield gap reduces or turns negative, then equities start to look more attractive (than bonds) from a relative valuation perspective.
It can be seen in the chart above that when the gap has become negative in the past (like in year 2012 beginning, year 2013) then it has offered buying opportunities in equities—as indicated by the Nifty 1 year forward return.
Presently, with the market correction the gap has turned negative (as highlighted in the above chart) and is the biggest gap we have seen since the global financial crisis in 2008-09. This indicates that equities have started to look more attractive on a relative basis.
One of the other major reason for current global market fall is, massive fall in crude oil prices.
Crude oil prices were weak due to Coronavirus concerns, and the recent price-war between Saudi Arabia & Russia has further aggravated the crude price fall
This is beneficial for a net oil importing country like India, where crude oil accounts for a large part of our imports.
India imports ~1.3 billion barrels of crude every year. $20/barrel fall in crude price will result in an annual savings of ~$26 billion. This will in turn help to reduce our current account deficit. Market estimates indicate that a $10/barrel fall in crude price helps to reduce current account deficit by around 40 bps (0.4%). This also helps in keeping fiscal deficit and inflation in check.
RBI’s latest inflation forecast had assumed India’s basket crude oil: $62.6 a barrel. The fall in crude oil prices is likely to be disinflationary. This will provide room for RBI to cut rates further.
Bond yields and interest rates have fallen, helping to bring down cost of capital for companies
The 10-year benchmark bond yield has fallen by more than 120 bps (1.2%) over the past year, and RBI has cut interest rates (repo rate) by a cumulative 135 bps (1.35%). RBI has also taken various steps to increase monetary transmission of interest rates & improve liquidity in the system.
This fall in bond yields & interest rates will help to reduce cost of capital (cost of borrowing) for companies, and therefore is beneficial for them.
India’s forex reserves are at an all-time high of ~$480 billion, and provides buffer / stability
India’s forex reserves are at an all-time high of ~$480 billion and provides buffer / stability.
Import coverage ratio (no. of months of imports that forex reserves can cover) stands presently at around 12 months, which is quite healthy. During the Fed taper tantrum of 2013 import coverage ratio had dropped to around 6-7 months
There is likelihood of shift of manufacturing from China to other countries as the firms start diversifying their supply chain. India can welcome those companies to become part of global supply chain. This can support India’s growth for years to come. Samsung, a Korean chaebol contributes 28 % of Vietnamese GDP and generates revenue of $ 62 billion from Vietnam
Fear of the unknown is driving the markets. It is not irrational, as we are fighting with the unknown. History does not repeat, but it rhymes. As the fog lifts on the possible containment of the virus, the markets would view the situation differently. As the spread is contained, and lock down is removed, the current prices could look attractive.
Also, let us see the history of past incidences like SARs, EBOLA, ZICA. Initially, they understandably created panic. Once scientists were able to find a solution, the economy and the markets stabilized and recovered.
Indian market are attractive from fundamental perspective. It is difficult to catch the bottom and top of markets. Investors will do well to remember that historically, investments made in challenging/volatile times, have generally been rewarding for investors over the next 3 years. Adding patient money in 2 or 3 instalments is recommended.