BSE Sensex (-3.8%) fell in May, amidst rising number of Covid cases in the country, extension of lockdowns and escalating tension between the US and China. However, towards the end of May, markets rallied on improving global sentiment as economies across the world emerged out of lockdowns. During the month, the Prime Minister announced a big bang Rs.20 trillion stimulus package (including monetary measures announced by RBI), which, however, fell short of market expectations as the fine print disclosed limited stimulus on an incremental basis. During the month, the RBI cut the repo rate by 40 bps to 4%, the lowest since 2000.

India entered the list of top 10 countries hit by coronavirus as confirmed cases rose 5 fold in a month to 170k+, but death rates still remained much lower than average. During the month, government extended the lockdown for 2 more weeks to May end, albeit with significant relaxations. Activity levels continued to improve through the month, although still significantly lower than normal. Post June 1, India is prepared for significant opening up in non-hotspots with only containment zones seeing an extension of lockdown till June 30.

In terms of India’s domestic economic activity indicators, which were already exhibiting weak trends, were hit significantly in the last couple of months due to nationwide lockdown. Foreign Institutional Investors (FIIs) turned net buyers in May to the tune of $1.8bn (vs marginal net sellers in April) whereas Domestic Institutional Investors (DIIs) also were net buyers of $1.5bn. In terms of sectoral indices, during the month Auto, Healthcare, Capital goods and FMCG outperformed, whereas Bankex, Consumer Durables, Realty and Oil & Gas underperformed the BSE Sensex.

The fiscal stimulus announced by the government in May is a reflection of the fine balance that the govt. of the day has to achieve between the need to do a bare minimum for the most distressed parts of the economy as a consequence of the lockdown and its ability to do so. The stimulus makes an honest attempt to provide some upfront solace to several affected sectors such as SME/MSME, NBFCs, agriculture, migrants and to states as well. Given that bulk of the initiatives are in the nature of credit guarantees, the impact and utility of many of the elements of the stimulus package will only be known with time. While in the first instance, it will help spur credit demand within the intended sectors, it is the subsequent outcomes on credit behaviour and credit quality that will determine the success of the initiatives. What’s interesting is that the Govt. has also chosen to expedite a few structural reforms in these times, some of which like opening up the market for agricultural produce, commercial mining, hike in FDI for defence to 74% and further push to privatization could have important positive long - term ramifications.

While gradual restoration of economic activity starting June would be helpful in normalising production capacity and employment, return of consumer confidence and demand would be equally critical. On current reckoning, such growth normalization can take 2-3 quarters. More so, the lifting of lockdown comes in the backdrop of rising intensity of the disease, which brings in its own set of complexities. In a post-COVID world, the new normal for India Inc. will likely involve dealing with a defensive consumer, cautious borrowing and lending practices, conservative capital investing by corporates, greater digital and online intervention and even higher dependence on state support for driving growth in the system.

It, however, should be noted that Indian markets have materially underperformed global and regional markets CYTD and hence a quick catch up with the rest of the world in the coming weeks as economic activity is restored, cannot be ruled out. But with valuations already having recovered to parity with long-term averages, it would be hard to argue for material upside thereafter.

At Invesco, we continue to maintain a calibrated approach at all times. Markets are currently at a stage where one cannot be overly aggressive or very defensive either. Trajectory of economic recovery is unclear at this stage and the next few quarters may necessitate constant readjustment on either side. Hence it may be in one’s best interest to take a middle path to portfolio construction with regard to sector exposure, market cap bias and a good balance between growth and value stocks. Many earnings-based valuation determinants can likely throw up incorrect conclusions in the near term due to dislocation in earnings. Today, investment decisions that discount near term earnings profile but are justifiable based on long-term intrinsic or franchise value of enterprises attract our attention. Medium term we do take a more constructive stance on the economy and markets as a whole, but we remain measured in our conduct with regard to portfolio choices. We keep our growth expectations muted while simultaneously increasing the bar on quality of businesses and balance sheets as our guide to our choice of investments.

The prolonged economic lockdown across the country has impacted the income and earnings of several corporates and households. It has impacted both the organized and the unorganized sector. The decline in revenue has led to a sharp weakening of the aggregate demand with the economy. Financial positions are getting weaker as borrowers are now insecure about their ability to repay an existing loan. The financial health of the government balance sheet also seems to be worsening as tax collections have dropped over the months. The lockdown has impacted the corporates and the government alike.

The extension of moratorium by RBI by another 3 months till end of Aug’20 highlights the degree of the credit repayment challenges. The rising risk aversion amongst the banks has slowed down fresh credit disbursement and the moratorium is expected to slow it down further. The NPA levels within the financial sector is expected to rise and over time reflect the economic stress.

As a positive for bonds, the lack of demand within the economy is expected to soften the headline inflation sharply albeit some disruptions in the supply chain particularly in food and healthcare. The dislocation of migration workers is also expected to lead to disruptions at some point in time leading to some spikes in inflation. However, all these shocks are from the supply side and not from demand. Hence the rate reduction cycle is expected to continue till the time there is pick up in loan growth and surpasses deposit growth. Eventually the economy will revive only if the money starts rolling and gets spent.

The Monetary Policy Committee (MPC) members have been proactive and have been reducing the repo and reverse-repo rates ahead of the scheduled meetings. Between Feb’19 and till date the total repo rate reduction has been 250bps. The recent one of 40bps was in late May’20 ahead of the scheduled June’20 meeting. RBI has also been infusing surplus cash into the banking system in order to make good the cash withdrawals from banks and nudge the risk appetite of the banks.

So far, the rate reductions by MPC has not resulted in equivalent lower loan rates and bond yields due to low risk appetite of the banks. The surplus cash with the banks has not been invested into productive assets and mostly is invested back with RBI at the reverse-repo rate (presently at 3.35%).

The recent Rs. 20 lakh stimulus package is a combination of monetary actions (so far), fiscal stimulus and loans (by creating an environment such that loan demand picks up). While the strain on the fiscal position is not too high, the actual fiscal position will be clear only towards the end and in this financial year (FY), the strain seems to be likely from drop in tax collections rather than more of government spending. In this FY, the government’s ability to spend more seems absolutely limited due to drop in tax collections. Hence, bulk of the spending this year will be met from market borrowings. High dependence on market borrowings amidst drop in economic growth creates a strain on government fiscal position and lays bare the governments credit position. The recent Moody’s sovereign rating downgrade while not a big shock but the rating outlook of negative remains a worry.

Foreign investors have been net sellers of Indian debt in May’20 as well. They have sold close to Rs. 19,000 crore last month ( out of Rs. 1 lakh crore net selling YTD). Despite the selling by the Foreign Portfolio Investments (FPIs), the bond yields have softened by ~10bps in May’20.

Outlook

• We expect both growth and inflation to slow down sharply over the next few months. RBI forecasts a contraction of GDP in FY21.
• The economy would need the private sector investments and consumption to pick up along with huge fiscal and monetary stimulus to recover.
• The challenges of the banks (mostly due to rise in NPA, drop in capital adequacy and jump in cash withdrawals from bank accounts) remains the biggest hurdle.
• While RBI is addressing the cash needs of the banks, unfortunately the surplus cash is unable to address the credit stress within the economy.
• Expect further rate reductions and much bigger quantum of liquidity infusion. The Open Market Operations (OMO) and Long-Term Repo Operations (LTRO) of much larger quantum may continue. However, the marginal benefit of every fresh rate reduction is declining.
• After the net selling by FPIs slows down, and the market participants overcome the initial shock of the big increase in govt. borrowing, we expect that the demand from the domestic banks (led by huge surplus cash with them) to start pushing the yields lower for at least the sovereign bonds and blue-chip AAA credits (in the absence of any risk appetite).

Recommendation