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The general framework we used in the banks is that banks were to some extent lagged indicators of economic realities. When things are going good, banks have a long tailwind of good growth. When things go bad, they impacts the banks with a delay and they have a long headwind of that impact as well. We saw it in the last NPA cycle, when despite the economy recovering well, many banks continued to struggle with delinquencies and bad loans. Just now we have gotten through that big cycle. In that sense, we should recognise that problems that come up in the economic system will show up with a lag in the banking system.
Second is, yes the current situation will put undue pressure on both SMEs, MSMEs and retail loans, and wherever there has been an impact on businesses and impact on the earnings of those borrowers, we would see stress developing in the bank books, whether you are a retail bank or microfinance bank or MSME bank or even big corporate bank. We might see some incidence of stress and, therefore, one need to be careful in taking exposure to banks.
We do have reasonably meaningful exposure to private sector banks, but even among private sector banks, there are multiple incidences of stress, multiple incidences of the pain in the recent past, which then got transmitted, leading to meaningful erosion in equity values. So when there is a big economic headwind, whether it is a public bank or a private bank, there will be consequences and we are aware of it.
While some of these banks are extremely well managed or well capitalised, and have very good risk systems and extremely competent people managing them, from a bottom-up basis, we remain confident of many of these investments. We also recognise that they will have to traverse to these turbulent times and come out on the other side.
Historically, it is seen that when the market cycle changes, market leadership also changes. When the TMT bubble got pricked, infrastructure stocks made a comeback. When infrastructure stocks got a hit, consumer stocks made a comeback. Where do you think this change in market disruption will lead us? Do you think good old private banks and consumer names will still dominate market share or the market will now migrate to let us say pharma, PSUs, high-dividend yielding stocks? What is your sense?
A good thumb rule to start with is which sectors are going to get least impacted during this down cycle or sluggish economic period. Clearly, staples which are required for day-to-day consumption will get relatively less impacted, though some of these stocks are richly valued, some have meaningfully corrected as well. So one can be constructive towards that. There are also sectors which are extremely important at this juncture, and they do not require leverage and people to borrow money to spend. These are definitely healthcare companies. And even telecom, I would add to that. These are essentials in some sense, and one need not have to borrow to consume these products and, therefore, I would say there are enough ideas to pick up from healthcare and telecom, even to some extent IT, though classic defensives are the ones which would remain defensive in my own understanding. That is one way to approach the market.
The other way is, what are the things that are likely to come back when things normalise. Even within the discretionary consumption space, is it going to be retail stocks or it is going to be auto or is it going to be cement? So there, our pecking order would be that the ones which involve less borrowing and, therefore, easy to normalise or the ones which will recover in terms of discretionary spending. Some of the retail names which involve no high-ticket purchases would tend to recover fast. Automobiles will be the next, especially lower-valued two wheelers and, maybe, small cars. And then probably homes and construction and cement. So they are going to be little back-ended, because this would involve fresh outlays. To the extent that people are going to complete their existing constructions, there is going to be demand coming back.
I would rather wait and watch for demand factors to improve at that juncture. So, these are the two kinds of framework I will use at this juncture. I will not try to call out what are the big leaders that are going to be in the next cycle. The last cycle we had financials, we had some bit of new-age tech. It is not very clear at this juncture what is going to lead the rally. I would like to look for a framework that involves first ones, which are less impacted, and second is what will come back at the earliest point of time.
A word on the government action. Some would argue that all other governments globally have done huge stimulus, we have not heard anything which could be called as disproportionately high from the Indian government so far. First they have done what is the need of the hour, which is to transfer money via the direct benefit transfer route to the poorest of the poor. The Reserve Bank of India on the expected lines has cut rates and given a moratorium. But we have not got what could be called as a big-bang package for industry or the affected sectors. Are markets disappointed on that front, because nothing has come out so far?
You are right. The government has done a fairly good job of providing some safety net to the poor in terms of income support or provision of food and ration. So there has been some kind of protection for the poor. That is where a significant efforts of the government have gone in the initial weeks of the Covid breakout. Some of the measures RBI and the government announced are more to kind of protect or avoid the tail event of the big negative breaking out. These are not necessarily aggregate demand-boosting measures or employment-generating measures. We are yet to see a meaningful effort from the government on growth stimulation and employment generation activities. We may see that post the lockdown period or towards the later part of the lockdown period. The market is expecting something on that. It does require government stimulus to come out of the growth shock.
We have entered that growth air pocket and we are going to have trouble to come out on our own without a stimulus package. Stimulus can be in multiple sectors; it can be in automobile sector through a scrappage policy, it can be for housing sector, through higher tax benefits; and it can be to any other sector through some kind of income-tax rate cuts. The government has got a lot of powerful tools to stimulate the economy and we have to acknowledge that. Hopefully, they will come up with a slew of such measures to get the economy back in shape. But as things stand today, we have not yet seen anything of that magnitude.
The medical crisis will get over sooner or later. But after that, where do you think so much of liquidity will move, with zero per cent interest rates now in the US and with everybody hungry and desperate for growth, where will flows move now?
Globally, interest rates have taken a nosedive clearly, and people are benefitting out of the fall in rates. But domestically we have seen a massive stickiness of rates. Borrowers continue to borrow at high interest rates despite extremely low inflation and low growth. I think we are running super high real rates and that needs to moderate. If globally liquidity can be harnessed and we may take some bit of policy measures to ensure that borrowing costs come down, of course, it will put some pressure on the savers, but at this juncture, it is the cost of borrowing which is significantly high and disconnected with the economic reality. It will provide the much-needed cushion for any kind of economic stress. I think that is where the liquidity should be focussed at.
If it goes to market without really leading to drop in the cost of capital, then we will look at another bubble kind of situation, which we should avoid. So the policy measures should be directed towards harnessing the global liquidity as well as domestic liquidity to bring down the cost of borrowing meaningfully.
Ultimately for equity investors there are two or three variable factors which we need to look at: entry point which is valuation, projected earnings, underlying cost of inflation and cost of borrowing. So if you have to connect everything and weave a thread based on the current entry point, inflation, cost of borrowing, what do you think equity as an asset class for the next two to three years proposes? Because equity is always a function of cost of borrowing, and cost of borrowing is slow. I do not know how can one calculate the terminal rates now?
Yes, that may be a mathematical problem. For a second, I would keep it outside this framework that you are suggesting. Are we at the right cost of capital commensurate with our current growth and inflation? To my understanding, that is a clear No. We still have a way to go there meaningfully. Having said that, are these the right valuations for us to say that the entry points are fantastic? I would not be able to say it with high conviction that we are at the bottom or a trough valuations per se. But we are getting there, and that is why I would not like to be fussy too much about where the bottom lies. So, maybe you will get one out of the three-four variables in the equation correct. A lot depends on the time period of normalisation.
While entry points may be right, how long it takes for us to normalise will also determine what is your holding period return. If we normalise quickly, you will make a high holding period return. If we normalise gradually, you will make more moderate holding period returns. So, the mental model that we are all running unfortunately differs from one person to another. That is the beauty of the markets. That would determine what is the expected return.
My own guess is that even if growth comes back to the pre-Covid rates and even if valuations do not get back to that kind of levels, and there is earnings recovery beyond fiscal 2021, we would see returns that may beat fixed income returns comfortably. And that may be a good starting point for making incremental decisions. Of course, we have to recognise that people have suffered meaningful losses by investing in equities over the last few years, and therefore, it will be insensitive to say that people have to keep pumping money irrespective of whether they made money or not. But if you have to do some kind of a zero budgeting and look from here onwards, I would say we are on a reasonably good wicket, except that we may need to probably wait it out a little long.
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