DSP NETRA OCTOBER 2023

US Personal Consumption Expenditures Deflator fell to 2.1% over the past 3 months, indicating ongoing disinflation despite recent favorable factors. US manufacturing declined for most of 2023 & credit growth is slowing, particularly in banking credit. This suggests a slip in economic growth. Surprisingly, long bond yields, which typically track economic growth & inflation, have risen in the last few weeks with the US 10-year yield reaching 4.7%, a level last seen 16 yrs ago.

Why?
The level of budgetary deficits that US is running at this time is large. At the same time the US Fed is also selling bonds and not helping the US treasury. This is probably the first time that US Fed is selling bonds when US fiscal deficit is high and borrowing is close to monthly records. This is one reason among others why yields are rising.

The rise in yields would probably face headwinds from slowing economic growth. Watch out for US employment data which can change market expectation of rates & halt the rise in treasury yields.

The US federal interest payment is now at $970 billion & on course to hit $1 trillion soon. This number seems too big, but the US economy has been here before.

The last time US interest payments reached 3.6% of GDP, the debt to GDP was under 40%. The US doesn’t have that favorable backdrop anymore. This means incremental fiscal support can’t help the economy chug along, and tight monetary policy will sacrifice growth significantly.

The most likely outcome and target for the Fed is to cause the economy to slow down, bring inflation lower, and ease monetary policy. Otherwise, it will threaten the stability of the US Dollar as the reserve currency, which the US can’t afford.

Investors who are aligned and willing to play the long inflation trade via commodity equities like base metals, Oil & Gas and such would be better off revisiting their hypothesis. These businesses may face disinflationary or deflationary headwinds ahead.

The US AAA Corporate bond spread over the US Treasury is 30bps below its long period average. The AAA Corp. bond spread over US Treasury bonds averages 110bps and is currently - 80bps.The last time this happened was the week before two Bear Stearns hedge funds went under in 2007. Today, there are no signs of such stress, but two red flags are visible.

First, the US Fed has begun to shrink its balance sheet, aka bond sales, at an accelerated pace. In the beginning of 2023, QT was halted by the SVB and regional banking crises. This is tightening in earnest.

Second, the Federal Reserve is waiting to see core inflation hard data fall drastically before it eases on rates. This higher for 'so far’ is making it hard for incremental consumption to remain steady. Take a look at mortgage applications, credit card delinquencies, auto loan uptake, and retail sales. All these data points are slowing.

US high-yield (junk) bonds offer a risk premium over US mortgage rates. There have been a few past instances when this wasn’t the case, usually when liquidity was abundant. Once again, US junk bonds are trading close to mortgage rates, which is unsustainable given that liquidity is drying up at a fast clip.

Credit conditions for consumers are pretty tight. Credit card interest rates are 500 basis points higher than their previous lifetime high, and auto loan rates are touching 7.5%, the highest in a decade. At these high interest rates, 7.6% for housing loans, 7.5% for auto loans, and 21% for credit cards, US consumer demand is likely to slow.

The US economy has benefited tremendously from very strong consumer demand trends and has avoided a recession because of it. This level of interest is highly restrictive and signals caution for investors. Slow demand can translate to weaker earnings growth for corporations and, hence, lower stock prices.

When Dr. Copper outperforms US Treasury bonds, it is usually inflationary, but only when the ratio of copper to bonds is rising because copper prices are moving higher. Currently, this ratio is rising because bond prices are falling faster than copper prices. This is the first sign of disinflationary pressures building up.

In fact, copper forward curves indicate contango. This condition occurs when current prices are trading below forward prices. The contango for copper indicates that current demand conditions are fairly benign and supply is adequate. There is little incentive to hold the metal.

Historically, demand-side inflation has moved with copper prices due to copper’s close association with usage in a number of consumption-oriented old economy sectors. Expect inflation, corporate toplines, tax collections, and other headline numbers to head in the same direction. Lower.

REER, or Real Effective Exchange Rate, gauges a currency's worth by considering not just nominal exchange rates but also adjusting for price level i.e. inflation differences with trading partners, offering a broader view of its value.

A very high level of USD Real Effective Exchange Rate (REER) indicates that the U.S. dollar is strong and overvalued relative to a basket of other foreign currencies.

This is the highest level that the USD REER has been since July 2002 and close to its last cycle peak of 129. In fact, USD hasn’t been as strong as it is now since the Nixon shock of 1971 barring the ultra tight monetary policy exercised by Fed Chair Volcker.

This means that USD has drifted to an extreme. This is the result of differing policies in US and rest of the world, but from here on, the ability of US Dollar to sustainably remain strong will be challenged.

Expect a weaker US Dollar to benefit one commodity the most – Gold.

China has been transitioning from an economy heavily reliant on manufacturing and exports to one that is more focused on services and domestic consumption. As this transition occurs, the demand for commodities like cement and steel, which are essential for infrastructure and construction, may plateau or grow at a slower pace. China experienced significant overcapacity in industries such as steel and cement, partly due to rapid expansion in the past. This overcapacity has led to market saturation.

China's government has sought to control debt levels and reduce financial risks in the economy. As a result, there has been a tightening of credit and restrictions on investment in industries with overcapacity, which can limit the ability of companies to expand production.

These trends are disinflationary & point to a long, stretched phase of China’s growth normalization. This is also a drag on commodity prices.

Global trade growth & corporate toplines (revenue) move together directionally. During periods of high inflation, commodity companies benefit tremendously from high product prices, and corporate revenues rise faster. However, this relationship becomes untenable when underlying growth begins to slow. A decline in world trade volumes can be indicative of a broader global economic slowdown.

When the global economy is not growing at a healthy rate, consumer demand for products & services tends to weaken. This can result in lower sales growth for S&P 500 companies, esp those with significant exposure to international markets.

Roughly 40% to 45% of S&P 500 revenues are generated outside of the U.S. Sales growth has been a key contributor to very high corporate profitability in the US. This can be a source of reduced profitability and equity market stress in the US and elsewhere in the coming quarters.

Base effect is the primary driver of lower revenue growth for BSE 500 companies. But even after adjusting for base, a large number of firms are reporting topline deceleration.

Last quarter, nearly one in three firms reported a decline in sales over the same period of last year. Post-COVID, Indian firms have enjoyed very strong profitability. The primary driver of profitability was cost cutting, an initial decline in raw material costs, and then very strong topline growth aided by fiscal stimulus across the world.

Out of these three levers, topline growth has been the key driver, along with margin expansion. We believe that the outlook for both of these vectors is becoming murky & sales growth momentum is slowing. India has enjoyed a rich price-to-earnings multiple because it has delivered earnings growth. If earnings disappoint, valuations will also adjust lower. Watch this trend with caution.

In Oct’21, Indian markets peaked after a stellar rally. Since then, the complexity of the market has changed. Large caps have struggled to generate significant returns, while smaller firms have performed better.

Recently, as a sign of investors chasing the recent performance, the SME segment has seen a large outperformance over other segments.

Since the COVID bottom, the SME segment has delivered stellar 86% CAGR returns. This is not just exceptional but also a sign that markets have become overheated. Some recent IPOs on the SME platform have generated exceptional interest from investors. A few IPOs garnered 286x and 450x subscriptions for small issue sizes.

A large dose of caution in the smaller segments would serve investors better.

Currently, Nifty is trading at 22.7 times trailing earnings and at an ROE of 13%.

History shows that when Nifty trades within these broad ranges of valuations, forward returns are south of 10%. The 10-year GSec is earnings about 7.2% and a AAA Corporate bond yields 7.75% at this time. The attractiveness of equities is diminished with attractive opportunities present in bonds.

The more we stretch valuations by purchasing more expensive companies, the lower the likelihood of earnings above average returns.

Hence, diversify. Across assets. Multi Asset.

India enjoyed a steady & strong growth phase in the noughties. Private consumption (15% CAGR from FY06 to FY11) and investment (15% CAGR from FY02 to FY10) grew at a strong clip.

After the COVID slump, India’s consumption and investments have started to make a comeback. This is likely to lead to a phase of steady growth. The growth rate may not be as high as the best phase in the past, but it is likely to result in an exit from the slower growth phase of the last decade.

Businesses that are profitable and can generate steady cashflows should be in focus, specifically at times when their valuations become attractive.

If the markets are correct, BFSI, Auto Ancillary, Healthcare, Infra, Gas Distribution, and Capital Goods would be structural focus areas to benefit from this trend.