India

Highlights The Biden administration is combining Trumpian nationalism with a renewed push for US innovation in a major infrastructure bill that is highly likely to become law. Populism and Great Power struggle with China and Russia are structural forces that give enormous momentum to this effort. Don’t bet against it. President Biden’s $2.4 trillion infrastructure and green energy plan has a subjective 80% chance of passing into law by the end of the year, as infrastructure is popular and Democrats control Congress. The net deficit increase will range from $700 billion to $1.3 trillion depending on the size of corporate tax hikes in the final bill. The second part of Biden’s plan, the roughly $2 trillion American Families Plan, has a much lower chance of passage – at best 50/50 – as the 2022 midterm elections will loom and fiscal fatigue will set in. While the US infrastructure package is a positive cyclical catalyst, it was largely expected, and the Biden administration still faces early stress-tests on China/Taiwan, Russia, Iran, and even North Korea. Game theory helps explain why financial markets cannot ignore the 60% chance of a crisis in the Taiwan Strait. A full-fledged war is still low-probability but Taiwan remains the world’s preeminent geopolitical risk. In emerging markets, stay short Russian and Brazilian currency and assets – and continue favoring Indian stocks over Chinese. Feature The “arsenal of democracy” is a phrase that President Franklin Delano Roosevelt used to describe the full might of US government, industry, and labor in assisting the western allies in World War II. The US is reviving this combination of productive forces today, with President Joe Biden’s $4 trillion-plus American Jobs and Families Plan unveiled in Pittsburgh on March 31. The context is once again a global struggle among the Great Powers, albeit not world war (at least not yet … more on that below). The US is reviving its post-WWII pursuit of global liberal hegemony – symbolized by its role, growing once again, as the world’s chief consumer and chief warrior (Chart 1). Biden promoted his plan to build up the US’s infrastructure and social safety net explicitly as a historic and strategic investment – “in 50 years, people are going to look back and say this was the moment that American won the future.”1 It is critical for investors to realize that they are not witnessing another round of COVID-19 fiscal relief. That task is already completed with the Republican spending of 2020 and Biden’s own $1.9 trillion American Rescue Plan Act (ARPA), which together with the vaccine rollout are delivering a jolt to growth (Chart 2). Chart 1America Pursues Hegemony Anew America Pursues Hegemony Anew America Pursues Hegemony Anew Chart 2Consensus Expects 6.5% US GDP Growth After American Rescue Plan Consensus Expects 6.5% US GDP Growth After American Rescue Plan Consensus Expects 6.5% US GDP Growth After American Rescue Plan Our own back-of-the-envelope estimates of growth suggest that there is considerable upside risk even under current law (Chart 3). The output gap is also guesstimated here, and it will tighten faster than expected, especially as the service sector revives on economic reopening. Chart 3Back-Of-Envelope: US GDP And Output Gap Show Upside Risk After American Rescue Plan Act (ARPA) The Arsenal Of Democracy The Arsenal Of Democracy A growth overshoot is even more likely considering that the first part of Biden’s proposal, the $2.4 trillion American Jobs Plan consisting mostly of infrastructure and green energy, is highly likely to pass Congress (by July at earliest and December at latest, most likely late fall). Our revised estimates for the US budget deficit show that this bill will add considerably to the deficit in the coming years, peaking in three or four years, thus averting the “fiscal cliff” in 2022-23 and adding to aggregate demand in the years after the short-term COVID-era cash handouts dry up (Chart 4). The net deficit increase will be $700 billion if Biden gets all of his tax hikes and $1.3 trillion if he only gets half of them, according to our sister US Political Strategy. Chart 4US Budget Deficit Will Remain Fat In Coming Years The Arsenal Of Democracy The Arsenal Of Democracy We give Biden’s $2.4 trillion American Jobs Plan an 80% chance of passing through Congress by the end of the year. Infrastructure is broadly popular – as President Trump’s own $2 trillion infrastructure campaign proposal revealed – and Democrats have just enough votes to push it through the Senate via budget reconciliation, which requires zero votes from Republicans. Biden’s political capital is still strong given that his approval rating will stay above 50% as long as Trump is the obvious alternative and the Republicans are deeply divided over their own future (Chart 5).2 The second part of his plan, the $1.95 trillion American Families Plan, is much less likely to pass before the 2022 midterm elections – we would say 50/50 odds at best, if the infrastructure deal passes quickly. Chart 5Biden’s Political Capital Is Sufficient To Pass Another Major Law The Arsenal Of Democracy The Arsenal Of Democracy Of course there are very important differences between Biden’s $2.4 trillion infrastructure plan and the similarly sized proposal that Trump would have unveiled this month had he been re-elected: Biden’s proposal is probably heavier on innovation and research and development, and certainly heavier on unionization and labor regulation, than Trump’s would have been. Biden’s plan integrates infrastructure with sustainability, renewable energy, and climate change initiatives that will help the US catch up with Europe and China on the green front. The plan will consist of direct government spending – rather than government seed money to promote private investment. It will be partially offset by repealing the corporate tax cuts in Trump’s signature Tax Cuts and Jobs Act. Most importantly – from a geopolitical point of view – Biden is making a bid for the US to resume its post-WWII quest for global liberal hegemony. He argued that the US stands at the crossroads of a global choice between “democracies and autocracies” and that rebuilding US infrastructure is ultimately about proving that democracies can create consensus and “deliver for their people.” Autocratic regimes, fairly or not, routinely call attention to the divisiveness of modern party politics in the West and the resulting policy gridlock which produces bad outcomes for many citizens, resulting in greater domestic dysfunction and “chaos.” It is important to note that this bid for hegemony will be more, not less, destabilizing for global politics as it will make the US economy more self-sufficient and insulated from the world. It will intensify the US-China and US-Russia strategic competition while making it more difficult for Biden to conduct bilateral diplomacy with these states given their differences in moral values and frequent human rights violations. What is happening now is the culmination of political shifts that pre-date the pandemic, but were galvanized by the pandemic, and it is of global, geopolitical significance for the coming decade and beyond.3 Biden and the establishment Democrats – embattled by populism on their right and left flanks – are shamelessly coopting President Trump’s “Make America Great Again” nationalism with a larger-than-life, infrastructure-and-manufacturing initiative that emphasizes productivity as well as “Buy American” protectionism. Biden explicitly argued that Americans need to boost innovation to “put us in a position to win the global competition with China in the upcoming years.” At Biden’s first press conference on March 25, he made a similar point about China: So I see stiff competition with China. China has an overall goal, and I don’t criticize them for the goal, but they have an overall goal to become the leading country in the world, the wealthiest country in the world, and the most powerful country in the world. That’s not going to happen on my watch because the United States are going to continue to grow and expand.4 The US trade deficit is set to widen a lot further under this massive domestic buildout. It aims to be the largest government investment program since Dwight Eisenhower’s building of the highways or the Kennedy-Johnson-Nixon space race. But it explicitly aims to diminish China’s role as a supplier of US goods and materials and the US trade deficit already shows evidence of economic divorce (Chart 6). The US is bound to have a larger trade deficit due to its own savings-and-investment imbalances but it has a powerful interest in redistributing this trade deficit to its allies and reducing over-dependency on China, which is itself pursuing strategic self-sufficiency and military modernization in anticipation of an ongoing rivalry this century. Chart 6Biden's Coopts Trump's Trade And Manufacturing Agenda Biden's Coopts Trump's Trade And Manufacturing Agenda Biden's Coopts Trump's Trade And Manufacturing Agenda Bottom Line: Biden’s $2.4 trillion American Jobs Plan has an 80% chance of passing Congress later this year with a net increase to the fiscal thrust of between $700 billion and $1.3 trillion, depending on how many and how high the corporate tax hikes. The other $2 trillion social spending part of Biden’s plan has only a 50/50 chance of passage. The infrastructure and green energy rebuild should be understood as a return of Big Government motivated by populism and Great Power competition – it is a geopolitical theme with enormous momentum. The result will be faster US growth and higher inflation expectations, with the upside risk of a productivity boom (or boomlet) from the combination of public and private sector innovation. Investors should not bet against the cyclical bull market even though any increase in long-term potential GDP is speculative. A Fourth Taiwan Strait Crisis And The Cuban Missile Crisis Biden’s American Jobs Plan reserves $50 billion for US semiconductor manufacturing, a vast sum, larger than expectations and far larger than the relatively small public investments that helped revolutionize the US chip industry in the 1980s. But it will take a long time for these investments to pay off in the form of secure and redundant supply chains, while a semiconductor shortage is raging today that is already entangled with the US-China rivalry and tensions over the Taiwan Strait. The risk of a diplomatic or military incident is urgent because the chip shortage exacerbates China’s vulnerabilities at a time when the Biden administration is about to make critical decisions regarding the tightness of new export controls that cut off China’s access to US semiconductor chips, equipment, and parts. If the Biden administration appears to pursue a full-fledged tech blockade, as the Trump administration seemed bent on doing, then China will retaliate economically or militarily. Before going further we should point out that there are still areas of potential US-China cooperation under the Biden administration that could reduce tensions this year (though not over the long run). Biden and Xi Jinping might meet virtually as early as this month to discuss carbon emission reduction targets. Meanwhile China is positioning itself to serve as power-broker on two major foreign policy challenges – Iran and North Korea. Biden expressly seeks Chinese and Russian assistance based on the mutual interest in nuclear non-proliferation. Notably, Beijing’s renewed strategic dealings with Iran over the past month highlight its confidence that Biden does not have the appetite to stick with Trump’s “maximum pressure” but rather will seek to reduce sanctions and restore the 2015 nuclear deal. Hence China will seek to parlay influence over Tehran in exchange for reduced US pressure on its trade and economy (Chart 7). Beijing is making a similar offer on North Korea. Chart 7China Holds The Key To Iran, As With North Korea? China Holds The Key To Iran, As With North Korea? China Holds The Key To Iran, As With North Korea? Ironically both Iranian and North Korean geopolitical tensions should skyrocket in the short term since high-stakes negotiations are beginning, even though they are ultimately more manageable risks than the mega-risk of US-China conflict over Taiwan. China cannot gain the advanced technology it needs to achieve a strategic breakthrough if the US should impose a total tech blockade, e.g. draconian export controls enforced on US allies. Yet it is highly unlikely to gain the tech by seizing Taiwan, since war would likely destroy the computer chip fabrication plants and provoke global sanctions that would crush its economy. The result is that China is launching a massive campaign of domestic production and indigenous innovation while circumventing US restrictions through cyber and other means. Still, a dangerous strategic asymmetry is looming because the US will retain access to the most advanced computer chips via its alliances and on-shoring, whereas China will remain vulnerable to a tech blockade via Taiwan. This brings us to our chief global geopolitical risk: a US-China showdown in the Taiwan Strait. Highlighting the urgency of the risk, Admiral John Aquilino, the nominee for Commander of the US Indo-Pacific Command, told the Senate Armed Services Committee that China might not wait six years to attack Taiwan: “My opinion is that this problem is much closer to us than most think and we have to take this on.”5 To illustrate the calculus of such a showdown – and our reasons for maintaining an alarmist tone and building up market hedges and safe-haven investments – we turn to game theory. Game theory is not a substitute for empirical analysis but a tool to formalize complex international systems with multiple decision-makers. An obvious yet fair analogy to a US-China-Taiwan crisis is the Cuban missile crisis of 1962.6 The standard construction of the Cuban missile crisis in game theory goes as follows: if the US maintains a blockade and the Soviets withdraw their missiles a compromise is achieved and war is averted; if the US conducts air strikes and the Soviets maintain or use their missiles then war ensues. The payouts to each player are shown in the matrix in Diagram 1. Diagram 1Cuban Missile Crisis, 1962 The Arsenal Of Democracy The Arsenal Of Democracy One concern about this construction is that the payouts may underestimate the costs of war since nuclear arms could be used. We insert a comment into the diagram highlighting that the payouts could be altered to account for nuclear war. Note that this alteration does not change the final outcome: the equilibrium scenario is still US blockade and Soviet withdrawal, which is what happened in reality. If we model a US-China-Taiwan conflict along similar lines, the US takes the role of the Soviet Union while China stands where the US stood in 1962 (Diagram 2). This is a theoretical scenario in which the US offers Taiwan a decisive improvement in its security or offensive military capabilities. However, because of the unique circumstances of the Chinese civil war, in which the victors established the People’s Republic of China in Beijing in 1949 and the defeated forces retreated to Taiwan, China’s regime legitimacy is at stake in any showdown over Taiwan. If Beijing suffered a defeat that secured Taiwan’s independence while degrading Beijing’s regime legitimacy and security, the Chinese regime might not survive the domestic blowback.7 Diagram 2Fourth Taiwan Strait Crisis – What Happens If The US Offers Game-Changing Military Support To Taiwan? The Arsenal Of Democracy The Arsenal Of Democracy Thus we reduce the Chinese payout in the case of American victory. In the top right cell of Diagram 2, the row player’s payout falls from two points (2ppt) in the first diagram to one point (1ppt) in this diagram. This seemingly slight change entirely alters the outcome of the game. Beijing now faces equally bad outcomes in the event of defeat, whereas victory remains preferable to a tie. Therefore as long as China believes that the US will not resort to nuclear weapons to defend Taiwan (a reasonable assessment) then it may make the mistake of opting for military force to ensure victory. Fortunately for global investors the US is not providing Taiwan with game-changing military capabilities, although it is ultimately up to China to decide what threatens its security and the US is in the process of upgrading Taiwan’s defense in an effort to deter Beijing from forceful reunification. Thus the exercise demonstrates why we do not expect immediate war – no game-changer yet – but at the same time it shows why war is much likelier than the consensus holds if the military or political status quo changes in a way that China deems strategically unacceptable. A lower-degree Taiwan crisis should be expected – i.e. one in which the US maintains tech restrictions, offers arms sales or military training that do not upend the military balance, or signs free trade agreements or other significant upgrades to the US-Taiwan relationship.8 We would give a 60% probability to some kind of crisis over the next 12-24 months. The global equity market could at least suffer a 10% correction in a standard geopolitical crisis and it could easily fall 20% if US-China war appears more likely. What would trigger a full-fledged Taiwan war? We would grow even more alarmed if we saw one of three major developments: Chinese internal instability giving rise to a still more aggressive regime; the US providing Taiwan with offensive military capabilities; or Taiwan seeking formal political independence. The first is fairly likely, the second lends itself to miscalculation, and the third is unlikely. But it would only take one or two of these to increase the war risk dramatically. Bottom Line: The Taiwan Strait is still the critical geopolitical risk and Biden’s policy on China is still unclear. Iranian and North Korean tensions will escalate in the short run but the fundamental crisis lies in Taiwan. Since some kind of showdown is likely and war cannot be ruled out we advise clients to accumulate safe-haven assets like the Japanese yen and otherwise not to bet headlong against the US dollar until it loses momentum. Emerging Markets Round-Up In this section we will briefly update some important emerging market themes and views: Chart 8Favor USMCA Over Putin's Russia Favor USMCA Over Putin's Russia Favor USMCA Over Putin's Russia Russia: US-Russia tensions are escalating in the face of Biden’s reassertion of the US bid for liberal hegemony, which poses a direct threat to Russia’s influence in eastern Europe and the former Soviet Union. Ukraine is expected to see a renewed conflict this spring. The top US and Russian military commanders spoke on the phone for the second time this year after Ukrainian military reports indicated that Russia is amassing forces on the border. We also assign a 50/50 chance that the US will use sanctions to prevent the completion of the NordStream II pipeline from Russia to Germany, an event that would shake up the German election as well as provoke a Russian backlash. The Russian ruble has suffered a long slide since Putin’s invasion of Georgia in 2008 and Crimea in 2014 and the country’s currency and equities have not staged much of a comeback amid the global cyclical upswing and commodity price rally post-COVID. We recommend investors favor the Canadian dollar and Mexican peso as oil plays in the context of American stimulus and persistent Russian geopolitical risk (Chart 8). We also favor developed market European stocks over emerging Europe, which will suffer from renewed US-Russia tensions. Brazil: Brazilian President Jair Bolsonaro’s domestic political troubles are metastasizing as expected – the rally-around-the-flag effect in the face of COVID-19 has faded and his popular approval rating now looks dangerously like President Trump’s did, relative to previous presidents, which is an ominous warning for the “Trump of the South,” who faces an election in October 2022 (Chart 9). The COVID-19 deaths are skyrocketing, with intensive care units reaching critical levels across the country. The president has reshuffling his cabinet, including all three heads of the military in an unprecedented disruption that compounds fears about his willingness to politicize the military.9 Meanwhile the judicial system looks likely (but not certain) to clear former President Luiz Inácio Lula da Silva to run against Bolsonaro for the presidency, a potent threat (Chart 10). Bolsonaro’s three pillars of political viability have cracked under the pandemic: the country remains disorderly, the systemic corruption and the “Car Wash” scandal under the former ruling party are no longer at the center of public focus, and fiscal stimulus has replaced structural reform. Chart 9Brazil: Will ‘Trump Of The South’ Face Trump’s Fate? The Arsenal Of Democracy The Arsenal Of Democracy Our Brazilian GeoRisk Indicator has reached a peak with Bolsonaro’s crisis – and likely breaking of the fiscal spending growth cap put in place at the height of the political crisis in 2016 – while Brazilian equities relative to emerging markets have hit a triple bottom (Chart 11). It is too soon for investors to buy into Brazil given that the political upheaval can get worse before it gets better and a Lula administration is no cure for Brazil’s public debt crisis, though a short-term technical rally is at hand. Chart 10Brazil’s Lula Looks To Be A Contender In 2022? The Arsenal Of Democracy The Arsenal Of Democracy Chart 11Brazil: Policy Risk Peaks, Equities Hit Triple-Bottom Versus EM Brazil: Policy Risk Peaks, Equities Hit Triple-Bottom Versus EM Brazil: Policy Risk Peaks, Equities Hit Triple-Bottom Versus EM India: A lot has happened since we last updated our views on India, South Asia, and the broader Indian Ocean basin. Farmer protests broke out in India, forcing Prime Minister Narendra Modi to temporarily suspend his much-needed structural reforms to the agricultural sector, while China-backed military coup broke out in Myanmar, and the US election set up a return to negotiations with Iran and the Taliban in Afghanistan. Perhaps the biggest surprise was the Indo-Pakistani ceasefire, despite boiling tensions over India’s decision to make Jammu and Kashmir a federal union territory. The ceasefire is temporary but it does highlight a changing geopolitical dynamic in the region. India and Pakistan ceased fire along the Line of Control where they have fought many times. The ceasefire does not resolve core problems – Pakistan will not stop supporting militant proxies and India will not grant Kashmir autonomy – but it does show their continued ability to manage the intensity of disputes while dealing with the global pandemic. An earlier sign of coordination occurred after the exchange of air strikes in early 2019, which preceded the Indian election and suggested that India and Pakistan had the ability to control their military encounters. India’s move to revoke the autonomy of Jammu and Kashmir in August 2019, along with various militant operations, created the basis for another major conflict this year. After all, the Kargil war in 1999 followed nuclear weaponization, while the 2008 conflict followed the Mumbai attack. But instead India and Pakistan have agreed to a temporary truce. A major India-Pakistan conflict would be a “black swan” as nobody is expecting it at this point. Not coincidentally, India and China also reduced tensions after the flare-up in their Himalayan territorial disputes in 2020. China may be reducing tensions now that it no longer has to distract its population from Trump and the US election. China is shifting its focus to the Myanmar coup, another area where it hopes to parlay its influence with a Biden administration preoccupied with democracy and human rights. Sino-Indian tensions will resume later, especially as China continues its infrastructure construction at the farthest reaches of its territory for the sake of economic stimulus, internal control, and military logistics. The Biden administration is adopting the Trump administration’s efforts to draw India into a democratic alliance. But more urgently it is trying to withdraw from Afghanistan and cut a deal with Iran, which means it will need Indian and Pakistani cooperation and will want India to play a supportive role. Typically India eschews alliances and it will disapprove of Biden’s paternalism. For both China and Pakistan, making a temporary truce with India discourages it from synching up relations with the US immediately. Still, we expect India to cooperate more closely with the US over time, both on economic and security matters. This includes a beefed up “Quad” (Quadrilateral Security Dialogue) with Japan and Australia, which already have strong economic ties with India. Biden’s attempt to frame US foreign policy as a global restoration of democracy and liberalism will not go very far if he alienates the largest democracy in the world and in Asia. Nor will his attempt to diversify the US economy away from China or counter China’s regional assertiveness. Therefore Biden will have to take a supportive role on US-India ties. We are sticking with our contrarian long India / short China equity trade (Chart 12). India cannot achieve its geopolitical goals without reforming its economy and for that very reason it will redouble its structural reform drive, which is supported by changing voting patterns in favor of accelerating nationwide economic development. India will also receive a tailwind from the US and its allies as they seek to diversify production sources and reduce supply chain dependency on China, at least for health, defense, and tech. Meanwhile China’s government is pursing import substitution, deleveraging, and conflict with its neighbors and the United States. While Chinese equities are much cheaper than Indian equities on a P/E basis, they are not as pricey on a P/B and P/S basis (Chart 13) – and valuation trends can continue under the current macro and geopolitical backdrop. Indian equities are more volatile but from a long-term and geopolitical point of view, India’s moment has arrived. Chart 12Contrarian Trade: Stick To Long India / Short China Contrarian Trade: Stick To Long India / Short China Contrarian Trade: Stick To Long India / Short China Bottom Line: Stay long Indian equities relative to Chinese and stay short Russian and Brazilian currencies and assets. These views are based on political and geopolitical themes that will remain relevant over the long run but are also seeing short-term confirmation. Chart 13Indian Stocks Not As Over-Priced On Price-To-Book, Price-To-Sales Indian Stocks Not As Over-Priced On Price-To-Book, Price-To-Sales Indian Stocks Not As Over-Priced On Price-To-Book, Price-To-Sales Investment Takeaways To conclude we want to highlight two investment takeaways. First, while the market has rallied in expectation of the US stimulus package, Biden must now get the package passed. This roller coaster process, combined with the inevitable European recovery once the vaccine rollout gets on its feet (Chart 14), will power an additional rally in cyclicals, value stocks, and commodities. This is true as long as China does not tighten monetary and fiscal policy too abruptly, a risk we have highlighted in previous reports. Chart 14Europe's Vaccination Problem Europe's Vaccination Problem Europe's Vaccination Problem While the US is pursuing “Buy American” provisions within its stimulus package, its growing trade deficit shows that it will be forced to import goods and services to meet its surging demand. This is beneficial for its nearest trade partners, Canada and Mexico, and Europe – as well as China substitutes further afield in some cases. Our European Investment Strategist Mathieu Savary has pointed out the opportunities lurking in Europe at a time when vaccine troubles and lockdowns are clouding the medium-term economic view, which is brightening. He recommends going long the “laggard” sectors and sub-sectors that have not benefited much relative to “leaders” that rallied sharply in the wake of last year’s stimulus, vaccine discovery, and defeat of President Trump (Chart 15). The laggard sectors are primed to outperform on rising US interest rates and decelerating Chinese economy as well (Chart 16). Therefore we recommend going long his basket of Euro Area laggards and short the leaders. Chart 15Europe’s Laggards And Leaders The Arsenal Of Democracy The Arsenal Of Democracy Chart 16Macro Forces Favor The Laggards over the Leaders Macro Forces Favor The Laggards over the Leaders Macro Forces Favor The Laggards over the Leaders Chart 17Will OPEC 2.0 Maintain Production Discipline To Keep Oil Supplies Tight? Will OPEC 2.0 Maintain Production Discipline To Keep Oil Supplies Tight? Will OPEC 2.0 Maintain Production Discipline To Keep Oil Supplies Tight? Commodities – especially base metals – will continue to benefit from the global and European reopening as well as the US infrastructure buildout, assuming that China does not shoot its economy in the foot. Our Commodity & Energy Strategy highlights that global oil prices should remain in a $60-$80 per barrel range over the coming years on the back of tight supply/demand balances and ongoing OPEC 2.0 production management (Chart 17). We continue to see upside oil price risks in the first half of the year but downside risks in the second half. The US pursuit of a deal with Iran may trigger sparks initially – i.e. unplanned supply outages – but this will be followed by increased supply from Iran and/or OPEC 2.0 as a deal becomes evident.   Matt Gertken Vice President Geopolitical Strategy mattg@bcaresearch.com   Footnotes 1 White House, "Remarks by President Biden on the American Jobs Plan," Pittsburgh, Pennsylvania, March 31, 2021, whitehouse.gov. 2 A bipartisan bill is conceivably, barely, since Republicans face pressure to join with such a popular bill, but they cannot accept the corporate tax hikes, unionization, or green boondoggles that will inevitably occur. 3 The pandemic and President Trump’s hands-off attitude toward it helped galvanize this revival of Big Government, but the revival was already well on its way prior to the pandemic. 4 White House, "Remarks by President Biden in Press Conference," March 25, 2021, whitehouse.gov. 5 Again, "the most dangerous concern is that of a military force against Taiwan," though he implied that Beijing would wait until after the February 2022 Winter Olympics before taking action. He requested that the US urgently increase regional military defense. See Senate Armed Services Committee, "Nomination – Aquilino," March 23, 2021, armed-services.senate.gov. 6 At that time the Soviet Union stationed nuclear missiles in Cuba that threatened the US homeland directly and sent a convoy to make the missile installation permanent. The US imposed a blockade. A showdown ensued, at great risk of war, until the Soviets withdrew and the Americans made some compromises regarding missiles in Turkey. 7 Note that this was not the case for the US in 1962: Cuba did not have special significance for the legitimacy of the American republic and the American regime would have survived a defeat in the showdown, although its security would have been greatly compromised. 8 Taiwan is proposing to buy a missile segment enhancement for its Patriot Advanced Capability-3 missile defense system for delivery in 2025, though this is not yet confirmed by the Biden administration. See for example Yimou Lee, "Taiwan To Buy New U.S. Air Defence Missiles To Guard Against China," Reuters, March 31, 2021, reuters.com. 9 See Monica Gugliano, "I Will Intervene! The Day Bolsonaro Decided To Send Troops To The Supreme Court," Folha de São Paulo, August 2020, piaui.folha.uol.com.br.

Highlights The Biden Administration's $2.25 trillion infrastructure plan rolled out yesterday will, at the margin, boost global demand for energy and base metals more than expected later this year and next.  Global GDP growth estimates – and the boost supplied by US stimulus – once again will have to be adjusted higher (Chart of the Week). Energy and metals fundamentals continue to tighten. OPEC 2.0's so-far-successful production management strategy will keep the level of supply just below demand, which will keep Brent crude oil on either side of $60/bbl. Base-metals output will struggle to meet higher demand from the ongoing buildout of renewables infrastructure and growing electric-vehicle sales. Of late, concerns that speculative positioning suggests prices will head lower – or, at other times, higher – are entirely misplaced: Spec positioning conveys no information on price levels or direction.  Energy and metals prices, on the other hand, do convey useful information on spec positioning, demonstrating specs do not lead the news or prices, they follow them. Short-term headwinds caused by halting recoveries and renewed lockdowns – particularly in the EU – will fade in 2H21 as vaccines roll out, if the experience of the UK and US are any guide.  Continued USD strength, however, would remain a headwind. Feature If the Biden administration is successful in getting its $2.25 trillion infrastructure-spending bill through Congress, the US will join the rest of the world in the race to re-build – in some cases, build anew – its long-neglected bridges, roads, schools, communications and high-speed transportation networks, and, critically, its electric-power grid.  There's a lot of game left to play on this, but our Geopolitical Strategy group is giving this bill an 80% of passage later this year, after all the wrangling and log-rolling in Congress is done. In and of itself, the infrastructure-directed spending coming out of Biden's plan will be a catalyst for higher US industrial commodity demand – energy, metals and bulks.  In addition, it will support the lift in the demand boost coming out of higher GDP growth globally, which will be pushed higher by US fiscal spending, as the Chart of the Week shows.  Of note is the extremely robust growth expected in India, China and the US, which are among the largest consumers of industrial commodities globally.  Overall growth in the G20 and globally will be expansive in 2022 as well. Chart of the WeekBiden's $2.25 Trillion Infrastructure Bill Will Boost Global Commodity Demand Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Higher GDP growth translates directly into higher demand for commodities, all else equal, as can be seen in the relationship between EM and DM GDP, supply and inventories and Brent crude oil prices in Chart 2.  While we have reduced our Brent forecast for this year to $60/bbl on the back of renewed demand-side weakness in the EU due to problems in acquiring and distributing COVID-19 vaccines, we expect this to be reversed next year and into 2025, with prices trading between $60-$80/bbl (Chart 3).  OPEC 2.0, the oil-producer coalition led by the Kingdom of Saudi Arabia (KSA) and Russia, has done an excellent job of keeping the level of oil supply below demand over the course of the pandemic, which we expect to continue to the end of 2025.1 Chart 2Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Higher GDP Growth Presages Higher Commodity Demand Chart 3Brent Crude Oil Prices Will Average - / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 Brent Crude Oil Prices Will Average $60 - $80 / bbl to 2025 As the Biden plan makes its way through Congress, markets will get a better idea of how much diesel fuel, copper, steel, iron ore, etc., will be required in the US alone.  What is important to note here that the US is just moving to the starting line, whereas other economies like China and the EU already have begun their investment cycles in renewables and EVs.  At present, key markets already are tight, particularly copper (Chart 4) and aluminum (Chart 5).  In both markets, we expect physical deficits this year and next, which inclines us to believe the metals leg of this renewables buildout is just beginning – higher prices will be required to incentivize the development of new supply.2  Chart 4Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Copper Will Post Physical Deficit... Chart 5...As Will Aluminum ...As Will Aluminum ...As Will Aluminum This is particularly important in copper, where growth in mining output of ore has been flat for the past two years.  Copper is the one metal that spans all renewables technologies, and is a bellwether commodity for global growth.  We expect copper to trade to $4.50/lb (up ~ $0.50/lb vs spot) on the COMEX in 4Q21 on the back of increasing demand and tight supplies – i.e., falling mining supply and refined copper output growth (Chart 6). Worth noting also is steel rebar and hot-rolled coil prices traded at record highs this week on Chinese futures markets.  Stronger steel markets continue to support iron ore prices, although the latter is trading off its recent highs and likely will move lower toward the end of the year as Brazilian supply returns to the market.3  We use steel prices as a leading indicator for copper prices – steel leads copper prices by ~ 9 months.  This makes sense when one considers steel is consumed early in infrastructure and construction projects, while copper consumption occurs later as airports and houses are fitted with copper for electric, plumbing and communications applications. Chart 6Copper Ore Output Flat Copper Ore Output Flat Copper Ore Output Flat   Does Speculative Positioning Matter? Of late, media pundits and analysts have cited an unwinding of speculative positions in oil and metals markets following sharp run-ups in net long positions as a harbinger of weaker prices in the near future (Chart 7).4  At other times, speculation has been invoked as a reason for price surges – e.g., when oil rocketed  toward $150/bbl in mid-2008, which was followed by a price collapse at the start of the Global Financial Crisis (GFC).5 Brunetti et al note, "The role of speculators in financial markets has been the source of considerable interest and controversy in recent years. Concern about speculative trading also finds support in theory where noise traders, speculative bubbles, and herding can drive prices away from fundamental values and destabilize markets." (p. 1545) Chart 7Speculative Positioning Lower In Brent Than WTI Speculatives Positioning Lower in Brent Than WTI Speculatives Positioning Lower in Brent Than WTI We recently re-tested earlier findings in our research, which found that knowledge of how specs are positioned – either on the long or the short side of the market – conveys no information on the level of prices or the change that should be expected given that knowledge.  However, knowledge of the price level does convey useful information on how speculators are positioned in futures markets.6 In cointegrating regressions of speculative positions in crude oil, natural gas and copper futures on price levels for these commodities, we find the level of prices to be a statistically significant determinant of spec positions. We find no such relationship using spec positions as an explanatory variable for prices.7 On the other hand, Chart 2 above is an example of statistically significant relationships for Brent and WTI price as a function of supply-demand fundamentals displaying coefficients of determination (r-squares) of close to 90% in the post-GFC period (2010 to now).  This supports our earlier findings regarding spec behavior: They follow prices, they don't lead them.8 We are not dismissive of speculation.  It plays a critical role in markets, by providing the liquidity that enables commodity producers and consumers to hedge their price exposures, and to investors seeking to diversify their portfolios with commodity exposures that are uncorrelated to their equity and bond holdings.  Short-Term Headwinds Likely Dissipate COVID-19 remains the largest risk to markets generally, commodities in particular.  The mishandling of vaccine rollouts in the EU has pushed back our assumption for demand recovery deeper into 2H21, but it has not derailed it.  We expect COVID-related deaths and hospitalizations to fall in the EU as they have in the UK and the US following the widespread distribution of vaccines, which should occur in the near future as Brussels organizes its pandemic response (Chart 8).  Making vaccines available for other states in dire straits will follow, which will allow the global re-opening to progress as lockdowns are lifted (Chart 9). Chart 8EU Vaccination Rollouts Will Boost Global Economic Recovery Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals Chart 9Global Re-Opening Has Slowed, But Will Resume In 2H21 Fundamentals Support Oil, Bulks, And Metals Fundamentals Support Oil, Bulks, And Metals The other big risk we see to commodities is persistent USD strength (Chart 10).  The dollar has rallied for the better part of 2021, largely on the back of improving US economic prospects relative to other states, and success in its vaccination efforts.  The resumption of the USD's bear market may have to wait until the rest of the world catches up with America's public-health response to the pandemic, and the global economy ex-US and -China enters a stronger expansionary mode. Bottom Line: We remain bullish industrial commodities expecting demand to improve as the EU rolls out vaccines and begins to make progress in arresting the pandemic and removing lockdowns.  Global fiscal and monetary policy, which likely will be bolstered by a massive round of US infrastructure spending beginning in 4Q21 will catalyze demand growth for oil and base metals.  This will prompt another round of GDP revisions to the upside.  The dollar remains a headwind for now, but we expect it to return to a bear market in 2H21. Chart 10The USD's Evolution Remains Important The USD's Evolution Remains Important The USD's Evolution Remains Important   Robert P. Ryan Chief Commodity & Energy Strategist rryan@bcaresearch.com Ashwin Shyam Research Associate Commodity & Energy Strategy ashwin.shyam@bcaresearch.com   Commodities Round-Up Energy: Bullish Going into the April 1 meeting of OPEC 2.0 today, we are not expecting any increase in production.  OPEC earlier this week noted demand had softened, mostly due to the slow recovery from the COVID-19 pandemic in the EU, which, based on their previous policy decisions, suggests the producer coalition will not be increasing production.  The coalition led by KSA and Russia will have to address Iran's return as a major exporter to China this year, which appears to have been importing ~ 1mm b/d of Iranian crude this month (Chart 11).  This puts Iran in direct competition with KSA as a major exporter to China, in defiance of the US re-imposition of sanctions against Iranian exports.  China and Iran over the weekend signed a 25-year trade pact that also could include military provisions, which could, over time, alter the balance of power in the Persian Gulf if Chinese military assets – naval and land warfare – deploy to Iran under their agreement.  Details of the deal are sparse, as The Guardian noted in its recent coverage.  Among other things, government officials in Tehran have come under withering criticism for entering the deal, which they contend was signed with a "politically bankrupt regime."  The Guardian also noted US President Joe Biden " is prepared to make a new offer to Iran this week whereby he will lift some sanctions in return for Iran taking specific limited steps to come back into compliance with the nuclear agreement, including reducing the level to which it enriches uranium," in the wake of the signing of this deal. Base Metals: Bullish Copper fell this week, initially on an inventory build, and has now settled right under the $4/lb mark, as investors await details on the US infrastructure bill unveiled in Pittsburgh, PA, on Wednesday.  According to mining.com, a major chunk of the proposed bill will be devoted to investments in infrastructure, which will be metals-intensive.  Precious Metals: Bullish Gold fell further this week, as US treasury yields rose, buoyed by the increased US vaccine efforts and President Biden’s proposed spending plans (Chart 12). USD strength also worked against the yellow metal, which has been steadily declining since the beginning of this year.  COMEX gold fell below the $1,700/oz mark for the third time this month and settled at $1,683.90/oz on Tuesday. Chart 11 Sporadic Producers Will Be Accomodated Sporadic Producers Will Be Accomodated Chart 12 Gold Trading Lower On The Back of A Strong Dollar Gold Trading Lower On The Back of A Strong Dollar     Footnotes 1     Please see Five-Year Brent Forecast Update: Expect Price Range of $60 - $80/bbl, which we published 25 March 2021.  It is available at ces.bcaresearch.com. 2     Please see Industrial Commodities Super-Cycle Or Bull Market?, which we published 4 March 2021 for additional discussion, particularly regarding the need for additional capex in energy and metals markets. 3    Please see UPDATE 1-Strong industrial activity, profit lift China steel futures, published by reuters.com 29 March 2021. 4    See, e.g., Column: Frothy oil market deflates as virus fears return published 23 March 2021. 5    Brunetti, Celso, Bahattin Büyüksahin, and Jeffrey H. Harris (2016), " Speculators, Prices, and Market Volatility," Journal of Financial and Quantitative Analysis, 51:5, pp. 1545-74, for further discussion. 6    Please see Specs Back Up The Truck For Oil, which we published 26 April 2018, and Feedback Loop: Spec Positioning & Oil Price Volatility published 10 May 2018.  Both are available at ces.bcaresearch.com. 7     We group money managers (registered commodity trading advisors, commodity pool operators and unregistered funds) and swap dealers (banks and trading companies providing liquidity to hedgers and speculators) together to test these relationships. 8    In our earlier research, we also noted our results generally were supported in the academic literature.  See, e.g., Fattouh, Bassam, Lutz Kilian and Lavan Mahadeva (2012), "The Role of Speculation in Oil Markets: What Have We Learned So Far?" published by The Oxford Institute For Energy Studies.   Investment Views and Themes Strategic Recommendations Commodity Prices and Plays Reference Table Summary of Closed Trades Higher Inflation On The Way Higher Inflation On The Way

Highlights Indian private sector banks have shown a remarkable improvement in their operating efficiency and have largely cleansed their balance sheets. Further, they have plenty of room to grow as they will continue to grab market share from public sector banks. Investors should go long Indian banks and short EM banks. EM equity portfolios should upgrade the Indian bourse from neutral to overweight. Feature Indian bank stocks have been the star performers among emerging markets banks over the past 20 years (Chart 1). They have consistently outperformed the broader Indian markets too, except in 2020 (Chart 2). What led to such a sustained outperformance? And more importantly, are Indian banks still a buy? Chart 1Indian Bank Stocks Have Been The Star Performer Among EM Banks Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 2Indian Banks: 2020 Underperformance Is Reversing Are Indian Banks A Buy? Are Indian Banks A Buy?   Changing Landscape Our research indicates that listed Indian banks have displayed remarkable improvement in their operating efficiencies in the past 15 years. Lately, they have also cleansed their balance sheets meaningfully. Before we delve deeper into the drivers of their outperformance and prospects, we need to be aware of the changing structure in the Indian banking sector, and the disconnect it has created between banks’ assets versus banks’ market capitalization. Even though India’s public sector (PSU) banks have been steadily losing their market share to private ones over the past three decades, they still dominate the Indian banking scene with a 60% slice in terms of assets and loans. Private sector banks’ market share is a third of the total, with the rest belonging to foreign banks and smaller local banks. Yet, Indian bank stock indexes are comprised predominantly of private sector banks. For example, they make up 95% of India’s MSCI bank index1 – a share that has risen rapidly over the past decades. India’s bank stock performance, therefore, has been largely a reflection of its private sector banks. Robust Operating Efficiency Chart 3Indian Private Banks Have Shown Remarkable Operating Efficiency... Are Indian Banks A Buy? Are Indian Banks A Buy? In terms of operational efficiency, Indian private sector banks have shown significant improvement over the past 20 years. Their operating profit-to-assets ratio went up from around 2% in 2000 to 2.8% currently (Chart 3, top panel). On the flip side, PSU banks’ operating profits have dwindled to 1.6% of their assets. The improving performance of private sector banks also boosted India’s bank stock indexes as they continued to have ever larger weights therein. This remarkable divergence between the operating profits of public and private banks has been caused by several factors:  Private sector banks have been more aggressive than PSU banks in terms of the assets they accumulated, as well as in their management of asset-liability mismatch. This has helped them generate significantly higher net interest income relative to their assets (Chart 3, middle panel). Over the past several years, private sector banks have ramped up their loan book (higher-yielding) while trimming their investments portfolio (lower-yielding government paper). The opposite has happened with PSU banks (Chart 4, top panel). As a result, private banks’ interest income relative to their assets has risen more than that of PSU banks. In their loan portfolio, private banks maintained a higher share of term loans relative to working capital loans (Chart 4, bottom panel). Term loans often entail higher yield as they typically lock-in funds for a longer period than do working capital loans. But term loans also need to be funded by longer duration liabilities to avoid asset-liability mismatch. These liabilities are typically term deposits. Since term deposits cost more than demand or savings deposits, it’s important to balance the term liabilities with term assets. Private sector banks have mobilized term deposits in line with their needs to finance their term loans (Chart 5, top panel). PSU banks, on the other hand, have had much more (higher-cost) term deposits compared to their term loans. Chart 4...Supported By Prudent Asset-Liability Management... Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 5...That Yielded Higher Cost-Adjusted Return On Loans... Are Indian Banks A Buy? Are Indian Banks A Buy?   This is one of the reasons why the profitability of banks loans for private banks, after adjusting for funding costs, has been superior to that of PSU banks (Chart 5, bottom panel). Private banks have also made a stronger foray into the world of unsecured loans (Chart 6). These are typically credit card loans and personal lines of credit. Since unsecured loans usually earn a higher rate of interest, this strategy has worked in favor of boosting their net interest margins. Finally, private banks have always had significantly more non-interest income (i.e., fee-based income). This has helped improve their operating profits meaningfully (Chart 3, bottom panel). Notably, in terms of employee cost and other operating costs, private sector banks do not do any better than PSU banks. In fact, the operating expenditure as a percentage of assets has always been higher for private banks than for PSU banks (Chart 7). This divergence has mainly been due to a difference in employee compensation expenditure. Chart 6...And An Aggressive Credit Strategy Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 7Private Banks' High Operating Cost Was More Than Offset By A Higher Operating Income Are Indian Banks A Buy? Are Indian Banks A Buy?   Put differently, the “operating efficiency” of private sector banks stems from their built-in business model, in which they take slightly more business risks than their PSU counterparts. But in the process, private banks earn significantly more operating income than PSU banks. This more than offsets their relatively higher operating expenditure resulting in higher operating profitability (Chart 3, top panel). Crucially, private sector banks have steadily taken market share from PSU banks in all four types of loans: agricultural, industrial, services, and personal loans (Chart 8). Their loan book is also quite balanced, with no excessive exposures to any type of borrowers (Chart 9). Yet, their presence in the economy is proliferating at a fast clip. It’s no wonder then that their stock prices have commanded a steady premium over their PSU counterparts. They also gradually displaced the latter in India’s stock market indexes. Chart 8Private Banks Are Grabbing Market Shares In All Areas... Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 9...But They Are Not Over-Exposed To Any One Type Of Loans Are Indian Banks A Buy? Are Indian Banks A Buy?   The Saga Of NPLs And Provisions The diverging operating profits of public and private sector banks got more accentuated when it came to net profits. The reason is a much higher share of bad loans among PSU banks. This forced PSU banks to make higher loan loss provisions, which weighed on their net profits (Chart 10). One development that aggravated PSU banks’ market share and NPL woes is the rising trend of disintermediation by corporate borrowers. Large industrial sector borrowers have been increasingly relying on corporate bond markets for their financing needs instead of bank credit. Indeed, disintermediation of large industrial loans is the main reason why overall bank credit in India has decelerated so much recently. Excluding this sector, bank credit growth has been quite decent (Chart 11). Chart 10Private Banks' Robust Operating Margins Let Them Make Aggressive NPL Provisions Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 11PSU Banks Got Disproportionately Hurt By Decelerating Industrial Loans Are Indian Banks A Buy? Are Indian Banks A Buy?   Chart 12 shows that the amounts raised by corporates via local debt issuance has far outstripped the incremental bank credit to the industrial sector in the past.  One incentive for large firms to issue debt instead of taking on more credit is that corporate bond yields for top borrowers (AAA and AA rated) have been lower than the prime lending rates of banks. With bond markets maturing in India, corporates are increasingly taking advantage of the situation (Chart 13). Chart 12Large Industrial Firms Shunned Bank Credit In Favor Of Debt Issuance... Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 13...As Financing Cost Via Debt Issuance Became Increasingly More Attractive Are Indian Banks A Buy? Are Indian Banks A Buy?   This general shift in credit markets caught PSU banks off-guard. Since almost 90% of all industrial loans were from PSU banks at the beginning of the past decade (Chart 8), the disintermediation process hurt them disproportionately compared to private banks. PSU banks are also now stuck with an ever higher share of old, ageing industrial loans in their books. Older loans are more prone to turning into NPLs as compared to fresh, newly issued loans. This is one of the reasons why the NPL ratio has been higher for PSU banks. Private sector banks, on the other hand, have had a relatively higher share of their loan book in personal and services sector loans. These loans have traditionally been much less prone to turning sour. RBI’s data shows that the stressed loans in the personal loans sector have remained around 2% for the past several years while that of industrial loans hovered in double digits (Chart 14). This is another reason why private sector banks faced relatively lower NPL problems over the years.  The top panel of Chart 15 shows the gross NPL ratios of both public and private sector banks. The middle panel shows the yearly provisions they made as a share of their total loans. Chart 14Industrial Loans Have A High Propensity To Become NPL; Personal Loans Low Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 15Private Banks' Copious NPL Provisioning Led To Lower Net NPL Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 16In Past Decade Private Banks Have Provisioned For Half Of Their Average Loan Book! Are Indian Banks A Buy? Are Indian Banks A Buy? Evidently, over the years private banks have made nearly as much provisions (as a % of loans) as their PSU counterparts, even though the former has had much less gross NPLs. This is why private banks’ balance sheets are cleaner now, i.e., they have less net NPLs (Chart 15, bottom panel). Notably, these data also indicate that private sector banks have set aside a mammoth INR 5.5 trillion as cumulative provisions over the past ten years. This would be equivalent to 55% of their average gross loans outstanding that existed over a five-year period between 2010 and 2014 (both years inclusive) (Chart 16). Since most of these provisions have since been used up to write-off bad loans, one could estimate that around half of the loans that existed in the early 2010s have since been written off. The same figure for PSU banks would be INR 14 trillion, and about a third of their average loans between 2010 and 2014 have already been provisioned for. These figures are all as of March 2020, i.e., before the pandemic kicked in. This entails that Indian banks’ balance sheets, especially those of private sector banks, were largely clean going into the pandemic. The reported net NPL ratio of 1.5% for private sector banks as of March 2020 is therefore a credible figure. The Pandemic And Its Aftermath Banks’ NPLs will surely rise as the negative ramifications of the prolonged country-wide lockdown becomes clearer in the months ahead. That said, the RBI and banks have taken several prudential measures to minimize the fallout: During the pandemic, the RBI (and later the Supreme Court) had allowed a loan moratorium period from March to August 2020. Borrowers needed not to pay any instalment or interest for loans during that period, and their loans would still not be downgraded to NPLs. What’s more, for loans up to INR 20 million (all small, medium and micro enterprises, and personal loans), the borrowers won’t have to pay the foregone instalments after the moratorium period is over. They won’t have to pay even the incremental interest that will have accrued on their loans as their principal balance stayed higher for six months than if they would have continued making repayments. The federal government has agreed to pay for the incremental interest, which has mitigated the loss of profitability for banks on these loans. Thus, most borrowers are unlikely to face sudden, additional debt servicing burdens after the moratorium period is over. This would help in avoiding more accounts from turning bad. Banks, at the same time, did make separate provisions – whenever instalments or interests remained overdue during the pandemic – as if no moratorium was in place. As such, banks have already taken the hit in their income statements for any slippage in their loan books. Excluding the moratorium-period new NPLs and provisions, private sector banks’ regular stock of provisions stood at 80% of their gross NPLs as of September 2020. For some listed private banks, the figure was well over 100%. For PSU banks, this figure was 70.5% as of last September. Hence, the bottom line is that in the absence of further pandemic and lockdown-related growth slumps, the private sector banks’ NPL profile is quite benign. To assess the future impact on banks’ NPL and capital adequacy, the RBI conducted a stress test in January this year: As per their projections (not forecast), in the worst case scenario where GDP would grow only at 3.8% in the six months from April to September 2021 (against the IMF’s base line projection of 11.5% growth in April 2021 to March 2022), the gross NPL ratio of PSU banks could rise from 9.7% in September 2020 to 17.6% a year later. For private sector banks, it could rise from 4.6% to 8.8%.  In that case, assuming that banks will set aside another 4% of loans as provisions this year (as they did last year), net NPLs for PSU banks will rise from 2.9% to 6.8%, but that of private banks will remain largely unchanged at 1.2%. Since private banks dominate the bank stock index, there will be a muted negative ramification on stock prices, if any, on account of such a pessimistic scenario of a new wave of NPLs.   Investment Conclusions Indian private sector banks have had plenty of tailwinds: high net interest margins and profitability, good asset-liability management, and exposure to good-quality credit. Besides, they have been aggressive in the provisioning of their NPLs. More importantly, going forward, these banks have plenty of room to grow. Their market share is still relatively small, and India’s bank credit to-GDP ratio is also relatively low at 55% of GDP. Including corporate bonds, total borrowings of non-financial, non-government sectors are still not high at 72% of GDP (Chart 11, bottom panel). Post-pandemic, once India’s economy gets back in the groove, these banks are very well placed to exploit the opportunity over a sustained period. This warrants a bullish view on Indian private sector banks: While their valuation remains expensive, they have fallen somewhat compared to the past several years. Given their balance sheets are now much cleaner than they were in the recent past, they offer a better risk-reward profile (Chart 17). A good harvest and lingering domestic demand weakness will keep inflation in check in India. This also means that the RBI is unlikely to raise rates anytime soon. Periods of low inflation and no monetary tightening are beneficial for both banks and borrowers. Indeed, bank stocks usually do well, both in absolute terms and relative to overall markets, whenever inflation is under control (Chart 18). Chart 17Bank Valuations Are Better Than In Recent Years Given Balance Sheets Are Cleaner Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 18Muted Inflation And Lower Policy Rates Are Supportive Of Bank Stocks Are Indian Banks A Buy? Are Indian Banks A Buy?   Investors should go long Indian banks and short EM banks. We recommend dedicated EM equity portfolios to use the latest relapse in India’s relative equity performance to upgrade the country's allocation from neutral to overweight (Chart 19). India’s yield curve remains steep with the ten-year swap rate 120 basis points above the policy rate. Indian local currency government bonds offer value relative to both US and EM bonds. The spread of India’s GBI bond index over the same duration of US and EM local currency bonds are 570 and 150 basis points respectively. Investors should stay on with our recommendation to receive ten-year swap rates. Finally, the rupee is likely to stay well bid thanks to a strong balance of payments – which was boosted by copious capital flows (Chart 20). A potential rebound in the US dollar could produce a mild setback in the rupee. However, this currency will outperform the majority of EM exchange rates. Chart 19Upgrade Indian Stocks To Overweight In An EM Portfolio Are Indian Banks A Buy? Are Indian Banks A Buy? Chart 20A Strong Balance Of Payment Is Supportive Of Indian Rupee Are Indian Banks A Buy? Are Indian Banks A Buy?   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com   Box 1 A Note On India’s Agriculture Reforms We published a report on India’s Agricultural reforms on November 19, 2020 where we elaborated on why this law was very important for India’s structural outlook. As we contended therein, it’s a highly politically sensitive issue. Expectedly, it was met with political resistance from a few political parties and a section of farmers. Just to provide some context to the agitations, out of the 500 million agricultural workers in India, only about 50 thousand or so large farmers from a particular region in India are protesting. While these protesters have significant political clout, they can hardly be called representative of all farmers. As to the reason for these protests, the new law will upend the monopoly and vested interests of many large farmers who benefitted from the current system for decades. Even though the reforms will usher in private capital, improving overall farm productivity, they will also introduce competition in procurement and distribution. The latter will certainly hurt many large farmers who practically run the current “mandi” system (designated marketplaces where farmers sell their produce). It’s still uncertain how this will play out. As many as 11 rounds of discussions between the farmers’ representatives and the government failed to sort out the issue. Meanwhile, the Supreme Court intervened and formed a committee to look into the matter over the next six weeks, but the protesting farmers have refused to accept its involvement and forthcoming ruling. The government’s offer to put the act on hold for the next 12-18 months while discussion continues has also been refused by the farmers. The protesters’ sole demand is a complete repeal of the law. Our best guess is, eventually, there will be some modification in the most contentious parts of the new laws, and the roll out will probably be delayed by a year or so. In any case, we will keep you updated. Footnotes 1 The MSCI India Financials index makes up 27% of the broader MSCI India index, and the MSCI India Banks index makes up 20%. The latter is dominated by private sector banks with 19% weights, and figure in only one PSU bank, the State Bank of India (SBI), which has an index weight of 1%. However, SBI’s assets or deposits are still higher than the rest of the index constituents (all private sector banks) combined.

Highlights India has continued its structural reforms agenda with the agriculture and labor market reforms being the latest development. In the agriculture sector, the government is inviting private capital and ushering in free markets after decades of state intervention. This could turn out to be a game-changer for a sector that employs half of India’s labor force, and yet one that is marred by very low productivity and inefficiency. Taken together, the reforms undertaken in the past few years will boost the nation’s productivity and, hence, potential growth rate. Such changes warrant upgrading Indian stocks to neutral within an EM equity portfolio. Feature Undeterred by the chaos of the pandemic, India unveiled its latest rounds of structural reforms during the lockdown. These dealt with the hitherto untouched areas of agriculture and labor markets and represent the latest tranche of what has been a series of piecemeal, yet significant, structural reforms initiated over the past several years. Taken together, these reforms are set to have far-reaching consequences on the economy and asset markets in the coming years. Crucially, the country’s demographic dividend could also turn out to be more positive than is usually acknowledged. We will elaborate on the significance and likely market impacts of all these developments in several reports in the coming months. Today, we begin with the Modi government’s attempt at agricultural reform – a highly contentious and politically-charged issue in India. Agriculture Has Been India’s Achilles Heel On the face of it, agriculture, and allied activities (i.e., fishing, forestry, and animal husbandry), makes up only 15% of India’s GDP. Yet, the sector employs nearly half of India’s 500 million strong labor force, either directly or indirectly. Surely, to achieve sustainable growth the country needs to see strong productivity gains in its largest employed sector. Yet for decades, the sector has remained mired in inefficiencies, extremely low productivity, and structural bottlenecks. To understand the significance of agriculture reforms, one needs to understand the backdrop: India’s food markets have been highly regulated and are subject to various restrictions on exports, imports and even on domestic purchasing and stocking. Food availability and farm incomes therefore depend on local food production and prices, rather than on global agricultural prices. Local food production, in turn, oscillates with the country’s rainfall pattern; since barely half the arable land has any irrigation facilities (Chart 1). Chart 1In India, It's Still Higher Rainfall = More Food Supply, And Vice Versa India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Severe land fragmentation has been another feature of India’s farmlands. The rapid growth of its rural population and, unlike China, low rates of migration to urban areas due to lack of labor-intensive large-scale manufacturing, have rendered India’s countryside overpopulated – causing perennial land-fragmentation. As much as 86% of the farmers have a landholding of just 2 hectares or below – and this number has steadily risen over the past several decades (Chart 2). Shrinking size of landholdings have hindered farm-mechanization, hurting agricultural productivity and income growth. With capital expenditures exceeding 35% of GDP over the past decade, India boasts one of the highest capital expenditure paradigms in the world (relative to GDP). Nevertheless, its agriculture sector remains grossly underinvested. If anything, agricultural capex has been declining as a share of both total investment expenditure and GDP. The reason is India’s archaic laws, which have tried to shield farmers from the free markets for decades, and in the process, have discouraged the private sector from investing (Chart 3). Chart 2Number of Small Farmers With Tiny Landholdings Kept Rising; Stymying Farm Productivity India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Chart 3Capital Investments Completely Eluded India's Agriculture Sector ... India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) All this has choked the productivity of Indian farmlands. At 3.2 tons per hectare, the cereal yield in India  remains much lower than many other comparable developing nations (China: 6.0 tons/hectare; Indonesia: 5.2; Vietnam: 5.4; Brazil: 5.2; Argentina: 5.4; South Africa: 5.6) - as per the World Bank’s Food and Agriculture Organization. Chart 4... Leading To Lower Income, But Higher Inflation India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Lower agricultural productivity entails lower output and higher food prices. Indeed, despite a very low starting point, real growth in agriculture never matched the rest of the economy. And yet, it displayed much greater inherent inflationary pressures (Chart 4). The authorities’ principal solution to alleviate chronic farmer poverty has been to purchase farm produce at a pre-announced ‘Minimum Support Price’ (MSP) for several crops such as paddy, wheat, oilseeds, cotton, jute, and many types of coarse cereals and lentils. While this approach ensures that farmers get a minimum price for their produce, it also hinders market forces. The reason is that since the government is by far the single largest purchaser, the MSP effectively sets the market price. What’s more, MSPs themselves are rarely free from political considerations. The result is that these administratively set prices often end up directing the course of inflation in India, both in rural and urban areas (Chart 5). This is because with a weight of 43% in the urban consumption basket (52% in the rural basket), food inflation dictates Indian households’ inflation expectations. It also sets wage expectations. Those expectations usually spill over into future inflation via second-round effects (Chart 6). Chart 5Government's Minimum Support Prices Are Often The Architect Of India's Inflation Trajectory ... India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Chart 6... As Food Prices In India Dictate Non-Food Inflation Also India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) The key reason why reforms have excluded India’s agricultural sector for so long has a lot to do with the country’s political landscape. It is considered too touchy and too big a vote bank to tinker with. The fact that most farmers live at a subsistence level means that they are unable to bear the pain of adjustment even for a short time – which most reforms initially entail. A high illiteracy rate also makes them prone to opposition party propaganda, which often stresses short-term benefits for farmers. Finally, there is always a fear that if tinkering with the status-quo were to result in escalating food inflation, it could seriously damage the incumbent government in the polls. Agricultural reform has thus far been thought of as a suicidal idea for any ruling party. It is in this context that one needs to assess the significance of recent steps. What Do The New Reforms Entail? In a past report back in 2008, we had pointed out that in order to improve Indian agriculture’s structural outlook, the following was needed: Commercialization, which will bring about economies of scale; Food price liberalization, which will free the farmers from selling their produce only at a government-mandated market; Investments in irrigation. Importantly, the three laws1 passed by the Parliament of India in September of this year address the first two issues above: commercialization and price liberalization. The lawmakers materially amended the ‘Essential Commodities Act’ of 1955, a law enacted at the time of food scarcity in the country. The law had given the government power to notify any commodity as ‘essential’, and control its production, distribution and impose a stock limit. As a result, private buyers have had very limited ability to buy or hoard farm produce. Farmers therefore largely sold their produce to government-authorized agents and/or marketplaces (called ‘mandis’).   The new laws will ease the rules on sale, prices and stock limits of farm products. Farmers now can sell their produce directly to private players such as food processors or supermarket chains, at market-determined prices. Farmers can also engage in ‘contract farming’, where they tailor their products as per the needs of a specific buyer, at a pre-determined price. On their part, private buyers can now buy, sell, distribute and hoard the hitherto ‘essential’ commodities without legal prohibitions. This will, in turn, encourage new private capital expenditure in the agricultural sector. As they will now be able to purchase farm produce without limitation, private corporations will have an incentive to provide the latest technologies and farm practices to the farmers. Small farmers will have an incentive to engage in group farming to reap economies of scale. With infusion of new capital, both farm productivity and farmers’ incomes are expected to rise.   Chart 7Reforms Will Usher In Private Capex Helping Farmers Shifting To More Remunerative Crops India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Tiny landholdings in India are often inadequate to provide a subsistence income via regular food grain cultivation. Farmers therefore have an incentive to move toward more lucrative fruits, vegetables and other commercial crops. However, fruits and vegetables are perishable items and need proper and timely transportation and storage facilities.  In the past, the lack of such facilities prematurely halted the shift away from food grain cultivation to non-food grains (Chart 7). With legal obstacles on buying and hoarding now gone, private companies will be encouraged to step in to provide the requisite infrastructure. This will help boost both farmers’ income and availability of farm produce. To be sure, the Modi administration announced that the current ‘mandi’ system and the procurement of crops by the government at the MSPs will continue. In fact, the government has since announced the new MSPs for the coming winter crops. Farmers therefore will now have a choice about where to sell their produce. This choice will make them free from the control of the middlemen who practically run the government ‘mandis’. This will also help smooth the transition to a more market-based system.  Chart 8Surging Investments in Irrigation Will Help Reduce Dependence on Rainfall India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Importantly, over the past few years, the authorities have also begun investing in irrigation projects in significant measure. As mentioned above, a lack of proper irrigation has been a major impediment to farm yield. In the coming years that problem is likely to ease somewhat (Chart 8).  More generally, state and central governments have in recent years been allocating ever higher budgets to rural economic generation schemes. This will also help boost rural incomes (Chart 8, bottom panel). Bottom Line:  The new laws will largely remove decades-long barriers that separated Indian farmers and investors from the free market. This will boost productivity and output in the agriculture sector; which, in turn, will lead to lower food prices overall. Since food is by far the single largest expenditure item for most Indian households, lower food prices mean more disposable income for discretionary spending. That is bullish for both the economy and asset markets. In addition, lower food inflation would lead to lower inflation expectations, and eventually lower realized inflation – a significant positive for India.  A Word About Other Reforms Chart 9India Is Cutting Subsidies As Part Of Free Market Reforms India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) What is truly encouraging is that the agriculture reform measures seem to be just part of a broader set of free market reforms that began a few years back. Several other reforms, such as diesel price deregulation, have already taken place. Diesel prices in India are now linked to global prices as subsidies have been withdrawn. In the same vain, subsidies on food and fertilizers are also being reduced, making them more market-driven (Chart 9). In our future reports, we will discuss several other structural reforms being undertaken, as well as their likely impact on the economy. The Cyclical Outlook: A Recovering Economy While the reforms mentioned above will have an economic impact over the long term, India’s intermediate-term growth outlook is also looking up. The country experienced one of the most stringent lockdowns among major economies; and yet there are signs that economic activity is almost back to pre-pandemic levels: Chart 10Economic Activity Is Fast Getting Back To Pre-Pandemic Levels India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) The number of E-way bills issued is a measure of current economic activity. These bills are required for transporting goods – both within the state and between states –  under the Goods & Services Tax collection mechanism. Chart 10 illustrates that goods transportation is back to pre-pandemic levels. Consistently, GST tax collection for October has been the highest since February this year and represents a 10.2% YoY rise from October last year. Unlike most other major economies, the lockdown in India hurt its industrial sectors much more than its services sectors. This is because most manufacturing and construction businesses had to abide by the strict government-mandated lockdown norms, whereas the prevalence of informal businesses within the services sector helped them, to a certain extent, avoid such regulations. The upshot is that, with the economy re-opening, industrial sectors will now see a stronger and prolonged acceleration in the months ahead. Industrial production growth had already turned positive by September. It will get a further boost from pent-up demand for consumer goods– as is evident in accelerating vehicle sales (Chart 10, bottom two panels).   Notably, India’s reported Covid-19 recovery rate (at a very high 93.5%) and mortality rate (at a very low 1.5%) are among the best in the world2 (aside from North Asia). This has greatly eroded popular concern and political support for any further lockdown, even in the event of a second wave. As such, economic activity will likely continue to gather steam.       Investment Conclusions Exchange Rate: Chart 11A Strong Balance Of Payment Is Bullish For Indian Rupee India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Despite facing its first recession in living memory, the Indian rupee has held up well. This is because of the significant improvement in the country’s balance of payment (BoP) — which is supportive of the currency (Chart 11, top panel). The improvement in the BoP is both due to a current account balance that turned positive recently for the first time in 15 years, as well as consistent capital inflows (Chart 11, bottom panel). Meaningful foreign portfolio inflows have continued to pour in since March this year boosting Indian stocks (Chart 12). Going forward, as the economy re-opens, capital inflows in the form of FDI and external commercial borrowings will also likely resume (Chart 13). This is bullish for the rupee as well. Chart 12India Witnessed A Surge In Foreign Portfolio Inflows India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Chart 13FDI And External Commercial Borrowings Will Likely Resume As The Economy Re-opens India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I)   Fixed-Income Markets: Investors should continue receiving 10-year swap rates in India. Over the next year inflation will moderate as food prices have begun to ease. Given the abundant rainfall last summer, a good harvest is expected (Chart 1 on page 2) – which will further dampen food prices.   Even if RBI raises the policy rate, long term rates are unlikely to spike. In fact, they could fall – if markets perceive the RBI as being too hawkish. The yield curve is also quite steep with the 10-year swap rate 77 basis points above the policy rate (Chart 14). Indeed, Indian local currency bonds offer value relative to both US and EM bonds. The spread of India's GBI bond index over the same duration US and EM local currency bonds are 560 and 130 basis points, respectively (Chart 15). Chart 14Steep Yield Curve In India Offers Value At The Long End Of the Curve ... India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I) Chart 15... Especially Compared To EM And US Fixed Income Markets India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I)   Equities: Relative to the EM equity benchmark, Indian stocks have recently underperformed; and now offer a good entry point for dedicated EM equity portfolios. In view of the country’s progress in implementing structural reforms, we are cautiously optimistic about its improving longer-term outlook. As such, we recommend upgrading Indian markets to neutral in an EM portfolio (Chart 16). Granted, valuations are expensive, but part of the premium can be attributed to India being one of the few countries implementing reforms. Chart 16Indian Stocks Underperformance Is Late; Upgrade Them To Neutral In An EM Portfolio India’s Reform Drive: How Momentous? (Part I) India’s Reform Drive: How Momentous? (Part I)   Rajeeb Pramanik Senior EM Strategist rajeeb.pramanik@bcaresearch.com     Footnotes 1The three laws are: (1) The Farmers' Produce Trade and Commerce (Promotion and Facilitation); (2) The Farmers (Empowerment and Protection) Agreement of Price Assurance and Farm Services; (3) The Essential Commodities (Amendment) Act. 2The recovery rate in US has been 60.5%; in Brazil: 91%; Russia: 75%; Italy: 37%. Mortality rate in US has been 2.2%; in Brazil 2.8%; Russia 1.7%,; Italy 3.8%; Spain 2.7%; and the UK 3.7%. Source: Haver Analytics and Deutsche Bank; Data as of 18th November 2020.

Highlights The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. While dedicated EM equity investors should for now maintain an underweight position in India within an EM equity portfolio, they should consider upgrading this bourse on potential near-term underperformance. Absolute-return investors should consider buying this bourse on a setback in the coming months. Fixed-income investors should continue receiving 10-year swap rates but use any rupee selloff to rotate into cash bonds. Feature Indian share prices have staged a remarkable comeback following the financial carnage in March. However, the outlook for the economy and for corporate profits does not justify the current level of share prices. While this thesis is applicable to most markets around the world, the gap between share prices and economic activity is even larger in India. Chart I-1Loans To Companies Are Muted In India Loans To Companies Are Muted In India Loans To Companies Are Muted In India In particular: The credit and liquidity crunch has been more acute in India than in many other EM and DM economies. Bank loan growth has surged in many countries as companies have borrowed to avoid a liquidity crunch due to a plunge in sales. However, in India bank loans to companies been shown little improvement (Chart I-1). This means that enterprises in India have not been able to draw on bank loans – to the same extent as they have done elsewhere – to attenuate a liquidity crunch stemming from revenue contraction. As a result, Indian enterprises have retrenched more in terms of both employment and capital spending, and their rebound has been more muted. As an example, the global manufacturing and non-manufacturing PMIs have risen above the 50 line but the same measures in India remain below the 50 line (Chart I-2). India’s employment index from the Manpower group has fallen to a record low as of early July (Chart I-3). As a result, household nominal income growth – which was slumping before the pandemic – has fallen much further. Chart I-2India Is Lagging In Global Recovery India Is Lagging In Global Recovery India Is Lagging In Global Recovery Chart I-3India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor India: Employment Conditions Are Very Poor   Passenger car and commercial vehicle sales have plummeted (Chart I-4). Corporate investment expenditure and production have crashed. Manufacturing output, capital goods production and imports all plummeted in March and April and rebounded only mildly in June (Chart I-5). Chart I-4India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... India: Discretionary Spending Is Slow To Recover... Chart I-5...As Are Production And Investment ...As Are Production And Investment ...As Are Production And Investment Table I-1India: Share Of Each Equity Sector In Profits & Market Cap Strategy For Indian Equities And Fixed-Income Strategy For Indian Equities And Fixed-Income Economic activity will improve gradually but the level of activity will remain below the pandemic level for some time. As a result, corporate profits will be slow to revive. Odds are that it will take more than one and half years before the EPS of listed companies reach their 2019 level. This is especially true for severely hit sectors – financials, industrials, materials, and consumer discretionary stocks – which together account for 44% of listed companies’ profits. The sectors less affected by the pandemic recession – namely, consumer staples, information technology and health care – together account for 30% of corporate profits (Table I-1). A Breakdown In The Monetary Transmission Mechanism Impediments to rapid economic recovery are the modest fiscal stimulus and a breakdown in the monetary transmission mechanism. While India announced a large fiscal stimulus, much of this is made up of loan guarantees. Some measures like central bank purchases of government bonds also do not represent actual fiscal spending. Chart I-6 illustrates that government spending has risen only moderately and it has been offset by the drop in the credit impulse. Provided that the credit impulse will remain weak due to reasons we discuss below, the aggregate stimulus will not be sufficient to produce a robust and rapid recovery. The outlook for the economy and for corporate profits does not justify the current level of share prices. Critically, the monetary policy transmission mechanism was impaired even before the pandemic broke out in India, and the situation has gotten worse since March. Even though the Reserve Bank of India (RBI) has been reducing its policy rate, the prime lending rate has dropped very modestly (Chart I-7). Indian commercial banks which are saddled with non-performing loans (NPLs) have been reluctant to reduce their lending rates. Chart I-6Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Drag From Credit Impulse Has Offset Fiscal Stimulus Chart I-7India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate India: Very Little Decline In Prime Lending Rate   Even though AAA local currency corporate bond yields have dropped, BBB corporate bond yields remain above 10% (Chart I-8). This compares with 5-year government bond yields of 5%. Critically, in real (inflation-adjusted) terms, borrowing costs remain elevated (Chart I-9). Such elevated real borrowing costs will continue to hinder credit demand. Chart I-8Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Corporate Bond Yields Remain Elevated Chart I-9Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive Borrowing Costs In Real Terms Are Restrictive   Finally, banks might be reluctant to originate much credit because of the rise in NPLs and the uncertainty over the extension of government guarantees on pandemic-induced NPLs and their own recapitalization programs. Bottom Line: Limited fiscal stimulus and a broken monetary transmission mechanism herald lackluster economic and profit recoveries. Beyond Mega Caps The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. The MSCI equity index has rallied by 50% since its late March lows and stands only 7% below its pre-pandemic highs in local currency terms. Yet, the MSCI equal-weighted index and small caps are, in local currency terms, still 15% and 16% below their pre-pandemic highs, respectively (Chart I-10). The performance of the overall equity index has been exaggerated by the rally in Reliance Industries’ share price as well as information technology stocks, consumer staples and health care. The 150% surge in Reliance Industries stock price since late March lows is due to company-specific rather than macro factors. This company presently accounts for 15% of the MSCI India index. The monetary policy transmission mechanism was impaired even before the pandemic broke out in India. In addition, info technology, consumer staples and health care (including sales of personal care products and medicine) have benefited due to the pandemic. By contrast, equity sectors leveraged to the business cycle in general and discretionary spending in particular have all underperformed. Importantly, bank share prices have been devasted due to poor economic growth and rising NPLs. India’s mega-cap stocks that have led the rally since March lows are expensive, as anywhere else. Finally, India’s equal-weighted equity index has failed to meaningfully outperform the EM equal-weighted index after underperforming severely in late 2019 and Q1 2020 (Chart I-11). Chart I-10Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Muted Revival In Broader Equity Universe Chart I-11India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance India Relative To EM: Little Outperformance   Bottom Line: The advance in Indian share prices has been amplified by the rally in large-cap stocks. Meanwhile, the equal-weighted and small-cap indexes have done considerably worse reflecting the downbeat economic conditions. Equity Valuations And Strategy Chart I-12Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... Indian Equity Valuations Are Elevated On A Market-Cap Basis... As discussed earlier, India’s equity market leaders like information technology, consumer staples and health care are already expensive, trading at a trailing P/E ratio of 23, 47 and 33, respectively. The rest of the equity market is not expensive, but its profit outlook is mediocre. As to other valuation metrices, the market seems to be moderately expensive both on an absolute basis and versus the EM equity benchmark: The 12-month forward P/E ratio is 22.5, the highest in the decade (Chart I-12, top panel). Relative to the EM benchmark, on the same measure is trading at 50% premium (Chart I-12, bottom panel). Based on the equal-weighted equity index – i.e. stripping out the effect of large-cap stocks on the index, Indian equities are overvalued in absolute terms (Chart I-13, top panel). On this equal-weighted measure, Indian stocks are currently trading at a 35% premium versus their EM peers (Chart I-13, bottom panel). The cyclically-adjusted P/E ratio is close to the historical mean (Chart I-14, top panel). Chart I-13...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis ...And On An Equal-Weighted Basis Chart I-14Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio Cyclically-Adjusted P/E Ratio   However, the CAPE ratio is agnostic to corporate earnings on a cyclical horizon. It assumes corporate profits will revert to their long-term rising trend (Chart I-14, bottom panel). This is not assured in the next six months in our opinion. Hence, a lackluster profits recovery – profits disappointments – is a risk to the performance of India’s bourse in the coming months. Equity Strategy: Weighing pros and cons, we recommend that dedicated EM equity investors maintain an underweight position in India within an EM equity portfolio. However, they should consider upgrading this bourse on potential near-term underperformance. The strong rally in certain mega-cap stocks has masked the muted revival in the broad equity universe. Absolute-return investors should consider buying this bourse on a setback in the coming months. Odds are that the index could drop up to 15% in US dollar terms triggered by a potential global risk-off phase and domestic profit disappointments. Currency And Fixed-Income Chart I-15Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India Consumer Inflation Is Not A Problem In India We have been recommending receiving 10-year swap rates in India since April 23 and this recommendation remains intact. As argued above, the economic recovery will be gradual, and the output gap will remain negative for some time. Consequently, wages and inflation will likely surprise on the downside. Even though headline and core inflation rates have recently picked up, this has been due to a rise in food prices, transportation and personal care products (Chart I-15). Hence, there are not genuine inflationary pressures in India and the RBI will be making a mistake if it stops easing due to rises in headline or core CPI readings. Food prices have been rising for a while due to supply shocks. Importantly, the rise in food prices should not be interpreted as genuine inflation. Meanwhile, personal care products include gold jewelry and this CPI sub-component has therefore been rising due to the surge in gold prices (Chart I-15, bottom panel). Finally, transport costs have been on the rise due to supply chain bottlenecks in India as a result of COVID-19 and due to the rise in global oil prices. The broken monetary transmission mechanism means that the RBI will have to cut rates by much more. The fixed-income market is not discounting rate cuts.  There is value in long-term rates in India. The yield curve is very steep – the spread between 10-year and 1-year swap rates is 92 basis points. In addition, 10-year government bond yields are currently yielding 522 basis points above 10-year US Treasurys. We are not particularly concerned about public debt. Central government debt was at 52% of GDP before the recession and total public debt (including both central and state governments) was 80% of GDP. The same ratios are much higher in many other EM and DM economies. Chart I-16India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance India's Stock-To-Bond Ratio Is At A Critical Resistance Finally, the rupee could correct as the US dollar rebounds from oversold levels, but foreign investors should use that setback in India’s exchange rate to rotate from receiving rates to buying 10-year government bonds outright, i.e., taking on currency risk. The RBI has been accumulating foreign exchange reserves, meaning it has been preventing the currency from appreciating. The current account is balanced and the financial/capital account has passed its worse phase. India will continue to attract foreign capital due to its long-term appeal and higher-than-elsewhere interest rates.  Domestic investors should favor bonds over stocks in the near term (Chart I-16). Bottom Line: Continue betting on lower interest rates in India. Fixed income investors should switch from receiving rates to buying 10-year government bonds on a correction in the rupee in the coming months. Dedicated EM local currency bond portfolios should continue overweighting India.     Arthur Budaghyan Chief Emerging Markets Strategist arthurb@bcaresearch.com Ayman Kawtharani Editor/Strategist ayman@bcaresearch.com Footnotes