NBFC woes will weigh on indices

Selling now guarantees losses, and the only way to handle this would be to average down

After the appointment of the new board, we're learning that the tentacles of Infrastructure Leasing & Financial Services (IL&FS) were spread even wider than most people guessed. The company had over 300 subsidiaries and the board is struggling to assess the new information. Various directors have to be replaced in the subsidiaries and a fresh audit has to be performed to get a clearer picture of the financial status. 

It will take a while to untangle everything. There's at least Rs 900 billion (bn) in debt outstanding and the sequence of defaults in the past few months indicates that this will be hard to service. There are also multiple infra projects, which are likely to stall due to IL&FS exposure. 

The group will be looking to sell off any valuable assets that it can, for whatever prices it can get. It's hard to judge how much it could get for its 28 build-operate-transfer (BOT) road projects, and various other items in its portfolio. It will depend on the level of project completion, and various other details. Ongoing lawsuits and criminal investigations will also destroy value. 
 

The larger damage to the economy could arise through contagion, however. The financial sector was already under a lot of pressure and the IL&FS fiasco could trigger a larger crisis. The defaults have led to a debt market crash, and badly affected the debt mutual funds segment. Yields have shot up. The ratings of other non-banking financial companies (NBFCs) are also likely to come under scrutiny in a classic example of locking the stable door after the horse has bolted. 

Nobody is willing to lend to NBFCs at the moment, regardless of their ratings, except at a big premium to benchmark Government of India yields. This is also happening at a time when foreign portfolio investors are cutting back on rupee debt, so that adds to the pressure for corporates trying to raise credit. 

Plus, it's the second half of the 2018-19 fiscal and the government (and all state governments) has to borrow more. The banking crisis continues, or at least, it gives every appearance of continuing - we won't know until the public sector banks with large non-performing assets declare their Q2 results. 

Credit is likely to get tighter than it already has and, at the same time, the Reserve Bank of India has more or less signalled its intention to continue hiking rates. More expensive credit will affect the second half results for sure. Every rate-sensitive business is going to pay more than it bargained for in the second half. Downgrades of earnings and of corporate debt are likely to be common in the next two quarters. 

There is also a very real chance that consumption will slow, if retail customers think that they're paying too much for equated monthly instalment-driven purchases. In addition, retail investors who got used to steady gains after December 2016, have experienced serious capital losses in the past few months as the stock market has travelled down. That could cause a negative wealth effect — people consume more when they have the cushion of capital gains even if those gains are unrealised. 

 Finally, we are just moving into election season. From here, till the next central government is installed, policy will take second place to politics. If there are reverses for the BJP in the upcoming assembly elections, the market will react badly. While share prices have fallen, the market has not yet started to factor in negative electoral possibilities. So there's a big overhang of events and news flow that's likely to cause volatility.  

Given all this, the chances of further losses across financial assets, especially for financial sector stocks, and rate-sensitives, looks to be pretty high. What do you do, if your portfolio is overweight in financial sector stocks? Note that any passive investor holding a Nifty-oriented portfolio is overweight by default since financials (banks and NBFCs combined) comprises one-third of the Nifty by free-float weight. 

Divesting from the financial sector is extremely difficult and selling now guarantees losses. One way to handle this would be to bite the bullet and average down. Any investor with big exposure will have to double down by buying at lower levels. 

Be prepared for massive sell-offs in this space however. Given overvaluation, NPAs, and a poor macro-environment, there could be 50 per cent price retractions from current levels. The bottom could come around the period of the General Elections.