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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 />
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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
1/4/2019 The struggle for India’s soul - The World in 2019<br />
The World in 2019<br />
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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 />
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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 />
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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