(Mar 13): The Tantallon India Fund closed down 2.85% in February with markets skewered by pandemic and recession fears. The extreme volatility in the last two weeks are a stark reminder of the speed and intensity of global market corrections when sheer panic drives algorithmic and high-frequency trading strategies.
With US 10-year treasury yields at sub-1%, and crucially, given the sharp decline in the policy-sensitive two-year note, expectations would seem to have shifted squarely towards more global monetary easing.
The coronavirus has forced us to confront the likelihood of potentially severe economic dislocations and the risk of higher realised volatility across risk assets as politicians muddle through myriad healthcare and fiscal “fixes”.
However, we should not underestimate the resolve of central bankers working in concert to try and prevent a demand shock that would almost inevitably follow any sharp contraction in liquidity.
We can expect global central banks to do “more” to try and stabilise markets, to buffer supply-side economic shocks, and to shore up consumer confidence.
That said, lower interest rates and easing of liquidity conditions are not going to fix “broken” supply chains across North Asia and industrial Europe and North America. Over the next two to three quarters, we should expect negative operating leverage to play out in the full glare of dismal year-on-year comparisons. Corporate earnings “shocks” should also be expected.
Given the recent frenzy for duration and haven assets, we are surprised by how well-behaved credit markets have been in the face of substantially higher equity market volatility. Further bouts of “unwinding” of credit and equity risk should be expected given that an extended period of low volatility and stable credit spreads, and lower-than-historical-average default rates, have probably bred complacency.
Gaining of risk mitigation strategies
On a more positive note, India will be a substantial beneficiary of global supply chain risk mitigation strategies relocating manufacturing capacity away from China due to persistent trade war and tariff concerns, rising costs, and most recently, significant disruption to global supply chains due to the coronavirus outbreak in China.
Over the last two years, Vietnam and India have emerged as the top destinations for global supply chains looking to diversify capacity away from mainland China.
Foreign direct investment (FDI) inflows into India in the current fiscal year ended March 31, 2020, are tracking at close to a historically high US$50 billion ($69 billion), 10% higher y-o-y, accounting for about 3.5% of total global FDI flows.
More importantly, a review of the projects undertaken by various ministries showed the FDI pipeline into India seemed to have doubled in the last year to US$180 billion.
Our base-case assumption is for FDI inflows to be in the range of 1.8–2% of GDP over the next three years, suggesting FDI inflows could increase to about US$100 billion annually.
Historically, the services and the financial services in particular, has accounted for the bulk of FDI flows into India.
Impact of FDI and deficit on the rupee
Over the last two years, catalysed by Modi’s reforms and corporate tax cuts for new manufacturing capacity, there has been a distinct shift towards manufacturing sector FDI into chemicals, automobiles, electronics, computer hardware, textiles, food processing, pharmaceuticals, and energy renewables capacity.
Given our expectations of further land and labour reforms, infrastructure spending, a large domestic market, and relatively low labour costs catalysing further FDI inflows, we expect India’s current account deficit to trend at about 1.5% of GDP, suggesting a stable backdrop for the rupee with fair value in the INR70–75 range versus the US$.
Meanwhile, the violence on the streets in Delhi protesting the new citizenship bill peaked with Trump’s visit to India. And although the rupee has weakened over the last week, it is too soon to assess the short-term growth “drag” from the coronavirus outbreak in India. The saving grace is that India is currently not that well integrated into global supply chains, limiting the potential negative impact.
Over the medium term, India is a significant beneficiary of lower commodity and energy prices and the FDI opportunity as global supply chains diversify away from China.
The official policy priority seems to be to ensure macro stability rather than stretching fiscally to stimulate near-term demand and growth. The focus is therefore on accelerated divestments to fund infrastructure investments, better transmission of the Reserve Bank of India’s monetary policies, and on supply-side measures to drive investments, job creation, exports, and productivity.
Notwithstanding the short-term concerns on rising coronavirus infections in India, slowing industrial production globally, and the risk of margin compression for the banks as short-term rates fall sharply, we expect the positive inflection in India’s corporate earnings cycle to be sustained over the next 3-5 years on the back of strong operating leverage, industry consolidation and domestic consumption.
Short-term volatility to persist
In the short term, we would acknowledge the risk of more uncomfortable volatility in Indian risk assets as markets re-calibrate the intensity of the coronavirus outbreak and its attendant drag on growth and corporate profitability.
That said, a combination of coordinated global monetary easing, surplus domestic liquidity, the collapse in energy prices, further domestic structural reforms, and evidence of the Indian growth cycle inflecting positively augurs well for Indian risk assets.
We expect policy decisions to revive growth and the earnings cycle, while ongoing structural reforms will support risk appetite and market multiples.
The market earnings yield gap, and in particular, valuations for small and mid-cap stocks, seem to be discounting a chronic domestic slowdown.
We expect our portfolio companies to deliver on earnings and cash flows compounding at 15%+ annually over the next three years and are looking for opportunities to intentionally add to our exposure.
Spotlight on pharma
The stock we are highlighting this month is Natco Pharma, a speciality generics manufacturer with strong complex chemistry skills. The company has successfully transitioned from being a small Active Pharmaceutical Ingredient manufacturer with a profitable domestic oncology business, to being an R&D-driven, complex generics manufacturer with a very strong domestic business, a credible emerging markets franchise, a compelling US specialty pharmaceutical pipeline, and a nascent global agrochemical business.
Despite a slew of successful generic launches in the last three years for key innovator drugs like Copaxone, Doxil, Tamiflu, Tracleer, and Sovaldi, we believe that the market is structurally under-appreciating the quality of Natco’s new product launch pipeline, the strategic relationships with global pharma majors to mitigate distribution and litigation risks, and the upside in the agro-chemicals business.
We expect Natco to grow its revenues at a 15%+ compound annual growth rate over the next three years, versus the market building-in a more sedate +7% CAGR.
Having analysed the data from the distribution channels, we expect the global market share for generic Copaxone to continue to inch up over the next three years with minimal price erosion.
Meanwhile, the US generic launches of Revlimid, Nexavar and Imbruvica will be meaningfully accretive.
In addition, new generic launches in Canada, Brazil, and the Philippines will surprise on the upside while the domestic oncology, cardiology and diabetes franchises will sustain visible growth.
The new investments into the agri-business are significantly underappreciated. Having carefully assessed the company’s target complex molecules strategy, and having built conviction in Natco’s complex chemistry skills, we believe multiple options in its agrochemicals pipeline will be realised over the next 3-5 years.
We expect Natco’s earnings to compound in excess of 20% annually over the next three years, versus the market’s pedestrian projection of a 6% compound annual run rate.
