Exuberant bond market could be the trigger for correction in stocks: Ambit’s Mukherjea

Indian equities are expensive at current levels, but that alone may not be enough to cool the ongoing rally, feels Saurabh Mukherjea, CEO, Ambit Capital.

“(Equity) Valuations are fantastic and could remain that way for a while,” Mukherjea told Moneycontrol in a freewheeling chat.

Mukherjea feels a bubble is building in the bond market, and the bursting of that bubble could rattle the stock market as well.

According to Ambit data, close to close to Rs 4 trillion (USD 60 billion) has been pumped into bond and liquid mutual funds in India over the past three years.

Mukherjea says that the sluggishness in the real estate market, and other policy measures likes the war on black money and demonetisation have also contributed to increased inflows into the financial markets, particularly into bond funds, which are perceived to be low risk.

“Three years ago, close to 300 billion dollars was going into residential real estate annually; that has now fallen to 100 billion dollars. So the real estate refugees have now come to the financial markets—both equities and debt, but mostly debt,” said Mukherjea.

Flush with money, debt schemes of mutual funds have been buying non-convertible debentures and commercial papers issued by companies.

“In many cases, the only collateral mutual funds have for the commercial papers is the equity pledged by the promoters,” he said. “When the share price falls, the promoters pledge more shares, but those too are pretty much worthless,” he said, adding that it was not clear if the promoters would be in a position to repay the

He says the value of the NCDs issued by many of the NBFC companies are suspect because of the deterioration in the quality of their loan book. NBFCs most lend to small and medium enterprises, and those have been hit hard as the government tries to formalize the economy.

Another cause of worry is the craze for AT1 (additional tier 1) bonds—also called perpetual bonds--issued by banks and non-banking finance companies, cautions Mukherjea.

“These are bonds, but with equity like qualities. And many are being issued by PSU banks in poor financial health,” Mukherjea said, adding that mutual funds were buying these bonds because there were limited avenues to park the huge inflows.

The issuing bank/NBFC can skip coupon payment on these bonds in times of weak financial performance.

“My hypothesis is that credit downgrades will exceed upgrades for some more time and that will hit the NAVs (net asset values) of many bond funds,” Mukherjea said.

“People are taking 7-9 percent returns for granted; my fear is that they could even lose their principal in what they think to be zero risk instruments,” he said., adding, “…and when that happens, they will start pulling money from equities as well, which anyway are a far more risky asset class.”

There are other storm clouds as well building up as well, which Mukherjea feels the markets could be underestimating.

He says indicators other than those released by the Central Statistical Organisation show the economy is still struggling.

“People I have been speaking to say the rate of job creation is worst in almost 20 years. If you look at credit quality, as measured by rating downgrades versus upgrades, the picture is bleak. If the economy was recovering, the NPA problem would have been arrested by now. We thought the problem was only with banks, but if you look at the Q4 earnings of NBFCs, it is evident that it is not just the large corporates that are struggling; small and medium firms too are hurting.

There is no decisive recovery yet in truck sales, fuel consumption (excluding aviation fuel) is weak, cement sales are down. The only bright spots are two wheeler and car sales, which reflect some degree of consumer confidence,” Mukherjea said.

He feels the implementation of GST will cause a major disruption in the economy in the near term as small and medium enterprises will be hit hard.

“Every economy functions on a broad set of rules, which underpin the economic activity in that country. By implementing GST, the rules of the game are being changed.

When that happens, players who were used to the old rules will get disoriented. When hockey moved from grass to astro-turf, the European countries became good at it. Indians who were better at controlling the ball on an uneven surface, were no longer the masters.

When you formalize the economy, some of the larger players will benefit. But scores of SME players, who are present in every nook and cranny, will be thrown out on to the road,” he said.

According to Mukherjea, the profit margin of most small companies is the tax they evade. That will no longer be possible under GST.

“The losers will be plenty; the winners will be big, but few,” said Mukherjea, adding that whenever are radical policy measures, the bottom 20 percent in every industry get wiped out.

“What the stock market does not realise is that when winners are few and losers plenty, it is a pyrrhic victory. There will be consolidation in many sectors, but demand will vanish as many will be unemployed,” he said.

According to Mukherjea, the minimum wage stipulation means that many small companies will be forced to fire staff as they cannot legally pay them below the minimum wage.

Mukherjea is no hurry to buy stocks for now.

“Whenever I hear the word liquidity driven rally, I get cautious. And whenever I hear that the India story is over, the bull in me wakes up,” he said.