Pain and gain

19 April 2020

After the sudden wealth destruction, lifting of the lockdown can boost stock valuations indiscriminately due to demand spike

The covid-19 pandemic pummeled markets worldwide in the second half of March. A decline for consecutive days as infection cases and toll numbers mounted would be punctuated with a short-lived smart recovery, reacting to fiscal and monetary injections. The immediate lesson from the severest wealth destruction in decades that has dwarfed similar eruptions including the 2000 tech bubble burst and the 2008 financial crisis is that investors have to be prepared for unforeseen disruptions and not get fixated on the seven-year bull-and-bear cycles. Black Swan events have the nasty habit of recurring instead of visiting once in a while. Sometimes it might have Chinese characteristics. Other times it might be the implosion of reckless risk-taking and lax supervision. If spread of misery does not seem to have any boundaries, pockets of prosperity, in contrast, tend to remain confined. Even as the US economy was booming, China was slowing due to trade tariff tensions and India due to stress in the financial services sector. On the other hand, no nation remained immune from the credit crunch over 11 years ago. The second learning, therefore, is the US continues to exert influence over other countries but at the same time is not dependent on any other nation’s well being for its health. The gains from the inflow of its capital are outweighed by inflation and asset bubbles in emerging economies.

The third outcome is that the markets are not amenable to reason during extreme bouts of pessimism and optimism. US equity indices were scaling new highs when unemployment was negligible and plumbed to record depths as jobless claims started climbing up from three million. These were expected to cross 10 million by the first week of April. A tight job market implies higher cost to retain and recruit employees for managing growth. Interest rates are ramped up to discourage indiscriminate borrowing and ensure funds find their way into productive projects. The impact is felt on the margins. Earnings growth slows down. Valuations should cool as any further expansion has to be through volumes and not by price hikes. Yet, such logic did not prevent the Dow Jones Industrial Average from scaling new highs. Similarly, if the market is forward looking, US stocks should begin recouping their losses as a growing pool of talent will be available for hiring at bargain salaries. In India, the Nifty came off its lifetime milestone in January 2020 because of revision in the application of dividend tax. Instead of 20% levy on the distributable net profit, the payout will be treated as income in the hands of the recipients. The globally accepted practice caused such a heartburn that the benchmarks never recovered from their glory despite economic indicators such as manufacturing index and goods and services tax collections pointed to a recovery in the offing.

India’s emphasis on making available more money at an affordable price to businesses and distributing cash and food to the weaker sections adds up to just 3.2% of the GDP as against UK’s 14%, Germany 20% and US 10%. The conservative number should provide comfort that the liquidity is focused and will not stretch government’s finances to stall investments in thrust areas. The central bank will have room to keep interest rates benign. If a few nations prefer to be outliers even while conforming to the general trend of loose money policy during an emergency is the third observation, the fourth conclusion is that the past does not always provide a roadmap. Isolating citizens and cutting off trade and travel are unique responses to a crisis that too is novel. Governments by and large preferred to have a healthy population over a buoyant economy. Eventually, the quarantine, ranging from 14 days to 40 days, will begin to produce results. The growth in new patients will slow, flatten and decline. Determining when and how to lift the lockdown will be a crucial piece in the strategy to come on tops of the crisis. A calibrated drawdown holds the key for the release of pent-up demand without overwhelming the infrastructure. Governments and companies establishing control over the comeback process will emerge winners. As India is not a homogeneous market, the path to recovery will be uneven for most companies. Many side players will spurt on a sudden spike in demand, flatten and eventually give up the gains as the situation normalizes. Several counters’ struggle to come back on track will be prolonged as they might have been in the forefront of absorbing the impact of the upheaval. Many others will prove to be duds due to the irreversible change in the way goods and services are consumed hereafter.

-Mohan Sule