When the U.S sneezes, the world catches a cold!

28 Feb 2024 , 09:42 AM

Projections indicate that the United States is expected to experience a growth rate of 1.6%, a decline from the 2.5% growth seen in 2023. Similarly, Japan’s growth forecast stands at 0.9%, down from 2.0% in 2023. The Eurozone is projected to achieve a growth rate of 0.7%. Overall, the global average growth forecast is estimated to be 2.4%, lower than the 2.6% recorded in 2023. Of particular note is that the growth rates of major economies such as the US, Japan, and the Eurozone are all below the anticipated global average. This suggests that for global growth to be sustained, it will heavily rely on the performance of emerging markets (EM) like India. Emerging markets often have the potential for higher growth rates compared to advanced economies due to factors such as demographic trends, technological advancements, and infrastructure development. Therefore, in the context of weaker growth forecasts for major economies, the contribution of emerging markets becomes increasingly crucial in driving overall global economic expansion.

Although the surface appearance suggests stability and growth within the United States economy, a closer examination reveals concerning underlying trends. While the economy is indeed expanding, much of this growth is fuelled by government expenditure rather than sustainable private sector activity. This reliance on government spending has contributed to a significant debt-to-GDP ratio, currently standing at 120%, which is a cause for alarm. Furthermore, despite being in a period of economic prosperity, the fiscal deficit remains high, leaving little room for implementing countercyclical measures in the event of an economic downturn. In order to sustain growth in the long term, significant adjustments are required. The government would need to be prepared to substantially widen its deficit and increase its debt levels. However, such measures come with their own risks and challenges, including potential inflationary pressures and concerns about fiscal sustainability. At present, there is no significant pressure on the Federal Reserve to lower interest rates, given the apparent strength of the economy. Typically, interest rate cuts are employed as a monetary policy tool to stimulate economic activity during periods of slowdown or recession. Therefore, for any rate cuts to occur, one would essentially need to hope for an economic downturn to prompt such action from the Federal Reserve. This underscores the delicate balance between economic growth, fiscal responsibility, and the role of monetary policy in maintaining stability within the US economy.

David Rosenberg, an economist, suggests that there is an 85% probability of the US economy entering a recession in 2024. He maintains the view that although the recession has been postponed, it remains highly likely. Rosenberg’s economic model, signalling an 85% chance of a US recession, marks its highest reading since the 2008 Financial Crisis. Notably, the model has demonstrated its superiority over the yield curve indicator. In 2023, while the former indicated a mere 12% chance of a recession, the latter suggested 50%. Since 1999, Rosenberg’s model has consistently provided timely warnings of recessions without generating any false signals¹.

In the December quarter of 2023, both the UK and Japan faced a technical recession, highlighting the likelihood of more widespread economic difficulties. Reports suggest that 18 other nations, such as Canada, South Africa, and New Zealand, are similarly teetering on the edge of recession. Noteworthy is Germany’s contraction of 0.3% during the same period, given its status as the Eurozone’s largest economy, potentially jeopardizing the region’s overall growth. Furthermore, the Eurozone as a whole experienced stagnation, reporting zero percent growth in Q4.²

Although India remains a bright spot as it has shown a relatively robust GDP performance, no country can escape the impact of globalization. The Indian economy faces vulnerability to external pressures, especially due to its heavy dependence on service exports, which serve as a vital revenue stream for the IT sector. Additionally, the upward trend in global prices may lead to heightened import costs for India, adding to the strain on its economic stability.

Where to Invest during such a difficult time?
 

The solution lies in understanding the current phase of the business cycle. For instance, if one’s analysis suggests that economic growth is decelerating or contracting, yet equity valuations do not fully account for the potential impact on corporate profits and cash flows, one may opt to bolster their portfolio cash position by divesting weaker stocks, which are particularly vulnerable to downturns. Sector rotation can also be employed, with profit booking in high-risk positions from more aggressive sectors and reinvested into safer, low-beta stocks in sectors such as consumer staples and utilities, or into investments offering attractive dividend yields. The figure below tells us how the financial cycle often precedes the business cycle.

 

Stocks typically lead the economy by an average of six to nine months. For instance, the stock market often hits bottom and begins to rise while the economy is still in a full recessionary phase. Similarly, stocks tend to peak and commence a downward trend into the next bear market while the economy is still in a robust expansion phase. If the analysis indicates that the market has reached a bottom and is poised for an upward trend in anticipation of economic expansion, conventional wisdom suggests reducing exposure to defensive sectors and reallocating funds to aggressive or cyclical sectors. Examples include automobile and durable goods manufacturers, as well as technology stocks, as businesses and consumers tend to postpone significant purchases during economic downturns but catch up on these expenditures when conditions improve. Conversely, if the economy is already in an expansion phase and the stock market is well into a bull market, increasing allocations to industrial, basic material, and energy stocks is advisable. This is because inflation typically accelerates later in the business cycle, and rising commodity prices typically bolster the profits of these companies.³

 

As a number of countries are experiencing contraction and some are already in a technical recession as discussed earlier, it would be wise to allocate more towards defensive sectors like Utilities and Pharma. India’s power demand growth is real and frantic measures are necessary to ensure energy security; call by power ministry to add 80GW/500GW thermal/RE capacity and accommodative stance by CERC in its draft tariff regulations are good reflections. We note that India’s per capita power consumption is at an inflection point and can mirror the trends in China. However, this could happen if India is able to address the sticky issues plaguing the sector, including inefficient operations of SEBs, fuel shortages, and transmission bottlenecks. Recent comments from the Power ministry suggest that the government is actively looking at stepping up coal based capacity additions to meet the rising demand. This is in addition to the >350GW RE capacity addition that the government has envisaged by 2032. In that regard, the entire industry presents a substantial opportunity for growth in the coming 8-10 years. Capital expenditure in the power sector, especially in generation, has a cascading impact and is poised to initiate a long-term investment cycle spanning a decade. It’s worth noting that the power sector’s representation in the overall market is currently close to multi-year lows, indicating significant potential for enhancement with anticipated investments aimed at addressing increasing demand. Moreover, sector valuations are now no longer considered distressed. However, relative to their historic peak, valuations are also not expensive. Moreover, the pool of investible stocks has also shrunk considerably, for which the quality names in the sector seem to be either trading at fair multiples or slightly above basis near-term earnings.  Utility stocks seem to price in earnings growth until FY25/26, at a time when growth visibility extends for the next decade and the pool of investible stocks has shrunk considerably (Figure 1). We like NTPC, and Torrent Power the most, as revenue models are sustainable, scalable, backed by impeccable track record. Tata Power also stands out with its diversification strategy (upgrade to ADD). We like others (CESC, NHPC, PWGR etc) as well, but await a better entry point.

 

The forecast for the pharmaceutical sector as a whole in 2024 remains optimistic. There has been a reduction in the severity of price erosion in the US generic market, resulting in a slight improvement in the business performance, margins, and earnings of major export-oriented pharmaceutical companies in 2023. Additionally, the domestic pharmaceutical market in India continues to experience consistent growth of 9-10% annually. Many mid-cap companies are surpassing the growth rate of the domestic pharmaceutical market by 300-400 basis points per annum, thereby enhancing business diversity, profitability, and return indicators. India Healthcare delivery market is expected to sustain its 13-14% Cagr over the next four to five years, driven by increasing prevalence of chronic diseases, rising affordability levels, medical tourism, and government’s push on primary healthcare in rural markets. According to some media reports, the government is reportedly developing a new PLI scheme targeted at the pharmaceutical sector. The aim is to enhance the manufacturing of essential chemicals crucial for API production and decrease reliance on China for these supplies⁴. Our top-picks in the Pharma sector are Sun Pharma, Mankind, JB Pharma and Aurobindo while the top picks in the Hospital sector are Apollo and KIMS and recommend to add Max and Rainbow on corrections.

Hence, we believe that one should increase their allocation to these two sectors which can help tide over the increasingly cloudy macro environment.

 

 

References:

¹  The US now has an 85% chance of recession in 2024.
² 18 other countries apart from UK and Japan at risk of a recession

³  Applied Equity Analysis and Portfolio Management by Robert A. Weigand

⁴ Government mulling new PLI scheme for pharma sector