‘The days of cheap money are behind us’

The year 2018 was a gloomy one for many in the market—a year many would like to forget and move ahead. Volatile crude oil prices, a falling rupee, a rising number of frauds, and tension over a global trade war marred investor sentiment and triggered volatility in the Indian stock market. The benchmark BSE Sensex gained only 6% compared to over 28% in 2017. India also lost its best-performing market tag; in terms of returns, it is now the third-best among emerging markets (Brazil 15.03%, Russia 11.79%, India 5.96%), and the third among the world’s major economies such as the U.S., U.K., China, France, and Germany.

Apart from concerns over the U.S.-China trade war and oil prices, the upcoming general election also has the potential to set off a ripple of anxiety across Dalal Street in 2019. However, Saurabh Mukherjea, founder of Marcellus Investment Managers, believes otherwise. In an interview with Fortune India, he says elections have no bearing on the economy or stock markets. Edited excerpts:

On the cost of money

The U.S. 10-year bond yield, the spine of the global financial market, is somewhere around 3.1-3.2%. Before the Lehman crisis, it was 5%; my reckoning is that we have now begun the process of normalising the U.S. 10-year bond yield. The 3.2% will gradually drift towards 5% over the next two-three years. As the cost of money rises globally, rather normalises, we leave behind us an era of super cheap money. All risk asset classes will see a moderation in prices, whether that’s cryptocurrencies, oil, Western and Indian equities, or junk bonds. This will be the most powerful underlying dynamic which will underpin the next two-four years—the normalisation of the U.S. 10-year bond yield.

Closer home, there’s a further overlay on this dynamic. The Indian three-month commercial paper (CP) rate peaked at around 12% in August 2013, when Raghuram Rajan became governor of the Reserve Bank of India (RBI). As Narendra Modi came to power, monies came into the financial system, and the Indian three month CP rate started falling. And parallel to that, the U.S. 10-year bond yield also fell, so money was getting cheap globally. In India, we added the further dynamic of a prime minister that investors liked.

Demonetisation supercharged that dynamic. People brought the cash out of their almirahs and mattresses and shoved it inside the banking system. Demonetisation was announced in November 2016; by next July, the three-month CP rate was at 6%, almost half of what it had been four years ago. As the financial system normalised—the money went back into the almirahs and mattresses, the three-month CP rate is once again being normalised.

So it’s no surprise the CP rate has gone closer to 8% from around 6% two years ago. My reckoning is, much like the U.S. 10-year bond yield, the Indian three-month CP rate will also keep rising. So if the cost of money in our country drifts up, then for anything that is funded by that money—cars, trucks, real estate developments, etc—you dampen the economic activity associated with these items. Obviously, if a home loan was 7.5% you are more keen to buy than if it was 9.5%, which is what we are heading towards, I think. We are already seeing a slowdown in demand for cars and trucks; disbursals for home loans have slowed. This dynamic of the pronounced rise in the cost of money will persist for the next six-seven months, perhaps longer. So both global and local factors point to money getting dearer.

On India’s fiscal position and growth

Another domestic dynamic we have some visibility on is the fiscal position. It is reasonably clear since the goods and services tax (GST) rollback of October 2017, which, I think, was the biggest tax cut India has ever seen, GST collections have been persistently mediocre. This puts the government on a weak fiscal wicket. Therefore, regardless of who wins the upcoming general election, it is almost inevitable the July 2019 Budget will bring about fiscal course correction, specifically a slowdown in government spending. The government is the main driver of capital expenditure in our country. If in July 2019 there is a slowdown in government spending, combined with the rise in the cost of money, it will translate into a fairly significant economic slowdown. All of that put together suggests the first quarter of FY19 was the zenith of the economic cycle. We have already moderated in the second quarter and will moderate further in the second half of the current fiscal year. And there’s a reasonable chance FY20 will also be a sluggish year.

On the stock markets

It is becoming increasingly evident double digit earnings growth this year looks unlikely now. This is the fifth or perhaps sixth year in a row where corporate earnings growth has been in single digits. A recent report said for the top 1,000 stocks in India, the 10-year compound annual growth rate in earnings per share was 4%, whereas for the stock price the CAGR was 11%. Therefore, what you’ve seen is a meaningful re-rating of Indian equities. Earnings growth is likely to stay at 5-7% for this fiscal year and the next as well. Hence, the Indian stock market as a whole looks 10-15% overvalued. The benchmark Nifty at 9,500 would be a fair value to me.

But just because the stock market as a whole is overvalued, doesn’t mean there’s nothing to buy. As the Indian economy has become super competitive, growth in profits has become limited to a select few stocks. Only outstanding franchises which are run efficiently with strong and sustainable competitive advantages are able to demonstrate double digit earnings growth year after year. Because these companies are scarce, the market has put them on a pedestal; these stocks are almost worshipped with divine fervour.

If you look at India, over the past 10 years only 15 companies have grown their revenue at 10% per annum, with a return on capital employed of 15%—that scarcity premium will persist. And this will become the defining feature of Indian capitalism where in every sector one or maybe two companies will be able to grow at a reasonable pace and everybody else will be kind of a bystander and they will watch these one or two highly efficient and well-run companies who take up a large part of the profit pie of the whole sector.

We are creating a very unique form of capitalism which is giving the consumer a fair deal—our flights are cheap, cabs are cheap, phone calls are cheap but very few companies are making money which is why consumption booms in our country while private capex stagnates. The manifestation of the practical effect of this on the stock markets is that a narrow group of companies come to be seen as outstanding franchises which can outperform year after year. So my point of view is you can continue buying these kinds of companies. But don’t go and buy the market as a whole on some delusional notion around elections or the India story.

On the rupee

If you look at the history, since 1991 we’ve given up around 4% of the value of the rupee per annum, because broadly that’s the inflation differential between us and the U.S. From the time Rajan became RBI governor, if you apply the 4% formula and compound it, now the rupee should be at around 80 against the dollar. It is at around 70—significantly overvalued. I don’t think the rupee will find stability at these levels.

On the upcoming general election

Elections have no bearing whatsoever on the economy or the stock markets. It’s a good drama, it is interesting to watch, but nobody should make stock market investments based on exit polls and election results