Inflationary fears, yield curve inversion worries

• Powell’s pivot makes it clear that the Fed is behind the curve and we should be expecting the Fed to tighten monetary policy. The strength in the US economy and persistently elevated inflationary expectations would seem to demand far more restrictive policies can try and re-establish “price stability”.

• We are concerned by the yield curve inversion over the last few weeks: Will the Fed have no choice but to tip the economy into recession?
• While keeping a wary eye on bond markets and implied volatility, we continue to model a “risk-free” rate of 3% on 10-year US Treasuries can establish valuation buffers for the stocks we are invested in.
• Over-leveraged balance sheets and stock price multiples will be tested, especially where companies fail to deliver on revenue/margin assumptions and guidance.
• When the tide goes out ... recent “accidents” such as nickel on the London Metal Exchange and Barclay’s US$600 million ($815 million) structured note blunders are just the first of more to come.

• Putin’s invasion of Ukraine, and Russia and China’s “no limits” partnership have expanded geopolitical risk premiums. The 30-year peace dividend following the fall of the Berlin Wall has been spent. Is Xi prepared to bet on Russia as a buttress in China’s increasingly fraught relationship with the US? Will China’s reserves and boundless appetite for Russian commodities provide the “workarounds” against the sanctions on Russia? At the risk of hyperbole, a new Cold War is probably underway.

• Globalisation may well have died, thanks to Trump tariffs, Covid dislocations, China’s zero-Covid insistence and rolling lockdowns, and the war in Ukraine. Just-in-Time is so 20th century. The new mantra is Just-in-Case.

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• The relocation of global supply chains away from China has prioritised the “localisation” of essential commodities and key manufacturing inputs to ensure access to and reliability of supply.
• Stockpiling of inventory, duplicative capex to increase localisation and higher working capital intensity feature repeatedly in management commentary, with obvious negative implications for margins and free cash flow.

• Energy security trumps energy transition. The messaging on and the political acceptance of fuel rationing in Germany and Austria says it all.

• Fossil fuels have found a new lease of life. Eschewing the short-term opportunity in coal, we have chosen instead to focus on the supply chain for Liquified Natural Gas (LNG) from upstream exploration to transport tankers, storage terminal and re-gasification facilities, and pipelines.
• Renewables will see significant new investments as will the upgrading of the grids while somehow coming to terms with the dependence on Chinese scale manufacturing for solar panels, and wind turbines and blades.
• A mini renaissance in nuclear energy is underway with Germany, the UK, Japan and South Korea signalling their acceptance of nuclear remaining a core part of their energy strategies for the foreseeable future.

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• Commodity shortages and price volatility will weigh on corporate margins and profitability, exacerbating the choke points from still-stressed global supply chains limiting production. The greatest vulnerability sits in the current constraints on Russian exports of oil and gas, coal, nickel, palladium, aluminium, steel, wheat, barley, maize and edible oils.

Domestic fund flows

Domestic fund flows have been remarkably stable. We have written in the past about the baton being handed over to domestic investors given the resilience of the markets in the face of almost US$30 billion of foreign institutional selling over the last 12 months is noteworthy.

• Our conviction remains that Indian households, even with the likelihood of higher yields on bank deposits, will continue to allocate incremental flows to equities which will ultimately determine both the direction and valuation reference points for the Indian market that is selling at approximately 18x one year forward earnings.
• Reserve Bank of India data suggests that household net worth remains largely in bank deposits (25% of net worth) and physical assets (property: 50%; gold: 15%).
• Equity investments are currently tracking at some 5% of annual savings. Over the last five years, domestic equity mutual funds have seen about US$80 billion of inflows, 60% of which have been via systematic investment plans with regular monthly commitments.

Food Inflation and Food shortages will weigh heavily on geopolitics as we wrestle with yet another humanitarian crisis. Perversely, the Indian rural economy stands to benefit.

• Russia and Ukraine account for significant fertiliser, wheat, barley, maize, and edible oil supplies across Africa, the Middle East, Latin America and Asia. Lower yields and the reality of fields lying fallow as farmers battle tanks across Ukraine will dramatically reduce grain and food availability in the short to medium term.
• Rural India’s key cash crops are wheat, rice, maize, soya bean and mustard, with wheat alone accounting for 40% of the land under cultivation. Rising prices for cotton, soya bean, lentils and sugar are an added boost.
• Our analysis suggests that net realisations to rural India, reflecting rising export prices and after adjusting for higher input fertiliser and diesel costs, could be in the 18%–20%- plus range relative to the last two years of depressed rural incomes.

Stock of the month

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We expect Siemens India to compound revenues at more than 20% CAGR over the next three years, while market consensus would seem to be pencilling in a sub-15% run rate.

• Sustained tailwinds from (a) the government’s production-linked incentives to encourage industrialisation and job creation, (b) the investments being made in infrastructure broadly and the railways in particular, (c) investments in energy efficiency and electrification and (d) the explosive growth in new data centres being set up across the country
• We are yet to build in any estimates for the opportunity in the upcoming tender for High Voltage Direct Current (HVDC) transmission lines, or the revenue opportunities from the recent acquisition of the grid technology firm, C&S Electric.

We expect Siemens India to compound earnings at 30%-plus annually over the next three years, almost 50% higher than current consensus expectations.

• Management has systematically invested in operational efficiencies, process optimisation and logistics, delivering on a globally competitive cost structure that should be able to absorb higher raw material input costs.
• Mix improvements, economies of scale, and strong operating leverage will support a 75bps–100bps uplift to operating margins annually.
• We expect a sustained uplift in ROE/ROCE to the 20%-plus levels, before building in any of the revenue/cost synergies from the C&S Electric acquisition or the HVDC tender.

In conclusion

The Fed’s pivot to a much more restrictive monetary policy, Putin’s invasion of Ukraine and the second derivative impact on commodity prices and geopolitical risk premiums, and the seemingly inexorable reversal of three decades of globalisation mark a tectonic shift in the market’s risk/reward dynamics.

• We expect markets to remain extremely volatile in the near-term, and are particularly mindful of (1) continued selling by foreign institutional investors, (2) margin pressure from component shortages and higher input commodities, and (3) current account and rupee vulnerability to substantially higher energy prices.
• We continue to validate our conviction in India’s structural reforms and infrastructure investments, a strong private sector capex cycle, significant new export opportunities, a recovering rural economy, digitisation, and significant pent-up consumer demand as vaccination rates continue to improve. Given the recent volatility, we are patiently looking to deploy capital in companies where we can underwrite an idiosyncratic opportunity over the next three to five years, and where valuations are attractive relative to the visibility of earnings and cash flows.

The Tantallon India Fund is a fundamental, long-biased, India-focused, total return opportunity fund, registered in the Cayman Islands and Mauritius. The fund invests with a three-to-five-year horizon, in a portfolio (25 to 30 unlevered positions), market cap/sector/capital structure agnostic, but with strong conviction on the structural opportunity, scalable business models and management’s ability to execute. Tantallon Capital Advisors, the advisory company, is a Singapore-based entity, set up in 2003, and holds a Capital Markets Service Licence in Fund Management from the Monetary Authority of Singapore