Higher oil and food prices weigh on India's outlook

• Denied a “quick, decisive victory at minimal cost” with sanctions starting to bite and an increasingly demoralised military complex, Putin might be encouraged to seek face-saving ceasefire terms. Given where we are, and the stark alternative couched in significant further loss of life, that would be a good outcome. However, based upon what we currently “know”, it is difficult to project a speedy de-escalation or give a specific timeline. We intend to remain patient.

• Here are some of the more obvious takeaways, reflected in our current portfolio convictions and positioning:

• Geopolitical risk premiums have gone up and are likely to remain elevated. The peace dividend from the fall of the Berlin Wall has been paid out.
• Yes, energy prices have spiked but warnings of the 1970s oil shock are probably a touch premature.
• Inflation-adjusted, crude is at levels last seen during the Iranian revolution in 1979, when Persian Gulf oil producers accounted for 30%+ of global crude production versus Russia’s current 10% share of global crude production.
• Global oil intensity, which refers to the number of barrels of oil consumed per real dollar of GDP, is half of what it was in the 1970s.
• Europe’s extreme dependence on Russian gas is seasonal, limiting the drag from curtailed gas shipments over the next six to eight months.
• Perhaps, Biden’s overtures to Venezuela and Iran, and more persistent outreach to the peeved monarchy in Saudi Arabia and the UAE, will yield a compensatory uplift in global crude production, complementing the revival in the US shale patch.

In the short to medium term, elevated energy and food prices will weigh on growth, and crucially, inflationary expectations, limiting most central banks’ ability to interject a monetary buffer.

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• Beware, the “Fed-put” is meaningfully lower than the last decade or more of policy action would suggest. If commodities continue to move higher, we should expect monetary policy to become increasingly restrictive.
• Beware being whipsawed in the risk-on/off tussle between price stability, employment/ growth, and whether policymakers will look through nearterm volatility in energy and food prices, or not.
• Beware the extreme volatility in commodity prices, probably more reflective of hedge fund “positioning” and forced margin calls, as opposed to fundamental demand/supply dynamics will weigh on growth, and crucially, inflationary expectations, limiting most central banks’ ability to interject a monetary buffer.

• Energy security and energy transition are not mutually exclusive. Germany specifically, Europe broadly, and North Asia, cannot achieve energy independence from Russian gas without hitting the restart button on nuclear energy while continuing to make significant new commitments to renewables.

• We expect commodity shortages/ price volatility to 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, and vegetable oils.

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• Third-derivative angst: China. Conventional wisdom suggests that Putin’s aggression is underwritten by China. Will China’s reserves and boundless appetite for Russian commodities and Chinese banks, provide the “workarounds” against the sanctions on Russia? Or will the mounting risks to global stability, growth and trade, or the threat of severe sanctions being imposed upon Chinese intermediaries facilitating Russian transactions, be enough to encourage Xi to mediate?

To be clear, Putin’s invasion of Ukraine has altered the market’s near-term risk/reward dynamics. However, the pull-back in valuations allows us to cherry-pick idiosyncratic longer-term opportunities.

• Fact 1: 394 stocks in the BSE500 have corrected by more than 20% from their 52-week highs, while 215 have corrected by more than 40% from their 52-week highs.

• Fact 2: India’s oil consumption as a percentage of GDP is currently tracking at 0.6%, well below the 20-year average of 1%, testament to the withdrawal of subsidies, improving fuel efficiencies and the growth in renewables in the overall energy mix.

• Fact 3: Elevated energy prices will be a drag. At an average of US$100/ barrel of crude, we would model a –75bp hit to the current account deficit, a +90bp uplift to reported inflation, and potentially, a –3% hit to the currency to account for inflation differentials.

• A weaker rupee will be a tailwind for exporters, including IT services companies and pharmaceutical companies.
• Assuming sanctions on Russian exporters for the next six months, vertically integrated Indian aluminium and steel exporters will be beneficiaries.
• Accelerated commitment to renewables (solar, wind, hydro, ethanol) will sustain significant investments in the grid and non-fossil fuel alternatives.

Stock focus of the month

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The stock that we would like to highlight this month is Linde India (LIIL). After the global merger between Praxair and Linde, LIIL is India’s largest industrial and medical gases company, and a key enabler in India’s energy transition to clean energy, and corporate India’s systematic efforts to establish and achieve specific decarbonisation and sustainability goals. We believe the market is structurally underestimating the revenue/cost synergies from the merger and the sustained demand for industrial gases as India builds out its manufacturing and industrial base.

We expect Linde India to compound revenues at 20%+ annually over the next three years, with consensus modelling a more modest 15% CAGR.

• The market is structurally underestimating the demand for industrial and medical gases given the significant investments in renewables, infrastructure, steel, manufacturing and light engineering, electronics, and hospitals.
• Bolt-on regionals acquisitions in packaged gases and O&M services will allow for increased customer penetration, sustaining strong recurring income.
• We expect Linde India to compound profits at 30%+ annually over the next three years, with consensus estimates suggesting a more modest 18% CAGR.
• We have conviction in the revenue/cost synergies from the Praxair merger. Thanks to pricing discipline, mix improvement, and economies of scale, operating margins should improve by 150bp+ annually over each of the next three years.
• The investments in captive wind and solar farms will translate to an additional margin uplift over the next three years.

In conclusion, we would reiterate that Putin’s invasion of Ukraine does alter the market’s near-term risk/reward dynamics.

• Given unprecedented uncertainty and significantly higher geopolitical risk premiums, we are comfortable with our decision to raise significant cash in our portfolios until we can better assess the second- and third-derivative fallout from Putin’s war.
• 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 spiking commodity prices, and (3) current account and rupee vulnerability to substantially higher energy prices.
• We continue to validate our longer-term conviction in India’s structural reforms and infrastructure investments, a strong private sector capex cycle, and significant pent-up consumer demand.

We are patiently looking for opportunities to increase our exposure to the idiosyncratic opportunities in financial services, industrialisation, infrastructure and logistics, and the consumer and digital economies, where valuations are increasingly attractive relative to the visibility on 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-fiveyear 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 in 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

Photo: Bloomberg