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31 Mar 2018 by Research and Ranking
February’s Weakness Spills To March As Markets Continue Readjustment (Newsletter - Feb-Mar '18)

Indian markets gave up all their gains of 2018 and some more in February (and till mid-March). Mirroring a global sell off and disappointed by the proposal to levy a 10% LTCG tax, the markets corrected by almost 5% each for both Nifty50 and Sensex.

Infact at the time of writing (~23rd March), the Nifty50 is down about 5.06% on YTD basis and 10.17% from highs made in January. And the story is same with the Sensex.

sensex - feb-march-2018

The pain was further enhanced by discouraging global cues (Fed rate hike, rebound in global oil prices) and the already-gargantuan problem of PSU bank NPAs deepening further by detection of $2 billion fraud.

But all was not bad as the green shots are finally visible on the economic front. India's GDP grew at a multi-quarter high of 7.2% in Q3 2017-18 compared with 6.5% in Q2 2017-18.

PSU Banks hit by Frauds. More skeletons in Cupboard?

In what could become one of the biggest frauds of the Indian economy, government-owned Punjab National Bank got hit by almost Rs 13,500 Cr (or $2 billion+). The main culprits were diamond merchants Nirav Modi and Mehul Choksi. The modus operandi included but wasn’t limited to issuing fraudulent LOUs to accused’s companies without going through proper channels and bypassing mandatory requirements for transaction recording.

After detection of this large fraud, there have been a slew of similar but smaller frauds after RBI directed banks to file complaints against erring companies. This is after RBI announced a new bad-loan-resolution framework and abolished a plethora of existing loan-restructuring mechanisms. Markets naturally have been brutal on PSU banking pack and have thrown them off the cliff. Markets are afraid that the full picture is still not out in the open and there may be more bad news in store.

As was expected to happen after such a massive fraud, there is a growing voice to make big changes in the PSU banking landscape. But this is not as easy as it sounds.

We agree that if this had happened in a private bank, there would have been a run on the banks as there would have been no government support. And it might have compromised the entire banking system of the country.
Frauds in the banking systems happen everywhere. There is nothing new about them. But the bigger issue is that a fraud of this magnitude went undetected for several years and this is what has rattled everyone.
Many want the government to push for privatization of PSU banks. But it would be fair to say that this may not be the right time for such a move - both from the government’s perspective and also from a valuation standpoint. If possible, it would rather make sense to increase valuation (not easy given current context) and exit at a later stage, rather than making this a big distress sale. That’s not all. As we had highlighted in an earlier view too (link), the point here is not just about the ownership. Rather, it’s about the separation between ownership and management.

Consolidation is also something that is on the table for debate. Our view is that we don’t need 20+ PSU banks. But right now, once again it is not the right time for merging weaker banks with stronger ones and then, making the new entity overall weaker.

Fingers are being pointed at the regulator (RBI) too. Though it is correct to an extent, it is also true that the regulator itself cannot conduct the audit of every branch of every single bank in the country. Banks are audited at multiple levels like internal auditors, external auditors, concurrent auditors, statutory auditors, etc. So, blame cannot be put on RBI alone for this negligence (more so due to the size of the negligence). Regulators can show the direction, come up with frameworks. Expecting them to go the last mile is not a mature view.

RBI governor recently argued that the governance problem of public sector banks was due to the constitution of their boards. The boards of these banks are constituted with government’s handpicked nominees who only answer to the government. So practically speaking, their loyalty is not even to the bank on whose board they sit on. So effectively, they don’t even have to bother about the regulator. So RBI itself is handcuffed in such situations.

Fed Rate Hike Continues

Inspite of the recent rise of DIIs and retail participation in markets via equity funds, the impact of foreign funds cannot be under appreciated. So when the US central bank said that it would raise its benchmark interest rate citing a strengthened economic outlook, it is bound to raise some incremental concerns in markets like India. This is because higher interest rates in the US generally lead to outflow of foreign funds from the emerging markets.

The Fed has been raising rates slowly since 2015, moving away from the ultra-low levels put in place during the last financial crisis. They have further signaled that barring any unexpected developments, this rate hike cycle will continue for sometime. This is clearly a firming up of the future trajectory of policy tightening, as is also evident from the graph below:

Federal Funds Rate 2016-2018

There is another issue that may have a bigger impact than this rate hike (discussed below)

Beginning of a new Trade War?

In last couple of weeks, it seems that Donald Trump led US administration is taking initial steps to begin a trade war with various nations.

The US has announced fresh tariffs on certain imports from China. In addition, President Trump has promised or rather threatened that there will be many more of such trade sanctions in near future.

China being China, has responded by announcing its own tariffs on certain American imports. Infact, in his statement, the Chinese commerce ministry has made it very clear that "China doesn’t hope to be in a trade war, but is not afraid of engaging in one. China hopes the United States will pull back from the brink, make prudent decisions, and avoid dragging bilateral trade relations to a dangerous place." Some experts are of the view that in extreme cases, China may even consider using its holdings of dollars and treasury bonds in retaliatory action. Though prospects of such moves are extremely remote.

Any trade hostilities between economic superpowers is likely to impact geopolitical equations. There is no doubt about it. But to be fair, it is too early to see through the full extent of these moves. More so because it’s difficult to predict what someone like President Trump will do next.

It is also possible that these moves might be a precursor to future negotiations which US wants to have with China.

But as of now, it seems that the top targets of trade sanctions are the countries with which US has the biggest deficit - like China, Japan, Mexico and Germany. So, India may not be at the top of the list for time being. But a prolonged trade war or stress between big economies will make things difficult for India too.

R&R View on Economy & Markets

Indian equities have come off their recent peaks. And as is clearly evident, the markets are in a slow grind down.

This can be difficult for new market participants who are unaccustomed to market falls in recent years. But for experienced investors who have seen the ups and downs of markets, this is fairly normal.

Infact even after two discouraging months, the indices are down by only about 10%. And that is very important to understand. Strong bull markets regularly witness such intermittent falls of 10-20%. And that is exactly where the opportunities hide. A smart investor can buy stocks of fundamentally strong businesses at reasonable valuations after such periodic corrections. We have already written about this approach here.

A slew of events and a not-so-cheap valuation forced markets to correct and that is healthy from a long-term perspective. But despite this pullback, the current investment environment, coupled with solid reforms and a long runway for economy’s growth, Indian equity markets of today offers even more opportunities than were available till just two months back!

So this is not the time to be skeptical about the prospects for Indian equities. Rather, if someone was waiting on the sidelines having concerns about recent run-up and increased valuations, then this is a good opportunity to enter and increase exposure to equities now.

On that note, we end this newsletter and as always, appreciate you for taking time to read this message. Do share your views/comments by email/comment section below.

Team Equentis

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