Why Neelkanth Mishra turned underweight on metals

Markets based on the experience of the first wave are assuming that the impact of the second wave on the economy is going to be limited and they are playing on the recovery trade. Do you think markets are getting slightly complacent?
The economy will be fine. We will have our issues but the growth will surprise. In fact, we are now saying that for FY22, the consensus real GDP growth forecast of about 9-9.5% is perhaps 200 bps lower than it needs to be and increasingly it is looking likely that FY23 growth numbers need to be bumped up meaningfully. And let me explain why I feel so strongly about this. There are two ways of forecasting; one way of forecasting is you take year-on-year growth and you say that this was my base, on this I grow 9% on that I grow 6.5-7% which is what I think most people do.

In times like these, there is significant volatility at the bottom of the pandemic, the Second Wave. The GDP in our estimate was at one point running 21% below FY20 levels and now it is rebounding very fast. It is perhaps better as a forecasting method to look at the pre pandemic path.

There was a 6-6.5% CAGR pre pandemic path which we were on even before the pandemic hit and we are below that. People generally use the year-on-year growth numbers and then measure where we are versus the pre pandemic path. I think a better methodology given all the volatility in year-on-year numbers is to start with that assumption and then see what growth you are getting.

So on that measure, before the pandemic if you apply a 6.5% kind of growth CAGR for three years, FY23 should have been a 121 or 120.56 if FY20 was 100. Current forecasts by consensus of FY23 GDP are at about 107-108 right now. I see no reason why that should not be at 114-115. We are still below the pre pandemic path and that is something that we need to worry about. But the recovery in terms of estimates and growth is likely to be far better than what is currently being expected.

In times like these, suppose you are a sector analyst or a stock analyst and you need to forecast FY23, what are you going to rely on? You are going to rely on the fact that the house economist or consensus economic growth is x and therefore let me anchor to that. This is not the case in normal years. In normal years, the differences in growth are in tens of basis points okay, if they are at 6.5% I am at 6.3% or something like that.

In these cases where FY23 GDP could be 5-6% higher than what is currently being forecast, the likelihood of earnings estimates needing to get revised is very high. FY23 Nifty EPS has already gone up from about 750-760 in September last year to 860. This is very, very rare. Generally, we are used to starting here and ending 33% lower. This time, we have seen a 10-12% increase. Therefore, if I was the policymaker, I would worry about the fact that we are below the pre pandemic path because there is spare capacity in the economy and there is a problem with jobs. But at the same time, I need to be cognisant of the fact that the numbers need to be upgraded and therefore the markets are going to be fine.

Your call on suddenly turning underweight on metals from overweight certainly surprised me. The logic here is valuations and China. Can we ignore China and focus on the US and India?
One cannot talk about metals without talking about China. We need to be cognisant that they are now 55-60% of the demand in most of the metals. One needs to be very aware of what is happening in China. But there is something much bigger happening and as the economies are opening now and I keep talking about the supply chain bull wave, last year even though car sales did not really fall to zero globally, there were periods where the car makers were not manufacturing. Therefore if one moves from that end demand, the same can be applied for many other supply chains.

If the car manufacturing production slows down, the component demand and subcomponent demand slows down and eventually steel demand slows down. Just like what we saw in late 2008, early 2009, there was a period where there were no steel orders and steel capacities were shut and this was the downward leg of the supply chain bull wave.

If everyone destocks in the value chain, the end demand moves only slightly downward. There can be a possibility that there is no steel order at all as it falls to zero. The reverse of that is also equally likely and that was the reason we were overweight metals. In December, we added to our tactical overweight on metals as we saw the global economy and the global supply chains revamping. Now, we are going to see a leg down.

In the US, the lumber prices had just shot up and now they are correcting equally sharply. We are seeing that in palm oil and we are very likely to see that in steel as well. and that is the argument. So it is less about structural demand issues. They generally move around only 2-3% and it is more about the inventory cycle. This is not the inventory cycle that you see at distributors but the inventory cycle as seen in lumber for example. Small distributors and even someone doing repair work at home are storing up on lumber and when prices go up like that — from $500 to $1500 in the US — then it is very likely that people would be frontloading their demand and all that.

So I think it is a call on that. And that also predicates our upgrade of materials like cement where some of these elements are costly in the sense that in cement you cannot build inventory and so one is safe on the demand side so that there is not too much excess inventory being built there. On the cost side, something like petcoke is getting hit by the same supply chain bull wave which is hurting plastics and other petrochemicals.

Now, the petrochemical margins are starting to come off and at this stage it looks like a leap of faith as I think they will keep falling and let me find stocks where these become cost elements and therefore these stocks can see margin tailwinds six months down the line.

Ideally, one needs to be four to six months ahead in the market. I expect his bull wave two start correcting downward and that was the reason we switched from steel to aluminium and we went from overweight to underweight on the metals and added to cement and some other discretionary stocks which can benefit from this cost reduction.