The markets have had a horrendous start to 2016. The Nifty is down about 11 per cent in US dollar terms and the mid-cap indices are down nearly 15 per cent. This is one of the worst ever beginnings to a year, and panic is slowly starting to set in. Many mid-caps are down 25-30 per cent. Foreign Institutional Investors (FIIs) are seemingly non-stop sellers, and even domestic institutions have slowed their buying. So what's happened? Why the sudden sell-off?
First of all, this is not an India specific phenomenon; global markets are in stress, and most large emerging market (EM) equity markets are down between 10-15 per cent. Even US equities are now back to end-2014 levels. Volatility is rampant.
There seems to be genuine capitulation in EM assets, as investors throw in the towel after five years of underperformance. The possibility of a yuan devaluation has further spooked investors. The final nails in the coffin for EM assets seem to be the decimation of global commodities and China's slowdown. Oil and EM assets seem to be moving down in lockstep.
There are growing fears of the world economy slipping into another recession. The International Monetary Fund (IMF) has again cut its growth estimates, highlighting continued vulnerabilities in EMs and most global investment banks are rushing to cut their growth numbers. Many market observers expect global central banks to eventually restart unconventional monetary policies to fend off deflation and recessionary pressures.
Why is India caught up in this crossfire? Aren't falling commodity prices a huge benefit to our economy? Why should we worry about a US Federal Reserve interest rate hike when our external funding needs are minimal? (The current account deficit is slightly over one per cent of gross domestic product, or GDP). Aren't we the fastest growing major economy in the world? The only large EM economy for which the IMF did not reduce numbers? Hasn't our currency been one of the strongest in EM?
All the above are true, and we are very well positioned from a relative perspective. But the travails of the EM asset class are overpowering all other factors. We are now paying the price for our relative attractiveness.
India has been a universal overweight for most EM funds; our relative weight within EM portfolios had never been higher. As these funds now face redemptions, they have no choice but to sell India. They are unwilling to let the India weight go any higher. It is also one of the few markets where FIIs may still have some profits. Given the de-rating of other markets, India valuations were also screening expensive. Over-owned, expensive and with negative revisions, you can see why India was also sold down. This selling will persist, as the EM unwind is not over.
There is also a growing sense of disillusionment with the Narendra Modi government. Structural reforms are either not on the table or being stymied by politics. There is a perceived lack of talent and urgency in the government, and no sense of economic vision. The economy is proving far more difficult to jumpstart than anyone had envisaged, and we have had to endure three years of zero earnings growth. The cycle of earnings cuts continues unabated, with even 2016-17 numbers needing downwards adjustment. Deflationary wholesale price index (WPI) trends have proven to be far more corrosive to corporate performance than most had envisaged, and the lack of any pass-through of the oil windfall to either corporate margins or consumption has been a surprise.
Investors fear a systemic crisis in the banking system, with seemingly no solution for the public sector banks (PSBs) bar a government bail-out.
Given the extent and pace of the sell-off, there will undoubtedly be a pull-back rally. The markets are oversold, and will bounce. The question is: What should one do in this bounce?
If you believe that we are at the beginning of another 2008-type episode, then any rally should be sold into. It is still not too late. Will China be the new sub-prime? Is there a looming risk shock to EM assets? I don't subscribe to this chain of thought, but it is a definite possibility. Fears of a systemic crisis are building.
If, on the other hand, you believe like I do that we are within 12 months of genuine acceleration in the economy and that the government realises that the coming months are critical in terms of policy action and implementation, then it is too late to sell now. Hopefully, the bulk of the price decline is already done. The coming year is the last window this government has where it can take decisions without one eye focussed on elections. The coming Budget is the last where some genuine non-populist reform will be possible. I also sense renewed focus on the prime minister's part on the economy, as he realises that we are not seeing the growth and jobs he promised. I think much of the work done in the past 18 months - be it on roads, rail, coal, power, ease of business and so on - will start showing results over the coming 12 months. It has taken this long to untangle the inherited mess. The rupee's adjustment to more realistic levels will also improve the competitiveness of the country. We are going to see a boost to consumption, regardless, as the various pay awards are implemented. In a deflationary global environment, some more rate cuts may be possible. Real rates (using WPI) are still much too high. Corporate profitability at some stage has to improve. We are at 15-year lows for profit share to GDP. This number should normalise over time, as I see no reason why this series has moved to a new, structurally lower level.
Many stocks are now looking quite attractive, especially in the large-cap universe where much of the foreign selling is ongoing. This fall presents a real chance for everyone to improve the quality of their portfolio. The only fear I have is the stability of domestic capital flows. We have seen sustained flows into equity mutual funds over the past 18 months. Much of this is now underwater. If domestic flows turn negative, then we have no offset to the continued foreign selling, which can then become disruptive. If domestic flows hold, we can use this sell-off to build positions, if domestic investors fold, then we are in serious trouble.
The writer is at Amansa Capital.
These views are his own
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
