The Sensex and Nifty seem near a cyclical peak though the declines in Indian midcap/smallcap shares have been draconian. There is no doubt in my mind that, after a stellar 2017, investors sentiment in the Indian equities market is at an inflection point in April 2018: The old adage “don’t fight the Fed”, so frequently heard when the Federal Reserve expanded its balance sheet from $900 billion to $4.5 trillion in Wall Street’s first post Lehman decade, has an eerie echo now that the world’s most powerful central bank will shrink its balance sheet by $500 billion in the next twelve months. This will come at the same time as tight US labour market and rising wage inflation will force Chairman Powell into at least two more Fed Funds rate hikes, probably at the June and September FOMC conclaves.
A protectionist Trump White House, a resurgent China, the peak of the global central banking money pumping engine, higher US interest rates, an ominous rise in LIBOR funding costs, a new Cold War between the West and Vladimir Putin’s Kremlin means that the tailwinds for emerging markets could well turn “stormy” (a word the US President no doubt relishes!) in 2018. This will necessarily erode the bullish macro zeitgeist for Indian equities in 2018 even though the domestic growth story is intact, as the car sales growth data attest. Yet it is impossible to be complacent with the Volatility Index at 20, Brent crude at $72, the Indian rupee at 65, a tight fiscal deficit target and the recent political shocks in Rajasthan, Bihar and UP by elections. Emerging markets tend to have a nervous breakdown when uncertainty replaces stability, as it is happening as I write.
Indian equities still face downside risks even though Dalal Street suffered its first real correction since March:
– One, expectations for 20 – 24% earnings growth on Nifty companies are far too high and the market is thus vulnerable to disappointment.
– Two, the alleged role of ICICI Bank CEO Chanda Kochhar’s husband in a suspect $500 million Videocon loan, coming so soon after the $1.8 billion looted by absconding diamond merchant Neerav Modi (Nimo in the Age of Namo!) in the Punjab National Bank loan scam has stunned foreign investors about the sheer systemic corruption and governance deficit in Indian banking. Since Indian banks happen to be the highest weight sector component of the broader Indian market indices, it is natural for India’s equity risk premium to rise.
– Three, Indian mutual fund inflows into equities have fallen in March, at the same time as foreign investors trim the largest consensus overweight in emerging markets. Indian equities are expensive at 18 times earnings and 3.5 times book value.
– Four, political risk is also creeping back into the market as investors realise that BJP Prime Minister Narendra Modi is not a sure thing winner in the 2019 general elections. Major state elections make it prudent to be cautious in India’s summer of political discontent!
– Five, the spectacular rise in Brent crude from $45 last summer to $72 now amplifies the deterioration in the Indian current account deficit and thus harms the rupee’s short term prospects against the US dollar.
– Six, the 100% rise in Volatility Index (VIX) since 2017 on Wall Street and the fallout from a potential US-Chinese trade war will not leave Indian equities unscathed.
– Seven, The Reserve Bank of India (RBI) kept its policy rates unchanged with a dovish tilt to their language on inflation. I cannot understand how the RBI reduced inflation projections for fiscal 2019 at a time when the price of crude oil has risen more than 50% from its cyclical lows, thanks to the success of the Saudi-Russian OPEC output cut deal. Moreover, the 25 – 30% rise in Indian mutual fund assets in the past year spells (the old Alan Greenspan blast from the past) irrational exuberance to me.
– Eight, the introduction of long term capital gains tax on Indian equities is anathema to my tribe of global investors. This is unquestionably going to reduce the marginal propensity to add to India allocations among global fund managers on the eve of rises in US dollar, inflation, fiscal deficits, liquidity, profit disappointment and election risk. I see foreign smart money exiting Asian markets, notably Philippines, South Korea, Taiwan, Indonesia, Hong Kong and the Middle Kingdom. This could well be India’s fate in 2018.
Stock Pick – Prologis is the world’s top industrial property landlord
Hardly any major landlord in the world – and none I know in the GCC – can boast 22% rental growth in their property portfolio. Yet this is exactly what happened at Prologis, the world’s preeminent industrial property and logistics REIT whose financial charms I have waxed elopement in the past decade. Prologis is the world’s largest global industrial REIT with 690 million square feet of warehouse space in the US, Europe and Asia. Ironically, Prologis will continue its rental growth momentum as rents on their properties continue to rise, given the sheer scale of E-commerce demand and the existing US warehouse supply deficit. Even without no raise in the occupancy ratio, I expect its stellar growth in net operating income to continue in 2018, possibly at least 100 basis points above management guidance of 4.5%. Other than rent increases, the other engine of Prologis revenue growth is at least $1.8 – 2 billion in project development.
With low vacancy, rental increases, global leasing it projects and a massive development pipeline, is mathematically impossible for Prologis’s net operating margins not to rise in 2018 – Prologis, is building giant multi-story warehouses in the US, starting in Seattle and San Francisco, leveraging its past construction of such mega-warehouses in China and Southeast Asia. Since land is so expensive in both Seattle and the Bay Areas, these 600,000 square foot logistics monsters will have almost zero vacancy rates and command exceptional pricing power
There is a chronic lack of warehouse space in both Los Angeles/Long Beach and the East Coast. All existing Prologis warehouses in southern California and New York have 99% occupancy ratio, making this the world’s most attractive, liquid, industrial property landlord for me. Other than data centers and medical labs, industrial REIT’s are the finest property investments I know in the US, London and Singapore. Industrial real estate in prime global cities in an asset class niche where supply has consistently lagged demand since the 2008 financial crisis.
Prologis offers exceptional growth potential in the decade ahead. E-commerce is a mere 15% of the current portfolio but no less than one-third of its 50 million plus square feet development project pipeline. Industrial economists at Stanford have estimated that E-commerce alone will necessitate 340 million square feet of warehouse construction in the next three years. This is my ultimate rationale why Prologis is a must own growth asset for any sophisticated industrial property investor, with its cash on cash portfolio yield of 6.4%.
It is also true that E-commerce requires three times the warehouse space of traditional retailing or shopping mall, a business with as much growth potential as black and white television. We are seeing nothing less than a revolution in the logistics of distribution and freight transportation in the world’s most attractive megacities. Prologis owns five times more warehouses than its closest peer, making it a de facto dominant oligopolistic in one of the world’s most attractive, fastest growing and difficult to replicate property market niches. I would not be surprised if its acquisitions agenda does not include Liberty now that it has existed the medical office space.
Prologis’s global scale enables it to handle $1.3 trillion in goods flowing through logistics networks. Since 60% of the US population lives within 100 miles of a Prologis building, it is the ideal distribution center for E-commerce. It is no coincidence that Amazon is Prologis’s largest client and occupies 16 million square feet of warehouse space. Prologis is the Warehouse King of Wall Street.
Prologis is not inexpensive at 20 times estimated funds from operations. Its dividend yields is 3%, a pittance to the 7 – 8% div yields I would get in Singapore industrial REIT’s a decade ago. Yet it deserves its valuation premium. It has pricing power, a technological moat, the ultimate global industrial development platform and economies of scale none of its peers can hope to replicate. I expect hundreds of billions of dollars to exit shopping mall/retailing shares in the next three years. They will be rotated to industrial REIT’s. Rental growth will work its magic at lease expiration. Its stellar balance sheet will enable it to leverage the global growth of E-commerce. Adjusted funds from operations (AFFO) growth can well accelerate to 8%. Of course, industrial real estate is hugely correlated with economic growth so a global recession would be fatal for Prologis shares. I recommend a 54 – 56 new money entry level for a 70 target.
Macro Ideas – Russia’s financial meltdown, sanctions and Syria
The world witnessed Black Monday in Moscow last week as Russian stock markets plunged 8% and the rouble tanked 5% against the US dollar in a single session. The reason? Financial panic after the US tightened financial sanctions on Vladimir Putin’s closest cronies to punish the Kremlin for its intervention in the 2016 Presidential election, the poisoning of a former MI6 double agent in Salisbury and his support for Syria’s Baathist regime (“Animal Assad” as Trump’s tweet put it), which murdered civilians yet again with a chemical bomb attack in Douma.
It was surreal to see Sberbank (Russia’s biggest bank, in existence since the reign of Tsar Alexander II in the 1860’s) plunge 17% and baby oligarch Oleg Deripaska’s Rusal fall 50% in a single session. Borrowing costs for Russian companies will now rise in the global capital markets. Foreign markets will shut down for Russian exporters. Despite $72 Brent crude, Russia runs a tangible risk of a double dip recession. This was the biggest trauma for Russian equities since Putin’s 2014 annexation of Crimea from Ukraine. The MICEX index, among the lowest valued major emerging market indices on the planet, fell below its 200 day moving point average. After all Russia traded at 6.4 times earnings before the plunge, cheaper than Pakistan and Nigeria.
Putin’s geopolitical brinkmanship has only bought Russia financial disaster, as the destruction of Yukos, the invasion of Georgia and Ukraine, the use of Gazprom as a foreign policy tool and the Syrian military intervention attests. Britain, France, Germany and the US have acted against the Kremlin in unison in the Sergei Skripal spy poisoning case. While oil prices are near three year highs (oil and gas is 25% of the Russian GDP, making the Kremlin a petrocurrency state), tighter sanctions could still trigger the highest capital flight since the end of the USSR and tip a fragile economy into recession. Russian sovereign dollar debt has widened to 200 basis points above Uncle Sam debt, immediate post Brexit levels, when oil prices were in free fall. Geopolitical risk has now widened. Russia’s credit default swaps. Putinomics has failed Russia. If the Tsar’s soldiers voted with their feet (a Lenin quote), Putin’s creditors voted with their Bloomberg screen!
Aluminium has soared more than 12% on the London Metal Exchange as Deripaska’s Rusal supplies 6% of global supplies and has now been shut out of US markets and US dollar funding sources. Rusal supplied more than a third of the inventories on the LME, which will now reject its metal. After all, Rusal is the world’s largest producer of aluminium outside China, has lost 50% of its value in Hong Kong and will no longer be able to deliver aluminium on either London’s LME or Chicago’s CME. My call? Stay long aluminium as prices have to rise higher to meet the demand of international trading houses who can no longer buy from Rusal. Deripaska will have to transfer his smelters to offshore allies, possibly via Kremlin blessed deals with China. Rusal’s collapse could deal a political blow to the Putin regime since it employs 60,000 people and generates 16% of Russia’s export earnings. A debt restructuring of Rusal is also inevitable.
Credit default swaps (CDS), like Shakira’s hips, do not lie. Russia’s sovereign CDS has blown out 40 basis points last week to 165 after Trump’s warning for Putin to “get ready” for US missile attack on Syria. Both Trump and Putin are playing a game of geopolitical chicken in the Middle East whose endgame could well poison international relations forever.
The US, British and French attack on Syria’s chemical weapon facilities was precise and not a prelude to regime change. The best geopolitical hedge for now is oil and gas shares on Wall Street, undervalued relative to crude prices. I would avoid BP since it owns 19% of the Kremlin’s energy colossus Rosneft. However, Total benefits from the Saudi Crown Prince’s recent visit to the Élysée Palace and the $9 billion deal with Aramco. It is almost certain that Trump will roll back or scrap the Great Power nuclear deal with Iran in May. This means a protracted supply shock premium in the oil market even as Bank Rossiya halts its rate cutting program. My call to buy the Canadian dollar at 1.30 for a 1.25 target has thus been vindicated by world events. The loonie is a classic petrocurrency. The ideal FX trade if the Syria military crisis escalates? Long Norwegian kroner and short the Turkish lira!
