Through Arun Malhotra
Hiatus! The markets need to breathe; they have shown a dramatic increase with high intensity since March 2020. The pause could come in the form of a price correction or a time correction, but some kind of pause is needed. The euphoria in the small and mid-cap space is doomed to end, and if we’re to stick to the story, it always ends ugly. This time it will be no different and the retail business will be at the reception. The trigger comes, and it always comes from unknown sources.
Retailer participation in the cash market is currently at an all time high, close to 70%, reflecting the retail frenzy and the Robin Hood Effect. Stocks, which are rather unknown stocks, increase by 30-40% in a week, simply based on the flow of messages on social media. Some companies saw their operations shut down during the second wave, while stocks continue to roar.
We expect a short term correction which should help clear the foam. Quarterly numbers are likely to be weak and can act as a trigger for the fall. The second wave affected many families directly or indirectly, especially in level 2 and level 3 cities, which may have an impact on the consumption pattern in the short and medium term. FII flows were very volatile and turned negative late. Some of the fundamentals and macroeconomic factors are weak while valuations are also a cause for concern. For example, higher prices for raw materials, including steel, energy and chemicals, will cause inflationary prices on margins in all sectors and could also exert inflationary pressures in the economy. The economic shutdown has also resulted in increased inventory levels and slowing demand will make it difficult for businesses to pass the higher costs on to consumers.
Global factors do not look very encouraging either, with growth expected to slow in Europe and other parts of the world. The US balance sheet has reached historically high levels and appears unsustainable. The stimulus ushering in tons of liquidity into the financial system has led to a recovery in stock markets around the world. This surge in liquidity has to stop somewhere and cannot go on forever. Central banks have lent a hand to fuel the rally in stock markets, with lower interest rates and accommodative monetary policy, acting as a sort of catalyst for rising asset prices. We could see the rate tightening cycle begin 6-9 months from the last quarter of the current calendar year. Locally, India’s economy is slowly opening up as foreclosure restrictions are relaxed.
Macroeconomic factors according to the latest data from July 6 showed steady improvement in key indicators. While TPS collections were at 92,000 Crs for last month and were lower than expected, industrial indicators are slowly approaching pre-Covid levels with energy consumption at record levels as the index of mobility is always lower. About 22% of the population has been vaccinated and active cases are declining. India has so far vaccinated around 340 million of its population, including 64 million people who have been vaccinated with both doses. The increase in vaccination and the decrease in active cases will lead to a faster restoration of economic activity and a resumption of growth.
In terms of a sectoral approach, we believe that few sectors were directly affected by the second wave, namely FMCG, durable consumer goods, hospitality, tourism, airlines and others. consumer-related sectors that will face headwinds due to the economic foreclosure. The supply chain between industries has been affected, with logistical and economic disruptions, and on top of that, psychological fear due to Covid will lead to underinvestment and underconsumption on the part of consumers, and therefore lower growth and profitability for companies in these sectors.
The IT sector continues to show strong demand and momentum, driven by large contracts and the surge in digitization. We value the IT space as the high demand environment and steady gains of deals will ensure revenue visibility, while the availability of a skilled workforce, wage inflation and high attrition can put pressure on operating margins. The demand for cybersecurity and cloud services is also on the rise.
Another area we love from an investment perspective for 12-18 months is Financial Services, Mortgage Lenders, and Insurance. The quality of assets should remain stable for the sector. The other sector in which we are optimistic is that of Capital Goods, driven by the resumption of the Capex cycle. We have seen an increase in the prices of raw materials – cement, metals, energy, renewables and usage levels have been continuously on the rise. This should lead to increased investment, aided by PLI incentives in other sectors such as electronics, consumer durables and pharma.
I think retail demand will come with a vengeance, which will be the basis for new investment and the investment cycle to kick start. Another important dimension to look for is debt reduction, both on the balance sheets of companies and developers. A lot of capital has also been released from the resolutions of significant assets under NCLT. Favorable public spending and global demand as well as LIP incentives could accelerate the investment cycle and hence the preference for capital goods stocks. The benefits of structural reforms undertaken such as GST, RERA, NCLT, PLI, etc. are starting to show up in some pockets and overall Indian history is expected to move forward with some short-term pause.
(Arun Malhotra is Founding Partner and Portfolio Manager, CapGrow Capital Advisors. The views expressed are those of the author.)