Calendar year 2020, so far, has been a pure roller-coaster ride for the equity markets. Equities saw a massive drawdown across the globe in Q1 amid a tragic fallout from the spread of Covid-19. After a dismal Q1, the markets bounced back in Q2 amid easing local & global lockdown conditions. Indian equity markets also recovered sharply in line with the global markets – on the back of strong FPI inflows.
Since the March lows, equity markets have rallied meaningfully supported by fiscal and monetary measures announced by the world economies. This coupled with increased retail investor participation in equities, led to a sharp rally. The S&P BSE 500 advanced 51.5%, since the March lows till Sept 4.
Exhibit 1: Global market performance in INR
As equity and other risk or growth assets fell during the onset of Covid-19, we took the opportunity to add exposure to assets that we believed had become more attractive from a reward for risk perspective. In the March-April period, we implemented this view by adding to our domestic equity positions, European equities, and Asia ex-Japan equities.
Global GDP has been severely hit by the lockdown with major world economies reporting contraction. India’s GDP saw a contraction of 23.9% YoY in Q2. Investments contracted by 47.5% YoY as companies refrained from spending on capex because of weak demand conditions. Private consumption contracted by 26.7% YoY as demand got severely impacted by the nationwide lockdown. Government expenditure grew at 16.4% YoY with the fiscal stimulus/measures announced by the government, largely welfare schemes.
Some of the high-frequency lead indicators suggest growth improvement over the last couple of months as the lockdown restrictions were eased. Auto companies reported high passenger vehicle sales in July as compared to June amid unlocking of pent-up demand, although y-o-y growth is still negative. Tractor sales and two-wheeler sales also increased significantly in the last couple of months – early signs of rural demand pick-up. Indian manufacturers signaled a rebound in production volumes with August PMI coming in at 52 (expansion zone) against 46 reported in July. The services PMI for August at 41.8 is up from 34.2 reported for July, indicates a slower rate of decline in business activity. Over the short-term, government expenditure is likely to support growth with expectations of another round of front-end fiscal measures, although the fiscal room is limited.
The global growth contraction and weak domestic recovery cast doubt on the Indian growth prospects in the near term with real GDP growth for 2020-21 expected to be negative. Weak macros and rising Covid-19 cases resulting in localized lockdowns could still drag the economy growth in the near term. However, over the medium to long term, productive capacity should return with a pick-up in government expenditure, investments, and consumer spending, reviving economic growth.
Has anything changed fundamentally?
This is an unusual market cycle where on the one side the global economy is contracting by double digits, corporates are reporting losses, job cuts, low or no capex, and weak private consumption. On the other side, stock markets see a strong recovery from recent lows and continue to look robust. Risk-averse investor behavior during times like this would avoid equities and prefer assets like debt and gold which tend to do well in terms of protecting investors wealth. Low or negative real rates globally added to gold’s safe-haven appeal. A fundamental driver for equities to rally in the current cycle could be low-interest rate/cost of equity. This could be partially justified with record low-interest rates which have a positive impact on discounted cash flows of corporates.
Exhibit 2: Indian equities – Trailing P/E and ROE
With the recent rally in the Indian markets, our valuation-driven framework suggests stretched market valuations. Our valuation implied return forecasts indicates that the return expectation from Indian equities is lower than what they were at the start of 2020, with all three market-cap segment offering low real returns.
Indian mid and small-cap stocks have traded at lofty P/Es. The current valuations indicate a significant premium to our fair value assumption. On the other hand, the current margin and ROE are lower than the fair (long-term) assumption. Our valuation implied return framework factors a higher long-term margin and ROE estimate as compared to the current low margin and ROE that Indian equities offer – indicating a positive reversion impact on the return expectations.
We believe investors are unaware to the cash flow generation and the meager returns on equity that these companies offer. Rather, investors are relying on the benefits of future growth opportunities to stoke returns. In our view, this is not good investor behavior and we avoid investing in expensive assets, hoping for growth to materialize. Rather, we opt for assets that are priced below their intrinsic value and offer attractive margins of safety.
Risk-reward model and spread to fair return expectation
Two main indicators that we focus on are 1) the relative ranking of assets based on our proprietary risk-reward model 2) 10-year return expectations vs fair (long-term). The risk-reward ranking of assets helps us identify segments that are attractive from a valuation standpoint and avoid those that rank low. A negative spread to fair would mean that the 10-year return expectation is lower than the fair return estimate – indicating that an asset is overvalued and vice-a-versa. Both of these indicators combined with qualitative assessment drives our Valuation-driven Asset Allocation (VDAA) calls.
Portfolio action
With this backdrop, we have changed our VDAA weights across portfolios. We decided to cut down allocation to Indian equities across all four portfolios i.e. further underweight allocation vis-à-vis our neutral or benchmark allocation. The allocation is shifted to the medium to long term debt segment which ranks relatively better and offers attractive real term spreads. At a market-cap level, we continue to favor large-caps over mid and small-caps.
Why rebalancing is necessary?
One of the key elements that any investor must consider when managing a portfolio is when and how frequently to rebalance back to target weights. While this may appear to be a simple topic, the effectiveness of a portfolio manager's rebalancing approach can have a profound impact on the returns and risk of a portfolio and is especially important at times of market stress. A thoughtful approach to rebalancing is therefore an essential part of a valuation-driven philosophy. Left unchecked, our exposures will not resemble our best ideas. Yet, executed too aggressively or regularly and we expose the portfolio to unnecessary turnover (taxes and fees) and the potential for drag.
The rally in equity markets led to the domestic equity weight in the portfolios drift away from the revised VDAA weights or the target weights. In such a scenario, we believe, it is highly important to stay the course and keep the asset class weights of a portfolio aligned to the latest target allocations. As a result, we decided to reduce some of the risk. The main lever we are using to reduce overall portfolio risk is to trim our domestic equity allocation.
We continue to focus on risk-adjusted returns—not just returns—and have a constructive view on our ability to navigate different market pathways going forward. In this unique economic situation, we are actively reviewing our views across asset classes and portfolio positioning.
