June 2022 / Q1 FY23

01Is Inflation Really Bad for the Economy and Markets?

The biggest concern in front of global leaders and investors alike is the record inflation levels globally. Developed economies of US and UK have reported the highest annual increase in inflation over the last 40 years — 8.6% and 9.1% respectively[2]. We have seen a good cool-off in commodity prices over the last fortnight, however, prices still remain at significantly elevated levels from their lows, causing central bankers to expedite interest rate hikes and squeeze liquidity in their effort to tame inflation.

Before we proceed, first let us try to understand how all the variables are interlinked.

Inflation causes a rise in prices of goods and services, which adversely impacts consumer sentiment as things become expensive to consume. This prompts central bankers to raise interest rates to squeeze liquidity from the market and curb consumption to soften prices. The corporate sector, due to lower demand outlook and high interest rates, delays capacity expansion plans and looks to reduce costs by laying off employees and reducing wages.

All this results in lower demand which helps cool down prices, and inflation is controlled — but GDP growth slows down as consumption and manufacturing activity slow down.

To revive the demand, central banks reduce interest rates. With lower rates, consumer and corporate sentiment improve. Consumers start borrowing and spending on discretionary items, thereby increasing demand. Due to improvement in demand outlook, corporates undertake capacity expansion plans by borrowing at lower rates and increasing their workforce. Increased manufacturing and consumption activity lifts GDP and corporate profit. This in turn results in moderate inflation as economic activity picks up.

02How Does Interest Rate Rise Impact the Market?

2ARealignment of Portfolio from Equity to Bonds

As interest rates rise, investors tend to shift their equity allocation to bonds as bond yields become more attractive. With risk-free rates going up, money tends to flow out of emerging markets into safe havens of US treasury, leading to a sell-off in equity markets — more particularly emerging markets. In line with this, we are already experiencing substantial sell-off in emerging markets over the last couple of months. FPIs have withdrawn ~₹3 trillion since October 2021 from the Indian market[3].

2BMoney Eventually Chases Growth After Initial Volatility

Post the initial sell-off and realignment, money eventually tends to chase growth again. There is enough empirical evidence that the market tends to pick up again and post substantial returns after the realignment phase that typically lasts for 6–9 months.

2CShift from High-PE Stocks to Deep Value / Dividend Plays

Interest rates and PE are inversely related — a higher interest rate regime generally leads to a de-rating of PE, leading to a sell-off in high-PE stocks. As cost of capital increases, investors prefer stable and free-cash-flow-generating companies over high-growth ones. In this kind of environment, investor interest generally moves to dividend plays and / or deep value investing — i.e. investing in companies where valuations are below their intrinsic value, as they tend to withstand this volatility better. We have again experienced this happening in India as well as the US, especially in the new-age tech and loss-making companies.

Looking back at every Fed Funds rate hike across the last two cycles (2005–06 and 2015–22), we tabulate the 1m / 3m / 6m return for the Nifty 50 and the Dow Jones Industrial Average following each hike date. Returns rebound sharply over a 6-month window across most cycles even when the immediate 1m read is negative.

The pattern is consistent: short-term volatility around the hike, but a strong 6-month rebound across most cycles. Markets are forward-looking — they price in the rate path and then chase growth again.

03Rising Interest Rates Generally Does Good to the Market

We have gone back 40 years to understand the impact of changing interest rate cycle on the economy as well as the markets:

We have seen similar trends in India as well:

04Current Cycle Is Not Like the Usual Cycle

Over the last few years, developed economies did not see a significant growth in GDPs. This, coupled with the pandemic, prompted central banks to provide monetary stimulus to their citizens to keep the economy afloat.

The fiscal stimulus provided by the US government did not result in GDP growth — it only helped in maintaining the GDP and in fact prevented a possible recession. On the contrary, a good chunk of the free cash distributed found its way into financial assets such as new-age tech companies and cryptos, which resulted in obscene valuations of those assets.

Unlike a typical economic cycle, high inflation today is not because of increased demand / growth in GDP, but is more a supply-chain-driven issue due to:

4AHow Can This Be Corrected?

With Fed’s dot plot indicating interest rates rising to 3.75–4% over the next 12 months, financial / speculative assets have seen a good correction over the last couple of months — metals correcting around 20–30%, agri commodities 10–15%, crude ~10%[6].

We feel that even while monetary policies do their bit, they alone may not be enough to curb inflation. Raising interest rates beyond a point may more likely lead to demand destruction and potentially a recession — defeating the very purpose of infusing money to save the economy in the first place.

In fact, US Fed Chair Powell in his recent testimony to Congress accepted that raising interest rates will not help reduce fuel and food prices, and rate hikes may result in demand slowdown[7].

05Indian Economy Shows a Lot of Resilience: Silver Lining in Global Chaos

India’s GDP surpassed its pre-pandemic (2019–20) level by 1.5%, and the recovery remains robust in 2022–23 so far. The inflation print for May was lower than the previous month after seven months of continuous rise[8].

Inflation in India today is not as bad as in the US. This is partly because our government did not print money to keep the economy afloat during the pandemic. Also, India is largely independent (except for crude) when it comes to producing basic commodities, which helped India deal with supply-related issues in a better way.

A large part of the inflation India is facing is on account of increased crude prices globally and shortage of commodities induced by the Russia-Ukraine crisis — food and fuel prices constitute 60% of the CPI.

We feel that current elevated levels of crude oil are not sustainable as it will lead to demand destruction, which will reduce the demand for oil and thereby cool down prices. Similarly, any increase in supply of oil shall also result in a reduction of prices. Either way, India will benefit from a reduction in oil prices as it will help curb imported inflation.

06A Lifetime Opportunity for Indian Manufacturing

As mentioned above, increasing sourcing of raw materials from Asian countries by the developed nations is likely to benefit India as well. Export opportunities for domestic as well as global players will open as countries look to diversify their supply chains.

One can argue that a slowdown in the developed countries can hamper the export demand. It can very well happen that the overall demand may not increase for a while, but Indian players can possibly increase their share in the pie by replacing existing suppliers (similar to the China + 1 theme that played out in chemicals). India’s share in global merchandise exports is only 1.8% (the 10-year average)[10].

In addition to above, the Indian government has set an ambitious target of achieving USD 1 trillion exports (current exports stood at USD 0.4 trillion). The government has taken multiple steps such as (a) introduction of PLI schemes, (b) reduction in tax rates, (c) Make in India initiatives, (d) Free Trade Agreements etc. to increase domestic manufacturing. All the above tailwinds can help India increase its export share as well as the creation of necessary infrastructure and required capacities.

072003-07 Deja Vu: Stage Set for a Manufacturing / Private Capex-Driven Bull Run

While the market volatility and supply-chain issues are expected to normalise in the near term, we feel the current situation reminds us of the bull run in India during 2003–07, as well as the manufacturing-driven bull run in Japan during the 1970s.

We expect capital goods, infrastructure, and manufacturing themes to play out once again in the coming years, fuelled by domestic and global players setting up capacities to cater to global demand as countries look to diversify their supply chains. Having said that, investors will have to follow a bottom-up approach to look for companies that are best placed to ride the up-cycle that is expected in the coming years.

To emphasise this further, even though the textile industry is currently facing headwinds (and is expected to face headwinds going forward as well) due to an increase in cotton prices and slowdown in demand in export markets — one of our portfolio companies (a leading manufacturer and exporter of knitted garments for infants and children) has mitigated the elevated prices by increasing prices, operating leverage and cost-control measures. The company has a robust order book and is in a position where it has been rejecting orders due to high demand and unavailability of skilled labour. The company has invested ₹20 crore to build a hostel for housing its labour, in order to address its labour bottleneck. They are on course to start production in their second shift within a few months.

08Why Our Style Should Do Well from Here

With value investing coming back in vogue, we believe that our kind of investment style — where we are focused on “deep value investing” — should do extremely well in this kind of environment. Our continuous focus on manufacturing, engineering, infrastructure — the very sectors which are likely to see high growth — puts us in extremely good stride from an investment perspective.

As always, please feel free to reach out to us with your comments, suggestions, and feedback.

Sources

01

Equitree Capital internal performance records as of 30th June 2022. Returns over one year are annualised; individual portfolio performance may differ. Nifty 50 / Nifty Small Cap 100 down 13% / 29% from October 2021 / January 2022 peaks; ~20% alpha over the prior 2 years.

02

US Bureau of Labor Statistics; UK Office for National Statistics — May 2022 CPI prints: US 8.6% YoY (highest since 1981), UK 9.1% YoY (40-year high).

03

Stockedge.com; Equitree Capital — FPI net outflows from Indian equities, October 2021 – June 2022 (~₹3 trillion cumulative).

04

World Bank; Ambit Capital; Equitree Capital — 40 years of US Fed Funds rate cycles, S&P 500 absolute returns, and US GDP growth (1974–2020).

05

Bloomberg; World Bank; Ambit Capital; Equitree Capital — RBI repo-rate cycles, Sensex absolute returns, and India GDP growth across four cycles (2004–2018).

06

US Federal Reserve dot plot (June 2022 SEP) — terminal Fed Funds rate of 3.75–4% over 12 months. Commodity correction figures: industry trade press, June 2022.

07

US Federal Reserve Chair Jerome Powell — Semiannual Monetary Policy Report testimony to the US Senate Banking Committee, 22 June 2022.

08

Ministry of Statistics & Programme Implementation (MoSPI); RBI — India FY22 GDP 1.5% above pre-pandemic level; May 2022 CPI print.

09

Reserve Bank of India Governor Shaktikanta Das — Monetary Policy Committee press interaction, 8 June 2022.

10

Ministry of Commerce; WTO — India share in global merchandise exports (10-year average 1.8%); USD 1 trillion export target vs USD 0.4 trillion current.

11

RBI; Bloomberg; Equitree Capital — 2003 vs 2022 macro snapshot (repo rate, banking net NPA, corporate leverage, tax rate, inflation, earnings growth).

12

Capitaline; Ambit Capital; Equitree Capital — 2003-07 sector profit CAGR; manufacturing, engineering and real-economy sectors outperformed the 41% median profit growth.