Commentary
Commentary
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CY2022 - Here we come
While the second year of the pandemic resulted in more morbidities and cases than the first, fear
of the virus reduced dramatically. The paranoia of constant hand washing and surface cleaning,
which had become a regular routine in the lifestyle for most of us, gradually gave way to a sense of
"DEKHI JAAYEGI". If "normalization" meant washing hands, as irregularly as we did in 2019, then by the
end of CY2021, normalization had clearly set in. Mask wearing, also become a ritual to escape a monetary
fine rather than a practice to protect from the virus. Over the last six months more chins have been
protected by face masks than ever before in the history of mankind - a practice which could be seen from
US to India from Brazil to Iran!
The market similarly, stubbornly refused to comply with the law of gravity till the high of 18th October 2021. Market observers went almost hoarse shouting an imminent correction, till it finally occurred. How "healthy" such a correction would be, will unfold in the coming months!
Unlike the "institutions" driven market rally in 2009-20, this one has a strong retail undertone. Participation
from retail investors has upstaged professional investors since Apr'20. Impact of this is visible - Meme
stocks in the US, the "SIP" culture in high quality companies in India, and Option trading in Korea and
Taiwan. In this context, this rally looks more like the 1998-00 Tech "bubble" when day trading became
a buzzword. The other correlated factor is the average age of the retail participant - Millennials. Most
grizzly, grey haired market veterans have been cooling their heels on the sidelines, waiting for a "rational"
market, post a "much needed" correction - from Sept'20 onwards!
IPO - Pricy exit for PEs:
Another feature of the market since the rally started in Apr'20 has been the steady stream of IPOs, mainly companies going public with a partial/full exit from an existing financial investor (mainly a PE firm), or a promoter selling part of their holdings. Again, such a trend is global and not just limited to India. With a savvy Financial investor on the Selling side, Buyers, it would appear, should have been more cautious? Unfortunately, not. As investors, both professional and retail segment has lapped up these IPOs with an alacrity not registered for more than a decade. While results of these IPOs post listing remain mixed, the few outsized winners give hope to all participants, that the next one could score for them that outsized return! The deluge of IPOs, does not appear to be slowing down - as per Prime Database, over 50 companies have filed for SEBI clearance and another 33 are expected to file. Thankfully, with some debacles in the recent past, valuation ask may become more subdued (at least) in the near future.
Financials, lose their Mojo:
Private Sector Banks and NBFCs have been the biggest winners of the last decade - HDFC Bank's weight in Nifty between 2008-2020 went up 5x. For professional investors, such a trend reversal, can be catastrophic (ask us). A "habit" developed over the last decade is to start with Financials weight in the benchmark and then decide a marginal under or overweight, in 2018, the MF schemes outperforming their benchmarks had weightage of Financials at 40% +. While, foreigners have been constant sellers of Financials, the sustained buying by domestic institutional investors (DII), despite their emerging heft, has not been able to reverse the tide for Financials. Thus, the largest weightage across most portfolios drags down returns and relative performance.
IT Services, the only "KNIGHT" in shining armour:
IT Services, on the other hand, has been the only "knight" in shining armour. Though, valuations haven't reached the "bubble" levels of 1999-00, yet, a segment still expected to report earnings growth similar to Nifty now trades at 1.5x the Nifty multiples. Within IT services, mid-sized (by revenues) IT companies have outperformed their larger peers and have graduated to Large Cap (from Mid-Caps) in a short span of 18 months as investors are willing to pay premium for higher growth. Indian IT services, may or may not change the post pandemic world, it surely has changed the fortunes of the agile Fund Manager sitting pretty with a weightage of 20%+.
Inflation and unintended consequences:
Inflation, has returned! After hiding for almost a decade globally, though intermittently spotted in emerging markets like India, inflation returned. Over the last 18 months, inflationary pressure in Industrial Commodities, especially Steel and Cement, have helped companies operating in these segments clean up their balance sheet to an extent which even a Sci-Fi author may not have been able to ever forecast - from debt laden to net cash neutral by the end of FY 22!
Finally, Earnings returned with a bang:
After several false starts, earnings growth tepid since FY 16, returned with a bang in FY 21 and H1 FY 22. Equally important was the cycle of upgrades which has remained positive over the last five quarters, a welcome change from the previous cycle of downgrades.
The market similarly, stubbornly refused to comply with the law of gravity till the high of 18th October 2021. Market observers went almost hoarse shouting an imminent correction, till it finally occurred. How "healthy" such a correction would be, will unfold in the coming months!
Factors driving the markets:
IPO - Pricy exit for PEs:
Another feature of the market since the rally started in Apr'20 has been the steady stream of IPOs, mainly companies going public with a partial/full exit from an existing financial investor (mainly a PE firm), or a promoter selling part of their holdings. Again, such a trend is global and not just limited to India. With a savvy Financial investor on the Selling side, Buyers, it would appear, should have been more cautious? Unfortunately, not. As investors, both professional and retail segment has lapped up these IPOs with an alacrity not registered for more than a decade. While results of these IPOs post listing remain mixed, the few outsized winners give hope to all participants, that the next one could score for them that outsized return! The deluge of IPOs, does not appear to be slowing down - as per Prime Database, over 50 companies have filed for SEBI clearance and another 33 are expected to file. Thankfully, with some debacles in the recent past, valuation ask may become more subdued (at least) in the near future.
Financials, lose their Mojo:
Private Sector Banks and NBFCs have been the biggest winners of the last decade - HDFC Bank's weight in Nifty between 2008-2020 went up 5x. For professional investors, such a trend reversal, can be catastrophic (ask us). A "habit" developed over the last decade is to start with Financials weight in the benchmark and then decide a marginal under or overweight, in 2018, the MF schemes outperforming their benchmarks had weightage of Financials at 40% +. While, foreigners have been constant sellers of Financials, the sustained buying by domestic institutional investors (DII), despite their emerging heft, has not been able to reverse the tide for Financials. Thus, the largest weightage across most portfolios drags down returns and relative performance.
IT Services, the only "KNIGHT" in shining armour:
IT Services, on the other hand, has been the only "knight" in shining armour. Though, valuations haven't reached the "bubble" levels of 1999-00, yet, a segment still expected to report earnings growth similar to Nifty now trades at 1.5x the Nifty multiples. Within IT services, mid-sized (by revenues) IT companies have outperformed their larger peers and have graduated to Large Cap (from Mid-Caps) in a short span of 18 months as investors are willing to pay premium for higher growth. Indian IT services, may or may not change the post pandemic world, it surely has changed the fortunes of the agile Fund Manager sitting pretty with a weightage of 20%+.
Inflation and unintended consequences:
Inflation, has returned! After hiding for almost a decade globally, though intermittently spotted in emerging markets like India, inflation returned. Over the last 18 months, inflationary pressure in Industrial Commodities, especially Steel and Cement, have helped companies operating in these segments clean up their balance sheet to an extent which even a Sci-Fi author may not have been able to ever forecast - from debt laden to net cash neutral by the end of FY 22!
Finally, Earnings returned with a bang:
After several false starts, earnings growth tepid since FY 16, returned with a bang in FY 21 and H1 FY 22. Equally important was the cycle of upgrades which has remained positive over the last five quarters, a welcome change from the previous cycle of downgrades.
Yeh toh thik hai, what about CY2022 Outlook?
The following factors should not be overlooked by investors going into CY2022:
Fear the politics?
CY2022 sees the return of grueling state elections, 7 of them. Of which 5 would be held in H1 CY22. While elections by themselves may not trigger a market collapse, volatility could be more pronounced in CY22 as compared to earlier years. Equally worrying could be a well-meaning, though market unfriendly measure like LT Capital gains tax re-imposition in the Union Budget of 2018.
Inflation and interest rates:
After the unintended consequence of inflation, as registered by metal and cement companies, the more negative impact of inflation could be felt during CY22 - rate hikes. Already, Central Banks across dispersed countries ranging from Brazil to England have announced rate hikes. The course which the US Fed is expected to take during CY22 could have a rippling effect across the globe. Unlike the past, current action/statements of Central banks across the world appear to be asynchronous - with ECB and Japan willing to wait before contemplating a rate hike; China PCB, cutting rates to boost growth and tackle the Real Estate debacle (similar to Indian real estate market slowdown post CY15); while US Fed is willing to consider a rate hike (or more than one). RBI amidst these distinct positions taken globally, would most probably follow the US Fed? Or not? My own take, till this pandemic does not get "converted" to an "endemic" - with either reducing virility of the virus with each new strain or the emergence of a credible medical cure with reduced hospitalization & morbidities - pray Molunpiravir or Paxlovid or some other antivirals succeed - Central Bankers' will focus on the "bark rather than bite"! Most Central Banks will be "willing" to be behind the inflation curve, expecting (and praying) stronger supply to check rising prices. In a pandemic, the economic recovery is too fragile to be tested with rate hike.
India's moment? Will India emerge as a destination for global supply?
While the last two decades have clearly implanted China as the manufacturing hub for the world, the recent geo political tensions, provide India with an opportunity to move from the side stage of global supply to an emerging and central player in the global supply chain for the future. The Government's PLI schemes could be a critical cog in this equation. However, given the wide gamut of industries which the Government has identified -from semi-conductors to Pharmaceutical API, to electric vehicles - our bureaucratic excellence, may yet focus its energies on developing world beating schemes rather than helping create the environment which nurtures world beating companies. The cynic in me, for once, wants to be proven wrong.
There are IPOs and then there will be LIC IPO:
By most indications, LIC ipo should hit the market before Mar'22. Post listing, on a free-float adjusted basis, LIC will not emerge as the largest financial stock. However, it will have a significant presence. An important sidelight of the market rally since Apr'20 has been the comeback of PSU stocks. While, such a rally may have been triggered by the intense valuation discount which made these companies attractive for investors. To sustain this uptrend, the Government needs to use the LIC IPO as an opportunity to communicate a blueprint of its long term strategy for wealth creation through listed PSU companies. Such a communique could further boost investor interest in these companies. The process of listing LIC surely has been an arduous affair, kudos to all involved. However, the real challenge - to sustain and grow its market cap post the listing - will start soon, this could also have a rub off effect on other listed PSU companies.
Finally, earnings:
Will CY22 be like CY06 or CY11 - After the initial phase of market uptrend - lasting 500-600 days, the next 600 days depend on the trajectory of earnings growth. For this time to be similar to CY06, we have relatively strong macroeconomic indicators - current account deficit is less than 1.5% of GDP; inflation is modest by historical context; Banks credit growth cycle has yet to begin, Banking system CD ratio is comfortable at 73-74%, exports growth is higher than imports; Corporate balance sheets have shown a significant deleveraging. Thus, rate hikes will be modest and measured. Finally, earnings growth cycle is still strong with upgrades outnumbering downgrades. This gives us the most comfort that despite the increasing volatility, the underlying trend should remain intact.
CY22 could be a year where the markets revisit a higher level of volatility, a feature missing though most part of the period since April'20. While, the underlying trend should remain positive, there could be periods of markets "consolidating". Second half of CY22, could be better than the first. During such phases of increased volatility, we would recommend - Aggressive Hybrid; Balanced Advantage, Flexicap and Largecap as products for the conservative/cautious investor. For the more experienced aggressive investor's, Value fund would be the recommendation. From a long-term wealth creation perspective, an investor could take a goal based approach for a rewarding investment experience. While, staggered approach could inculcate the habit of investing in a more disciplined manner; one could take exposure through lumpsum investment as well based on the risk tolerance level and asset allocation approach.
Source: Bloomberg
Missing: A Year In Review
"It's your face I'm looking for
On every street".
- Mark Knopfler
The writing of a year end investment note is almost by definition a process of reminiscing. In most years this is simple and almost workmanlike. You go back in your mind and review all major market moving events, the evolution of parameters relevant for your line of business. If memory falters, you reach for your Bloomberg terminal or previous written commentaries. Towards the end, you pretend (as you do every year) that just for the time being a magic crystal ball has come into your possession. This allows you to rise above your current short-term views and leanings to forecast the year ahead, possibly accounting for breaks in patterns and trends that are in dominance at the time of your writing. Mercifully, since you are one of some fifty others who are doing the same thing, the reader (if you're lucky enough to have any of those) largely forgets about these commentaries soon after the skimming through; thereby allowing you to start all over again at the next year end, and without subjecting your previous views to an uncomfortable audit against actual market outturns.
There's no room for emotions in the above process. Just like the turning of the world, it must happen. And yet there are years where reminiscing isn't that easy, where neither the terminal nor your previous commentaries can help because the issue isn't at all that you can't remember. Rather, as you start to relive the memories of the year, you find with alarm your mind frame turning in a way completely unsuited to the writing of an investment note.
You get up and stand at the window. The mood you're in would be consistent with an overcast sky and rain drops tracing their way across the pane. Instead there's bright sunshine outside and the world keeps turning with all the usual bedlam emanating from its axis. You look back at your waiting laptop. The prompt mocks you with its incessant flashing from the top of a blank page. You sigh and sit back down. Maybe you're still whole or maybe the year has taken pieces out of you. The deadline doesn't care about what is missing in you.
While one has to accept getting back to the humdrum, one still struggles to generate the optimism that usually creeps into such year-end writings. Thus, and with due apologies to the reader(s?) for testing both patience and disposition, this note is themed around what's been missing.
Missing: The Earlier Fed Framework
The Fed would most likely be wondering by now as to how it got to this place of disequilibrium. CPI is close to 7% and it is still expanding balance sheet while keeping policy rates at effective lower bound. To be fair this characterization is a bit dramatic, since inflation will surely begin to fall as some of the commodity spikes roll over and the base effect kicks in. That said, it is likely that even as it falls from the current lofty levels, inflation still remains firmer than what the Fed may be comfortable with for longer. This is because stickier components of inflation, including rents and wages, are now rising. There's also a risk that higher for longer inflation feeds more into expectations thereby becoming somewhat self-reaffirming. No matter how one cuts it, the current monetary policy set up looks quite inappropriate and the US system seems the most in dis-equilibrium amongst all major markets currently.
The question posed above is thus a valid one: How did the Fed get to this place? It will be recalled that the Fed translated its experience of the labor market in the last few years into a revamped monetary policy framework. This involved deliberate modest overshoots on inflation for some period to make up for previous shortfalls, as well as being reactive rather than being proactive. The experience driving this suggested that labor markets could get much tighter than previously thought (unemployment rate could fall lower than what the Fed considered trend rate earlier) and yet there would be no broad-based signs of wage pressure. Thus armed, it applied this to the post pandemic world. In effect it was targeting a single variable, employment, safe in the knowledge that persistent inflation wouldn't be a problem at least till the labor market had reclaimed its pre-pandemic state. In the process, it seemed content to term all origins of inflation as transitory. However, what it probably didn't account for till very recently is that the very nature of the labor market may have changed. This may have been owing to behavioral change triggered by the pandemic but probably more importantly owing to the very large fiscal transfers made to the public, a significant part of which translated into a savings buffer. Whatever the reasons, the labor market in various parameters is already feeling much tighter than it was pre-pandemic even as the headline unemployment rate is still somewhat higher than what it was then.
More generally, while supply bottlenecks are a global phenomenon, the problem is particularly acute in the US as there has been a surge in demand as well. Apart from forced savings during pandemic and the resultant pent-up demand, a US-specific factor is the very large cumulative fiscal stimulus that has been delivered since the start of the pandemic. At a top down level, the implication should have been obvious: an economy getting pushed way beyond trend rate of growth, in this case as a result of an almost over-the-top stimulus program, would obviously suffer imbalances. However, this also has the benefit of hindsight and it must be said even today there is a set of notable voices who think most of the current inflation will indeed prove to be transitory. Nevertheless, had the Fed still operated off its earlier framework and would be looking to anticipate inflation rather than react to it, it is possible that it would have commenced policy normalization much sooner than what is actually the case today. Importantly, now that it is fully 'awake' to this reality, the prospects of faster normalization are now very much on the table with consequent implications for the rest of the world, especially developing markets. What is missing, however, also is any discernable concern in the bond markets so far. Thus longer term yields in the US, and elsewhere in the developed world, continue to languish in earlier ranges and yield curves have flattened. Thus the markets seem to be still signaling comfort with relatively lower terminal rates in this cycle, even as they expect the journey of normalization to start soon enough.
Missing: A Global Equilibrium
Simplistically speaking one can visualize a global financial equilibrium as follows: The developed markets (DMs) led by the US are the custodians for global financial conditions (loosely defined as how easy or difficult funds flows are with all associated implications on cost as well as availability) while the emerging markets (EMs) lead growth. This is the natural dynamic since DMs print the so-called reserve currencies of the world but have low trend growth rates. So capital naturally looks for avenues around the world. EMs in turn have higher trend growth and are natural magnets for this capital. The easy financing conditions in the first phase of a upcycle also provide an important tailwind to a nascent growth recovery in the new upturn. Then as the growth cycle becomes self-sustaining financial conditions start tightening as DM central banks move to normalize policy. However, this can be easily digested by now as growth is robust enough to absorb some financial tightening, so long as it isn't disruptive.
What is described above is, like mentioned, somewhat simplistic but nevertheless represents an important framework from which to view the current scenario. Owing to a very large fiscal response and a significantly different Fed reaction function, the US has been both the growth driver for the world as well as the chief custodian for easy financial conditions over the last year or so. Thus Fed has expanded balance sheet aggressively, and real rates have been driven to historic lows, while the government has delivered a massive fiscal injection. While this has been good while it has lasted, it can be clearly seen that this dynamic is unsustainable. In fact 2022 may very well be about the unsustainability manifesting itself. The base case (as well as hope) is that this unwind happens in degrees. This will still mean that the going is tougher than before, but will nevertheless provide enough time for the world to readjust. Thus, financial conditions for the world led by US policy normalization would gradually tighten. EMs are generally in better shape from an external account standpoint and policy makers are much more keenly aware of external risks. This should allow for a relatively smooth adjustment process. The fiscal impulse in the US will slow but growth should still be relatively supported both from accumulated savings of households as well as from future (albeit lighter) fiscal endeavors. Meanwhile, Chinese policy is signaling a shift towards supporting growth which should allow the 2nd largest economy to start shouldering some of the global growth burden (even with weaker growth linkages with the rest of the world than before). This should enable the world to downshift towards a slower but more sustainable growth rate and with somewhat tighter but again more realistic levels of global financial conditions.
However, the above doesn't mean that things cannot get disruptive. Risks include inflation pressures potentially leading to a more hawkish than currently expected Fed policy response thereby tightening financial conditions more disruptively, successive virus waves not allowing a freer growth runway, etc. Irrespective this has risk management implications for EM policy makers, including for central banks. We will return to this topic below.
Missing: An Equitable Impact From the Crisis
The notorious "K" shaped recovery format doesn't need new elaboration. Briefly it implies that the economic impact on the well-to-do firms and individuals, who could preserve incomes and production capacities, was almost absent. Indeed, it even resulted in forced savings and market share gains thus allowing these economic agents to come back stronger. However, the situation has been dramatically different for those who couldn't preserve incomes or production capacities. Here the economic impact, especially after health expense burdens, has been sustained and crippling. Thus, while financial markets and headline economic narratives have celebrated the return of the 'upper arm of the "K"', medium term assessments (even economic ones, let alone the welfare urgency) have to take into account the aggregate impact as well. DMs were able to provide a much better fiscal cushion thereby compressing the "K" (although the response was arguably clearly excessive in the US with attendant distortions as being witnessed currently). EMs, on the other hand, have been more fiscally constrained and even an exact assessment of the help needed would have been challenging given the dominance of the unorganized sector. In India as well, fiscal policy had clear constraints and which it largely succeeded in optimizing admirably.
There are potential implications from both the crisis as well as policy response from a perspective of macro- economic aggregates. Some of these themes are common across the world: the supply side congestions, exaggerated goods demand (both as a result of the pent-up effect as well as from constraints in consuming services), the slower return of labor, etc. In some economies the effects from these are getting accentuated as a result of the policy response; case in point is the US where demand-supply mismatches including in the labor market may have gotten starker owing to hyper monetary and fiscal stimuli. In the case of India, the macro- economic effect may be quite different, but nevertheless very important. While this is purely speculative as of now, but it is possible that the supply side (or productive capacity) destruction in India has been large given the larger presence of smaller unorganized producers and with obvious constraints on fiscal as noted above. If true, this would have policy implications for how to look at the ongoing demand revival: not just in relation to where we are versus a pre-pandemic point in time but also in relation to the near- term absorptive capacity of the system. The recent widening in the trade account, and to a lesser extent the stickiness in core inflation, if sustained would definitely point to the need for a closer look from monetary policy into a sustainable demand versus supply equilibrium.
Missing: The Concept Of Marginal Utility In Monetary Policy
We keep returning to the Fed because of the notably large, unprecedented in recent history, disequilibrium in the US economy currently. A large part of this, as explained in an earlier section above, is probably owing to the revised framework. This is partly probably just plain bad luck, since it would have been very difficult to anticipate the framework would so quickly be subject to such a large shock. What is more difficult to attribute purely to misfortune is the continued insistence of the Fed to refuse to account for increasingly persuasive evidence till almost the mid of November. Beyond a point, such calibrations aren't about a particular view but rather only about allowance for a probabilistic distribution of other possibilities in the face of evidence that is increasingly turning somewhat inconsistent with what one has so far been thinking. Looked at another way it is about a greater focus on the concept of marginal utility, or indeed on risk management.
Thus given that the assessment is about taking the first baby-steps out of an extreme level of accommodation, presenting the argument as a binary one is probably patently false. An earlier recognition to taper, while continuing to delink it to actual rate hikes, may have probably been a better acknowledgment of the evolving distribution of risks as well as that of the rapidly diminishing marginal utility of continued accommodation at those levels. Whereas now the Fed is largely hostage to the narrative, an unenviable position for any central bank that is fundamentally supposed to drive expectations and from there actual economic outcomes.
To be clear, the situation in India is nowhere like that in the US. At the same time, the basic concepts still apply. It is probably not appropriate to position the argument as a binary one (growth needs support and will fall off if policy tightens or words to that effect) when the start point is still an emergency levels of overnight rates. Similarly, both the points about the evolving distribution of risks (again irrespective of who is ultimately right or wrong) as well as marginal utility of the current overnight rate would both suggest a greater recognition towards a need to continue to move forward in the normalization process. To be clear, and even as the commentary remains solidly oriented towards supporting growth, RBI is well on its way towards normalization. The tool of choice thus far is the so-called variable rate reverse repo (VRRR) for liquidity absorption and setting an effective blended return on excess liquidity for banks very close to the repo rate. It is hoped that this percolates over a period of time to other market participants as well who don't have access to the RBI window. We also think that even as RBI has largely discontinued support for the bond market for now, it may still need to be sporadically present over the course of the year to ensure that the yield curve 'evolves in an orderly fashion' even as the journey continues towards normalizing the effective overnight rate. Thus while the inherent steepness of the yield curve is an obvious cushion, it is only a necessary and not a sufficient condition for orderly evolution of the yield curve given the relative lack of depth in demand relative to the supply of bonds likely in the year ahead.
Missing: Nuance In Investment Narratives
One must admit to some 'force-fitting' in these section titles in line with the theme of the investment note. For example, the suggestion that nuance is missing in all investment narratives will be a great exaggeration. Further, if one is critiquing the universe then one must acknowledge one's own investment views as a subset of the object of criticism! Recovering from this unexpected bout of self-admonishment however, our inspiration behind pursuing this section title can be best summarized in this quote often attributed to Albert Einstein:
"Everything should be made as simple as possible, but not simpler".
The dominant theme in fixed income market over most of the past year has understandably been safeguarding against the rising rates cycle ahead. In connection with this, floating rate funds have found topical interest during this period. This also is understandable and indeed the general experience so far appears to have been satisfactory. However, one still laments the lack of nuance in many such narratives, a deficiency that may yet lead to differentials cropping between expectations and reality. Thus both that interest rate swaps are already building a significant rate tightening cycle ahead as well as the fact that floating rate bonds have an element of their performance that is much beyond that embedded in the coupon reset frequency are either ignored or at best glossed over. As another instance, the traditional approach to defense via increasing allocation to money market funds isn't stress tested for the fact that, given the steepness of the curve, it is actually the money market points that are the most susceptible to volatility (in terms of yield change, obviously with lower price impact given their very low duration) and hence some sort of a bar-bell (exposure both to intermediate maturity as well as overnight) may actually return better outcomes on a risk-adjusted basis. Yields to maturity (YTMs) still get preponderance rather than holding period returns (HPRs) while simultaneously concerns with respect to the macro environment and associated prospects of market volatility are discussed.
The loss of nuance is probably consistent with that in other areas of discussion, including in monetary policy as discussed in the previous section.
And Finally...Missing: A Word Count Cap For This Note!
If one is left a reader or two laboring on still, then one is grateful. Reminiscing is dangerous business. You never know how long or dangerous a path it takes you down. In the present instance, the road seems to already have stretched long and tedious and one must therefore look to bring proceedings towards an end. Ironical almost, but the reader would note that in a year end commentary built around the theme of missing what is perhaps most starkly missing is a prognosis on the year ahead. The endeavor instead has been to recap, paint the framework, provide a base case and then be open to the idea that there is a probability distribution to outcomes.
To recap, DMs led by the US have been both the growth engine as well as custodian of financial conditions of the world. This makes for an unsustainable equilibrium as one or both of these balls can very easily get dropped. The couple of years ahead will likely see a transition towards the more traditional set up where economies fall back towards respective trend rates of growth (which means that skew moves back in favor of EMs) while financial conditions adjust towards a more sustainable level (from extreme accommodation currently). However, this will still likely imply lower aggregate global growth rates and the risk of some mini-accidents / shocks in the process of transition can never be ruled out, even as they aren't the base case. One of these could be a risk of overtightening of financial conditions with consequent effects on EMs. Another could be that the baton falls somewhere in between the growth handover from DMs to EMs.
Given these, and the range of outcomes that they imply, it is high time that central banks turn towards risk management (as they have in certain regions) from the unequivocal champions of growth that they have been thus far. To be clear, most of this championing has been necessary and desirable, but there is always a point that necessitates basic considerations of risk management and acknowledging the probability distribution of outcomes. The place where travel is starting from and the associated rapidly diminishing marginal utility of staying there even if the base case is right, have to be additional considerations. The US Fed seems now seized of this consideration and the year ahead looks one of policy normalization, even as the bond markets continue to signal that 'well begun will indeed be half done'. Our own RBI has begun too even as commentary remains quite dovish thus far. Going forward, policy normalization may still require sporadic bond market interventions in order to control the pace of pass through and in line with the often expressed desire for an orderly evolution of the yield curve.
The year ahead will thus likely be one of this transition and hence will likely continue to throw up significant volatility. A fixed income strategy that seems durable to us for the times is the idea of bar-belling where cash / near cash is balanced with intermediate maturity points (for example 3 to 6 years) to arrive at one's aggregate target maturity in line with investment horizon and risk appetite. This allows for benefitting from the steep yield curve as well as preserves some flexibility. Then as the rate cycle matures and the yield curve flattens somewhat, the cash component can be deployed at appropriate maturity points thereby elongating maturity on the whole book. The narrative on credit is much better, but spreads for the most part are quite low especially when compared with the relatively higher term spreads on offer (one is compensation for taking credit risk, the other for taking duration risk and hence an analysis of relative attractiveness is relevant). Given this, and the continued prospects for volatility as we turn the year, our preference would remain for a quality-oriented bar-bell. Active duration funds, granted the attendant two-way risks from attempts at 'alpha' generation, may also be appropriate provided the allocation is patient and is manageable in size so as to be able to withstand intermittent volatility.
It's time then to move on from this year. It has taken much from many and has caused people shaped pieces to go missing in a lot of hearts. If yours is one such heart, then here's to hoping that there are still pieces left that hold you together, that there's a place that still exists if not of laughter then at least for a quiet refuge from time to time, that there's room for hope, and that these most sincere best wishes for a new year actually mean something to you.
Wishing You A Very Happy New Year.
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On every street".
- Mark Knopfler
The writing of a year end investment note is almost by definition a process of reminiscing. In most years this is simple and almost workmanlike. You go back in your mind and review all major market moving events, the evolution of parameters relevant for your line of business. If memory falters, you reach for your Bloomberg terminal or previous written commentaries. Towards the end, you pretend (as you do every year) that just for the time being a magic crystal ball has come into your possession. This allows you to rise above your current short-term views and leanings to forecast the year ahead, possibly accounting for breaks in patterns and trends that are in dominance at the time of your writing. Mercifully, since you are one of some fifty others who are doing the same thing, the reader (if you're lucky enough to have any of those) largely forgets about these commentaries soon after the skimming through; thereby allowing you to start all over again at the next year end, and without subjecting your previous views to an uncomfortable audit against actual market outturns.
There's no room for emotions in the above process. Just like the turning of the world, it must happen. And yet there are years where reminiscing isn't that easy, where neither the terminal nor your previous commentaries can help because the issue isn't at all that you can't remember. Rather, as you start to relive the memories of the year, you find with alarm your mind frame turning in a way completely unsuited to the writing of an investment note.
You get up and stand at the window. The mood you're in would be consistent with an overcast sky and rain drops tracing their way across the pane. Instead there's bright sunshine outside and the world keeps turning with all the usual bedlam emanating from its axis. You look back at your waiting laptop. The prompt mocks you with its incessant flashing from the top of a blank page. You sigh and sit back down. Maybe you're still whole or maybe the year has taken pieces out of you. The deadline doesn't care about what is missing in you.
While one has to accept getting back to the humdrum, one still struggles to generate the optimism that usually creeps into such year-end writings. Thus, and with due apologies to the reader(s?) for testing both patience and disposition, this note is themed around what's been missing.
Missing: The Earlier Fed Framework
The Fed would most likely be wondering by now as to how it got to this place of disequilibrium. CPI is close to 7% and it is still expanding balance sheet while keeping policy rates at effective lower bound. To be fair this characterization is a bit dramatic, since inflation will surely begin to fall as some of the commodity spikes roll over and the base effect kicks in. That said, it is likely that even as it falls from the current lofty levels, inflation still remains firmer than what the Fed may be comfortable with for longer. This is because stickier components of inflation, including rents and wages, are now rising. There's also a risk that higher for longer inflation feeds more into expectations thereby becoming somewhat self-reaffirming. No matter how one cuts it, the current monetary policy set up looks quite inappropriate and the US system seems the most in dis-equilibrium amongst all major markets currently.
The question posed above is thus a valid one: How did the Fed get to this place? It will be recalled that the Fed translated its experience of the labor market in the last few years into a revamped monetary policy framework. This involved deliberate modest overshoots on inflation for some period to make up for previous shortfalls, as well as being reactive rather than being proactive. The experience driving this suggested that labor markets could get much tighter than previously thought (unemployment rate could fall lower than what the Fed considered trend rate earlier) and yet there would be no broad-based signs of wage pressure. Thus armed, it applied this to the post pandemic world. In effect it was targeting a single variable, employment, safe in the knowledge that persistent inflation wouldn't be a problem at least till the labor market had reclaimed its pre-pandemic state. In the process, it seemed content to term all origins of inflation as transitory. However, what it probably didn't account for till very recently is that the very nature of the labor market may have changed. This may have been owing to behavioral change triggered by the pandemic but probably more importantly owing to the very large fiscal transfers made to the public, a significant part of which translated into a savings buffer. Whatever the reasons, the labor market in various parameters is already feeling much tighter than it was pre-pandemic even as the headline unemployment rate is still somewhat higher than what it was then.
More generally, while supply bottlenecks are a global phenomenon, the problem is particularly acute in the US as there has been a surge in demand as well. Apart from forced savings during pandemic and the resultant pent-up demand, a US-specific factor is the very large cumulative fiscal stimulus that has been delivered since the start of the pandemic. At a top down level, the implication should have been obvious: an economy getting pushed way beyond trend rate of growth, in this case as a result of an almost over-the-top stimulus program, would obviously suffer imbalances. However, this also has the benefit of hindsight and it must be said even today there is a set of notable voices who think most of the current inflation will indeed prove to be transitory. Nevertheless, had the Fed still operated off its earlier framework and would be looking to anticipate inflation rather than react to it, it is possible that it would have commenced policy normalization much sooner than what is actually the case today. Importantly, now that it is fully 'awake' to this reality, the prospects of faster normalization are now very much on the table with consequent implications for the rest of the world, especially developing markets. What is missing, however, also is any discernable concern in the bond markets so far. Thus longer term yields in the US, and elsewhere in the developed world, continue to languish in earlier ranges and yield curves have flattened. Thus the markets seem to be still signaling comfort with relatively lower terminal rates in this cycle, even as they expect the journey of normalization to start soon enough.
Missing: A Global Equilibrium
Simplistically speaking one can visualize a global financial equilibrium as follows: The developed markets (DMs) led by the US are the custodians for global financial conditions (loosely defined as how easy or difficult funds flows are with all associated implications on cost as well as availability) while the emerging markets (EMs) lead growth. This is the natural dynamic since DMs print the so-called reserve currencies of the world but have low trend growth rates. So capital naturally looks for avenues around the world. EMs in turn have higher trend growth and are natural magnets for this capital. The easy financing conditions in the first phase of a upcycle also provide an important tailwind to a nascent growth recovery in the new upturn. Then as the growth cycle becomes self-sustaining financial conditions start tightening as DM central banks move to normalize policy. However, this can be easily digested by now as growth is robust enough to absorb some financial tightening, so long as it isn't disruptive.
What is described above is, like mentioned, somewhat simplistic but nevertheless represents an important framework from which to view the current scenario. Owing to a very large fiscal response and a significantly different Fed reaction function, the US has been both the growth driver for the world as well as the chief custodian for easy financial conditions over the last year or so. Thus Fed has expanded balance sheet aggressively, and real rates have been driven to historic lows, while the government has delivered a massive fiscal injection. While this has been good while it has lasted, it can be clearly seen that this dynamic is unsustainable. In fact 2022 may very well be about the unsustainability manifesting itself. The base case (as well as hope) is that this unwind happens in degrees. This will still mean that the going is tougher than before, but will nevertheless provide enough time for the world to readjust. Thus, financial conditions for the world led by US policy normalization would gradually tighten. EMs are generally in better shape from an external account standpoint and policy makers are much more keenly aware of external risks. This should allow for a relatively smooth adjustment process. The fiscal impulse in the US will slow but growth should still be relatively supported both from accumulated savings of households as well as from future (albeit lighter) fiscal endeavors. Meanwhile, Chinese policy is signaling a shift towards supporting growth which should allow the 2nd largest economy to start shouldering some of the global growth burden (even with weaker growth linkages with the rest of the world than before). This should enable the world to downshift towards a slower but more sustainable growth rate and with somewhat tighter but again more realistic levels of global financial conditions.
However, the above doesn't mean that things cannot get disruptive. Risks include inflation pressures potentially leading to a more hawkish than currently expected Fed policy response thereby tightening financial conditions more disruptively, successive virus waves not allowing a freer growth runway, etc. Irrespective this has risk management implications for EM policy makers, including for central banks. We will return to this topic below.
Missing: An Equitable Impact From the Crisis
The notorious "K" shaped recovery format doesn't need new elaboration. Briefly it implies that the economic impact on the well-to-do firms and individuals, who could preserve incomes and production capacities, was almost absent. Indeed, it even resulted in forced savings and market share gains thus allowing these economic agents to come back stronger. However, the situation has been dramatically different for those who couldn't preserve incomes or production capacities. Here the economic impact, especially after health expense burdens, has been sustained and crippling. Thus, while financial markets and headline economic narratives have celebrated the return of the 'upper arm of the "K"', medium term assessments (even economic ones, let alone the welfare urgency) have to take into account the aggregate impact as well. DMs were able to provide a much better fiscal cushion thereby compressing the "K" (although the response was arguably clearly excessive in the US with attendant distortions as being witnessed currently). EMs, on the other hand, have been more fiscally constrained and even an exact assessment of the help needed would have been challenging given the dominance of the unorganized sector. In India as well, fiscal policy had clear constraints and which it largely succeeded in optimizing admirably.
There are potential implications from both the crisis as well as policy response from a perspective of macro- economic aggregates. Some of these themes are common across the world: the supply side congestions, exaggerated goods demand (both as a result of the pent-up effect as well as from constraints in consuming services), the slower return of labor, etc. In some economies the effects from these are getting accentuated as a result of the policy response; case in point is the US where demand-supply mismatches including in the labor market may have gotten starker owing to hyper monetary and fiscal stimuli. In the case of India, the macro- economic effect may be quite different, but nevertheless very important. While this is purely speculative as of now, but it is possible that the supply side (or productive capacity) destruction in India has been large given the larger presence of smaller unorganized producers and with obvious constraints on fiscal as noted above. If true, this would have policy implications for how to look at the ongoing demand revival: not just in relation to where we are versus a pre-pandemic point in time but also in relation to the near- term absorptive capacity of the system. The recent widening in the trade account, and to a lesser extent the stickiness in core inflation, if sustained would definitely point to the need for a closer look from monetary policy into a sustainable demand versus supply equilibrium.
Missing: The Concept Of Marginal Utility In Monetary Policy
We keep returning to the Fed because of the notably large, unprecedented in recent history, disequilibrium in the US economy currently. A large part of this, as explained in an earlier section above, is probably owing to the revised framework. This is partly probably just plain bad luck, since it would have been very difficult to anticipate the framework would so quickly be subject to such a large shock. What is more difficult to attribute purely to misfortune is the continued insistence of the Fed to refuse to account for increasingly persuasive evidence till almost the mid of November. Beyond a point, such calibrations aren't about a particular view but rather only about allowance for a probabilistic distribution of other possibilities in the face of evidence that is increasingly turning somewhat inconsistent with what one has so far been thinking. Looked at another way it is about a greater focus on the concept of marginal utility, or indeed on risk management.
Thus given that the assessment is about taking the first baby-steps out of an extreme level of accommodation, presenting the argument as a binary one is probably patently false. An earlier recognition to taper, while continuing to delink it to actual rate hikes, may have probably been a better acknowledgment of the evolving distribution of risks as well as that of the rapidly diminishing marginal utility of continued accommodation at those levels. Whereas now the Fed is largely hostage to the narrative, an unenviable position for any central bank that is fundamentally supposed to drive expectations and from there actual economic outcomes.
To be clear, the situation in India is nowhere like that in the US. At the same time, the basic concepts still apply. It is probably not appropriate to position the argument as a binary one (growth needs support and will fall off if policy tightens or words to that effect) when the start point is still an emergency levels of overnight rates. Similarly, both the points about the evolving distribution of risks (again irrespective of who is ultimately right or wrong) as well as marginal utility of the current overnight rate would both suggest a greater recognition towards a need to continue to move forward in the normalization process. To be clear, and even as the commentary remains solidly oriented towards supporting growth, RBI is well on its way towards normalization. The tool of choice thus far is the so-called variable rate reverse repo (VRRR) for liquidity absorption and setting an effective blended return on excess liquidity for banks very close to the repo rate. It is hoped that this percolates over a period of time to other market participants as well who don't have access to the RBI window. We also think that even as RBI has largely discontinued support for the bond market for now, it may still need to be sporadically present over the course of the year to ensure that the yield curve 'evolves in an orderly fashion' even as the journey continues towards normalizing the effective overnight rate. Thus while the inherent steepness of the yield curve is an obvious cushion, it is only a necessary and not a sufficient condition for orderly evolution of the yield curve given the relative lack of depth in demand relative to the supply of bonds likely in the year ahead.
Missing: Nuance In Investment Narratives
One must admit to some 'force-fitting' in these section titles in line with the theme of the investment note. For example, the suggestion that nuance is missing in all investment narratives will be a great exaggeration. Further, if one is critiquing the universe then one must acknowledge one's own investment views as a subset of the object of criticism! Recovering from this unexpected bout of self-admonishment however, our inspiration behind pursuing this section title can be best summarized in this quote often attributed to Albert Einstein:
"Everything should be made as simple as possible, but not simpler".
The dominant theme in fixed income market over most of the past year has understandably been safeguarding against the rising rates cycle ahead. In connection with this, floating rate funds have found topical interest during this period. This also is understandable and indeed the general experience so far appears to have been satisfactory. However, one still laments the lack of nuance in many such narratives, a deficiency that may yet lead to differentials cropping between expectations and reality. Thus both that interest rate swaps are already building a significant rate tightening cycle ahead as well as the fact that floating rate bonds have an element of their performance that is much beyond that embedded in the coupon reset frequency are either ignored or at best glossed over. As another instance, the traditional approach to defense via increasing allocation to money market funds isn't stress tested for the fact that, given the steepness of the curve, it is actually the money market points that are the most susceptible to volatility (in terms of yield change, obviously with lower price impact given their very low duration) and hence some sort of a bar-bell (exposure both to intermediate maturity as well as overnight) may actually return better outcomes on a risk-adjusted basis. Yields to maturity (YTMs) still get preponderance rather than holding period returns (HPRs) while simultaneously concerns with respect to the macro environment and associated prospects of market volatility are discussed.
The loss of nuance is probably consistent with that in other areas of discussion, including in monetary policy as discussed in the previous section.
And Finally...Missing: A Word Count Cap For This Note!
If one is left a reader or two laboring on still, then one is grateful. Reminiscing is dangerous business. You never know how long or dangerous a path it takes you down. In the present instance, the road seems to already have stretched long and tedious and one must therefore look to bring proceedings towards an end. Ironical almost, but the reader would note that in a year end commentary built around the theme of missing what is perhaps most starkly missing is a prognosis on the year ahead. The endeavor instead has been to recap, paint the framework, provide a base case and then be open to the idea that there is a probability distribution to outcomes.
To recap, DMs led by the US have been both the growth engine as well as custodian of financial conditions of the world. This makes for an unsustainable equilibrium as one or both of these balls can very easily get dropped. The couple of years ahead will likely see a transition towards the more traditional set up where economies fall back towards respective trend rates of growth (which means that skew moves back in favor of EMs) while financial conditions adjust towards a more sustainable level (from extreme accommodation currently). However, this will still likely imply lower aggregate global growth rates and the risk of some mini-accidents / shocks in the process of transition can never be ruled out, even as they aren't the base case. One of these could be a risk of overtightening of financial conditions with consequent effects on EMs. Another could be that the baton falls somewhere in between the growth handover from DMs to EMs.
Given these, and the range of outcomes that they imply, it is high time that central banks turn towards risk management (as they have in certain regions) from the unequivocal champions of growth that they have been thus far. To be clear, most of this championing has been necessary and desirable, but there is always a point that necessitates basic considerations of risk management and acknowledging the probability distribution of outcomes. The place where travel is starting from and the associated rapidly diminishing marginal utility of staying there even if the base case is right, have to be additional considerations. The US Fed seems now seized of this consideration and the year ahead looks one of policy normalization, even as the bond markets continue to signal that 'well begun will indeed be half done'. Our own RBI has begun too even as commentary remains quite dovish thus far. Going forward, policy normalization may still require sporadic bond market interventions in order to control the pace of pass through and in line with the often expressed desire for an orderly evolution of the yield curve.
The year ahead will thus likely be one of this transition and hence will likely continue to throw up significant volatility. A fixed income strategy that seems durable to us for the times is the idea of bar-belling where cash / near cash is balanced with intermediate maturity points (for example 3 to 6 years) to arrive at one's aggregate target maturity in line with investment horizon and risk appetite. This allows for benefitting from the steep yield curve as well as preserves some flexibility. Then as the rate cycle matures and the yield curve flattens somewhat, the cash component can be deployed at appropriate maturity points thereby elongating maturity on the whole book. The narrative on credit is much better, but spreads for the most part are quite low especially when compared with the relatively higher term spreads on offer (one is compensation for taking credit risk, the other for taking duration risk and hence an analysis of relative attractiveness is relevant). Given this, and the continued prospects for volatility as we turn the year, our preference would remain for a quality-oriented bar-bell. Active duration funds, granted the attendant two-way risks from attempts at 'alpha' generation, may also be appropriate provided the allocation is patient and is manageable in size so as to be able to withstand intermittent volatility.
It's time then to move on from this year. It has taken much from many and has caused people shaped pieces to go missing in a lot of hearts. If yours is one such heart, then here's to hoping that there are still pieces left that hold you together, that there's a place that still exists if not of laughter then at least for a quiet refuge from time to time, that there's room for hope, and that these most sincere best wishes for a new year actually mean something to you.
Wishing You A Very Happy New Year.
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