“SKEPTICISM AND PESSIMISM AREN’T SYNONYMOUS. SKEPTICISM CALLS FOR PESSIMISM WHEN OPTIMISM IS EXCESSIVE. BUT IT ALSO CALLS FOR OPTIMISM WHEN PESSIMISM IS EXCESSIVE.” HOWARD MARKS, IN HIS NEWSLETTER ‘THE LIMITS OF NEGATIVISM”

“I’ve been in China for 27 years, and this is probably the lowest confidence I’ve ever seen,” said a senior China strategist commenting on Chinese equities on 24 Jan 2024 on CNBC. Incidentally, China H Shares (China stocks listed in HK) made its low of the current cycle on 22 Jan 2024, and rallied more than 30% since then, making it the best-performing frontline global index over the last 3 months! H Shares were valued at 8x TTM P/E and 0.8x P/B at the lows. The China Revival: With many false starts to China’s recovery, the fair question is whether this is real. China reported a manufacturing PMI of 51.4 in Apr’24, the highest since Feb 2023, indicating expansion. Global investors pumped in ~$40bn over Feb and Mar 2024, reversing the $44bn outflows in January. A continued asset allocation shift from the most expensive emerging market to the most unloved emerging market is a risk. With 18% ownership of Indian equities, FPIs still play a meaningful role in funds flow. A positive rub-off of China’s revival is improving the outlook for resources and metals– the BSE metal index rallied 10% in April to new all-time highs.

                  Chart 1: China’s rising Manufacturing ISM                                   Chart 2: China’s gradual IIP growth                                                         

 

                       Chart 3: China vehicle sales recovering                                       Chart 4: China’s rising steel production                                                       

 

The American confusion: Is the US economy too hot or is it slowing down? The market dumped the rate cut expectations for this year after the strong manufacturing PMI and the CPI print. However, there are signs of cracks appearing in the labour market. After a strong print of 315k in March, the non-farm payroll missed the 240k estimate in April to land at 175k, and the internals are even weaker. Most of the hiring is from non-cyclical sectors like healthcare. Also, personal consumption slowed down to 2.5% in Q1CY24 vs. 3.3% in Q4CY23. Confusion on the outlook is worse than the clarity on weakness for discretionary spends as reflected in earnings reports and guidance of most Indian IT services companies. Hopes of a strong rebound in Indian IT services, for now, is deferred.

 

Chart 5: US GDP weaker than expected….                                       Chart 6: Personal Consumption: Goods vs. Services     

 

 

The vigilant regulator: The Indian market and the banking regulator are watching for signs of irrational exuberance with a hawk’s eye. RBI has initiated a series of decisive actions against banks and NBFCs to curb excesses and ensure full regulatory compliance. Mid-cap and small-cap stocks collapsed in March after SEBI asked mutual funds to release liquidity health checks, but bounced back violently in April (small-cap index up 11%). Nonetheless, while prevention is better than cure, these moves also present a near-term risk to the markets.

 

Chart 7: RBI’s actions on Banks/NBFCs

 

The Need for Speed: Ambit 365 has been nimble, and we are ensuring the nimbleness by keeping the individual stock weights in the 2-4% range and taking profits off the table quickly – faster than usual. Even FPIs and MFs have realized the need for speed as reflected in institutional daily turnover doubling in the last few months compared to their 2023 average run rate. In April, Ambit 365 made 2.5% (pre-fees and pre-tax), taking YTD returns to 7.6% and returns since inception (6 Oct 2023) to 11.8%. 40% of the long book returns were from metals and resources (Vedanta, NMDC and Hindalco). PSU banks also contributed handsomely (SBI and BOB). IT Services shorts were top contributors to the short book (LTI, Mphasis and Infosys).

TALE OF TWO GLOBAL SECTORS– METALS AND IT SERVICES

Metals: Creating Value

Improving manufacturing PMI in the 2 largest economies in the world is positive for metals demand. CRU estimates China steel demand to rise 9% YoY, outpacing supply at +3.9% YoY in Q1CY24E. India’s steel demand is rising at 12-13% CAGR; the Indian steel industry’s capacity utilization inched up to 91% in FY24. Copper has been on a tear (up 20% in 6 months) on rising demand from EV/data centers/RE, and is in a supply deficit in 2024. Aluminum benefits from substitution effect (and due to sanctions on Russia).

In a huge deviation from past behavior, Indian metals companies have become more disciplined in capital allocation and expansion. While Indian steel companies are expanding capacity, most of the expansion is gradual and brownfield. As a result, ROCE is estimated to rise over the next 5 years, which will drive valuations to higher bands as compared to history.

 

Chart 8: Indian steel companies– incremental RoCE trajectory expected

IT SERVICES: RECOVERY PUSHED BACK

Accenture’s revenue guidance cut from 2-5% for the full year to 1-3% in March set the bearish tone for the IT companies. Most Indian IT companies in their results commentary warned of weak demand and macro uncertainty, leading to a reset for FY25 growth and margin expectations to a lower level. Analysts were expecting growth to revive strongly this year.

 

Chart 9: Nifty IT saw highest earnings cut in the last decade

 

WE SEE RISKS

The Sine Curve sees the list of risks getting longer. If the Chinese revival continues, valuation-wary asset allocators will move to China at the expense of India. Regulatory action in India, especially on BFSI, has become more frequent, offsetting better-than-expected margins and hence earnings performance for the March quarter. On the day we wrote this newsletter, PSU banks and PSU NBFCs tumbled 4-10% triggered by an RBI discussion paper on increasing the provision cover on standard assets for project finance loans. Reaction to news and earnings reports has become violent with even high-quality mega caps moving close to 10% on slight earnings beat or miss. Such heightened activity typically indicates a lack of confidence and usually precedes meaningful corrections. Hyperactivity is reflected in daily traded turnover on Indian exchanges. Recent average daily turnover is Rs1.3trn/day, 30% higher than January volumes! Ambit 365 will manage the rising list of risks by keeping the per-stock weight towards the low end, regularly booking gains, and following tighter stop triggers. If the Sine Curve’s reading is right, that we are close to a meaningful market correction, an index hedge will also work nicely. The time to make the index work for the fund may be around the corner.