China's Economic Stimulus Creates Mixed Impact Across Global Sectors

Abhay Agarwal: First of all, my views on the Chinese market reflating are not based on any special love for China, or from the fact that Indian flows will drop significantly if China reflates. I think as investors, we are always looking globally and thereby in India, of mispriced opportunities that can consume a large amount of capital, because that's where the large institutional investors focus on. Now, China has been a start and stop market for many years now. In fact, if you go back from ‘93 I was seeing the data sometime back, and it's difficult to believe that there's a negative return.

If you look at from ‘93 to where China is right now, where Indian markets have gone up 13 times over the same time. But you know, that's a long period to consider. If you look at it from a short-term basis, you know, the Chinese economy has seen a very sharp cyclical slowdown, especially post Covid. I think if any economy got hit by Covid, it was the Chinese economy, and their internal consumption fell off the cliff, and we saw that in Real Estate, in Auto's general slowdown. As a result, what happened was that the large Chinese manufacturers, who are biggest suppliers of commodities, like nonferrous metals, chemicals, agro chemicals, electronic items, semiconductors, rare earth minerals, for EV batteries, they all were forced to dump in the market, in the global markets, and that had impact on pricing, severe pricing damage across the board.

Now, as the Chinese government now has decided, clearly, they have made that intent very clear, and more announcements are expected. What will happen is that the Chinese economy, with that support, will start deflating, which means that, you know, consumption will come back, because the government is now hell bent on putting money in the hands of consumers, making credit easily available for house buyers, auto buyers, anybody that wants to take credit to consume anything. So I think that is where China is headed. Is a very large economy, and I think when it starts consuming, there will be impacts of, you know, multiple multitudes in the global market, especially commodity consumers like India.

One is that there could potentially be a rise in commodity prices, especially nonferrous metals and chemicals and agro chemicals which will be good for Indian producers, but Indian consumers like auto, capital goods and infrastructure companies may suffer because, frankly, post Covid, we have had a very stable input price regime. We haven't seen any price hikes in commodities, especially oil. So that is one risk I see for the Indian manufacturers, who are consumers of these things but at the same time, exporters and players in this space that had no pricing power will benefit.

So, I expect benefits for companies like Hindalco, Tata Steel, JSW Steel, Vedanta. These are not my recommendations, but since we are discussing the impact of Chinese deflation. So, I think that is the outcome. So again, another data point. Four years ago, we saw India's weightage in MSCI Emerging Market Index was 8%, China was 46%. We thought it was a massive discrepancy, and that got filled up as Indian market went up and now there was a point recently when Indian markets weightage in MSCI Emerging market was higher by a point than Chinese market.

Clearly that was an over shooting, you know, of that weightage. But now I think it will go back to the mean. India will probably go back to around 20% China will go back to about 35% so you will see flows coming back into China. So that's the view on China. But I don't believe that the Indian market will suffer because Chinese markets will go up. I think there is plenty of capital that is ready to go into both emerging markets. 

Abhay Agarwal: Indian market at its current market cap level of around $4 trillion is a decadal opportunity. We all believe in that, you know, firmly believe that this four will become six, six will become eight, eight will become 12, you know, over the next five, eight to 10 years, so there will be pockets of opportunities for new leadership to emerge. At the same time, valuations have always been high and have been holding back serious flows into the Indian market.

What we are going to struggle with, clearly, in the short term, again, you know, it's a six-month to one-year perspective that there will be a cyclical slowdown, which is already evident in consumer-led consumption, and the reasons for that are that there is been a price inflation in consumable items that I think the inflation data is not really catching. So what we are seeing is a higher spike in food prices, in other consumable items.

Secondly, credit availability is not as easy and cheap as it was one year ago, and RBI has been tightening the norms, making credit flow more difficult to the unsecured retail buyers, because they do not want to create a credit bubble, and rightly so. The impact of that is that there is a cyclical downturn. We're seeing that, you know, we've seen that in the recent festive sales, auto inventories are at all-time high, you are seeing real estate prices being, you know, cut a little bit to get demand going. Imply paint consumable items. You know, we've seen the demand slowdown. Now, this is not a structural shift. I think it's very good that we have a bit of a soft landing like this, so that we form a solid base to take off from there.

So my expectations from the broad index for the next six to 12 months are muted, but at the same time, I think astute stock picking is where money will be made. It has always been made in India by backing sectors, backing teams, backing companies, slightly ahead of time, even if they are on a high growth curve and look expensive. But if you go back, you know we played, for instance, the whole PLI theme where Dixon has come out.

Again, these are not buying recommendations, but as an example, you know, Dixon has come out and created almost a Rs 1 lakh crore market cap from, you know, Rs 10,000 crore four, five years ago. So, I think it has always been an expensive stock. So similar to that, there will always be themes that will be available to investors who are willing to bet on a contrary basis and make money off that. But from an index level, I think where the valuations are and where the cyclical slowdown is, it may be difficult to make money over the next 12 months.  

Abhay Agarwal: I think one space that is a very heavy weightage in the index, and therefore, gets a lot of flows, but we believe, is going to be challenged for growth and margins both, you know, is the entire lending space through large banks, small banks, PSU banks, NBFCs, both for corporate and retail. I think we have seen three things happen there.

One is that RBI is increasing risk weightages for unsecured lending, and even for secured lending, they have increased risk weightages. So RBI is very cautious that they don't want an asset bubble to build up. Secondly, the cost of money hasn't come down, it has actually gone up. We saw EMIs for cars at about 7.5% the same time last year, it's about 8.7% now... So there is a demand slowdown, you know and credit card expenses, credit card spends is where banks are reigning in.

The corporate credit also has not picked up as banks would like it to, because the private capex is pretty slow right now. So I think if you look at these and there is a deterioration clearly in the entire microfinance book, we have seen collection efficiency fall from 98% to 96% and then 94% and then 92% and it will probably be below 90% in this earnings as we get into.

So, I think there are issues with the whole lending space right now. People should tone down their expectations of double-digit growth from banks, and also, they will see margin compression, because cost-to-income ratios are consistently going up. Deposits are not as easily available as they were. So the entire banking and financial services spaces, where we are quite underweight, and we expect that, you know, it will probably flatline. Again, a great long term space, but something that investors should be cautious of. The second is I.T. services. I think that is something that we have kept for later, so we can discuss that at that time.

Abhay Agarwal: No, I would actually not argue against that, because I think these are both good points and valuation has been if you look at an historical perspective. You know, lower than that, and there is expectation of demand pickup. But I think both these valuations can still go down, you know, further from here, and you still see banks trade at two and a half times book value. You are still seeing credit demand going down, and the opportunities for global investors are plenty.

You can buy a JP Morgan, you know, a Citibank at close to one time book value, one- and half-times book value. These are global leaders. Again, the Chinese banks nobody wants to test them trading at point two, five times book value, still growing. So for global investors, there are other opportunities. Indian valuations have adjusted, but still not in that, you know, absolutely attractive zone that you close your eyes and say, yes, this is what you want to buy.

There is quality, but the growth is tapering, so I don't think the valuations, even now, at the current level of growth, justify themselves. I think there is room for valuations to adjust down and at the same time, when the credit demand book picks up, when the banks go back to 20% kind of, you know, book growth level, there will be plenty of time for investors in between to, you know, add these stocks to their portfolio.

Abhay Agarwal: There are emerging sectors. So, I break it up into two parts, one is within the emerging sectors, where we are seeing opportunities. I think there are spaces like semiconductors. I think semiconductors will be a giant size theme in India. Unfortunately, there are very few companies playing them right now, but if you just Google, you'll find companies like K and CG power trying to set up, you know, their OSAC manufacturing facilities.

There are companies we're seeing that are getting into chip design space with government support for the first time. So, I think the semiconductor space will be a big space. The second space we are looking at with a lot of interest right now, and there are already three listed opportunities. Is the whole CDMO, or contract manufacturing for Indian domestic market. You know, right now, what has happened is that there has been a lot of focus on companies like Divi’s, rightly so, leaders in international CDMO with some global customers. But there is a big, big opportunity in the domestic CDMO business.... There have been announcements and discussion papers put out from the government that clearly says that the government, for the first time, wants to support large scale manufacturing, and with good manufacturing practices, they don't really want these small plants, and, you know, to be present at the Indian domestic pharma market growth.

So, I think there are opportunities in that space. So, these are all the new emerging spaces, and in the traditional spaces. I think the Pharma rally has been quite, you know, astounding. People have missed it, largely because nobody believed that the pharma companies would get re-rated. But now we believe that there is still five years of clear runway ahead for the large cap Indian pharma companies like Divi’s and Dr Reddy's, because of the work that they have done over the last five years in cleaning up their operating practices and building a very strong pipeline of launches in the U.S. market. So I think the Pharma space is looking very attractive despite the recent runup.

Insurance is a space that we are very, very bullish on healthcare, health insurance, life insurance, non-life insurance. I think these are the three spaces, which will continue to do well for the next five to 10 years. The third space that we are kind of contra-bullish on, and it's not a popular theme, will probably not be a theme for some time. It's a non-ferrous Metal space because I think these companies like Hindalco and Vedanta and Nalco, the entire basket, if you look at it, have really become very efficient miners over the last five years when the commodity prices were depressed.

I think as the prices go up, there will be a phenomenal operating and financial leverage that these companies will benefit from, because they have a very, very low debt balance sheet right now, at least most of them. So I think as the commodity prices grow up, you will see a re-rating both in multiple valuation and also in terms of earnings growth. So I think these are the three or four spaces that we are seeing opportunities. 

Abhay Agarwal: Well, semiconductor I think, as I said, very few companies right now, but that opportunity space will increase. So, as I said, CG Power has already announced its plans to set up a facility. Then there is Keynes that has started talking about it. I think some of the other companies, we're seeing a lot of action in the startup space, by the side, by the way, because when we invest through our startup fund, we are seeing companies that are benefiting from government support and the whole Shakti Architecture, designed by the IIT Madras team that is available for Indian companies for free to design their own semiconductors — ASICs, you know, for single design and also now getting into FPGA and other spaces.

So, I think in the listed space, I would say there are few opportunities, but these opportunities will grow because companies will identify that. So, investors should keep an eye out for this opportunity.

Abhay Agarwal: I think where we are, I don't see a risk of earnings growth reduction in these spaces and the reason for that is that India will be a very vibrant capital market for next decade. The leadership positions across the board have already been created in this capital market, infrastructure company that we can call them. So, exchanges, there are only two, BSE, NSE, and Commodity Exchange, it's only MCX. If you look at depositories, it's only CDSL and NSDL. If you look at registrars from the CAMS and KFintech. In brokerages, if you see discount brokerages, it is Angel One which is listed. There is no other listed company of the same size and scale there.

So once the industries are in the high-growth space, high-growth zone, and leadership positions are already consolidated to a level that it is very difficult for new entrants to come in, and some of these businesses, I think the outcome is that valuation multiples will also stay high in line with the earnings growth. So, I think, for the next couple of years, as the capital markets improve, there will be new listings. The market cap goes from $4 trillion to $6 trillion. These companies will continue to make money. You know, in some quarters, you may see results not as good, but I think the only risk for investors here is overpaying for some of these companies, but the risk that earnings growth will slow down is not there. So, the only thing you have to worry about is, look, am I getting too late into this play? If I come in with this valuation, how much return will I make over a five-year view perspective? That's the only risk I see. Other than that, I don't see a risk of earning downturn in any of these companies.

Abhay Agarwal: We have been tracking this and talking about this for almost a year now, and I don't think anything has changed. I think the Indian companies are still too dependent on the US markets. Even if the US market comes back. I don't think the pricing model that worked earlier, which was a fixed cost pricing that worked in the favour of services model that Indian companies have created, which is largely time and material based, I think that whole model is now passe, you know, it's not something that the customers are used to anymore, because they want to pay a fixed price for projects. So, the problem for Indian IT companies are not just a slowdown in the US market. It's also, how do they reorient their business model to go from time and material pricing to fixed cost pricing and then compete with, you know, startups in the U.S. companies like Snowflake and all which are scaled up doing, you know, product-based pricing.

So, I think the challenges for Indian companies are far and many that they have to deal with, both in the short term and in the medium term. So, I wouldn't believe that just if the US market demand also comes back, the Indian companies will suddenly see a double-digit growth. You know, you look at even the current guidance is like, you know, anemic, 1%, 2%, 3%, 3.5% growth in top line.

I mean, I don't find that attractive at all as an equity investor, you know, why would I invest in a company that is generating cash flow but growing at 3% or 4% in the best case, you know, I think for investors, there are much better opportunities than you know that in the large cap IT,  at the same time in the small cap IT services companies I am seeing some very good innovative products and any innovative approach coming up I think those companies will probably do better than the large cap IT service companies.