The Alpha Investor Issue #1, Nov 2019

What’s driving up the stock markets? It sure as hell isn’t the economy!

INSIDE THIS ISSUE Dear Investor,

1. Cover Story In our continued endeavour to deliver the best-in-class advisory, we bring to you our monthly investment newsletter – The Alpha Investor. 2. Indian Markets Financial markets are dynamic, ever-changing and complex. The Alpha 3. Indian Macro Investor is our effort to help you navigate through all this and stay 4. Global Markets ahead of the curve. 5. Global Macro Themes We will cover Indian and Global markets and economy. We will also cover some key global macro themes that could have an impact on the Indian markets. In this issue, we will cover Fed’s QE and yield curve inversion. We will try to make this newsletter richer in content and research with every passing issue. Happy reading! Shubham Satyarth Co-founder, Finpeg

Smart solutions for smart money

The Alpha Investor | Issue# 1

The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

What’s Inside?

COVER STORY: WHAT’S DRIVING UP THE STOCK MARKETS? IT SURE AS HELL ISN’T THE ECONOMY! ...... 3 INDIAN MARKETS – NIFTY SCALES NEW HIGHS ...... 4

1. SUMMARY AND OUTLOOK ...... 4 2. EQUITY MARKET WRAP FOR THE MONTH ...... 5 3. EQUITY MARKET VALUATIONS ...... 3 4. DEBT MARKET WRAP FOR THE MONTH ...... 4 4. WHAT IS THE “SMART” MONEY DOING? ...... 5 INDIAN ECONOMY – IS THERE A RECOVERY IN SIGHT? ...... 6

1. SUMMARY AND OUTLOOK ...... 6 2. GDP AND THE ECONOMY – HAS IT BOTTOMED OUT? ...... 7 3. INFLATION AND MONETARY POLICY ...... 8 4. EXCHANGE RATE – RUPEE HAS BEEN FAIRLY STABLE AGAINST USD THIS YEAR ...... 9 GLOBAL MARKETS – IT’S BEEN A PARTY SO FAR! ...... 10

1. GLOBAL EQUITY MARKETS ...... 10 2. GLOBAL DEBT MARKETS ...... 11 3. DOLLAR AND GOLD ...... 12 GLOBAL MACRO THEMES ...... 13 1. GLOBAL ECONOMY OVERVIEW ...... 13 2. FED HAS STARTED “NOT QE4” ...... 14 3. US TREASURY YIELD CURVE INVERTED AND THEN STEEPENED BACK IN 2019 ...... 15

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 | The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

Cover Story: What’s driving up the stock markets? It sure as hell isn’t the Economy!

After correcting by almost 11.5% (from its June high), markets have seen a breakaway rally with NIFTY up almost 12.5% from its bottom on 19th September 2019.

While it’s been a party globally, for India the rebound started with corporate tax cut announced on 20th September. NIFTY rallied a whopping 8% in a matter of just 2 trading days. How much of the 10- percentage point cut in effective tax rate translates into actual EPS growth will be clear only in FY2020. However, there is no denying the fact that tax cut was a sharp booster dose for India Inc’s earnings.

But the current rally is not driven by optimism (and expected earnings growth) generated by the tax cuts? It should be noted that once the euphoria got over, NIFTY had already shed bulk of the gains (closed at 11,174 on 4th October).

Something else happened around that time. Federal Reserve (Central Bank of USA) resumed their quantitative easing program. Technically, they are not calling it QE but for all intent and purpose it is QE4 (with US$ 320 bn injected so far in just over 2.5 months). At the same time, ECB (European Central Bank) started their own QE. And to top it off, news of a potential closure of US China Trade deal started doing the rounds.

And that is what’s been driving up the markets. Despite a slowdown which is worse than even the most pessimistic estimates. Despite a headline GDP of 4.5% being the lowest in last 26 quarters. Despite the fact that there are is no visible signs of recovery (as indicated by high frequency indicators). And despite stretched valuations.

NIFTY (on a trailing PE basis) is trading 2 standard deviations above its historical average. Although, on a forward PE basis, NIFTY is closer to its historical average. However, forward PE is based on a consensus assumption of 25% earnings growth in FY2021. In our view, given economic headwinds, 25% growth appears stretched. Interestingly, mid and small cap valuations now appear reasonable.

We believe that global factors will continue to guide the market direction in the near term. What happens with the trade deal? What direction will the Fed take? When will US economy enter into a recession? Answer to these questions will have a far greater bearing on the Indian markets than what is happening with our own Economy. At least in the near term.

From a portfolio perspective, we are still underweight equity with an equity allocation of 25%. Our probabilistic model shows a rather “directionless” market in the next 6-12 months. Any correction from here could be an opportunity to go overweight to 50% - 75% equities.

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 | The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

Indian Markets – NIFTY scales new highs

1. Summary and outlook

Post the June 2019 high of 12,088, NIFTY corrected by 11.4% to hit a bottom on 19th September. And we all know what happened on the morning of 20th September. Government announced a huge cut in corporate tax rates with effective tax rate being reduced to 25% (a 10-percentage point reduction).

Buoyed by the tax cut, NIFTY rose 8% in just 2 trading days. Since 20th September, NIFTY has continued its uptrend, scaling a new lifetime high of 12,151 on 28th Nov.

Despite clear signs of slowdown (GDP growth of 5% in 2QCY19 and 4.5% in 3QCY19), markets continue to ignore the macro signals. More on Indian economy here.

What is causing this euphoria?

More than domestic factors, the recent uptrend is driven by a surge in global liquidity driven by “money printing” by central banks (US Fed and ECB). Discussed more in detail here.

Plus, there is “optimism” that US and China might reach an agreement on the trade deal. This yo- yoing of stock markets across the globe on “trade deal tweets” is indeed a unique and a bizarre phenomenon.

Indian analysts are also betting on a potential bottoming of GDP growth and a recovery going forward. We will discuss this assumption in our macro section.

Will this rally last? It is difficult to say so. Probabilistically speaking, given the stretched valuations, there is a significant chance of a correction in the near term. But at the same time, as long as these global money taps are open, we could continue to see markets make new highs.

We, at Finpeg, are underweight equity with an equity allocation of 25%. Our probabilistic model is showing a rather “directionless” market in the next 6-12 months. Any correction from here could be an opportunity to go overweight to 50% - 75% equities.

While the consensus view on the street is that mid and small caps are now attractive in terms of valuations, we continue to remain cautious. Any rally fueled by easy money (rather than fundamentals) means that when the taps turn dry and outflow begins, everything takes a beating.

On the debt side, interest rates have come down significantly during the year. From highs of 8% in September 2018, 10Y GSEC yield has come down to 6.5% levels. This has meant that duration funds and gilt funds have done pretty well during this period.

We believe that on the debt side, if the horizon is for 2-3 years, AAA-rated accrual funds with minimal duration risk is the best bet in current scenario. We would avoid any duration or credit risk.

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 | The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

2. Equity Market wrap for the month

Table 1: Index Returns as of Nov 30th, 2019

1 Month 3 Months 6 Months 1 Year Year to date

NIFTY 1.79% 9.37% -0.27% 11.63% 10.50%

NIFTY Mid Cap 3.85% 10.03% -5.02% -0.99% -3.75%

BSE Small Cap 0.96% 8.18% -9.22% -5.52% -8.17%

NIFTY Auto -4.07% 15.36% -2.91% -11.35% -11.94%

NIFTY Bank 6.53% 16.47% 0.92% 17.76% 16.62%

NIFTY FMCG -4.02% 5.87% 2.30% 2.36% 1.90%

NIFTY IT -2.58% -6.32% -8.33% 3.37% 3.79%

NIFTY Pharma 4.74% 1.46% -4.06% -8.32% -7.79%

Mid and small caps finally performing in line with the large caps

After almost 18-20 months of massive underperformance, mid and small caps seem to be doing well in this current rally.

Unlike the previous NIFTY high in June 2019, this rally has been more broad-based with both mid and small caps performance in line with the large caps.

It might also be noted that advance-to-decline ratio of NIFTY has been 40:10 in the last 3 months as against year-to-date advance-to-decline ratio of 23:27 (implying that year-to-date, 27 out of 50 NIFTY stocks are still in red). See Exhibit 2.

Exhibit 1: Mid and small caps have performed in Exhibit 2: Monthly advance-to-decline ratio of line with large caps NIFTY 50 stocks Index performance since Jan 2018 24000 14000

12000 22000

10000 20000 8000 18000 6000 16000 4000 14000 2000 12000 0 8 8 8 8 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 9 9 9 -1 -1 1 -1 -1 1 1 1 -1 -1 1 1 -1 -1 1 -1 -1 1 1 1 -1 -1 1 n r- r y - l- g- t v- c- n r- r y - l- g- t v- a eb a p a n u u ep c o e a eb a p a n u u ep c o J F A Ju -J A S O N D J F A Ju -J A S O N - - M - M - 2 ------M - M - 2 - - - - 2 2 2- 2 2- 2 0 2 2 2 2 2 2 2 2- 2 2- 2 0 2 2 2 2 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 NIFTY Mid Cap 100 BSE Small Cap NIFTY

Source: BSE and NSE Source: NSE

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 | Source: NSE

The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

3. Equity Market Valuations

Cheap money, dovish central banks and optimism around the trade deal has pushed market (NIFTY) valuations to new peaks.

NIFTY (on a trailing PE basis) is trading 2 standard deviations above its historical average (Exhibit 3). That’s as expensive as it gets. PB levels look reasonable (around historical average). However, take that with a pinch of salt given the higher weightage of Banking and Financial companies in NIFTY currently as compared to any other time in history.

Exhibit 3: NIFTY trading above 2 SD of historical PE Exhibit 4: On P/B levels, NIFTY valuation looks values reasonable. NIFTY PE NIFTY PB 7 29 6.5 6 5.5 24 5 4.5 19 4 3.5 14 3 2.5 2 9 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 -9 -0 -0 -0 -0 -0 -0 -0 -0 -0 -0 -1 -1 -1 -1 -1 -1 -1 -1 -1 -1 9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9 c c c c c c c c c c c c c c c c c c c c c 9 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 e e e e e e e e e e e e e e e e e e e e e c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- c- -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D -D e e e e e e e e e e e e e e e e e e e e e 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 D D D D D D D D D D D D D D D D D D D D D 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 1- 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 P/B Average 1SD 2SD P/E Average 1SD 2SD

Source: NSE Source: NSE

Mid and small cap valuations have come off sharply from their peaks in 2017. Purely from a valuation perspective, mid and small caps look fairly attractive now.

However, as discussed, in a rally fuelled by liquidity, when the tap turns off, everything takes a beating. We therefore continue to remain cautious and continue to rely on our model score to help us decide on the overall asset allocation.

Exhibit 5: Mid Cap valuations have come off Exhibit 6: Small Cap valuations have come off significantly and appears reasonable now significantly and is in the attractive zone NIFTY Mid Cap 150 PE BSE Small Cap P/B 3 60 2.8 50 2.6 40 2.4 30 2.2 20 2 10 1.8 0 1.6 1.4 06 07 08 09 10 11 12 13 14 15 16 17 18 19 r- r- r- r- r- r- r- r- r- r- r- r- r- r- p p p p p p p p p p p p p p 5 5 5 6 6 6 6 7 7 7 7 8 8 8 8 9 9 9 9 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 -A -A -A -A -A -A -A -A -A -A -A -A -A -A r- l- t- - r- l- t- - r- l- t- - r- l- t- - r- l- t- 3 3 3 3 3 3 3 3 3 3 3 3 3 3 p u c n p u c n p u c n p u c n p u c 0 0 0 0 0 0 0 0 0 0 0 0 0 0 A J O Ja A J O Ja A J O Ja A J O Ja A J O P/E Average 1 SD 2 SD PB Average 1 SD 2 SD

Source: BSE Source: NSE

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 |

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4. Debt Market wrap for the month

The Reserve Bank of India (RBI) has been on a rate cutting spree, lowering rates for 5 consecutive times (paused in December policy meet). This has brought down the repo by 110 bps to 5.15% (the lowest since March 2010).

As a result, the short-end of interest rate curve (3-month GOI Treasury Bill) declined from its peak of 7% in Sep 2018 to 4.9% as on Nov 30th 2019 (a decline of 210 bps). The longer end (GSEC 10 Year) has also come down from its peak of 8% in September 2018 to 6.5% (Exhibit 7). Declining interest rate has meant that gilt funds and long duration funds have done pretty well during this period.

Table 2: Returns of Gilt and Medium to Long duration Funds

Scheme Name 1M 3M 6M YTD 1Y IDFC Bond Fund - Income Plan 0.52% 0.86% 5.50% 8.06% 12.16%

ICICI Prudential Bond Fund 1.00% 2.49% 5.83% 7.91% 12.12%

HSBC Debt Fund 0.48% 0.74% 4.91% 7.67% 11.76%

IDFC G Sec Fund 0.50% 1.13% 6.33% 9.94% 15.04%

DSP Govt Sec Fund 0.49% 1.29% 6.35% 10.07% 14.41%

Nippon India Gilt Securities Fund 0.53% 0.89% 5.95% 9.71% 14.36%

The spread between yields of AAA rated bonds and GSEC remains high for longer maturities (see Exhibit 8) making AAA rated accrual strategy attractive. This also highlights the overall risk aversion in the market towards corporate credit.

Exhibit 7: GSEC yields have come off sharply in last Exhibit 8: Spread between AAA and GSECs remains 1 year high Indian GSEC yields Yield Curve

10 9.5 12.00 9.3 9.5 9 9 10.00 8.5 8.5 8.5 7.9 7.8 8.00 8 7.7 7.2 7.3 7.5 7 6.00 7 6.5 6.5 6.5 6.2 4.00 5.8 6 5.5

2.00 5.5

1 1

1 5

/ /

0 0 0 1 year 3 Year 5 Year 10 Year GSEC10Y GSEC3M GSEC AAA AA A

Source: Bloomberg Source: Bloomberg

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 |

The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

4. What is the “smart” money doing?

FIIs have been a big buyer in the Indian equity markets in 2019. After being a net seller in 2018, FIIs have pumped in Rs 93,784 cr year-to-date (till 30th Nov).

If the run rate continues, this would be only the 4th year in the last 10 years when FIIs have pumped over 1 lac crore in a calendar year (see Exhibit 10).

While the FIIs were a net buyers in the first half of the year, they sold sharply in the months of July and August (which also corresponded with NIFTY correcting by over 10%). The buying activity has since then picked up sharply with FIIs buying almost Rs 25,000 cr in November. This makes November the 4th biggest month of FII inflows into the Indian equity market (see Exhibit 9).

The story remains similar in the debt market segment as well but the buying has not been as intense. So, 2019 marks the first year since 2012 when FIIs have been a net buyer in both the segments and at the same time have bought more equities than debt.

Exhibit 9: Monthly FII/FPI inflows in Equity markets Exhibit 10: Calendar year FII inflows in Equity and

Monthly FII/FPI Inflows (Equity) Debt markets ₹40,000 Yearly FII/FPI Inflows ₹30,000 ₹2,00,000 ₹20,000 ₹1,50,000 ₹10,000 ₹1,00,000

₹0

0 0 1 1 2 2 3 3 4 4 5 5 6 6 7 7 8 8 9 9

1 1 1 1 1 1 1 1 1 1

------

l l l l l l l l l

l ₹50,000

n n n n n n n n n

-₹10,000 n

u u u u u u u u u u

a a a a a a a a a a

J J J J J J J J J J

J J J J J J J J J J -₹20,000 ₹0 -₹30,000 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019 -₹50,000 YTD -₹40,000 FII Equity Average -₹1,00,000 Equity Debt

Source: NSDL Source: NSDL

Exhibit 11: Monthly Domestic Institutional Investors Exhibit 12: Calendar year DII inflows in Equity and (DII) inflows in Equity markets Debt markets

Monthly DII Inflows (Equity) Yealy DII inflows ₹30,000 ₹7,00,000 ₹25,000 ₹6,00,000 ₹20,000 ₹5,00,000 ₹15,000 ₹4,00,000 ₹10,000 ₹3,00,000 ₹5,000

₹0 ₹2,00,000

- -

-₹5,000 -

n n

n ₹1,00,000

e a

J J

M M -₹10,000 M ₹0 -₹15,000 2014 2015 2016 2017 2018 2019

DII Equity Average Equity Debt

Source: Moneycontrol Source: Moneycontrol

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 |

The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

Indian Economy – Is there a recovery in sight?

1. Summary and Outlook

Indian economy has been in the news. And not for good reasons. The September quarter (3QCY19) headline GDP growth of 4.5% was the slowest in 26 quarters.

The slowdown is driven by cyclical as well as domestic structural factors. Cyclically, the whole world is slowing and India is no exception. However, the impact of this cyclical slowdown has been aggravated by a number of domestic factors such as deleveraging, banking NPA mess and the subsequent clean up, credit squeeze, high real interest rates and lack of adequate fiscal stimulus.

While we can have endless debate on what’s causing the slowdown, as an investor, we should focus on whether the growth rate has bottomed or not. And if there is a rebound in sight.

While high frequency indicators have not yet bottomed, our YoY change framework (explained later) shows that we will likely have a rebound in 4QCY19 or 1QCY20. Will this be a temporary rebound or beginning of a new cycle of growth remains to be seen.

High frequency indicators like IIP for the month of September shrunk by 4.3% and is unlikely to bottom before November 2019.

Retail inflation (as measured by CPI) has been increasing steadily this year after bottoming out in Jan 2019. The headline retail inflation for the month of October was 4.62%. Our YoY and base effect framework suggest that inflation has not yet topped. Also, this uptick in inflation is a global phenomenon with major economies showing signs of mildly accelerating inflation in last 2-3 months.

Higher retail inflation has prompted RBI to take a surprise pause in rate cuts in its December 5th policy meet. Despite slowing economy, RBI decided to keep the repo rate unchanged at 5.15%.

While the slowdown is real, we at Finpeg, continue to be believers in the long-term growth prospects of the Indian economy and hence the Indian stock markets. Purely from a stock market perspective, in the near term, we believe global factors will drive the markets more than news around domestic economy.

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 | The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

2. GDP and the economy – has it bottomed out?

The September quarter (3QCY19) headline GDP growth of 4.5% was the slowest in 26 quarters. And the slowdown has been real. GDP growth peaked in 1QCY18 at 8%. Since then it has been a secular decline every quarter (see Exhibit 13).

More than the slowdown, the key question is if there is a rebound in sight? The answer to this may lie in the chart shown in Exhibit 14. It tracks the year-on-year change in GDP growth rates. Basically, if GDP growth in 3QCY19 was 4.5% and in 3QCY18 was 7%, YoY change will be -2.5%.

This YoY change chart is significant because it has been a very solid indicator of growth bottoming out. Take for instance Dec 2008 and March 2012 quarters – YoY change bottomed and the next quarter, GDP growth bottomed. In June 2017 quarter, both YoY change and GDP growth bottomed together. As can be seen in Exhibit 1, YoY change bottomed in 2QCY19 and therefore, there is a high probability that 3QCY19 was a bottom for GDP growth rate as well. In any case, a rebound in GDP growth rate is a very likely event in next 1-2 quarters.

Exhibit 13: Real GDP growth has been on a Exhibit 14: YoY change in GDP growth rate downward trajectory bottomed in 2QCY19 Quarterly GDP Growth YoY change in growth 14.00 15.00 12.00 10.00 10.00 8.00 5.00 6.00

4.00 0.00

1 1

0 0

2.00 0

3 3

-5.00 3

0 0

0.00 0

/ /

/ -10.00

0 0 0 Real GDP Growth Average -15.00

Source:MOSPI Source:MOSPI

Index of Industrial Production (IIP) growth plummeted to negative 4.3% in the month of September (the last available data). It is worth noting that YoY change in IIP was still falling in September. Also, given the high base in October 2018, YoY change seems unlikely to have bottomed in September and will most likely bottom out in October. This means we could likely see a rebound in IIP growth in December 2019 (Exhibit 16).

Exhibit 15: IIP has been contracting sharply for past Exhibit 16: YoY change in IIP growth rate was still few months falling in September 2019

IIP Growth Monthly YoY change in IIP growth 25.00 25.00 20.00 20.00 15.00 15.00 10.00 10.00 5.00

0.00

7 8 9 9 0 0 1 1 2 3 3 4 4 5 6 6 7 7 8 8 9

5.00 7

0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

-5.00 0

2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

/ / / / / / / / / / / / / / / / / / / / / /

1 6 1 8 3 0 5 2 7 2 9 4 1 6 1 8 3 0 5 2 7

0.00 -10.00 4

0 1 0 0 0 0 1 0 1 0 0 0 0 1 0 0 0 0 1 0 1 0

6 7 8 8 9 0 0 1 2 2 3 4 4 5 6 6 7 8 8 9

0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0

2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2

-5.00 2 -15.00

/ / / / / / / / / / / / / / / / / / / / /

2 8 4 2 8 4 2 8 4 2 8 4 2 8 4 2 8 4 2 8

1 0 0 1 0 0 1 0 0 1 0 0 1 0 0 1 0 0 1 0 0 -20.00 -10.00 -25.00 IIP Growth Average -30.00

Source:MOSPI Source:MOSPI

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 |

The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

3. Inflation and monetary policy

Retail inflation (as measured by CPI) has been increasing steadily this year after bottoming out in Jan 2019. The headline retail inflation for the month of October was 4.62% (see Exhibit 15) driven primarily by food price inflation.

YoY change in inflation rate is still climbing (Exhibit 18) which indicates that inflation rate itself has not yet topped.

Also, we are now seeing an increased divergence between CPI and WPI inflation (4.46 percentage point in October). Food prices, which has a much higher weightage in CPI, the main reason for this divergence. Collapsing WPI is an indicator of overall slowdown in manufacturing activity and benign crude prices.

Exhibit 17: Divergence between CPI and WPI Exhibit 18: YoY change in inflation rate still increasing climbing Indian Inflation Rate YoY change in inflation rate 20.00 20.00

15.00 15.00

10.00 10.00

5.00 5.00

0.00

8 9

9 0.00

8 9

2 2

-5.00 2

8 3

-5.00 0

0 1 -10.00 -10.00 CPI Change (YoY) WPI Change (YoY) CPI Change (YoY) YoY change in Inflation Rate

Source: CEIC, Finpeg Research Source: CEIC, Finpeg Research

Higher retail inflation (above RBIs target) has prompted RBI to take a surprise pause in rate cuts in its th December 5 policy meet. Despite slowing economy, RBI decided to keep the repo rate unchanged at 5.15% (see Exhibit 20). This pause comes after 5 consecutive rounds of rate cuts where repo was lowered by 110 bps.

Exhibit 20: RBI keeps repo rate unchanged at 5.15% Exhibit 19: Benign crude price has been one of the reasons for low WPI inflation in its December policy meet

WTI Crude (USD/barrel) RBI Repo Rate 160 10.00% 140 9.00% 120 8.00% 100 7.00% 80 6.00% 60 5.00% 40

20 4.00%

5 6 7 7 8 9 9 0 1 1 2 3 3 4 5 5 6 7 7 8 9 9

0 0 0 1 1 1 1 1

0 0 0 0 1 1 1 1 1 1 1 1 1 1

------

t t t t t t t t

n b n b n b n b n b n b n b

c c c c c c c

0 c

e u e u e u e u e u e u e

J O J O J O J O J O J O J O

F F F F F F F

0 0 1 2 3 4 5 5 6 7 8 9 0 0 1 2 3 4 5 5 6 7 8 9

0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1

/ / / / / / / / / / / / / / / / / / / / / / /

1 1 9 7 5 3 1 1 9 7 5 3 1 1 9 7 5 3 1 1 9 7 5 3

1 0 0 0 0 0 1 0 0 0 0 0 1 0 0 0 0 0 1 0 0 0 0 0 Repo Rate Average

Source: MacroTrends, Finpeg Research Source: Reserve Bank of India

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 |

The Alpha Investor, Nov 2019 | Issue #1 | Finpeg

4. Exchange Rate – INR has been fairly stable against USD this year

INR has been fairly stable against the USD in 2019 depreciating by 3%. INR appreciated in the first half of year before bottoming out in June 2019 at around 68.9 levels. Since then, INR has been gradually weakening. INR has also been stable against major currencies across the world (Table 3):

Exhibit 21: Rupee has been under pressure since Exhibit 22: Rupee has been fairly stable this year bottoming out in June 2019 with YTD depreciation of 3% USD INR Annual USD INR (yoy,%) 80 30 22.00 70 25 20 60 17.00 15 50 10 12.00 40 5 7.00 30 0 -5 2.00 20 -10 10 -3.00 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 D -15 00 00 00 00 00 00 00 00 00 00 01 01 01 01 01 01 01 01 01 T 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 2 9Y 0 -20 01

-8.00 2

9 0 1 2 3 4 5 6 7 8 9 0 1 2 3 4 5 6 7 8 9

0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1

/ / / / / / / / / / / / / / / / / / / / /

1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1 1

1 -13.00

0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 0 INR Depreciation Average Annual Depreciation USD/INR USD INR (YoY)

Source: MacroTrends, Finpeg Research Source: MacroTrends, Finpeg Research

Table 3: INR against major currencies (% change, positive number is depreciation)

Currency 1 Month 1 Year Euro (EUR) 0.71 -1.99

Canad ian Dollar (CAD) -0.29 1.37 Aus tralian Dollar (AUD) 0.01 -4.70

British Pound (GBP) 1.68 2.31

Singapore Dollar (SGP) 0.30 1.06

Jap anese Yen (JPY) 0.84 4.35

Indonesian Rupiah (IDR) 0.00 4.08 Korean Won (KOW) -1.96 -4.90

Vietnamese Dong (VND) 0.00 3.33

Thai Baht (THB) 0.60 9.26

Hong Kong Dollar (HKD) 0.47 0.41

Chinese Yuan (CNY) -0.40 -1.90

Brazilian Real (BRL) -2.70 -6.80 Source: Economic Times

THE ALPHA INVESTOR, NOV 2019 | ISSUE #1 |

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Global Markets – It’s been a party so far!

1. Global Equity Markets

Globally, equity as an asset class has had an amazing year so far. In fact, we in India have been actually lagging compared to other equity markets. And all this has happened despite a global slow down. Table 4 below tracks the performance of some major indices across the world.

Table 4: Performance of major indices across the world

Indices 1M 3M 6M 12M YTD S&P 500 3.09% 7.33% 14.45% 16.51% 25.14%

Nasdaq 4.35% 8.82% 18.17% 20.55% 30.00%

Russel 2000 3.28% 8.67% 10.51% 9.96% 19.81%

FTSE 0.21% 1.93% 2.25% 9.58% 9.09%

DAX 2.53% 10.86% 12.24% 22.43% 25.11%

Stoxx 600 2.19% 7.37% 9.97% 18.68% 22.01%

Nikkei 225 1.97% 12.51% 14.12% 8.34% 19.08%

Shanghai Composite -2.29% -0.49% -0.63% 10.24% 16.50%

Hang Seng -1.20% 2.42% -2.04% 0.73% 4.84%

NIFTY 1.79% 9.37% 14.45% 11.46% 10.50%

Source: Bloomberg, Finpeg Research

It has indeed been a party! Barring a very few countries, most of the stock indices are in green this year. US Indices have done phenomenally well. Even US mid cap index (Russel 2000) is yielding almost 20% year-to-date.

Europe has also been great. FTSE 100 has been more subdued (especially for past 6 months) owing to Brexit issues. DAX has been phenomenal despite clear signs of recession in Germany.

China has been strong despite uncertainty around trade war and despite a clear slowdown in the Chinese economy. And despite political unrest in Hong Kong, HK is still up 4.8% YTD (though down 4.4% in last 6 months).

It should be noted that the world indices had hit a bottom in December 2018 and year-to-date returns are reflective of that. Plus, as mentioned above, there has been a surge in global liquidity driven by accommodative (and easing) central banks.

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2. Global Debt Markets

Globally, bond markets had a great time in the first 9 months of year with longer end of the yield curve bottoming out in September 2019. The shorter end joined the party in the second half as central banks around the world started lowering their policy rates.

Falling long rates and stable short rates also led to yield curve inversion in US in May (more on this in our Macro theme section). With longer end yields rebounding post September, and shorter end collapsing, yield curve steepened back in October.

After a tumultuous 2018 which saw both short end and the long end rise, 2019 saw the long end (10Y) fall 85 bps while the short end mimic it by 84 bps. Since September, the longer end has continued to rise steadily.

Another interesting development in 2019 longer duration bonds turning negative in many economies in Europe and Japan. Exhibit 24 shows German and Japanese 10-year yields turning negative in March 2019.

Exhibit 23: A good year for the bond markets as Fed Exhibit 24: German and Japanese 10Y GSEC yields cuts rate thrice went negative in March 2019 US 10Y and 3M GSEC yields 10Y GSEC yields 3.50 6 3.00 5 2.50 4 2.00 3 1.50 2

1.00 1

0.50 0

- l

0.00 l

g n

-1 y

1 1

1 5 -0.50 9

-2

0 0 0 US10Y US3M Germany Japan

Source: Bloomberg Source: Bloomberg

Collapsing bond yield in the first 9 months of this year was primarily driven by the world in a “risk- off” mode with bond markets anticipating an imminent recession (and hence flight to safe assets). With the start of “NOT QE” by US Fed in September, the yields have jumped sharply.

Exhibit 25: Corporate Bond Spread in US over 10Y Another interesting risk indicator topped in June

Treasury 2019. The spread of AAA and BBB rated

Corp Bond Spread over 10YT corporate debt yields over 10-Year US treasury 7.00 was at its highest in June 2019. Since then the 6.00 spreads have been falling (Exhibit 25). 5.00 4.00 3.00 Since the spread is the extra yield that investors 2.00 demand for lending to the corporates, higher 1.00 spread indicates higher risk aversion. Falling

0.00

0 0 1 2 3 4 5 5 6 7 8 9 0 0 1 2 3 4 5 5 6 7 8 9

0 0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1 1

/ / / / / / / / / / / / / / / / / / / / / / /

/ spread indicates that market is moving more

1 9 7 5 3 1 1 9 7 5 3 1 1 9 7 5 3 1 1 9 7 5 3

1 0 0 0 0 0 1 0 0 0 0 0 1 0 0 0 0 0 1 0 0 0 0 0 towards a “risk-on” mode. BBB AAA

Source: Bloomberg

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3. Dollar and Gold

On an absolute level, the United States Dollar (USD) is as strong as it has ever been. While DXY might be below its life-time highs, on a trade-weighted basis, dollar is as strong as it has even been (Exhibit 26).

Notwithstanding the absolute strength, USD has had a fairly stable year with DXY (US Dollar Index) up 2% year-to-date and TWEXB (Trade Weighted Dollar Index) up 1.7% (Exhibit 27).

Exhibit 26: On a trade weighted basis, dollar is as Exhibit 27: Dollar has had an uneventful year w.r.t strong as it has ever been major currencies Dollar Index Dollar Performance 140.00 10.0% 9.1% 130.00 8.0% 120.00 6.0% 6.0% 110.00 1.8% 100.00 4.0% 0.9% 1.7% 2.2% 90.00 1.6% 1.5% 2.0% 0.9% 80.00 70.00 0.0% 1M 3M 6M YTD 1Y 2Y

60.00 -2.0%

0 1 2 3 4 5 6 7 8 9 0 1 1 2 3 4 5 6 7 8 9

0 -1.7% -0.9%

0 0 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1 1 1

/ / / / / / / / / / / / / / / / / / / / /

/ -0.6%

2 1 0 9 8 7 6 5 4 3 2 1 2 1 0 9 8 7 6 5 4

1 -4.0%

1 1 1 0 0 0 0 0 0 0 0 0 1 1 1 0 0 0 0 0 0 0 DXY TWXEB DXY TWEXB

Source: FRED Source: Bloomberg

Gold wakes up from its long winter slumber

Gold had a long winter where it traded in narrow band of USD 1100-1200/oz for almost 5 years (2014 -2018). After hitting an all-time high in 2011, Gold had a consistent decline followed by a flattish period since then. But all that changed in 2019 (Exhibit 28). It’s been a great year for Gold as an asset class.

Interestingly, in INR terms, Gold has actually outperformed NIFTY in last 20 years (CAGR since 2000). Obviously, it has underperformed equities in last 10 years but things could change now.

At Finpeg, we remain positive on Gold from a medium-term perspective of 2-3 years.

Exhibit 28: Gold has finally woken up from its long Exhibit 29: Gold has outperformed S&P 500 index winter slumber since Jan 2000 in CAGR terms Gold Prices (USD/Oz) Gold vs Equity 2,000.0 30.0% 1,800.0 25.3% 1,600.0 25.0% 17.6% 21.3% 1,400.0 19.2% 20.0% 6.7% 1,200.0 7.3% 1,000.0 14.3% 14.0% 7.2% 11.4% 15.0% 10.7% 800.0 10.5% 11.3% 10.9% The Gold Winter 9.1% 600.0 10.0% 8.9% 8.6% 400.0 4.2% 3.9% 200.0 5.0% 2.1%

0.0

7 8

9 0.0%

1 1

6 5

4 YTD (abs.) 1Y 5Y 10Y Since 2000

0 0 0 Gold Gold S&P Gold (INR) NIFTY

Source: Goldprice.org Source: Goldprice.org, Bloomberg, BSE

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Global Macro Themes

In this section, along with an overview of the global economy, we will talk about some key macro themes and their implications for the Indian stock market.

1. Global Macro Snapshot

Table 5: Overview of major and emerging economies

US Germany Japan UK Euro GDP (yoy, 3QCY19) 2.00% 0.50% 1.80% 1.00% 1.40% Inflation (yoy, Oct 2019) 1.80% 1.10% 0.20% 1.80% 1.00% 10Y Gsec (latest) 1.81% -0.31% -0.01% 0.77% 0.18% Central Bank Rates (latest) 1.75% 0.00% -0.10% 0.75% 0.00%

China Indonesia Brazil GDP (yoy, 3QCY19) 6.00% 5.02% 1.20% Inflation (yoy, Oct 2019) 3.80% 3.13% 2.54% 10Y Gsec (latest) 3.23% 7.09% 6.86% Central Bank Rates (latest) 4.15% 5.00% 5.00%

Central Banks around the world turned dovish (Exhibit 30) as growth slowed down and inflation remained benign (albeit some recent uptick).

US, China and Eurozone economies are all slowing down (Exhibit 31). Germany went into contraction in 2QCY19 but bounced back in 3QCY19 thus narrowly avoiding a recession. The only exception has been Japan which went into recession in the second half of 2018. Since then, growth in Japan has seen a secular uptick.

But overall, there is a slowdown globally. The real question is if is this is the final slowdown of this expansionary cycle (since 2009) or a mid-way slowdown like 2015. I guess we will know soon enough!

Exhibit 30: Central Banks in US and China cutting Exhibit 31: Japan went into recession in 2018 and rates as growth slows down has bounced back. US and China Policy Rates GDP Growth (yoy,%) 3 4.40% 8.00 7.00 2.5 4.35% 6.00 4.30% 2 5.00 4.25% 1.5 4.00 4.20% 3.00 1 4.15% 2.00 1.00 0.5 4.10% 0.00 0 4.05% -1.00 17 17 17 17 18 18 18 18 19 19 19 Y Y Y Y Y Y Y Y Y Y Y 16 16 16 16 17 17 17 17 18 18 18 18 19 19 19 19 C C C C C C C C C C C 1/ 4/ 7/ 0/ 1/ 4/ 7/ 0/ 1/ 4/ 7/ 0/ 1/ 4/ 7/ 0/ Q Q Q Q Q Q Q Q Q Q Q 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 1 2 3 4 1 2 3 4 1 2 3 US China Euro Japan US China

Source: Bloomberg Source: TradingEconomics

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2. Fed has started “NOT QE4”

We are seeing a surge in global liquidity driven by major central banks opting for Quantitative Easing (QE). While the Fed (US Central Bank) has not named it QE, the rate at which the money is being injected into the system actually overshadows some of the previous rounds of QE.

From raising rates and quantitative tightening in 2018 to lowering rates and finally easing, the Fed has done a complete pivot in just 9 months (without any major changes in growth and inflation numbers).

In September 2019, the overnight repo rate (the rate at which Banks lend to each other) spiked above 10%, triggering a panic in the markets. Repo rate spike was simply the final manifestation of an acute USD shortage. The shortage was only compounded by raising of debt ceiling in July 2019 which lead to US treasury sucking up even more liquidity.

Reacting to the turmoil in the repo market, Fed decided to inject liquidity in the system. And what started as an intervention in the overnight market, has now been extended to longer-term lending market as well as US Treasuries. Since September, Fed has injected almost US$ 320 bn in to the system.

While Fed may not like to call it QE, Fed’s balance sheet has started rising again and is almost back to the levels where it started QT (Exhibit 32).

Exhibit 32: Central Banks in US and China cutting Exhibit 33: NIFTY overlaid with the dates of various rates as growth slows down QE by Fed QE1 QE2 QE3 FED Balance Sheet (USD bn) 14000 1 0.9 4500 12000 0.8 4000 10000 0.7 3500 8000 0.6 0.5 3000 6000 0.4 2500 4000 0.3 2000 0.2 2000 1500 0.1

0 0

6 7

1000 8

1 1

0 0 500 0 07 08 09 10 11 12 13 14 15 16 17 18 19 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ 1/ QE Dates NIFTY 0 0 0 0 0 0 0 0 0 0 0 0 0

Source: FRED Source: NSE, Finpeg Research

What are the implications for Indian stock markets?

As we have seen, since Fed started it’s “NOT QE4”, markets across the globe have been on a booster dose and the same is true for India (despite weakening economy). The world which was in a “risk- off” mode in the first half of the year is now in a “risk-on” mode.

Global Liquidity is always good for the stock markets. Extra liquidity starts chasing riskier assets and stock markets get a boost. Exhibit 33 shows a chart of NIFTY overlaid with the past QE dates. Barring

QE2 (overlapping with Eurozone crisis), NIFTY has performed phenomenally in the other 2 QEs (1 and 3). And now we are in “NOT QE4”. Therefore, notwithstanding the fundamentals, the party could go on as long as Fed keeps injecting liquidity into the system.

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Further, any signs of stress in the US capital markets could prompt the Fed to actually increase the quantum of injections and maybe call it QE4 officially. In the past 2 years, we have seen the Fed making market performance as a barometer for its policy effectiveness.

But here is a sobering thought….

But one thing should be kept in mind – Fed has already started lowering rates (now at 1.75%) and already started pumping liquidity. And the US economy is nowhere close to a recession. What will it do when an actual recession hits? Remember, last time the recession hit (Jan 2008) Fed’s policy rate was 5.2% and its balance sheet was under US$ 1 tn. Today the policy rate is already 1.75% and balance sheet size is in excess of US$ 4 tn.

Here is a good resource for those interested in knowing more about repo rate and Fed’s subsequent action - Repo: How the financial markets' plumbing got blocked. For those interested in knowing more about QE and its history, you can read - Explaining Quantitative Easing – QE.

3. US Treasury yield curve inverted and then steepened back in 2019

In general, longer duration bonds should yield more than the shorter duration bonds since investors demand extra yield to keep their money invested for a longer tenure. Therefore, a 10-year US Treasury bond should (and generally does) yield more than a 3-month Treasury bill. But there are rare occasions when the opposite happens – 3-month starts yielding more than 10-year bonds. This phenomenon is called yield curve inversion.

We had such an event in 2019. The risk-off mode in the first 6 months of this year saw 10-year yields on US treasury drop below 1.5%. As a result, the 10-year and 3-month US treasury yield curve inverted in May 2019 (3-month yields became more than 10-year yield) and then steepened back in Oct 2019 as Fed started lowering its policy rates and 10Y yields rebounding back to 1.8% levels.

In general, yield curve is a precursor to recession. “Sustained” inversions of the yield curve have preceded every recession since at least the 1960s (see Exhibit 34). “Sustained” is an important word here. And this inversion lasted for over 5 months. So yes, it was a “sustained” inversion.

Exhibit 34: “Sustained” inversions of the yield curve have preceded every recession since at least the 1960s 8.00 1

0.9 6.00 0.8 4.00 0.7

0.6 2.00 0.5

0.00

3 4 5 7 8 9 0 2 3 4 5 7 8 9 0 2 3 4 5 7 8 9 0 2 3 4 5 7 8 9 0 2 3 4 5 7 8 9 0 2 3 4 5 7 8 9

2 0.4

6 6 6 6 6 6 6 7 7 7 7 7 7 7 7 8 8 8 8 8 8 8 8 9 9 9 9 9 9 9 9 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1

/ / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / / /

4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7 0 1 4 7

0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0 1 0 0 0

-2.00 0.3

0.2 -4.00 0.1 -6.00 0 US Recession 10Y-3M Spread

Source: Bloomberg, Finpeg Research

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Here is an excellent article on everything you want to know about yield curves, why they invert and why is a recession imminent once the curve inverts - Inverted Yield Curve and Why It Predicts a Recession?

What does yield curve inversion mean for Indian stock markets?

Assuming that the yield curve is right and there is an imminent recession in the US economy. With S&P 500 up 25% year-to-date, it would also be safe to assume that the stock markets are not pricing in a recession.

Recessions are generally bad for the stock markets. Last two US recessions (2000 and 2008) saw NIFTY collapse by over 50% both the times. It may not be as bad this time, but, as an when the signs of a recession becomes obvious, it will not be good news for the Indian markets. Further, stock markets are generally a leading indicator. Therefore, we could see markets correcting before an actual recession hits the US economy.

There is a school of thought that says that a US recession may not impact the performance of the Indian markets. The argument is that we have had only two historical precedence (2000 and 2008).

While this is true to an extent, don’t forget the high degree of correlation between stock markets across the globe. Therefore, purely from a probabilistic framework, there is a very high chance that if US stocks correct, Indian markets will follow.

A case in point is 2015 when the world economy had a soft landing instead of going into a full-blown recession. Stock markets across the world (including India) corrected by 15% - 20%.

Exhibit 35: Yield curve inversion and US recession Exhibit 36: High degree of correlation between has had huge impact on NIFTY returns NIFTY and S&P NIFTY vs US Yield Curve NIFTY vs S&P 14000 4.5 14000 3500 4 12000 3.5 12000 3000 10000 3 10000 2500 2.5 8000 2 8000 2000 6000 1.5 6000 1500 1 4000 0.5 4000 1000 0 2000 2000 500 -0.5

0 -1 0 0

8 9 0 1 3 4 5 6 7 8 9 0 1 2 3 4 6 7 8 9

9 0 0 0 0 0 0 0 0 0 1 1 1 1 1 1 1 1 1

/ / / / / / / / / / / / / / / / / / / /

9 0 1 2 1 2 3 4 5 6 7 8 9 0 1 2 1 2 3 4

1 1 1 0 0 0 0 0 0 0 0 0 1 1 1 0 0 0 0 0 NIFTY 10Y-3M Spread NIFTY S&P

Source: Bloomberg, NSE, Finpeg Research Source: NSE, Bloomberg, Finpeg Research

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