Probable Risks and Possible Mitigation Measures
There are massive headwinds coming for the Indian frontline indices. The coming forces are massive and secular in nature. The indices like NIFTY and SENSEX are going to suffer big cuts in their valuation and price. The correction may remain in force until the next 3 years and things are going to go worse before becoming better. We have suggested some remedies for riding out this hurricane to minimize the pain in the conclusion.
The following chart shows the US 30 year constant maturity yield from 1986 to the present.
It can be clearly seen in the above graphic that a major trend line marking the peaks of the 30-year yield has been recently broken decisively near 3.25%. This is not looking like a cyclical peak but rather like a change in the long-term trend with rates set to rise in the US.
This trend in the rise of long-term interest rates across the U.S. shall accelerate pretty fast as already the U.S. is at the highest employment level since 100 years.
The double whammy is also being brought about by the increased issuance of treasury bonds due to large budget deficits being run by the federal U.S. government.
Interest Rates Rising in the US
After 10 years of loose credit conditions and stimulus packages, businesses are used to easy money i.e. cheap borrowing. Investors who have become used to loose monetary conditions want the status quo to continue.
With the US offering relatively higher capital protection and freedom from exchange rate risk, capital outflows from emerging markets like India are increasing. As investors now react to stronger signals from the US with rising growth, strengthening dollar and rising yields; money is flowing out from India and seeking security with relatively higher returns in the old world. As a result, investors are selling riskier stocks and bonds in emerging markets in favour of safer US assets.
The beginning of the Bear Market in US Bonds
US sovereign issuance is set to rise further in 2018 due to the budgetary deficit. The average issuance has been increasing steadily and has come up to around $700 billion over the past 2 years. It looks like this average could move up to 1trillion over the coming 2 -3 years. Trends in 2018 have suggested that total issuance will end at around $1.2 trillion as the $1 trillion level has been exceeded as of August.
If the demand for bonds remains constant or starts to decline, this mismatch between demand and supply could lead to bond prices dropping and bond yields rising sharply. A large portion of the total debt outstanding is a non-investment grade, around $2.4 trillion, and it has almost doubled over the last 10 years.
The dollar is gaining with respect to almost every currency in the world and especially against currencies in the emerging markets like India. The Rupee is one of the worst performing currencies this year falling more than 15% from around 63 INR per USD to a low of 72.90. However, attempts from the RBI as well as the Government have begun to slow this fall through open market operations and tightening interest rate policy. If capital outflow is kept under check, the Rupee could stabilize in the near term near 70 INR per USD.
Crude Getting Expensive
Apart from capital outflows which are probably in the near future, the current account is also taking a hit from the price of crude which has almost doubled from around 45 USD per barrel in mid-2017 to 82.07 USD per barrel as of 30th September 2018 as Russia and the OPEC countries stay silent on possible output increases. With Crude oil forming a massive chunk of India’s imports, India is starting to feel the pinch as the price of crude based products such as petrol and diesel is skyrocketing. 100 dollar oil is looking possible day by day. The massive cut in Iranian oil exports due to sanctions is the culprit here.
However, there is a possibility that the government could start cutting state taxes such as the VAT (Value Added Tax) on petrol and diesel as it forms a major chunk of the price or try to bring petrol under the purview of the GST with the tax capped at around 30-35%. This can provide much-needed relief to the people and the government can gain some standing in the eyes of the population before the upcoming general elections in 2019.
The Rising Cost of Capital
The interest rate cycle has slowly but surely bottomed out in India. The Central Bank has raised key policy rates twice in quick succession so far in 2018 due to rising inflation. As interest rates increase and easy money becomes scarce due to signals of growth and robustness from the US, refinancing could become increasingly difficult for India.
Cost of capital is rising for Indian corporates as well. With the yield curve taking cues from the actions at the short end of the curve by the government, rates are getting higher across the whole spectrum of maturities. Apart from that, there is an environment of increased uncertainty and as a result, the credit risk premiums are on a rise in the corporate debt market. This has been brought about by the recent scandals which have been unearthed in the financial sector in India.
The NBFC’s will have big refinancing obligations which if made good shall have to be done at much higher rates.
The Possible Effects
1. Debt Fund Redemptions
If there is even a hint of more NBFCs following on the footsteps of DHFL and IL&FS, there could be a rush to exit from debt fund schemes. A lot of Debt Funds in India hold commercial papers and other credit securities of such NBFCs and they could be at a risk of getting run over by investors exiting on a large scale. There is a need for reassurances by the companies and funds in question. This reassurance is slated to arrive quickly to prevent the atmosphere from turning sour and provide relief in the short term.
2. Equity Fund Redemptions
Supported by a tsunami of liquidity, the valuation of the Indian equity market has breached historical record highs. The Nifty PE to Bond Yield Ratio is at a level seen during the Dot Com Bubble and the Sub-Prime Crisis. The newest generation currently participating in the equity markets does not have an active memory of the 2008 crisis or in fact any major financial meltdown at all. The SIP Mania supported by widespread advertising is causing massive liquidity to flow into the markets. Somewhat unjustified valuations are finding support by this liquidity flow into mutual funds.
However, it is reasonable to say that these investors who are used to ever-increasing NAVs will fall victim to the loss aversion bias the moment they see their investments fall into red ink. Redemptions could increase in these domestic funds causing mutual funds to decelerate the pace of buying activity or even try to get out from some companies whilst high valuations last. Add to this the fact that FIIs are already on a selling spree and are getting out as quickly as they can in search of higher returns elsewhere, hence, the Indian equity markets could come into the clutches of an extended bear stronghold.
During the last financial crisis in 2007-8, the Indian households held 14% of their assets in financial instruments. During the crash, the holding fell to 8%. The same story can be repeated here.
As and if the investor sentiment turns negative over the coming months, the equity markets in India could be in for a long overdue correction in terms of both price and time. The redemption risk in both equity and bond funds is increasing and a rush for the exit could be sparked by a worsening of the credit quality environment.
Valuations are at record highs which is always a precarious situation and a small push is enough to set the ball rolling from the top. Yields will rise further in India and the PE will correct until it reaches a sustainable level. The Nifty P/E to Bond Yield ratio analysis suggests that the Nifty could come down to 8500-9000 levels over the next 3 years. The fall can be more severe if the 30 years U.S. Treasury yield breaches 6%.
Actions by the government and the central bank will provide cues to the markets over the coming months. The government will and should take measures to stabilize things if they look to get out of hand. The primary manoeuvres will involve stabilizing the Rupee to maintain an atmosphere of certainty for foreign investors. It remains to be seen what the actions will be to check the rising prices of crude based products. However, one thing which is almost absolutely certain is that the government will not sit on the side lines and watch the situation get out of hand.
We advise that Investors should be varied of new investments but on a cautious lookout for good opportunities as and when they present themselves during the market correction.
Solutions to the crisis.
- Invest in Government bonds
- Invest in small savings instruments like PPF etc.
- Invest is shares of companies having low PE ratio but with good management.
- Invest in good companies that are going through bad times due to a one-time event.