This morning, while listening to the Brexit results, I chanced upon a conversation on a business channel. The same anchor who a few months ago said it was futile to forecast, was waxing eloquent about how Brexit could be worse than the Lehman crisis and how it could affect Indian equity markets for years.
This is not 2008. The Lehman crisis was a “heart attack” to the banking system. There was a crisis of “inter-bank” trust and inter-bank lending froze as no one knew which bank could fail like Lehman (as no one knew what toxic assets they held). As a result, economic activity near froze.
Markets dislike uncertainty and Brexit is a huge political uncertainty. Things could become worse as it could be the start of the end for the Euro with other countries opting for their own stay or leave referendums. Hence, a significant market correction in developed markets is par for the course, especially when results were contrary to expectations.
However, unlike 2008, no bank lending stops tomorrow; the UK has 2 years to negotiate new trade agreements. And in opting for a greater degree of freedom to protect its interests, the UK and other European countries may actually be better off long term.
Implications for India
Geopolitical events do affect the Indian economy as we are increasingly linked with global financial flows. Traditionally, the Rupee comes under pressure, which starts a vicious cycle. However, at the present moment, we have all time high FX reserves, a very low Current Account deficit, and significant FX inflow from FDI. Moreover, with earnings gathering momentum, a normal monsoon forecast, and key legislation like GST on its way, there is no rational reason for a run on the Rupee.
Due to spill over of sentiment, while a correction is par for the course, predictions of multi-year head wind for Indian equity markets are hard to understand, especially
- When most Indian companies may have very limited direct exposure to these events. For example, I cannot understand how demand for power or cement in India will be impacted by the Brexit vote!
- Capital chases relative growth and stability
For sure, Indian companies with significant market or supply chain exposure to the UK will be affected. Rather than pressing the panic button and bolting for the exits, we need to calmly examine
- How events such as Brexit affect the earnings trajectory of such companies that we own in the long term?
- Do the current valuations of these companies price in the earnings uncertainty?
- How do we construct a portfolio of companies whose earnings can be protected from global uncertainty?
We have no competence in predicting how deep, how long the markets could stay weak. We would also urge you to refrain listening to the opinions of those who make a living trying to predict market movements.
We will perhaps witness higher volatility as the Brexit drama soon gives way to the US Elections and the markets fear of a Donald Trump Presidency. Unnecessary activity – the desire to do something to give oneself the comfort of action – often results in adverse outcomes when examined through the long term perspective.
We have counselled buying Gold (as a hedge) and keeping a portion of the portfolio in Cash for events like Brexit.
- Gold: We would still advice a 3-5% allocation in Gold the portfolio. Loss of faith in Central Bankers with a deep political crisis in Europe is very much a possible scenario at present.
Cash buffer: A mere 3% market correction does not merit deployment of this buffer. If Indian markets fall another 10%, or individual stocks we like go below certain threshold levels, while confidence in earnings growth remains, we will ask you to re-load the elephant gun.