Market Strategy - Post the USA downgrade

Politics has incentives that economics cannot under-stand”, said French philosopher Blaise Pascal (the mathematician after whom we know Pascal Law’s). The current turmoil in the world economic scenario due to the downgrade of the US sovereign, which raises fears of a double-dip recession, stands testimony to that.

When the US government decided to raise its debt ceiling after waiting until the eleventh hour, instead of cheering the decision, the markets actually gave it a thumbs-down. The reason that is being bandied about is that the road map prepared by the US for its fiscal consolidation falls short of what would be necessary to stabilise the government’s debt, which touched a level of USD 14.30 trillion. This led to the downgrading of the US sovereign rating by Standard & Poor’s (S&P) from ‘AAA’ to ‘AA+’ and consequently triggered mayhem in the world equity market. Since then, it has been quite a difficult time for investors globally. It looks like the bears have drawn their claws out, and are in no mood to spare anyone. At least, this is what the decline witnessed by global equity indices in the last one week indicates, and India is no exception to that.

To quantify this and put the numbers in perspective, since the beginning of August 2011, the Dow Jones Industrial Average (DJIA) has declined by 11%, the S&P by 13%, the HangSeng by 10%, the Nikkei by nine% and the Shanghai by seven%. During the same period, India’s leading equity indices, the Sensex and the Nifty, also witnessed a decline of eight%. The impact is clearly seen in the advance decline ratio too. Since August 4, there have been seven declines on the BSE, against one advance. The story is no different on a year to date (YTD) basis, and there is hardly any global market that is providing positive returns. In fact, India is the worst-performing market in the Asia-Pacific region, on YTD basis.

It is obvious that when the going gets bad, there are more questions than answers. Many investors have seen their hard-earned money vanish into thin air. Hence, the questions are looming large. What will the exact impact of the downgrade be? Where is the bottom? How much more pain must investors suffer? From what levels will the market bounce back? These are the questions that are playing on the minds of the Indian investors, which have not received answers yet. The investors are now nervously waiting and watching from the sidelines.  As always, DSIJ tries to answer the queries that are clouding investors’ minds, to help them make their strategy during these confusing times.

What Triggered The Meltdown?

Let us first understand what has happened and why. S&P has down-graded the US sovereign rating from ‘AAA’ to ‘AA+’. The reasons cited for the downgrade are as follows. The first is the US fiscal consolidation plan, which falls short of what would be necessary to stabilise medium-term debt dynamics. Secondly, it mentioned that US governance and policy making has become less stable, less effective and less predictable. The worst part is that S&P has further stated that they could lower the long-term rating to ‘AA’ within the next two years, if that the country sees lesser reduction in spending than agreed upon, higher interest rates or new fiscal pressures.[PAGE BREAK]
How will it impact the global markets?

The downgrade of the world’s largest economy and superpower will surely have an impact on the global stock markets. The simple reason for this is that the US government bond yield is the bare minimum return required for any US dollar-denominated asset. As America’s ‘risk-free rate’ is fundamental to the pricing of all financial assets in the country, the downgrade will result in a re-pricing of most of its financial assets in a downward direction. Further, mortgages, corporate debt and other loans will become more expensive, and in turn the capex cycle will get impacted. Business confidence would sink again, leading to a prolonged period of high unemployment rates. So, an overall impact will be seen in the US economy, and ultimately in the global markets. Further, with more that 46% of the debt issued by the US government held by foreign countries, it will matter that much more. Now that the superpower has been hit, a cascading effect will be seen in other countries, including India. The severity of the event can be judged from the fact that the G7, which includes the most powerful countries, and the G20, have both immediately agreed to co-operate for the alignment. Another factor is that it has been proven historically, that an economy takes a long time to recover following a downgrade. In the past, Canada has taken seven years, and Australia has taken almost 18 years to return to an ‘AAA’ rating. Of course, there is no guarantee that a country would be able to climb back up to an ‘AAA’ grade.

How will this impact the Indian Equity Markets?

With an increasing interlinking of global markets, any slowdown will impact the Indian markets too. IT and textile companies exporting to the US will witness some of the impact. “We do not believe that India can be immune to a US slowdown. Still, if the US double-dips, growth should slow to 6.5%, given that high interest rates are already hurting”, says Jyotivardhan Jaipuria, MD, Head of Research, DSP Merrill Lynch.

Dinesh Thakkar, CMD-Angel Broking, adds, “Markets could be re-calibrated a little lower, since growth prospects in the near term look a little weaker, but I do not expect a Lehman-like situation. The US and Euro problems do add to near-term uncertainty, which will lead to range-bound movement in our markets in the near term”. Further, one of the most important points is that the Indian equity markets are largely driven by FII money, and if they do not invest, it will have a negative impact on the liquidity front in the stock market. We are already witnessing lower volumes, and any further impact can only make matters worse. Previously, we have seen how bad the situation can become if the FIIs turn into net sellers.

Some Other Negative Factors

A rating downgrade by other agencies is expected and may happen in the due course – We have already mentioned that only S&P has downgraded the rating, and the other two leading agencies, Moody’s and Fitch, have not done so. We do not feel that this will create much of an impact going ahead. The fear of suffering is worse than the suffering itself. Similarly, the downgrade by others seems to be already priced in. It is a good thing that the problems have come to the fore. The first step to solving a problem is to accept that one exists. And if there is a problem, there is bound to be a solution. We feel that the US government is capable of handling the issue, and will surely take corrective action. When this happens is only a matter of time.[PAGE BREAK]
Sentiments are still not good -– Due to the current sudden downturn, sentiments are far from positive. Further, memories of the 2008 downturn are still fresh in the minds of investors, which will make them more risk-averse. Retail investors do not want to participate as yet. This is evident in the falling volumes on both the bourses. But again, it is well-known that market sentiments do not take much time to change.

Positive Factors

Inflation may cool off – While we have only talked about the negative factors till now, the situation has certain positives too. First and the foremost is the reduction in commodity prices. In a scenario of rising inflation, falling commodity prices will provide much needed succour. Concurs Dhiraj Sachdev, Vice President and Senior Fund Manager, HSBC Global Asset Management, “From the Indian perspective, the markets are well-placed in terms of growth as well as the monetary policy. The good thing is that if the situation persists, then it is expected that prices of commodities are likely to decrease, and this is a positive for the economy of the emerging markets, as the inflation pressures will recede”. The Q1 FY12 results show that there has been an increase of 23% in raw material prices. Hence, if commodity prices witness some amount of decline, it will help companies improve on the margin front. Further, we have been repeatedly stating that inflation has been a big threat to the Indian growth story. So, the fall in commodity prices will help the government to battle the inflationary monster, which is currently hovering in the higher single-digits. As a result, the RBI, which has been quite hawkish on account of higher inflation in the recent past, may start reversing the hike in interest rates.

Political situation is expected to improve – Another lesson learnt from the recent turmoil is that a government’s reluctance or inability has an impact on sovereign ratings. We feel that the Indian government, which has been quite dormant in terms of policy reforms, will now be more active. The dormant phase is evident from the fact that as many as 80 draft proposals are pending for passage in the Indian Parliament, including the important ones on FDI in retail, DTC and GST. After the recent developments, we expect that the UPA government will be on its toes. Some amount of momentum on the reforms front can also be expected ahead of the 2014 elections.

We are still the second-fastest growing economy -– Another positive factor is that despite the global recession in 2008, India’s GDP growth was 6.8%. Further, its recovery was much faster than that of its global peers. Going for-ward, the long-term story is still intact, and the 7.75-8% growth also looks good. This makes India the second fastest-growing major economy in the world. If you consider the ballpark figure, the corporate growth should be around 20%. The domestic consumption story remaining intact is another reason for the long-term story not being impacted.

FIIs will not find another India soon – FII money has been the driving force of the Indian markets. So, it is important to know how they are faring. Due to recent events, there has been some amount of sell-off. However, we feel that this is just a kneejerk reaction. Readers would recall that in the previous issue of DSIJ, we had provided reasons why FIIs will flock back to the Indian markets. We are of the opinion that it will be difficult for them to find a new destination providing the breadth and depth that Indian markets have. While certain markets like Indonesia and Sri Lanka (Colombo Stock Exchange) are providing positive returns, the overall market capitalisation of Colombo is even less than that of India’s highest market cap company. [PAGE BREAK]
What To Do At Current Levels

Discipline is what key at the current levels. As mentioned earlier, there is the steady domestic consumption story to count on, and hence the current fall in the markets should be taken as an opportunity to build a long-term portfolio. Here again, it is important that you remember not to jump to the markets with all your arms and ammunition.

Try an SIP and invest in a staggered manner – The best way to withstand the volatility is to stagger your investments. Buy in small lots over an extended period of time. This is one reason why fund managers ask investors to go for an SIP, wherein investors allot small portions of investment on a monthly basis. Historically, it has been proved that an SIP is the right way in turbulent times. Andrew Holland, CEO Investment Advisory, Ambit Capital, says, “We are, at present, not suggesting that investors take a position. Rather, we are advising them to wait for a while before taking position”.

Avoid small cap/mid cap stocks and stick to frontline counters – The cur-rent fall in the markets has resulted in many frontline counters being avail-able at lower valuations. We are of the opinion that avoiding the small counters and focusing on the ‘A Group’ will be a prudent strategy. “At this point, it makes sense to look to add to your long-term portfolio, any quality companies, across sectors, which you are getting at cheap valuations”, adds Thakkar. Avoid the mid cap and small cap counters, as they do not provide exit opportunities. In 2008, investors lost a good chunk despite entering the mid cap stock at good levels, as no exit opportunity was there on account of circuit filters.

Do not over-leverage your position –Leveraging positions is not a bad strategy in itself, but over exposing one’s position beyond one’s risk appetite can be pretty dangerous for retail investors. In fact, investors hardly tend to assess their appetite before investing. There are many small investors who invest in derivatives without understanding them properly. Remember, that derivatives are a hedging tool, and thus, speculations in the same should be avoided. Further, borrowing comes at a cost, and one cannot generate profits unless and until the cost is recovered. Hence, borrowing and then investing is the wrong strategy. So invest from your own money.

Avoid herd mentality and do not panic in any situation – Panic is the most dangerous word, which can change a wise decision into a foolish one in no time. Investors have generally repented whenever they have sold in panic, and experience in the past, like that in 2008 and 2006 definitely reinforces this fact. Those who sold in panic in the 2008 mayhem may be cursing themselves, as the markets bounced back with-in 18 months, to scale new heights. Those who believed in a long-term story reaped the benefits. Panic distorts the sound decision-making abilities of investors, which is the most crucial element while making investments.

Go for good dividend-yielding stocks – Generally, it is stated that when the indices start falling, good dividend-yielding stocks are safer investments. The more the stock plunges, the better the yield gets. So invest in stocks having a good history of dividend payment. Do not go for speculative trade – There are very few investors who make regular money on a short-term basis. In contrast, there are many who have made money by investing in the right companies and keeping a long-term horizon. Anyway, the markets are highly volatile, and hence trading by way of speculation will only be suicidal in the current scenario, as the stop-loss may be triggered in no time. Our advice is to find good value picks for a horizon of at least the next three years. The markets are not going to bounce back in a hurry, and this provides an opportunity to build a good portfolio.[PAGE BREAK]
Sectors to go for and sectors to avoid – With regard to the sectors to enter, we feel optimistic about domestic consumption stories, like FMCG. Even defensive sectors like pharmaceuticals, banking as well as oil and gas can be looked at. Commodity-related stocks like metals and textiles are the ones to avoid. Sachdev concludes, “We believe in the consumption story, and are bullish on sectors like ceramics, tiles, liquors and consumer durables. We also like the commodity user segment, as we are expecting commodity prices to correct”.

Conclusion