What the Fed is happening?

01st May 2022

Dear Fellow Investors,

Hope everyone is keeping healthy and cheerful.

As per a report printed by the Economic Times, the following facts were observed –

In the past 10 years, 543 new stocks got listed, out of which 62.2% of the companies stopped trading. 3% of the companies dropped more than 80%. 6 stocks turned into penny stocks (below Rs 10) while 4% of stocks dropped 50–80%. 15% are still trading below the issue price.

The good part is out of the 543 new listings, 6% have risen 10–50%, 5% have grown 50–100% and 6% have outperformed by growing 1x-3x. 15 stocks are more than 300% up.

To find such multi-baggers and outperformers in the markets, one not only needs to study the good companies but rather avoid the bad companies.

“If we avoid the bad decisions, our good decisions will automatically take care of the returns.”

As we see markets currently, it has been filled with volatility. Be it interest rates, the Russia-Ukraine war, the changing export-import policies, rising labour shortage, inflation et cetera.

Despite all of it, almost all major global equity indices are higher than where they were just before the Russian intrusion in March.

Going forward, the broader market might remain range-bound and internal sectoral themes playing out giving fruitful returns.

With corporate results being announced, many companies and sectors have come out with better than expected results. We see the trend of good economic and market growth going forward.

Hopefully, a reduction in the intense clash in the Russia/Ukraine region will also lead to softening of other commodities and allay the fear of inflation meaningfully.

The demand scenario continues to be very strong, as the country opens up to normalcy after two years of Covid related lockdowns.

Indian rural economy should witness strong growth over the year as the Agri produce and prices have been good. Boast by the rural economy is one of the key factors playing a decisive role in consumer demand and mass consumption across all sectors.

The above pictorial representation of data relates to the calendar year and not the financial year. However, it can be inferred that no one theme keeps on reaping the maximum benefits and shifts keep on happening.

Currently, also we think that the markets are in a similar situation and portfolio rebalancing is important.

(Refer to previous letters for our insights on the sectors.)

One example we would like to share with everyone is that of sudden falls in share prices. Though in Indian markets, a single day downfall could still be limited. In US markets it can be disastrous, like what recently happened with Netflix falling 39% in a single day.

We don’t have any opinion on the share, just for the topic, we would like to take it up here. A 39% fall will take 64% gains to reach the previous levels.

But here is where things break down between buying an individual company that has declined a lot and buying an index that has declined a lot — there is no guarantee that the individual company will ever recover. Netflix may never get back to its old highs, slowly declining into the graveyard of market history.

However, with an index fund like the Nifty 50, this is unlikely to occur. Though there are exceptions to this rule (i.e. Japan since 1989, Greece since 2008, etc.), the probability of the Nifty 50 never recovering from a crash is quite low.

Why? Because, unlike an individual company, the Nifty 50 is always changing. The companies that represented the Nifty on 21st April 1997 are very different from companies today. Though the line has gone up and to the right, what that line represents has changed dramatically over the decades.

With the economic and technological development over time, new companies have been brought into the index and old companies have been kicked out.

More importantly, this rate of change might be accelerating. the average longevity of a company in the Nifty 50 index has been on a gradual decline over the past few decades.

What makes this situation even better is that we are likely to beat 70–80% of other active investors simply by buying and holding this list of companies! It’s the biggest free lunch in investing and there is no close second.

One exciting news for us has been that the two richest Indians’ are in the top ten riches of the world — carrying a net worth of Rs. 17 Lakh crores.

Thinking in terms of numbers, just 22 years ago, Rs 17 Lakh crores was also India’s GDP. That was quick!

No doubt India seems to be having all the potential for multi-decadal growth and one ought to participate with the nation.

Finally coming down to the one question today in the world of financial media. What do Fed rate hike, balance sheet run-off and yield curve inversion mean for markets?

“Interest rates are to asset prices like gravity is to the apple. They power everything in the economic universe.”

The US Federal Reserve raised the Fed funds rates by 25bps in March 2022. The Fed governors are indicating bigger hikes (50 bps) and that too many times over. So why is the Federal Reserve of the US raising rates?

1. The world economy is moving out of COVID led disruption, directing less need for quantitative easing and liquidity currently.

2. Ultra-low interest rates promote aggressive lending and borrowing which allows the economy to recover quickly — that’s no longer needed.

3. The world is currently flush with funds. Depository reserves are almost twice of the pre-covid era.

4. Another part is “taming inflation”.

Although most of the inflationary pressure pass-through has been because of record-high commodity prices, there is another component. The massive dose of fiscal stimulus, tight labour market and high demand for goods has pushed inflation.

There is nothing unusual with the demand revival playing out currently, most post-recession/disruption periods see a surge in inflation readings due to supply-side issues (doubled with logistics issues) and return of demand.

Fiscal stimulus and slow monetary policy normalization have elongated the inflation trajectory, but fiscal stimulus ain’t the sole reason for inflation being high currently.

With deep “negative-real interest rates”, a few rate hikes won’t deter the current growth trajectory. We believe money will gravitate to stuff that can’t be printed (Real-assets).

Secondly, consider balance sheet run-off, as the buzz says “Tapering”. Tapering is nothing but reducing the total assets on the balance sheet.

After 2020, Fed increased its books by printing money and increasing its debt market, now the quantitative tightening is just going to reverse this as the treasury pays off its government-backed securities and won’t counterbalance — reducing the money in circulation.

What’s the impact of the higher rates and QT on markets?

When both these aspects reverse, along with no additional fiscal stimulus it will cause an eco-slowdown as per history books, but certainly today the outlook can be expanded to look further.

Neither the interest rates nor the tapering process has been large enough to counterbalance the post-covid recovery.

There will be a squeeze in valuation multiples, like Price to earning, for stocks. These act like gravity for apples but keep the snowball rolling wealth creation.

Lastly, yield curve inversion. Today, a 2-year yield bond is higher than a 10-year yield bond. This inversion indicates that the bond market anticipates slower growth and lower inflation ahead.

Inverting isn’t always healthy for the economy and might be an early signal of increasing uncertainty.

An interesting study of how stocks perform when the yield curve inverts, which is a market indicator that often occurs before a recession. The problem with using yield curve inversions as a sell signal for stocks is that the indicator does not always work.

For example, the yield curve inverted in August 2019, but stocks are up 68% since then. The best approach could be to ignore the yield curve as an indicator altogether.

However, we must accept that the yield curve inversion, if it remains for 90 days, signals that the party is probably close to ending. If US markets go into a significant decline, equity markets globally will struggle, at least initially, till differentiation sets in and the fundamentals prevail again.

In conclusion, we think the US and world economy face headwinds and the most vulnerable will be the sector commanding high valuations.

Silver lining: Global growth cycle is not synchronous. Countries like India, China and some other emerging markets are witnessing a growth recovery and strength.

While we are entering a dangerous phase for the US economy and markets, there may be a phase of sector rotation and higher markets ahead. Growth stocks could weaken and investors may move into value. That is possible.

Happy Investing!!

Leaving everyone with a thought –

“There are two times in a man’s life when he should not speculate: when he can’t afford it, and when he can.” — Mark Twain

With Respect,

Chandranshu & Priyaanshu

+91–9953726305 & +91–8800967088

cachandranshu@outlook.com priyaanshu@live.com

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I am chartered accountant by profession and investor into Indian Equities for my living. Love to read on a wide variety of topics.

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Priyaanshu Agrawal

Priyaanshu Agrawal

I am chartered accountant by profession and investor into Indian Equities for my living. Love to read on a wide variety of topics.

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