Higher Interest Rates after a very long time will turn Investor attention to Dividend Growth

Higher Interest Rates after a very long time will turn Investor attention to Dividend Growth

The US Federal Reserve will meet in a couple of days  and I  expect it to  increase interest rates. This would mark its only hike in 2016, despite early year indications of many more. The path thereafter is less clear, though growing reflationary forces, reinforced by a probable fiscal expansion under US president elect Donald Trump and new appointments to the Fed board, could imply a more hawkish central bank down the road.

In any case, I believe government bond yields have seen their lows. The 35-year bull market in bond prices is facing sunset; higher yields and steeper yield curves are on the horizon. Income seekers, for years tormented by low bond yields, may welcome the prospect of rising rates.

Yet structural changes to the global economy, ageing populations, weak productivity and the debt overhang following the financial crisis are a notable offset. These should limit growth and, with a glut of savings in emerging markets, put a cap on how high rates go. As such, yields are likely to reside in a lower range than they have historically.

That means investors should not turn away from equities for income. I believe dividend growth stocks remain one of the most fertile fields for income seekers. Equities become the key income source as low economic growth and excess global savings helped push bond yields to record lows. Equities today provide more than 70 per cent of the income in a global 60 per cent to 40 per cent stock-bond portfolio, my analysis shows, even after the recent rise in bond yields. This compares with an average of just 46 per cent since 1990.  I expect equities to remain the key source of income for investors even as bond yields rise.

A rise in rates could hurt high yielding dividend stocks with premium valuations and low growth rates, so-called bond proxies. Yet it does not weaken the case for all dividend paying equities. In fact, it reinforces our preference for dividend growers.

As overall portfolio returns are likely to be lower over the next five years, dividend income is likely to become a larger component of return. This is particularly true when you consider that bond yields have bottomed and stocks have little room to run amid high valuations and tepid earnings growth.

I see dividend growth stocks, quality companies with enough free cash flow to sustain dividend increases over time, having an upper hand in this environment. They are less susceptible to rising rates than high yielders.

Dividend growers also have a clear return advantage relative to bonds. As rates rise and bond prices fall, many of these stocks could generate positive returns thanks to the power of compounding dividends and earnings growth. My analysis shows valuations of global developed stocks would need to fall some 30 per cent over the next five years to generate negative returns, a very unlikely scenario.

Part of the reason bond yields are rising is that growth and inflation expectations are rising. Higher inflation expectations also favor dividend growth companies, which are typically able to raise prices, and payouts, in reflationary environments.

Both the search for income and the strong case for dividend growers are global trends. Yield opportunities are scarce throughout the world, and the need for equity income remains high as retired populations increase and investment income is challenged to supplant pay cheques.

But dividend growth opportunities exist across sectors and regions. US financials, for one, may have appreciation potential given the steepening yield curve, the prospect of looser regulation and investors filling long-held sector underweights. In addition, I can see US bank revenues benefit more than in past rate-hiking cycles as the Fed raises rates slowly. With little competition for deposits in this cycle, banks should be able to earn more on loans without a commensurate increase in deposit rates.

One tailwind for US investors may be tax reform. If a repatriation tax on US earnings held overseas were enacted, US companies’ cash flows would enjoy the windfall, a potential positive for dividend growth. Technology stands out in this regard.

Rising bond yields are a headwind for income stocks. But I believe a focus on dividend growth is still likely to offer both income and potential for attractive relative returns.

-Farzan Ghadially

Big Impact of Demonetization across sectors like Retail, Real Estate and Banking

Big Impact of Demonetization across sectors like Retail, Real Estate and Banking

A few weeks after Narendra Modi, India’s prime minister, declared 86 per cent of the country’s bank notes invalid overnight, corporate India is only beginning to understand how the move is likely to change the way companies do business.

For many, the measure could prove historic. Digital payments companies, for example, are reporting that demand for their services has increased several hundred per cent, and some have brought forward their growth targets by a year or more.

Other sectors have more reasons to worry. Consumer goods companies are trying to determine whether the short term interruption to sales, which are often made in cash, might lead to a more protracted downturn and there is a property slump that might last for over two years.

For the economy, as a whole, my  prediction is  that this will pause growth, which has been running at more than 7 per cent a year. The Sensex share index has lost 6 per cent since the announcement, falling under 26,000 for the first time since May.

Many economist, have described the move as being like shooting at the tyres of a racing car.

However the long-term implications might yet be positive, if the government can use some of the extra revenue it expects to garner from the measure to offer a fiscal boost, such as sweeping tax cuts in next year’s budget, by giving more funds in the hands of people to send rather than trying to increase the government spending as it would take its own time and the result would be rather very disappointing.

If that does happen, by giving more breaks to the people on the whole I  expect much of corporate India to recover after the turmoil. But whatever happens, different sectors are likely to feel the benefit or the pain to very different degrees.

Banks

Beleaguered bank staff might not feel it right now, but demonetization is likely to prove a major boost to their banks balance sheets, as a slew of money that might have otherwise stayed as cash is now deposited.

My estimate is that 80 per cent of the country’s notes will return to the banking system, which will increase deposit growth by up to 10 per cent.

Of which I expect about half of that to stay in the system long term, which would increase pretax profits — especially at public sector banks that usually have bigger retail networks  by up to 15 per cent.

The problem for all banks, however, is that both consumer spending and the housing market are expected to slow in the next few months as people rein in their spending and companies struggle to keep their supply chains going without cash.

These competing pressures have sent Indian bank stocks on a rollercoaster ride. Shares in State Bank of India, for example one of the biggest public sector lenders initially climbed 12 per cent in the first few days after the move, but have since fallen back 9 per cent.

Consumer goods

Consumer goods companies are counting the cost of the sudden shortage of cash. From items as small as medicines or household goods to larger appliances such as dishwashers or washing machines, much of India’s consumer economy runs on banknotes.

 Sale of white goods items such as air conditioners and TVs, almost 40 per cent of such purchases come via cash which will be hot major time due to this move.

Luxury consumer goods would be hit even harder as a large part of sale is this segment is done using cash and a major hit is anticipated.

Even companies with large financial clout are having to adjust. A number of multinational consumer companies have started   renegotiating credit terms with its small-scale distributors around the country that have seen sales collapse.

Property

India’s property market is likely to be one of the hardest hit from demonetization, not least because buying or building houses has been the most common way to launder black money. But due to the fact that 15 or 20 per cent of real estate transactions in India involve illicit cash.

My estimates are that It may take several years for currency to normalize in the ‘black’ economy. This would slow down transactions, and hurt prices of real estate and land.

However bigger, more reputable developers will be unaffected, given that most of their transactions come via bank loans. Larger companies will also be able to take market share from smaller rivals in the long term. Hence the larger and well established developers who have systems and processes in place would benefit at the cost of the smaller developers.

The secondary sales market in real estate would slow down major time and the kind of slow down would be in place for the next 2 to 3 years.

Hence the real-estate industry that was already in the ICU has been put on the ventilator and days to come would be very hard. 

Ecommerce

While bricks-and-mortar retailers struggle to attract customers many of whom are instead standing in line at the bank  this should be an opportunity for India’s ecommerce companies to hoover up market share.

Executives from many of those companies, including Amazon, Flipkart and Snapdeal — India’s biggest online retailers — have welcomed the move. But in the short-term business has suffered, mainly because about 70 per cent of online commerce in India is paid for by cash on delivery.

The trend in the last week or so after the immediate shock is seen that   the fall in cash-on-delivery transactions has offset the rise in card payments. While business from the larger towns and cities has gone up, overall sales fell 7 to 8 per cent following the government’s announcement.

Several online platforms have even put temporary restrictions on purchases paid for by cash on delivery. Others are offering discounts on card transactions.

However, many are optimistic about what this could mean for the online market in the long term.

However the reality so far is that the 6% fall in the Sensex index since large bank notes were declared invalid 70% Amount of online commerce in India paid for by cash on delivery and this would take a major impact on the online business as the cashless penetration would be reasonable in Metros and larger cities but in tier 2 and tier 3 cities the preferred form of payment is cash on delivery which would take a long time to normalize and the impact would be felt on the overall numbers.

_ Farzan Ghadially

Present Cash Crunch will not have a major impact on curb Black Money Campaigns

Present Cash Crunch will not have a major impact on curb Black Money Campaigns

Indian prime minister Narendra Modi’s surprise ban on Rs500 and Rs1,000 notes was designed like a game of musical chairs, intended to catch out Indians with stashes of illicit black money, earned through corruption or simply hidden from tax officials. Estimates state that black money stored in notes is any where between 6 to 13 % only, hence the pain seems to be more than the overall gain in this exercise. 

Until November 8, black money was circulating merrily through the economy, powering purchases of luxury apartments, gold jewelry, foreign holidays, lavish weddings, and more. But with New Delhi’s overnight ban on using the high-value bank notes and its proclamation that notes not turned in to banks by December 30 will be worthless pieces of paper; the music abruptly stopped.Hence any person who holds the so called black money would end up laundering the amount by taking a discount which in being reported in the market anywhere between 25 to 40%. Banks so far have reported that almost 5 lac crs has been deposited/ exchanged so going by this trend by 30th December if this figure really swells the question is where was the black money ? The problem is banks would report total deposit/ money exchanged however India being such a large agriculture economy a farmer can go to the bank and deposit the money claiming that it is his money which would be treated as tax free and would be withdraw at a latter date and could be returned to the original providers of the monies after the charges as a discount. 

Another problem is in order to change these notes and launder the black money the route of gold could be used there by increasing demand for gold import there by rupee pressure on the rupee which could have long term impact of the trade balance of the country. We have already seen with two weeks the volatility in the rupee, almost touching 69 to the $. 

Indians with illicit cash squirreled away face a choice of acknowledging their hidden wealth or losing it, unless they can circumvent the system. Among those hard hits are Indian politicians who rely on hidden slush funds provided by donors to finance their costly election campaigns.

It is probably no coincidence that the clampdown on cash comes just as Uttar Pradesh, India’s largest state, is gearing up for important state elections, whose outcome could influence Mr Modi’s own re-election prospects in 2019. The opposition parties have made claims that there is no question that part of his motive is to choke off funds to the rival parties and this would swing the UP elections in favor of BJP.

Political parties’ rapacious demand for cash for electioneering has long been seen as one of the major drivers for Indian businesses to generate and maintain large stashes of black money, hidden from tax officials’ eyes. Mr Modi’s own glittering, high-tech 2014 national election campaign is thought to be one of the most expensive. The political system needs the lubrication of money and which every party can provide this lubrication would end up doing better than the rest in the elections.

During forthcoming state elections, parties especially in opposition will undoubtedly face problems, as political funding dries up. Furious rivals of Mr Modi’s ruling Bharatiya Janata party claim it had advance notice of the move that rendered 86 per cent of India’s cash supply virtually useless.

But the cash crunch is unlikely to purify India’s democracy without substantive reforms to bring transparency and accountability to its opaque campaign finance system.

It will make a one-time dent in election spending, but it’s not going to have any long-term impact because you are just going to regenerate black money.

India’s political parties have been hooked on secret donations since the decades after independence, when extensive state control over the economy encouraged businessmen to foster strong ties with political elites.

Political funding grew more opaque in 1969, when then prime minister Indira Gandhi banned corporate donations to political parties.

As the incumbent with all that power, the Congress would find ways of twisting people into giving below the table, but others wouldn’t have those benefits, Modi’s calculation is somewhat similar as it seems. 

Though corporate contributions were made legal again in the 1980s, political parties still closely guard the identity of their donors.

India ostensibly has strict and, many argue, unrealistically low campaign spending limits, but they too are riddled with loopholes, applying only to individual candidates, and not to parties. Parties’ financial accounts are not subjected to any independent auditing either.

Amid the disruption unleashed by his currency ban, Mr Modi has talked a good game about purging black money from the economy. But until political parties, including the BJP, are compelled to lift the veil of secrecy over those pumping monies into their coffers, India’s democracy will remain infected by black money

It will make a one-time dent in election spending, but have no long-term impact. 

_Farzan Ghadially

The Volatility shock till 8th November

The Volatility shock till 8^th November

History will be rewritten and the World Markets would get direction on 8^th November when US elections will be held ...Till then be prepared for a lot of Volatility in markets all over the world.

We had our October surprise, and it should not have been surprising. We should also be prepared for a November surprise, and treat rising volatility in the week before the US election as a racing certainty.

What is beyond doubt is that the markets are scared of a victory for Donald Trump. Volatility remains low, but the Vix index has risen sharply twice since June’s Brexit vote on September 12, after Hillary Clinton was taken ill and admitted having pneumonia, and this week after a tracking poll showed Mr Trump in the lead.

To deal with this we must break the issue into component parts. First, who is going to win, with what probability? Second, is that probability priced in? And third, what effects would each outcome have on markets?

Note that the outcome is not binary. A Clinton victory may be accompanied by control of the House, while a Trump victory could be accompanied by Republican loss of the Senate. There are also possibilities that Mr Trump does not accept a defeat, or of a constitutional crisis following a tie in the electoral college extreme and unlikely events that would spell disaster for global markets.

So, who is going to win? Prediction markets capture prevailing opinion and put a number on it. They may not be right, but they express the prevailing wisdom. Growing publicity for their remarkable success in calling elections.

There are different markets, but all show remarkable assuredness that Mrs Clinton will prevail. PredictWise, which aggregates prediction markets, has never shown the Democrat’s chances as lower than 72 per cent and puts them at 84 per cent. But this conceals a wide variation. PredictIt shows Mr Trump’s chances doubling in the past week to 37 per cent. The Iowa Electronic Markets, the longest continuously operative prediction market, which is less liquid than some, shows Mrs Clinton’s chances at only 57 per cent.

Latest polls show her advantage in the RealClearPolitics average falling to only 1.7 percentage points, from 7.1 percentage points two weeks ago, and behind in Florida, Ohio, Nevada and North Carolina. That makes the prediction market odds on a Trump win sound generous.

It therefore looks as though the probability of a Trump victory remains under-priced on markets, and could easily swing wildly in the next few days. It is a property of betting on a binary out come as the event approaches, there is less time for a bet to pay off. That means volatility will rise. If anyone betting on Clinton has doubts, they have only a few days to sell, and doing so will depress the price further. Big swings in prediction markets in the last few days of a campaign are the norm.

The impact? Markets have not moved much so far in part because it is unclear what a win for Mr Trump would mean. His policies are unclear. This intensifies the chance of risk premia rising. But US Treasuries are havens. People buy them even on news that is ostensibly bad for the credit of the US. Treasury prices rose in 2011 after Standard & Poor’s downgraded their credit rating. So victory for a man who says he might deliberately default on Treasury debt might lead people to buy more US government paper.

A further issue is that Mr Trump might try a big fiscal stimulus, with infrastructure spending and tax cuts. This would mimic Ronald Reagan, and imply a strong dollar and higher bond yields which might be good for the US economy but terrible for international asset prices.

So, the next week is perilous. A little gold, or some Vix futures, might be a good idea, treated as an insurance premium. Volatility could easily rise far higher from here. And within reason, it is good to hold cash. It gives optionality. Cash can be rapidly redeployed, and that is appealing.

Finally, Trump futures offer value. Anyone who bought one for 9 cents on the dollar on the Iowa market two weeks ago has made a 365 per cent profit, and should consider selling. But some exchanges still put his chances below 20 per cent.

Trump futures have made a 365% profit in two weeks consider selling and taking home the profit.

The VIX in the Indian market would rise to a great extent as Trump victory could impact many sectors like IT and IT related, Pharma etc ... which have a great exposure to the US market in a big way and would lead to a correction in the market with a period of uncertainty till the time there is complete clarity on way the Trump policies would shape out or were they just election promises. In case of a Clinton victory, there would be a mild positive for the markets for a few days and then it would be treated as a non-event as no major change in policy is seen that would make any material impact on any sector as such. Hence there would be lot of volatility in the markets till a real clear picture emerges.

_ Farzan Ghadially

Active Involvement by Fund managers helps overall valuation

Active Involvement by Fund managers helps overall valuation

With the ferrous competition in the financial industry within India and overseas, Investment as with many other products that need to be sold to customers, is about marketing and branding. Find the right catchword or slogan and the brand might catch on. There by giving a USP there by creating a niche product which help selling it to new customers or existing customers as a product that is different there adding to their portfolio and helping the financial institution make the sale.  this is not just about appearance the search for an effective re branding might also reveal the critical change to a product that will give it appeal and deliver value to customers.

The field of what was once known as “ethical” investing may be at the early stages of a makeover. Once thought of as a form of risk mitigation nobody wants to own the company that commits the next big scandal, ethical investing has become an attempt to generate a superior return. In its old form, as a screen to exclude the sin sectors such as tobacco and alcohol, it signally failed.  Excluding the sin stocks merely made them cheaper for those with fewer scruples, and the net result was that ethical funds underperformed.

But ethical investing has since been superseded by periods of SRI (socially responsible investing), ESG (environmental, social and governance) and sustainable investing and the latest term “engagement”.

From a marketing point of view, there is nothing much wrong with ESG at present. The amount of institutional money managed according to some kind of environmental or social mandate is continually growing, and they funds are    actually making money. Companies that show up with good sustainability practices, for example, tend to outperform in the long run.

World over many large institutions and some of them even in India in the last couple of years have been speeding time and money in building up their ESG practices. ESG is seen as a defense of the active management industry against passive investing, although it has also become a focus of indexing groups. All the main indexing groups have a suite of indices that purports to capture ESG factors best. In this way it is being treated almost as a smart beta risk factor that can generate returns and take advantage of a market anomaly, such as value or momentum.

A focus on engagement could rescue ESG as a form of truly active management. The hope is that it will be a strategy that makes money for savers while helping to improve the world into which they will eventually retire and that their descendants will have to inhabit. Due to the ultra-low and negative interest rate regime that the world is witnessing at present.

The argument in favor of intervening with companies is that if you can persuade a company to behave in a way that is more appealing to investors then the price will go up, there by yielding a better overall return and creating the alpha in the portfolio.  Those who engage with companies have an opportunity for superior returns. Those who ignore companies and veto them will be too late to the party and could lose out on the relative out performance.

Anecdotal research with data from large institutional investors showed that a marked out performance by stocks it held, once the investor had successfully intervened on an environmental or social issue, such as reducing carbon emissions targets. There was no downside if the engagement was unsuccessful, the company merely tracked the index there by showing that probability of creating the alpha was significantly higher.  Significantly, there were no such clear cut returns after engagements on corporate governance issues.

This shows a difference between engagement and activism, where investors take stakes in a company and then enter into often aggressively hostile fights with the board. This demanding approach is far less likely to work in emerging markets, where many companies are still controlled by their founding families and where local regulations are often unhelpful to minority investors.

There is a lot of value add that a private equity investor does to a company, one of the significant ones is the one on engagement on such issues there by adding a premium to the valuation and helping the founders make a good exit price.

With active fund managers seeing the advantage of the additional return that the overall market gives for active involvement, increasing number of fund managers on Wall street as well as Dalal street are interested in active improvement with companies.

_ Farzan Ghadially  

Negative Interest Rates: Blessing or Pain for real long term Investors.

Negative Interest Rates: Blessing or Pain for real long term Investors.

There were plenty of warning signs that the Bank of Japan’s policy of negative interest rates was doomed and the world over the new phenomenal of negative interest rates really been questioned. 

The first sign was a rise in the yen in January, when the policy was introduced. It was both unexpected and unwanted since a handful of exporters such as Toyota, which benefit from a cheap currency, have been a significant source of growth for decades.

Then there were also sounds of distress from Government Pension Investment Fund , the Japanese pension fund, and Japan Postal Savings. They feared that the prices of financial assets were increasingly artificial thanks to central bank policies. Invest today and lose tomorrow when the stimulus policies cease or reverse.

By April, there was a lot of criticism from number of quarters. In the month of September the central bank announced a review of its actions, which culminated in its decision not to push interest rates further into negative territory.

Across all markets that central banks have been engaged in unconventional monetary policies, there have been many victims in the financial community. They include pension funds, insurers and asset managers, as well as ordinary households hoping to earn something on their savings but that don’t have access to the leveraged opportunities of the wealthy. Yet it was not until the banks started feeling the pain that central banks seemed to reconsider.

It is interesting, albeit somewhat puzzling, to note banks clout, which contrasts markedly with that of others in finance. And the muscle of banks persists, despite them mattering less and less.

Especially in Japan, banks still depend on the gap between the short term rates at which they borrow and the long term rates at which they lend for their profits. The Bank of Japan’s latest measures, are intended to steepen the yield curve and address banks’ anxieties about their after tax profits. That is especially true of Japan’s many smaller regional banks the shares of which foreign fund managers are now shorting due to the current interest rate scenario.

There is a similar dynamic elsewhere. Virtually all those who have been hit by central bank policies have, eight years after the crisis that gave rise to them, been reluctant to point out that they have proved ineffective and costly.

One of the few larger investors to speak out and destroy the myths has been Swiss Re. Indeed, 18 months ago it attempted to quantify the costs in foregone income to both US savers and European insurers as a result of the respective central bank policies on both sides of the Atlantic.

That is why earnings of US insurers have dropped well in advance before those of the banks. One such example is Metropolitan Life warned in its most recent quarterly results that it needed to bolster its reserves by $2bn largely because of a squeeze from low interest rates. Many research reports by leading brokerage houses have mentioned that low growth and low rates weigh on active manager performance.

In the US, one reason insurers are so reluctant to criticize the policies of the Federal Reserve, is that the insurance industry currently falls under the purview of local state regulators and they fear above all else coming under the much more critical eye of a national regulator such as the Fed, hence would prefer to refrain to comment on the policy as such. But in reality the plight of their clients, average Americans, continues to worsen, and as they age, their standard of living will drop further.

There by now making it impossible for retirees to ensure quality of life and others to save for secure retirement through the deposit and investment options suitable for and available to low/modest income households.  Current income distribution distortions are thus likely only to get worse faster as savings fall into ever deeper holes. Contemplate rising inflation without rising savings returns and be particularly afraid and leading to further problems.

_Farzan Ghadially