After a stellar 28% return in 2017, the BSE Sensex (down 2%) and the NSE Nifty 50 indices in India been a disappointment in 2018 to date. The emerging markets convulsions in May were compounded by the political shock for the BJP in Karnataka. The financial markets have also been alert due to the oil price related slippage in India’s current account deficit (every $10 rise in Brent means a 0.50% rise in the Indian CAD), the depreciation in the rupee, poor bank earnings due to increased provisions, distress in small caps/SME, earnings downgrades in 2018, outflows by foreign funds from Dalal Street and the increasing realisation that the RBI was far too dovish on inflation and will have to do a policy U-turn that will mean at least two more rate hikes to take the policy rate to 6.75%.
India is the most expensive major emerging market in the world at 20 times forward earnings, an unjustifiable metric at a time when earnings growth expectations are inflated, tax collection has dismal (thus a rise in the fiscal deficit) and interest rates are set to rise. While a positive monsoon and strong private consumption creates opportunities in Indian equities, my preferred strategy is to short the Sensex at 35600 and the Nifty at 10800 for a 8 – 10% correction that is highly probable this summer. Note the Nifty Midcap 100 index has fallen 13% in 2018, a classic response to higher rates and lower investor flows. This index has the potential to fall another 20% in 2018. Q4 earnings growth was dismal, a 8% decline due to increases in bank provisions. Ex financials, Nifty sales was up 15% and profit after tax was up 5 – 7% in 4Q, a decent if not blowout performance.
Bank provisions rise when their asset quality deteriorates and this is a chilling omen for the short term simply not priced into the stratosphere valuations of both the Sensex and the Nifty. Inflation due to high commodities prices will also force the Reserve Bank of India (RBI) to go hawkish at its next monetary policy conclave, even though it raised interest rates on June 6. This will exacerbate weakness in earnings growth in media, consumer, healthcare and cement shares. Pharma faces competitive and regulatory headwinds in the US. Telecoms and cement lack pricing power. Obviously, Indian IT will be a beneficiary of the depreciated rupee and the spectacular bull market in Silicon Valley tech shares. The Modi government’s focus on urban housing and rural spending is bullish for infrastructure stocks. The rise in gross refining margins and high oil prices is bullish for energy shares.
I doubt that the Nifty can rise much above 10800 in the current macro milieu as a rise in interest rates, a rise in political risk and fall in earnings per share (EPS) growth is an argument for a lower valuation multiple, possibly as low as 16 – 17 times forward earnings. However, there is no reason to expect a bear market in India, even if the BJP faces a credible threat from a united opposition in the 2019 general election and the 20 – 22% estimates for 2018 earnings growth are way too high. Sectors to avoid like the plague? Telecom, pharma and real estate, where Modinomics assault on black money has triggered a “Black Death” in asset values. It is far easier to pinpoint stocks that will be credible buys after a 8 – 10% market correction. My preferred stocks in India are Mahindra and Mahindra, Maruti Suzuki, HDFC Bank, Nestle, Infosys, TCS, Spice Jet, and Apollo Hospitals.
While I can easily envisage Maruti Suzuki trading at 10,000 rupees sometime in 2019, I prefer to buy its shares somewhere in the 7400 – 7600 rupee range. Maruti wholesale volumes are growing at a 26% rate while there is robust demand for the new hatchback model Swift across India, with waiting periods and minimal dealer discounts. The firm operates at 100% capacity utilization even as Suzuki will expand its Gujarat plant next year. Maruti Suzuki is one of the most exciting revenue/margin growth stories in India. It is entirely possible that the shares trade at 28 times fiscal 2020 estimates or 10,000 rupees in the next twelve months. I concede this is one of the world’s most expensive auto stocks yet its earnings predictability and sheer growth potential justifies its premium valuation.
Currencies – Will the Euro-Dollar exchange rate fall to 1.15?
The Napoleonic era scholar Karl von Clausewitz defined “war as the continuation of politics by other means”. Von Clausewitz’s dictum also applies to trade wars and the American President flies into a G-7 summit in Quebec facing pressure from even his closest allies and deeply isolated in international relations. Moreover, as Argentina’s $50 billion IMF funding package and the failure of the Brazilian central bank’s intervention demonstrates, the selling in emerging market currencies has not abated. The disappointment in Germany and French industrial production data suggests the economic momentum in the Old World is stalling. The German trade surplus also fell in April. These factors all ensured that the US dollar clawed back some of its losses against the Euro, which was dramatically sold at its recent highs of 1.1840. This means the trading range for next week will be 1.1840 and the May 29 low of 1.1510 and the fundamentals suggest Planet Forex is itching for another spasm of short Euro selling as there is no way the ECB can embrace quantitative tightening amid myriad data and political risks.
The Euro’s 340 pip rally above its 1.1510 recent low is now over and that the single currency will trade significantly lower in the next six weeks. Why? One, foreign exchange markets have finally cottoned on the fact that the Trump White House’s trade war blitzkrieg is bearish for its consensus synchronized global growth scenario. This is far more negative for Europe and the emerging markets than the US. This also suggests a global safe haven bid in the US dollar. Two, there is nothing stable about a coalition government in Rome dominated by a far-left Five Star Movement, whose leader Luigi Di Maio (the Prime Minister is a mere mouthpiece of Italy’s power brokers) is on an open collision course with the EU over budgets, pensions, debt and his planned tax cuts. Both Di Maio and Matteo Salvini, leader of the far right Liga (a secessionist political party now morphed into anti-immigrant, anti-Euro populists) reject the Fiscal Compact between Rome and Brussels.
Three, if trade wars and the prospect of an Italian fiscal revolt was not awful enough, Germany, one third of the Eurozone GDP and Europe’s economic colossus, can no longer play the role of its growth locomotive. The miss on industrial production and the trade surplus shows that 2Q and 3Q Eurozone data will soften even as high oil prices cause an inflation uptick. Four, the Euro is exhibiting exhaustion in its bullish momentum on the charts. I expect it to violate several key uptrend lines and the death cross has now happened. I believe the proximate target is the 1.1650 low witnessed on May 25.
The bid in the US dollar against emerging market currencies is unmistakable. The Turkish lira, Mexican peso and South African rand are all being slammed as I write. Not even the RBI’s rate hike could prevent selling in the Indian rupee. My recommendation to short the MSCI emerging market index seven weeks ago has been money making strategy. This is contagion, even if Wall Street ignores it.
Sterling’s plunge from 1.43 to 1.32 was a swift, brutal vote of no-confidence by the currency gnomes on the monetary policy divergence between the Fed and the Bank of England as well as the toxic politics of Downing Street, Westminster and the Brexit negotiation process. Sterling can really not make a significant thrust to 1.36 as the Fed’s FOMC hikes rates in June and September while the Bank of England remains on hold.
While Theresa May has survived yet another political mini-crisis, all is not hunky-dory in the British Cabinet or in its relations with EU Brexit negotiator Michel Barnier. Barnier has rejected the Tory government’s Irish backstop proposal. If cable cannot manage a convincing close above 1.34, the rational strategy will be to continue to remain short the currency of the sceptered isle, as the primary bearish downtrend resumes with a vengeance. The UK services PMI data was positive but there is zero prospect for UK data to be strong enough to cause Governor Carney to hike the base rate before November. There is simply no wage growth inflation data to change the current monetary policy stance of the Old Lady of Threadneedle Street. As the divergent rate outlook of the US and UK widens, selling pressure could see sterling depreciate to 1.26 this summer.
Macro Ideas – The bearish case for Brazil’s stock market
Charles de Gaulle once dissed Brazil when he said the world’s third largest emerging market after China and India was “a country of the future and always will be”. Brazil is a land of fabulous opportunities and exquisite beauty but it is haunted by political and financial demons from its decades as a brutal military dictatorship. When I first visited Rio and Sao Paulo in the early 1990’s, President Collor had just been impeached after allegations of cocaine binges, the currency was renamed three times after it lost public confidence, hyperinflation and a foreign debt crisis crippled Latin America’s largest economy. In 2018, Brazil is still haunted by the Jato Lavo consumption scandal that led to the ouster of President Dilma Rousseff and the criminal conviction of populist Workers Party head of state Lula da Silva.
The unelected but pro-business government of President Michel Temer faces an election in October that he is not guaranteed to win. Temer, who succeeded to the Presidency in August 2016 after Dilma’s removal from power, reformed restrictive labour laws, rolled back the credit subsidy regime from state banks, provided political space for the central bank to combat inflation, presented legislation to Congress on pension reform and courted Wall Street with the promises of structural reform. Unfortunately, Temer does not have the personal charisma of the trade union firebrand Lula and runs a caretaker, not an elected government. He could well be gone in the October election.
Brazil has been hit hard by capital flight, a plunge in the real, the Bovespa and a devastating trucker’s strike that threatens a return to recession and a spike in the budget deficit. The established political parties have all been tainted by the Jato Lavo corruption scandal and Jair Bolsonaro, the populist front runner, is known as the Trump of Brazil. The trucker’s strike has meant huge losses for Brazil’s chicken farmers and soybeans exporters. Petrobras’s CEO has been forced to resign. Wall Street fund managers have slashed their exposure to Brazil’s sovereign debt and the Bovespa. There is no real catalyst for a rally in Brazil unless Temer or a center-right candidate with a credible economic blueprint (Senhor Jair has none). Brazil, which just recovered from its most vicious recession since the Great Depression, can well slip into double digit recession because of the sheer scale of the damage done by the trucker’s strike. It will be a pity if the next leader of Brazil’s 200 million citizens is a populist with no economic agenda or reformist vision.
Petrobras’s New York ADR rose 300% since early 2016, when oil prices bottomed and the impeachment of Dilma Rousseff became certain. However, Petrobras has now fallen more than 40% since its recent highs. While I cannot recommend trying to catch a falling knife when Brazil’s macro, politics and fiscal outlook is so uncertain, Petrobras shares trade 18% below its book value of $12 a share. Petrobras’s 2021 domestic liquids production target of 2.77 million barrels a day is totally unrealistic. For now, I maintain Petrobras ADR as a short, down to a $8 target. I much prefer Banco Itau Unibanco, Brazil’s preeminent commercial and investment bank, which benefits from Temer’s state bank credit reforms.
The Brazil Real, 3.90 as I write despite significant central bank intervention. The resignation of Petrobras CEO Pedro Parente, under pressure from trade unions and striking truck drivers, has amplified the loss of confidence in Brazil’s macroeconomic future. The central bank in Brasilia also failed to restore investor confidence in the Real with its $1.5 billion swap offer. The rise in the Brazil credit default swaps is ominous as it is significant and it means investors are bracing for another sovereign credit downgrade. The central bank will need to engineer far higher interest rates to stabilize the real. The Brazil Real has dropped 15% in 2018, joining the basket case currencies such as the Turkish Lira and the Argentine Peso. The truckers strike has not only paralyzed Brazil’s economy but also increased worries in the capital markets that Michel Temer will be defeated by a populist in October and trigger a fiscal/external debt crisis of confidence. This means the optimal strategy is to stay short the Brazil index fund (EWZ), which can well fall from its current 36 to 30 by October.
