Explained: The road to economic recovery

The return of economic activity and declining active Covid-19 cases in India have raised hopes of recovery. Yet a second wave in Europe and US raise concerns. What is the way forward for businesses and investors?

What factors will determine the recovery path for firms?

In the epic battle of the Mahabharata, the virtuous Pandavas survived and prospered while the vicious Kauravas lost everything. Leverage, cost structure, governance, access to capital and adaptiveness determine the virtuosity of a firm. Firms with less leverage, good governance, and the ability to raise capital, cut costs with the precision of a surgeon‘s knife, and innovate to adapt in the current situation will not only survive but also prosper. Our economic recovery will be a function of top-down factors like fiscal and monetary stimulus as well as bottom-up entrepreneurial efforts.

When the pandemic continues, what factors raise hopes of recovery?

Active cases are coming down despite normalisation of economic activities. A vaccine breakthrough seems to be on the horizon. Lower oil, gold and Chinese goods imports have made India current account-surplus. Foreign exchange reserves are about to exceed foreign exchange debt. Global firms are opening up their purses for direct as well as portfolio investment. Agriculture reforms will materially benefit a large rural population. Labour reforms and postal life insurance schemes are steps in the right direction for India becoming a manufacturing hub, although a lot more needs to be done on the ground.

The September 20 quarterly results are by and large ahead of street expectations. Margins have expanded across sectors due to deep cost cuts. In sectors like auto and consumer durables, volumes are ahead of expectations. Many attribute it to pent-up demand. Demand, pent up or otherwise, has recovered due to steps taken in the past. However, it needs to be sustained in the future by further measures.

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Where is policy focus needed?

The monetary policy is accommodative but credit transmission needs to improve further. Policy rates are at lifetime low levels but the cost of borrowing needs to be lowered for below-AA rated borrowers. Fiscal stimulus has supported growth at the bottom of the pyramid but sectors like travel, tourism, hotel, retailing, aviation, infrastructure etc require more support. The path of fiscal prudence is important but it needs to be achieved by raising non-tax resources like proceeds from strategic divestment and monetisation of assets, unlocking capital stuck in gold lying in tijori etc.

Ease of doing business has improved but rule of law needs to be improved. Despite good intentions, commercial disputes are getting addressed like the never-ending trial of the 1992 security scam rather than the quick, everyone-wins solution of Satyam. Our laws are being made for the lowest common denominator as crooks escape without adequate punishment. This increases the cost of compliance for the rest. Investment cannot pick up sustainably unless rule of law is experienced by investors. Big has become bigger in these challenging times, but eventually small and medium firms need to become competitive and prosper.

Is the global resurgence of Covid-19 a threat to the stock market recovery?

The stock market has responded enthusiastically with large cap indices trading a little below their pre-Covid highs. Flows and improving fundamentals have pulled the market to current levels. Undoubtedly, we are not out of the woods. Factors like the ongoing second wave in the US and Europe, the US election results etc will impact our markets, albeit on a temporary basis.

Amid such concerns, what can drive the market going forward?

The stock market will be driven by the long-term growth trajectory. Global capital in an era of abundant liquidity and ultra-low interest rates will chase returns (US junk bonds are trading at life-time low yields). For many investors, growth or Innovation will be a proxy for returns.

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There is a money-making opportunity for a disciplined stock-picker. On one side, defensive sectors like FMCG, pharma, tech etc are trading at high valuations. On the other hand, public-sector undertakings and public-sector banks are trading at lifetime low valuations. On the one hand, big is becoming bigger, but on the other hand the market is valuing David far more than Goliath. The future is becoming uncertain due to massive disruption, but is most exciting for the disruptor. Within a sector, there is a wide range of returns as winners get rewarded disproportionately. There is plenty of information and news, but it is difficult to determine facts.

Which sectors or themes hold promise for investors going forward?

At the cost of going wrong, a few trends are worth capturing from a moneymaking point of view:

# Sustainable long-term growth is visible in sectors where India is becoming part of the global supply chain. Sectors like contract manufacturing and chemicals are at a take-off stage, like the IT sector at the beginning of the century, albeit with high valuations.

# Firms on the wrong side of ESG (environment, social and corporate governance) investment will get de-rated. Their profits will get low valuation irrespective of growth.

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# Challengers/disruptors will get high valuations despite capital burn. Firms doing disintermediation will get rewarded disproportionately.

# Sector where PSUs dominate, such as banking and insurance, will provide long-term growth opportunities to private firms.

Investors will make money in this market with lots of discipline and a bit of luck. Portfolios that have virtuous companies like the Pandavas will outperform portfolios with vicious companies like the Kauravas.

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