The market feels really bad..and the feeling is correct. A lot of people have tried to give it a name: A bear? A roiling bear in a cyclical bull? A pull back? A correction. No matter what you call it, it isn’t fun.
Let’s start with the US:
There is growing concern among economists and market experts about the future for U.S. growth. As per Morgan Stanley, tax cuts benefits will fade and U.S. economic growth will slow from 3.5% in the third quarter to 2.6% this quarter. The calculations point to a 2018 overall growth rate of 2.9% slipping to 2.3% in 2019 (and no recession until maybe 2020). According to Marko Kolanovic, a top analyst at J.P. Morgan Chase, there’s a yawning chasm between the real U.S. economy and how markets are behaving. “Positive GDP and earnings are ‘reality,’ which is currently starkly disconnected from equity sentiment, valuation and positioning” (Kolanovic has a 3,100 target for the S&P 500).
The U.S. and China skirmish hasn’t been resolved yet, but there is some progress. At the recent G20 meeting, both presidents agreed to a 90-day trade truce – effectively postponing the new 25% tariffs (up from the current 10% tariffs) on $200 billion worth of Chinese imports. The official statement also noted that China will purchase agricultural, energy, industrial and other American products to help reduce the trade imbalance. The fact that President Trump and China’s President Xi agreed to a 90-day trade truce is a step in the right direction.
The US Fed hiked rates taking the target range for its benchmark funds to 2.5%. Central Bank officials now forecast two hikes in 2019 (down from three previously projected). While higher volatility that comes with less monetary support warrants somewhat lower equity valuations and lower risk positioning, the current decline is a disconnect from the fundamentals of economic growth and corporate profits. Pessimism is an easier sale than optimism and it is difficult to determine how long it will take for the connection to get restored.
Slower economic growth implies slower growth, not a decline in profits and not necessarily a steep decline in stock prices. Be patient.
Moving on to Europe:
Can the Brexit saga get any worse? Prime Minister May remains in power but the challenge to oust her has reduced her influence, especially in the European Union. She faces an uphill task of successfully implementing Brexit. The takeaway to note is that no matter what happens, the net result is a weak British pound.
Looking at the other major economies, both Italy and Germany suffered negative GDP growth in the third quarter. Italian unemployment surged by 139,000 in the past two months and its unemployment has reached 10.6%, up from 10.1% two months ago. France is one of the most heavily taxed countries in the developed world. As per OECD, France tops the chart with a total tax take equal to 46.2% of GDP in 2017 (the OECD average is 34.2%). France showed what can happen if taxes are raised (diesel in this case to combat climate change). The widespread reaction, series of “yellow vests” protests have damaged the French economy. French finance minister Bruno Le Maire reported that small retailers have seen revenue plunge between 20% and 40% and the hotel industry was seeing reservations down 15% to 25%.
So, the not only is the British pound weak, but the Euro is also fragile, triggering more capital flight into the U.S. dollar. The U.S. yield curve should normalize.
Closer home in India:
While the year started on a high, the second half has made investors feel that we are moving from one crisis to the next. A few words in particular have kept the market on tender hooks – IL&FS, NBFCs, Fiscal Deficit, US Rates (and therefore Indian rates and currency), RBI Governor, Elections. There is enough to fear and it doesn’t take much for the markets to dip, but the reverse is not holding true.
On the growth front, GDP growth slowed in Q2FY19 at 7.1% compared to 8.2% in Q1FY19. Within equity markets, FIIs (mid December) have been net sellers of Indian equities at c. USD4.6bn while DIIs recorded largest flows since 2008 of c. USD15.9bn. With crude prices settling at lower levels (read our crude outlook paper) the rupee recovered from its recent lows of 74. With easing liquidity in the bond market G-sec yields reduced to 7.4% (mid December). Fiscal deficit remains in question given the overhang of pre-election sops.
So where do we go from here?
Interest rates: One big driver is inflation and while rural inflation is under control, RBI is still watching urban inflation indicators which are on the higher side. The second driver is the interest rate parity between the USD and the INR – so the impact on the rupee/flows when the fed raises rates may impact rates here. Predicting rates is dangerous, however we can hazard a directional trend – that we are at/near the peak and over a 12 month period rates should decrease.
Macro indicators. Positive indicators are emerging. Credit growth is at c. 14% (the highest since December 2013) and deposit growth is close to c. 10% (close to pre demonitisation levels). Debt markets have stabilised and new commercial paper is being placed (yields were high, but liquidity is returning). Bank recapitalisation remains an overhang, but this has been there for long and will get resolved. The macro moves slowly, but it is beginning to move.
Elections: If predicting interest rates is dangerous, taking a call on elections – the less we say the better. But does it really matter? The Sensex in Jan 14, 1980 (when Late Mrs. Gandhi became PM) was 123, May 22 2004 (when Mr. Singh became PM) was 5,123 and May 26, 2014 (when Mr. Modi became PM) was 24,717. If the market is truly reflective of corporate India, then election results may bring volatility, but economic policy, growth and corporate profitability is not put to vote.
In summary:
While all is not hunky dory, there is no reason to believe the world is coming to an end. Sophisticated investors make returns because they know how to deal with uncertainty. Discipline is the first step to becoming sophisticated and the coming year will test our discipline to the max. Keep a regular track of your portfolio – investing with a long term horizon is critical, but it is regular portfolio monitoring that will generate alpha or at least prevent major downside movements.
Position yourself to take advantage of opportunities – the next 6 to 12 months will provide plenty.