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WWRR Vol.2.017

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Strategy<br />

Market<br />

INDIA<br />

DECEMBER 31, 2018<br />

UPDATE<br />

BSE-30: 36,068<br />

Bye-bye 2018, welcome 2019. 2018 was an eventful but disappointing year for global<br />

equity markets. The Indian market was among the better performers with +3% return<br />

in INR terms and -6% in USD terms. We expect 2019 to be a better year for Indian<br />

equities although the list of events that can potentially derail things in 2019 is quite<br />

long. We expect 10-15% return in 2019 on (1) strong earnings revival, (2) moderate derating<br />

and (3) assuming no major global macro and domestic political shocks.<br />

QUICK NUMBERS<br />

2018: Bad starting point; losing battle from Day 1<br />

The paltry 3% return for the Indian market (Nifty-50 Index) in INR terms and -6% return in USD<br />

terms simply reflects a bad starting point for the market in 2018—(1) overvalued market and<br />

(2) overvalued currency. The Indian market de-rated significantly through 2018 (see Exhibit 1) to<br />

16.7X 12-month forward ‘EPS’ from 20.1X at the beginning of 2018 and the INR corrected<br />

sharply (see Exhibit 2) against the USD along with most DM and EM currencies. Nonetheless,<br />

the Indian market was among the best performers in 2018 (see Exhibit 3) although the<br />

performance was quite varied across sectors and stocks (see Exhibits 4-5).<br />

2019: Better starting point in terms of valuation, currency<br />

Current macro-economic conditions and valuations are quite supportive and drive our<br />

expectations of decent (10-15%) equity returns in 2019. The market is reasonably valued (see<br />

Exhibit 6) although the reasonable valuations reflect strong earnings revival over FY2019-21.<br />

1HFY19 net profits of the Nifty-50 Index grew 12%, which imparts some confidence about<br />

FY2019 profits; we expect 14% growth. Also, the INR seems to be fairly valued (see Exhibit 7);<br />

we see mild depreciation in 2019 compared to the sharp correction that it saw in 2018.<br />

1HCY19: Plentiful events to shake the faith<br />

Global and Indian equity markets will have to contend with several events in 1HCY19. (1) The<br />

US Fed’s rate actions linked to the strength of the US economy will be a key variable; the US<br />

economy continues to display strong momentum (see Exhibit 8) and stronger-than-expected<br />

economic data could surprise the market negatively in terms of the extent of rate increases by<br />

the Fed (see Exhibit 9). (2) The progress on China-US trade issues will be another variable with<br />

the US holding the threat of further increases in tariffs on Chinese imports from March 1, 2019.<br />

(3) The level of oil prices linked to further US action against Iran’s oil exports (current exemption<br />

to eight oil importing countries from Iran ends on May 4, 2019) will matter particularly for<br />

India’s macro. (4) India will hold national elections in April-May 2019 and the outcome is quite<br />

uncertain post the strong performance of the main opposition party in recent state elections;<br />

these states contributed handsomely to BJP’s victory in 2014 (see Exhibit 10).<br />

<br />

<br />

<br />

Nifty-50 Index<br />

delivered 3% in INR<br />

terms, -6% in USD<br />

terms in 2018<br />

Nifty-50 Index<br />

trading at 15.9X<br />

FY2020E and 13.8X<br />

FY2021E net profits<br />

Nifty-50 Index net<br />

profits to grow 14%<br />

in FY2019, 27% in<br />

FY2020 and 15% in<br />

FY2021<br />

Sanjeev Prasad<br />

Sunita Baldawa<br />

2HCY19: Earnings will matter once India is past the election hump<br />

Anindya Bhowmik<br />

We expect earnings growth to be the biggest driver of the Indian market in 2019/FY2020. Our<br />

14% and 27% growth in the net profits of the Nifty-50 Index for FY2019 and FY2020 may look<br />

high but this largely reflects earnings revival in ‘corporate’ banks from a low base (see Exhibit<br />

11). On an ex-banks basis, we expect FY2019 and FY2020net profits of the Nifty-50 Index to<br />

grow 9% and 14%. We would refer readers to our December 20, 2018 report for more details.<br />

For Private Circulation Only. FOR IMPORTANT INFORMATION ABOUT KOTAK SECURITIES’ RATING SYSTEM AND OTHER DISCLOSURES, REFER TO THE END OF THIS MATERIAL.


Dec-03<br />

Dec-04<br />

Dec-05<br />

Dec-06<br />

Dec-07<br />

Dec-08<br />

Dec-09<br />

Dec-10<br />

Dec-11<br />

Dec-12<br />

Dec-13<br />

Dec-14<br />

Dec-15<br />

Dec-16<br />

Dec-17<br />

Dec-18<br />

Strategy<br />

India<br />

Minor changes in recommended large-cap. Model Portfolio<br />

We increase the weight of AXSB by 150 bps to 400 bps and reduce the weights for HDFC,<br />

HINDALCO and MM by 40-70 bps to accommodate the increased weight of AXSB. Exhibit<br />

12 is our recommended large-cap. Model Portfolio.<br />

We add CIFC to our recommended mid-cap. Model Portfolio (see Exhibit 13).<br />

Exhibit 1: The Indian market de-rated significantly through 2018<br />

12-m rolling forward PE of Nifty-50 Index, March fiscal year-ends, 2004-19 (X)<br />

24<br />

P/E (X) Avg. Mean+1SD Mean-1SD<br />

20<br />

16<br />

12<br />

8<br />

4<br />

Source: Bloomberg, Companies, Kotak Institutional Equities estimates<br />

Exhibit 2: The Indian Rupee depreciated significantly against major DM currencies in 2018<br />

Performance of INR versus other major currencies (%)<br />

Current Change (%)<br />

Price 1-mo 3-mo 6-mo YTD 1-y 3-y<br />

Performance of different currencies versus INR<br />

INR/BRL 18.0 0.3 1.4 (2.4) 7.1 7.2 (7.1)<br />

INR/CNY 10.2 (1.6) 4.5 1.6 (3.3) (3.6) 0.3<br />

INR/EUR 80.0 (1.0) 5.8 0.1 (4.3) (4.5) (9.8)<br />

INR/GBP 89.0 (0.4) 6.8 1.6 (3.1) (3.4) 10.1<br />

INR/JPY 0.6 (3.2) 0.6 (2.3) (10.6) (11.0) (13.4)<br />

INR/MYR 16.9 (1.6) 4.3 0.8 (6.6) (6.9) (8.8)<br />

INR/RUB 1.0 3.7 12.5 8.0 10.4 9.9 (9.0)<br />

INR/USD 69.9 (0.4) 4.4 (1.5) (8.6) (8.9) (5.3)<br />

INR/ZAR 4.9 3.5 6.1 2.1 6.0 6.2 (12.0)<br />

Performance of different currencies versus USD<br />

ARS/USD 37.7 2.1 9.7 (25.4) (50.6) (49.1) (65.5)<br />

BRL/USD 3.9 (0.6) 4.5 (0.4) (14.5) (14.5) (0.4)<br />

CNY/USD 6.9 1.1 (0.1) (3.7) (5.4) (5.0) (5.7)<br />

EUR/USD 0.9 1.1 (1.1) (1.7) (4.9) (4.9) 5.1<br />

GBP/USD 0.8 (0.0) (2.3) (3.1) (6.0) (5.9) (15.6)<br />

IDR/USD 14,390 (0.6) 3.6 - (5.8) (5.8) (4.2)<br />

JPY/USD 110.1 3.2 3.5 0.8 2.4 2.3 9.2<br />

KRW/USD 1,111 0.9 0.1 0.8 (3.9) (4.0) 5.8<br />

MYR/USD 4.1 1.2 0.1 (2.3) (2.1) (2.1) 3.9<br />

THB/USD 32.3 1.9 (0.2) 2.6 0.7 0.7 11.4<br />

TRY/USD 5.3 (1.4) 12.3 (12.7) (28.2) (28.3) (44.9)<br />

RUB/USD 69.6 (3.6) (6.7) (8.9) (17.1) (17.1) 4.2<br />

ZAR/USD 14.4 (3.5) (1.0) (3.8) (13.8) (13.8) 7.6<br />

Source: Bloomberg, Kotak Institutional Equities<br />

KOTAK INSTITUTIONAL EQUITIES RESEARCH 3


India<br />

Strategy<br />

Exhibit 3: The Indian market was among the best performing markets in 2018<br />

Performance (not annualized) of emerging and developed markets over period of time (%)<br />

% change in local currency % change in USD<br />

1-mo 3-mo 6-mo CYTD 1-yr 3-yr 5-yr 1-mo 3-mo 6-mo CYTD 1-yr 3-yr 5-yr<br />

Developed markets<br />

Australia (0) (9) (9) (7) (7) 7 5 (4) (11) (13) (16) (16) 3 (17)<br />

France (6) (14) (11) (11) (11) 2 10 (4) (15) (13) (15) (15) 7 (9)<br />

Germany (6) (14) (14) (18) (18) (2) 11 (5) (15) (16) (22) (22) 3 (8)<br />

Hong Kong (2) (7) (11) (14) (14) 18 11 (3) (7) (11) (14) (14) 17 10<br />

Japan (10) (17) (10) (12) (12) 5 23 (8) (15) (10) (10) (10) 15 17<br />

Singapore (2) (6) (6) (10) (10) 6 (3) (1) (5) (6) (12) (12) 11 (10)<br />

UK (3) (10) (12) (12) (12) 8 0 (3) (12) (15) (17) (17) (6) (23)<br />

US (Dow Jones) (10) (13) (5) (7) (7) 32 39 (10) (13) (5) (7) (7) 32 39<br />

US (S&P500) (10) (15) (9) (7) (7) 22 34 (10) (15) (9) (7) (7) 22 34<br />

MSCI World (8) (14) (10) (11) (11) 13 13<br />

Emerging markets<br />

Brazil (2) 11 21 15 15 103 71 (2) 15 20 (2) (2) 107 4<br />

MSCI China (7) (11) (19) (21) (21) 19 12 (7) (11) (19) (21) (21) 18 11<br />

India (0) (1) 1 3 3 37 72 (0) 3 (1) (6) (6) 30 53<br />

Indonesia 2 4 7 (3) (3) 35 45 1 6 5 (9) (9) 29 22<br />

Korea (3) (13) (12) (17) (17) 4 1 (2) (13) (12) (21) (21) 10 (4)<br />

Malaysia 1 (6) (0) (6) (6) (0) (9) 2 (6) (3) (8) (8) 4 (28)<br />

Mexico (1) (16) (13) (16) (16) (4) (3) 3 (20) (13) (16) (16) (16) (35)<br />

Philippines 1 3 4 (13) (13) 7 27 1 5 5 (17) (17) (4) 7<br />

Russia (5) (11) (8) (8) (8) 41 (26) (5) (11) (8) (8) (8) 41 (26)<br />

Taiw an (2) (12) (10) (9) (9) 17 13 (1) (12) (10) (11) (11) 26 10<br />

Thailand (5) (11) (2) (11) (11) 21 20 (4) (12) (0) (11) (11) 35 22<br />

MSCI EM (3) (8) (10) (17) (17) 21 (4)<br />

Source: Bloomberg, Kotak Institutional Equities<br />

Exhibit 4: IT and FMCG were the top performing sectors in 2018<br />

Performance of sectoral indices (%)<br />

Healthcare<br />

IT<br />

% Change 1 month<br />

Sensex<br />

Auto<br />

Metal<br />

Realty<br />

Capital goods<br />

Banks<br />

FMCG<br />

BSE Smallcap<br />

BSE Midcap<br />

O&G<br />

(4) (3) (2) (1) 0 1 2 3 4 5<br />

Metal<br />

IT<br />

O&G<br />

Healthcare<br />

% Change 3 months<br />

Auto<br />

Sensex<br />

BSE Smallcap<br />

FMCG<br />

BSE Midcap<br />

Realty<br />

Banks<br />

Capital goods<br />

(15) (10) (5) 0 5 10 15<br />

Realty<br />

Auto<br />

Metal<br />

BSE Smallcap<br />

% Change 6 months<br />

Healthcare<br />

BSE Midcap<br />

O&G<br />

IT<br />

Sensex<br />

Banks<br />

FMCG<br />

Capital goods<br />

(15) (10) (5) 0 5 10<br />

Realty<br />

BSE Smallcap<br />

Auto<br />

Metal<br />

O&G<br />

BSE Midcap<br />

Healthcare<br />

Capital goods<br />

Banks<br />

Sensex<br />

% Change CYTD<br />

FMCG<br />

IT<br />

(40) (30) (20) (10) 0 10 20 30<br />

Source: Bloomberg, Kotak Institutional Equities<br />

4 KOTAK INSTITUTIONAL EQUITIES RESEARCH


Strategy<br />

India<br />

Exhibit 5: Almost 40% of stocks of KIE coverage universe declined more than 20% in 2018<br />

Number of stocks of KIE universe in various performance buckets (X)<br />

Below -20%<br />

Below -20%<br />

Betw een -20 and -<br />

10%<br />

Betw een -20 and -<br />

10%<br />

Betw een -10 and<br />

0%<br />

Betw een -10 and<br />

0%<br />

Betw een 0 and<br />

10%<br />

Betw een 0 and<br />

10%<br />

Above 20%<br />

Betw een 10 and<br />

20%<br />

% Change 1 month<br />

Above 20%<br />

Betw een 10 and<br />

20%<br />

% Change 3 months<br />

0 20 40 60 80 100 120<br />

0 10 20 30 40 50 60 70<br />

Below -20%<br />

Below -20%<br />

Betw een -20 and -<br />

10%<br />

Betw een -20 and<br />

-10%<br />

Betw een -10 and<br />

0%<br />

Betw een -10 and<br />

0%<br />

Betw een 0 and<br />

10%<br />

Betw een 0 and<br />

10%<br />

Betw een 10 and<br />

20%<br />

% Change 6 months<br />

Betw een 10 and<br />

20%<br />

% Change CYTD<br />

Above 20%<br />

Above 20%<br />

0 10 20 30 40 50 60<br />

0 10 20 30 40 50 60 70 80<br />

Source: Bloomberg, Kotak Institutional Equities<br />

Exhibit 6: We expect earnings of the Nifty-50 Index to grow 14% in FY2019 and 27% in FY2020<br />

Valuation summary of Nifty-50 sectors (full-float basis), March fiscal year-ends, 2019E-21E (based on current constituents)<br />

Mcap.<br />

Adj. mcap.<br />

Earnings growth (%) PER (X) EV/EBITDA (X) Price/BV (X) Div. yield (%)<br />

(US$ bn) (US$ bn) 2019E 2020E 2021E 2019E 2020E 2021E 2019E 2020E 2021E 2019E 2020E 2021E 2019E 2020E 2021E 2019E 2020E 2021E<br />

Automobiles & Components 84 46 (16) 46 17 24 16.7 14.3 9.0 7.0 6.0 2.7 2.4 2.1 1.1 1.3 1.4 11.0 14.4 14.9<br />

Banks 230 169 64 107 24 31 14.8 11.9 — — — 2.4 2.1 1.8 0.5 0.8 0.9 7.8 14.2 15.2<br />

Capital Goods 29 25 33 0.6 14 21 21 18.3 18 17 15 3.6 3.3 2.9 1.6 1.6 1.8 17.3 15.7 16.1<br />

Commodity Chemicals 19 9 17 24 18 57 46 39 36 29 24 14 12 11 0.8 1.0 1.2 24 27 28<br />

Construction Materials 23 9 43 22 19 21 17.0 14.3 9.9 8.8 7.7 1.9 1.7 1.5 0.4 0.4 0.4 9.0 9.9 10.6<br />

Consumer Staples 106 53 13 14 13 40 35 31 27 24 21 12 11 10.0 1.6 1.8 2.1 29 31 32<br />

Diversified Financials 90 71 (1.3) 22 22 30 25 20 — — — 4.6 4.1 3.6 1.0 1.1 1.4 15.5 16.6 17.7<br />

Electric Utilities 32 13 17 14 14 10.4 9.1 8.0 8.2 7.3 6.5 1.3 1.2 1.1 3.0 3.5 3.9 12.9 13.4 13.9<br />

Fertilizers & Agricultural Chemicals 6 4 9.5 15 11 16.1 14.0 12.6 10.6 9.0 7.8 3.5 3.0 2.5 1.2 1.4 1.6 22 21 19.8<br />

Gas Utilities 12 4 55 3.5 8.0 11.4 11.0 10.2 7.2 6.9 6.3 1.8 1.7 1.5 3.1 3.2 3.5 16.0 15.2 15.0<br />

IT Services 193 81 16 12 8.9 19.0 17.0 15.6 13 11.4 10.4 4.6 4.1 3.8 1.9 3.2 3.5 24 24 24<br />

Media 7 4 11 17 13 28 24 22 17 15 13 5.4 4.7 4.2 0.9 1.2 1.5 18.8 19.4 19.3<br />

Metals & Mining 37 23 21 5 10.0 7.8 7.5 6.8 5.6 5.4 5.0 1.1 1.0 0.9 2.0 2.3 2.3 14.6 13.9 13.7<br />

Oil, Gas & Consumable Fuels 180 72 7.7 9.5 6.9 11.9 10.9 10.2 7.5 6.7 6.1 1.6 1.5 1.4 2.8 3.1 3.2 13.6 13.7 13.5<br />

Pharmaceuticals 27 15 19 35 25 26 19.4 15.6 14 10.4 8.3 2.7 2.4 2.1 0.6 1.0 1.2 10.1 12.4 13.8<br />

Retailing 12 6 28 25 20 57 46 38 38 30 24 14 11 9.5 0.5 0.6 0.8 24 25 25<br />

Telecommunication Services 25 9 NM NM NM NM NM NM 9.1 8.4 7.1 2.3 2.5 2.7 2.5 2.5 2.6 NM NM 1.5<br />

Transportation 11 4 9 11 28 19.2 17.2 13.5 14 11.8 10.5 3 3 2.4 0.3 0.5 0.4 17.5 16.7 18.0<br />

Nifty-50 Index 1,122 545 14.2 27 14.8 20 15.9 13.8 9.9 8.8 7.9 2.7 2.4 2.2 1.5 1.9 2.1 13.2 15.2 15.6<br />

Nifty-50 Index (ex-banks) 892 572 9.1 14.1 12.2 18.4 16.2 14.4 9.9 8.8 7.9 2.7 2.5 2.3 1.8 2.2 2.4 14.8 15.5 15.8<br />

Nifty-50 Index (ex-energy) 942 545 16.8 33 17.2 23 17.4 14.8 11.1 9.8 8.7 3.0 2.7 2.4 1.3 1.7 1.9 13.1 15.7 16.4<br />

RoE (%)<br />

Notes:<br />

(a) We use consensus numbers for Indiabulls Housing Finance and Kotak Mahindra Bank.<br />

Source: Kotak Institutional Equities estimates<br />

KOTAK INSTITUTIONAL EQUITIES RESEARCH 5


FOMC meeeting dates<br />

Nov-09<br />

May-10<br />

Nov-10<br />

May-11<br />

Nov-11<br />

May-12<br />

Nov-12<br />

May-13<br />

Nov-13<br />

May-14<br />

Nov-14<br />

May-15<br />

Nov-15<br />

May-16<br />

Nov-16<br />

May-17<br />

Nov-17<br />

May-18<br />

Nov-18<br />

India<br />

Strategy<br />

Exhibit 7: The INR on REER basis is closer to its fair value<br />

Trend in 36-country trade weighted REER (2004-05=100)<br />

125<br />

36-currency REER 5-year average 10-year average<br />

120<br />

115<br />

112.4<br />

110<br />

105<br />

100<br />

95<br />

Source: RBI, CEIC, Kotak Institutional Equities<br />

Exhibit 8: Recent data shows continued strong growth in the US economy<br />

Trend in key economic variables for the US economy<br />

Monthly indicators Nov-17 Dec-17 Jan-18 Feb-18 Mar-18 Apr-18 May-18 Jun-18 Jul-18 Aug-18 Sep-18 Oct-18 Nov-18<br />

Average private earnings (yoy, %) 2.4 2.7 2.8 2.6 2.7 2.6 2.7 2.7 2.7 2.9 2.8 3.1 3.1<br />

Conference Board consumer confidence (X) 128.6 123.1 125.4 130.8 127.7 125.6 128.0 126.4 127.4 133.4 138.4 137.9 135.7<br />

Core PCE (yoy, %) 1.5 1.5 1.5 1.5 1.8 1.8 2.0 1.9 2.0 1.9 1.9 1.8 1.9<br />

CPI (yoy,%) 2.2 2.1 2.1 2.2 2.4 2.5 2.8 2.8 2.9 2.7 2.3 2.5 2.2<br />

Core CPI (yoy, %) 1.7 1.8 1.8 1.8 2.1 2.1 2.2 2.3 2.3 2.2 2.2 2.1 2.2<br />

Housing starts (SAAR, '000) 1,303 1,210 1,334 1,290 1,327 1,276 1,329 1,177 1,184 1,280 1,237 1,217 1,256<br />

Industrial production (yoy, %) 3.5 3.1 3.2 3.9 3.6 4.8 3.0 3.5 4.2 5.5 5.6 3.7 3.8<br />

ISM manufacturing (X) 58.2 59.3 59.1 60.8 59.3 57.3 58.7 60.2 58.1 61.3 59.8 57.7 59.3<br />

ISM non-manufacturing (X) 57.4 55.9 59.9 59.5 58.8 56.8 58.6 59.1 55.7 58.5 61.6 60.3 60.7<br />

Non-farm payrolls ('000) 216 175 176 324 155 175 268 208 165 270 118 250 155<br />

Participation rate (%) 62.7 62.7 62.7 63 62.9 62.8 62.7 62.9 62.9 62.7 62.7 62.9 62.9<br />

Personal savings rate (% of disposable income) 6.2 6.2 7 7.4 7.2 6.9 6.8 6.8 6.7 6.6 6.3 6.1 6.0<br />

Retail sales excl. automobiles (sa, yoy, %) 7.0 6.3 4.8 5.7 5.3 5.1 7.0 6.7 7.2 6.5 4.8 5.8 4.8<br />

S&P house price index (yoy, %) 6.4 6.3 6.4 6.7 6.7 6.7 6.5 6.4 6.0 5.6 5.2 5.1<br />

Unemployment rate (%) 4.1 4.1 4.1 4.1 4.1 3.9 3.8 4.0 3.9 3.9 3.7 3.7 3.7<br />

Quarterly indicators Dec-16 Mar-17 Jun-17 Sep-17 Dec-17 Mar-18 Jun-18 Sep-18<br />

CAD/GDP (%) (2.4) (2.3) (2.4) (2.3) (2.4) (2.3) (2.2) (2.3)<br />

GFD/GDP (%) (3.1) (3.4) (3.7) (3.4) (3.4) (3.7) (3.7) (3.8)<br />

Real GDP (SAAR, qoq, %) 1.8 1.2 3.1 2.8 2.3 2.2 4.2 3.5<br />

Source: Bloomberg, CEIC, Kotak Institutional Equities<br />

Exhibit 9: Markets expect US Fed to hold rates in 2019<br />

Implied probabilities of Fed funds rate based on Fed fund future contract prices (%)<br />

Federal funds rate (%)<br />

2.00 2.25 2.50 2.75 3.00<br />

30-Jan-19 1.6 98.4<br />

20-Mar-19 1.5 93.4 5.1<br />

01-May-19 1.5 89.7 8.6 0.2<br />

19-Jun-19 1.4 85.3 12.7 0.6<br />

31-Jul-19 2.3 84.6 12.5 0.6<br />

18-Sep-19 2.2 80.8 15.9 1.2<br />

30-Oct-19 3.0 80.1 15.7 1.2<br />

11-Dec-19 0.3 9.8 74.4 14.4 1.1<br />

Source: CME, Kotak Institutional Equities<br />

6 KOTAK INSTITUTIONAL EQUITIES RESEARCH


Strategy<br />

India<br />

Exhibit 10: BJP won 62 out of 65 seats in Chhattisgarh, Madhya Pradesh and Rajasthan in the last<br />

general elections<br />

Current number of seats in Lok Sabha by states<br />

Name of state Members BJP INC<br />

Andhra Pradesh 25 2 —<br />

Arunachal Pradesh 2 1 1<br />

Assam 14 7 3<br />

Bihar 40 22 2<br />

Chhattisgarh 11 10 1<br />

Goa 2 2 —<br />

Gujarat 26 26 —<br />

Haryana 10 7 1<br />

Himachal Pradesh 4 4 —<br />

Jammu and Kashmir 6 3 —<br />

Jharkhand 14 12 —<br />

Karnataka 28 15 9<br />

Kerala 20 — 8<br />

Madhya Pradesh 29 26 3<br />

Maharashtra 48 22 2<br />

Manipur 2 — 2<br />

Meghalaya 2 — 1<br />

Mizoram 1 — 1<br />

Nagaland 1 — —<br />

Odisha 21 1 —<br />

Punjab 13 1 4<br />

Rajasthan 25 23 2<br />

Sikkim 1 — —<br />

Tamil Nadu 39 1 —<br />

Telangana 17 1 —<br />

Tripura 2 — —<br />

Uttar Pradesh 80 68 2<br />

Uttarakhand 5 5 —<br />

West Bengal 42 2 4<br />

Total 543 272 48<br />

Rest of India (a) - (c) 340 242 17<br />

Chhattisgarh, Gujarat, MP, Rajasthan and UP 171 153 8<br />

Notes:<br />

(1) BJP has lost three seats in Madhya Pradesh and Rajasthan in by-elections after the 2014 general elections.<br />

Source: Lok Sabha, Election COmmission, Kotak Institutional Equities<br />

KOTAK INSTITUTIONAL EQUITIES RESEARCH 7


India<br />

Strategy<br />

Exhibit 11: Banks, IT services, metals & mining and oil, gas & consumable fuels sectors to drive incremental profits of the Nifty-50 Index in<br />

FY2019-20E<br />

Break-up of net profits of the Nifty-50 Index across sectors, March fiscal year-ends, 2016-21E (based on current constituents)<br />

Incremental profits<br />

Net profits (Rs bn) Contribution (%) 2019E<br />

2020E 2021E<br />

2016 2017 2018 2019E 2020E 2021E 2017 2018 2019E 2020E 2021E (Rs bn) (%) (Rs bn) (%) (Rs bn) (%)<br />

Automobiles & Components 311 292 287 241 352 411 8 8 6 7 7 (46) (9) 111 11 58 8<br />

Tata Motors 140 94 68 4 72 105 3 2 0 1 2 (64) (13) 68 7 33 5<br />

Banks 485 495 320 526 1,088 1,350 14 9 13 22 24 206 42 562 54 261 36<br />

Axis Bank 82 35 3 47 108 122 1 0 1 2 2 44 9 61 6 14 2<br />

ICICI Bank 97 98 68 53 171 205 3 2 1 3 4 (15) (3) 118 11 34 5<br />

State Bank of India 100 105 (65) 67 351 466 3 (2) 2 7 8 132 27 284 27 115 16<br />

Capital Goods 41 59 72 97 97 110 2 2 2 2 2 24 5 1 0 13 2<br />

Commodity Chemicals 18 19 20 23 29 34 1 1 1 1 1 3 1 6 1 5 1<br />

Construction Materials 49 58 55 79 96 115 2 2 2 2 2 24 5 17 2 18 2<br />

Consumer Staples 134 144 162 183 209 236 4 5 5 4 4 21 4 26 2 27 4<br />

Diversified Financials 127 147 213 210 256 311 4 6 5 5 5 (3) (1) 46 4 55 8<br />

Electric Utilities 121 177 186 218 248 282 5 5 6 5 5 33 7 30 3 34 5<br />

Fertilizers & Agricultural Chemicals 11 18 22 24 27 31 1 1 1 1 1 2 0 4 0 3 0<br />

Gas Utilities 22 38 46 71 74 80 1 1 2 1 1 25 5 2 0 6 1<br />

IT Services 553 604 610 709 794 864 18 18 18 16 15 99 20 85 8 70 10<br />

Media 10 13 14 16 19 21 0 0 0 0 0 2 0 3 0 2 0<br />

Metals & Mining 9 168 275 331 348 383 5 8 8 7 7 57 12 16 2 35 5<br />

Tata Steel (19) 40 81 108 97 112 1 2 3 2 2 27 6 (11) (1) 15 2<br />

Oil, Gas & Consumable Fuels 781 1,013 981 1,056 1,157 1,236 29 29 27 23 22 75 16 100 10 80 11<br />

Coal India 143 93 70 161 164 168 3 2 4 3 3 91 19 3 0 4 0<br />

ONGC 174 217 223 249 279 269 6 7 6 6 5 25 5 30 3 (10) (1)<br />

Reliance Industries 253 299 350 399 465 524 9 10 10 9 9 49 10 66 6 59 8<br />

Pharmaceuticals 91 92 60 72 97 121 3 2 2 2 2 11 2 25 2 24 3<br />

Retailing 7 8 11 14 18 22 0 0 0 0 0 3 1 4 0 4 0<br />

Telecommunication Services 63 61 44 (9) (13) 10 2 1 (0) (0) 0 (54) (11) (4) (0) 23 3<br />

Transportation 29 39 38 42 47 60 1 1 1 1 1 4 1 5 0 13 2<br />

Nifty-50 Index 2,861 3,444 3,419 3,905 4,944 5,675 100 100 100 100 100 486 100 1,039 100 732 100<br />

Nifty-50 change (%) 2.2 20.4 (0.7) 14.2 26.6 14.8<br />

Nifty-50 EPS (FF) 384 439 448 507 658 763<br />

Source: Companies, Kotak Institutional Equities estimates<br />

Exhibit 12: 'Barbell' portfolio of 'growth' and 'value' stocks<br />

KIE large-cap. model portfolio<br />

Price (Rs) KIE weight Price (Rs) KIE weight<br />

Company 31-Dec-18 (%) 31-Dec-18 (%)<br />

Automobiles & Components<br />

Gas Utilities<br />

Mahindra & Mahindra 804 4.0 GAIL (India) 360 3.1<br />

Maruti Suzuki 7,466 2.7 Gas Utilities 3.1<br />

Tata Motors 173 1.5 Insurance<br />

Automobiles & Components 8.2 ICICI Prudential Life 325 2.2<br />

Banks Insurance 2.2<br />

Axis Bank 620 4.0 IT Services<br />

HDFC Bank 2,122 10.1 Infosys 660 9.5<br />

ICICI Bank 360 9.6 L&T Infotech 1,731 2.1<br />

IndusInd Bank 1,599 2.2 Tech Mahindra 723 2.7<br />

State Bank of India 296 5.9 IT Services 14.3<br />

Banks 31.8 Metals & Mining<br />

Capital Goods Hindalco Industries 226 1.9<br />

L&T 1,438 5.5 Vedanta 202 1.9<br />

Capital Goods 5.5 Tata Steel 521 1.9<br />

Diversified Financials Metals & Mining 5.7<br />

HDFC 1,970 8.2 Oil, Gas & Consumable Fuels<br />

LIC Housing finance 489 2.2 ONGC 150 1.8<br />

Diversified Financials 10.4 Reliance Industries 1,121 8.4<br />

Electric Utilities Oil, Gas & Consumable Fuels 10.2<br />

NTPC 149 1.9 Pharmaceuticals<br />

Pow er Grid 199 2.7 Cipla 520 2.0<br />

Electric Utilities 4.7 Sun Pharmaceuticals 431 2.0<br />

Pharmaceuticals 4.0<br />

BSE-30 36,068 100<br />

Source: Kotak Institutional Equities estimates<br />

8 KOTAK INSTITUTIONAL EQUITIES RESEARCH


Strategy<br />

India<br />

Exhibit 13: We recommend mid-cap. stocks in automobiles & components, banks, capital goods, diversified financials and gas utilities<br />

KIE mid-cap. model portfolio<br />

Fair<br />

Price Value Upside Mkt cap. EPS (Rs)<br />

PER (X) PBR (X) RoE (%)<br />

Company Sector Rating (Rs) (Rs) (%) (Rs bn) (US$ mn) 2019E 2020E 2021E 2019E 2020E 2021E 2019E 2020E 2021E 2019E 2020E 2021E<br />

CESC Electric Utilities BUY 669 790 18 89 1,269 89 106 114 8 6 6 0.7 0.7 0.6 9 11 11<br />

Cholamandalam Diversified Financials ADD 1,260 1,425 13 197 2,819 75 91 114 17 14 11 3.4 2.8 2.4 21 21 22<br />

Escorts Automobiles & Components BUY 706 1,050 49 60 1,239 57 67 75 12 11 9 2.1 1.8 1.6 17 17 17<br />

Equitas Holdings Banks BUY 125 160 28 43 611 4 8 11 28 15 11 1.8 1.6 1.4 6 11 13<br />

Federal Bank Banks BUY 93 105 13 185 2,645 6 8 10 15 12 10 1.5 1.4 1.3 9 12 13<br />

Jubilant Foodw orks Hotels & Restaurants BUY 1,252 1,370 9 165 2,365 24 33 43 51 38 29 12.4 9.5 7.3 28 29 29<br />

Kalpataru Pow er Transmission Capital Goods BUY 392 540 38 60 862 30 36 42 13 11 9 1.9 1.7 1.4 16 16 17<br />

Laurus Labs Pharmaceuticals BUY 380 460 21 40 578 15 28 33 25 14 11 2.5 2.1 1.8 10 17 16<br />

Max Financial Services Insurance BUY 445 510 15 120 1,711 6 6 6 71 70 69 — — — 8 8 8<br />

Mindtree IT Services ADD 865 1,080 25 142 2,032 45 55 63 19 16 14 4.4 3.7 3.2 25 26 25<br />

Petronet LNG Gas Utilities BUY 224 280 25 336 4,813 16 18 21 14 12 11 3.2 2.9 2.6 23 24 25<br />

Prestige Estates Projects Real Estate ADD 220 270 23 82 1,180 6 7 8 34 29 27 1.7 1.6 1.5 5 6 6<br />

Sadbhav Engineering Capital Goods BUY 211 340 61 36 519 15 18 19 14 11 11 1.7 1.5 1.3 13 14 13<br />

Shriram City Union Finance Diversified Financials ADD 1,575 1,875 19 104 1,488 142 158 189 11 10 8 1.8 1.6 1.4 16 16 16<br />

Shriram Transport Diversified Financials BUY 1,240 1,450 17 281 4,027 107 124 143 12 10 9 1.9 1.7 1.5 17 17 17<br />

Source: Companies, Kotak Institutional Equities estimates<br />

KOTAK INSTITUTIONAL EQUITIES RESEARCH 9


December 12, 2018 05:15 AM GMT<br />

India Equity Strategy | Asia Pacific<br />

2019 Outlook: Odds in Favor of<br />

Equities<br />

Fundamentals (both macro and corporate) appear to be at the<br />

start of a new up cycle, valuations are at mid cycle and market<br />

sentiment or psychology looks depressed. On balance, equity<br />

shares appear to offer more upside than downside.<br />

MORGAN STANLEY INDIA COMPANY PRIVATE LIMITED+<br />

Ridham Desai<br />

EQUITY STRATEGIST<br />

Ridham.Desai@morganstanley.com<br />

Sheela Rathi<br />

EQUITY STRATEGIST<br />

Sheela.Rathi@morganstanley.com<br />

+91 22 6118-2222<br />

+91 22 6118-2224<br />

Our 2019 outlook note is inspired by Howard Mark's latest book "Mastering the<br />

Market Cycle". As Howard Mark says where we are in the cycle contains<br />

significant information about where we could be heading. So where exactly are<br />

we in the cycle as far Indian stocks are concerned: the political cycle (measured<br />

as policy certainty) is likely to turn down, growth is likely moving higher, credit<br />

growth seems to be at the beginning of a new cycle, terms of trade are<br />

improving, rates are probably taking a brief pause before continuing to head<br />

higher, profit margins appear to be at the start of a new up cycle, valuations are<br />

bang in the middle of the historical range and could go either way depending on<br />

other factors, and sentiment is more likely to improve from post crisis lows.<br />

After a volatile 2018, on balance equities could be poised for better returns in<br />

2019 with the caveat that the Indian electorate does not deliver a shock verdict<br />

in the forthcoming 2019 elections by delivering a fragmented coalition<br />

government.<br />

Index target: Our Dec-19 Sensex target at 42,000, an INR and USD upside of<br />

20% and 25% compared to our MSCI EM index USD upside of 7%.<br />

Portfolio approach: We like GARP stocks among Banks, Discretionary<br />

Consumption and Industrials – both large and mid-caps. We are underweight<br />

Consumer Staples, Technology, Healthcare, Materials and Utilities. We are<br />

neutral on Energy and Telecoms.<br />

Morgan Stanley does and seeks to do business with<br />

companies covered in Morgan Stanley Research. As a<br />

result, investors should be aware that the firm may have a<br />

conflict of interest that could affect the objectivity of<br />

Morgan Stanley Research. Investors should consider<br />

Morgan Stanley Research as only a single factor in making<br />

their investment decision.<br />

For analyst certification and other important disclosures,<br />

refer to the Disclosure Section, located at the end of this<br />

report.<br />

+= Analysts employed by non-U.S. affiliates are not registered with<br />

FINRA, may not be associated persons of the member and may not<br />

be subject to NASD/NYSE restrictions on communications with a<br />

subject company, public appearances and trading securities held by<br />

a research analyst account.<br />

1


Portfolio Strategy<br />

We continue to back growth at a reasonable price. We believe the way to construct<br />

portfolios is to buy stocks of companies with the highest delta in return on capital. We<br />

expect market performance to broaden and hence also like mid-caps where the forward<br />

growth is not reflecting share price performance.<br />

Recap of our biggest sector views:<br />

Consumer Discretionary (+500bp): Strong consumer loan growth and rising real<br />

incomes drives our view.<br />

Financials (+500bp): Credit costs may have peaked driven by the bankruptcy<br />

process and a recovery in economic growth. Recapitalization should also help the<br />

Corporate banks. Loan growth prospects are improving as the economy gathers<br />

pace. Non-banks face growth slow down.<br />

Industrials (+400bp): Private capex is likely turning, and public capex remains<br />

strong.<br />

Technology (-600bp): Business momentum has been strong, but stocks have rerated<br />

and recent outperformance probably prices in INR depreciation.<br />

Consumer Staples (-300bp): Margins seemed to have peaked and relative earnings<br />

growth may falter over the coming months more due to a recovery in earnings in<br />

the broad market likely causing relative multiples for the sector to come under<br />

pressure.<br />

Healthcare (-200bp): The sector remains challenged by regulatory burdens.<br />

Utilities (-200bp): We prefer cyclical exposures.<br />

Materials (-100bp): Funding source for our overweights.<br />

Index Target: On our December 2019 target of 42,000, the BSE Sensex would trade at a<br />

forward P/E of 16.5x, and at a trailing P/E of 20x, slightly higher than the 25-year trailing<br />

average of 19x.<br />

Base case (50% probability) – BSE Sensex: 42,000: All outcomes are moderate.<br />

Growth accelerates slowly. We expect Sensex earnings growth of 21% YoY in F2019<br />

and 24% YoY in F2020.<br />

Bull case (30% probability) – BSE Sensex: 47,000: Better-than-expected outcomes,<br />

most notably on policy and global factors. The market starts believing in a strong<br />

election result (one party has a clear majority). Earnings growth accelerates to 29%<br />

in F2019 and 26% in F2020.<br />

Bear case (20% probability) – BSE Sensex: 33,000: Global conditions deteriorate and<br />

the market starts pricing in a poor election outcome (a hung parliament). Sensex<br />

earnings grow 16% in F2019 and 22% in F2020.<br />

2


Exhibit 1: BSE Sensex Outlook: Risk-Reward for Dec. 19<br />

48,000<br />

45,000<br />

42,000<br />

39,000<br />

36,000<br />

33,000<br />

30,000<br />

27,000<br />

24,000<br />

21,000<br />

Jun-14<br />

Sep-14<br />

Dec 19 Fwd probability-weighted<br />

outcome @ 42000<br />

Dec-14<br />

Mar-15<br />

Base Case<br />

(Dec 2019)<br />

Jun-15<br />

Sep-15<br />

Dec-15<br />

Apr-16<br />

Jul-16<br />

Oct-16<br />

Source: RIMES, Morgan Stanley Research (E) estimate<br />

Jan-17<br />

Apr-17<br />

Current Price<br />

(Dec 10, 2018)<br />

Jul-17<br />

Oct-17<br />

Feb-18<br />

May-18<br />

Aug-18<br />

34960<br />

Nov-18<br />

47000(+34%)<br />

Feb-19<br />

Historical<br />

Performance<br />

42000(20%)<br />

33000 (-6%)<br />

May-19<br />

Sep-19<br />

Dec-19<br />

Exhibit 2: Sector Model Portfolio<br />

Perform ance relative to M SC I India<br />

Sector O W / U W (bps) M T D YT D 12M<br />

M SC I India -5% -4% -1%<br />

C onsumer D isc. 500 -3% -24% -22%<br />

C onsumer Staples -300 8% 19% 17%<br />

Energy 0 -8% 4% 1%<br />

Financials 500 10% 3% 1%<br />

H ealthcare -200 -10% -9% -6%<br />

Industrials 400 11% 0% 0%<br />

Technology -600 -4% 30% 31%<br />

M aterials -100 -4% -14% -11%<br />

Telecoms 0 -7% -45% -45%<br />

U tilities -200 -5% -15% -17%<br />

Source: RIMES, MSCI, Morgan Stanley Research; Past performance is no guarantee of future results.<br />

Exhibit 3: Focus List<br />

Sector<br />

R ating<br />

Price as on<br />

N ov 14, 2018<br />

M C ap ($<br />

Avg 3M T /O<br />

R el to M SC I India<br />

YT D Perf<br />

12m Perf<br />

Bajaj Auto C ons. D isc. EW 2,725 10.9 19 -15% -14% 8%<br />

M &M C ons. D isc. O W 711 11.6 42 -1% 3% 22%<br />

Titan C ons. D isc. O W 907 11.1 42 10% 13% 26%<br />

ITC Staples O W 270 45.7 49 7% 4% 14%<br />

R eliance Industries Energy O W 1,090 95.3 175 23% 20% 22%<br />

Bharat Financial Financials ++ 982 1.9 18 2% -1% 110%<br />

H D FC Bank Financials O W 2,089 78.3 106 16% 15% 22%<br />

IC IC I Bank Financials O W 346 30.8 114 15% 13% 45%<br />

Indusind Bank Financials ++ 1,554 12.9 65 -2% -6% 25%<br />

Shriram Transport Financials O W 1,091 3.4 24 -23% -20% 29%<br />

IC IC I Pru Life Financials O W 307 6.1 7 -16% -18% 7%<br />

SBI Financials O W 274 33.7 103 -8% -12%<br />

2Y Fw d EPS<br />

Prestige Estates Financials O W 198 1.0 1 -35% -35% 6%<br />

Apollo H ospitals H ealthcare O W 1,177 2.3 12 2% 0% 91%<br />

Ashok Leyland Industrials O W 100 4.1 38 -12% -14% 21%<br />

Adani Ports Industrials O W 359 10.3 21 -8% -8% 9%<br />

Eicher M otors Industrials O W 22,405 8.4 37 -23% -22% 22%<br />

L & T Industrials O W 1,368 26.4 48 13% 13% 17%<br />

Asian Paints M aterials O W 1,274 16.9 27 15% 13% 16%<br />

U ltratech C ement M aterials O W 3,777 14.3 19 -9% -8% 23%<br />

bn)<br />

($ m n)<br />

G row th<br />

Source: RIMES, Morgan Stanley Research; ++ Rating and price target for this company have been removed<br />

from consideration in this report because, under applicable law and/or Morgan Stanley policy, Morgan Stanley<br />

may be precluded from issuing such information with respect to this company at this time. Past performance<br />

is no guarantee of future results. Transaction costs and dividends not included.<br />

Exhibit 4: Key Themes in Our Portfolio: We Prefer Growth Stocks and<br />

Wide Sector Positions<br />

Themes Implications Stocks<br />

Capex<br />

Companies that have done capex over<br />

the past 5 years<br />

Reliance Industries<br />

Unloved and underowned<br />

stocks<br />

Valuations and momentum<br />

Prestige Estates<br />

Rising ROCE<br />

Delta in ROCE probably more important<br />

Asian Paints, Titan<br />

Earnings revisions<br />

Growth at a reasonable<br />

price<br />

Source: Morgan Stanley Research.<br />

than just the level<br />

Earnings momentum is a key share price<br />

driver<br />

As a style growth is likely to lead<br />

performance in the coming months<br />

MMFS<br />

Bajaj Auto, HDFC Bank, ITC<br />

Exhibit 5: Style Performance: GARP in Form<br />

5000%<br />

4000%<br />

3000%<br />

2000%<br />

1000%<br />

0%<br />

-1000%<br />

-2000%<br />

-3000%<br />

Value Growth Quality Junk Momemtum<br />

Cumulative YoY trailing<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: RIMES, Morgan Stanley Research<br />

Exhibit 6: Morgan Stanley forecasts at a glance<br />

F2017 F2018E F2019E F2020E<br />

G DP G rowth (new) 7.1% 6.7% 7.6% 7.6%<br />

IIP G rowth 4.6% 4.4% 4.9% 5.2%<br />

Av erage CPI 4.5% 3.6% 3.9% 4.3%<br />

Repo Rate (year end) 6.25% 6.00% 6.50.% 7.25%<br />

CAD% of G DP -0.7% -1.9% -2.5% -2.3%<br />

Sensex EPS 1443 1479 1789 2210<br />

Sensex PE 24.2 23.6 19.5 15.8<br />

EPS growth YoY 2.3% 2.5% 21.0% 23.5%<br />

Broad M arket Earnings G rowth 0.0% 3.0% 20.0% 22.0%<br />

Broad M arket PE 28.7 27.9 23.2 19.1<br />

Source: RIMES, MSCI, Morgan Stanley Research (E) estimates<br />

Note: Prices as of December 10, 2018. Past performance is no guarantee of future<br />

results. Results shown do not include transaction costs.<br />

3


Assessing the Cycle - 2019 in Better Shape than 2018<br />

India's relative policy uncertainty appears to be at a cycle<br />

peak. When we combine this with the fact that India is<br />

heading into elections, a roll over is the most likely<br />

outcome. Surprisingly, despite high policy certainty for four<br />

years running, India's relative performance against EM has<br />

been weak. This tells us that on its own policy certainty is<br />

not enough to drive share prices.​<br />

Exhibit 7: Policy Uncertainty Index<br />

0<br />

50<br />

100<br />

150<br />

200<br />

250<br />

300<br />

350<br />

400<br />

450<br />

India Economic Policy Uncertainity Index relative to World (3MMA) (pushed forward 3M) on reverse scale -LS<br />

MSCI India YoY perf. Relative to ACWI<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: Economic policy uncertainty index, RIMES, MSCI, Morgan Stanley Research<br />

95%<br />

85%<br />

75%<br />

65%<br />

55%<br />

45%<br />

35%<br />

25%<br />

15%<br />

5%<br />

-5%<br />

-15%<br />

-25%<br />

-35%<br />

-45%<br />

The investment rate has now gone well below trend -<br />

reminiscent of the 2002-03. With the counter cyclical<br />

government capex already in place, capacity utilization and<br />

asset turn above average, and growth likely improving, a<br />

private capex cycle is in the offing post elections. This sets<br />

the stage for an improvement in corporate profit margins.<br />

Exhibit 8: Investment as % of GDP<br />

45%<br />

Investment(% of GDP) Linear (Investment(% of GDP))<br />

40%<br />

35%<br />

30%<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

F1952<br />

F1955<br />

F1958<br />

F1961<br />

F1964<br />

F1967<br />

F1970<br />

F1973<br />

F1976<br />

F1979<br />

F1982<br />

F1985<br />

F1988<br />

F1991<br />

F1994<br />

F1997<br />

F2000<br />

F2003<br />

F2006<br />

F2009<br />

F2012<br />

F2015<br />

F2018<br />

Source: CEIC, Morgan Stanley Research<br />

Growth appears to have troughed led by benign inflation, a<br />

turn in government capex, recovery in consumption and<br />

exports, and the passage of one time shocks like GST and<br />

demonetization.<br />

As a consequence, credit growth, which put in a bottom last<br />

year, seems to be entering a new cycle. Indeed, the peak of<br />

previous cycle was way above history and thus the recent<br />

trough was well below history.<br />

Exhibit 9: Manufacturing PMI<br />

64<br />

62<br />

60<br />

58<br />

56<br />

54<br />

52<br />

50<br />

48<br />

46<br />

44<br />

HSBC India Manufacturing Purchasing Managers’ Index<br />

Jan-06<br />

Jul-06<br />

Jan-07<br />

Jul-07<br />

Jan-08<br />

Jul-08<br />

Jan-09<br />

Jul-09<br />

Jan-10<br />

Jul-10<br />

Jan-11<br />

Jul-11<br />

Jan-12<br />

Jul-12<br />

Jan-13<br />

Jul-13<br />

Jan-14<br />

Jul-14<br />

Jan-15<br />

Jul-15<br />

Jan-16<br />

Jul-16<br />

Jan-17<br />

Jul-17<br />

Jan-18<br />

Jul-18<br />

Source: Markit Economics, Morgan Stanley Research<br />

Exhibit 10: Trailing 3-year Bank credit growth<br />

36%<br />

32%<br />

28%<br />

24%<br />

20%<br />

16%<br />

12%<br />

8%<br />

4%<br />

Oct-91<br />

Oct-93<br />

Oct-95<br />

Oct-97<br />

Oct-99<br />

Oct-01<br />

Trailing 3-yr Credit Growth<br />

Oct-03<br />

Oct-05<br />

Oct-07<br />

Oct-09<br />

Oct-11<br />

Oct-13<br />

Oct-15<br />

Oct-17<br />

Source: RBI, Morgan Stanley Research<br />

4


India's terms of trade went through a Yo-Yo ride last year.<br />

For now, with crude oil suffering a supply-led price fall, the<br />

terms of trade have once again shifted in India's favor.<br />

India's responds to supply shortage led spikes in oil - we<br />

have tried to identify these by measuring oil performance to<br />

copper (both commodities assumed to respond similar to<br />

improvement in global demand). We find that India's USD<br />

equity performance plots directionally against the<br />

oil/copper relative performance (as one would expect).<br />

Exhibit 11: Brent relative performance<br />

Brent crude Rel to Copper YoY Returns MSCI India Rel to EM YoY Returns<br />

80%<br />

60%<br />

40%<br />

20%<br />

0%<br />

-20%<br />

-40%<br />

-60%<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: RIMES, MSCI, Bloomberg, Morgan Stanley Research<br />

Exhibit 12: India 10 year yield<br />

-30%<br />

-20%<br />

-10%<br />

0%<br />

10%<br />

20%<br />

30%<br />

40%<br />

Whether the 10-year yield's recent peak is the peak of this<br />

cycle will demand primarily on how India's growth pans out<br />

next year. Since we are constructive on growth, to us it<br />

seems that bond yields may have further to rise in this<br />

cycle.<br />

Consistent with the economic cycle, short rates are likely to<br />

move higher albeit with a pause in the coming months given<br />

the benign headline inflation and reasonable real rates.<br />

Source: Bloomberg, Morgan Stanley Research<br />

Exhibit 13: Policy Rates<br />

12%<br />

11%<br />

Repo Rate Rev repo 91D Yield<br />

10%<br />

9%<br />

8%<br />

7%<br />

6%<br />

Revenue growth for Corporate India is already accelerating<br />

for the past several quarters and is now at a five-year high.<br />

Revenue growth could be heading higher in 2019.<br />

5%<br />

4%<br />

3%<br />

Apr-02<br />

Sep-02<br />

Feb-03<br />

Jul-03<br />

Dec-03<br />

May-04<br />

Oct-04<br />

Mar-05<br />

Aug-05<br />

Jan-06<br />

Jun-06<br />

Nov-06<br />

Apr-07<br />

Sep-07<br />

Feb-08<br />

Jul-08<br />

Dec-08<br />

May-09<br />

Oct-09<br />

Mar-10<br />

Aug-10<br />

Jan-11<br />

Jun-11<br />

Nov-11<br />

Apr-12<br />

Sep-12<br />

Feb-13<br />

Jul-13<br />

Dec-13<br />

May-14<br />

Oct-14<br />

Mar-15<br />

Aug-15<br />

Jan-16<br />

Jun-16<br />

Nov-16<br />

Apr-17<br />

Sep-17<br />

Feb-18<br />

Jul-18<br />

Dec-18<br />

May-19<br />

Oct-19<br />

Source: RBI, Bloomberg, Morgan Stanley Research<br />

Exhibit 14: Broad Market Revenue Growth<br />

30%<br />

Revenue growth (Broad Market -<br />

1178 cos) RS<br />

10%<br />

-10%<br />

Sep-04<br />

Sep-05<br />

Sep-06<br />

Sep-07<br />

Sep-08<br />

Sep-09<br />

Sep-10<br />

Sep-11<br />

Sep-12<br />

Sep-13<br />

Sep-14<br />

Sep-15<br />

Sep-16<br />

Sep-17<br />

Sep-18<br />

Source: Capitaline, Company data, Morgan Stanley Research<br />

5


The share of profits in GDP or profit margin seem to be<br />

putting in a trough and could be entering a new mediumterm<br />

cycle, which could last for five years and result in<br />

strong profit growth.<br />

Exhibit 15: India Corporate Profit to GDP<br />

8%<br />

7%<br />

6%<br />

5%<br />

4%<br />

3%<br />

2%<br />

1%<br />

0%<br />

Corporate Profits to GDP<br />

F1992<br />

F1993<br />

F1994<br />

F1995<br />

F1996<br />

F1997<br />

F1998<br />

F1999<br />

F2000<br />

F2001<br />

F2002<br />

F2003<br />

F2004<br />

F2005<br />

F2006<br />

F2007<br />

F2008<br />

F2009<br />

F2010<br />

F2011<br />

F2012<br />

F2013<br />

F2014<br />

F2015<br />

F2016<br />

F2017E<br />

Source: CMIE, Morgan Stanley Research (E) estimates<br />

Like with profit margins, ROEs also seem to be putting in a<br />

bottom and preparing for a new up cycle. Asset turn has<br />

already risen.<br />

Exhibit 16: ROE Trend<br />

24% ROE Trend<br />

22%<br />

20%<br />

18%<br />

16%<br />

14%<br />

12%<br />

10%<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

Valuations appear to be mid-cycle compared to<br />

fundamentals, which seem to be coming out of a cycle<br />

trough. We prefer to use PB as a valuation metric versus PE<br />

given how depressed earnings are relative to trend.<br />

Valuations could head either way in the short run<br />

depending on factors other than fundamentals such as<br />

India's election outcome and global events.<br />

Source: Worldscope, RIMES, Morgan Stanley Research<br />

Exhibit 17: India PB ratio<br />

7<br />

MSCI India<br />

PB<br />

LTA<br />

6<br />

+1 Stdev<br />

-1 Stdev<br />

5<br />

4<br />

3<br />

2<br />

1<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: RIMES, MSCI, Morgan Stanley Research<br />

EV/sales is also at long-term averages and pricing in some of<br />

the recovery in margins that could be in the pipeline.<br />

Exhibit 18: Sensex EV/Sales<br />

5.0<br />

4.5<br />

4.0<br />

3.5<br />

3.0<br />

2.5<br />

2.0<br />

1.5<br />

1.0<br />

0.5<br />

Sensex EV/Sales<br />

LTA Avg.<br />

Nov-95<br />

Nov-96<br />

Nov-97<br />

Nov-98<br />

Nov-99<br />

Nov-00<br />

Nov-01<br />

Nov-02<br />

Nov-03<br />

Nov-04<br />

Nov-05<br />

Nov-06<br />

Nov-07<br />

Nov-08<br />

Nov-09<br />

Nov-10<br />

Nov-11<br />

Nov-12<br />

Nov-13<br />

Nov-14<br />

Nov-15<br />

Nov-16<br />

Nov-17<br />

Nov-18<br />

Source: Company data, Morgan Stanley Research<br />

6


Relative to bonds, equities are at the top of their post crisis<br />

range. If a growth cycle is not forthcoming, the relative<br />

valuations will turn down as they have since 2010. In<br />

contrast, if profit growth starts accelerating (as we expect),<br />

the relative equity/bond valuations could break the range.<br />

Sentiment indicators also appear to be cycle troughs like<br />

our proprietary sentiment indicator, which made a post crisis<br />

low in October.<br />

Exhibit 19: Equity vs. Bond Yields<br />

2.5<br />

2.4<br />

2.3<br />

2.2<br />

2.1<br />

2.0<br />

1.9<br />

1.8<br />

1.7<br />

1.6<br />

1.5<br />

1.4<br />

1.3<br />

1.2<br />

1.1<br />

1.0<br />

0.9<br />

0.8<br />

0.7<br />

0.6<br />

0.5<br />

0.4<br />

0.3<br />

0.2<br />

0.1<br />

0.0<br />

1994<br />

Equity multiple (using 12M fwd PE) over bond multiple (using 10-year bond yields)<br />

Feb-00<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

Mar-03<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

Jan-08<br />

2007<br />

Dec-08<br />

Source: RIMES, MSCI, Bloomberg, Morgan Stanley Research<br />

2008<br />

2009<br />

Exhibit 20: Composite Sentiment Indicator<br />

2.0<br />

1.5<br />

1.0<br />

0.5<br />

Composite Sentiment Indicator (CSI)<br />

Jan-04<br />

Jun-99<br />

Nov-06<br />

Jan-08<br />

Oct-09<br />

Oct-10<br />

2010<br />

Nov-10<br />

2011<br />

2012<br />

Jun-14<br />

Sep-11 Jun-13<br />

2013<br />

2014<br />

Jul-15<br />

2015<br />

Nov-16<br />

2016<br />

Overbought<br />

2017<br />

SELL ZONE<br />

0.0<br />

Market breadth, one of the components of our sentiment<br />

indicator, has come close to a new all time low. An upturn is<br />

in the offing, which means the broad market's relative<br />

performance to the narrow indices will likely improve in<br />

2019.<br />

-0.5<br />

-1.0<br />

-1.5<br />

-2.0<br />

1998<br />

May-03<br />

May-00<br />

Dec-98<br />

Sep-01<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

Aug-06<br />

2007<br />

Apr-07<br />

2008<br />

Oct-08<br />

Source: RIMES, Bloomberg, ASA, BSE, CDSL, Morgan Stanley Research<br />

Exhibit 21: Market breadth - BSE500<br />

100%<br />

90%<br />

80%<br />

70%<br />

60%<br />

50%<br />

40%<br />

30%<br />

20%<br />

10%<br />

0%<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

Source: RIMES, BSE, Morgan Stanley Research<br />

2009<br />

2010<br />

% stocks above 200 DMA<br />

2009<br />

2010<br />

2011<br />

2011<br />

2012<br />

2012<br />

2013<br />

2013<br />

Sep 13<br />

2014<br />

Sell Zone<br />

2014<br />

2015<br />

2015<br />

Dec 16<br />

Feb 16<br />

2016<br />

Buy Zone<br />

2016<br />

BUY ZONE<br />

Oversold<br />

2017<br />

2017<br />

2018<br />

2018<br />

7


FPI flows have also made a cycle low, and with India<br />

ownership in the average EM portfolio down to seven-year<br />

lows, there is a good case for a turn in FPI flows in 2019.<br />

This is also consistent with our constructive EM call. Which<br />

domestic flows are making new highs, we would caution<br />

against using a cycle argument here since domestic flows<br />

seem to be in a structural uptrend.<br />

Exhibit 22: Flows data<br />

35,000<br />

12M trailing flows (US$ mn)<br />

30,000<br />

25,000<br />

20,000<br />

15,000<br />

10,000<br />

5,000<br />

-<br />

(5,000)<br />

(10,000)<br />

FPI flows<br />

DMF flows<br />

Total Flows<br />

(15,000)<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Inter day volatility has risen sharply over the past three<br />

months and the adjoining chart suggests that it is likely to<br />

come down in the coming months. That said, the market has<br />

to negotiate the usual rise in volatility associated with<br />

elections.<br />

Source: CDSL, SEBI, BSE, Morgan Stanley Research<br />

Exhibit 23: Interday Volatility<br />

100%<br />

80%<br />

60%<br />

3M change in 3M Rolling Interday<br />

Volatility<br />

40%<br />

20%<br />

0%<br />

-20%<br />

-40%<br />

Medium- and long-term equity returns could have put a<br />

floor last year and may continue their ascent in 2019.<br />

-60%<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

Source: Bloomberg, Morgan Stanley Research<br />

2015<br />

2016<br />

2017<br />

2018<br />

Exhibit 24: Sensex 3 year and 10 year gap<br />

80%<br />

70%<br />

60%<br />

50%<br />

40%<br />

30%<br />

20%<br />

10%<br />

0%<br />

-10%<br />

-20%<br />

40%<br />

10-year CAGR Sensex35%<br />

performance<br />

30%<br />

1989<br />

1990<br />

1991<br />

1992<br />

1993<br />

1994<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: Bloomberg, Morgan Stanley Research<br />

3-year CAGR Sensex<br />

performance<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

-5%<br />

8


Likewise for medium term relative returns for India vs. EM<br />

which could be in India's favor in 2019. Accordingly we are<br />

overweight India in our EM country portfolio.<br />

Historical value-at-risk tells us how much tail risk could be<br />

in the price. Given how low this number is, one thing seems<br />

certain that the market is not concerned about tail risks –<br />

something to be aware of.<br />

Exhibit 25: MSCI India relative perf. to EM<br />

25.0%<br />

20.0%<br />

15.0%<br />

10.0%<br />

5.0%<br />

0.0%<br />

-5.0%<br />

-10.0%<br />

-15.0%<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

Source: RIMES, MSCI, Morgan Stanley Research<br />

Exhibit 26: One month VAR<br />

-28%<br />

-24%<br />

-20%<br />

99%/One-month VaR for BSE Sensex<br />

Historically when VaR hits 12% VaR,<br />

tail risks seemed to be in play<br />

MSCI India price change relative to EM (3-year CAGR)<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

-16%<br />

-12%<br />

-8%<br />

-4%<br />

The correlation of returns across stocks has been rising in<br />

2018 after putting an all time low during the year. This tells<br />

us that macro/markets are driving stocks rather than<br />

idiosyncratic factors (i.e., stock picking is not in vogue for<br />

now). These correlations have still some distance to go to<br />

previous peak levels so the portfolio narrative is still one of<br />

rising market/macro effect rather than picking stocks.<br />

0%<br />

1981<br />

1983<br />

1985<br />

1987<br />

1989<br />

1991<br />

1993<br />

1995<br />

1997<br />

Source: Bloomberg, Morgan Stanley Research<br />

Exhibit 27: Correlation across stocks<br />

55%<br />

45%<br />

35%<br />

Stock pickers'<br />

time, Sep-04<br />

1999<br />

2001<br />

2003<br />

Explanatory Power of Market Effect<br />

Stock pickers' time, Jul-06<br />

Stock pickers' time,<br />

Jun-09<br />

2005<br />

Stock pickers'<br />

time, Dec -11<br />

2007<br />

2009<br />

2011<br />

2013<br />

2015<br />

Stock pickers'<br />

time, Mar-16<br />

2017<br />

1Y Rolling R-<br />

squared<br />

25%<br />

15%<br />

5%<br />

Time for macro,<br />

Aug-03<br />

Time for<br />

macro, Jul-05<br />

Time for macro, Time for macro,<br />

Aug-07 Oct-10<br />

Time for macro<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: RIMES, MSCI, Morgan Stanley Research<br />

9


1/4/2019 The impact on India's economy of demonetised currency returning to banks<br />

ECONOMY AND FINANCE<br />

GOVERNMENT AND POLICY<br />

OPINIONS<br />

The impact on India’s economy of demonetised<br />

currency returning to banks<br />

The pre-mature clamour based on single dimensional criteria of “all the money came back to<br />

banks” is meaningless by itself.<br />

SHASHANK GOYAL DECEMBER 25, 2018<br />

Prime Minister Narendra Modi<br />

<br />

Engagements 14863<br />

Get selected articles on WhatsApp<br />

<br />

In November 2016, Prime Minister Modi announced the withdrawal of two high-value<br />

currency denominations from circulation with immediate effect. Some social media<br />

economists and mainstream journalists had speculated that a large chunk of unaccounted<br />

cash may not return to the banks, thus resulting in a windfall for the government.<br />

When most demonetised currency returned to the banks, questions were raised on the<br />

success of demonetisation itself. However, evaluating demonetisation’s success on this basis<br />

alone would be jumping the gun.<br />

In December 2016, Tim Worstall in his article in Forbes had argued that –<br />

The only practicable method of retaining the value of those old notes was to deposit them into the<br />

banking system.<br />

However, we should also note that those same amounts of cash which have been deposited are<br />

now inside the reporting system for tax. And undoubtedly there will be some decent portion of<br />

those deposits which were formerly black money and which now will be righteously taxed.<br />

- Advertisement -<br />

https://www.opindia.com/2018/12/modi-government-impact-of-demonetised-currency-returning-to-banks-on-indias-economy/ 1/11


1/4/2019 The impact on India's economy of demonetised currency returning to banks<br />

- Article resumes -<br />

In other words, a chunk of currency not returning to banks would have ensured a large but<br />

one-time dividend to the government. On the other hand, most money returning to banks<br />

would ensure sustained bene ts in tax revenue spread over the long term.<br />

Two years later now in December 2018, data on tax revenue has con rmed this hypothesis,<br />

as detailed below.<br />

Expansion of Taxpayers base<br />

Per published data, the number of Income Tax returns have zoomed by 57% since<br />

demonetisation<br />

IT returns led in FY14 were 3.79 crore<br />

IT returns led in FY16 was 4.36 crore, implying that growth over 2 years period before<br />

demonetisation was 15%<br />

IT returns led in FY18 was 6.84 crores, implying that growth over 2 years period after<br />

demonetisation was signi cantly higher at 57%<br />

Number of High Net Worth individuals, declaring income above Rs 1 crore, has surged by<br />

68% since demonetisation<br />

Filers with 1 crore+ declared income in AY15 were 48,416<br />

Filers with 1 crore+ declared income in AY18 were 81,344 (up by 68%)<br />

Filers with 1 crore+ income, added in 69 years before demonetisation were 48,416<br />

New lers with 1 crore+ income, added in just 2 years after demonetisation were 32,928<br />

A surge in Direct Tax collections<br />

The direct tax growth rate has soared to a 7 year high of 17%<br />

FY15 – 8.9%<br />

FY16 – 6.9%<br />

FY17 – 14.6% (noticeable jump in growth rate after demonetisation)<br />

FY18 – 17.1%<br />

Direct tax buoyancy has more than tripled after demonetisation and touched 1.9<br />

FY16 – 0.6<br />

FY17 – 1.3<br />

FY18 – 1.9<br />

from FY08 to FY16, direct tax buoyancy had hovered between 0.5 and 1.1<br />

Source: Financial Express<br />

https://www.opindia.com/2018/12/modi-government-impact-of-demonetised-currency-returning-to-banks-on-indias-economy/ 2/11


1/4/2019 The impact on India's economy of demonetised currency returning to banks<br />

Higher tax buoyancy after FY16 indicates increasing tax compliance<br />

At Tax buoyancy of 0.5, an 8% increase in GDP results in (0.5 * 8) only 4% increase in tax<br />

revenue for government<br />

At Tax buoyancy of 2.0, an 8% increase in GDP results in (2.0 * 8) 16% increase in tax revenue<br />

for government<br />

Hence, with the same economic growth, the government can now expect a much higher tax<br />

collection year after year to spend on healthcare, education and infrastructure development<br />

Exponential growth in Digital Payments:<br />

Lack of cash during demonetisation provided the necessary impetus to bring behaviour<br />

change in consumers adopting digital payments. As per the data published by National<br />

Payments Corporation of India (NPCI):<br />

UPI (India’s homegrown payment system) based digital payments in India have grown<br />

exponentially since 2016<br />

the number of transactions:<br />

Aug 2016 – 93,000<br />

Nov 2018 – 52.5 crore (up by 5,645 times)<br />

value of transactions:<br />

Aug 2016 – 3.1 crore<br />

Nov 2018 – 82,000 crore (up by 26,451 times)<br />

Source: India Brand Equity Foundation<br />

https://www.opindia.com/2018/12/modi-government-impact-of-demonetised-currency-returning-to-banks-on-indias-economy/ 3/11


1/4/2019 The impact on India's economy of demonetised currency returning to banks<br />

Morgan Stanley has reported that digital payments are up almost three times, from 2.5% of GDP<br />

to 7% of GDP<br />

The proportion of cash transactions in total consumer spending has reduced by 10% (from 78%<br />

in 2015 to 68% in 2017) as reported by the head of payments practice for the Asia Paci c at<br />

Boston Consulting Group<br />

The exponential rise of digital payments in India received global attention and was covered<br />

extensively in Forbes, International Business Times, livemint, Entrepreneur, Financial Express,<br />

Bloomberg and other business publications<br />

Deposited amounts are traceable to source and are<br />

under scrutiny<br />

During demonetisation, deposits were made in about 1 crore bank accounts<br />

Just 1.5% of these accounts (about 1.5 lakh accounts) hold more than two-thirds (Rs. 10 lakh<br />

crore) value of deposits with an average deposit of Rs. 3.31 crore in each account<br />

Data Source: Time of India<br />

So far, 18 lakh accounts where deposits do not match known sources of income have been<br />

discovered. Tax notices have been sent to them and recoveries are expected from many<br />

The outcome and status of government scrutiny are accessible on the government portal for<br />

Operation Clean Money. Few prominent Success Stories of such tax recoveries and detailed<br />

reports are accessible on the portal<br />

Many companies who deposited large cash amounts were later found to exist only on paper.<br />

Many such companies have not come forward to claim those deposits due to fear of legal action.<br />

Per MoneyControl, such unclaimed deposits amount to Rs. 37,500 crore as of now<br />

It must be understood that since demonetisation in November 2016, only one tax cycle has<br />

been completed so far.<br />

https://www.opindia.com/2018/12/modi-government-impact-of-demonetised-currency-returning-to-banks-on-indias-economy/ 4/11


1/4/2019 The impact on India's economy of demonetised currency returning to banks<br />

Demonetisation – November 2016<br />

End of Fin Year – March 2017<br />

Next End of Fin year – March 2018<br />

Tax ling deadline – August 2018<br />

Individuals who deposited large amounts during demonetisation would be cross-checked for<br />

their tax ling in AY18 and subsequent future years. Hence, the bene ts of demonetisation<br />

need to be evaluated over a long-term into future.<br />

The pre-mature clamour based on single dimensional criteria of “all the money came back to<br />

banks” is meaningless by itself.<br />

Shashank Goyal<br />

IIM-A alumnus, Software Sales Professional,<br />

Writes about business, economy and politics; Passionate about numbers, facts and<br />

analysis<br />

Tweets @shashankgoyal01<br />

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TOPICS Arun Jaitley Demonetisation formal economy Good governance indian economy modi government<br />

Narendra Modi<br />

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demonetisation was a failure is<br />

totally misplaced<br />

https://www.opindia.com/2018/12/modi-government-impact-of-demonetised-currency-returning-to-banks-on-indias-economy/ 5/11


MARKET INSIGHTS<br />

The investment outlook for 2019<br />

The investment outlook for 2019: Late-cycle risks and opportunities<br />

AUTHORS<br />

IN BRIEF<br />

• The U.S. economy should slow but not stall in 2019 due to<br />

fading fiscal stimulus, higher interest rates and a lack of workers.<br />

Even as unemployment falls further, inflation should be<br />

relatively contained.<br />

• Central banks in the U.S. and abroad will tighten monetary policy<br />

in 2019 – this should continue to push yields higher. In the later<br />

stages of this cycle, investors may want to adopt a more<br />

conservative stance in their fixed income portfolios.<br />

• Higher rates should limit multiple expansion, leaving earnings as<br />

the main driver of U.S. equity returns. With earnings growth set to<br />

slow, and volatility expected to rise, investors may want to focus<br />

on sectors that have historically derived a greater share of their<br />

total return from dividends.<br />

• After a sharp fall in valuations in 2018, steady economic growth<br />

and less dollar strength may provide international equities some<br />

room to rebound in 2019. However, the climb will be bumpy and<br />

investors should ask themselves, in the short run, whether they<br />

have the right exposure within different regions and, in the long<br />

run, whether their exposure to international equities overall<br />

is adequate.<br />

• There are significant risks to the outlook for 2019. The Federal<br />

Reserve may tighten too much; profit margins may come under<br />

pressure sooner than anticipated; trade tensions may escalate or<br />

diminish; and geopolitical strife may force oil prices higher.<br />

• Timeless investing principles are especially relevant for investors<br />

in what appears to be the later stages of a market cycle. Investors<br />

may wish to tilt towards quality in portfolios along with an<br />

emphasis on diversification and rebalancing given higher levels<br />

of uncertainty.


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

INTRODUCTION<br />

2018 has been a difficult year for investors as long bull markets<br />

in both U.S. equities and fixed income have encountered strong<br />

headwinds, and international stocks have underperformed<br />

following a very strong 2017. Shifting fundamentals in an<br />

aging expansion have certainly played their part in slowing<br />

investment returns, as the U.S. Federal Reserve (Fed) has<br />

gradually tightened U.S. monetary policy, a new populist<br />

government in Italy has revived Eurozone fears and Middle<br />

East turmoil has led to more volatile oil prices.<br />

However, the single most important issue moving global<br />

markets in 2018 was rising trade tensions, and this will likely<br />

also be the case in 2019. In a benign scenario, the U.S. and<br />

China come to an agreement on trade issues, potentially<br />

allowing the dollar to fall and emerging market (EM) stocks to<br />

rebound following a very rocky 2018. In an alternative<br />

scenario, an escalating trade war could slow both the U.S. and<br />

global economies with negative implications for global stocks.<br />

While investors will likely focus attention on trade tensions and<br />

other risks to the forecast, it is also important to form a<br />

baseline view of the outlook. And so in the pages that follow,<br />

we outline what we believe is the most likely scenario for the<br />

U.S. economy, fixed income, U.S. equities and the global<br />

economy and markets. We also include a section exploring<br />

some risks to the forecast and end with a look at investing<br />

principles and how they can help investors weather what could<br />

be a volatile year ahead.<br />

U.S. ECONOMICS: FINDING MORE RUNWAY<br />

Entering 2019, the U.S. economy looks remarkably healthy,<br />

with a recent acceleration in economic growth, unemployment<br />

near a 50-year low and inflation still low and steady. Next July,<br />

the expansion should enter its 11th year, making this the<br />

longest U.S. expansion in over 150 years of recorded economic<br />

history. However, a continued soft landing, in the form of a<br />

slower but still steady non-inflationary expansion into 2020,<br />

will require both luck and prudence from policy makers.<br />

On growth, real GDP has accelerated in recent quarters and is<br />

now tracking a roughly 3% year-over-year pace. However,<br />

growth should slow in 2019 for four reasons:<br />

First, the fiscal stimulus from tax cuts enacted late last year<br />

will begin to fade. Under the crude assumption of an<br />

immediate fiscal multiplier of 1, the stimulus from tax cuts<br />

would have added 0.3% to economic activity in fiscal 2018<br />

(which ran from October 2017 to September 2018), 1.3% in<br />

fiscal 2019 and 1.1% in fiscal 2020. However, it is the change<br />

in stimulus, rather than the level of stimulus that impacts<br />

economic growth, so this tax cut would have added 0.7% and<br />

0.6% to the real GDP growth rate in the current and last fiscal<br />

years, respectively, but should actually subtract 0.1% from the<br />

GDP growth rate in the next fiscal year.<br />

Second, higher mortgage rates and a lack of pent-up demand<br />

should continue to weigh on the very cyclical auto and<br />

housing sectors.<br />

Third, under our baseline assumptions, the trade conflict with<br />

China worsens entering 2019 with a ratcheting up of tariffs to<br />

25% on USD 200 billion of U.S. goods. Even if the conflict does<br />

not escalate further, higher tariffs would likely hurt U.S.<br />

consumer spending and the uncertainty surrounding trade<br />

could dampen investment spending.<br />

Finally, a lack of workers could increasingly impede economic<br />

activity. Over the next year, the Census Bureau expects that<br />

the population aged 20 to 64 will rise by just 0.3%, a number<br />

that might even be optimistic given a recent decline in<br />

immigration. With the unemployment rate now well below<br />

4.0%, a lack of available workers may constrain economic<br />

activity, particularly in the construction, retail, food services<br />

and hospitality industries.<br />

Under this scenario, the U.S. unemployment rate should fall<br />

further. Real GDP growth impacts employment growth with a<br />

lag, and a few more quarters of above-trend economic growth<br />

could cut the unemployment rate to 3.2% by the end of 2019,<br />

which would be the lowest rate since 1953. However, we do not<br />

expect the unemployment rate to fall much below that level,<br />

as remaining unemployment at that point would largely be<br />

non-cyclical.<br />

2 THE INVESTMENT OUTLOOK FOR 2019


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

Civilian unemployment rate and year-over-year wage<br />

growth for private production and non-supervisory workers<br />

EXHIBIT 1: SEASONALLY ADJUSTED, PERCENT<br />

14%<br />

12%<br />

10%<br />

8%<br />

6%<br />

4%<br />

2%<br />

0%<br />

May 1975: 9.0%<br />

Nov. 1982: 10.8%<br />

Jun. 1992: 7.8%<br />

50-year avg.<br />

• Unemployment rate<br />

• Wage growth<br />

Jun. 2003: 6.3%<br />

Oct. 2009: 10.0%<br />

6.2%<br />

4.1%<br />

Oct. 2018:<br />

3.7%<br />

Oct. 2018: 3.2%<br />

’70 ’75 ’80 ’85 ’90 ’95 ’00 ’05 ’10 ’15 ’18<br />

Source: BLS, FactSet, J.P. Morgan Asset Management.<br />

Guide to the Markets – U.S. Data are as of October 31, 2018.<br />

As unemployment continues to fall, wage growth may rise<br />

somewhat further, as it did in October, as shown in Exhibit 1.<br />

However, the lack of responsiveness of wages to falling<br />

unemployment this far in the expansion speaks to a lack of<br />

bargaining power on the part of workers that should persist<br />

into 2019, holding overall wage inflation in check.<br />

Finally, consumer inflation should remain relatively stable in<br />

2019. A mild acceleration in wage growth will, undoubtedly,<br />

put some upward pressure on consumer prices. However, a<br />

recent rise in the U.S. dollar and fall in global oil prices should<br />

both work to keep inflation in check. Higher tariffs might, of<br />

course, add to consumer inflation in the short run. However,<br />

their depressing effect on economic activity would likely<br />

counteract this. With or without higher tariffs, we expect<br />

consumer inflation, as measured by the personal consumption<br />

deflator, to end 2019 in much the same way as 2018, very close<br />

to the Fed’s 2.0% long-run target.<br />

With regards to the U.S. dollar, the currency may face some<br />

further upward pressure early in 2019 as U.S. growth remains<br />

strong and uncertainty around trade abounds. However, later<br />

into the year, the combination of a slowing U.S. economy, a<br />

more cautious Fed and tightening by international central<br />

banks should cause the U.S. dollar to end 2019 flat to down<br />

compared to the end of 2018.<br />

FIXED INCOME: TIME FOR THE BUBBLE PACK<br />

U.S. fixed income investors have faced a tough environment in<br />

2018. Faster growth, growing fiscal deficits and balance sheet<br />

reduction pushed the U.S. 10-year yield from 2.40% at the end<br />

of 2017 to 3.15% by mid-November. The Bloomberg Barclays<br />

U.S. Aggregate has fallen 2.3% year-to-date, looking set to end<br />

2018 in negative territory – only the fourth year since 1980<br />

that the benchmark has registered an annual decline. So what<br />

might 2019 hold for investors in bonds?<br />

The Fed should continue to raise rates early in 2019, adding<br />

two more rate hikes by mid-summer and pushing the federal<br />

funds rate to a range of 2.75%-3.00%. However, if economic<br />

growth slows in the second half of 2019, inflation should<br />

remain remarkably stable for this late in the cycle. This could<br />

allow the Fed to pause its hiking cycle at that point, and<br />

economic data may not give them reason to resume<br />

tightening again.<br />

A number of other central banks will also join the Fed in<br />

gradually tightening monetary policy in 2019. The European<br />

Central Bank will finish purchasing assets by January 2019 and<br />

should begin raising rates by mid-2019. Other central banks,<br />

such as the Bank of England and the Bank of Japan, should<br />

engage in some form of modest tightening.<br />

Some investors may see this global tightening as a concerning<br />

development since, in many ways, central banks have provided<br />

the training wheels to help stabilize markets over the course of<br />

this cycle. However, the gradual removal of these training<br />

wheels shows that central banks believe economies can now<br />

cycle on without their support – a sign of strength, not of<br />

weakness. Nevertheless, while the removal of this support<br />

should be viewed as a positive, it could trigger increased<br />

volatility and gradually rising yields.<br />

So how should investors be positioned going into next year?<br />

As we get later into this economic cycle, it is important that<br />

investors begin to bubble pack their portfolios. This, in effect,<br />

means dialing back on some of the riskier bond sectors and<br />

seeking the safety of traditional fixed income asset classes.<br />

This step may involve sacrificing some upside in the short term<br />

for additional protection.<br />

J.P. MORGAN ASSET MANAGEMENT 3


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

At this point in the cycle, investors should remember the<br />

diversification benefits of core bonds, as highlighted in<br />

Exhibit 2. Exhibit 2 shows that higher yielding, riskier asset<br />

classes, such as EM debt or high yield, may offer more yield,<br />

but with stronger correlations to the S&P 500. Therefore, if<br />

equities fall sharply, riskier bond sectors will not provide much<br />

protection. In short, higher yield equals higher risk.<br />

Late in the cycle investors should remember higher yield<br />

equals higher risk<br />

EXHIBIT 2: CORRELATION OF FIXED INCOME SECTORS VS. S&P 500<br />

AND YIELDS<br />

8%<br />

7%<br />

6%<br />

5%<br />

4%<br />

3%<br />

US government<br />

US non-government<br />

International<br />

Safety<br />

Sectors<br />

Spain<br />

MBS<br />

Global x-US<br />

Germany FranceUK<br />

US agg<br />

US 30y<br />

US 10y<br />

US 2y<br />

US 5y Australia<br />

Japan<br />

Canada<br />

Munis<br />

Italy<br />

TIPS<br />

US IG<br />

EU<br />

ABS<br />

Floating<br />

Higher risk<br />

sectors<br />

Euro HYz<br />

US HY<br />

EMD USD<br />

EMD local<br />

Euro IG<br />

2%<br />

-0.4 -0.2 0.0 0.2 0.4 0.6 0.8<br />

Source: Bloomberg, FactSet, ICE, J.P. Morgan Asset Management. Data are as of<br />

July 7, 2018.<br />

International fixed income sector correlations are in hedged US dollar returns as<br />

U.S. investors getting into international markets will typically hedge. EMD local<br />

index is the only exception – investors will typically take the foreign exchange risk.<br />

Yields for all indices are in hedged returns using three-month London interbank<br />

offered rates (LIBOR) between the U.S. and international LIBOR. The Bloomberg<br />

Barclays ex-U.S. Aggregate is a market-weighted LIBOR calculation. Data are as of<br />

September 12, 2018.<br />

A common theme in this cycle has been the hunt for yield, with<br />

investors moving into unfamiliar asset classes searching for<br />

higher returns to offset the low yields in core bonds. This isn’t<br />

necessarily an incorrect strategy in the early or middle stages<br />

of an economic expansion; however, in the late cycle this<br />

approach becomes riskier. Instead, investors should consider<br />

trimming higher-risk sectors and rotating into safer, higherquality<br />

assets. Areas like short duration bonds offer some yield<br />

to investors with downside protection.<br />

The key takeaway for investors is that central banks will<br />

continue to tighten monetary policy in 2019, inflicting some<br />

pain on bond-holders. However, at this stage in the cycle, the<br />

focus should begin to switch from yield maximization to<br />

downside protection. In short, now is the time to start adding<br />

bubble pack to portfolios.<br />

EQUITIES: A LITTLE MORE DEFENSE AS THE<br />

LIQUIDITY SAFETY NET IS REMOVED<br />

The end of 2018 has served as a reminder that stock market<br />

volatility is alive and well. Investors have recognized that trees<br />

do not grow to the sky, and that the robust pace of profit and<br />

economic growth seen this year will gradually fade in 2019 as<br />

interest rates move higher. While history suggests that there<br />

are still attractive returns to be had in the late stages of a bull<br />

market, the transition away from quantitative easing and<br />

toward quantitative tightening has contributed to broader<br />

investor concerns. Many equate this new environment to<br />

walking on an investment tightrope without the liquidity safety<br />

net that has been present for over a decade.<br />

While it is true risks are beginning to build, there are still some<br />

bright spots. First, earnings growth looks set to slow from the<br />

+25% pace seen this year, but does not look set to stop, as<br />

shown in Exhibit 3. Consensus forecasts point to annual<br />

earnings growth of 10%-12% next year; risks to this forecast<br />

are to the downside, but earnings could still grow at a mid to<br />

high single-digit pace in 2019, providing support for the stock<br />

market to move higher.<br />

S&P 500 year-over-year EPS growth<br />

EXHIBIT 3: ANNUAL GROWTH BROKEN INTO REVENUE, CHANGES IN<br />

PROFIT MARGIN & CHANGES IN SHARE COUNT<br />

60%<br />

40%<br />

20%<br />

0%<br />

-20%<br />

-40%<br />

-60%<br />

<br />

-31%<br />

Share of EPS Growth 3Q18 Avg.’01-’17<br />

• Margin 17.7% 3.8%<br />

47%<br />

• Revenue 9.1% 3.0%<br />

• Share count 1.7% 0.2%<br />

3Q18*<br />

Total EPS 28.5% 6.9%<br />

27% 27% 29%<br />

24%<br />

<br />

19% 19% <br />

17%<br />

13% 15%<br />

15% 15% 11% <br />

<br />

<br />

5% 6%<br />

0% <br />

<br />

<br />

-6%<br />

<br />

-40%<br />

<br />

-11%<br />

’01 ’02 ’03 ’04 ’05 ’06 ’07 ’08 ’09 ’10 ’11 ’12 ’13 ’14 ’15 ’16 ’17 1Q18 2Q18 3Q18<br />

Source: Compustat, FactSet, Standard & Poor’s, J.P. Morgan Asset Management.<br />

Earnings per share levels are based on annual operating earnings per share except<br />

for 2018, which is quarterly.*3Q18 earnings are calculated using actual earnings for<br />

68.3% of S&P 500 market cap and earnings estimates for the remaining companies<br />

Percentages may not sum due to rounding. Past performance is not indicative of<br />

future returns. Guide to the Markets – U.S. Data are as of October 31, 2018.<br />

4 THE INVESTMENT OUTLOOK FOR 2019


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

The risks to earnings, however, lie in profit margins and trade.<br />

2018 has seen profit margins expand significantly on the back<br />

of tax reform, but with both wage growth and interest rates<br />

expected to rise further next year, margins should begin to<br />

come under pressure. Importantly, we believe that profit<br />

margins should revert to the trend, rather than the mean,<br />

and as such we are not expecting a sharp adjustment from<br />

current levels.<br />

Trade is a less quantifiable risk – we believe an escalating trade<br />

war with China could have a significant direct impact on S&P<br />

500 profits, and could have further indirect costs depending on<br />

the extent of Chinese retaliation and the dampening impact of<br />

the turmoil on business confidence and the global economy.<br />

However, on a close call, we believe that the U.S. and China will<br />

avoid escalation beyond an increase in tariffs on USD 200<br />

billion of Chinese goods, scheduled for January 1st, and a<br />

predictable Chinese response to this move.<br />

A backdrop of rising rates will not only pressure profit margins<br />

and earnings, it will also pressure valuations. Years of<br />

quantitative easing by the world’s major central banks pushed<br />

investors into risk assets – most notably equities – as they<br />

sought to generate any sort of meaningful return. However,<br />

short-term interest rates are now positive after adjusting for<br />

inflation, creating some viable competition for stocks. With the<br />

Fed expected to hike rates at least two more times in 2019,<br />

higher yields seem set to remain a headwind to stock market<br />

valuations over the coming months.<br />

Slower earnings growth and more muted valuations certainly<br />

do not seem like an ideal fundamental backdrop for equities.<br />

While it is true that the outlook is beginning to look less bright,<br />

it is important to remember two things: markets care about<br />

changes in expectations more than they care about<br />

expectations themselves, and the stock market tends to<br />

generate solid returns at the end of the cycle.<br />

As prospects for slower economic growth become clearer in<br />

the middle of next year, the Fed may signal it will pause. Such<br />

a signal, or a trade agreement with China, could lead multiples<br />

to expand, pushing the stock market higher and potentially<br />

adding years to this already old bull market. However, even if<br />

the bull market does end in the next few years, it is important<br />

to remember that late-cycle returns have typically been<br />

quite strong.<br />

This leaves investors in a tough spot – should they focus on<br />

a fundamental story that is softening, or invest with an<br />

expectation that multiples will expand as the bull market runs<br />

its course? The best answer is probably a little bit of each. We<br />

are comfortable holding stocks as long as earnings growth is<br />

positive, but do not want to be over-exposed given an<br />

expectation for higher volatility. As such, higher-income<br />

sectors like financials and energy look more attractive than<br />

technology and consumer discretionary, and we would lump<br />

the new communication services sector in with the latter<br />

names, rather than the former. However, given our expectation<br />

of still some further interest rate increases, it does not yet<br />

seem appropriate to fully rotate into defensive sectors like<br />

utilities and consumer staples. Rather, a focus on cyclical value<br />

should allow investors to optimize their upside/downside<br />

capture as this bull market continues to age.<br />

INTERNATIONAL EQUITIES: DOES THE FOG LIFT<br />

IN 2019?<br />

Going into 2018, we had expected international equities to<br />

continue the climb they began the prior year. As the year<br />

comes to a close, major regions outside of the U.S. seem set<br />

to deliver negative returns in U.S. dollar terms. Looking at a<br />

breakdown of international returns in 2018, as shown in<br />

Exhibit 4, it is easy to see that the climb was halted not<br />

because the plane itself was not solid, but because there was a<br />

lot of fog on the runway. Said another way, fundamentals<br />

themselves were positive in 2018, but a multitude of risks<br />

dented investor confidence, causing significant multiple<br />

contraction and currency weakness across the major regions.<br />

As a result, the question for 2019 is whether the fog will begin<br />

to lift, improving sentiment toward international investing and<br />

permitting international equities to take off once again.<br />

2018 was a year of souring sentiment towards international<br />

EXHIBIT 4: SOURCES OF GLOBAL EQUITY RETURNS, TOTAL RETURN, USD<br />

25%<br />

Total return<br />

• EPS growth outlook (local)<br />

20%<br />

• Dividends<br />

• Multiples<br />

15%<br />

• Currency effect<br />

10%<br />

5% 3.0%<br />

<br />

0%<br />

-5%<br />

-6.7%<br />

<br />

-9.4%<br />

-10%<br />

-10.6%<br />

<br />

-15.4%<br />

-15%<br />

<br />

-20%<br />

-25%<br />

U.S. Japan Europe ex-UK ACWI ex-U.S. EM<br />

Source: FactSet, MSCI, Standard & Poor’s, J.P. Morgan Asset Management.<br />

All return values are MSCI Gross Index (official) data, except the U.S., which is the<br />

S&P 500. Multiple expansion is based on the forward P/E ratio and EPS growth<br />

outlook is based on next twelve month actuals earnings estimates. Data are as of<br />

October 31, 2018.<br />

J.P. MORGAN ASSET MANAGEMENT 5


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

The first factor affecting confidence abroad was<br />

disappointment around economic growth. In absolute terms,<br />

global economic data remained on much more solid footing in<br />

2018 compared to the crisis-filled years of 2011 to 2016. This<br />

allowed earnings growth to continue improving, a process that<br />

began only in 2016 for many regions outside of the U.S.<br />

However, economic data did cool a bit from 2017’s hot climate<br />

and, crucially, it did disappoint expectations, especially in the<br />

Eurozone and Japan. We do expect economic data in these<br />

regions to improve a bit in 2019, giving investors greater<br />

confidence in the 10% and 8% 2019 earnings estimates for the<br />

Eurozone and Japan, respectively.<br />

In the Eurozone, we should see an improvement from 2018’s<br />

somewhat mysterious slowdown, with growth averaging closer<br />

to 2%. While we expect the European Central Bank to take its<br />

first steps toward policy normalization in mid-2019, this will be<br />

a very gradual process. As a result, monetary conditions will<br />

remain very accommodative in the region, providing ongoing<br />

support to private credit growth, a falling unemployment rate,<br />

rising wages and high consumer and business confidence. Our<br />

base case assumption of a continued détente between the<br />

European Union and the U.S. on trade should also provide<br />

support to business confidence and activity; however, a<br />

stronger euro will limit the support net exports are able to<br />

provide to growth. In addition, as usual, domestic politics will<br />

continue to provide pockets of turbulence. We do not expect an<br />

easy resolution to the budget standoff between the Italian<br />

government and the European Commission, keeping growth in<br />

Italy subdued, but we also do not expect a departure of Italy<br />

from the euro, which greatly limits the contagion to the rest of<br />

the region.<br />

In addition, March marks the official departure of the UK from<br />

the European Union. The road to a deal will not be easy, but<br />

we ultimately assume that a deal occurs, avoiding a scenario in<br />

which the UK “crashes” out of the European Union. This would<br />

remove a key uncertainty for the UK, resulting in an<br />

acceleration in business investment and consumer spending.<br />

As the Bank of England speeds up its normalization next year,<br />

we are likely to see sterling strengthen.<br />

For Japan, 2018 also brought some economic disappointments,<br />

with some clearly temporary as a result of a multitude of<br />

natural disasters. Growth should pick up a bit above 1% next<br />

year, as nascent but rising wage growth supports consumption<br />

early in the year and our base case of no escalation of trade<br />

tensions between the U.S. and Japan provides some support to<br />

business sentiment and activity. However, some adjustment in<br />

the Bank of Japan’s policy may place some upward pressure on<br />

the yen, limiting the support from net export growth. Lastly,<br />

growth may become very bumpy during the second half of the<br />

year if the Japanese government does decide to proceed with<br />

the VAT hike in October.<br />

While an improvement in economic growth in Europe and<br />

Japan in 2019 would get the international plane further down<br />

the runway, investors should take note that the resulting<br />

monetary policy normalization and currency strength will<br />

create winners and losers in these markets. Big exporters,<br />

which make up a significant portion of these markets, will likely<br />

see their earnings come under pressure once converted back<br />

into local currency. However, the financial sector may finally<br />

see some tailwinds after years of headwinds from low or<br />

negative interest rates.<br />

The second factor affecting confidence in 2018 was the multifront<br />

trade fight between the U.S. and its major trading<br />

partners. In our base case scenario, we do not expect a quick<br />

resolution to trade tensions between the U.S. and China in<br />

2019 and investors will be very sensitive to Chinese economic<br />

data during the year. Ultimately, we do expect the multitude of<br />

stimulus measures from the Chinese government to provide a<br />

floor to Chinese GDP growth at 6%. Should economic data<br />

falter more than expected, we expect the Chinese government<br />

to enact further fiscal stimulus in order to shore up activity and<br />

confidence. This would lift a very crucial fog for EM economies<br />

and risk assets more broadly.<br />

6 THE INVESTMENT OUTLOOK FOR 2019


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

The last major issue affecting confidence in 2018 was the<br />

strength of the U.S. dollar, as it put into doubt the EM<br />

economic and earnings story. Our expectation of further dollar<br />

strength early in the year will likely restrain EM assets;<br />

however, as Chinese data stabilizes, the Fed pauses and the<br />

dollar’s climb reverses later in the year, EM assets may finally<br />

have some room to take off. However, as global liquidity<br />

continues to be drained next year, not all EM planes will fly at<br />

the same altitude. Investors are likely to continue being very<br />

selective, focusing on countries where economic growth<br />

differentials are widening versus developed markets, fiscal<br />

policy remains responsible and external vulnerabilities are kept<br />

in check. For specific EM countries, domestic politics will play<br />

an idiosyncratic role in performance, with delivery from newly<br />

elected leaders important in several big Latin American<br />

countries, and with key elections in focus in Asia, such as<br />

India’s May general election.<br />

While the checklist of concerns for the global economy remains<br />

long in 2019 it is important to note that valuations fell sharply<br />

in 2018 to reflect them. If economic growth picks up in Europe<br />

and Japan, Chinese growth finds a floor and the U.S. dollar<br />

weakens, international equities could rebound. This would be<br />

especially true if, as we expect, the U.S. economy slows down<br />

but does not show signs of imminent recession.<br />

However, the climb will be bumpy – as such, it may not a year<br />

to make big bets on international over U.S. equities. Rather,<br />

investors should ask themselves whether they have the right<br />

exposure in different regions. In addition, for many U.S.<br />

investors, the right question is not whether to overweight<br />

international equities this year, but whether to move anywhere<br />

close to being equal weight. The reality is that U.S. investors<br />

remain under-allocated to international equities, which<br />

comprise only 22% of equity holdings compared to a 45%<br />

weighting in the MSCI global benchmark. Given structurally<br />

higher economic growth in EM and cyclically more favorable<br />

starting points in other developed markets, this international<br />

exposure will be crucial for long-term U.S. investors over the<br />

next decade.<br />

The truth is that the plane ride to Paris or Tokyo or Shanghai<br />

can be long and can be bumpy, but the destination is worth it –<br />

and tickets are on sale right now.<br />

RISKS TO THE OUTLOOK: WHAT COULD GO WRONG?<br />

Our outlook, as outlined above, is generally positive, though<br />

cautiously so. But there are risks to that outlook, and they are<br />

worth discussing in some detail.<br />

The macro backdrop for 2019 should remain supportive, with<br />

above-trend growth slowing to more sustainable levels in the<br />

second half. But this outlook relies on a specific set of<br />

circumstances, namely the persistence of only modest trade<br />

tensions between the U.S. and China and a moderate Fed.<br />

Unfortunately, these circumstances are far from guaranteed.<br />

The path of trade negotiations is unclear: an escalation in<br />

tensions could further slow economic growth, both in the U.S.<br />

and abroad, though a swifter resolution could be supportive of<br />

improved global growth. In addition, while not our base case,<br />

the recent strength in wage growth could be sustained and<br />

feed through to higher inflation. This could force the Fed to<br />

drive interest rates higher, muzzling growth and increasing the<br />

probability of a recession.<br />

A late-cycle surge in inflation would obviously have<br />

implications for the bond market, too. On one hand, a rapid<br />

rise in U.S. interest rates would lead to more acute pain for<br />

fixed income investors in the short run. On the other, to the<br />

extent that this tightening stoked recession fears, higherquality<br />

debt would look relatively more attractive. Investors, in<br />

turn, may be forced into a difficult juggling act: balancing<br />

short-term duration risk with a long-term need for a portfolio<br />

ballast. Beyond this, should trade tensions escalate further and<br />

global growth slow, international central banks may be forced<br />

away from normalization, resulting in persistently low interest<br />

rates overseas.<br />

As it currently stands, though, the valuation argument for<br />

overweighting stocks and underweighting bonds still seems<br />

clear, although less compelling than a year ago. Moving into<br />

2019, bond yields may rise relative to stock dividend yields and<br />

earnings growth should slow. As shown in Exhibit 5, history<br />

tells us that rising interest rates should drag on equity<br />

performance. This suggests the need to gradually move U.S.<br />

stock/bond allocations to a more neutral stance.<br />

J.P. MORGAN ASSET MANAGEMENT 7


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

Correlations between weekly stock returns and interest rate movements<br />

EXHIBIT 5: WEEKLY S&P 500 RETURNS, 10-YEAR TREASURY YIELD, ROLLING 2-YEAR CORRELATION, MAY 1963 – OCTOBER 2018<br />

0.8<br />

0.6<br />

0.4<br />

Positive<br />

relationship<br />

between yield<br />

movements<br />

and stock<br />

returns<br />

When yields are below 5%,<br />

rising rates have historically<br />

been associated with rising<br />

stock prices<br />

0.2<br />

Correlation Coefficient<br />

0.0<br />

-0.2<br />

-0.4<br />

Negative<br />

relationship<br />

between yield<br />

movements and<br />

stock return<br />

-0.6<br />

-0.8<br />

0% 2% 4% 6% 8%<br />

10%<br />

12% 14%<br />

10-year Treasury yield<br />

16%<br />

Source: FactSet, FRB, Standard & Poor’s, J.P. Morgan Asset Management.<br />

Returns are based on price index only and do not include dividends. Markers represent monthly 2-year correlations only. Guide to the Markets – U.S. Data are as of October 31, 2018.<br />

The near-term outlook for international equities is perhaps<br />

even more uncertain than for U.S. stocks. Recent volatility,<br />

particularly around mounting trade tensions, has left<br />

international equities trading at a deep discount to both the<br />

U.S. and history. But the question of whether or not this<br />

valuation advantage will result in relatively better returns in<br />

2019 is a close call. Though meaningful progress has been<br />

made on numerous fronts, the outlook for U.S.-Chinese trade<br />

relations is murky; should tariff negotiations collapse,<br />

sentiment would erode and global growth may slow further. By<br />

contrast, if relations improve and trade tensions ease, growth<br />

may be stronger, both in the U.S. and abroad, than anticipated.<br />

The relative risk allocation, between stocks and bonds and<br />

between the U.S. and international, could therefore shift.<br />

Moving into 2019, investors will need to be mindful of the risks<br />

while rooting out investing opportunities in a late-cycle<br />

environment. U.S. bonds will be further challenged, though<br />

duration may be more harmful should inflation get out of hand;<br />

U.S. stocks look attractive, though that may change as rates<br />

continue to rise; and international equities look fundamentally<br />

sound, but trade uncertainty makes their near-term prospects<br />

unclear. Moreover, lurking beneath the surface is a final<br />

point of contention: the direction of oil prices. Given multiple<br />

Middle-East hot spots, a spike in energy costs is certainly<br />

possible and would have broad-based ramifications: slowing<br />

global growth, reduced spending power and limited interest in<br />

risk assets. If this transpires, the outlook for 2019 would<br />

change for the worse.<br />

8 THE INVESTMENT OUTLOOK FOR 2019


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

INVESTING PRINCIPLES: DIMMING THE DIALS<br />

We conclude our year-ahead outlook by revisiting investing<br />

principles that hold across market environments. While these<br />

principles are timeless, they are probably most important to<br />

consider in the later stages of economic and market cycles.<br />

Being “late cycle” may invoke troubling memories of 2008;<br />

however, fundamentals suggest that today’s financial<br />

environment is quite different. Indeed, this late-cycle period<br />

could be long, sticky and drawn out, just like the broader cycle.<br />

Calling the end would be a fool’s errand, and could result in<br />

missed opportunities.<br />

Thinking of a light dimmer can be helpful. The jarring<br />

experience of turning a light on in a dark bedroom after<br />

(hopefully) eight hours of restful sleep is less than ideal.<br />

Equally, at night, plunging a room into darkness can be<br />

disquieting as your eyes adjust. However, dimmers, which<br />

gradually ease a light on and off, can avoid these displeasures.<br />

Risk exposure in an investment portfolio can be viewed the<br />

same way. While the financial press often speaks of being “in”<br />

or “out” of the market, we know that’s the equivalent of our<br />

jarring light switch. Dimming the dials, which tune our<br />

exposure in portfolios, makes for a better investor experience<br />

as the investment landscape shifts.<br />

For 2019, we are dialing up good quality fixed income exposure<br />

(the tried and true diversifier in a downturn) and dimming<br />

down credit risk. We are maintaining equity exposure.<br />

However, given the outperformance of the U.S. throughout<br />

most of the bull market and depressed valuations abroad,<br />

investors should consider dialing up international back to a<br />

neutral position. Lastly, we are staying diversified. As we move<br />

closer to the next recession, volatility is likely to remain<br />

elevated. Having a well- thought out plan can prevent<br />

behavioral biases from taking a hold and hurting returns.<br />

It’s telling to note that late-cycle returns tend to be substantial,<br />

as shown in Exhibit 6. While the nature of, and end to, each<br />

cycle differs, since 1945, the average return for the U.S. equity<br />

market in the two years preceding a bear market has been<br />

about 40%; even in the six months preceding the onset of a<br />

bear, that return has averaged 15%. This suggests that exiting<br />

the market too early may leave considerable upside on the<br />

table. Moreover, timing the exit also requires timing<br />

re-entrance. Few can make one good timing call correctly.<br />

Making two is harder still and in the long run, timing mistakes<br />

tend to significantly hurt returns.<br />

Average return leading up to and following equity<br />

market peaks<br />

EXHIBIT 6: S&P 500 TOTAL RETURN INDEX, 1945-2017<br />

50%<br />

40%<br />

30%<br />

20%<br />

10%<br />

0%<br />

-10%<br />

-20%<br />

41%<br />

24 months<br />

prior<br />

23%<br />

12 months<br />

prior<br />

15%<br />

6 months<br />

prior<br />

Equity market peak<br />

Average return<br />

before peak<br />

8%<br />

3 months<br />

prior<br />

Average return<br />

after peak<br />

-7%<br />

3 months<br />

after<br />

-11%<br />

6 months<br />

after<br />

-14%<br />

12 months<br />

after<br />

-1%<br />

24 months<br />

after<br />

Source: FactSet, Robert Shiller, Standard & Poor’s, J.P. Morgan Asset Management.<br />

Chart is based on return data from 11 bear markets since 1945. A bear market is<br />

defined as a decline of 20% or more in the S&P 500 benchmark. Monthly total<br />

return data from 1945 to 1970 is from the S&P Shiller Composite index. From 1970<br />

to present, return data is from Standard & Poor’s. Guide to the Markets – U.S. Data<br />

are as of October 31, 2018.<br />

While diversification will continue to be key in 2019, in any one<br />

year a diversified portfolio is never the best performer.<br />

However, its benefit truly shows over the long run, as shown in<br />

Exhibit 7. Over the last 15 years, a hypothetical diversified<br />

portfolio had an average annual return of just over 8%, with a<br />

volatility of 11% – an attractive risk/return profile. The last six<br />

years have marked the outperformance of U.S. large cap<br />

stocks. However, gradually rising wages and interest costs and<br />

fading fiscal stimulus in the U.S. suggest that next year’s<br />

performance will likely be lower. With that in mind, a wellbalanced<br />

diversified approach is warranted and over time has<br />

shown to be a winning strategy for long-run investors.<br />

Investors should be especially thoughtful in managing their<br />

money in a late-cycle environment. Some good rules to follow<br />

include: using a “dimmers” approach to asset allocation;<br />

employing strategies to participate in the upside, while trying<br />

to mitigate downside risk through hedging; avoiding big<br />

directional calls, concentrated positions or risky bets; retaining<br />

good quality fixed income, even if recent performance is<br />

disappointing; have a bias to quality across asset classes;<br />

prioritize volatility dampening; and take capital gains where it<br />

makes sense. Most importantly, rebalance, stick to a plan and<br />

remember: get invested and stay invested.<br />

J.P. MORGAN ASSET MANAGEMENT 9


THE INVESTMENT OUTLOOK FOR 2019: LATE-CYCLE RISKS AND OPPORTUNITIES<br />

Asset class returns<br />

EXHIBIT 7<br />

2003-2017<br />

2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 YTD Ann. Vol.<br />

EM<br />

Equity<br />

56.3%<br />

Small<br />

Cap<br />

47.3%<br />

DM<br />

Equity<br />

39.2%<br />

REITs<br />

37.1%<br />

High<br />

Yield<br />

32.4%<br />

Large<br />

Cap<br />

28.7%<br />

Asset<br />

Alloc.<br />

26.3%<br />

Comdty<br />

23.9%<br />

Fixed<br />

Income<br />

4.1%<br />

Cash<br />

1.0%<br />

REITs<br />

31.6%<br />

EM<br />

Equity<br />

26.0%<br />

DM<br />

Equity<br />

20.7%<br />

Small<br />

Cap<br />

18.3%<br />

High<br />

Yield<br />

13.2%<br />

Asset<br />

Alloc.<br />

12.8%<br />

Large<br />

Cap<br />

10.9%<br />

Comdty<br />

9.1%<br />

Fixed<br />

Income<br />

4.3%<br />

Cash<br />

1.2%<br />

EM<br />

Equity<br />

34.5%<br />

Comdty<br />

21.4%<br />

DM<br />

Equity<br />

14.0%<br />

REITs<br />

12.2%<br />

Asset<br />

Alloc.<br />

8.1%<br />

Large<br />

Cap<br />

4.9%<br />

Small<br />

Cap<br />

4.6%<br />

High<br />

Yield<br />

3.6%<br />

Cash<br />

3.0%<br />

Fixed<br />

Income<br />

2.4%<br />

REITs<br />

35.1%<br />

EM<br />

Equity<br />

32.6%<br />

DM<br />

Equity<br />

26.9%<br />

Small<br />

Cap<br />

18.4%<br />

Large<br />

Cap<br />

15.8%<br />

Asset<br />

Alloc.<br />

15.3%<br />

High<br />

Yield<br />

13.7%<br />

Cash<br />

4.8%<br />

Fixed<br />

Income<br />

4.3%<br />

Comdty<br />

2.1%<br />

EM<br />

Equity<br />

39.8%<br />

Comdty<br />

16.2%<br />

DM<br />

Equity<br />

11.6%<br />

Asset<br />

Alloc.<br />

7.1%<br />

Fixed<br />

Income<br />

7.0%<br />

Large<br />

Cap<br />

5.5%<br />

Cash<br />

4.8%<br />

High<br />

Yield<br />

3.2%<br />

Small<br />

Cap<br />

-1.6%<br />

REITs<br />

-15.7%<br />

Fixed<br />

Income<br />

5.2%<br />

Cash<br />

1.8%<br />

Asset<br />

Alloc.<br />

-25.4%<br />

High<br />

Yield<br />

-26.9%<br />

Small<br />

Cap<br />

-33.8%<br />

Comdty<br />

-35.6%<br />

Large<br />

Cap<br />

-37.0%<br />

REITs<br />

-37.7%<br />

DM<br />

Equity<br />

-43.1%<br />

EM<br />

Equity<br />

-53.2%<br />

EM<br />

Equity<br />

79.0%<br />

High<br />

Yield<br />

59.4%<br />

DM<br />

Equity<br />

32.5%<br />

REITs<br />

28.0%<br />

Small<br />

Cap<br />

27.2%<br />

Large<br />

Cap<br />

26.5%<br />

Asset<br />

Alloc.<br />

25.0%<br />

Comdty<br />

18.9%<br />

Fixed<br />

Income<br />

5.9%<br />

Cash<br />

0.1%<br />

REITs<br />

27.9%<br />

Small<br />

Cap<br />

26.9%<br />

EM<br />

Equity<br />

19.2%<br />

Comdty<br />

16.8%<br />

Large<br />

Cap<br />

15.1%<br />

High<br />

Yield<br />

14.8%<br />

Asset<br />

Alloc.<br />

13.3%<br />

DM<br />

Equity<br />

8.2%<br />

Fixed<br />

Income<br />

6.5%<br />

Cash<br />

0.1%<br />

REITs<br />

8.3%<br />

Fixed<br />

Income<br />

7.8%<br />

High<br />

Yield<br />

3.1%<br />

Large<br />

Cap<br />

2.1%<br />

Cash<br />

0.1%<br />

Asset<br />

Alloc.<br />

-0.7%<br />

Small<br />

Cap<br />

-4.2%<br />

DM<br />

Equity<br />

-11.7%<br />

Comdty<br />

-13.3%<br />

EM<br />

Equity<br />

-18.2%<br />

REITs<br />

19.7%<br />

High<br />

Yield<br />

19.6%<br />

EM<br />

Equity<br />

18.6%<br />

DM<br />

Equity<br />

17.9%<br />

Small<br />

Cap<br />

16.3%<br />

Large<br />

Cap<br />

16.0%<br />

Asset<br />

Alloc.<br />

12.2%<br />

Fixed<br />

Income<br />

4.2%<br />

Cash<br />

0.1%<br />

Comdty<br />

-1.1%<br />

Small<br />

Cap<br />

38.8%<br />

Large<br />

Cap<br />

32.4%<br />

DM<br />

Equity<br />

23.3%<br />

Asset<br />

Alloc.<br />

14.9%<br />

High<br />

Yield<br />

7.3%<br />

REITs<br />

2.9%<br />

Cash<br />

0.0%<br />

Fixed<br />

Income<br />

-2.0%<br />

EM<br />

Equity<br />

-2.3%<br />

Comdty<br />

-9.5%<br />

REITs<br />

28.0%<br />

Large<br />

Cap<br />

13.7%<br />

Fixed<br />

Income<br />

6.0%<br />

Asset<br />

Alloc.<br />

5.2%<br />

Small<br />

Cap<br />

4.9%<br />

Cash<br />

0.0%<br />

High<br />

Yield<br />

0.0%<br />

EM<br />

Equity<br />

-1.8%<br />

DM<br />

Equity<br />

-4.5%<br />

Comdty<br />

-17.0%<br />

REITs<br />

2.8%<br />

Large<br />

Cap<br />

1.4%<br />

Fixed<br />

Income<br />

0.5%<br />

Cash<br />

0.0%<br />

DM<br />

Equity<br />

-0.4%<br />

Asset<br />

Alloc.<br />

-2.0%<br />

High<br />

Yield<br />

-2.7%<br />

Small<br />

Cap<br />

-4.4%<br />

EM<br />

Equity<br />

-14.6%<br />

Comdty<br />

-24.7%<br />

Small<br />

Cap<br />

21.3%<br />

High<br />

Yield<br />

14.3%<br />

Large<br />

Cap<br />

12.0%<br />

Comdty<br />

11.8%<br />

EM<br />

Equity<br />

11.6%<br />

REITs<br />

8.6%<br />

Asset<br />

Alloc.<br />

8.3%<br />

Fixed<br />

Income<br />

2.6%<br />

DM<br />

Equity<br />

1.5%<br />

Cash<br />

0.3%<br />

EM<br />

Equity<br />

37.8%<br />

DM<br />

Equity<br />

25.6%<br />

Large<br />

Cap<br />

21.8%<br />

Small<br />

Cap<br />

14.6%<br />

Asset<br />

Alloc.<br />

14.6%<br />

High<br />

Yield<br />

10.4%<br />

REITs<br />

8.7%<br />

Fixed<br />

Income<br />

3.5%<br />

Comdty<br />

1.7%<br />

Cash<br />

0.8%<br />

Large<br />

Cap<br />

3.0%<br />

Cash<br />

1.4%<br />

Small<br />

Cap<br />

-0.6%<br />

REITs<br />

-0.9%<br />

Asset<br />

Alloc.<br />

-2.3%<br />

Fixed<br />

Income<br />

-2.4%<br />

High<br />

Yield<br />

-2.4%<br />

Comdty<br />

-4.1%<br />

DM<br />

Equity<br />

-8.9%<br />

EM<br />

Equity<br />

-15.4%<br />

EM<br />

Equity<br />

12.7%<br />

Small<br />

Cap<br />

11.2%<br />

REITs<br />

11.1%<br />

Large<br />

Cap<br />

9.9%<br />

High<br />

Yield<br />

9.6%<br />

DM<br />

Equity<br />

8.6%<br />

Asset<br />

Alloc.<br />

8.3%<br />

Fixed<br />

Income<br />

4.1%<br />

Cash<br />

1.2%<br />

Comdty<br />

-0.3%<br />

EM<br />

Equity<br />

23.0%<br />

REITs<br />

22.3%<br />

Small<br />

Cap<br />

18.8%<br />

Comdty<br />

18.8%<br />

DM<br />

Equity<br />

18.4%<br />

Large<br />

Cap<br />

14.5%<br />

High<br />

Yield<br />

11.3%<br />

Asset<br />

Alloc.<br />

11.0%<br />

Fixed<br />

Income<br />

3.3%<br />

Cash<br />

0.8%<br />

Source: Barclays, Bloomberg, FactSet, MSCI, NAREIT, Russell, Standard & Poor’s, J.P. Morgan Asset Management.<br />

Large cap: S&P 500, Small cap: Russell 2000, EM Equity: MSCI EME, DM Equity: MSCI EAFE, Comdty: Bloomberg Commodity Index, High Yield: Bloomberg Barclays Global HY<br />

Index, Fixed Income: Bloomberg Barclays US Aggregate, REITs: NAREIT Equity REIT Index. The “Asset Allocation” portfolio assumes the following weights: 25% in the S&P 500,<br />

10% in the Russell 2000, 15% in the MSCI EAFE, 5% in the MSCI EME, 25% in the Bloomberg Barclays US Aggregate, 5% in the Bloomberg Barclays 1-3m Treasury, 5% in the<br />

Bloomberg Barclays Global High Yield Index, 5% in the Bloomberg Commodity Index and 5% in the NAREIT Equity REIT Index. Balanced portfolio assumes annual rebalancing.<br />

Annualized (Ann.) return and volatility (Vol.) represents period of 12/31/02 – 12/31/17. Please see disclosure page at end for index definitions. All data represents total return<br />

for stated period. Past performance is not indicative of future returns. Guide to the Markets – U.S. Data are as of October 31, 2018.<br />

10 THE INVESTMENT OUTLOOK FOR 2019


Key Trends in Retail Non-Banking<br />

Finance Companies<br />

December 31, 2018


Agenda<br />

01 02 03 04 05<br />

Retail Credit<br />

Trends<br />

Liquidity<br />

Impact on<br />

Growth<br />

Asset Class<br />

Wise<br />

Growth and<br />

Outlook<br />

Asset<br />

Quality<br />

Trends<br />

Financial<br />

Performance<br />

and Outlook<br />

2


Retail Credit Trends<br />

3


Retail Credit Growth- 2-year CAGR of 18% vs overall credit growth of 10%<br />

Exhibit 1 : Total Credit<br />

Rs. 91 trillion September 2016<br />

Rs. 109 trillion<br />

September 2018<br />

SCB Retail<br />

17%<br />

HFC-Others<br />

2%<br />

HFC-Retail<br />

6%<br />

SCB Retail<br />

18%<br />

HFC-Others<br />

2%<br />

HFC-Retail<br />

8%<br />

NBFC - Retail<br />

6%<br />

NBFC - Retail<br />

8%<br />

SCB-Others<br />

60%<br />

NBFC - Infra<br />

& Corporate<br />

9%<br />

SCB-Others<br />

54%<br />

NBFC - Infra<br />

& Corporate<br />

10%<br />

Retail credit share increased from 29% to 34% in the last 2 years<br />

Source: ICRA Research; Company/ Company Investor presentations ; Total credit is credit sum of scheduled commercial banks, NBFCs and Housing Finance Companies; Bank retail credit<br />

is as per the sectoral classification of personal loans<br />

4


Mar-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Retail Credit- H1FY2019 credit growth highest in the last 5 years<br />

27%<br />

Exhibit 2 : YoY growth trends<br />

25%<br />

25%<br />

23%<br />

21%<br />

19%<br />

17%<br />

15%<br />

13%<br />

20%<br />

17%<br />

17%<br />

16%<br />

23%<br />

22%<br />

20%<br />

18%<br />

20%<br />

18%<br />

15%<br />

11%<br />

9%<br />

HFCs NBFC Banks Total<br />

Retail NBFC growth pulled up while retail-HFC tapered during H1FY2019<br />

Source: ICRA Research; Company/ Company Investor presentations ; Bank retail credit is as per the sectoral classification of personal loans<br />

5


Retail-NBFC Credit Break-up- Share of unsecured personal credit increased<br />

Exhibit 3 : September 2016 Rs. 5.7 trillion September 2018 Rs 8.3 trillion<br />

Commercial<br />

Vehicle, 22%<br />

Passenger<br />

Vehicle, 16%<br />

Personal<br />

Credit, 7%<br />

Gold Loans,<br />

10%<br />

Microfinance,<br />

6%<br />

Constuction<br />

Equipment, 5%<br />

Tractor, 5%<br />

2/3- Wheeler,<br />

3%<br />

Others, 1%<br />

Passenger<br />

Vehicle, 14%<br />

Commercial<br />

Vehicle, 22%<br />

Personal<br />

Credit, 9%<br />

Gold Loans<br />

, 8% Microfinance,<br />

8%<br />

Constuction<br />

Equipment, 5%<br />

Tractor, 4%<br />

2/3- Wheeler,<br />

4%<br />

Others, 2%<br />

LAP+SME, 25%<br />

LAP+SME, 25%<br />

Source: ICRA Research; Company/ Company Investor presentations<br />

❖ Retail-NBFC credit stood at Rs. 8.3 trillion; accounts for ~ 45% of the total estimated NBFC credit (~ Rs. 19 trillion); NBFCs losing share in competitive<br />

asset segments, like new commercial vehicle, passenger vehicle etc to banks.<br />

❖ NBFCs continues to focus on LAP+SME credit, to diversify lending mix and to ward-off competitive pressures; focus on lower ticket lending (


Retail-NBFC – Key asset classes drive growth<br />

Exhibit 4 : Asset class wise growth-September 2018<br />

Exhibit 5 : Asset class wise growth<br />

Source: ICRA Research; Company/ Company Investor presentations<br />

❖ Retail-NBFC credit growth was driven largely by LAP+SME, CV and unsecured credit (personal credit and microfinance); although almost all segments<br />

witnessed revival in FY2018 and this continued into H1FY2019. H1FY2019 growth rates was on the back of the lower pace of growth in H1FY2018<br />

❖ Competitive pricing pressures in some key segment, constrained funding availability and expected uptick in delinquencies would temper overall<br />

growth in the near to medium term<br />

❖ Growth would moderate in H2FY2019 and access to funding would be key driver in FY2020<br />

7


Liquidity Impact on Growth<br />

8


Conditions in H1FY2019-I<br />

Exhibit 6 : NBFC Borrowing Profile- Mar-18- Concentrated with Banks and MFs<br />

Exhibit 7 : Retail-NBFC Credit- Robust growth in FY2018 and H1FY2019<br />

Source: RBI ;<br />

SCB-Scheduled Commercial Banks, MF- Mutual Funds<br />

❖ NBFC resource profile is concentrated between Banks and Mutual Funds (MFs) - together accounting for 75-80% of total NBFC borrowings<br />

❖ Insurance companies largely focus on higher rated credit<br />

Note: NBFC credit excludes entities converted to banks and SFBs;<br />

Source: ICRA Research; Company/ Company Investor presentations<br />

❖ Retail-NBFC credit growth was quite robust - 22-23% during FY2018 and ~25% (YoY) growth in H1FY2019<br />

9


Conditions in H1FY2019-II<br />

Exhibit 8 : Retail-NBFC Funding profile- CP share increased sharply<br />

Exhibit 9 : Market Liquidity- Tightened in H1FY2019<br />

Source: ICRA Research; Company/ Company Investor presentations of ICRA sample entities<br />

Source: RBI; ICRA Research; Net Repo includes Term Repo<br />

❖ CP share of Retail-NBFCs increase sharply in Q1FY2019; close to 30% of incremental credit growth during H1 funded by CPs; this was ~ 60% for Q1<br />

❖ Market liquidity moderated significantly in CY2018 ; the daily average turned deficient at Rs 206 billion in (Jul-Sep 18) vis a vis a surplus of Rs 240<br />

billion in (Apr-Jun 18); deficient stood at Rs 506 billion in September 2018<br />

10


Current Position... Risk lower than at end of Q2FY2019<br />

Exhibit 10 : Bank credit to NBFCs- Increased steeply in Sep-18 and Oct-2018<br />

Exhibit 11 : MF Credit to NFBCs- ST debt stabilised; LT debt increased steadily<br />

Source: RBI; ICRA Research<br />

Source: SEBI; ICRA Research<br />

❖ Bank credit to NBFCs jumped sharply in September 2018 and increased further in October 2018~ roughly by about Rs. 0.7 billion, which was the<br />

estimated funding requirement in September 2018 to offset pressures on account of CP maturities in Q3FY2019<br />

❖ MF CP exposure dipped marginally from the peak levels in August 2018; exposure to long-term debt increase, indicating appetite from MFs for good<br />

quality credit<br />

❖ Support from funders (banks and MFs) were adequate for most retail financiers, however it may not support portfolio growth witnessed over the<br />

recent past. Banks also participated actively in the loan sell downs by some NBFCs<br />

11


Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Immediate measures taken by Retail-NBFCs...I<br />

Exhibit 12 : On-book Liquidity Trends of Retail-NBFC- Buffers added<br />

Exhibit 13 : Retail-NBFC- Positive Cummlative Mismatch % of total assets<br />

improved 12%<br />

11%<br />

5.0%<br />

4.7%<br />

10%<br />

9%<br />

9% 8% 9%<br />

4.0%<br />

8%<br />

7%<br />

3.5%<br />

3.5%<br />

6%<br />

5%<br />

3.0%<br />

2.6%<br />

2.3%<br />

4%<br />

3%<br />

2.0%<br />

2%<br />

1.0%<br />

0%<br />

Upto 3 months Over 3 to 6 months Over 6 months to<br />

one year<br />

18-Mar Sep-18<br />

Over 1 year to 3<br />

years<br />

(Cash+ liquid assets)/ AUM<br />

Source: ICRA Research, Annual Report, Company data<br />

Source: ICRA Research ;<br />

Set of about 20 Retail-NBFCs accounting for 70% of total NBFC-retail credit<br />

❖ NBFCs augmenting liquidity buffers - - cash/ cash equivalents, to witness a sharp increase. Focus was on securing bank facilities, drawl and keep as<br />

cash/FDs/ investments<br />

❖ Retail-NBFC ALM is generally are characterized by “Positive Cumulative ALM mismatches” in the near term bucket; this improved over March 2018<br />

as entities maintained on-book liquidity and slowed credit growth<br />

12


LAP+SME<br />

CV<br />

Unsecured Credit<br />

PV<br />

Gold Loan<br />

Immediate measures by Retail-NBFCs...II<br />

Exhibit 14 : Retail-NBFC Credit- Growth to Moderate<br />

Exhibit 15 : Retail-NBFC -Growth in Key asset segments to slow<br />

60%<br />

48%<br />

50%<br />

43%<br />

40%<br />

35%<br />

30% 25% 25% 27%<br />

22%<br />

19%<br />

20%<br />

16%<br />

15%<br />

9% 11%<br />

8% 8% 10%<br />

10%<br />

0%<br />

Y-o-Y growth (Mar-18) Y-o-Y growth (Sep-18) Y-o-Y growth (Mar-19) E<br />

Source: ICRA Research, Annual Report, Company data<br />

Source: ICRA Research<br />

❖ Retail-NBFC credit growth for FY2019 to moderate to 16-18% vis a vis 24-25% YoY growth witnessed in H1FY2019; Thus, growth rate in the second<br />

half is expected to roughly halve to about ~12%<br />

❖ Key asset segments- LAP+SME, CV to witness sizeable slowdown in credit growth<br />

13


Asset Class Wise Growth and Outlook


Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

in Rs. billion<br />

Growth %<br />

Commercial Vehicle - Growth to moderate in H2<br />

Exhibit 16 : AUM movement of NBFC- CV Segment<br />

1000<br />

900<br />

800<br />

700<br />

600<br />

500<br />

400<br />

300<br />

200<br />

100<br />

0<br />

30%<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

Exhibit 17 : AUM growth trends – Headwinds to exert pressure on growth<br />

35%<br />

30%<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

-5%<br />

New CV Used CV Overall-Growth<br />

Source: ICRA Research, NBFCs, Investor presentations<br />

-10%<br />

New CV-Growth Used CV-Growth Overall-Growth<br />

❖ NBFC credit stood at about Rs. 1.9 trillion as on September 30, 2018, registering a growth of about 27%, on a YoY basis; highest in last 4-5 years,<br />

driven by growth in new vehicle sales and healthy used CV financing trend<br />

❖ New CV segment registered a more than 30% YoY growth on the back of a lower base, while used CV segment grew at a healthy pace of ~ 22%.<br />

❖ Exposures to M&HCV segment and large fleet operators to face increased pricing pressure from banks; NBFCs to remain competitive in LCV and small<br />

fleet operators (SFO) and owner-cum-operator segments<br />

❖ Pricing pressure, liquidity constraints, moderation in demand from SFOs to exert pressure on growth ; 15-16% credit growth projected for FY2019<br />

15


Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

In Rs. billion<br />

Growth %<br />

Passenger Vehicle – High competitive pressures<br />

Exhibit 18 : AUM movement of NBFC- PV Segment<br />

1200<br />

20%<br />

Exhibit 19 : AUM growth trends – Expected to remain in line with recent trends<br />

25%<br />

1000<br />

800<br />

600<br />

400<br />

10%<br />

20%<br />

15%<br />

10%<br />

200<br />

0<br />

0%<br />

5%<br />

0%<br />

Managed Advances<br />

Source: ICRA Research, NBFCs, Investor presentations<br />

% Growth<br />

New-PV Used-PV Overall-PV<br />

❖ NBFC PV segment credit stood at ~Rs. 1.1 trillion as on September 30, 2018, registering a YoY growth of 11% (9-10% growth in FY2018 and FY2017)<br />

❖ NBFCs accounted for 30% of total PV credit in March 2018; share moderated from 34% in March 2014<br />

❖ New vehicle financing not be impacted significantly by the tightened liquidity for NBFCs; used vehicle growth however could see moderation because<br />

of reliance on NBFC funding<br />

❖ Tepid sales growth and high competitive pressures from banks to keep NBFC credit growth at 7-9% in FY2019<br />

16


In Rs. billion<br />

Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

LAP & SME Credit- Growth to moderate in H2<br />

Exhibit 20 : AUM movement of LAP+SME Segment<br />

Exhibit 21 : Sizeable unmet demand<br />

2500<br />

40%<br />

2000<br />

1500<br />

1000<br />

500<br />

0<br />

35%<br />

30%<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

LAP SME % Growth-LAP+SME<br />

Source: ICRA Research, NBFCs, Investor presentations<br />

Source: Investor Presentation of Banks/NBFC/HFCs and ICRA research & Estimates<br />

Assumption: Average credit per MSME enterprise is taken to be about Rs. 0.7 million; no of MSME to grow at a<br />

CAGR of about 4%<br />

❖ NBFC Liquidity squeeze to impact overall credit flow to the LAP+SME segment; Overall market size (Bank + NBFC + HFC) = Rs. 18 trillion in March 2018;<br />

NBFC share at 13% up from 7% in March 2015.<br />

❖ NBFC and HFC fastest growing segments ~ 25% CAGR (March 2015- March 2018) ; Bank credit grew ~8% ; Not easy for NBFC customers to avail bank<br />

credit<br />

❖ Significant reliance on NBFC funding, vulnerability to adverse fuel prices, elongated working capital cycle, increased interest rates and moderation in<br />

demand to impact operational viability and credit profile of SMEs<br />

❖ Notwithstanding sizeable unmet demand, NBFCs faced with liquidity tightening to go slow on this segment; growth to moderate to 18-20% for FY2019 17


Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

in Rs. billion<br />

In Rs. billion<br />

Gold loan and 2-Wheelers<br />

Exhibit 22 : AUM movement of Gold loan Segment<br />

700<br />

20%<br />

Exhibit 23 : AUM movement of 2-Wheeler Segment<br />

350<br />

40%<br />

600<br />

15%<br />

300<br />

35%<br />

500<br />

400<br />

300<br />

200<br />

100<br />

10%<br />

5%<br />

0%<br />

-5%<br />

-10%<br />

-15%<br />

250<br />

200<br />

150<br />

100<br />

50<br />

30%<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0<br />

-20%<br />

0<br />

0%<br />

Managed Advances<br />

Source: ICRA Research, NBFCs, Investor presentations<br />

% Growth<br />

Managed Advances<br />

❖ Gold loans by Retail-NBFCs stood at about Rs. 650 billion as on September 30, 2018, registering a YoY growth of 15%<br />

% Growth<br />

❖ Entities faced with competing products- unsecured SME credit, microfinance and, from new players in the NBFC space and, SFBs ; growth of about 9-<br />

11% in FY2019 envisaged, in view of the prevailing liquidity conditions.<br />

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -<br />

❖ 2-Wheeler segment to faced headwinds on sales because of hike in insurance premiums , increase in interest rates and expected moderation in rural<br />

demand ; sales growth estimated to be 8-10% in FY2019 vis a vis 14.8% growth registered in FY 2018<br />

❖ Rs. 325 billion 2-wheeler portfolio of NBFCs grew by 37% (YoY) in September 2018, on a low base; growth estimated at 26-28% for FY2019<br />

18


Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Mar-14<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Rs. Billion<br />

Rs. Billion<br />

CE & Tractor- Competition from banks to increase<br />

Exhibit 24 : AUM movement of CE Segment<br />

450<br />

400<br />

350<br />

300<br />

250<br />

200<br />

150<br />

100<br />

50<br />

0<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

-5%<br />

-10%<br />

Exhibit 25 : AUM movement of Tractor Segment<br />

400<br />

350<br />

300<br />

250<br />

200<br />

150<br />

100<br />

50<br />

0<br />

25%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

Managed Advances<br />

Source: ICRA Research, NBFCs, Investor presentations<br />

% Growth<br />

Managed Advances<br />

% Growth<br />

❖ CE sales grew at a healthy pace with demand from the road sector; sales growth expected to remain robust at 17-20% for CY2018, while some slowdown<br />

is expected in CY2019; being the general election year<br />

❖ Competitive pressures from banks to increase, as cost of funding for NBFCs has increased quite sharply. NBFC credit growth for FY2019 is estimated at<br />

15-17%<br />

- - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - - -<br />

❖ Tractors sales growth of 16% for April-November 2018 (22% growth in FY2018) to support financing demand. Concerns around uneven rainfall is partly<br />

mitigated by central govt’ thrust on rural spending, hike in crop MSPs and loan waivers, which would put cash in the hands of the borrowers<br />

❖ NBFCs, however are likely to face competition from banks; credit growth estimated to be around 15-17% in FY2019<br />

19


Asset Quality Trends


Mar-15<br />

Mar-16<br />

Mar-17<br />

Sep-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Jun-15<br />

Sep-15<br />

Dec-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Sep-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

3.4%<br />

1.7%<br />

3.3%<br />

2.2%<br />

2.3%<br />

2.6%<br />

2.3%<br />

4.3%<br />

4.9%<br />

5.2%<br />

4.8%<br />

4.5%<br />

2.40%<br />

4.80%<br />

2.20%<br />

4.5%<br />

5.1%<br />

5.6%<br />

5.2%<br />

4.5%<br />

4.7%<br />

Asset Quality Trends- Improved during H1FY2019<br />

Exhibit 26 : 90+dpd movement for Retail NBFCs<br />

6.0%<br />

Exhibit 27 : NPA Movement- (Excluding NBFC-MFIs)<br />

6%<br />

5%<br />

5.5%<br />

5.0%<br />

4.5%<br />

4.0%<br />

5.3%<br />

4.9%<br />

4.6%<br />

5.0% 4.7%<br />

4.8%<br />

4.7%<br />

4.4%<br />

4.5%<br />

4.3%<br />

4.2%<br />

4.0%<br />

4%<br />

3%<br />

2%<br />

1%<br />

0%<br />

3.5%<br />

90+ dpd 90+dpd-Excl-MFIs 90+ dpd-Excl-MFIs (6 month Lagged)<br />

Source: ICRA Research; Company/ Company Investor presentations of ICRA sample entities<br />

❖ 90+ dpd (excluding MFIs) declined further to 4.2% from 4.4% in March 2018;<br />

6-month lagged stood at 4.6% in June 2018<br />

❖ Provision coverage adequate and range-bound at 50-55%<br />

❖ Solvency ratio is stable at about 12-13% over last 2-3 quarters<br />

Gross NPA % Net NPA % Gross NPA %-90 day lagged<br />

Source: ICRA Research; NBFC/ NBFC Investor presentations of ICRA sample entities<br />

Exhibit 28 : Solvency and Provision coverage- (Excluding NBFC-MFIs)<br />

60%<br />

55%<br />

50%<br />

45%<br />

40%<br />

35%<br />

30%<br />

25%<br />

20%<br />

20%<br />

15%<br />

10%<br />

5%<br />

0%<br />

❖ Asset quality pressures to increase as disbursement slows in Q3 and Q4 FY2019<br />

Provisioning Coverage (LHS) Net NPA/ Net worth<br />

Source: ICRA Research; NBFC/ NBFC Investor presentations of ICRA sample entities<br />

21


Mar-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Jun-15<br />

Sep-15<br />

Dec-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Segment Wise Asset Quality Trends-I<br />

CV- Quality improved during H1FY2019; pressures expected<br />

going forward<br />

10.0%<br />

9.0%<br />

Exhibit 28: NBFC CV- 90+ dpd Trends<br />

12.0%<br />

10.0%<br />

8.0%<br />

CE- Overdues to inch-up if demand does not improve in a<br />

commensurate manner<br />

Exhibit 29 : NBFC CE-90+ dpd Trends<br />

8.0%<br />

7.0%<br />

6.0%<br />

4.0%<br />

2.0%<br />

4.0%<br />

6.0%<br />

5.0%<br />

6.4%<br />

5.6%<br />

5.2%<br />

3.5%<br />

PV- Range-bound asset quality indicators<br />

Exhibit 30: NBFC PV- 90+ dpd Trends<br />

4.0%<br />

3.0%<br />

2.8%<br />

3.0%<br />

3.4%<br />

3.1%<br />

2.5%<br />

2.0%<br />

1.5%<br />

Overall CV<br />

Overall CV (6 month lagged)<br />

New CV<br />

Used CV<br />

New CV (6 month lagged)<br />

Source: ICRA Sample of select NBFCs and ICRA research<br />

1.0%<br />

22


Mar-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Mar-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Segment Wise Asset Quality Trends-II<br />

To stabilize around current levels and remain range-bound going<br />

forward<br />

7.0%<br />

6.0%<br />

5.0%<br />

4.0%<br />

3.0%<br />

2.0%<br />

1.0%<br />

0.0%<br />

Exhibit 31: NBFC Gold 90+dpd (lagged) Trends<br />

1.8%<br />

5.0%<br />

4.5%<br />

4.0%<br />

3.5%<br />

3.0%<br />

2.5%<br />

2.0%<br />

Delinquencies to increase as refinancing to the segment is<br />

witnessing slowdown<br />

Exhibit 32: NBFC-LAP+SME-90+dpd Trends<br />

4.4%<br />

Trend expected to reverse partially in the near- term<br />

Asset quality remain high and range-bound<br />

20.0%<br />

15.0%<br />

10.0%<br />

5.0%<br />

Exhibit 33: NBFC Tractor- 90+dpd Trends<br />

8.9%<br />

7.5%<br />

7.0%<br />

6.5%<br />

6.0%<br />

5.5%<br />

Exhibit 34: NBFC 2W-90+ dpd Trends<br />

6.0%<br />

0.0%<br />

5.0%<br />

Source: ICRA Sample of select NBFCs and ICRA research<br />

23


Asset Quality- Challenges set to re-surface<br />

Exhibit 35 : 90+ dpd movement for key asset classes (Sep-18 Vs Sep-17)<br />

Source: ICRA Research; Company/ Company Investor presentations of ICRA sample entities<br />

❖ LAP+SME segment borrower to be faced with higher refinance cost and delays in incremental<br />

credit as liquidity position is tighter than the past<br />

❖ Vehicle finance segments faced with subdued demand and, higher operating and finance costs<br />

Asset Class<br />

LAP+SME<br />

CV<br />

Passenger Vehicle<br />

Gold Loans<br />

Construction Equipment<br />

Tractor<br />

Unsecured Personal<br />

Credit<br />

Microfinance<br />

Outlook


Financial Performance and Outlook


Jun-15<br />

Sep-15<br />

Dec-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Jun-15<br />

Sep-15<br />

Dec-15<br />

Mar-16<br />

Jun-16<br />

Sep-16<br />

Dec-16<br />

Mar-17<br />

Jun-17<br />

Sep-17<br />

Dec-17<br />

Mar-18<br />

Jun-18<br />

Sep-18<br />

Earnings Profile- Improved in H1FY2019; pressures expected<br />

Exhibit 36 : Profitability Trend – continues to improve (Excluding captive financiers and MFIs) Exhibit 37: Cost of funding<br />

11%<br />

8.0%<br />

8.5% 8.3%<br />

7.6% 7.9%<br />

6.0%<br />

10%<br />

10.1%<br />

4.0% 3.9%<br />

4.0%<br />

3.6% 3.6%<br />

9.5%<br />

2.0%<br />

0.0%<br />

1.8% 1.9%<br />

1.9%<br />

2.1%<br />

1.8%<br />

9%<br />

8%<br />

8.4%<br />

8.5%<br />

8.6%<br />

NIO/AMA<br />

Operating Expense / AMA<br />

PAT/AMA<br />

Credit Provisions/ AMA<br />

Source: ICRA research; Company/ Company Investor presentations; AMA-average managed assets<br />

Cost of funds-Quarterly<br />

❖ Net profitability (12-month trailing) improved to 2.1% in September 2018, up from 2.0% in March 2018 (1.7% in March 2017), supported by<br />

reduction in credit costs , operating costs remained largely stable<br />

❖ Expected contraction in operating profits and increase in credit cost to impact net profitability; estimated at about 1.6-1.8% for FY2019


Earnings Profile- Operating profits to witness contraction<br />

Confluence of factors could impact earnings of NBFCs in the current fiscal-<br />

Increase in the cost of funds (COF)<br />

Considering a managed leverage of 5.5-6 times; Weighted average cost of funds to increase by 45-50 bps in FY2019<br />

Slowdown in growth would impact operating efficiencies<br />

Every 1% decline in portfolio growth (from 19-20%) would impact operating efficiency by about 2-3 bps ; expect 5-10 bps impact<br />

Carrying cost of additional liquidity buffer<br />

ICRA expects entities to hold incremental buffer of about 2-3% of the total assets; thus, impact could be about 5-15 bps on<br />

NIMs depending on the NBFC current business yield<br />

* net of pass on of 50% of the borrowing cost increase<br />

Impact on operating profit estimated at 30-50 bps *<br />

Expected Stress on asset quality<br />

Stress expected in vehicle finance and SME credit segments because of the increase in fuel costs and expected slowdown in<br />

meeting incremental financing in case of SMEs


Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Mar-15<br />

Mar-16<br />

Mar-17<br />

Mar-18<br />

Sep-18<br />

Capitalisation- Adequate for medium term growth<br />

Exhibit 38 : Net-worth/ AUM<br />

Exhibit 39 : Gearing – Managed debt/networth<br />

18%<br />

16%<br />

16.3%<br />

15.7%<br />

16.0% 15.9%<br />

16.1%<br />

6.0<br />

5.5<br />

5.4 5.5 5.4<br />

5.3 5.3<br />

14%<br />

5.0<br />

4.5<br />

12%<br />

4.0<br />

10%<br />

3.5<br />

8%<br />

3.0<br />

❖ Capital profile continues to remain healthy, as internal capital generation improved and some entities raised capital to support growth<br />

❖ No significant capital requirement envisaged, notwithstanding that internal generation would moderate, as growth-rate is estimated to also dip


Thursday, 3 January 2019 Page 1<br />

For important disclosures please refer to page 16.<br />

Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Asset prices and the Fed<br />

Verbier<br />

How resilient is the American economy to monetary tightening? This is one of the questions posed<br />

in the new Asia Maxima quarterly (see Asia Maxima – Trade and tightening, 2 January 2019). GREED &<br />

fear’s base case has been that the American economy reverts to trend growth in 2019 following last<br />

year’s fiscally-driven acceleration. This would suggest a growth rate of 2.2%, which is the average<br />

growth rate since the recovery began in 2009 prior to the tax cut last year.<br />

Still the risk of an uglier outcome will rise if there is a nasty decline in asset prices. This is because in<br />

a post quantitative easing world, the normal causality taught in economic textbooks has reversed. By<br />

which GREED & fear means that asset prices now drive economies rather than the reverse.<br />

This has now become a highly-relevant point for investors, as asset prices declined last year as<br />

Federal Reserve quantitative tightening kicked in. The Fed’s balance sheet contracted by US$373bn<br />

in 2018 (see Figure 1). Investors should not assume this is a coincidence. For now at least the Fed’s<br />

quantitative tightening is set to continue at a pace of US$50bn a month, while the ECB confirmed in<br />

December it will stop quantitative easing from the end of 2018, even though the growth outlook in<br />

its region has deteriorated of late. Still, the ECB balance sheet will not shrink from its current size of<br />

€4.67tn, given that maturing bonds will continue to be reinvested.<br />

Figure 1<br />

Federal Reserve balance sheet contraction plan<br />

5.0<br />

4.5<br />

4.0<br />

3.5<br />

3.0<br />

2.5<br />

2.0<br />

1.5<br />

1.0<br />

0.5<br />

0.0<br />

(US$tn)<br />

Source: CLSA, Federal Reserve<br />

Other assets<br />

Agency debt & MBS<br />

Treasury securities<br />

Jan 07<br />

May 07<br />

Sep 07<br />

Jan 08<br />

May 08<br />

Sep 08<br />

Jan 09<br />

May 09<br />

Sep 09<br />

Jan 10<br />

May 10<br />

Sep 10<br />

Jan 11<br />

May 11<br />

Sep 11<br />

Jan 12<br />

May 12<br />

Sep 12<br />

Jan 13<br />

May 13<br />

Sep 13<br />

Jan 14<br />

May 14<br />

Sep 14<br />

Jan 15<br />

May 15<br />

Sep 15<br />

Jan 16<br />

May 16<br />

Sep 16<br />

Jan 17<br />

May 17<br />

Sep 17<br />

Jan 18<br />

May 18<br />

Sep 18<br />

Jan 19<br />

May 19<br />

Sep 19<br />

By contrast, the Fed’s balance sheet has already shrunk by US$396bn since September 2017, a<br />

decline of 9% since the balance-sheet contraction began in October 2017. At its peak, the balance<br />

sheet totalled US$4.5tn. If the Fed continues to shrink the balance sheet by the scheduled US$50bn<br />

a month during the coming year, it will have declined by a further 14.7% by the end of 2019.<br />

In such a context of accelerating tightening, credit spreads now need to be watched closely for signs<br />

of rising stress in the system. For they will be the signal of an uglier decline in asset prices than just<br />

a correction of stock market excesses, in terms of a derating of high PE growth stocks.


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

If the potential systemic risk in America is “credit”, it is also the case that 2018 ended with credit<br />

markets beginning to price these risks. Spreads on triple-B corporate bond yield over US Treasuries<br />

have risen by 62bps since early October to 193bps. While the spread on US high-yield bonds has<br />

risen by 228bps since early October to 531bps in late December, the highest level since August<br />

2016, and is now 527bps (see Figure 2).<br />

Figure 2<br />

Bloomberg Barclays US corporate bond yield spreads (BBB-rated and High-Yield corporate bonds)<br />

4.0<br />

3.5<br />

3.0<br />

2.5<br />

2.0<br />

1.5<br />

(ppt) BBB-rated High-Yield (RHS) (ppt)<br />

9<br />

8<br />

7<br />

6<br />

5<br />

4<br />

3<br />

1.0<br />

2<br />

Jan 11<br />

Jul 11<br />

Jan 12<br />

Jul 12<br />

Jan 13<br />

Jul 13<br />

Jan 14<br />

Jul 14<br />

Jan 15<br />

Jul 15<br />

Jan 16<br />

Jul 16<br />

Jan 17<br />

Jul 17<br />

Jan 18<br />

Jul 18<br />

Jan 19<br />

Source: Bloomberg<br />

Also the price of the S&P/LSTA Leveraged Loan Index has now declined to its lowest level since July<br />

2016, though the long-term chart still shows there is a lot of room for a further fall (see Figure 3).<br />

GREED & fear continues to recommend hedging equity portfolios by shorting this index, as well as<br />

Eurozone corporate credit spreads. The Eurozone investment-grade and high yield corporate bond<br />

spreads have risen by 82bps and 257bps from their lows reached in early 2018 (see Figure 4). The<br />

past year also ended with reports of credit markets tightening up as it suddenly became difficult, if<br />

not impossible, to finance high-yield bonds or leveraged loans. Thus, there was seemingly not a<br />

single high-yield financing by a US corporate in December. The last month this was the case was<br />

November 2008.<br />

Figure 3<br />

S&P/LSTA Leveraged Loan Price Index<br />

105<br />

100<br />

95<br />

90<br />

85<br />

80<br />

75<br />

S&P/LSTA Leveraged Loan Price Index<br />

70<br />

65<br />

60<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

2019<br />

Source: Bloomberg<br />

Thursday, 3 January 2019 Page 2


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 4<br />

Eurozone investment-grade vs high-yield corporate bond spreads<br />

180<br />

(bp)<br />

Eurozone investment-grade corporate bond spread<br />

(bp)<br />

750<br />

160<br />

Eurozone high-yield corporate bond spread (RHS)<br />

650<br />

140<br />

550<br />

120<br />

450<br />

100<br />

350<br />

80<br />

250<br />

60<br />

Jan 16<br />

Feb 16<br />

Mar 16<br />

Apr 16<br />

May 16<br />

Jun 16<br />

Jul 16<br />

Aug 16<br />

Sep 16<br />

Oct 16<br />

Nov 16<br />

Dec 16<br />

Jan 17<br />

Feb 17<br />

Mar 17<br />

Apr 17<br />

May 17<br />

Jun 17<br />

Jul 17<br />

Aug 17<br />

Sep 17<br />

Oct 17<br />

Nov 17<br />

Dec 17<br />

Jan 18<br />

Feb 18<br />

Mar 18<br />

Apr 18<br />

May 18<br />

Jun 18<br />

Jul 18<br />

Aug 18<br />

Sep 18<br />

Oct 18<br />

Nov 18<br />

Dec 18<br />

Jan 19<br />

150<br />

Note: Investment-grade bonds based on the Bloomberg Barclays Euro Aggregate Corporate Bond Index. High-yield bonds based on the BofA<br />

Merrill Lynch Euro High Yield Index. Source: Bloomberg, Federal Reserve Bank of St. Louis<br />

Such market action, in terms of rising credit stress, suggests to GREED & fear that an end is nearing<br />

to the monetary tightening cycle in the US. Yet the so-called “dot plots” incorporating Fed governors’<br />

interest rate forecasts still suggest 50bps of tightening in 2019 and 25bps in 2020. This looks<br />

unlikely in the extreme.<br />

GREED & fear’s view remains for only one more rate hike and even that is far from certain given that<br />

rising credit spreads, if not correcting FANG stocks, are increasingly likely to get the attention of the<br />

Fed, regardless of Powell’s comments at his December press conference about the balance sheet<br />

contraction being on “autopilot” (see GREED & fear – Autopilot aversion, 20 December 2018).<br />

Meanwhile it is no surprise that monetary tightening expectations in the money markets have<br />

reduced considerably over the past quarter in response to the increasingly negative stock market<br />

action. The implied rate of the December 2019 Fed funds futures has fallen from 2.93% in early<br />

November to 2.37% at present, implying no further tightening whatsoever (see Figure 5).<br />

Figure 5<br />

December 2019 Fed funds futures implied rate<br />

3.0<br />

(%) Dec-19 Fed funds futures implied rate<br />

2.9<br />

2.8<br />

2.7<br />

2.6<br />

2.5<br />

2.4<br />

2.3<br />

2.2<br />

2.1<br />

Jan 18<br />

Feb 18<br />

Mar 18<br />

Apr 18<br />

May 18<br />

Jun 18<br />

Jul 18<br />

Aug 18<br />

Sep 18<br />

Oct 18<br />

Nov 18<br />

Dec 18<br />

Jan 19<br />

Source: Bloomberg<br />

Thursday, 3 January 2019 Page 3


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

What about the American stock market? While credit spreads, along with the shape of the yield<br />

curve, are most important in terms of signalling an inflection point in monetary tightening, the equity<br />

market also plays its role. Having diverged from the weakening trend in other stock markets in the<br />

first three quarters of last year, there was a lot of room for the American stock market to play catch<br />

up on the downside, which is clearly what happened last quarter. The S&P500 declined by 14% in<br />

4Q18, compared with 11.8% and 7.8% declines in the MSCI AC World ex-US and MSCI Emerging<br />

Markets (see Figure 6).<br />

Figure 6<br />

S&P500, MSCI AC World ex-US and MSCI Emerging Markets performance since the beginning of 2018<br />

12<br />

(%chg)<br />

9<br />

6<br />

3<br />

0<br />

-3<br />

-6<br />

-9<br />

-12<br />

-15<br />

-18<br />

S&P500<br />

MSCI AC World ex-US<br />

MSCI Emerging Markets<br />

-21<br />

Jan 18<br />

Feb 18<br />

Mar 18<br />

Apr 18<br />

May 18<br />

Jun 18<br />

Jul 18<br />

Aug 18<br />

Sep 18<br />

Oct 18<br />

Nov 18<br />

Dec 18<br />

Jan 19<br />

Source: CLSA, Datastream<br />

Indeed there is now in GREED & fear’s view a risk of extreme American underperformance if<br />

potential turmoil in the credit markets causes American equity investors finally to take a more<br />

critical look at years of financial engineering financed by leverage in corporate America. This has<br />

resulted in a dramatic collapse in tangible book value for the S&P500, which has fallen by 22% since<br />

June 2014 (see Figure 7).<br />

Figure 7<br />

S&P500 tangible book value<br />

360<br />

340<br />

320<br />

300<br />

280<br />

260<br />

240<br />

S&P500 tangible book value<br />

220<br />

Jan 10<br />

May 10<br />

Sep 10<br />

Jan 11<br />

May 11<br />

Sep 11<br />

Jan 12<br />

May 12<br />

Sep 12<br />

Jan 13<br />

May 13<br />

Sep 13<br />

Jan 14<br />

May 14<br />

Sep 14<br />

Jan 15<br />

May 15<br />

Sep 15<br />

Jan 16<br />

May 16<br />

Sep 16<br />

Jan 17<br />

May 17<br />

Sep 17<br />

Jan 18<br />

May 18<br />

Sep 18<br />

Source: Bloomberg<br />

Thursday, 3 January 2019 Page 4


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

From a more mundane earnings standpoint, there is also a growing risk both short term and long<br />

term for the US market. The short-term risk is the unhelpful base effect given the tax reform-driven<br />

surge in US corporate profits in the first half of last year. S&P500 as-reported earnings rose by 23%<br />

YoY in 1H18. The longer-term risk is that corporate profit margins are at a record high, even after<br />

adjusting for last year’s tax cut, and look like they are peaking. The S&P500 operating profit margin<br />

has risen from 8% in 4Q15 to a record 12.1% in 3Q18 and an annualised 11.3% (see Figure 8).<br />

Figure 8<br />

S&P500 annualised operating profit margin<br />

12<br />

(%) S&P500 annualised operating profit margin<br />

11<br />

10<br />

9<br />

8<br />

7<br />

6<br />

5<br />

4<br />

Mar 01<br />

Sep 01<br />

Mar 02<br />

Sep 02<br />

Mar 03<br />

Sep 03<br />

Mar 04<br />

Sep 04<br />

Mar 05<br />

Sep 05<br />

Mar 06<br />

Sep 06<br />

Mar 07<br />

Sep 07<br />

Mar 08<br />

Sep 08<br />

Mar 09<br />

Sep 09<br />

Mar 10<br />

Sep 10<br />

Mar 11<br />

Sep 11<br />

Mar 12<br />

Sep 12<br />

Mar 13<br />

Sep 13<br />

Mar 14<br />

Sep 14<br />

Mar 15<br />

Sep 15<br />

Mar 16<br />

Sep 16<br />

Mar 17<br />

Sep 17<br />

Mar 18<br />

Sep 18<br />

Source: S&P Dow Jones Indices<br />

This risk of peaking profit margins is especially the case given the rising “late cycle” costs facing US<br />

corporations, in particular rising wage costs as reflected in the fact that the past two months have<br />

seen the biggest year-on-year rise in average hourly earnings growth since April 2009. Average<br />

hourly earnings growth rose from 2.8% YoY in September to 3.1% in October and November (see<br />

Figure 9).<br />

Figure 9<br />

US average hourly earnings growth<br />

3.7 (%YoY)<br />

US average hourly earnings growth for all private employees<br />

3.5<br />

3.3<br />

3.1<br />

2.9<br />

2.7<br />

2.5<br />

2.3<br />

2.1<br />

1.9<br />

1.7<br />

1.5<br />

Mar 07<br />

Sep 07<br />

Mar 08<br />

Sep 08<br />

Mar 09<br />

Sep 09<br />

Mar 10<br />

Sep 10<br />

Mar 11<br />

Sep 11<br />

Mar 12<br />

Sep 12<br />

Mar 13<br />

Sep 13<br />

Mar 14<br />

Sep 14<br />

Mar 15<br />

Sep 15<br />

Mar 16<br />

Sep 16<br />

Mar 17<br />

Sep 17<br />

Mar 18<br />

Source: US Bureau of Labour Statistics<br />

Sep 18<br />

The evidence that wage pressure is finally picking up in America nearly 10 years after the recovery<br />

began continues to be viewed by GREED & fear as more of a threat to profits, and therefore to<br />

stocks, than as a harbinger of a pickup in inflation. Indeed core inflation increasingly looks like it has<br />

peaked out in this cycle. Core CPI and core PCE inflation slowed from 2.4% and 2.0% YoY<br />

Thursday, 3 January 2019 Page 5


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

respectively in July to 2.1% and 1.8% in October, though rising to 2.2% and 1.9% in November (see<br />

Figure 10).<br />

Figure 10<br />

US core CPI and PCE inflation<br />

3.0<br />

(%YoY) US core CPI inflation Core PCE inflation<br />

2.5<br />

2.0<br />

1.5<br />

1.0<br />

0.5<br />

Jan 03<br />

Jul 03<br />

Jan 04<br />

Jul 04<br />

Jan 05<br />

Jul 05<br />

Jan 06<br />

Jul 06<br />

Jan 07<br />

Jul 07<br />

Jan 08<br />

Jul 08<br />

Jan 09<br />

Jul 09<br />

Jan 10<br />

Jul 10<br />

Jan 11<br />

Jul 11<br />

Jan 12<br />

Jul 12<br />

Jan 13<br />

Jul 13<br />

Jan 14<br />

Jul 14<br />

Jan 15<br />

Jul 15<br />

Jan 16<br />

Jul 16<br />

Jan 17<br />

Jul 17<br />

Jan 18<br />

Jul 18<br />

Source: US Bureau of Labour Statistics, Bureau of Economic Analysis<br />

Figure 11<br />

US M2 growth<br />

14<br />

12<br />

(%YoY)<br />

US M2 growth<br />

10<br />

8<br />

6<br />

4<br />

2<br />

0<br />

1960<br />

1962<br />

1964<br />

1966<br />

1968<br />

1970<br />

1972<br />

1974<br />

1976<br />

1978<br />

1980<br />

1982<br />

1984<br />

1986<br />

1988<br />

1990<br />

1992<br />

1994<br />

1996<br />

1998<br />

2000<br />

2002<br />

2004<br />

2006<br />

2008<br />

2010<br />

2012<br />

2014<br />

2016<br />

2018<br />

Source: CLSA, Federal Reserve<br />

US money supply and credit related data are also giving an increasingly deflationary signal, thereby<br />

confirming the trend in the yield curve. M2 growth slowed from 7.5% YoY in October 2016 to 3.9%<br />

YoY in November (see Figure 11). Bank loans plus non-financial commercial paper outstanding<br />

growth also slowed from 8.4% YoY in May 2016 to 4.4% YoY in November 2018 (see Figure 12).<br />

While it has long been GREED & fear’s “Austrian” view to pay more attention to credit than narrower<br />

monetary aggregates, the reality of ongoing Fed balance-sheet contraction means money-supply<br />

data should not be ignored entirely, given that there are no real historic precedents for such<br />

quantitative tightening in peacetime. In this respect, it is also interesting to note the declining trend<br />

in US bank-deposit growth, which slowed to an eight-year low of 2.9% YoY in November, down<br />

from 5.1% in October 2017 (see Figure 13).<br />

Thursday, 3 January 2019 Page 6


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 12<br />

US bank loans plus non-financial commercial paper outstanding growth<br />

9<br />

(%YoY)<br />

8<br />

7<br />

6<br />

5<br />

4<br />

3<br />

2<br />

Jan 12<br />

Apr 12<br />

Jul 12<br />

Oct 12<br />

Jan 13<br />

Apr 13<br />

Jul 13<br />

Oct 13<br />

Jan 14<br />

Apr 14<br />

Jul 14<br />

Oct 14<br />

Jan 15<br />

Apr 15<br />

Jul 15<br />

Oct 15<br />

Jan 16<br />

Apr 16<br />

Jul 16<br />

Oct 16<br />

Jan 17<br />

Apr 17<br />

Jul 17<br />

Oct 17<br />

Jan 18<br />

Apr 18<br />

Jul 18<br />

Oct 18<br />

Source: CLSA, Federal Reserve<br />

Figure 13<br />

US bank deposit growth<br />

12<br />

11<br />

10<br />

9<br />

8<br />

7<br />

6<br />

5<br />

4<br />

3<br />

2<br />

Jan 00<br />

(%YoY)<br />

Sep 00<br />

May 01<br />

Jan 02<br />

Sep 02<br />

May 03<br />

Jan 04<br />

Source: CLSA, Federal Reserve<br />

Sep 04<br />

May 05<br />

Jan 06<br />

Sep 06<br />

May 07<br />

Jan 08<br />

Sep 08<br />

May 09<br />

Jan 10<br />

Sep 10<br />

May 11<br />

Jan 12<br />

Sep 12<br />

May 13<br />

Jan 14<br />

Sep 14<br />

May 15<br />

Jan 16<br />

Sep 16<br />

May 17<br />

Jan 18<br />

Sep 18<br />

If the above stance on the US looks very bearish, it is only fair for GREED & fear to point out that<br />

there is a risk to the above base case. This is that the positive side of the Trump economic agenda,<br />

namely tax cuts and deregulation as opposed to the negative of tariffs, revive the animal spirits in<br />

the American economy. A potential sign of this is the recent pickup in top-line revenue growth. Thus,<br />

S&P500 sales rose by 10.7% in 3Q18 following the 11.2% growth in 2Q18, the highest growth rate<br />

since 2Q11. The macro data also shows a similar trend, with total business sales, including<br />

manufacturers, retailers and merchant wholesalers, rising by 7.8% YoY in 2Q18 and 7.5% in 3Q18,<br />

the highest levels since 4Q11 (see Figure 14).<br />

Thursday, 3 January 2019 Page 7


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 14<br />

US total business sales growth<br />

15<br />

10<br />

(%YoY)<br />

US total business sales<br />

5<br />

0<br />

-5<br />

-10<br />

-15<br />

-20<br />

1993<br />

1994<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: CLSA, US Census Bureau<br />

However, set against this positive remains the growing evidence that higher interest rates are<br />

impacting the American economy, and this includes households as well as corporations. In this<br />

respect, the macro data showing a significant decline in US household debt relative to GDP in this<br />

cycle (see Figure 15) does not incorporate the reality of the extremely unequal distribution of<br />

income in America.<br />

Figure 15<br />

US corporate debt and household debt as % of GDP<br />

47<br />

46<br />

45<br />

(%GDP)<br />

US non-financial corporate debt % GDP<br />

US household debt % GDP (RHS)<br />

(%GDP)<br />

110<br />

100<br />

44<br />

43<br />

90<br />

42<br />

80<br />

41<br />

40<br />

70<br />

39<br />

38<br />

60<br />

37<br />

1990<br />

1991<br />

1992<br />

1993<br />

1994<br />

1995<br />

1996<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Source: Federal Reserve – Flow of Funds Accounts<br />

50<br />

This phenomenon was highlighted by the Federal Reserve’s triennial Survey of Consumer Finance<br />

(SCF) published in September 2017 which found that the top 1% of Americans have a larger share of<br />

wealth, in terms of net worth, than the bottom 90%. Thus, the share of the top 1% rose from 36.3%<br />

in 2013 to 38.6% in 2016, compared with a 22.8% share for the bottom 90%. The reality is that<br />

most Americans are still living month-to-month, which is why the stresses from monetary tightening<br />

are best shown by the rising interest payments made by American households. And when interest<br />

rates have been so low any rise at all is significant in percentage terms. Thus personal interest<br />

payments, excluding mortgages, rose by 14% YoY in November and are up 55% since mid-2013 (see<br />

Figure 16).<br />

Thursday, 3 January 2019 Page 8


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 16<br />

US personal interest payments<br />

360<br />

340<br />

320<br />

300<br />

280<br />

260<br />

240<br />

220<br />

200<br />

180<br />

(US$bn, saar)<br />

US personal outlays: Personal interest payments<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

Note: Consists of nonmortgage interest paid by households. Source: US Economic Analysis<br />

The conclusion remains, therefore, that the growth trend in America will start to converge with the<br />

weakening growth that has already been evident elsewhere. This global slowdown can be seen in<br />

charts of OECD leading indicators and global PMIs. Thus, the JPMorgan Global Manufacturing PMI<br />

declined from 52 in November to 51.5 in December, the lowest level since September 2016 (see<br />

Figure 17), while the OECD Composite Leading Indicator fell to a six-year low of 99.36 in October<br />

(see Figure 18). It can also be seen in the contraction in the German and Japanese economies last<br />

quarter and, most importantly, in the related continuing slowdown in China.<br />

Figure 17<br />

JPMorgan Global Manufacturing PMI<br />

57<br />

56<br />

55<br />

54<br />

53<br />

52<br />

51<br />

50<br />

49<br />

48<br />

(DI)<br />

Global Manufacturing PMI<br />

Jan-10<br />

Apr-10<br />

Jul-10<br />

Oct-10<br />

Jan-11<br />

Apr-11<br />

Jul-11<br />

Oct-11<br />

Jan-12<br />

Apr-12<br />

Jul-12<br />

Oct-12<br />

Jan-13<br />

Apr-13<br />

Jul-13<br />

Oct-13<br />

Jan-14<br />

Apr-14<br />

Jul-14<br />

Oct-14<br />

Jan-15<br />

Apr-15<br />

Jul-15<br />

Oct-15<br />

Jan-16<br />

Apr-16<br />

Jul-16<br />

Oct-16<br />

Jan-17<br />

Apr-17<br />

Jul-17<br />

Oct-17<br />

Jan-18<br />

Apr-18<br />

Jul-18<br />

Oct-18<br />

Source: IHS Markit<br />

In the specific case of China, it is important to highlight again that the critical driver of the<br />

slowdown has not been Fed tightening but domestic policy, in terms of the central government’s<br />

ongoing deleveraging campaign to squeeze the shadow banking sector. This squeeze has been<br />

underway since 2016 and is now probably past its peak, as in part signalled by the statement made<br />

following the annual Central Economic Work Conference (CEWC) held in late December. The<br />

statement said: “China will strengthen countercyclical adjustments in its macro policy, continue to<br />

implement proactive fiscal policy and prudent monetary policy, make pre-emptive adjustments and<br />

fine-tune policies at the proper times”. Targeted easing measures announced at the end of the<br />

Thursday, 3 January 2019 Page 9


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

conference include larger-scale tax and fee cuts for corporations and an increase in the issuance of<br />

special-purpose local government bonds.<br />

Figure 18<br />

OECD Composite Leading Indicator<br />

102<br />

(DI)<br />

101<br />

100<br />

99<br />

98<br />

97<br />

96<br />

95<br />

Jan 04<br />

Jul 04<br />

Jan 05<br />

Jul 05<br />

Jan 06<br />

Jul 06<br />

Jan 07<br />

Jul 07<br />

Jan 08<br />

Jul 08<br />

Jan 09<br />

Jul 09<br />

Jan 10<br />

Jul 10<br />

Jan 11<br />

Jul 11<br />

Jan 12<br />

Jul 12<br />

Jan 13<br />

Jul 13<br />

Jan 14<br />

Jul 14<br />

Jan 15<br />

Jul 15<br />

Jan 16<br />

Jul 16<br />

Jan 17<br />

Jul 17<br />

Jan 18<br />

Jul 18<br />

Source: OECD<br />

Nonetheless, it remains important to understand the sheer scale of deleveraging which has seen<br />

China bank asset growth running below nominal GDP growth since June 2017. At the risk of<br />

belabouring the point, GREED & fear will repeat the key data point. China depository corporations’<br />

asset growth has slowed from 15.8% YoY in November 2016 to 6.8% YoY in November 2018,<br />

compared with nominal GDP growth of 9.6% YoY in 3Q18 (see Figure 19).<br />

Figure 19<br />

China bank asset growth and nominal GDP growth<br />

28<br />

24<br />

(%YoY)<br />

China depository corporations' asset growth<br />

Nominal GDP growth<br />

20<br />

16<br />

12<br />

8<br />

4<br />

Jan 07<br />

May 07<br />

Sep 07<br />

Jan 08<br />

May 08<br />

Sep 08<br />

Jan 09<br />

May 09<br />

Sep 09<br />

Jan 10<br />

May 10<br />

Sep 10<br />

Jan 11<br />

May 11<br />

Sep 11<br />

Jan 12<br />

May 12<br />

Sep 12<br />

Jan 13<br />

May 13<br />

Sep 13<br />

Jan 14<br />

May 14<br />

Sep 14<br />

Jan 15<br />

May 15<br />

Sep 15<br />

Jan 16<br />

May 16<br />

Sep 16<br />

Jan 17<br />

May 17<br />

Sep 17<br />

Jan 18<br />

May 18<br />

Sep 18<br />

Source: PBOC, CEIC Data, National Bureau of Statistics<br />

Meanwhile, to GREED & fear, the above evidence of a global slowdown, combined with the growing<br />

prospects of America converging with that trend, has a silver lining for Asia and other emerging<br />

markets. That is because it raises the prospects of not only an end to Fed tightening but also an end<br />

to US-dollar strength, given the continuing negative correlation between a strong dollar and Asian<br />

and emerging markets. The correlation between the US Dollar Index and the MSCI Emerging<br />

Markets has been a negative 0.92 since the beginning of 2017 (see Figure 20).<br />

Thursday, 3 January 2019 Page 10


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 20<br />

MSCI Emerging Markets Index and US Dollar Index<br />

1,400<br />

MSCI Emerging Markets<br />

US Dollar Index (RHS)<br />

130<br />

1,200<br />

120<br />

1,000<br />

110<br />

800<br />

100<br />

600<br />

90<br />

400<br />

80<br />

200<br />

70<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

2019<br />

Source: Datastream, Bloomberg<br />

This is particularly important for China given that a strengthening US dollar has raised the risk of<br />

renewed capital outflow pressure; though in the past year China managed to control such outflow<br />

pressure despite the stronger US dollar, as reflected in the declining deficit in the net errors and<br />

omissions items in the balance of payments. Thus, the net errors and omissions deficit declined by<br />

42% YoY from US$156bn in 1Q-3Q17 to US$89bn in 1Q-3Q18; though it should be noted that it<br />

rose from US$11bn in 2Q18 to US$40bn in 3Q18 (see Figure 21), based on data released at the end<br />

of December.<br />

Figure 21<br />

China balance of payments: Net errors and omissions<br />

60<br />

(US$bn)<br />

China net erros & omissions<br />

Annualised (RHS)<br />

(US$bn)<br />

100<br />

40<br />

50<br />

20<br />

0<br />

0<br />

-50<br />

(20)<br />

-100<br />

(40)<br />

-150<br />

(60)<br />

-200<br />

(80)<br />

-250<br />

(100)<br />

-300<br />

Mar 01<br />

Mar 02<br />

Mar 03<br />

Mar 04<br />

Mar 05<br />

Mar 06<br />

Mar 07<br />

Mar 08<br />

Mar 09<br />

Mar 10<br />

Mar 11<br />

Mar 12<br />

Mar 13<br />

Mar 14<br />

Mar 15<br />

Mar 16<br />

Mar 17<br />

Mar 18<br />

Source: State Administration of Foreign Exchange (SAFE)<br />

What is clear in many parts of Asia is that there is significant room to ease monetary policy if Fed<br />

tightening ends and, with it, US-dollar strength. This is both because of a lack of inflationary<br />

pressures, as well as the willingness of Asian central banks to raise rates this cycle just to defend<br />

their currencies regardless of domestic growth. Indonesia is the best example of this dynamic, as<br />

discussed here last week (see GREED & fear – Unseasonal vol, 27 December 2018). India is also<br />

another country where the central bank, under new leadership, has potentially a lot of room to ease<br />

with the policy repo rate at 6.5% or 4.2 percentage points higher than CPI which is the Reserve<br />

Bank of India’s formal target. GREED & fear is Overweight both markets.<br />

Thursday, 3 January 2019 Page 11


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Still if there is lots of room to ease in the case of a potential trend change in the US dollar triggered<br />

by the Fed, Asia and emerging markets cannot look forward to another traditional trigger for the<br />

asset class in recent years. That is a massive coordinated Chinese stimulus. All the evidence is that<br />

the Chinese Government wants to avoid indulging in a renewed aggressive stimulus since it is now<br />

well understood in Beijing that this only increases systemic risks.<br />

The lack of an easy way out for Asia and emerging markets, courtesy of another mega China<br />

stimulus, means that prospects for the asset class are much less straightforward than in the past. In<br />

this respect, China as a consumption-driven economy has different attributes than China as an<br />

investment-driven economy. It will probably take time for investors to get used to this. Meanwhile if<br />

GREED & fear’s longstanding positive view on the resolution of the US-China trade dispute proves to<br />

be wrong, and China is panicked into a more aggressive stimulus, the short-term relief would be<br />

massively outweighed by the resulting massively increased long-term systemic risk. China’s total<br />

debt to GDP is after all now 253%, up from 138% in 2008 as a result of the post Lehman bankruptcy<br />

(see Figure 22).<br />

Figure 22<br />

China total non-financial sector debt to GDP<br />

260<br />

240<br />

(%)<br />

China total non-financial sector debt to GDP<br />

220<br />

200<br />

180<br />

160<br />

140<br />

120<br />

Source: BIS<br />

Mar 00<br />

Sep 00<br />

Mar 01<br />

Sep 01<br />

Mar 02<br />

Sep 02<br />

Mar 03<br />

Sep 03<br />

Mar 04<br />

Sep 04<br />

Mar 05<br />

Sep 05<br />

Mar 06<br />

Sep 06<br />

Mar 07<br />

Sep 07<br />

Mar 08<br />

Sep 08<br />

Mar 09<br />

Sep 09<br />

Mar 10<br />

Sep 10<br />

Mar 11<br />

Sep 11<br />

Mar 12<br />

Sep 12<br />

Mar 13<br />

Sep 13<br />

Mar 14<br />

Sep 14<br />

Mar 15<br />

Sep 15<br />

Mar 16<br />

Sep 16<br />

Mar 17<br />

Sep 17<br />

Mar 18<br />

Still, such an outcome seems unlikely to GREED & fear under Xi Jinping’s leadership. All the evidence<br />

is that Beijing is adjusting policy to an era of slower growth which is the natural consequence of the<br />

country’s ageing demographics, with the working-age population having peaked in 2011. Meanwhile<br />

amidst the increased bearish sentiment towards China last year and the likelihood of a continuing<br />

weakening in China data in the first few months of 2019, it is important to remember that Chinese<br />

households still enjoy positive real income and a high savings rate. Real per capita disposable income<br />

rose by 6.6% YoY in the first three quarters of 2018 (see Figure 23), while household savings are<br />

running at 32% of disposable income. These remain important bulwarks of support in what is now a<br />

consumption-driven economy.<br />

Still, life will be a lot easier for Beijing policymakers if the trade dispute with America is resolved and<br />

Fed tightening ends. On both points, Beijing’s agenda probably matches that of America’s 45 th<br />

president!<br />

Thursday, 3 January 2019 Page 12


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 23<br />

China real per capita disposable income growth<br />

14<br />

(%YoY) Urban Rural Nationwide<br />

12<br />

10<br />

8<br />

6<br />

4<br />

2<br />

0<br />

1997<br />

1998<br />

1999<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

9M18<br />

Source: National Bureau of Statistics<br />

A few words are due on the performance of GREED & fear’s long-only portfolios in a year where it<br />

was better to be hedged! The Asia ex-Japan long-only portfolio outperformed last quarter, declining<br />

by 5% in US-dollar terms on a total-return basis, compared with an 8.6% decline in the regional<br />

benchmark. Still for 2018 as a whole, the portfolio underperformed, declining by 18.2% compared<br />

with a 14.1% decline in the regional benchmark. This reflected the negative impact from the sharp<br />

selloff in Indian financial stocks in 3Q18. Indian financial stocks still account for 28% of the portfolio.<br />

The portfolio remains 47% invested in India.<br />

The long-term performance of the Asia ex-Japan thematic portfolio remains, for now, satisfactory.<br />

Since its inception at the end of 3Q02, the portfolio has risen on a total-return basis by 1,585% in<br />

US-dollar terms compared with a 435% increase in the MSCI AC Asia ex-Japan and a 329% increase<br />

in the S&P500 (see Figure 24). This means the portfolio has risen by an annualised 19% since<br />

inception, compared with an annualised 10.9% increase in the MSCI AC Asia ex-Japan and an<br />

annualised 9.4% gain in the S&P500.<br />

Figure 24<br />

Asia ex-Japan long-only portfolio total return performance vs MSCI AC Asia ex-Japan (US$ terms)<br />

2,400<br />

2,100<br />

(30 Sep 02=100) Asia ex-Japan thematic portfolio total return<br />

MSCI AC Asia ex-Japan total return<br />

1,800<br />

1,500<br />

1,200<br />

900<br />

600<br />

300<br />

0<br />

Oct 02<br />

Apr 03<br />

Oct 03<br />

Apr 04<br />

Oct 04<br />

Apr 05<br />

Oct 05<br />

Apr 06<br />

Oct 06<br />

Apr 07<br />

Oct 07<br />

Apr 08<br />

Oct 08<br />

Apr 09<br />

Oct 09<br />

Apr 10<br />

Oct 10<br />

Apr 11<br />

Oct 11<br />

Apr 12<br />

Oct 12<br />

Apr 13<br />

Oct 13<br />

Apr 14<br />

Oct 14<br />

Apr 15<br />

Oct 15<br />

Apr 16<br />

Oct 16<br />

Apr 17<br />

Oct 17<br />

Apr 18<br />

Oct 18<br />

Note: Total return performance in US dollar terms. Data up to 31 December 2018. Source: CLSA, Datastream<br />

Thursday, 3 January 2019 Page 13


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

As for the Japan long-only portfolio, introduced on 17 March 2005, it underperformed the Topix last<br />

quarter on a total-return basis, declining by 20.8% in yen terms compared with a 17.6% decline in<br />

the Topix. As a result primarily of last quarter, the portfolio also underperformed in 2018 declining<br />

by 19.6% in yen terms compared with a 16% decline in the Topix. While in US-dollar terms, the<br />

portfolio declined by 18% last quarter, compared with a 14.7% decline in the Topix. The portfolio<br />

was down 17.4% in US-dollar terms on a total-return basis in 2018, compared with a 13.7% decline<br />

in the Topix.<br />

From a longer-term perspective, the Japan portfolio is now up 173.3% in yen terms and 160.3% in<br />

US-dollar terms on a total-return basis since inception on 17 March 2005, while the Topix has risen<br />

by 63.1% in yen terms and 55.4% in US-dollar terms over the same period (see Figure 25). This<br />

translates into an annualised gain of 7.6% in yen terms since inception, compared with a 3.6%<br />

annualised gain for the Topix.<br />

Figure 25<br />

Japan long-only thematic portfolio total-return performance vs Topix (in yen terms)<br />

400<br />

350<br />

(17 Mar 05=100) Japan thematic portfolio total return<br />

Topix total return index<br />

300<br />

250<br />

200<br />

150<br />

100<br />

50<br />

Mar 05<br />

Sep 05<br />

Mar 06<br />

Sep 06<br />

Mar 07<br />

Sep 07<br />

Mar 08<br />

Sep 08<br />

Mar 09<br />

Sep 09<br />

Mar 10<br />

Sep 10<br />

Mar 11<br />

Sep 11<br />

Mar 12<br />

Sep 12<br />

Mar 13<br />

Sep 13<br />

Mar 14<br />

Sep 14<br />

Mar 15<br />

Sep 15<br />

Mar 16<br />

Sep 16<br />

Mar 17<br />

Sep 17<br />

Mar 18<br />

Note: Total-return performance in yen terms. Data up to 31 December 2018. Source: CLSA, Datastream<br />

Sep 18<br />

Finally a few words are due on gold. The gold-bullion price rose by 7.5% last quarter as Fed<br />

tightening expectations reduced. As a result, gold was down only 1.6% in 2018. This followed the<br />

13.1% rally in gold in 2017 (see Figure 26). The unhedged gold-mining index outperformed gold<br />

bullion last quarter, rising by 13.8%. But it was still down 16.5% for the whole of 2018 (see Figure<br />

27).<br />

The really positive trigger for gold will be renewed Fed easing and the resulting realisation by the<br />

consensus that the Fed will not be able to normalise monetary policy. But in the eyes of the<br />

consensus such an outcome has now been delayed, if not abandoned altogether. If the consensus<br />

proves to be wrong, gold-mining stocks remain the geared way of investing on such a Fed U-turn.<br />

They are now trading at July 2003 levels when the gold price was around US$360/oz.<br />

Thursday, 3 January 2019 Page 14


Christopher Wood christopher.wood@clsa.com +852 2600 8516<br />

Figure 26<br />

Gold bullion price<br />

2000<br />

(US$/oz)<br />

1800<br />

1600<br />

1400<br />

Gold bullion spot price<br />

200-day moving average<br />

1200<br />

1000<br />

800<br />

600<br />

400<br />

200<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

2019<br />

Source: CLSA, Bloomberg<br />

Figure 27<br />

NYSE Arca Gold BUGS Index<br />

700<br />

NYSE Arca Gold BUGS Index (HUI)<br />

600<br />

500<br />

400<br />

300<br />

200<br />

100<br />

0<br />

2000<br />

2001<br />

2002<br />

2003<br />

2004<br />

2005<br />

2006<br />

2007<br />

2008<br />

2009<br />

2010<br />

2011<br />

2012<br />

2013<br />

2014<br />

2015<br />

2016<br />

2017<br />

2018<br />

2019<br />

Source: Bloomberg<br />

Thursday, 3 January 2019 Page 15


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1/4/2019 The struggle for India’s soul - The World in 2019<br />

The contest will in part be a referendum on Narendra Modi, the 68-year-old prime minister<br />

who in 2014 brought his Bharatiya Janata Party (BJP) India’s rst single-party parliamentary<br />

majority in three decades. That landslide suggested broad endorsement for its pro-business<br />

and Hindu-nationalist agenda, as well as support for Mr Modi’s carefully tended mix of<br />

patriarchal mien, folksy talk and energetic boosterism. But after ve years in o ce, the halo<br />

surrounding the former tea-boy from Gujarat has faded. Mr Modi’s political magic button,<br />

marked “resentment at ruling elites”, no longer produces Pavlovian roars of approval. With<br />

his perfectly pressed pastel-coloured kurtas and hugging matches with world leaders, Mr<br />

Modi himself now looks pretty elite.<br />

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His party and its platform, which seemed an unstoppable juggernaut until halfway through<br />

Mr Modi’s term, has also grown less fearsome. The BJP still has more money by far than any<br />

rival, thanks to wealthy and loyal patrons. This is a key asset in Indian elections, as are the<br />

party’s superior discipline, better tactical commanders and, crucially, its close ties with<br />

grassroots Hindu-nationalist groups that provide reliable shock troops across the country.<br />

Yet for all this strength, the party’s record in power has looked surprisingly weak by many<br />

measures. This has alienated important constituencies.<br />

One of these is businesspeople, many of whom had seen Mr Modi’s powerful mandate as an<br />

opportunity to push through sweeping free-market reforms. Instead, misguided policies<br />

such as the overnight “demonetisation” of 86% of India’s currency in 2016, or inept ones<br />

such as the clumsy imposition of needlessly high and complex national sales taxes in 2018,<br />

or a failure to address a looming bad-debt crunch in state-owned banks, have tended to<br />

overshadow achievements including Mr Modi’s laudable scal probity and the passage of<br />

much-needed economic laws, for example on bankruptcy.<br />

But when it comes to revising land and labour laws that constrain India’s economic growth,<br />

or privatising unaccountable and ine cient state assets, the BJP has proved disappointingly<br />

timid. As for economic growth, Mr Modi has produced solid results, but his immediate<br />

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predecessor’s were better.<br />

https://www.economist.com/the-world-in/2018/12/30/the-struggle-for-indias-soul 2/7


1/4/2019 The struggle for India’s soul - The World in 2019<br />

At the other end of India’s vast social scale, farmers, lower-caste Hindus and religious<br />

minorities all have reason to have fallen out of love with the BJP. Mr Modi’s tenure has seen<br />

an ugly surge in violence directed against India’s less privileged, often by groups or<br />

individuals associated with the Hindu-nationalist right. The poor have also been hit by<br />

rising global oil prices, a weaker Indian rupee and falling farmgate prices. Intellectuals,<br />

journalists, academics and other opinion-makers, meanwhile, have been put o by the Modi<br />

government’s dictatorial style: rather than upend the stu y dominance of a long-entrenched<br />

establishment, as many had hoped, the BJP has simply inserted loyalists to run the same old<br />

system.<br />

All this works to the advantage of Mr Modi’s foes, most notably Congress, the legacy party of<br />

India’s independence movement. And so too does a force often described as the most<br />

powerful in India’s ckle political game, anti-incumbency. If this were the potent Congress<br />

party of past decades, the BJP’s doom would probably have been sealed. But despite being the<br />

only real national-level rival to the BJP, and indeed the only other party with a presence in<br />

every Indian state, Congress is a shadow of its former self. Its leader, too, is no match for Mr<br />

Modi in political skill: Rahul Gandhi may be younger, and may also have grown into his job<br />

as “crown prince” of the Nehru-Gandhi dynasty that has commanded Congress for four<br />

generations, but he lacks the BJP leader’s street- ghting tenacity.<br />

No one expects Congress to take on the BJP on its own, however, and Mr Gandhi has also<br />

been coy about whether he would actually seek to be prime minister. The likely strategy is<br />

for Congress to patch together a rainbow of anti-BJP forces, largely composed of the regional<br />

and identity-based parties whose growing importance has been a salient development in<br />

recent years. If Congress can hold together such a coalition—and that is a very big if—then<br />

Mr Modi’s days might be numbered.<br />

But that is not what makes this election so momentous. Beyond the struggle between parties<br />

and personalities, Indians sense an underlying struggle over the country’s soul. If Mr Modi<br />

wins a second term, his party may be even blunter in imposing its Hindu-nationalist vision<br />

of a more muscular, less tolerant India. Should Congress and its multifarious allies capture<br />

power, their critics fear, India will return to its bumbling, corrupt old ways. The more likely<br />

result: whoever rules, India will remain too wildly diverse for any one trend to dominate.<br />

This article appears in "The World in 2019", our annual edition that looks at the year ahead. See<br />

more at worldin2019.economist.com<br />

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https://www.economist.com/the-world-in/2018/12/30/the-struggle-for-indias-soul 3/7


Year Ahead 2019<br />

UBS House View<br />

Global<br />

Chief Investment Office GWM<br />

Investment Research<br />

Turning points<br />

a b


Navigating 2019<br />

Surprises for 2019?<br />

Key investment risks<br />

Selected Scenarios Scenario Description Expected 6m market performance for select asset classes<br />

Base case<br />

Positive outlook<br />

with increased<br />

volatility<br />

Global economic growth<br />

slows but remains solid,<br />

while ongoing trade tensions,<br />

monetary tightening, and<br />

uncertainty about growth<br />

keep volatility high.<br />

<br />

<br />

<br />

US equities +0%–5% due to solid economic<br />

activity supported by consumer and business<br />

confidence and capital access<br />

Eurozone equities +0%–5% amid political<br />

uncertainty surrounding Italy, Brexit, and the<br />

ongoing trade conflict<br />

EURUSD between 1.15 and 1.20 as monetary<br />

policy normalizes<br />

Key downside scenarios<br />

Trade: Further<br />

US sanctions<br />

US-China trade disputes<br />

induce a slowdown in China,<br />

considerable uncertainty, and<br />

a rerouting of global trade.<br />

More countries start to feel<br />

pain via disrupted supply<br />

chains.<br />

<br />

<br />

<br />

US equities down 5%–10% composed of a<br />

5% hit to our EPS estimates coupled with P/Es<br />

contracting 0%–5%<br />

Chinese equities down 20%–25% as sentiment<br />

falls further with negative economic consequences<br />

USD appreciates to around EURUSD 1.10 as<br />

US tariffs support the USD<br />

Fed ends the<br />

business cycle<br />

sooner<br />

As US inflation rises rapidly,<br />

the Fed is forced to hike rates<br />

at each FOMC meeting. This<br />

leads to a flat or inverted<br />

US Treasury yield curve by<br />

mid-2019, and an equity<br />

market sell-off. A US recession<br />

starts in early 2020.<br />

<br />

<br />

<br />

US equities down 10%–15% as valuations fall<br />

5–10% as fears about the end of the cycle rise,<br />

and earnings do not grow in 2019<br />

US high yield down 6%–9% as spreads widen<br />

toward recession levels, while mid- to longer-term<br />

US Treasury yields fall<br />

USD appreciates, bringing EURUSD to or below<br />

1.10 as the USD strengthens due to<br />

contractionary monetary policy<br />

18 Year Ahead 2019 – UBS House View


Navigating 2019<br />

Selected Scenarios Scenario Description Expected 6m market performance for select asset classes<br />

Key upside scenarios<br />

Trade:<br />

Negotiations<br />

avert additional<br />

sanctions<br />

China: Stable<br />

GDP growth<br />

Negotiations between the US<br />

and China result in actual<br />

progress and a reduction of<br />

trade barriers. Although<br />

tensions remain high, both<br />

countries agree on a trade<br />

truce.<br />

Chinese GDP growth returns<br />

to a 6.6%–6.8% range, and<br />

the current account balance<br />

goes back above USD 100bn.<br />

<br />

<br />

<br />

<br />

<br />

<br />

US equities +10%–15% as increased<br />

confidence in the cycle allows P/Es to expand to<br />

17.5–18x and 2019 EPS estimates for the<br />

S&P 500 hold in the mid-USD 170s<br />

Chinese equities +10%–15% due to a strong<br />

recovery on risk sentiment and better-thanexpected<br />

fundamentals<br />

USD depreciates to EURUSD 1.20–1.25<br />

Chinese equities +15%–20% due to a<br />

valuation recovery as growth beats consensus<br />

expectations<br />

EM bonds (EMBIGD) return 6%–7% as spreads<br />

tighten to around 310bps due to improving<br />

EM growth prospects<br />

CNY appreciates to USDCNY 6.50 as better-thanexpected<br />

Chinese growth supports the domestic<br />

equity market, preventing outflows and<br />

supporting inflows of capital<br />

Expected total returns over a 6-month horizon<br />

Note: Upside and downside scenarios are possible events outside<br />

of CIO‘s base case expectations. This list is not exhaustive. We are<br />

closely monitoring developments in the UK, Italy, and the Middle East<br />

among others.<br />

Source: UBS, as of 8 November 2018<br />

Expected trend in asset class<br />

<br />

–50% 0% +50%<br />

Year Ahead 2019 – UBS House View<br />

19


Navigating 2019<br />

Svalbard, Norway. Chris Zielecki, Stocksy<br />

Orienting for the next bear market<br />

We don’t currently see the conditions normally<br />

associated with an impending bear market.<br />

But investor concerns about how much<br />

upside is left in this bull market (see page 25)<br />

is directing attention toward how the next<br />

bear market might look.<br />

Expectations for how and when events might<br />

materialize are often set by recent experience.<br />

The two most recent bear markets (in the US<br />

at least) were much worse than average (see<br />

Table 1), so these memories may have left investors<br />

prone to overestimating the scale of<br />

any coming drawdown.<br />

In our view, the next bear market will likely resemble<br />

earlier, less severe ones. The size of recessions<br />

and bear markets are largely defined<br />

by excesses that built up during the boom<br />

years. And in comparison to the extreme equity<br />

valuations of 2000 leading to the dot.com<br />

bust, or the financial sector leverage that prevailed<br />

in 2007, the excesses this time appear<br />

more contained.<br />

We believe that the next equity bear market –<br />

when it occurs – is likelier to be an average<br />

bear, with a 25%–30% drop for global equities<br />

from the market peak.<br />

20 Year Ahead 2019 – UBS House View


Navigating 2019<br />

Table 1<br />

Diversified portfolios can protect against the most painful parts of equity bear markets<br />

Comparative statistics for equity bear markets since World War II<br />

Peak year 1946 1961 1968 1972 1987 2000 2007 Average<br />

US large-cap stocks<br />

Length of prior bull market* 169 184 78 31 157 155 62 119<br />

Time between market cycles** 204 190 84 50 179 158 87 136<br />

Peak Mar 1946 Dec 1961 Nov 1968 Dec 1972 Aug 1987 Aug 2000 Oct 2007<br />

Trough Nov 1946 Jun 1962 Jun 1970 Sep 1974 Nov 1987 Sep 2002 Feb 2009<br />

Recovery date Oct 1949 Apr 1963 Mar 1971 Jun 1976 May 1989 Oct 2006 Mar 2012<br />

Max drawdown –21.8% –22.3% –29.4% –42.6% –29.6% –44.7% –51.0% –34.5%<br />

Time to full recovery<br />

(new all-time high)***<br />

41 16 28 42 21 74 53 39<br />

Drawdown time*** 6 6 19 21 3 25 16 14<br />

Recovery time*** 35 10 9 21 18 49 37 26<br />

Months of prior gains “erased” 15 36 66 118 18 64 141 65<br />

60/40 stock/bond portfolio<br />

Peak May 1946 Dec 1961 Nov 1968 Dec 1972 Aug 1987 Aug 2000 Oct 2007<br />

Trough Nov 1946 Jun 1962 Jun 1970 Sep 1974 Nov 1987 Sep 2002 Feb 2009<br />

Recovery date Oct 1948 Mar 1963 Dec 1970 Jan 1976 Jan 1989 Oct 2004 Dec 2010<br />

Max drawdown –13.4% –13.0% –17.6% –26.4% –17.4% –21.7% –29.9% –19.9%<br />

Time to full recovery<br />

(new all-time high)***<br />

29 15 25 37 17 50 38 30<br />

Drawdown time*** 6 6 19 21 3 25 16 14<br />

Recovery time*** 23 9 6 16 14 25 22 16<br />

Months of prior gains “erased” 14 17 19 25 5 35 21 20<br />

* Months from previous trough to this cycle peak<br />

** Months between previous peak and this cycle peak<br />

*** Months<br />

Source: Morningstar Direct, R: PerformanceAnalytics, UBS as of 18 October 2018<br />

Year Ahead 2019 – UBS House View<br />

21


Equities<br />

Oslo, Norway. Ole Jørgen Bakken, Unsplash<br />

Equity investors should brace for<br />

volatility but stay invested. Politics,<br />

monetary policy, and incoming<br />

economic data will all contribute<br />

to higher volatility, but we don’t<br />

expect a recession, see valuations<br />

at a discount to historical averages,<br />

and note returns in the latter<br />

part of the cycle are often good.<br />

Look for value to outperform<br />

growth in the US and emerging<br />

markets, and consider neglected<br />

sectors like US financials and<br />

global energy.<br />

Late-cycle return potential. We do not<br />

expect a recession in 2019 and see global<br />

GDP expanding at 3.6%, with a mid-single<br />

digit rate of earnings growth. US stocks have<br />

returned 12% on average in the year leading<br />

up to the six months before the onset of a<br />

recession, based on data going back to 1945<br />

(see Fig. 1.4), but monetary policy, politics,<br />

and incoming data will all play a role in shaping<br />

the outlook.<br />

Favorable valuations. The 12-month forward<br />

price-to-earnings ratio of around 14x for<br />

global equities represents a 10% discount to<br />

the three-decade average (see Fig. 3.1). The<br />

equity risk premium, which gauges the attractiveness<br />

of stocks versus bonds, is around 6%<br />

versus an average since 1991 of 3.4%.<br />

Fig. 3.1<br />

Valuations are attractive relative to<br />

historical averages<br />

MSCI All Country World Index 12-month forward P/E<br />

and its 30-year average<br />

30x<br />

25x<br />

20x<br />

15x<br />

10x<br />

5x<br />

0x<br />

1988 1993 1998 2003 2008 2013 2018<br />

forward P/E MSCI ACWI<br />

30-year average<br />

Source: Thomson Reuters, UBS, as of 7 November 2018<br />

26 Year Ahead 2019 – UBS House View


Equities<br />

Prepare for volatility. Volatility increases in<br />

the latter stages of the economic cycle. Since<br />

1990, the VIX index has averaged 22 in the<br />

six months prior to the start of US recessions,<br />

versus 18 during other periods in which the<br />

economy is expanding.<br />

Our main messages for equity<br />

investors in 2019 are:<br />

– Diversify globally. No single region offers<br />

a uniquely compelling case. The US economy<br />

remains strong, but with a price-toearnings<br />

ratio of around 17x, valuations are<br />

15% higher than the global average. Eurozone<br />

and emerging market (EM) stocks<br />

have lower valuations, but both regions are<br />

more exposed to China’s slowdown. We<br />

favor global diversification within equity<br />

holdings, which should also help mitigate<br />

volatility.<br />

– Look for value and quality. We expect<br />

US and EM value to outperform growth,<br />

reversing their 2018 underperformance.<br />

“Quality” companies, meanwhile, with<br />

higher profitability, lower financial leverage,<br />

and less earnings variability than average,<br />

should withstand volatility better than the<br />

overall market.<br />

– Consider neglected sectors. Financials<br />

could be set to outperform in the US and<br />

China, thanks to rate rises and favorable<br />

changes in regulations in the former, and to<br />

economic stimulus in the latter. The US and<br />

European energy sectors also offer value.<br />

And we think oil prices will recover in early<br />

2019 (see page 51).<br />

Long-term outlook<br />

Returns in the coming decade will be lower<br />

than in the past decade. Higher interest rates<br />

and relative labor scarcity will pressure margins.<br />

The tech growth spurt will moderate.<br />

Share buybacks will become more expensive<br />

to finance.<br />

Within our long-term outlook, several themes<br />

stand out:<br />

– US-focused investors should diversify.<br />

US stocks have outpaced global equities by<br />

around 50 percentage points over the past<br />

seven years, returning a total of about<br />

150% ver sus 100%. Over the next seven<br />

years, we expect higher long-term returns<br />

outside the US. US stocks trade in line with<br />

their average trailing price-to-earnings (P/E)<br />

ratio over the past 30 years, while the<br />

global index is at a 20% discount.<br />

– Emerging markets for the long term.<br />

EM stocks face short-term headwinds, such<br />

as a strong US dollar and rising US interest<br />

rates. For more far-sighted investors, however,<br />

valuations are appealing, with a trailing<br />

P/E c.25% below the 30-year average.<br />

– Japanese stocks have a good long-term<br />

outlook. Japan is putting its history as a<br />

market suffering from weak inflation and<br />

poor corporate governance behind it. Still,<br />

the index is valued at just 12x trailing earnings<br />

– a 15% discount to global equities.<br />

Investors could benefit even more by<br />

holding unhedged positions in the market<br />

(see page 48).<br />

Year Ahead 2019 – UBS House View<br />

27


Equities<br />

Emerging market<br />

equities<br />

Concerns about rising interest<br />

rates, slower Chinese growth, and<br />

the US-China trade dispute drove<br />

a sell-off in emerging markets in<br />

2018. Headwinds and volatility<br />

will continue, but opportunities<br />

exist. Emerging market (EM) value<br />

stocks could be poised for a<br />

catch-up, while in APAC we see<br />

specific opportunities in South<br />

Korea, Vietnam, and Chinese<br />

“old economy” stocks.<br />

Vietnam. Qui Nguyen Unsplash<br />

– Value stocks could be ready for a catchup.<br />

Since 2012, the MSCI EM Value Index<br />

has underperformed its growth counterpart<br />

by 22%. The index’s price-to-book ratio of<br />

1x represents a 59% discount to the growth<br />

index’s against a 10-year average of 49%.<br />

– Consider indirect EM exposure. Investors<br />

who want exposure to EM economies, but<br />

dislike the volatility of EM stocks, could<br />

consider both Eurozone and US stocks<br />

with at least 20% exposure to emerging<br />

markets.<br />

– Brazil is worth monitoring. The country<br />

has a new president with a strong mandate,<br />

and stocks have already rallied on hopes of<br />

reform. The political situation remains uncertain<br />

and more clarity is needed before we’d<br />

advise increasing exposure to the market,<br />

but it could advance further if the government<br />

succeeds in putting the nation’s pension<br />

system on a more sustainable footing.<br />

32 Year Ahead 2019 – UBS House View


% of reserves<br />

2004Q3<br />

2005Q1<br />

2005Q3<br />

2006Q1<br />

2006Q3<br />

2007Q1<br />

2007Q3<br />

2008Q1<br />

2008Q3<br />

2009Q1<br />

2009Q3<br />

2010Q1<br />

2010Q3<br />

2011Q1<br />

2011Q3<br />

2012Q1<br />

2012Q3<br />

2013Q1<br />

2013Q3<br />

2014Q1<br />

2014Q3<br />

2015Q1<br />

2015Q3<br />

2016Q1<br />

2016Q3<br />

2017Q1<br />

2017Q3<br />

2018Q1<br />

% of reserve<br />

Strategy Note India January 1, 2019<br />

India<br />

Highlighted Companies<br />

Axis Bank<br />

ADD, TP Rs740.0, Rs619.9 close<br />

We believe asset quality will improve<br />

further from FY20 onwards as a large<br />

part of the stress is already recognised.<br />

The high provisioning coverage ratio<br />

(PCR) of +65% offers comfort. Operating<br />

profit could bounce back in FY20-21F. In<br />

our view, Axis’s strong retail franchise as<br />

well as robust current account and<br />

savings account (CASA) accruals are<br />

likely to continue.<br />

Bharat Petroleum<br />

ADD, TP Rs475.0, Rs362.8 close<br />

The fall in crude oil prices and stabilising<br />

currency are the biggest tailwinds for<br />

Indian OMCs. Among the pack, Bharat<br />

Petroleum remains our top pick.<br />

Britannia Industries Ltd<br />

HOLD, TP Rs3,354, Rs3,115 close<br />

We like Britannia from a long-term<br />

perspective as it offers multiple channels<br />

of earnings growth and would be a<br />

beneficiary of the shift from the<br />

unorganised to organised sector.<br />

Insert<br />

India Strategy<br />

USD: Trump shock; brace for volatile CY19<br />

■ The US$ is undergoing a structural adjustment; global demand for US$ may<br />

fall. Brace for volatility in equities. Gold may be the best asset class in CY19.<br />

■ Avoid anything related to American discretionary demand. Underweight IT. A<br />

slowing global economy is negative for commodities; stay Underweight.<br />

■ Indian domestic stories should do well. We like banks, consumption (despite<br />

bubble valuations), capital goods, utilities and oil marketing companies.<br />

Global headwinds; brace for volatility<br />

The status of the US$ as a global reserve currency is being threatened as large trading<br />

countries like China and Russia are making bilateral agreements to trade in their own<br />

currencies. Petrodollar, which was a primary source of US deficit funding, is losing its<br />

hegemony (albeit at a very sedate pace) to EM currencies. As a global reserve currency,<br />

the greenback is down 4% (from 64% in 2015 to 60% in 2Q18) but the euro has not taken<br />

its place. The Chinese yuan and yen are dominating now. Predicting the equilibrium level<br />

among these multiple forces is beyond the scope of this report. Brace for a volatile 2019.<br />

Tailwinds for India but need strong stomach to make money in 2019<br />

There are apparent tailwinds for India given falling crude oil prices and the worst of<br />

banking NPA already over. The capital goods sector is showing signs of a revival as well.<br />

However, currency could remain volatile, not because of current account deficit (CAD) or<br />

India-specific factors, but as part of the process of forming a new equilibrium. New trade<br />

agreements by India will open doors for Indian export companies. Add to that, the topsyturvy<br />

political equations that could emerge from the 2019 general elections, one needs a<br />

strong stomach to weather 2019, though we believe there is still money to be made.<br />

Go Underweight on IT but Overweight on banks and capital goods<br />

After all the hullabaloo about limiting H1B visas, etc., what the US has managed to do is<br />

increase services exports by US$10bn (or 4.5% increase yoy YTD Oct), certainly not<br />

enough but sufficient for political leaders to boast and create an overhang over Indian IT.<br />

Add to that the prospect of a slowing US economy, and IT becomes a clear underweight.<br />

The worst of the banks’ NPA cycle is over and prospects of a revival in the capex cycle<br />

make capital goods as well as corporate banks clear overweights.<br />

Underweight commodities; Overweight gold, FMCG, Auto and OMC<br />

Slowing global growth is negative for commodities; go underweight. This volatility and<br />

slowly but steadily rising dollar inflation are good for gold. In our view, gold is the asset<br />

class for 2019. Despite high valuations (we called it a bubble previously), FMCG is likely<br />

to do well. Falling crude prices are good for India’s oil marketing companies (OMCs).<br />

Figure 1: US$ is losing its status as the premier reserve currency but its position has<br />

not been taken up by the euro. The Chinese yuan is a new favourite and yen is making<br />

a comeback. Multiple trade agreements could also bring the rouble to the fore.<br />

Analyst(s)<br />

68<br />

67<br />

66<br />

U.S. dollars ( LHS) euros ( RHS)<br />

28<br />

26<br />

65<br />

64<br />

63<br />

24<br />

22<br />

Satish KUMAR<br />

T (91) 22 4880 5185<br />

E satish.kumar@cgs-cimb.com<br />

Siddharth GADEKAR<br />

T (91) 22 4880 5171<br />

E siddharth.gadekar@cgs-cimb.com<br />

62<br />

61<br />

60<br />

SOURCES: CGS-CIMB RESEARCH, IMF<br />

[ #Do Not Leave 'ANY UNUSED TEXT etc.’ After this Line OR they will appear in the Email]<br />

IMPORTANT DISCLOSURES, INCLUDING ANY REQUIRED RESEARCH CERTIFICATIONS, ARE PROVIDED AT THE END OF THIS REPORT. IF THIS REPORT IS DISTRIBUTED IN<br />

THE UNITED STATES IT IS DISTRIBUTED BY CGS-CIMB SECURITIES (USA), INC. AND IS CONSIDERED THIRD-PARTY AFFILIATED RESEARCH.<br />

20<br />

18<br />

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CY60<br />

CY63<br />

CY66<br />

CY69<br />

CY72<br />

CY75<br />

CY78<br />

CY81<br />

CY84<br />

CY87<br />

CY90<br />

CY93<br />

CY96<br />

CY99<br />

CY02<br />

CY05<br />

CY08<br />

CY11<br />

CY14<br />

CY17<br />

CY20F<br />

US BOP in US$ bn<br />

CY60<br />

CY62<br />

CY64<br />

CY66<br />

CY68<br />

CY70<br />

CY72<br />

CY74<br />

CY76<br />

CY78<br />

CY80<br />

CY82<br />

CY84<br />

CY86<br />

CY88<br />

CY90<br />

CY92<br />

CY94<br />

CY96<br />

CY98<br />

CY00<br />

CY02<br />

CY04<br />

CY06<br />

CY08<br />

CY10<br />

CY12<br />

CY14<br />

CY16<br />

India<br />

Strategy Note | January 1, 2019<br />

USD: Trump shock; brace for volatile CY19<br />

US President Trump’s apparent self-sabotaging measures which include trade<br />

barriers that are prompting countries to shun the US$ as a means of trade and<br />

increasing policy uncertainty, are creating an economic doomsday scenario for<br />

the US. The US needs to replenish its future dollar requirements as the budget<br />

deficit will only increase (at least for now, as projected by consensus), which<br />

means it has to remain a risk-free asset, but increasing uncertainty is reducing<br />

and undermining its leadership position. If the US economy deteriorates, the<br />

US$ will depreciate, interest rates will remain high (despite attempts by<br />

President Trump to talk it down) and the rest of the world may stop funding the<br />

US consumer. However, the outlook is bright for emerging market equities. We<br />

remain overweight on India. We believe the 2019 elections will be a minor blip<br />

against the backdrop of an overriding global trade war scenario and currency<br />

volatility prospects.<br />

The world has been funding US for decades now; this<br />

may not be the case in the future<br />

The US runs one of the highest budget deficits in the world but finances it at<br />

negligible costs. The riskless bond (so perceived) and dependency of global<br />

trade on the US$ have been the key determinants of this amazing success. The<br />

petroleum trade has always been done in US$ and all past attempts to break<br />

free of the dollar stranglehold have been met with decisive policy actions by the<br />

US to maintain the status quo. However, this scenario and the dominance of<br />

US$ might be coming to an end, in our view.<br />

US runs one of the highest budget deficits in the world but<br />

dollar demand keeps its US$ value high<br />

Being a US$20tr economy running a US$1tr deficit is not a big deal; the deficit is<br />

just 5% of the overall GDP. However, the rest of the world, which has a GDP of<br />

US$60tr by comparison, has to fund this US$1tr largess to the US consumer.<br />

What is more interesting is the fact that almost all global trade is financed using<br />

the US$ and hence, every country creates reserves of US$. As such, the<br />

greenback’s strength is not so much derived from the fundamentals of the US<br />

economy, but rather, is dependent on the rest of the world’s inclination to trust<br />

the US free market.<br />

Figure 2: Post 9/11, the US has consistently run a high fiscal<br />

deficit, in most cases to run its war efforts in the Middle East<br />

(Please see link)<br />

Figure 3: It has also run a significant BOP deficit over the years<br />

12.00%<br />

10.00%<br />

8.00%<br />

6.00%<br />

Budget deficit<br />

100.0<br />

0.0<br />

-100.0<br />

-200.0<br />

Title:<br />

Source:<br />

Please fill in the values above to have them entered in your<br />

4.00%<br />

2.00%<br />

0.00%<br />

-2.00%<br />

-4.00%<br />

-300.0<br />

-400.0<br />

-500.0<br />

-600.0<br />

-700.0<br />

-800.0<br />

-900.0<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

2


US$ billion<br />

US$ billion<br />

India<br />

Strategy Note | January 1, 2019<br />

It appears the rest of the world, which has been financing the<br />

US, is turning its back on the country<br />

Until now, the rest of the world and trade deficits (true trade deficits) have been<br />

financing the US budget, and the American consumer has been living the<br />

“American dream” of low inflation, low interest rates and state-funded social<br />

security.<br />

Figure 4: Foreign holdings of US treasuries are at the same level as they were in CY14. While China and Japan are reducing their<br />

holdings, new buyers, such as India, have stepped up.<br />

6,000<br />

5,000<br />

China Japan Ireland Brazil UK<br />

Switzerland Luxembourg Hong Kong Taiwan Cayman Islands<br />

Saudi Arabia India Singapore Belgium Russia<br />

Korea<br />

Others<br />

4,000<br />

3,000<br />

2,000<br />

1,000<br />

0<br />

882 1,058<br />

1,111 1,183 1,231 1,122<br />

1,091<br />

1,062<br />

766<br />

626<br />

690 670 623 580<br />

1,160 1,152 1,220 1,270 1,244 1,246<br />

551<br />

318 318 378<br />

727<br />

895<br />

1,058 1,185<br />

223 310 397 478<br />

CY00 CY01 CY02 CY03 CY04 CY05 CY06 CY07 CY08 CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16 CY17<br />

SOURCES: CIMB RESEARCH, Bloomberg, IMF and world bank data<br />

As such, the incremental deficit is being financed by the<br />

American public and institutions at large<br />

The impact of the financing of budget deficits by US institutions has been the<br />

crowding out of private investment. It is possible that President Trump’s<br />

repeated criticism of the US Federal Reserve and his unhappiness over what he<br />

perceives to be unnecessarily high interest rates stems from the fact that the US<br />

Government deficit has been crowding out private investments (Please see the<br />

link).<br />

Figure 5: The chart below shows the incremental purchases of US bonds by various entities. Foreign buying of US treasuries and<br />

long-dated bonds has declined significantly over the years.<br />

3,000<br />

2,500<br />

Private Depository institution US Saving Bonds Private<br />

State and Local Governments Insurance compnaies Mutual Funds State and Local Governments<br />

Foreign Holdings<br />

Other Investors<br />

2,000<br />

1,500<br />

1,000<br />

500<br />

0<br />

-500<br />

-1,000<br />

CY09 CY10 CY11 CY12 CY13 CY14 CY15 CY16 CY17 Mar- CY18 June - CY18<br />

SOURCES: CIMB RESEARCH, Bloomberg, World bank and IMF<br />

3


% of Reserve<br />

% of Trade in USD<br />

2004Q3<br />

USA<br />

2005Q2<br />

Italy<br />

2006Q1<br />

Germany<br />

2006Q4<br />

Spain<br />

2007Q3<br />

France<br />

2008Q2<br />

UK<br />

2009Q1<br />

Australia<br />

2009Q4<br />

Switzerl…<br />

2010Q3<br />

Norway<br />

2011Q2<br />

Sweden<br />

2012Q1<br />

Japan<br />

2012Q4<br />

Canada<br />

2013Q3<br />

Poland<br />

2014Q2<br />

Iceland<br />

2015Q1<br />

Thailand<br />

2015Q4<br />

Isreal<br />

2016Q3<br />

Turkey<br />

SK<br />

2017Q2<br />

Brazil<br />

2018Q1<br />

Indonesia<br />

India<br />

% of Reserve<br />

% of reserves<br />

2004Q3<br />

2005Q1<br />

2005Q3<br />

2006Q1<br />

2006Q3<br />

2007Q1<br />

2007Q3<br />

2008Q1<br />

2008Q3<br />

2009Q1<br />

2009Q3<br />

2010Q1<br />

2010Q3<br />

2011Q1<br />

2011Q3<br />

2012Q1<br />

2012Q3<br />

2013Q1<br />

2013Q3<br />

2014Q1<br />

2014Q3<br />

2015Q1<br />

2015Q3<br />

2016Q1<br />

2016Q3<br />

2017Q1<br />

2017Q3<br />

2018Q1<br />

% of reserve<br />

India<br />

Strategy Note | January 1, 2019<br />

US$ is losing its premier reserve currency status; however,<br />

the position has not been taken by euro; Asian currencies are<br />

the preferred bets<br />

Figure 6: Chinese yuan has made a remarkable entry as a world<br />

reserve currency and now has a 1.8% share. Yen has also been<br />

regaining its lost market share.<br />

Figure 7: Both yen and renminbi are making their presence felt<br />

as US$ and euro have seen their dominant positions deteriorate,<br />

albeit at a very slow pace.<br />

5.5<br />

5.0<br />

Japanese yen ( LHS) Chinese renminbi ( RHS)<br />

2.0<br />

1.8<br />

1.6<br />

68<br />

67<br />

66<br />

Title:<br />

Source:<br />

28<br />

U.S. dollars ( LHS) euros ( RHS)<br />

26<br />

4.5<br />

1.4<br />

1.2<br />

65<br />

24<br />

4.0<br />

1.0<br />

64<br />

3.5<br />

3.0<br />

0.8<br />

0.6<br />

0.4<br />

0.2<br />

63<br />

62<br />

61<br />

22<br />

20<br />

2.5<br />

0.0<br />

60<br />

18<br />

SOURCES: CGS-CIMB RESEARCH, IMF data<br />

SOURCES: CGS-CIMB RESEARCH, IMF data<br />

US$ has been the premier currency in global trade<br />

Figure 8: Even the developed world trades primarily in US$. For<br />

countries like India, almost its entire trade is US$ denominated.<br />

Figure 9: The 2015 data by Prof. Gita Gopinath show the world’s<br />

preference for US$.<br />

120%<br />

USD Imports<br />

USD Exports<br />

Title:<br />

Source:<br />

100%<br />

Please fill in the values above to have them entered in your<br />

80%<br />

60%<br />

40%<br />

20%<br />

0%<br />

SOURCES: CIMB RESEARCH, Research paper on https://www.nber.org/papers/w23988<br />

SOURCES: CIMB RESEARCH, Research paper on https://www.nber.org/papers/w23988<br />

Oil trade is dominated by US$<br />

All Gulf Corporation Council (GCC) countries peg their currencies to the US$<br />

and most of them run current account deficits; hence, trading in US$ becomes a<br />

priority for them. The lower the oil price, the greater is the propensity to bolster<br />

reserves to avert a crisis.<br />

While most of the GCC countries have progressed (in terms of<br />

withstanding the oil price shock) since 2015, their<br />

vulnerability is still high<br />

4


US$ bn<br />

US$ bn<br />

India<br />

Strategy Note | January 1, 2019<br />

Figure 10: IMF data shows how GCC countries have progressed<br />

in the past few years as well as how vulnerable they still are to<br />

oil price shocks<br />

Figure 11: The table below indicates the vulnerability of the GCC<br />

countries to an oil collapse and their need for large US$<br />

reserves<br />

SOURCES: CGS-CIMB RESEARCH, Lighthouse research, IMF data<br />

SOURCES: CGS-CIMB RESEARCH, https://www.brookings.edu/research/sustaining-the-gcccurrency-pegs-the-need-for-collaboration/<br />

Despite the rhetoric and trade wars, the US’s overall trade<br />

deficit has not come down<br />

Figure 12: US’s trade deficit has not come down. Although curbs on H1B visas may<br />

have resulted in increased services exports, overall trade deficit still increased by<br />

~10% (YTD Oct18)<br />

0<br />

-100<br />

-200<br />

CY16 till Oct CY17 till Oct CY18 till Oct<br />

226<br />

230<br />

225<br />

220<br />

-300<br />

215<br />

-400<br />

-500<br />

-600<br />

-412<br />

208<br />

-451<br />

212<br />

-503<br />

210<br />

205<br />

-700<br />

-620<br />

-664<br />

200<br />

-800<br />

-729<br />

195<br />

Total ( LHS) Goods ( LHS) Services( RHS)<br />

SOURCES: CGS-CIMB RESEARCH, COMPANY REPORTS<br />

The need to de-risk (politically as well as economically) from<br />

US$ is high for GCC and developing countries<br />

GCC as well as countries which own ~US$6tr worth of US government bonds<br />

are prone to political risks in the US. More so after the recent attempt by<br />

President Trump to browbeat the Federal Reserve. The US’s fiscal deficit is<br />

being financed by two key sources:<br />

● The global reserve of US$ which emanates from the US trade deficit/petrol<br />

dollars; and<br />

● The de-facto status of the US$ as the premier trading currency, which comes<br />

from the world’s deep faith in the Federal Reserve.<br />

These two factors keep the dollar demand high and strong. Also, there is<br />

widespread trust in the free trade practices of the US. This is why, despite all the<br />

fundamentals, the US enjoys the best credit rating and its bonds have a “safe<br />

haven” status. However, this trust is fragile, and if it were to break it would spell<br />

doom for the US. As such, it is not a surprise that most countries are doing their<br />

bit to de-risk from the US$.<br />

5


illion US$<br />

US$ bn<br />

India<br />

Strategy Note | January 1, 2019<br />

Multiple trade agreements between countries to trade in their<br />

respective currencies<br />

We list all such major agreements in the past 12 months<br />

1. India-Iran agreement to trade oil in INR and Iranian Rial<br />

2. India-UAE agreement to trade in INR/Dirham<br />

3. Russia-China agreement to trade in respective currencies<br />

4. China-Pakistan agree to do bilateral trade in yuan<br />

5. China and Japan signing FX-Swap deal<br />

6. China and Nigeria sign currency swap deal<br />

7. China-Iran deal on oil trading<br />

8. India-Russia defence deals in INR/Rouble<br />

Some of the events/developments which can impact US$<br />

negatively in the near future<br />

● Success of oil futures contract in Chinese yuan - While China has launched<br />

the exchange, its success will determine the fate of the Petrodollar to some<br />

extent.<br />

● India is likely to sign more deals with GCC countries to trade in Indian rupee<br />

in the coming years. Almost all the GCC countries have major Indian<br />

populations who remit significant US$ back home. These remittances are one<br />

of the major reasons for the high breakeven price of oil for most GCC<br />

countries. Hence, creating Indian rupee reserves and promoting imports from<br />

India will be a win-win scenario for India as well as the GCC countries, in our<br />

view.<br />

Figure 13: Remittances in US$ to India in 2017 by Indian<br />

diaspora in GCC countries<br />

16<br />

14<br />

12<br />

10<br />

11.2<br />

13.8<br />

Figure 14: Total US$ outflows to India (approximate figure for<br />

2017) indicates it will be in the interests of Bahrain/Oman to sign<br />

Rs trade agreements. India will benefit if Saudi signs as well.<br />

25.00<br />

20.00<br />

15.00<br />

Title:<br />

Source:<br />

20.23<br />

8<br />

10.00<br />

6<br />

4<br />

2<br />

1.3<br />

4.6<br />

3.3<br />

4.1<br />

5.00<br />

-<br />

-5.00<br />

1.46<br />

-1.21<br />

1.43<br />

-2.80<br />

-5.42<br />

0<br />

Bahrain Kuwait Oman Qatar Saudi UAE<br />

-10.00<br />

Bahrain Kuwait Oman Qatar Saudi UAE<br />

SOURCES: CGS-CIMB RESEARCH, World bank data base<br />

SOURCES: CGS-CIMB RESEARCH, World bank data base<br />

The US will have to lower war expenditure as the demand for<br />

US$ declines, which can create a downward spiral<br />

Going forward, national strategic concerns rather than plain economics will<br />

determine the fate of the US$, in our view. It will be interesting to see if China<br />

succeeds in pushing Saudi Arabia to trade crude in Chinese yuan. That will be a<br />

significant event which can the signal the beginning of the end of the US$’s<br />

dominance in world trade, in our view.<br />

What does it mean for Indian markets? Volatility but<br />

investors with strong stomachs should get rewarded<br />

The world changed in a fundamental way when the US shunned the gold<br />

standard and the US$ became the dominant currency post 1975. The strong<br />

6


YOY increase in FED balance sheet<br />

Mar-95<br />

Jun-96<br />

Sep-97<br />

Dec-98<br />

Mar-00<br />

Jun-01<br />

Sep-02<br />

Dec-03<br />

Mar-05<br />

Jun-06<br />

Sep-07<br />

Dec-08<br />

Mar-10<br />

Jun-11<br />

Sep-12<br />

Dec-13<br />

Mar-15<br />

Jun-16<br />

Sep-17<br />

Dec-18<br />

Consumer prices inflation in %<br />

CY00<br />

CY01<br />

CY02<br />

CY03<br />

CY04<br />

CY05<br />

CY06<br />

CY07<br />

CY08<br />

CY09<br />

CY10<br />

CY11<br />

CY12<br />

CY13<br />

CY14<br />

CY15<br />

CY16<br />

CY17<br />

CY18<br />

India<br />

Strategy Note | January 1, 2019<br />

relationship between Saudi Arabia and Petrodollar-driven US diplomacy drove<br />

most of the economics in the two decades that followed. The US emerged from<br />

the recession after the Lehman crisis and without inflation, only because the<br />

world funded the US’s fiscal deficit. If that changes in the coming years (and this<br />

is happening slowly), the markets are bound to be volatile. We advise shunning<br />

anything that drives revenue from US discretionary spending. We also believe<br />

that the best of the commodities is over. Although in a bubble valuation zone,<br />

consumption may still do well in CY19, in our view.<br />

Post Lehman crisis and unprecedented monetary expansion,<br />

people feared inflation but it never materialised…<br />

Figure 15: Post Lehman, there was unprecedented balance<br />

sheet expansion by the Federal Reserve<br />

100.0%<br />

80.0%<br />

Figure 16: Economists feared inflation but it never materialised<br />

as the world led by China purchased dollars<br />

4.50<br />

4.00<br />

3.50<br />

60.0%<br />

40.0%<br />

20.0%<br />

0.0%<br />

3.00<br />

2.50<br />

2.00<br />

1.50<br />

1.00<br />

0.50<br />

0.00<br />

-0.50<br />

-20.0%<br />

-1.00<br />

SOURCES: CIMB RESEARCH, Bloomberg<br />

SOURCES: CIMB RESEARCH, Bloomberg<br />

However, with the potential decline in the demand for US$, the<br />

US has to control its fiscal situation which may not be great<br />

news for US$ bulls<br />

The US has invested close to US$6tr in its “war against terror” (Please see the<br />

link here). The bulk of the deficit in the past few years may be the result of this<br />

costly war on terror and hence, the need to pull back from these costly<br />

battlefields. However, the fields the US is vacating may be taken over by Russia<br />

and China, both of whom are signing agreements with potential buyers of their<br />

crude/trade/military hardware in Chinese yuan and Russian rouble. The net<br />

impact is that the US$ is slowly but steadily losing its trade dominance. If the US<br />

fiscal deficit is not controlled quickly, then much against the wishes of President<br />

Trump, the Fed may have no choice but to keep raising rates.<br />

The coming years are going to be extremely volatile for Indian<br />

equities<br />

While domestic flows into equities have increased over the years, the emerging<br />

markets remain susceptible to what happens in the US. We believe Indian<br />

markets are going to be volatile in the coming years, as:<br />

● Global markets will remain volatile;<br />

● Given the near-term turbulence, currency is bound to remain volatile; and<br />

● The upcoming elections could lead to political risks. We believe the market<br />

does not care which political party wins the election, it needs stability. As<br />

such, if a coalition with different political beliefs wins the election, it will be<br />

negative for Indian equities.<br />

Indian market’s (NIFTY) valuations are neither cheap nor very<br />

costly, compared to recent history<br />

7


Metal index P/ B ratio<br />

Jan-12<br />

May-12<br />

Sep-12<br />

Jan-13<br />

May-13<br />

Sep-13<br />

Jan-14<br />

May-14<br />

Sep-14<br />

Jan-15<br />

May-15<br />

Sep-15<br />

Jan-16<br />

May-16<br />

Sep-16<br />

Jan-17<br />

May-17<br />

Jan-12<br />

Sep-17<br />

Apr-12<br />

Jan-18<br />

Jul-12<br />

May-18<br />

Oct-12<br />

Sep-18<br />

Jan-13<br />

Apr-13<br />

Jul-13<br />

Oct-13<br />

Jan-14<br />

Jan-12<br />

Apr-14<br />

May-12<br />

Jul-14<br />

Sep-12<br />

Jan-13<br />

Oct-14<br />

May-13<br />

Jan-15<br />

Sep-13<br />

Apr-15<br />

Jan-14<br />

Jul-15<br />

May-14<br />

Oct-15<br />

Sep-14<br />

Jan-16<br />

Jan-15<br />

Apr-16<br />

May-15<br />

Jul-16<br />

Sep-15<br />

Oct-16<br />

Jan-16<br />

Jan-17<br />

May-16<br />

Apr-17<br />

Sep-16<br />

Jul-17<br />

Jan-17<br />

Oct-17<br />

May-17<br />

Jan-18<br />

Sep-17<br />

Apr-18<br />

Jan-18<br />

Jul-18<br />

May-18<br />

Oct-18<br />

Sep-18<br />

India<br />

Strategy Note | January 1, 2019<br />

Figure 17: Nifty is neither cheap nor very costly vis-à-vis last 7 years’ valuations<br />

24.0<br />

Nifty Best_P/E Average +1 Stdev -1 Stdev +2 Stdev -2 Stdev<br />

22.0<br />

20.0<br />

18.0<br />

16.0<br />

14.0<br />

12.0<br />

10.0<br />

Figure 18: Metal index valuation is near historical average;<br />

however, it will go down as analysts cut their earnings estimates<br />

2.30<br />

2.10<br />

1.90<br />

1.70<br />

BEST_PX_BPS_RATIO Average<br />

+1 Stdev -1 Stdev<br />

+2 Stdev -2 Stdev<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

While metal index valuations are at reasonable levels, FMCG<br />

index is continuing its gravity defying moves<br />

Figure 19: On the other hand, FMCG index is continuing its<br />

gravity defying moves and is trading well beyond +2 s.d. of its<br />

long-term mean<br />

45.00<br />

40.00<br />

BEST _ PE ratio Average +1 Stdev<br />

Title:<br />

-1 Stdev +2 Stdev -2 Stdev<br />

Source:<br />

Please fill in the values above to have them entered in your<br />

1.50<br />

1.30<br />

1.10<br />

0.90<br />

0.70<br />

0.50<br />

35.00<br />

30.00<br />

25.00<br />

20.00<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

IT index may look attractive but we advise staying away from<br />

the sector given the uncertainty around US policy; Overweight<br />

oil marketing companies<br />

8


Jan-12<br />

May-12<br />

Sep-12<br />

Jan-13<br />

May-13<br />

Sep-13<br />

Jan-14<br />

May-14<br />

Sep-14<br />

Jan-15<br />

May-15<br />

Sep-15<br />

Jan-16<br />

May-16<br />

Sep-16<br />

Jan-17<br />

May-17<br />

Jan-12<br />

Sep-17<br />

Apr-12<br />

Jan-18<br />

Jul-12<br />

May-18<br />

Oct-12<br />

Sep-18<br />

Jan-13<br />

Apr-13<br />

Jul-13<br />

Oct-13<br />

Jan-12<br />

Jan-14<br />

May-12<br />

Apr-14<br />

Sep-12<br />

Jul-14<br />

Jan-13<br />

Oct-14<br />

May-13<br />

Jan-15<br />

Sep-13<br />

Apr-15<br />

Jan-14<br />

Jul-15<br />

May-14<br />

Oct-15<br />

Sep-14<br />

Jan-16<br />

Jan-15<br />

Apr-16<br />

May-15<br />

Jul-16<br />

Sep-15<br />

Oct-16<br />

Jan-16<br />

Jan-17<br />

May-16<br />

Apr-17<br />

Sep-16<br />

Jul-17<br />

Jan-17<br />

Oct-17<br />

May-17<br />

Jan-18<br />

Sep-17<br />

Apr-18<br />

Jan-18<br />

Jul-18<br />

May-18<br />

Oct-18<br />

Sep-18<br />

India<br />

Strategy Note | January 1, 2019<br />

Figure 20: IT companies may appear attractive as they are<br />

trading near mean; however, due to US policy uncertainty we<br />

are underweight on the sector<br />

Figure 21: BSE energy index has not factored in likely earnings<br />

upgrades; we are overweight on oil marketing companies<br />

(OMCs)<br />

24.00<br />

22.00<br />

BEST _ PE ratio Average +1 Stdev<br />

-1 Stdev +2 Stdev -2 Stdev<br />

2.00<br />

1.90<br />

1.80<br />

BEST _ PB ratio Average +1 Stdev<br />

Title:<br />

-1 Stdev +2 Stdev -2 Stdev<br />

Source:<br />

Please fill in the values above to have them entered in your<br />

20.00<br />

1.70<br />

1.60<br />

18.00<br />

1.50<br />

16.00<br />

1.40<br />

1.30<br />

14.00<br />

1.20<br />

12.00<br />

1.10<br />

1.00<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

Banks are our biggest Overweight and we particularly like<br />

corporate banks<br />

Figure 22: Most of the corporate banks are just coming out of the NPA cycle; hence,<br />

book value is depressed. As earnings revive, these banks are likely to perform well<br />

4.00<br />

P/b Ratio Average +1 Stdev<br />

3.50<br />

-1 Stdev +2 Stdev -2 Stdev<br />

3.00<br />

2.50<br />

2.00<br />

1.50<br />

1.00<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

Capital goods – valuations are low and signs of capex revival<br />

are apparent; Overweight<br />

9


Jan-12<br />

Apr-12<br />

Jul-12<br />

Oct-12<br />

Jan-13<br />

Apr-13<br />

Jul-13<br />

Oct-13<br />

Jan-14<br />

Apr-14<br />

Jul-14<br />

Oct-14<br />

Jan-15<br />

Apr-15<br />

Jul-15<br />

Oct-15<br />

Jan-16<br />

Apr-16<br />

Jul-16<br />

Oct-16<br />

Jan-17<br />

Apr-17<br />

Jul-17<br />

Oct-17<br />

Jan-18<br />

Apr-18<br />

Jul-18<br />

Oct-18<br />

India<br />

Strategy Note | January 1, 2019<br />

Figure 23: Capital goods’ valuations are near the trough levels of Sep 2013, and signs<br />

of revival are apparent. We recommend Overweight on the sector<br />

50.00<br />

45.00<br />

PE Ratio Average +1 Stdev<br />

-1 Stdev +2 Stdev -2 Stdev<br />

40.00<br />

35.00<br />

30.00<br />

25.00<br />

20.00<br />

15.00<br />

10.00<br />

5.00<br />

-<br />

SOURCES: CGS-CIMB RESEARCH, Bloomberg<br />

10


GDP accounting underestimates intangible capital, overstates nancial capital, and is all but oblivious to the the<br />

U.S.<br />

of human and social capital. A serious growth slowdown is coming.<br />

erosion<br />

American economy changed rapidly in the last half-century. We kept track of this transformation through the National<br />

The<br />

and Product Accounts (NIPA), a set of statistical constructs that were designed before these changes started. Our<br />

Income<br />

accounts have stretched to accommodate new and growing service activities, but they are still organized by their original<br />

national<br />

This can be seen in the growth of nancial activity and the e orts of many economists to t nance into our<br />

design.<br />

of national product and of economic growth. I argue in my paperthat our current economic data fail to describe<br />

measurement<br />

the path of growth in our new economy. They fail to see that the United States is consuming its capital stock now and<br />

accurately<br />

growth theory started with two papers by Robert M. Solow in the late 1950s. The rst paper showed that it was possible<br />

Modern<br />

create a stable model of economic growth using a Keynesian model of investment and capital. The second paper showed that<br />

to<br />

1/4/2019 The Hidden Decline in Human Capital—and the Danger Ahead<br />

Commentary ❯<br />

The Hidden Decline in Human Capital—and the<br />

Danger Ahead<br />

By Peter Temin<br />

JAN 2, 2019<br />

Blog<br />

will su er later, rather like killing the family cow to have a steak dinner.<br />

th<br />

this model failed to explain most of American growth in the rst half of the 20 century (Solow, 1956, 1957).<br />

https://www.ineteconomics.org/perspectives/blog/the-hidden-decline-in-human-capital-and-the-danger-ahead 1/4


economists expanded Solow’s model by adding additional types of capital: human capital, social capital, nancial capital.<br />

Other<br />

rst addition was to add human capital by measuring the e ect of education on productivity. This enabled economists to<br />

The<br />

with an expanded Solow model. The second addition was to add social capital. This was added in cross-sectional<br />

work<br />

and has not been applied to ongoing growth estimates. The third addition was added by assuming that wealth equals<br />

regressions<br />

capital, that is, nancial capital is indistinguishable from physical assets (Mankiw, Romer and Weil, 1992; Hall and Jones,<br />

physical<br />

Dasgupta, 2007; Piketty 2014).<br />

1999;<br />

additions furnished explanations of economic growth in the United States and other countries. The importance of these<br />

These<br />

was con rmed in many empirical studies, but the NIPA continues to calculate Private Fixed Investment, a<br />

contributions<br />

construct, as the investment part of GDP. This problem is acute in the data for nance. Philippon (2015, 1435)<br />

Keynesian<br />

that, “The unit cost of nancial intermediation does not seem to have decreased signi cantly in recent years.” As he<br />

concluded<br />

this is surprising on several grounds. I build on his work to understand whether this result is the result of how the<br />

says,<br />

data were collected.<br />

underlying<br />

disconnect infects the calculation of economic growth. Griliches (1990, 1994) noted over two decades ago that more and<br />

This<br />

of GDP is composed of services, which also have been called intangibles. It is hard to estimate the output of the nancial<br />

more<br />

for example, so it is measured by its inputs. As I will show, although this may give a useful measure of current activity, it is<br />

sector,<br />

informative about economic growth.<br />

less<br />

are two problems. It is hard to measure productivity if inputs and outputs are con ated. If we fail to include productivity<br />

There<br />

of an increasing part of the national product, we increasingly will underestimate the growth of the national product.<br />

growth<br />

if we do not have a good measure of output, it is almost impossible to measure investments in nance and other<br />

Further,<br />

If we do not have good measures of the various forms of capital listed here, we will not be able to think hard about<br />

intangibles.<br />

the literature on the national product, there are many treatments of these new forms of capital. In addition to nancial<br />

Outside<br />

human capital has been the center of explanations for the United States’ economic domination in the twentieth century<br />

capital,<br />

well as the progress of individuals within the United States (Golden and Katz, 2008; Heckman, Pinto and Savelyev, 2013).<br />

as<br />

capital has been the center of analyses of economic growth in the United States and elsewhere and in the long and short<br />

Social<br />

(Putnam, 1993, 2000; Dasgupta, 2007). Measuring these forms of capital poses many of the same problems as measuring<br />

run<br />

capital.<br />

nancial<br />

review in this paper the accounting methods used to compile investment data to understand how these other forms of capital<br />

I<br />

in an economy that has changed markedly since the 1950s. I conclude that current accounting of growth in GDP fails to<br />

behave<br />

the kind of investment that generates these other forms of capital. This conclusion has three implications. First, shortrun<br />

include<br />

growth as currently calculated bears more relation to short-run Keynesian analysis than to what we know about long-run<br />

growth. Second, nancial capital increases inequality more than it generates growth for the entire economy. Third, we<br />

economic<br />

now allowing human and social capital to depreciate, auguring ill for future economic growth in the United States.<br />

are<br />

of Mass Incarceration and Crime: An Analytic Model,” has just been published by the International Journal of Political<br />

Economy<br />

A revised version of an earlier INET Working Paper, it will be freely available on line for the month after January 5,<br />

Economy.<br />

1/4/2019 The Hidden Decline in Human Capital—and the Danger Ahead<br />

longer-run growth. Concern about this latter point provides the motivation for this paper.<br />

Peter Temin is Elisha Gray II Professor Emeritus of Economics at the Massachusetts Institute of Technology (MIT). His “The Political<br />

2019: https://www.tandfonline.com/do…<br />

References<br />

Dasgupta, Partha. 2007. Economics: A Very Short Introduction. Oxford: Oxford University Press.<br />

Golden, Claudia, and Lawrence F. Katz. 2008. The Race between Eduction and Technology. Cambridge, MA Harvard University Press.<br />

Griliches, Zvi (ed.). Output Measurement in the Service Sectors. Chicago: Chicago University Press, 1990.<br />

Griliches, Zvi. 1994. “Productivity, R&D, and the Data Constraint.” American Economic Review, 84 (1): 1-23.<br />

Hall, Robert E., and Charles I. Jones. 1999. “Why Do Some Countries Produce So Much More Output per Worker than Others?”<br />

Quarterly Journal of Economics, 83-116.<br />

https://www.ineteconomics.org/perspectives/blog/the-hidden-decline-in-human-capital-and-the-danger-ahead 2/4

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