The current Covid situation seems grim from a human aspect. Putting that aside, as much as we don’t want to, the impact of this second wave is likely to be limited. What the markets have learned from all the previous waves, all across the globe is that much of the economic impact is temporary. What happens during a Covid wave is that people lift their savings rate and then they come back and spend that money. Contrary to the popular view during the first lock-down that a lot of the economic activity loss would be permanent. Rather we learn that a lot of this is just a deferral of revenues and profits as far as corporate performance is concerned. We feel that the underlying thesis for the market despite the onset of a second wave will not change much.  As we’ve communicated several times over the past few months, we seem to have entered a new economic cycle & new profit cycle. The formula or the tools used by policy makers to start a new economic cycle is similar to the one used historically. Fiscal & monetary easing, Govt spending & starting a new lending cycle have all been in order. The onset of this new growth focused thinking has resulted in the onset of the structural bull market that will be driven by profit growth over the next 2 to 3 years. The risks to this prognosis, as we have also opined in the recent past, seems to rise of inflation in the US and around the world. Although the underlying theme seems to be bull market, this does not mean that there will not be corrections. As the risks or headwinds to this new economic cycle play out every now and then, there will be market corrections as well.

The risks to this bull market is primarily inflation. If markets around the world believe the federal reserve has fallen behind the curve and inflation has set in then this bull market could come to a halt. When inflation happens in the US or around the world emerging markets are hit the hardest. And if this plays out this time around then our market too will be hit hard. The current minor market correction is precisely for this reason. Consumer prices in the US jumped 4.2% in the 12 months through to April, up from 2.6% in March, marking the biggest increase since September 2008. The report from the US Labour Department comes amid fears that rising consumer prices could push up interest rates. On the back of this report, US stocks slid. Losses seen around the world on Tuesday extended into Wednesday amid investor concerns that higher inflation could lead the US central bank to raise interest rates more quickly than had been expected. This inflation bout has come about due to two reasons: pent up demand and supply bottlenecks. Both these factors seem to be transitional. Supply bottlenecks should go away once the economy and industry open out fully. The money behind the pent up demand will also soon be spent. This money has come from a combination of stimulus packages & lack of spending options & not from higher wages. They key here is whether this bout of inflation transitional, and we feel it could be. If it is transitional then the current drop in stock prices give us a huge investment opportunity. If inflation goes out of control then this US market downturn could impact globally and could be prolonged.

Another very big event we must not lose sight of is the corporate tax rate cuts of September 2019 in India. The govt at that time changed its position on how  it wants to drive economic growth. The way the govt, since September 2019, wants to drive growth is by increasing percentage of corporate profit share of GDP. The govt now wants to transfer profits to the private corporate sector in whichever way it can, be it through tax cuts, production linked incentives or non-fiscal measure such as new labour laws. Their hope is that this boost in profits will lead to a new investment cycle which in turn should create job creation, wages  and overall growth. This seems to be the right way to boost India’s economy. India is a labour surplus country & hence boosting wages and putting money in the hands of people usually creates immense inflation as we’ve learned several times in the past. All the signs we have so far is that the govt will stick to this policy. Even through the second wave it continues to facilitate improvement of corporate profits. All these factors above make our position clear. We prefer to buy cyclical over defensive and we prefer to buy mid & small caps over large caps.

If you have to evaluate long term growth, we have to evaluate the long term investment rate in the economy. The investment rate has gone through a pretty large deceleration. From the levels of nearly 40% of GDP during its peak, we’re down into the 20’s. What matters for estimated potential growth is the investment rate and efficiency of this investment (the incremental capital output ratio). So you have a certain capital that you invest and then there is the efficiency of this investment that will determine what growth is generated. India’s incremental capital output ratio for a long time has been around 4. During our peak investment growth, which was at about 40%, we generated about 10% growth. This however wasn’t sustainable and it won’t be in future as well. Unless it’s backed by a high rate of saving, you run into a current account deficit, which is nothing but saving minus investment. You cannot support this because you’ll dip into your reserve currency. And eventually that rate of investment needs to go down. At a guess, the sustainable investment rate for India is around 30%.

India’s capital efficiency is improving. A more evolved banking system, better infrastructure, GST & wider financial coverage are reasons for it. India’s incremental capital output ratio has dipped to 3.8 and there are signs that it will move towards 3.5. If we generate an investment rate of 30% with an incremental capital output ratio of around 3.5% then we can potentially generate growth that is around 8%. At the moment we are not there. We reckon the potential growth rate is about 6% at the moment. The pressure points are whether we can lift the investment rate and the efficiency rate of this money. So the question of raising investment goes back to the beginning of this note: the shift in policy that happened in September 2019. This is a policy created to boost investment. Good growth is the result of a boost in investment and realisation of healthy efficiency ratio. Our view is that about 3 years from now we could have a growth rate of about 8%. This can be sustained if policy making follows its current path and does not fall behind the curve.