One justification for higher stock prices has been that global interest rates are very low, supporting high valuations. Well, the US Fed seems now to disagree, pointing out in its recently released Financial Stability Report that “valuations for some assets are elevated relative to historical norms even when using measures that account for Treasury yields”.
In this setting, the Fed report says asset prices may be vulnerable to significant declines should risk appetite fall. But why will risk appetite fall, especially when central banks have proved more than willing to bend backwards to accommodate the markets? The report flags two concerns — disappointment about containing the virus, or a stalling of the recovery.
As far as developed markets are concerned, both the recovery and vaccination against the virus are on track. But Lael Brainard, one of the members on the Federal Reserve Board of Governors, warned, “The combination of stretched valuations with very high levels of corporate indebtedness bear watching because of the potential to amplify the effects of a re-pricing event.”
One such event could occur if the Fed is mistaken in its belief that the rise in inflation will be temporary. After all, commodity prices have jumped sky-high and there is much talk about a new commodity supercycle. Shipping rates, too, have risen, as seen from the Baltic Dry Index. As S&P Global Intelligence points out, if rising inflation has staying power, bond and equity markets could be upended. It could force central banks to raise rates, or at least to start tapering. The Bank of England said this week that it has “slowed somewhat” its pace of bond purchases after it raised its forecast for UK growth from 5 percent to 7.5 percent for 2021. Earlier in the week, US Treasury Secretary Janet Yellen said rates may have to rise to prevent the economy from overheating, before hastily backtracking.
In India, plagued with a vicious second wave and mini-lockdowns, there is little chance of any overheating, although supply bottlenecks could keep core inflation elevated. Tata Steel, thanks to high steel prices, could be one way to play the commodity boom. Sugar shares have also gained from rising prices.
While the US, the UK and now Europe are all doing well on the vaccination front, the Indian vaccination drive has slowed considerably because we don’t have enough supply. We had advocated a strong stand against the vaccine imperialism of the rich countries and were pleasantly surprised by the US support for a patent waiver for vaccine production. But it’s likely to take a long time to bear fruit — Germany has already opposed it.
Given the incompetence of governments, both at the Centre and the states, in tackling the second wave, we wondered why Amartya Sen’s thesis of democracy being able to avoid famines hasn’t worked in the fight against the pandemic. Thankfully, the courts have now started to act, demanding steps to ease the plight of hapless citizens.
So far, the Indian corporate sector has proved remarkably resilient. GST collections have been robust, although the momentum is unlikely to continue. Loan repayments have held up well. Perhaps that is why the relief measures announced by the RBI this week have been rather tepid, offering only partial relief.
One reason for optimism is external demand and a bet on Atul is one way to play the global recovery. Coforge could be another such play in the midcap IT space. Mahindra CIE’s business in Europe should do well. Goldiam International, which derives all its business from abroad, has been another pick. In this context, we also discussed Laurus Labs here and here.
But with the second wave showing few signs of ebbing, even industry lobbies such as CII and FICCI now want a national lockdown, a course of action also favoured by Anthony Fauci, the medical advisor to the US President, in this News18 India interview.
That is why we took a cautious approach to our stock calls. Take ABB India, where we said its valuation offers very little margin of safety. Similarly, we said Adani Ports’ valuation leaves little scope for appreciation. And we didn’t say yes to Yes Bank.
Most of our recommendations this week have been for the long term, such as Marico, Ambuja Cements, IndusInd Bank, Indian Hotels with its asset-light model, Trent, SIS Ltd and RBL Bank for those with high risk-appetite and Procter & Gamble Hygiene & Healthcare. We also looked at Dalmia Bharat for its strengthening balance sheet while Kotak Mahindra Bank is a core portfolio stock, for many excellent reasons.
A question that is often asked these days is the gulf between the relatively buoyant stock market and the devastation wrought by the pandemic’s second wave throughout the country. After all, as the poet Oliver Goldsmith wrote in ‘The Deserted Village’:
“Ill fares the land, to hastening ills a prey
Where wealth accumulates, and men decay.”
Prashant Jain, the CIO of HDFC Mutual Fund, told us in this interview that while the pandemic and the lockdowns will have a social effect, it won’t affect the economy much because the purchasing power of the masses is in any case limited. The upper middle class and the rich have been the least affected by the pandemic, as brought out in a report by Azim Premji University -- their savings are finding their way to the stock market. It is also true that listed companies have gained market share from SMEs and firms in the organised sector, another reason for markets to be supported. And then there is the belief that things will be all right again in a few months and pent-up demand will come roaring back, as it has done in the developed economies.
But the government supported the advanced economies with massive fiscal stimuli, unlike in India. Indeed, the government is now warning of a third wave. The demonetisation episode had shown that, despite some initial gains by the organised sector, ultimately it is aggregate demand that matters -- the April auto numbers already show the impact on two-wheeler and economy segment passenger vehicles. PMI data show that employment has been shrinking, even in the formal sector, for a year. In the face of such headwinds, will the consumption of the top third of households be enough to support aggregate demand? We will know soon enough.
I leave you with this delightful account
of the sometimes contradictory investment strategies used by the famous economist John Maynard Keynes. His most well-known account of the investment process, from Chapter 12 of his ‘The General Theory of Interest, Income and Money’, is this: “Professional investment may be likened to those newspaper competitions in which the competitors have to pick out the six prettiest faces from a hundred photographs, the prize being awarded to the competitor whose choice most nearly corresponds to the average preferences of the competitors as a whole; so that each competitor has to pick, not those faces which he himself finds prettiest, but those which he thinks likeliest to catch the fancy of the other competitors, all of whom are looking at the problem from the same point of view. It is not a case of choosing those which, to the best of one’s judgment, are really the prettiest, nor even those which average opinion genuinely thinks the prettiest. We have reached the third degree where we devote our intelligence to anticipating what average opinion expects the average opinion to be. And there are some, I believe, who practise the fourth, fifth and higher degrees.”
Take care,Manas Chakravarty