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Correction in equities triggered by a sell-off in bonds is only a flash in the pan for a long-term bull market

March 06, 2021 / 10:49 AM IST

Dear Reader,

Fed chairman Jerome Powell hardly said anything new in his interaction with the Wall Street Journal, but that didn’t stop the US markets from selling off and others promptly followed suit.

Sure, the talk is all about resurgent inflation leading to higher bond yields. But isn’t this rise in bond yields supposed to be a good thing, because it’s the result of higher growth? And higher growth is precisely what the Global Composite PMI for February shows, with the recovery being the strongest in the US, followed by India. The PMI for India confirmed that a cyclical recovery is under way, a fact borne out by our own recovery tracker. The RBI’s report on the state of the economy too was very bullish. Add to that the fiscal and monetary stimulus and the vaccination drive and growth can only get better. And just in case you were wondering why the government isn’t juicing the economy even more by allowing the private sector to start vaccinating people, we list some reasons here.

RBI Monetary Policy Committee member Ashima Goyal told us the fear in the bond markets is not only unfounded, but there is room for rates to fall if inflation expectations are anchored. But banks don’t seem to be heeding that advice at the moment and have instead lowered their holdings of government securities. How then should investors decide probable future levels of interest rates? Simple, just follow the 12-month OIS (overnight indexed swaps), says RBI research.

So what does that mean for equities? We said that, going by history, a fall in equities induced by a sell-off in bonds is just a blip in a long-term bull market and the US market is likely to shrug it off. After all, the Bank for International Settlements, that venerable bastion of conservatism, says that, if we take into consideration the very low levels of interest rates, there isn’t much froth in the overall markets.

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The contrary view, from the FT, is that it could mean the end of the party. How to reconcile these opposing viewpoints? We took a common sense approach to tell investors to take advantage of a two-way market to buy into good businesses. That is more or less the same advice that we distilled from Warren Buffet’s newsletter. Incidentally, this Indian technology-led financial services company ticks all the boxes of Buffett’s investment philosophy.

Companies are long on India’s domestic economy, as this interview with ABB India MD Sanjeev Sharma tells us. He said, however, that private capex is yet to pick up. That is also the sense we got from our analysis of the government’s GDP estimates for the current quarter, which show that it is government spending that is driving growth.

That is good for logistics players such as TCI. The spending on infrastructure and construction is great for commercial vehicles, as we pointed out here and here. The K-shaped recovery has, however, led to sluggish sales of entry-level two-wheelers, telling us we have a long way to go before all boats are lifted. Nevertheless, higher auto demand has been good for battery makers and for companies like Endurance Tech. Along with commercial vehicle makers, MSTC will be a key beneficiary of the government’s scrappage policy.

The rise in metals prices is another opportunity. The recovery is playing out nicely for steel companies such as SAIL and iron ore companies like NMDC. Rain Industries, one of the largest global players for carbon products, is seeing a steady improvement in the end-market—the global aluminium industry.

Companies are shaping their strategies to adapt themselves to the changed conditions, such as Nestle. In a very different industry, Wipro, through a large acquisition, has placed a bold bet.

The recovery is becoming broader. With travel picking up, Safari is emerging strongly from a difficult phase. We saw long-term promise in all IRCTC’s monopoly businesses. And we considered the potential in stocks in a diverse range of businesses, ranging from basic chemicals to fashion and retail.

The worry, with growth coming back, is that inflation too will raise its head. Global food price inflation, for instance, shows no signs of abating. Crude oil prices have jumped as Saudi Arabia extended its output cuts. Powell’s statement that there could be a temporary pick-up in inflation may therefore have spooked the bond markets. The US dollar too moved up, which is not good for emerging markets.

But then, higher inflation with higher growth is par for the course, as are higher bond yields. Equity investors know that very well—the fear is in those sections of the market that have gone up unreasonably, on liquidity alone.

In the weeks ahead, it is entirely possible that the Fed may cave in to the markets’ asking for more. After all, the Australian central bank has increased its bond purchases and the ECB has hinted that more QE could be in the offing.

On the other hand, this could be the opportunity for Powell to show some spine and stay firm. He has already said that he’s not going to taper bond purchases, but he should also be equally firm in saying there is no need for more accommodation. After all, the BIS said that financial conditions in the US and in emerging markets are the most accommodative in a decade.

What if the bubble gets bigger? The silver lining, as this FT piece pointed out, is that ‘financial excesses and productivity explosions are “interrelated and interdependent”. In fact, past market bubbles were often the mechanisms by which unproven technologies were funded and diffused — even if “brilliant successes and innovations” shared the stage with “great manias and outrageous swindles”.’

Cheers,

Manas Chakravarty
Manas Chakravarty

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