How to approach investing amidst the second wave

It’s a bad idea to declare victory before your opponent has retreated to peacetime quarters. The virus hadn’t, and by March, India’s case load began ramping up. In April, we set global records for fresh covid-19 cases, our hospitals ran out of beds, then oxygen. Families of patients pleaded for plasma and scarce medicines on social media. There was no dignity even in death, as crematoria scrambled for space, and firewood.

A national lockdown is ruled out, but local restrictions have come into place. Our streets are empty, parks padlocked, and daily air traffic has plummeted from about 275,000 passengers in early March to 118,000 on 27 April. In 2019, the average daily air traffic was 395,000. Migrant labour boarded trains and buses out of our cities, school-leaving exams were cancelled, or postponed, and the grand Indian wedding sent back into hibernation.

What does this do for the recovery of the Indian economy, awaited since at least 2018? We are now in the fog of war. There is so much we don’t know. Nevertheless, investors have to make decisions. So, I am going to describe the investment climate, point at the gaps, and from this incomplete picture, indicate asset classes where rewards seem to outweigh risks.

To start with, we know the global investment climate is being driven by central banks, led by the US Federal Reserve. Liquidity is circling the globe, in the search for yield. Some of that money found its way to India—last financial year, foreign institutional investment (FIIs) bought a record $37.5 billion of Indian equities, and by January 2021, investment in businesses (Foreign Direct Investment, FDI) was up 12% over the same period the previous year.

Meanwhile, to quote economist Stephen Roach: “The fiscal floodgates have been opened as never before: the $900 billion package of late 2020, followed by the $1.9-trillion American Rescue Plan in March, and now a proposed $2 trillion-plus of additional stimulus for infrastructure."

The US recovery, in other words, will be lavishly funded, and going into spring, is off to a super start. This recovery is driving a surge in commodity prices, which is a warning signal for India.

The key unknown here is how much of that money will come to India. As covid-19 cases surged in April, foreign equity investors pulled out $1.2 billion from Indian markets. We don’t know how this will shape, but Indian equities have always been very sensitive to foreign buying.

Within India Inc, companies have done extremely well over the last year. Companies were able to rapidly cut overheads, and improve margins. Add to this the ‘formalisation’ of the economy: beginning with demonetisation, through GST, and now into covid-19, smaller companies have been less equipped to survive the strains in our business environment. The big, listed companies have taken market share from the small.

Reflecting this, Indian shares are extremely expensive. Though the Nifty has fallen 4% from its March high of 15,432, it gained 72% over the year ending 31 March. Expressed as a multiple of earnings—the Price-Earnings, PE, ratio—the Nifty is at an extreme high. It has typically been priced between 10 and 30 times earnings, and currently rules at 35.

There are 3 good explanations why equities can sustain these levels—the interest of foreign investors; the low returns on other assets, like fixed deposits, real estate or government bonds; and the expectation of a bounce in earnings, as the economy recovers from covid.

However, there are many unknowns. Will a shift in market share be enough to sustain growth in corporate profitability? Unless growth is restored, will equity investors support Indian equities at record PE multiples? And what will be the impact of the second wave of covid-19 on the economy?

Indian economy

The economy had been anaemic well before covid-19 struck. From 8.2 % in March 2018, GDP growth dipped for eight successive quarters to 3.1 % in March 2020. During the last financial year, our economy probably shrunk by 10%. Till last month, Indian growth for FY22 was estimated to be around 12%.

Indian economic growth for the last decade has been called “jobless". Demonetisation was accompanied by a loss of 5 million jobs. At the end of 2019, the percentage of adult Indians in the labour force was about the lowest in the world, at 42%. With last year’s lockdowns, and reverse migration, our Labour Participation Rate (LPR) dropped another 2.5%. Only 37.6% of adult Indians were employed in the month of March 21.

Such a slide in income generation typically attracts government support.

Most of the Indian government’s support was monetary in nature, to improve liquidity, and support banks and industry with lower interest rates. ‘Fiscal’ support, to the worst affected individuals was only 2% of GDP. The long-standing MGNREGA program was supported, but there are reports of unmet demand for daily work under the scheme. Poverty has mounted, and a paper published by the Pew Research Center calculates that the pandemic has led an additional 75 million Indians into poverty.

The government’s ability to support consumption is constrained by its own finances. The central government’s fiscal deficit was 9.5% last year, a far cry from the fiscal responsibility target of 3%. Deficits reduce government spending in the future, and interest on loans already consumes 37% of annual tax revenue.

Economic growth is propelled by investment, but capital formation in India has been slipping, from a peak of nearly 40% of GDP in 2011, to 32.2% in FY19. Within this, the share of corporate investment has slipped from 41% to 36%. Household investment took up the slack, but this does not generate jobs.

Given this dismal situation, what will kickstart our recovery? The Reserve Bank of India’s bimonthly survey shows consumer confidence has been in a slump, at around 50% since September of last year. How will this revive? If consumers don’t spend, why will corporates invest? And our government’s hands are already tied by its debt burden.

Even while we look into our economic future, the immediate task is to arrest the current slide in activity and confidence. The tsunami of covid-19 in 2021 has created deep fear and insecurity, our health system does not seem able to cope, and only universal vaccination will dispel the fear of a savage disease.

At the time of writing, about 147 million vaccine doses have been administered. Some 2% of our population has been fully vaccinated, and about 8% have received 1 dose. The Serum Institute of India (SII) currently produces 60 million vaccines a month, and Bharat Biotech (BB), 10 million. This is not nearly enough to vaccinate even our adult population in a year.

There are many unknowns here: How long will it take for SII and BB to ramp up capacity? How many vaccine doses will the US government ship out, and when? How long will it take for Sputnik vaccines to be produced in India? And will private organisations be able to import other vaccines in sufficient numbers to make a significant impact on a population of 1.35 billion?

Investment matrix

So, from vaccinations and consumer demand to investment climate and government support—the Indian ecosystem is riddled with uncertainty. Here is one view on investing in this scenario:

Indian equities: Risk-reward is not in favour of Indian equities; they are highly priced, and except for exporters, especially IT businesses, our businesses face deep economic uncertainty. The Indian equity investor has climbed the wall of uncertainty through FY21 and returns on Indian equity investments have been good. But this has been true for asset prices across the world, except bonds.

Since asset prices are being driven by global liquidity, one has to look at the comparative performance of Indian and other equities.

US equities: Since September 2019, I have argued in these pages the case for investing in the US. Since then, the tech-heavy Nasdaq, as also the Dow, have hugely outperformed the Nifty.

US stocks will continue to have the edge, as the US government supports consumers with income transfers, and companies have deep access to cheap funds.

Over 50% of US adults have been vaccinated, and all adults are now entitled to free inoculation. Meanwhile, the US central bank is committed to keep interest rates low, which makes business expansion easier, and lowers the relative attraction of fixed-income assets.

Real estate: For long the favoured asset class for Indians, I cannot recommend Indian property right now. Even though interest rates are low, there is no appetite for real estate. The Indian family is financially stressed; the household debt-to-GDP ratio has been rising since 2018 and hit 37.1% by September 2020. This situation is not going to improve in a hurry.

Earlier this year, there was a fizz around commercial real estate, but that beverage has gone flat; signings for commercial real estate are down. Work From Home is not going away in a hurry, and I believe there will be more pain for this sector.

Fixed Income: At current rates, fixed deposits barely keep up with inflation. If you pay any income tax, you’re actually losing buying power when you keep money in the bank.

The same is true of government bonds; if interest rates in India rise, and I think this is inevitable, bonds will also lose value in the short-term. Corporate bonds offer better returns, but balancing risk and reward in this market is only for experienced players.

Gold: In times of uncertainty, gold has historically been a haven. When governments spend way beyond their means, and central banks print lots of money, gold typically shines. It has been the ‘anti-dollar’, the defence against a flood of cash. I bought gold in 2019, for these reasons, but I am no longer as enthusiastic. With the massive increase in dollar printing, ‘anti-dollar’ is still a sound theme, but it seems the players of this song have moved to cryptocurrencies.

Crypto: These are early days in crypto, and my understanding is primitive. Block-chain is a secure way of confirming both ownership and transfer of assets and will remove both costs and intermediaries from many transactions.

As this technology develops, sharper ways will be found to write block-chain into contracts, to eliminate manual approvals. Which cryptocurrencies will rule this world, is difficult to say.

But I’m riding the momentum and have put some risk capital into the two top names, Bitcoin and Ethereum, despite the additional Indian risk of a government ban.

The fear of excessive paper currency is finding comfort in these digital currencies whose supply is controlled, a sense of comfort that many seem to deeply value.

Mohit Satyanand is a businessman and investor.