From an investment strategy perspective, we continue to focus on LQV companies, i.e., companies that are ‘Leaders’ (L) in their respective sectors, with good ‘Quality’ of business + execution track record (Q) and are available at reasonable ‘Valuations’ (V), Unmesh Kulkarni – Managing Director Senior Advisor, Julius Baer India, said in an interview with Moneycontrol’s Kshitij Anand.
Q) The market seems to be taking one step forward and two steps back. What we saw in April was largely a bear market rally and at the beginning of May, we saw most of the gains evaporating. What are your views on markets in the near term?
A) We are currently in a ‘Bear Market’, which started with the steep fall in March. With the onset of COVID-19 and the pursuant lockdowns, there is no doubt that the economy will take a sizeable hit and so will earnings across the board.
While the March crash was because of fear of the unknown, the April rally was driven by hope. I hope that some antidote/vaccine would be announced somewhere in the world; hope that people would soon return to work.
The hope that the Indian government would announce some major fiscal package(s) for the people as well as for businesses. And, as that has not exactly materialised, the rally seems to be fizzling out from early May.
We currently have a neutral view on the Indian equity markets. While we feel that the markets have bottomed out in the panic of March, we think that the markets need time to digest the actual impact of the COVID-19 in terms of the extent of the slowdown, any systemic stress, and the impact on earnings.
This is why the markets may lack direction over the next couple of quarters; in other words, we are currently in a sell-on-rise type of market.
For markets to develop new optimism, we need the lockdowns to end, human and economic activity to resume and some longer-term support from the Government for the beleaguered part of the economy to accelerate the revival in demand and growth.Q) Road to earnings recovery looks bumpy especially for FY21 amid COVID-19 outbreak which pushed most countries into lockdowns. What is the kind of economic/earnings impact you foresee on the economy and sectors?
A) The COVID-19 episode and the lockdowns are likely to have a severe impact on the economy, for at least a couple of quarters, as it will take time for several parts of the economy to revive and return to pre-COVID levels in terms of demand and growth.
In a way, demand has been destroyed as people will like to postpone certain discretionary spending because of a fall in income, loss of jobs, or even due to some sense of insecurity.
Early results of Q4FY20 earnings season and management commentaries suggest more volatility and disruption in earnings ahead with several companies refraining from providing any sort of guidance till more clarity emerges.
The corporate earnings recovery story has been pushed back by a year, and we might see another level of reset in the Indian economy thanks to the COVID-19 related disruption.
The impact on the economy is likely to unfold in stages. The first-order effect would come from the global slowdown and trade disruptions, with sectors such as textiles, automobile parts/components and commodities taking a direct hit in their revenue growth, as volumes and realizations will come under pressure.
The second-order impact would come from the countrywide lockdown and social distancing, driving factory closures/lower utilisations, reduced labour wage growth, travel bans, and decimated retail consumption. This will weigh on sectors such as retailers, aviation & airport operators, hospitality & tourism, and roads.
Consequently, the resultant effects may also include liquidity crunch, besides reduced domestic consumption. Prolonged social distancing could potentially disrupt capital formation, and ultimately labour participation and productivity.Q) Which are the sectors that could brave the COVID-19 storm while level playing field for some might change. The recent one being the aviation sector. What are the other sectors that will undergo a massive overhaul and the world adjust to a new normal?
A) The COVID-19 pandemic and its economic impact are likely to put some medium-term brakes, both domestic and cross-border, on lifestyle and businesses, even after the lockdowns are lifted.
While there is some case for pent-up demand to show up just after lockdowns are lifted, the overall discretionary spend is likely to take a hit due to the potential loss of employment/income as well as overall prevailing uncertainty; this will keep demand for autos and some other high-ticket consumption items in check.
Demand for “services” of various types could also be affected as companies get into a cost-reduction mode. Trade, tourism/travel, and entertainment would be directly affected by spending cuts, social distancing, and curbs (forced or voluntary) on travel and cross-border movement of goods and people.
Financial services are likely to be affected this year with (a) overall demand coming down (b) risk of delinquencies going up among retail borrowers and (c) corporate stress going up, pulling down credit growth.
Industrial/Infrastructure spending can also see a pushback due to a decline in utilization levels and lower spending capacity/intent, in both the private and public sectors. And with the overall global slowdown, sectors such as commodities, shipping, and a certain type of exports are going to take some time to revive.
On the other hand, industries that are focused on essential consumption or which benefit from any changes in lifestyle post-COVID, are likely to be beneficiaries (to some extent). Demand for FMCG and staples will continue to hold up (though from the equity investment perspective their valuations are rich).
Pharmaceuticals and healthcare are likely to do well as (a) healthcare needs will stay high (incl. some preventive demand on account of COVID) (b) the US FDA seemingly becoming a bit relaxed in granting approvals to Indian pharma companies and (c) from equity market perspective, the sector had languished for about five years and had become relatively under-owned; hence, it is likely to be an out-performer in the near-to-medium term.
Some of the IT companies will benefit from changing business models and personal lifestyles (work from home) as well as the potential for increased outsourcing by global companies (from a cost reduction perspective). Here, opportunities could emerge in areas such as digital transformation and cloud migration as well as vendor consolidation, although on-site services will suffer due to restrictions on the movement of people.
The Telecom sector is already a clear beneficiary of the work-from-home environment, and the demand for internet services and entertainment is likely to continue post-COVID as people adjust to changes in lifestyle.
We believe that across industries, large corporates with strong balance sheets will likely withstand this onslaught, and will eventually gain market share at the cost of marginal players who could struggle for the next year.
From an investment strategy perspective, we continue to focus on LQV companies, i.e., companies that are ‘Leaders’ (L) in their respective sectors, with good ‘Quality’ of business + execution track record (Q) and are available at reasonable ‘Valuations’ (V).Q) How should investors construct the portfolio amid recession fears? What should be the ideal asset allocation strategy?
A) The current environment poses a challenge for growth; at the same time, there are concerns around liquidity and systemic stability, as there is a disruption in cashflows, supply-chain, and credit flows.
In such times, investors should ideally position their portfolios in favour of quality, safety, and liquidity.
With respect to the overall asset allocation, while it may be tempting to move away from equities in the current times of uncertainty, it would be in the best interest of investors to stay aligned with their strategic (long-term) asset allocation, as the longer-term potential of equities remains intact, and markets should gradually revert to their normal average by 2021.
Investors need to extend their time horizon, as equities may be range-bound (with a downward bias) over the next few months, while markets digest the data points emerging around growth and earnings.
Investors who are underweight equities in their portfolios could buy into market declines; on the other hand, investors should cut any overweight allocation to equities that they may have built over the last couple of years.
Within equities, a safer strategy would be large-cap companies and large cap-oriented equity funds, or at best multi-cap funds, as well as index funds.
Within fixed income, stay with short-to-medium term AAA debt fund strategies or AAA bonds; avoid both high yield and duration. High yield is likely to stay under pressure owing to the slowing economy, stress in balance sheets, and illiquidity in the secondary debt markets.
Duration strategies may be volatile as there is likely to be upward pressure on long-term yields owing to the large borrowing programme announced recently by the Government, and the expected jump in the fiscal deficit.
Q) How are FIIs positioned with respect to India? Do you foresee further selloff from the foreign investors?
A) FIIs were big sellers in March, as risk appetite collapsed amidst the rout in global markets. In April, with global markets as well as India staging a smart comeback, the FII selling abated to a large extend, although flows were still negative; the domestic flows primarily led the equity market rally.
Going forward, the road is expected to be bumpy. For foreign investors to turn optimistic on India, they will watch out for some long-term signals with respect to:
(a) Covid-19 peaking out in India (we are still in the “up” trajectory),
(b) lockdowns getting lifted and economic activity resuming (some part withdrawal of lockdown has just started, but we have still some time to go) and
(c) strong support from the Government and the RBI to revive growth and demand, as well as stabilize financial markets.
Given the extension of lockdowns and therefore the deeper impact on the economy and earnings, the FII activity is likely to be tepid for a few months, unless the Government steps in with some major package to revive demand and improve business sentiment.
Unless there is a global flow of liquidity towards equities as an asset class, including Emerging Market equities, in which case India could also benefit.Q) Although we are just 2 months into the bear market, can we say that we have hit a bottom? If not – what are the important levels which you are tracking?
A) As of now, it looks like we created the bottom in the markets – both globally and in India – on 23rd March. This was the time when fear was at its peak, large-scale uncertainty was prevailing around the globe and Covid-19 was on the fast rise everywhere.
Since then, things have progressed on the Covid-19 front. Several countries in Europe have seen their Covid-19 cases flatten out, the US too looks heading in a similar direction and China already claims it has conquered the virus.
Lockdowns are expected to be lifted soon in several countries. There has been a massive support, both fiscal and monetary, by various global governments and central banks. And work is fast happening on the vaccine front, or at least with respect to some mitigants.
Global markets have taken all these developments positively and marched ahead with a “sense of hope”. The Nasdaq has already turned positive in 2020. As of 8th May, the S&P has recovered 31% from its bottom of 23rd March; India too is currently up 22% from its recent bottom.
We expect that markets will take a breather after the smart comeback, and may even witness a correction from current levels as the real impact on the economies and company earnings pans out in the coming weeks.
Globally, analysts now expect Q2 S&P 500 earnings to decline 37% against the same period last year, followed by a sequential rebound in Q3 and Q4 (the full year 2020, 18% decline).
However, for the next year, the consensus now expects a 28% earnings rebound, and S&P 500 profits to reach pre-crisis levels towards the end of Q2 2021. We expect that the S&P 500 will continue to gradually move up from current levels towards the year-end.
Given that governments and central bankers globally are all on the rescue job, it looks unlikely that markets will get into the same panic mode as we witnessed in March.
Back home, Indian markets will mostly follow the global sentiment, though we are likely to lag the global markets for some time owing to our lockdown being much more severe and therefore the economic and earnings recovery will take that much longer to bottom out.Q) What is the kind of hit you are factoring in with respect to GDP growth? D-Street is also hopeful of another stimulus package and how do you compare India’s response with other countries with regards to dealing with COVID-19?
A) The IMF expects the global economy to contract sharply by 3% in 2020, much worse than during the 2008-09 financial crisis, but expects it to rebound to 5.8% in CY21, helped by monetary and fiscal policy support. For India, the IMF has lowered the CY20 growth forecast to 1.9% from 5.8% estimated in Jan’20.
On average, every month of lockdown results in an output loss of ~8.5% of the annual total. If 75% of the economy is locked down for two months, the output loss will ~13%.
The severity of the economic impact from the lockdown necessitates a significant policy response from the RBI as well as the Government, to contain any near-term damages and provide the necessary impetus to revive growth and improve business sentiment.
Globally, most central banks and governments have already sprung into action and announced monetary and fiscal packages (totaling ~USD14tn) to deal with the aftermath of the Covid-19 crisis. In India, RBI has so far been on the forefront and has doled out a large rate cut (75 bps cut in repo) as well as several liquidity injection measures, to bring stability to the financial markets.
The government, on the other hand, released an Rs. 1.7 trillion packages for the poor, as its initial policy response. However, much more is desired to support the frail economy.
It is widely expected that the government will come up, after due analysis, with a comprehensive fiscal package for the larger part of the economy, including the industry and small-scale enterprises.
The practical challenge that the Government faces is that its revenues are under severe strain, so any financing of the fiscal package will have to be done out of market borrowings.
Recently, the Government announced a hike in its borrowing programme for FY21 to Rs. 12 trillion (earlier announced Rs. 7.8 trillion), which is a signal that a package is soon on its way.
While that would be good news for the country and temporarily for the equity markets, it will leave the bond markets greatly worried, as the fiscal deficit will likely jump from 3.5% of GDP to 5.5% (est.).
Here too, the RBI will have to play a crucial role in monetizing some of the borrowings so that the overall bond supply in the markets reduces.
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