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18 March 2019 | 9:37PM HKT

India Strategy Views

‘Catch-up’ pre-election rally in India; Raising India back to

‘Catch-up’ pre-election rally in Indian equities driven by revival in FII inflows Sunil Koul
+852-2978-0924 | sunil.koul@gs.com
Over the past month, NIFTY has rallied 8% and recovered 65% of its ytd Goldman Sachs (Asia) L.L.C.

underperformance vs. the region (MXAPJ). The rally has been broad-based and led Timothy Moe, CFA
+852-2978-1328 | timothy.moe@gs.com
by cyclical sectors, mid/small-caps and value stocks. Foreign inflows have notably Goldman Sachs (Asia) L.L.C.

picked up with FII net buying US$4.5bn in the past one month as market Nitin Chanduka, CFA
+65-6654-5445 | nitin.chanduka@gs.com
expectations of a potentially stable government have risen in recent weeks. Goldman Sachs (Singapore) Pte

Kinger Lau, CFA

+852-2978-1224 | kinger.lau@gs.com
Goldman Sachs (Asia) L.L.C.
Election playbook: Cyclical rally; Rotation out of ‘quality’ to ‘value’
Richard Tang, CFA
NIFTY has rallied in five out of the past six general elections since 1996 with average +852-2978-0722 | richard.tang@gs.com
Goldman Sachs (Asia) L.L.C.
13%/5% returns in 3-mo/1-mo before the election results. Cyclicals like banks,
Ki Cheong Wong, Ph.D.
industrials, materials and autos have led. Stylistically, investors have rotated out of +65-6654-5393 | kc.wong@gs.com
Goldman Sachs (Singapore) Pte
‘quality’ stocks (strong balance sheets, stable growth) into value and mid-caps.
Alvin So, CFA
+852-2978-1585 | alvin.so@gs.com
Goldman Sachs (Asia) L.L.C.
What’s priced? Valuations fair relative to fundamentals but likely ‘overshoot’ n/t
John Kwon
Current domestic macro and market set-up looks better on most metrics compared +65-6654-6337 | jongmin.kwon@gs.com
Goldman Sachs (Singapore) Pte
to 2014 rally but current starting point for valuations is higher. At 18x P/E, current P/E
looks ‘fair’ relative to the macro backdrop, but we see potential for valuation
overshoot in the near term. Combining our implied cost of equity models, relative
P/E premium and earnings/bond yield gap analysis, we estimate an average 10% P/E
‘overshoot’ if valuation metrics go to the extremes during 2014/15.

Our View: Raising India back to overweight; NIFTY 12500 target in 12 months
We lowered India to marketweight in Sep on n/t macro/earnings risks, rich valuations
and political risks. We raise it back to OW given sharp underperformance in Jan/Feb,
better 3Q earnings and a pick-up in FII positioning from lows amid rising market
expectations of a potentially stable govt. We expect earnings to grow 16% this year
(highest in the region) and 18x target P/E with NIFTY to reach 12500 in 12 months.

Upside Ideas: Value Cyclicals, Oversold quality Mid-caps, NIFTY short-dated calls
Sectorally, we favor banks and domestic cyclicals over exporters and defensives. We
recommend short-dated NIFTY calls, value cyclicals and oversold quality
mid-caps to participate in the current rally.

Investors should consider this report as only a single factor in making their investment decision. For Reg AC
certification and other important disclosures, see the Disclosure Appendix, or go to
Goldman Sachs India Strategy Views

‘Catch-up’ pre-election rally in India driven by revival in foreign inflows

Indian equities have seen a ‘catch up’ pre-election rally over the past month
supported by a revival in foreign buying. In this report, we look at how markets
have historically traded around elections and how much is priced in at current
levels. We think risk-reward on India looks favorable again given sharp
underperformance in Jan/Feb, signs of improving earnings and a pick-up in foreign
positioning from lows amid rising market expectations of a potentially stable
government. We raise India back to overweight and favor domestic cyclicals over
defensives and exporters. We recommend short-dated NIFTY calls, value cyclicals
and oversold quality mid-caps to participate in the current market rally.

Context: ‘Catch-up’ rally in Indian equities amid revival in foreign inflows

n ‘Catch up’ rally in Indian equities: Over the past month, Indian equities have seen
a ‘catch-up’ rally with NIFTY rising 8% and recovering 65% of its ytd
underperformance vs. region (MXAPJ).
n The rally has been broad-based and led by ‘cyclicals’. Among sector indices,
cyclicals like PSU Banks, Energy, Metals, Real estate and Infra have outperformed
while defensive sectors like Pharma, FMCG (staples) and Tech have
underperformed. The rally has been broad-based as mid/ small-caps have also
recovered with NIFTY midcap index rallying 11% from its mid-Feb lows.
n ‘Style’ rotation from ‘quality’ to ‘Value’. Within styles, GARP and Value stocks
have led while styles like strong balance sheets, high ROEs and high EPS revisions
which are akin to the ‘quality’ factor have lagged.

Exhibit 1: Over the past 1 month, Indian equities have seen a Exhibit 2: Mid/small-caps have sharply recovered with NIFTY
‘catch-up’ rally with NIFTY rising 8% and recovering 65% of its ytd Midcap 100 index rising 11% from its mid-Feb lows and have
underperformance vs. region (MXAPJ) outperformed vs. large-caps

MSCI India/NIFTY performance vs MXAPJ NIFTY Midcap 100 vs NIFTY performance

(US$, rebased to 100) (rebased to 100)
115 140

110 NIFTY vs. MXAPJ 130

105 120

100 110

95 100 NIFTY Midcap 100

90 MSCI India vs MXAPJ 90 NIFTY

85 80


























Source: FactSet Source: Bloomberg

18 March 2019 2
Goldman Sachs India Strategy Views

Exhibit 3: Within sectors, cylicals such as NIFTY PSU Banks, Exhibit 4: Within styles, GARP and Value stocks have led while
Energy, Metals, Real estate and Infra have led in this rally while stocks with ‘quality’ factors like higher EPS revisions, strong
Pharma, Tech and Staples have lagged. Midcaps have Balance Sheets and higher ROEs have lagged in this rally
outperformed NIFTY

Sector returns over the past 1 month MSCI India style performance over the past 1-mo
(NSE sector indices performance since mid-Feb’19) (based on long-short,equal-weighted returns of top vs bottom quartile MSCI
16% 15% India stocks)
14% 12%
12% 11% 10% 10% 11% 4%
10% 9% 8% 9%
8% 8% 8% 0%
6% -4%
2% 1%

(High vs Low)

(High vs Low)
(High vs Low)

(High vs Low)


(Strong vs Weak)

EPS revisions
Dividend yield

(High vs Low)
(High vs Low)
(Cheap vs


Balance Sheet















Source: Bloomberg Source: FactSet, Bloomberg, Goldman Sachs Global Investment Research

n Market breadth has improved; risk appetite metrics have risen. Consequently,
the breadth of the market has improved with the percentage of BSE 200 stocks
trading above 200 DMA rising to 56% currently vs. only 25% in mid-February. Our
India equity risk barometer (ERB) has risen to 1.4 sd levels above mean, suggesting
rising risk appetite in Indian equities.

Exhibit 5: Consequently, breadth of the market has improved with % Exhibit 6: Our India equity risk barometer (ERB) has risen to 1.4 sd
of BSE 200 stocks trading above 200 DMA rising to 56% currently levels above mean, suggesting rising risk appetite in Indian
vs. only 25% in mid February equities
% of BSE 200 stocks trading BSE200 3 India ERB headline index (z-score) 12500
100% above their 200 DMA (RHS) High Risk Appetite
4800 11500
90% 2
80% 1.4 10500
70% 4300 1
50% 3800 0 8500
30% 3300 -1
20% 6500
10% 2800 -2
















Low Risk Appetite

-3 4500
Dec-10 Dec-11 Dec-12 Dec-13 Dec-14 Dec-15 Dec-16 Dec-17 Dec-18

Source: Bloomberg Source: Factset, Goldman Sachs Global Investment Research

n The rally has been supported by revival in FII buying ahead of elections. One of
the key drivers for the current rally has been revival in foreign investor sentiment
over the past few weeks. While most foreign investors had been on the sidelines till
recently (given election uncertainties) with offshore mutual fund allocations near
multi-year lows, market expectations of a potentially stable government have risen
over the past few weeks (as evidenced by recent opinion polls) spurring foreign
buying. FII have net bought US$4.5 bn in India over the past 1 month (largest among
the 7 EM Asian markets that provide exchange data on FII net buying).

18 March 2019 3
Goldman Sachs India Strategy Views

Exhibit 7: Offshore EM and Asian mutual fund allocations in India Exhibit 8: Foreign inflows have picked up sharply over the past
are near their multi-year lows month

bp India’s allocation in EM and AEJ mutual funds $4

Cumulative foreign flows in Indian equities
700 (OW/UW in bps, AUM: US$550 bn) (Since 2018, US$mn)
Dec’ 14
600 (550 bp) $2
300 -$2
100 160 bp -$4 Fund Flows (US$bn)
2016 2017 2018 YTD
-$6 FII 2.9 8.0 -4.6 4.5
-100 Domestic MFs 7.0 18.3 17.6 1.2
-200 -$8


























Source: EPFR, FactSet, Goldman Sachs Global Investment Research Source: Bloomberg

18 March 2019 4
Goldman Sachs India Strategy Views

Historical playbook: How do Indian equities trade around elections?

While we do not take any view on the outcome of upcoming elections in India,
parliamentary elections have historically been an important domestic catalyst for the
market given their bearing on policy choices and the progress of structural reforms.

In this section, we aim to address the key questions regarding how Indian markets have
historically traded around elections and what types of sectors and stocks have done well
in past pre-election rallies.

Pre-election rallies: What does history suggest?

We look at how Indian markets, sectors and stocks have traded around past election
cycles and summarize our observations below:

n Indian equities have historically traded well heading into elections. NIFTY has
rallied and outperformed the broader regional index (MXAPJ) in five out of the past
six general elections since 1996 and averaged 13% and 5% returns, three months
and one month before the election results, respectively. Markets have generally
performed well heading into the past general elections because previous
governments (except the current one) were mostly coalitions and the markets rallied
on hopes of a stable government.
n The pre-election rally has usually been led by cyclical sectors. During the past
pre-election rallies, domestic cyclical sectors such as banks, industrials, materials,
and autos have performed well while consumer staples, utilities and exporters (tech,
healthcare) have lagged.
n Stylistically, Value and mid-caps have outperformed quality. Looking specifically
at the previous election in 2014, we note that ‘Value’ and mid-cap stocks performed
well heading into elections while ‘quality’ stocks with stronger balance sheets and
stable growth lagged. In other words, investors sheltering in ‘safe havens’ or
‘quality’ stocks start to rotate into ‘value’ and ‘cyclical’ parts of the markets as
election uncertainty starts to fade. This insight informs our sector and stock
preferences as we discuss in the later section.
n Market volatility tends to rise in the run-up to elections and falls post elections
while foreign flows pick up as election uncertainty fades. Given the political
uncertainty and news flow regarding opinion polls and political alliances around
elections, volatility typically tends to rise in the run-up to elections and falls post
elections. In terms of flows, we note that foreign flows have generally picked up
close to elections as election uncertainty fades and picks up meaningfully after the

18 March 2019 5
Goldman Sachs India Strategy Views

Exhibit 9: NIFTY has traded well heading into five out of past six elections, averaging 13% returns in the 3 months before the election

NIFTY performance around general elections Absolute price performance-NIFTY (Local)

(average of past 6 elections since 1996)
3 month 1 month
14% 13% 1 month after 3 month after
before before
NIFTY NIFTY vs MXAPJ (US$) Election year election election
12% 10% election election
result result
10% result result
6% 1996 12% 2% 4% -6%
6% 5%
3% 1998 5% 12% 9% -13%
1999 12% 5% -9% 1%
2% 1%
2004 -23% -25% 7% 18%
0% 2009 58% 28% 4% 3%
-2% 2014 17% 6% 5% 5%
-4% -3% Avg. Move 13% 5% 3% 1%
3 month before 1 month before 1 month after 3 month after
election result election result election result election result
Median Move 12% 6% 4% 2%

Source: Bloomberg, Goldman Sachs Global Investment Research

Exhibit 10: Domestic cyclicals such as banks, industrials, materials and discretionary have performed well in the run-up to elections while
consumer staples, utilities and exporters have lagged

3 months before election 3 months after election

MSCI India sectors results MSCI India sectors results
(Relative performance (Relative performance vs.
2009 elections 2014 elections 2009 elections 2014 elections
vs. MSCI India) MSCI India)
Industrials 13% 29% Material 18% 7%
Financials 20% 13% Information Technology 16% 6%
Material 19% 11% Health Care (2%) 11%
Energy 10% 19% Consumer Discretionary 7% (1%)
Comm Services 14% 1% Industrials 9% (5%)
Consumer Discretionary 3% 2% Consumer Staples 3% (2%)
Utilities (25%) 5% Utilities 1% (3%)
Information Technology (10%) (23%) Financials (3%) (1%)
Health Care (24%) (14%) Comm Services (22%) 3%
Consumer Staples (60%) (5%) Energy (15%) (12%)

Source: MSCI, FactSet, Goldman Sachs Global Investment Research

Exhibit 11: Domestic cyclicals and financials led in the run-up to Exhibit 12: ‘Value’ and mid-cap stocks performed well heading into
2014 elections while defensives and exporters lagged elections in 2014 while ‘quality’ stocks with stronger balance
sheets and stable growth lagged
MSCI India sector performance around 2014 elections Styles performance around 2014 elections
Domestic cyclicals Value
Relative to MSCI India Long/short, sector neutral, eq wgt.,
(Industrials, Autos, Cement) (Cheap vs Expensive)
120 top vs bottom quartile
120 of BSE 200 stocks

110 Financials
Defensives GARP
100 (Staples, Telco, Utilities) Size (High vs Low)
90 Stable Growth
Balance Sheet (High vs Low)
90 (Strong vs weak)
80 Exporters
Start of Elections Election results Start of Elections Election results
70 80

























Source: FactSet, Goldman Sachs Global Investment Research Source: FactSet, Bloomberg, Goldman Sachs Global Investment Research

18 March 2019 6
Goldman Sachs India Strategy Views

How does the current election compare with recent past episodes?
While the historical analysis is helpful to see how markets have typically traded in
previous elections, we compare the current macro and market set-up to previous
elections (particularly to the 2014 elections) to gauge similarities and differences which
inform our view about the likely market reaction in coming months.

Performance and flows have so far lagged typical pre-election rallies but “catching
up”. We note that the current pre-election rally has started much later and has been
shallower than the typical past rallies. Foreign flows have also recently picked up and are
“catching up” with previous trends. In our view, the “delay” has largely been because,
this time around, the current government has been a stable majority government (as
opposed to coalition governments previously when markets rallied on hope of stability)
and the risk of a potentially less stable government (a lower majority) had kept most
foreign investors on the sidelines until recently.

Exhibit 13: NIFTY is catching-up with the typical past pre-election Exhibit 14: Indian equities have generally outperformed the region
rallies in the past heading into the elections
NIFTY performance around past elections NIFTY vs MXAPJ performance around past elections
125 115

120 NIFTY has generally

performed well heading 110
115 into elections NIFTY perf.
(avg. of past 6 elections 105
110 since 1996) NIFTY vs MXAPJ
(avg. of past 6 elections
105 since 1996, US$)
100 (Current perf.)
Election results
95 Election results
95 Start of Elections Start of Elections
Current NIFTY
90 90




Source: Bloomberg, Goldman Sachs Global Investment Research Source: Bloomberg, MSCI, FactSet, Goldman Sachs Global Investment Research

Exhibit 15: Foreign flows have recently picked up and are Exhibit 16: Volatility has typically risen heading into the elections
“catching up” with previous trends and fallen post elections
Cumulative FII equity flows before & after past India VIX before & after past general elections in
general elections in India (US$ bn) India
$30 90
$25 2014 elections 80 Volatility has typically
risen heading into the
$20 70 elections and fallen
$15 2004 elections 60 post elections

$10 50

$5 2009 elections 40 2009 elections

Current FII flow
$0 trend 30 Current Vix trend
Election results 10 2014 elections
-$10 Election results





















Source: Bloomberg, Goldman Sachs Global Investment Research Source: Bloomberg, Goldman Sachs Global Investment Research

Opinion polls suggest an increasing chance of the current leadership returning to

power. While taking no view on the outcome of the upcoming national elections, we
note that market consensus about a month ago was that the Modi-led BJP looks

18 March 2019 7
Goldman Sachs India Strategy Views

well-positioned to remain the single-largest party, and would return to power with
perhaps some additional allies needed (as suggested by our meetings with the leading
political analysts during our macro tour). However, several polling experts also noted that
the recent tensions between India and Pakistan have likely triggered some nationalistic
sentiment and shifted the focus of the election from the economy to security issues,
which could further increase the chances for the current leadership to return to power.
In fact, the recent opinions polls announced in the month of March show that the
BJP-led National Democratic Alliance (NDA) has gained ground and would be closer to
the midway majority mark of 272 seats in the 543-seat Lok Sabha.

We see better macro, fundamental and positioning set-up currently but starting
multiples are elevated. We compare the current market set-up in terms of macro
fundamentals, positioning, valuations and market technicals to the pre/post election
period in 2014 (as detailed in Appendix). We note that the current domestic macro
set-up looks better than in 2014 (given improving economic activity, lower inflation and
rates, stronger bank balance sheets). Liquidity dynamics are also supportive with
offshore positioning (within dedicated EM/AEJ mutual funds) improving from multi-year
lows and domestic funds getting inflows (albeit at a slower rate). Having said that, the
starting point for the current pre-election rally is higher in terms of multiples suggesting
lower upside on an aggregate basis (compared to the 17% rally that we saw 3 months
before the 2014 election results).

Exhibit 17: Recent opinions polls announced in the month of March Exhibit 18: The starting point for the current pre-election rally is
show that BJP-led NDA has gained ground higher in terms of multiples compared to previous election
episodes, suggesting lower upside on an aggregate basis

Opinion Polls for the general elections 2019 MSCI India 12-month forward PE (X) PE Change (%)
1 month 3 month
3 months 1 months 3 months 1 months
IndiaTV-CNX ABP News-C Voter after after
before before before before
Election election election
No of Period Period elections elections elections elections
year result result
seats won 1996 10.8 11.0 13.3 11.6 10% 8%
in 2014 Dec’18 Mar-19 Jan-19 Mar-19
1998 10.0 9.1 10.8 9.0 1% 11%
NDA 336 281 285 233 264 1999 14.2 13.7 12.7 14.6 0% 4%
2004 14.8 14.2 11.3 12.0 -28% -25%
UPA 60 124 126 167 141 2009 9.5 13.4 17.7 17.1 85% 31%
2014 14.0 14.9 16.3 16.0 11% 4%
Others 147 138 132 143 138 Median 12.4 13.5 13.0 13.3 5% 6%
543 543 543 543 543 2019 17.8 Current : 18.1X

Source: ABP News, IndiaTV News Source: FactSet, Goldman Sachs Global Investment Research

18 March 2019 8
Goldman Sachs India Strategy Views

How much is already priced in? Fair valuations but likely overshoot

With NIFTY already up 8% from its Feb lows, one of the key questions for equity
investors is how much election-related optimism is priced in and how does the
risk/reward look relative to the fundamental backdrop. Our base case remains flat target
valuations of 18x in 12 months as current valuations appear fair relative to the current
macro backdrop. However, there could be potential ‘valuation overshoot’ in the near
term on election-related news flow. A composite approach using various valuation
methodologies suggests a 10% overshoot on average if valuation metrics go to the
extremes during the 2014/15 election.

Indian equity valuations remain elevated relative to their long-term history

MSCI India headline 12-month forward valuations are at 18x, which is almost 1 s.d.
above its 15-year historical mean and about a 40% premium to MXAPJ (vs. 25%
average). At 18x forward PE, India remains the most expensive market in Asia.

Exhibit 19: Indian equity valuations remain elevated relative to Exhibit 20: ...and are trading at a 40% premium to the region
their historical range...

26X MSCI India 12-month forward P/E (since 2004)

NTM P/E premium / discount since 2004
Forward P/E Average 60% MSCI India vs MXAPJ 57%
22X 50% 50%
+1 SD -1 SD
40% 42%
40% +1 S.D. 39%
18X 30%

20% Mean:26%
10% -1 S.D.
































Source: MSCI, FactSet, Goldman Sachs Global Investment Research

Current valuations are largely ‘fair’ relative to the macro backdrop

Our PE macro model, which includes forward growth expectations (consensus GDP
growth estimates for India and our leading activity indicator for global growth) and
domestic CPI inflation, suggests that equities are currently trading at their ‘fair’ value of
18x P/E. Despite softer domestic and global growth over the past year, equity valuations
have, in part, been supported by declining inflation. Valuations have historically also risen
with falling rates/bond yields. So the sharp fall in bond yields over the past 6 months
(10-year yields down 85bp from Sep peak of 8.2%) has supported valuations with equity
valuations looking largely in line from a pure historical earnings/bond yield gap
perspective. With expectations of further pick-up in inflation and limited further room for
yields to go down, we see limited fundamental room for significant re-rating from
current levels.

18 March 2019 9
Goldman Sachs India Strategy Views

Exhibit 21: Current equity valuations look ‘fair’ relative to the macro Exhibit 22: With the sharp fall in bond yields over the past 6
backdrop; our model forecasts flat 18x target multiple in 12 months months, equity valuations look largely in line from a pure historical
equity/bond yield gap perspective
MSCI India macro model implied P/E
(x) Fwd. PE vs. 10-yr rates
Macro model PE 22X R† = 41%
20x R-sqr = 70% (since 2010)
(India/Global growth, CPI Current
Inflation) 20X


16x 18X 18X

14x 16X
14X Valuations have
10x Actual MSCI India PE historically
(12-mo fwd.) 12X corrected with rise
8x in bond-yields
6x 10X (since 2010)
6.0 6.5 7.0 7.5 8.0 8.5 9.0












India 10-Year Govt Bond Yield (%)

Source: FactSet, MSCI, Haver Analytics, Goldman Sachs Global Investment Research Source: Bloomberg, FactSet, MSCI, Goldman Sachs Global Investment Research

Quantifying a potential ‘valuation overshoot’ scenario

While our base case remains flat target valuations in 12 months, there could be a
potential ‘valuation overshoot’ in the near term on election-related news flow. If the
opinion polls in upcoming months indicate a rising chance for a majority government or
the government wins elections with a decisive mandate, markets could overshoot akin
to previous episodes. MSCI India has traded at a peak valuation of almost 23x and
50-60% P/E premium to region in the past suggesting room for potential ‘valuation
overshoot’. Additionally, light offshore investor positioning (as evidenced by multi-year
low allocations among Asian and EM mutual funds) could amplify price moves and
potential overshoot.

In order to quantify a potential ‘valuation overshoot’ scenario, we adopt a composite

approach considering valuation extremes during 2014/15 episode from several angles.
Specifically, we examine three approaches: a) relative PE models if PE premium goes
back to 2015 high; b) changes to our India implied cost of equity (ICOE) model if ICOE
goes back to 2014/15 low; and c) implied P/E if earnings/bond yield gap reverts to
2014/15 low. The bottom line is that equity valuations could see a 10% overshoot
on average if valuation metrics go to the extremes during the 2014/15 election.

We summarize the three approaches below:

n Relative P/E premium analysis: During the past 15 years, Indian equities have
traded at an average PE premium of 26% to the region (which is in line with the
relative GDP growth differentials between India and the rest of the region). During
the 2014 elections, India’s PE premium rose to 40% by the end of 2014 and peaked
at 52% by the middle of 2015. The PE premium has subsequently remained
elevated (averaging 40% since 2015 given the political stability and reforms).
Historically, 50-60% premium has consistently marked the relative peak for Indian
equities in 2007, 2015 and recently in August 2018. In a valuation overshoot scenario,
we assume PE premium goes back to highs of 2015 (52% premium) with MSCI
India PE of ~20x (which is coincidently peak PE post the 2008 crisis) and implies
11% upside from current levels.

18 March 2019 10
Goldman Sachs India Strategy Views

n Changes to India’s ICOE: As an overshoot case, a decisive majority for the winning
party could translate into a lower equity risk premium for the market. During the
2014 elections, India’s implied cost of equity (ICOE) dropped 30bp heading into the
elections in 2014 and another 60bp in the 9 months following the elections amid the
‘reform hope’ rally and touched a low of 11.1% as per our model. Given current ICOE
is already at 11.4% which is 0.5 s.d. on the expensive side of history, we assume it
could fall 30bp further to the 2015 low of 11.1% in our upside case. Based on our
ICOE model, a 30bp reduction in ICOE would translate into 8% upside from current

Exhibit 23: If we assume India’s ICOE will fall 30bp further to 2015 Exhibit 24: India ICOE model sensitivity: Every 25bp fall in COE
low, that would translate to 8% upside from current levels would translate to 6% upside from current levels, based on our
DDM model

15 Implied cost of equity, MSCI India (%) MSCI India fair-value % change under DDM model
14 20% A 25bp fall in COE
implies 6% upside for
MSCI India
13 MSCI India 12.7 10%
11.4% 5%
12 (-0.5sd) +6%

11 -5% Current
2014 general ICOE:11.4%
election results
10 -15%














10.75 11.00 11.25 11.50 11.75 12.00

Implied Cost of Equity (ICOE) (%)

Source: FactSet, MSCI, Goldman Sachs Global Investment Research Source: FactSet, MSCI, Goldman Sachs Global Investment Research

n Earnings/bond yield gap analysis: From an equity/bond yield gap perspective, the
gap between MSCI India earnings yield and the 10-year government bond yield has
recovered from its decade lows in August last year as earnings yields rose and bond
yields fell sharply. Our base case assumes moderate downside to equity valuations
if the yield gap continues to normalize to past historical averages. However, in our
valuation overshoot scenario, we assume the yield gap goes back to its lows during
2014/15, which implies potential upside of 13% from current levels.

18 March 2019 11
Goldman Sachs India Strategy Views

Exhibit 25: Equity/bond yield gap for India has recovered from its Exhibit 26: We see moderate downside if the yield gap reverts to
decade lows in August last year historical average; however if the yield gap goes back to 2014/15
low, we see 13% upside in overshoot scenario

(%) If yield gap closes to average

MSCI India Earnings Yield (1/NTM PE)
11 5%
Earnings/ MSCI India Implied
10 India 10-Year Govt 4% bond Implied Upside /
9 Bond Yield 3% Period Yield Gap Index PE downside
8 2% Base 3-Yr -1.6 16.6 -6%
7 1% case 5-Yr -1.8 17.1 -3%
6 0% (Average) Since 2010 -1.5 16.4 -8%
5 -1% If yield gap goes to 2014/15 lows
Avg. Yield -2% Upside
3 Yield Gap Gap -3% risk case 2014-15 -2.6 20.1 13%
(MSCI India Earnings Yield-10yr Govt. bond yield, RHS)
2 -4%














Source: MSCI, FactSet, Bloomberg, Goldman Sachs Global Investment Research Source: FactSet, MSCI, Goldman Sachs Global Investment Research

A composite average of the above three approaches suggests a 10% overshoot on

average if valuation metrics go to the extremes during the 2014/15 election.

Exhibit 27: Indian equity valuations could see a 10% overshoot on average if valuation metrics go to the extremes during 2014/15 election

Summary of potential valuation overshoot scenarios based on different approaches

Bull case ’overshoot’
Model Current scenario (Valuation metrics Potential
Approach Variable level go to 2015 levels) Upside
Relative P/E PE premium to
premium to the region goes to 2015
MSCI India MXAPJ region NTM P/E 18.0x 19.8x high (52% prem.) 10% Avg. 10%
valuation ICOE goes back to Valuation
models ICOE model Implied COE 11.4% 11.1% 2014/15 low 8% Overshoot
Earnings/Bond Yield Yield gap goes to
Gap model Yield gap -1.8% -2.6% 2014/15 lows 13%
Average 10%

Source: MSCI, FactSet, Goldman Sachs Global Investment Research

18 March 2019 12
Goldman Sachs India Strategy Views

Market and sector views: Upgrade India to overweight; Favor domestic

cyclicals over defensives and exporters

Raising India back to overweight: We downgraded India to marketweight in mid

September last year on near-term macro/earnings risks, stretched valuations and
election-related uncertainties. We expected foreign investors to stay on the sidelines
until the elections and NIFTY to perform better later this year after political uncertainty
waned and earnings recovered.

With India’s sharp underperformance in the first two months of this year (albeit partly
retraced), a better-than-expected 3QFY19 earnings season in February (with signs of
uptick in demand and improving asset quality trends) and pick-up in foreign flows (from
multi-year low positioning) amid rising market expectations of a potentially stable
government, we think risk/reward on India looks favorable again. On a full calendar-year
basis, we expect earnings growth in India to pick up to 16% this year and 14% next year
(highest in the region) vs. only 3%/8% for MXAPJ, which should drive NIFTY’s
outperformance. We expect NIFTY to reach our refreshed target of 12500 in 12
months (vs. 11700 earlier) with a flat target multiple of 18x (previously 17.4x – the
increase in our index target comes roughly half from earnings upgrades given
better-than-expected 3QFY19 earnings and half from a higher target multiple). We
expect returns to be driven largely by earnings with potential valuation overshoot in the
near term.

Exhibit 28: Despite the recent recovery, India remains a laggard so Exhibit 29: We expect India earnings to grow 16% this year and
far ytd 14% next year, highest in the region
EPS growth forecasts
Performance breakdown by market, MXAPJ (2019ytd)
GS top-down Consensus
40% FX impact Forward PE chg Market 2019E 2020E 2019E 2020E
30% Forward EPS chg Price Return (USD) Australia 3% 3% 4% 4%
China 6% 8% 11% 14%
20% Hong Kong 6% 7% 9% 10%
India 16% 14% 21% 19%
10% Indonesia 11% 12% 10% 12%
Korea -4% 11% -13% 16%
0% Malaysia 7% 5% 1% 7%
Philippines 10% 12% 12% 12%
-10% Singapore 5% 7% 6% 8%
Taiwan -2% 7% -3% 12%
Thailand 4% 10% 8% 8%
MXAPJ 3% 8% 4% 12%

Source: FactSet, MSCI, Goldman Sachs Global Investment Research

Sector views: Raising cyclicality in our allocations; Upgrade PSU banks, industrials
and autos to overweight
We increase the cyclicality in our sector allocations and upgrade PSU banks, industrials
and autos to overweight. We downgrade tech, metals and NBFCs to underweight.
Thematically, we prefer domestic cyclicals over defensives and exporters.

n Financials: We retain our overweight stance on private banks. Our analysts have
noted that retail loan growth remains strong while corporate-private banks continue
to see improving profitability on account of lower slippages. We upgrade PSU

18 March 2019 13
Goldman Sachs India Strategy Views

banks to overweight given sharp improvements in asset quality trends, attractive

valuations and likely pick-up in credit growth (as banks come out of narrow
banking/PCA and likely gain some market share from NBFCs). We downgrade
NBFCs to underweight given lingering concerns about liquidity, lack of clarity over
regulatory changes (around ALM norms) and potential asset quality issues (from
real-estate exposure). While NBFC valuations remain undemanding, a material
re-rating is unlikely in our view given continued uncertainty and likely lower
n Exporters: We downgrade tech to underweight as our analysts think profitability
could come under pressure given likely slower IT spending growth in 2H 2019,
pricing pressure (due to stiff competition and higher employee costs) and margin
headwinds from a stronger INR (from stronger FII inflows). We also expect the
sector to underperform in a cyclical-led rally given the defensive nature of the sector.
We retain Pharma at marketweight given signs of stabilization in the US generic
price erosion, light positioning and significant underperformance over the past few
years. However, earnings recovery seems gradual, suggesting balanced risk/reward.
n Defensives: We think defensives will continue to underperform as investors rotate
out of ‘safe haven’ / defensive stocks into cyclicals. We stay underweight staples
given their elevated valuations and crowded positioning. The sector has already
priced in better consumer demand (on the back of higher election spending) and a
shift in market share towards organized players. We also stay underweight telcos
given weak profitability and further earnings downgrade risk.
n Cyclicals: We upgrade industrials to overweight. For infrastructure stocks, we
expect outperformance to resume and earnings growth to pick up beyond the
temporary slowdown due to elections. The sector will continue to benefit from
government-driven infra capex in the near term and potential pick-up in private capex
in the medium term. With current sector valuation near average, risk reward looks
attractive in our view. We also upgrade autos to overweight. The sector is the
worst performing sector ytd (-10%) amid weak urban demand and typical
pre-election deferment of purchases and has significantly lagged the broader market
over the past year (almost 30% underperformance since 2018). Our analyst thinks
that the recent demand weakness should reverse over the next few months, barring
any renewed weakness in the rural economy. We stay marketweight on other
cyclical sectors like cement, metals and energy.

18 March 2019 14
Goldman Sachs India Strategy Views

Exhibit 30: We favor domestic cyclicals over staples and exporters; Exhibit 31: Relative valuations of domestic cyclicals have come
current entry point looks attractive relative to history down relative to staples and exporters over the past year

Relative Performance of MSCI India sectors since 2014 1.6 12-month forward P/E relative valuations (X)
160 (rebased to 100) (MSCI India sectors)
1.4 Domestic
150 Dom cyc vs Staples Cyclicals vs Exporters
140 Dom cyc vs Exporters
130 1.0
120 0.8 Domestic cylicals vs
110 Staples
0.2 Domestic Cyclicals = Industrials, Cement, Consumer cyclicals
70 0.0































Source: FactSet, Goldman Sachs Global Investment Research Source: FactSet, Goldman Sachs Global Investment Research

Exhibit 32: We raise the cyclicality in our sector allocations and upgrade PSU banks, industrials and autos to overweight

Consensus estimates


NIFTY Sectors NTM P/E (X)
Allocation (%) growth (yoy) growth (yoy) (X)

Private Banks OW 26% (9%) 65% 21.5 3.5

Autos OW 7% (1%) 16% 18.9 3.0
Industrials OW 5% 15% 17% 19.4 3.4
PSU Banks OW 2% (276%) NM 11.1 1.4
Oil & Gas MW 14% 13% 9% 12.9 2.1
Cement/other mat. MW 4% 6% 19% 28.5 3.3
Metals & Mining MW 3% 2% (4%) 8.0 1.0
Utilities MW 3% 10% 22% 10.2 1.4
Pharma MW 2% 51% 35% 21.9 2.9
Infotech UW 14% 16% 9% 17.6 4.9
NBFCs UW 10% 20% 15% 26.1 4.9
Staples UW 8% 11% 16% 31.4 9.1
Telco UW 2% 0% (1%) 110.4 2.3
NIFTY 100% 5% 26% 18.3 X 3.0 X

Source: FactSet, Goldman Sachs Global Investment Research

18 March 2019 15
Goldman Sachs India Strategy Views

Ideas: Short-dated upside options; Value Cyclicals and Oversold quality


We highlight three near-term ideas for investors to participate in the current rally: a)
short-dated NIFTY call options; b) ‘Value’ cyclicals rated Buy by our analysts; and c)
oversold ‘quality’ mid-caps.

1) Short-dated call options: For investors looking to positioning for upside in the run-up
to the elections while limiting downside risk, we recommend buying short-dated calls
on NIFTY. Short-dated implied vols have fallen over the past month as geopolitical risks
have subsided with NIFTY 1-mo ATM implied vols at 14pts, 3 vol points below mid-Feb
high and 5 vol points lower than its ytd high. We prefer outright calls to call spreads
given low cost-savings on call spreads currently (owing to low put-call skew). We also
note that NIFTY options are pricing in relatively lower election-related volatility /
‘event-risk’ in their term structure (compared to the 2014 elections). We recommend
buying NIFTY May-end expiry 11700 strike calls (2.4% OTM) at an indicative cost of

Risks: Buyers of outright calls risk loss of premium paid, if NIFTY rises less than 2.4%
(strike price) by May-end expiry.

Exhibit 33: NIFTY short-dated implied vols have fallen over the past Exhibit 34: NIFTY options market is factoring in a relatively lower
month as geopolitical risks have subsided election-related volatility / event risk in its term structure
compared to 2014
22 NIFTY ATM implied vol Term structure
NIFTY 1-mo ATM implied vol (%)
ATM implied vol (%)

16 22
Average 20

12 16
5-yr ago (2014 elections)
10 12












Source: Goldman Sachs Global Investment Research Source: Goldman Sachs Global Investment Research

2) Value cyclicals: As we noted before, we think ‘Value’ and ‘Cyclical’ parts of the
markets will perform better in coming months with investors rotating out of ‘safe haven’
or ‘quality’ stocks as political uncertainty continues to fade. We screen for top-quartile
‘Value’ stocks within cyclical sectors that are rated Buy by our analysts. Our list of 7
stocks trades at 16x forward PE and offers 16% earnings growth on a median basis. On
an equal-weighted basis, our ‘Value cyclicals’ list of stocks outperformed NIFTY by 15%
in the 3 months heading into 2014 elections. In terms of entry point, the list of stocks is
currently 17% below its 1-year high and trades at mid-cycle valuations suggesting
attractive risk-reward.

18 March 2019 16
Goldman Sachs India Strategy Views

Exhibit 35: We screen for top-quartile ‘Value’ cyclicals that are rated Buy by our analysts
Screening Criteria: 1) top-quartile Value stocks within BSE 200, 2) Cyclical sectors including financials, industrials, materials and consumer
discretionary, 3) rated Buy by GS analysts

Cyclicals B
Size and liquidity Fundamentals
Average GS
Listed FY20E/21E NTM LTM
Company Name Sector Quoted Price Mkt Cap EPS Growth P/E P/B
code (US$mn) z-score
(US$mn) (CAGR,%) (X) (X)

SBIN IS State Bank of India Financials INR 291 37,423 87 150% 5.4 1.0 (2.5) B
ICICIBC IS ICICI Bank Financials INR 388 35,998 103 90% 10.9 1.8 (1.4) B
LT IS Larsen & Toubro Industrials INR 1379 27,864 52 16% 19.4 3.1 (0.6) B*
MM IS Mahindra & Mahindra Consumer Discretionary INR 686 12,277 41 5% 15.5 2.4 (0.5) B
ADSEZ IS Adani Ports & SEZ. Industrials INR 365 10,885 23 17% 16.6 3.2 (0.8) B
JSTL IS JSW Steel Materials INR 287 9,992 29 1% 10.8 2.1 0.1 B
AL IS Ashok Leyland Industrials INR 94 3,966 34 -1% 13.3 3.3 (0.5) B

Average 32,606 66 37% 13.1 2.4 (0.9)

Note: Consensus estimates based on Factset estimates; B = Buy, * denotes stocks in our regional Conviction list; Pricing as of Mar 14, 2019; GS ratings are from our equity analysts.
SBI & ICICI Bank valuations are on standalone basis

Source: FactSet, Bloomberg, I/B/E/S, Goldman Sachs Global Investment Research

Exhibit 36: On an equal weighted basis, Our ‘Value cyclicals’ stock Exhibit 37: Our Value cyclical stocks are trading at mid-cycle
list outperformed NIFTY by 15% in the 3 months heading into 2014 valuations relative to their history
elections; Current entry point looks attractive

Indexed Performance 22x Value Cyclicals

160 (Value cyclicals vs MSCI India, eq. weighted, rebased to 12-month forward P/E (X)
100) 20x
18x +1 S.D
130 14x
120 12x Avg.
110 10x
-1 S.D
100 8x

90 6x





























Source: FactSet, Goldman Sachs Global Investment Research Source: FactSet, Goldman Sachs Global Investment Research

3) Oversold ‘quality’ Midcaps: While mid and small-cap stocks have recovered with
NIFTY Midcap 100 rallying 11% over the past month, the recovery follows a sharp
underperformance over the past 1-year. The relative performance of NIFTY Midcap 100 is
still more than 20% below its 2018 highs suggesting further room for upside. However,
earnings sentiment remains weak with mid and small cap stocks continuing to see
sharp earnings cuts. We thus remain selective in mid-caps and prefer stocks that have
been oversold but are seeing positive earnings momentum and have relatively stronger
balance sheets. We screen for Buy and Neutral-rated stocks within NIFTY Mid Cap 100
that are at least 10% below their 1-year high, have seen either EPS upgrades or slowing
downgrades (positive earnings momentum) over the past month and have relatively
stronger balance sheets. There is one Buy-rated stock among the 8 names in our
screen, TVS Motor (also on Conviction List).

18 March 2019 17
Goldman Sachs India Strategy Views

Exhibit 38: Mid-caps have further room to catch-up given large underperformance last year but earnings sentiment among mid and
small-caps remains very weak

Performance since 2018 105 Earnings Revisions NIFTY Midcap 100 NTM P/E
115 25
(rebased to 100) (FY20E, rebased to 100)
110 P/E @ start of
NIFTY 100 2018: 21.5X
105 NIFTY 20
95 15
90 NIFTY Current P/E:
85 NIFTY 10
Midcap100 16.2X
80 Midcap100 z-score:0.9
75 85 5
















Source: FactSet, Goldman Sachs Global Investment Research

Exhibit 39: We screen for oversold mid-caps with positive earnings momentum and stronger balance sheets

EPS rev > 0% OR non-sell

<-10% < 50% >3x EPS delta > 0 rated
Balance sheet
Size and liquidity Earnings Change Fundamentals
below Interest FY20E GS
6M Debt delta FY20E/21E Average
Listed 52 week Coverage Earnings NTM LTM Rating
BBG Quoted ADVT to (Change EPS PE/PB
Company Name Sector Mkt Cap high (EBIT/ revisions P/E P/B
code Price (US$m Assets in 1-mo Growth z-score
(US$mn) Interest (1-mo (X) (X)
n) (FY18, EPS (CAGR,%) (10-yr)
expense, change)
%) revisions
TVSL IS TVS Motor Company Consumer Disc. INR 492 3,365 12 (29%) 50% 3.6 (0.3%) 2% 21% 24.4 7.0 0.6 B*
EXID IS Exide Industries Consumer Disc. INR 229 2,805 7 (25%) (6%) 21.9 0.1% 7% 20% 21.6 3.4 0.2 N
PNB IS Punjab National Bank Financials INR 84 4,624 27 (19%) - - 5% 16% NM 11.4 1.0 (0.2) N
AMRJ IS Amara Raja Batteries Industrials INR 747 1,839 5 (18%) (2%) >100x 1% 5% 23% 21.1 3.8 0.0 N
KKC IS Cummins India Industrials INR 742 2,961 7 (16%) (12%) 59.1 (1%) 1% 11% 24.1 4.8 (0.4) N
CROMPTON IS Crompton Greaves Cons. Consumer Disc. INR 227 2,051 2 (16%) 4% 8.1 0.5% 1% 20% 31.3 14.3 (1.1) N
GUJS IS Gujarat State Petronet Utilities INR 180 1,462 1 (12%) 41% 6.8 (1%) 4% 8% 12.6 1.9 (0.1) N
GNP IS Glenmark Pharma. Health Care INR 630 2,562 8 (10%) 25% 4.4 (2%) 1% 22% 18.8 2.9 (0.1) N

Average 2,649 10 (18.9%) 6.0% 20 0.3% 3.5% 16.9% 19.9 4.8 0.1
Note: Consensus estimates based on Factset estimates; B = Buy, * denotes stocks in our regional Conviction list, N= Neutral; Pricing as of Mar 14, 2019; GS ratings are from our equity analysts.

Source: FactSet, Goldman Sachs Global Investment Research

18 March 2019 18
Goldman Sachs India Strategy Views

Appendix I: Comparing current macro/market set-up vs. 2014 election rally

Exhibit 40: Current macro and market set-up looks better than 2014 on most metrics but current starting valuations are higher than during
the 2014 election rally

How does the current rally compare to the previous rally in 2014 ?

1Q CY2014 1Q CY2019 Comments

Current Activity Indicator 6.6% 6.7% Similar

GDP Growth (% yoy, NSA) 5.3% 6.6% Pick up

Macro Indicators CPI Inflation (% yoy) 8% 2% Lower

Composite PMI 48.9 53.8 Expansion

IP (% yoy, 3m MA) 4% 4% Similar

Mfg. Capacity Utilization (%) 71.5 74.8 Improved

IP: Consumer Durable Goods (% yoy, 3m MA) 8% 6% Similar

IP: Capital Goods (% yoy, 3m MA) -4% 6% Improved

Investment PMI: Manufacturing 51.3 54.3 Improved
Demand Domestic car sales (% yoy, 3m MA) -6.4% -2.0% Improved

Airline passenger traffic (% yoy, 3m MA) 3% 12% Improved

CV Sales (% yoy, 3m MA) -25% -0.2% Improved

Loan growth (%) 13.9% (slowing) 14.4% (increasing) Improved

Total Stress loan as % total loans
(GNPL + restructured loans) 12% (Mar’14) 15.4% (Sep’18) Higher NPL recognition

Credit Demand Provisioning coverage ratio 52% (FY14) 59% (3Q FY19) Improved
Tier- 1 ratio (Capital adequacy ratio for PSU Banks) 11.4% (Mar’14) 11.3% (Sep’18) Similar
NBFC: share in total credit (%) NBFC’s systemically
14% (Mar’14) 17% (Mar’18)
more important

India 10Y yields 8.8 7.4 Lower rates

Interest rates
US 10Y yields 2.7 2.7 Similar

MXIN EPS growth (% yoy) -2% (3QFY14) 7% (3QFY19) Recovery

Equity MXIN Sales growth (% yoy, ex-fin.) 4% (3QFY14) 20% (3QFY19) Recovery
BSE200 erns sentiment
-11% -10% Similar
(12-mo fwd)

MSCI India Starting fPE/ tPB/ Z-score since ’04 14.7x / 2.8x / -0.3 17.8x / 3.0x / 0.7 Worse

MSCI India NTM P/E premia (vs MXAPJ) 25% 35% Worse
ICOE (%) 12 11 Worse

Mcap as % GDP 60% 76% Worse

FII Flows (US$ bn, 3-mo MA) 1362 1484 Favorable liquidity
Equity Flow /
Dom. MFs flows (US$ mn, 3-mo MA) -422 398 Favorable liquidity
AeJ/EM MF OW/UW (bp) 422 bp 162 bp Light positioning

ERB (1-yr Z-score) 1.9 1.4 Lower risk appetite

Sentiment Improving breadth;
% BSE200 stocks above 200 DMA (1-yr Z-score) 83% 56%
More room for upside

Source: CEIC, FactSet, Bloomberg, Goldman Sachs Global Investment Research

18 March 2019 19
Goldman Sachs India Strategy Views

Appendix II: India 2019 parliamentary elections: Important dates

The upcoming parliamentary elections in India will be held in seven phases from April 11
to May 19 with results being announced on May 23, 2019. The elections will be held for
543 seats/constituencies in the Lok Sabha (Lower House), which determines the
formation of India’s government. To form a majority, a party (or coalition) must win 272
seats. The ruling BJP-led alliance NDA (National Democratic Alliance) and opposition
congress-led alliance UPA (United Progressive Alliance) are the two major national
political alliances. Please see our economists’ report India, Lower House Election Dates
Announced for more details.

Exhibit 41: India’s 2019 parliamentary elections will be held in Exhibit 42: Current Composition of the Lower House of Indian
seven phases from April 11 to May 19; results will be announced on Parliament (by political party)
May 23
India parliamentary elections 2019 77 seats

Apr 11 - May 19 Parliamentary elections

302 seats Other parties
Election No. of No. of seats 140 seats
phases states /constituencies
Phase-1 11-Apr 20 91
Phase-2 18-Apr 13 97 Nominated/Independen
Phase-3 23-Apr 14 115 Lower House: 545 seats*
4 seats
Phase-4 29-Apr 9 71 BJP+: BJP, Akali Dal, Shiv Sena, and others
Phase-5 6-May 7 51 Congress+: Congress, TDP, RJD, NCP and others
Phase-6 12-May 7 59 Other parties: AIDMK, BJD, BSP, Left, SP and
Phase-7 19-May 8 59 *22 seats are vacant

May 23 Elections results

Source: Election Commission Source: Lok Sabha, Goldman Sachs Global Investment Research

18 March 2019 20
05 March 2019

Is the Small Cap Underperformance Over?

B&K Research
+91-22-4031 7000 1
Is the Small Cap Underperformance Over?
The Small Caps on an average (based on the BSE Small Cap Index) have underperformed their large cap Peers by
almost 40% over the last 13 months. The general view seems to be that this underperformance will continue at least
till the elections. We believe that the major part of the underperformance is over and it is time to increase the
allocation to smaller stocks in one’s portfolio. Why?
BSE Small Cap Index vs BSE Sensex 1. The ratio of the Small cap BSE Index to the BSE
Sensex has been a good indicator in the past and
it shows that when the underperformance 1
standard deviation below its mean, it does not
fall much beyond that.
2. The Relative performance of Small Caps depends
on how the Economy is doing. And many
indicators are suggesting that the Economy is
turning around. Even the Risk Factors of
Economic Growth seem to be in control.
3. The Valuations of the smaller stocks have also
corrected in this fall and are much more
Source: BSE, Bloomberg

So how should we play this?

It is impossible to predict exact bottoms. In the past we have seen that when the stress in the Economy is very high
the underperformance can undershoot the one standard deviation mark. However the good news is that over a 3
year even buying from these levels always gives a positive outperformance.
Given the current political, geo-political and external uncertainties, it may be a little early to be too aggressive. But,
this is definitely a good time to start accumulating your favourite smaller-cap stocks.
Here is a list of our favourite bottom up ideas:
Small-Caps : Heidelberg Cement, Inox Leisure, KEI Industries, Subros, Suven Life Sciences, VRL Logistics Westlife
Mid-Caps : Atul, Bayer Cropscience, Cholamandalam Investment, Gujarat State Petronet, Sanofi India, Trent 2
1. Underperformance of Small Cap stocks is largely
over based on our Indicator
The small cap Index vs the BSE Sensex is close (2% away) to - 1 standard deviation from its mean. Historically the
Index does not fall much below this level. This implies that the underperformance of the Small Caps vs the Large
Caps (let’s call this the Small Cap Relative Index or SCRI) is almost over.
BSE Small-Cap vs Sensex

Source: BSE, Bloomberg

What is the Risk?

A few times the Small Cap relative Index has undershot the -1 stdev mark. The worst case has been at 26% below the
current level. This happened when India was going through a currency Crisis in 2013 when India was considered one
of the Fragile 4 and was reeling from high Twin deficits. Even during the Financial Crisis the Small Cap relative Index
the Index turned from around the -1 standard deviation level. So in case we get back into a Crisis mode, the
downside could be another 30%.
Note: The starting point for this study has been chosen when M1 growth was at its average of around 13%. In fact
even if we chose other starting periods where the M1 growth is at 13%, the results are the same.
Historically if you bought the SCRI at its – 1 Standard deviation to the mean, you would not have lost your money in
any 3 year period. In general, the rise over any 3 year period has been significant.
2. The Small Caps do well when the Economy does
The SCRI has tracked the Economy pretty well. When the Economy does well, it tends to rise. The graph below shows
the SCRI vs smoothened M1 Growth over a period of 15 years. We have found M1 growth to be a good indicator of
the Economic activity (one exception being the demonetisation phase).

M1 Growth vs SCRI

Source: BSE, Bloomberg

The above implies that if the Economic activity turns for the better, there is a fundamental reason for the small cap
underperformance to end. The good news is that M1 growth is now at about its long term average. Also, that the
economy has bottomed out is getting confirmed by some of the other Economic activity indicators like Credit
growth and IIP growth.

Most indicators suggest that Economy has not only bottomed out but
seems to be picking up
Bank Credit Growth
Credit YoY Avg
std+1 std-1
30.0 Credit growth has picked up from
25.0 the lows in 2017. We expect the
20.0 growth momentum to continue as
15.0 industrial cycle picks up and
personal credit cycle continues its
good run.












Source: RBI, Bloomberg

IIP Growth
IIP growth has picked from levels
25.0 seen in the last 5 years: IIP growth,
20.0 IIP YoY which has averaged 6.1% since April
15.0 Avg 2000, had dipped to a flattish 4.0%
std+1 over the last 5 years. However, it
has picked up this year, averaging
5.0 4.6%, ytd. The growth should
0.0 further accelerate as capacity
utilization rises on the back of












IIP 12mma higher investments and election-
related sops to drive consumption.
Source: RBI, Bloomberg

Economy Capacity Utilization & GFCF
Capacity Utilisation %
85 25
83 Investments GDP YoY 20 September 2018 capacity utilization,
15 at 74.8%, a ten year average, would
77 10
have maintained its uptrend in the

last 3-4 months: Historically,
71 whenever capacity utilization has
gone above average, growth in
65 -15
investment has accelerated.










Source: RBI, Bloomberg

Govt Capex
Capital Expenditure of Centre+State in Rs bn
9000.0 45.0
8000.0 40.0
5000.0 20.0 Capital Expenditure of Centre and
4000.0 15.0
State is on the rise.
1000.0 -5.0
0.0 -10.0

Source: RBI, Bloomberg

Risk factors for Economic Growth are well under control

Inflation & Inflation Expectations

CPI Inflation

CPI avg stddev+1 stdev-1 CPI inflation is down and likely to
stay down for an extended period
6.00 helped by excess supply in food and
4.00 overall low commodity prices. We
expect CPI to rise from the current
(2.05%) level but stay below 3.0%
0.00 for a few months.













Source: RBI, Bloomberg

Inflation Expectation
Current perception of infla tion ra te
12 Infla tion expecta tions three months a hea d
Infla tion expecta tions one yea r a hea d


Household inflation expectation
9 shows a sharp drop (90 basis) in the
8 last survey in December 2018.

















Source: RBI, Bloomberg

Interest Rates

10 yr gsec and Repo
Structurally low inflation has
7.00 enabled the MPC to cut Repo rate
6.50 in the Feb policy. We expect
6.00 another 25 basis cut in April










Source: RBI, Bloomberg

Fiscal Deficit
7.0 Fiscal Def icit as % GDP


5.0 Even as some election related

4.0 dole-outs have caused fiscal deficit
3.0 target of 3.0% to be pushed to
2.0 FY21, overall deficit remains in the
1.0 manageable range.














Source: RBI, Bloomberg

Current Account Deficit
6.0 CAD as % GDP

4.0 CAD remains under control as

2.8 2.8 higher trade deficit is partly
neutralized by higher net
1.3 invisibles.
1.0 1.1
1.0 0.7

FY07 FY09 FY11 FY13 FY15 FY17 FY19( E )

Source: RBI, Bloomberg

INR Depreciation
Average INR & Depreciation vs USD
80 Avg INR 20
INR on the basis of Avg Cumulative Depreciation 15
Yrly Dep/Appr 10
60 5
-5 No substantial INR depreciation
40 -10 expected in the near term.
20 -25













Source: RBI, Bloomberg

3. The High Overvaluation of the Small Caps has also
BSE Small-Cap P/B vs BSE Sensex P/B
0.9 The small cap P/B vs the BSE Sensex
0.85 BSE (Small Cap P/B) P/B (let’s call this the SCBV) has
0.8 / (Sensex P/B) fallen 1.5% below the -1 standard
0.75 Mean deviation from its mean. Historically
the SCBV does not fall much below
Std Dev +1 this level. This implies that the fall
0.65 of the SCBV (underperformance of
0.6 Std Dev -1 small vs large caps) is almost over.












Source: BSE, Bloomberg

BSE Mid-Cap P/B vs BSE Sensex P/B

1.1 (BSE Mid Cap P/B) /
1 (Sensex P/B)
0.9 Mean The mid cap P/B vs the BSE Sensex
0.8 P/B (let’s call this the MCBV) on
0.7 the other hand is just 3% above its
Std Dev +1
Std Dev -1












Source: BSE, Bloomberg

March 12, 2019 I Economics
Survey on ‘Economic
Perspective for 2019’ CARE Ratings had launched its Survey on 'Economic Perspective for
2019' and reached out to experts in the various fields like CEOs, CFOs,
investors, analysts, economists and other stakeholders and gathered
their views on the economic perspective for India in 2019-20. The
Madan Sabnavis
Chief Economist objective was to assess the opinions on various aspects pertaining to
Madan.sabnavis@careratings.com economy in 2019-20. Broadly, the Survey covered,
+91-22- 6754 3489
 General elections and their outcome
 Effectiveness of policies implemented so far
 Macroeconomic perspectives
Dr Rucha Ranadive
Economist  Industries as growth drivers
rucha.ranadive@careratings.com  Banking
+91-22-6754 3531

285 participants responded to the Survey from various sectors like

Mradul Mishra (Media Contact) agriculture and allied, manufacturing, financial services, banking,
+91-22-6754 3515 infrastructure, real estate and services.

2% Services

Manufacturing Finance/Financi
23% al Services
Disclaimer: This report is prepared by CARE Ratings Ltd. 58%
CARE Ratings has taken utmost care to ensure accuracy and
objectivity while developing this report based on
information available in public domain. However, neither
the accuracy nor completeness of information contained in
this report is guaranteed. CARE Ratings is not responsible
for any errors or omissions in analysis/inferences/views or
for results obtained from the use of information contained
in this report and especially states that CARE Ratings has no
financial liability whatsoever to the user of this report
Based on 285 responses received for the Survey, the gist of the
responses has been summarised below;
Economics I Survey on Economic Perspective for 2019

Summary of Findings

 Most respondents feel that National Democratic Alliance (NDA) government will come back to power in 2019 either
with majority or in the form of coalition with new allies.
 Farm loan waivers will pressurise the fiscal situation of the state governments.
 Nearly 1/3rd of respondents feel that implementation of GST and resolution of banking system NPAs has been
unsatisfactory while ‘housing for all’, ‘power for all’ and ‘financial inclusion’ have been satisfactory. Therefore,
reaching out to the poor has been effective unlike the more complex issues like GST and NPA resolution.
 The economic growth in the upcoming fiscal year could be hindered on account of slowdown in global economy,
liquidity pressures in the banking system, Elections and rising crude oil prices.
 While most feel that inflation is likely to remain stable in 2019-20, the upside could emanate from rising crude oil
prices, adverse monsoon, fiscal slippage and depreciating rupee. MSPs are not a major concern.
 Main threat for fiscal slippage could arise from loan waivers announced by the government followed by higher
social expenditure and lower GST collections.
 The higher bank credit growth could be hampered due to overhang of NPA issue, liquidity pressures and stagnant
private investment growth.
 Majority of the respondents are unsure regarding the pick-up in the private investment.
 Hindrances for private investment pick up could be policy constraints, viability of projects, infrastructure
bottlenecks and low capacity utilisation.
 Healthcare, retail (including e-commerce), hospitality and tourism and infrastructure are some of the sectors that
are likely to witness uptick in the private investment.
 Growth in the industrial output will be driven by consumer durables, pharmaceuticals and drugs, construction,
automobiles and electronics.
 Corporate bond markets will be preferred mode for long term fund requirements while for short term
requirements, commercial paper would be preferred. Clearly a movement away from bank finance is expected to
some extent, albeit limited this year.
 With a view to improve the credit flow in the economy, measures related to enhanced lending to SMEs, low
interest rates, flexibility in PCA norms and merger of PSUs are essential.

Economics I Survey on Economic Perspective for 2019

General Elections in 2019

 Return of NDA government to power with absolute majority: Nearly 47% of the participants expect that the
existing NDA government will come back to power on their own while 34% said that there may not be absolute

 Coalition of the NDA with new allies to form government: If no absolute majority, it was asked whether there
would be a coalition government of NDA with new allies. 84% agreed on this.

Q1. In the forthcoming General Elections, do you expect the present Q2. If No, will there be a coalition of the NDA with new allies?
NDA government to get an absolute majority (more than 272
100% 84%
Can't 80%
say, 19%
Yes, 47% 40%
No, 34%
Yes No

Effectiveness of Policies by state and central government

 Announcements of farm loan waivers by Q3. As FRBM norms are stringent, will announcement of farm loan waivers by
the states: Many states have embarked on various states be a constraint on the respective state budgets for 2019-

announcing farm loan waivers despite tight

fiscal position. We asked whether these farm 10%
loan waivers, once implemented will be a
constraint on the state budgets for 2019-20
given that the FRBM norms are stringent. Yes,
90% agreed that these announcements will 90%
have a bearing on the fiscal situations of the
respective states.
Q4. How effective has been the policy implementation in
 Effectiveness of policy implementation: In the following?
the recent past, the government has 49%
50% 45%
announced various schemes such as housing 42% 41%
40% 32%
for all, financial inclusion, GST, resolution of 30% 31%
30% 25% 26%
NPAs by Banks, power for all. 20% 23%
20% 14%
9% 8%
 Participants indicated that implementation 10% 5%
2% 3%
of these policies has been satisfactory across 0%
Housing for all Financial GST Resolution of Power for all
various policies. Inclusion implementation NPAs by banks
Good Satisfactory Unsatisfactory Can't say

Economics I Survey on Economic Perspective for 2019

 GST implementation has been satisfactory as per 42% of the respondents though 30% are not satisfied. There is a
divided opinion with respect to resolution of NPAs in the banking system, 38% opine that implementation of policies is
satisfactory whereas 36% feel it is unsatisfactory.

 For the social oriented schemes the response has been very positive with over 2/3 being in favour.

Macroeconomic performance in 2019-20

 Economic growth: 40% are expecting the GDP Q5. What do you expect the GDP growth rate to be in 2019-20?
growth for 2019-20 at around 7%-7.5%, while 29% 50%
foresee it to be somewhere between 6.5%-7%. 40%
 23% people suggest that it would be above 7.5%. 19%
On the whole a little over 75% expect it to be 20%
below 7.5%. 10% 4%
Below 6.5% 6.5-7% 7-7.5% 7.5-8% Above 8%

 Risks to economic growth: More than 40% of Q6. In your opinion, what could be the top 3 risks to economic
participants think that liquidity pressures in the growth for the Indian economy in 2019-20?
banking system, slowdown in global growth and
Slowdown in global growth 44%
Elections would be risks for economic growth of
Liquidity pressures in banking system 44%
India in 2019-20.
Elections 40%
 More than 36% indicate that rising crude oil prices Rise in crude oil prices 36%
and fiscal slippages might pose another threat for Fiscal slippages 36%
high economic growth. Subdued investment activities 34%
Employment generation 28%
 As per respondents other risks pertain to Trade wars 23%
employment generation (28%), trade wars (23%)
Currency volatility 15%
and currency volatility (15%).

 Inflation: Nearly 64% are of the opinion that retail Q7. Do you expect retail inflation (consumer price inflation) to remain
inflation based on consumer price index will stable in 2019-20?
remain stable (at around 3.5-4%) in 2019-20. Can’t

No, 22%

Economics I Survey on Economic Perspective for 2019

 Upside risks to inflation: 74% feel that rising crude Q8: According to you, choose any 3 upside risks to inflation in
oil prices would pressurise the inflation going 2019-20?
ahead. More than 50% opine that adverse Rise in crude oil prices 74%
monsoons leading to lower agriculture production
Adverse monsoon 56%
(56%), fiscal slippages (51%) and weakness in the
rupee (50%) could result in higher inflationary Fiscal slippage 51%
pressures. Depreciating Rupee 50%
Higher remunerative prices to the farmers via
MSPs 33%
 33% expect increase in MSP can be another risk Implementation of pay commission
while implementation of pay commission recommendations
Increase in price of manufactured products
recommendations (18%) and increase in prices of and services 18%

manufactured products and services (18%) would

also be the factors associated with high inflation.

 Risks for fiscal slippages: 84% of the participants Q9: Choose the top 3 risks associated with fiscal slippage in 2019-
perceive loan waivers as a major risk for fiscal 20?
slippage. Loan waivers 84%
Higher social expenditure 60%
 While 60% attribute to higher social expenditure, Lower GST collections 57%
lower GST collections (57%) and lower Lower disinvestment proceeds 50%
disinvestment proceeds (50%) are the other Lower non tax revenue 33%
choices by the respondents. Lower direct tax collection 17%

 Risks for bank credit growth: Highest 87% of Q10: What could be the top 3 risks associated with bank credit
respondents attribute NPA overhand as a main risk growth in 2019-20?
for the bank credit growth going forward. NPA overhang 87%

 It has been followed by liquidity pressures (60%) Liquidity pressures 60%

and private investment not picking up (59%). Private investment not picking up 59%

Availability of capital 35%

 Other reasons pertain to availability of capital
Higher borrowing from other sources 32%
(35%), higher borrowing from other sources like
debt market, CPs and ECBs (32%) and high interest High interest rates 27%
rates (27%).

 Private investment picks up: 38% of the Q11: In 2019-20, will private sector investment pick up?
respondents are unsure regarding the pickup in
private investment in 2019-20 while 28% are sure
this will not happen. Can’t say, Yes, 34%

 Around 34% felt that there would be pickup.

No, 28%

Economics I Survey on Economic Perspective for 2019

 Factors hindering private investment: Q12: If No, please choose top 3 factors which could hinder private
Respondents, who do not foresee any pick up in investments?
private investment attribute it to policy constraints 80% 66%
(66%), viability of project (63%), infrastructure 60% 50% 53%
bottlenecks (53%) and low capacity utilisation 40% 26%
(50%) among others. 20%
Availability of Viability of Low capacity Cost of funds Infrastructure Policy
funds projects utilization bottleneck constraints

Industries as drivers of economic growth

 Sectors to witness pick up in private Q13: Choose top 5 sectors which are likely to see a pick-up in private
investment: As per the responses the investment in 2019-20?
top 5 sectors, which are likely to see pick
up in private investment are 80% 70% 72%
70% 58% 59%
60% 48%
50% 41% 36%
33% 31%
 Healthcare (72%), 40% 24%
30% 18%
 Retail (incl. e-commerce) (70%), 20% 11%
 Hospitality and tourism (59%), 0%

Real Estate





Hospitality and
Machinery and


Oil & Gas


Retail (including e-
Infrastructure (58%),


 Automobiles (48%).

 Industries to drive industrial output: Q14: Choose top 5 industries which are expected to drive the industrial
Consumer durables (80%) will be driver output in FY20?
for industrial output as per the majority
of the respondents. Other contributing 90% 80%
80% 69%
70% 60% 62% 56%
industries would be 60% 43% 42% 41%
40% 27%
 Pharmaceuticals and drugs (69%), 30%
 Construction materials (62%), 10%
 Automobiles (60%),

Refined petroleum

Machinery and

Oil & Gas





 Electronics (56%).
and drugs


Sources of borrowing preference for funding requirement: Nearly 59% are of the opinion that corporate bond market
would be a preferred avenue for raising long term funds over bank borrowings while for the short term borrowings
commercial paper would be preferred (51%).

Economics I Survey on Economic Perspective for 2019

Q15: Will companies prefer to raise long term funds Q16: Will companies prefer to raise short term funds through
through corporate bonds over borrowings from banks? commercial paper over borrowings from banks?
Can’t say,
say, 18% 17%

Yes, 51%
No, 23%
59% No,

 Banking sector measures to improve credit Q17: In order to improve the credit flow in the economy, which of
flow in the economy: Enhanced lending to the following banking sector measures will you recommend?
SME sector will improve credit flow in the 70% 61%
60% 52%
economy, opine highest 61% of respondents 42% 42%
followed by lower interest rates (52%), 40%
30% 24%
flexibility in PCA norms (42%) and mergers of 18%
public sector banks (42%). 10%
Flexibility in PCA Flexibility in IBC Enhanced Unconventional Mergers of Lower interest
norms norms lending to the modes like the public sector rate
SME sector RBI buying banks
securities of the
NBFC sector

 Monetary policy: With respect to monetary Q18: In FY20, do you expect the repo rate to
policy, 40% expect that the repo rate will 60%
remain stable while 39% suggest that there 39% 40%
would be a cut in the repo rate. The remaining 21%
21% suggest that repo rate will be increased in
Increase Decrease Remain stable

Policy reform expectations

Q19: Expectations of any policy reforms in your industry in 2019-20? Please specify.

These include
- Merger of PSUs,
- Rationalisation of GST rates
- Effective implementation of IBC
- Strengthening of liquidity norms
- Non-performing asset performance provisioning requirements
- Agriculture reforms
- Easy liquidity of credit to NBFCs
- Relaxation of PCA norms
- Employment generation
- Enhanced lending to MSMEs
- Faster clearances for businesses etc.

DISRUPTORS Deep dive into
25 March 2019 Institutional Equities

Swiggylicious Figure 1: Food delivery market – a snapshot DD MMM YYYY

We commence the “Disruptors” series, where we look
at players that have upended existing industries. In
our inaugural note, we look at Swiggy, the largest
online food delivery player in India delivering ~30m
orders a month. Through its disruptive approach to
food delivery, Swiggy has redefined eating-out in India,
reflected in ~22x sales growth over FY16-18. Its ability to
achieve order-level breakeven indicates a potential path to PAT
profitability. This along with shareholders with deep pockets and
the recent US$1bn raise suggest that this disruption is not
transient, but more structural in nature. While organised chains
should benefit the most from this disruption in food delivery
segment, we believe players with focus on menu innovations,
customer experience/brand development are best placed.

Aggressive growth engine: Swiggy has charted an aggressive sales

trajectory (up 22x over FY16-18) on the back of aggressive discounts,
partnership with more than 55,000 restaurants and 125,000+ strong
delivery fleet. With ~1m orders delivered daily (~40% market share),
Swiggy is now expanding to new cities and exploring adjacencies like
cloud kitchens, private brands and grocery delivery.

Achieved order-level breakeven in FY18: While Swiggy continues to

incur ~Rs4bn PAT loss annually, it has been able to achieve breakeven
in FY18 on a per-order basis, by improving revenue mix and reducing
costs. While its expansion into new cities may weigh on profitability, the
ability to achieve breakeven lends credence to the model and suggests
a possible path to PAT profitability.

Disrupting the way people eat: Swiggy has redefined the eating out
culture in India, using huge discounts to attract customers and a strong
delivery fleet to create a competitive advantage. We believe the national
appeal of organised chains makes them an ideal candidate to benefit
from the turbo-charged growth that food delivery is likely to witness.
However, we think focus of restaurants would need to be on menu Source: Company, IIFL Research
innovations, improving customer experience and brand development.

Avi Mehta avi.mehta@iiflcap.com Rishi Jhunjhunwala | rishi.jhunjhunwala@iiflcap.com Kunal Shah | kunal.shah@iiflcap.com

91 22 4646 4650 91 22 4646 4686 91 22 4646 4674
Institutional Equities Disruptors

Company snapshot – Swiggy Figure 2: Swiggy and Zomato are leaders in the online food aggregator market; Uber
Eats is a distant third
• Swiggy (Bundl Technologies Private Limited) is a leading food-
ordering & delivery platform in India, operating as a marketplace Monthly order run-rate (m)
for restaurants. It allows consumers to order online from any of
its 55,000+ partner restaurants across over 100 cities, and then, 30
which is then delivered to their homes through a fleet of 25
~125,000 delivery personnel.
• Apart from increasing convenience for customers, Swiggy also
expands the target market for restaurants, as even small, 15
standalone outlets are able to offer delivery as an option. 10
• The company was founded in 2014 by BITS Pilani graduates, 5
Sriharsha Majety and Nandan Reddy, when they decided to 30 28 10 8
explore the idea of “hyperlocal food delivery”. The third co- 0
Swiggy Zomato Uber Eats Food Panda
founder, Rahul Jaimini, brought in the technical expertise.
• The company has seen healthy growth in the last three years, Source: Media Reports, IIFL Research
with order run-rate ramping up, from 2m orders per month in
Dec-16 to ~30m orders currently. Figure 3: Naspers and Meituan Dianping have been key investors in recent rounds
• Swiggy also has presence in services like Swiggy Access (plug- Round Date Amount Key investors
and-play cloud kitchen), Swiggy Stores (home delivery of (US$ m)
essentials such as groceries, health products etc) and The Bowl Series H Dec-18 1,000 Naspers, Meituan-Dianping, DST Global, Tencent Holdings
Kitchen restaurant (private label cloud kitchen restaurant brand). Series G Jun-18 210 Naspers, DST Global, Meituan-Dianping
• It has recently launched a membership programme, Swiggy Series F Feb-18 100 Naspers, Meituan-Dianping
Super, wherein subscribers can avail unlimited free deliveries (for Naspers, Accel, Norwest Venture Partners, SAIF Partners,
orders more than Rs99) by paying a subscription fee of Series E May-17 80
Bessemer Venture Partners
Rs49/month. Further, members are also exempted from surge Series D Sep-16 15 Bessemer Venture Partners
fees (higher delivery charges during rains/high demand) and Jan/
have access to exclusive offers. Series C
42 NA
• Swiggy derives its revenues through three streams: i) Share of Series B Jun-15 17 Norwest Venture Partners
order value (‘take rate’) charged as a commission from
Series A Apr-15 2 Accel, SAIF Partners
restaurants; ii) Delivery charges to customers; and iii) Income
Source: Company, IIFL Research
from selling ad-space on its portal (i.e. Carousel income).
• Swiggy has raised US$1.5bn since Apr-15. Naspers (a South
African company with investments in leading ecommerce
companies) and Meituan Dianping (the largest food aggregator in
China) have been the key investors in the company.

avi .m eh ta @i i fl cap. c om 2
Institutional Equities Disruptors

Aggressive growth engine more than Rs99). Further, members are also exempted from surge
fees (higher delivery charges during rains/high demand) and have
access to exclusive offers. Note that this loyalty program is different
Swiggy has changed the way the Indian consumer views eating out. from that of Zomato, which has targeted the dine-in audience
It has developed a strong portfolio of partner restaurants and a fleet through its Zomato Gold offering. Zomato has since launched
of delivery persons to service customers. These strengths have Zomato Piggybank, which provides credits to users for each online
allowed it to enhance ordering convenience for customers; on the order.
back of these and aggressive discounts to lure customers, Swiggy
has emerged as the leading online food delivery player in India, Lastly, Swiggy earns carousel income from selling ad-space on its
servicing ~1m orders daily (~40% market share). portal. This is similar to the fee charged by Google for putting search
results on top.
A sense of the aggression of its sales growth can be envisaged from
the 22x growth witnessed in sales from Rs200m in FY16 to Rs4400m In FY18, commissions comprised 78% of Swiggy’s revenues,
in FY18. Aided by continued funding from strong investors, Swiggy followed by delivery charges (20%) and Carousel income (2%).
intends to expand its reach, to new cities, and sustain the healthy
growth momentum. Addition of value-added services such as Swiggy Figure 4: Commissions from restaurants account for the largest share of revenue,
Access (plug & play kitchen for restaurants) and private labels (own followed by delivery charges and advertising income
brands to aid margins) would further strengthened its position. Also,
it is using its delivery strength to expand into adjacencies such as (Revenue mix) Advertising income Delivery Income Commission Income
delivery of essentials like groceries etc. 0% 1% 2%
90% 17% 16%
Understanding Swiggy’s revenue model 80%
70% 82% 83%
As highlighted earlier, Swiggy is primarily in the business of 60%
delivering food from partner restaurants to customers. For this 50%
service, the company charges a commission rate to the restaurant 40%
and a delivery cost to the customer. However, the delivery cost
payable by the customer is partly subsidised by the restaurant. 10%
Swiggy charges 15-30% ‘take rate’ from restaurants, depending on FY16 FY17 FY18
the level of service provided and the size of the chain. In addition to
Source: Company, IIFL Research
this take rate charged as a commission from restaurants, Swiggy
also earns the delivery fee charged to customers.

The company has recently started levying a small fee for delivery.
However, to ensure that this does not weigh on customer additions,
Swiggy has launched a membership programme, Swiggy Super,
wherein subscribers can avail unlimited free deliveries (for orders

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Institutional Equities Disruptors

Well placed against competition Figure 5: Swiggy has used discounting to lure customers to its platform

Swiggy’s key competitor is Zomato, which has a strong restaurant

listing business and also enables customers to order online through
its website. However, Swiggy enjoys the first-mover advantage in
deliveries and carries out 100% of deliveries from its partner
restaurants. In contrast, some of Zomato’s orders are delivered by
the restaurants themselves. Given this, Swiggy charges a higher
take rate (commission rate) to restaurants vs Zomato.

Swiggy has a strong delivery fleet of ~125,000 riders, which it has

Source: Company, IIFL Research
continued to strengthen by providing healthy incentives to delivery
employees. Further, the high frequency of orders allows a delivery
Figure 6: Swiggy has seen a strong growth in the monthly order run rate
person to enjoy higher income levels.
Swiggy monthly order run-rate (m) 30.0
Also, Swiggy’s ability to attract customers to order from its platform 30
and its investments in heat maps of each city/partner restaurant
tech ensures a virtuous cycle of customer addition.
Strong order growth backed by discounting 15

Swiggy has raised US$1.5bn since Apr-15, with US$1bn funds raised 10
recently in Dec-18. Swiggy has used aggressive discounts to lure 5
customers to its platform. Further, the convenience of ordering food
at home attracted a large section of customers who were unable to 0
avail this service across restaurants/QSR players. This traction Nov-16 Aug-17 Nov-17 Jul-18 Feb-19
helped Swiggy grow its monthly order run-rate, from 2m in Nov-16 Source: Company, IIFL Research
to ~30m currently.
Strong traction in order growth has aided sales growth
Swiggy’s strong growth in orders has supported sales. Revenues
have increased to Rs4.4bn in FY18, from Rs1.3bn in FY17 and
Rs0.2bn in FY16. Further, Swiggy’s initiatives to pass on the delivery
cost to the customer and to monetise its brand strength have aided

avi .m eh ta @i i fl cap. c om 4
Institutional Equities Disruptors

This is reflected from the fact that the revenue mix has marginally Expansion into new cities
shifted towards delivery income (19% vs. 17% in FY16), while share In the first two years of operations (i.e. FY16/17), Swiggy had
of commission income dropped to 78% (vs. 82% in FY16). restricted its operations to the top eight cities. However, in the last
8-9 months, aided by ~US$1.1bn funding across 2 rounds, Swiggy
Further, Swiggy generated Rs100m in FY18 vs. Rs14m in FY17 by has sharply ramped up its presence to 108 cities/towns. Of this, ~65
monetising traffic on its portal. This was through income paid by cities have been added only in the last four months. Clearly, there
restaurants to advertise on Swiggy’s platform and reflects the has been a change in strategy, from using discounting as a means to
importance that restaurants have started to attach to their presence gain market share to gaining the first-mover advantage in new
on Swiggy’s platform. cities. We believe this expansion would drive the next phase of sales
growth for Swiggy.
Figure 7: Sales growth has been healthy on the back of healthy order growth
Figure 8: Swiggy has sharply expanded its presence in the last 9 months
(Rs m) Revenue (Rs m) - LHS % growth (RHS) (%)
5,000 4,420 600% No. of cities present
4,500 120 108
4,000 500%
3,500 100
2,500 300%
2,000 60
1,331 200%
1,000 40
500 201 14
20 8 8
0 0%
FY16 FY17 FY18 0
Source: Company, IIFL Research Mar-16 Mar-17 Jun-18 Mar-19
Source: Company, IIFL Research
Multiple legs to drive sales growth going forward Plug and play cloud kitchen
The plug & play cloud kitchen has been launched under the name
While the growth till date has been led by expansion in existing
“Swiggy Access”, which is a ~3,200sqft facility equipped with
cities, Swiggy is now looking to expand into new cities, to drive
kitchen spaces and gives restaurant partners access to delivery.
growth. Also, it is also been exploring adjacencies like: 1) a plug &
Each restaurant brings its own equipment and needs to start rolling
play cloud kitchen for own and third party brands; 2) home delivery
out operations. Swiggy helps restaurants optimise kitchen space
of groceries etc; and 3) development of own brands.
with details such as stock planning, demand forecasting, preparation
time and order edits. Restaurants do not pay a rental and are
instead charged a take-rate on the basis of revenues. As of Sep-18,

avi .m eh ta @i i fl cap. c om 5
Institutional Equities Disruptors

the Swiggy Access offering was available in five cities, with plans to
expand to over 30 cities by 2020.
Achieved order-level breakeven in FY18
Figure 9: Swiggy Access provides cloud kitchen facilities An analysis of Swiggy’s financial statements highlights that while it
has an asset-light balance sheet, it continues to generate PAT
losses, with ~Rs4bn PAT loss in FY18. However, to better
understand business profitability, we attempted to determine the
profitability on a per-order basis. For this, we estimate the yearly
order levels based on media reports. Our analysis suggests that
Swiggy has been able to achieve order level breakeven in FY18 on
the back of improvement in order level income and reduction in per-
order costs.

Source: Company, IIFL Research With Swiggy increasingly focused on expansion into new cities, we
believe this per-order breakeven may come under stress, given
Home delivery of essentials like groceries start-up costs in the new cities. Swiggy’s ability to expand margins
Swiggy has expanded into general deliveries from Feb-19, through through its new initiatives remains an upside risk to this estimate.
dark stores that would help deliver groceries, health products etc to
customers. The initial rollout is happening in Gurgaon, where Swiggy More importantly, Swiggy’s ability to achieve order-level breakeven
is partnering with 3,500 stores such as Le Marche, Guardian highlights ability of the company to achieve PAT breakeven with
Pharmacy and Zappfresh.com. It expects to use the expertise gained certain scale.
from the recent acquisition of “SuprDaily”, a milk delivery start-up
based in Mumbai. This expansion should allow Swiggy to follow the Figure 10: Per-order analysis suggests order-level breakeven achieved in FY18
path taken by its investor and peer in China − Meituan Dianping − Per order analysis* (Rs) FY17 FY18 YoY
and help grow revenues in existing cities. Swiggy stores would be Revenue
accessible from its existing app. Commissions 50 57 13%
Delivery charges 10 14 49%
Own food brands Advertising Income 1 2 159%
Swiggy has developed own restaurant brands, such as The Bowl Total revenues 60 73 21%
Company and Homely, to expand margins and control the entire
chain. A large share of these brand sales are based in Bengaluru, Less: Direct Costs (66) (64) -3%
though the company expects to expand to other cities. It has placed Less: Order cancellation costs (5) (5) -10%
ads for hiring chefs and workforce, to scale up private labels. These Profit per order (11) 3
own brands should help it capture food gross margins and thus drive Source: Company, IIFL Research; *Number of annual orders estimated based on media reports
a higher margin profile. Further, it should ensure that in new cities,
it is able to provide a consistent experience despite absence of
established chains. Swiggy has ensured that presence in own brands
does not hamper its ability to add partner restaurants.

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Institutional Equities Disruptors

Per-order income has seen healthy growth Overheads continue to weigh on PAT
While revenue growth has been healthy on the back of strong order Apart from these costs, Swiggy incurred Rs1.9bn in employee costs
growth, a closer analysis reveals that sales-per-order has witnessed and Rs1.5bn in advertising & marketing expenses. Hence, Ebitda
a healthy 21% growth in FY18. This has been on account of 13% loss stood at Rs4.1bn vs. Rs2.1bn in FY17. This, in turn, resulted in
increase in per-order commission. This increase in commission per a net loss of Rs4bn (vs. Rs2.1bn in FY17).
order is possibly driven on back of increase in take-out rates
charged by Swiggy and partly by growth in transaction sizes. We Figure 11: Swiggy − Detailed P&L
believe that the former has been a bigger driver for growth in per- (Rs m) FY16 FY17 FY18
order commission income. Revenues 201 1,331 4,420
Cost of operations (471) (1,450) (3,845)
Additionally, Swiggy has started charging customers for delivery. Loss on order cancellation (27) (110) (267)
This is reflected in the rising share of delivery income and an
Unit level profit (296) (230) 308
increase in per-order delivery income. Delivery income per-order
Employee costs (535) (899) (1,908)
grew 49% to Rs14.
Advertising expenses (254) (526) (1,549)
Cost control has aided per-order profitability Communication & IT (83) (173) (419)
Rentals (64) (99) (151)
As highlighted above, the order level breakeven was also driven by Others (134) (189) (385)
reduction in per-order direct costs. Operating costs per order Ebitda (1,366) (2,115) (4,103)
declined a marginal 3%, from Rs66 in FY17 to Rs64 in FY17. While Depreciation (41) (45) (71)
Swiggy has stopped sharing the breakup of such direct costs, most Finance costs - (18) (63)
of these costs are related to cost of delivery, as reflected in the FY17 Other income 35 126 263
Annual Report. In FY17, cost of delivery accounted for 94% of direct PBT (1,372) (2,052) (3,973)
costs, while payment gateway expenses (4%) and consumables Taxes - - -
(2%) accounted for the rest.
PAT (1,372) (2,052) (3,973)
Source: Company, IIFL Research
While details on what drove this decline are not available, anecdotal
evidence suggests that Swiggy has been reducing the incentives
paid to delivery personnel. Further, there is likely to be an increase Asset-light balance sheet
in employee productivity levels as Swiggy is able to increase the
number of orders that each delivery personnel can service. Swiggy operates a largely asset-light model, with fixed assets
(motorbike etc.) often owned by the delivery personnel who are paid
The loss on cancelled orders was similar on per total-order basis, at on a per-delivery basis. Working capital is negative, given minimal
Rs5/order in FY18. As a result, unit profitability has improved, from inventory and payables (58days) exceeding receivables (18days). In
Rs11/order loss to Rs3/order profit. fact, invested capital (equity + debt – cash & cash eq.) has been
negative in the last two years.

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Figure 12: Both, working capital and invested capital, negative for Swiggy
Balance sheet (Rs m) FY16 FY17 FY18
Disrupting the existing food services space
Net worth 2,005 1,413 8,987
Swiggy has disrupted the restaurant space, having changed the way
Debt - 500 141
customer approach eating out. It has enhanced affordability, variety
Other non-current liabilities/provisions 9 22 44 and the convenience of eating out for a customer, thereby driving
Total liabilities 2,014 1,936 9,172 strong growth in the food delivery space. Further, Swiggy has
enabled small restaurants to cater to a larger customer audience.
Fixed assets 74 123 292 Given shareholders with deep pockets and the recent US$1bn fund
Long-term investments - - 50 raise (Dec-18), we believe this focus on expanding market share
Other long term assets 23 26 124 across existing and new cities would continue, backed by aggressive
discounting to customers and spends on delivery personnel addition.
Inventories - 0 5 Further, China is an example that shows the high potential for the
Trade Receivables 38 58 222 market with multiple legs of growth possible. We believe Swiggy
with its common shareholders has the ability to chart a similar
Cash and Cash equivalent 2,013 2,083 9,643
growth path.
Other current assets 60 113 235
Trade Payables 76 242 697 We believe the increase in the customer eating-out frequency should
Other current liabilities 119 226 702 benefit the entire restaurant industry; though the benefits would be
Total assets 2,014 1,936 9,172 disproportionately higher for chained restaurants that enjoy national
brand appeal. However, chains would need to improve focus on
Working capital menu innovations, packaging solutions, enhancing customer
Inventory days - 0 0 experience, strengthening brand positioning and have store
Receivable days 69 16 18
additions in this changing industry to remain relevant.
Payable days 137 66 58
Working capital days (68) (50) (39) Deep-pocketed investors to aid growth
Invested capital (Rs m) (8) (170) (515)
As highlighted earlier, using its balance sheet strength, Swiggy has
Source: Company, IIFL Research
embarked on discounting to acquire customers/develop delivery
capabilities. This balance sheet strength has been on the back of the
US$1.5bn equity fund raising done since Apr-15.

Since its Series E round in May-17, Naspers and Meituan Dianping

have been the key investors in the company. Both investors have a
deep understanding of the online food services industry across
geographies. Meituan Dianping (Meituan) is the largest food
aggregator in China and fulfils ~16m orders in a month (~16x
Swiggy’s run rate). Naspers, on the other hand, is a South African

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Institutional Equities Disruptors

firm that has investments in leading food delivery companies such as 87% Cagr over CY13-17. Share of online channel hence increased,
Delivery Hero (present in over 40 countries) and ifood (leader in from 2% in CY13 to 13% in CY17, and is likely to touch 30% by
Brazil). Naspers further holds 31% stake in Tencent Holdings, which CY23.
was an early investor in Meituan Dianping and has also backed
Swiggy in its last funding round. In terms of number of orders, the China market stood at ~10bn
orders in CY18, implying a monthly run-rate of ~890m (12x India’s
Both these investors are well funded, especially Naspers, which current monthly run-rate of ~75m). This highlights the large
raised US$10bn in Mar-18 through a 3% stake sale in Tencent. opportunity landscape that Swiggy can pursue.

Figure 13: Have raised US$1.5bn since April-15 Meituan Dianping, market leader in China and an investor in Swiggy,
Round Date Amount Key investors commands ~60% market share. It has seen a strong 163% Cagr in
(US$ m) transaction value over CY15-18; this was aided by 116% Cagr in the
Series H Dec-18 1,000 Naspers, Meituan-Dianping, DST Global, Tencent Holdings number of orders and 22% Cagr in value per order. Further, its
Series G Jun-18 210 Naspers, DST Global, Meituan-Dianping average take-rate has improved, from ~1% in CY15 to 13.5% in
Series F Feb-18 100 Naspers, Meituan-Dianping CY18, resulting in 500% revenue Cagr over CY15-18.
Naspers, Accel, Norwest Venture Partners, SAIF Partners,
Series E May-17 80 Figure 14: Online food delivery has grown at 87% Cagr over CY13-17
Bessemer Venture Partners
Series D Sep-16 15 Bessemer Venture Partners (RMB bn) Online food consumption (RMB bn)*
Jan/May- 5,000
Series C 42 NA 4,169
Series B Jun-15 17 Norwest Venture Partners 4,000
Series A Apr-15 2 Accel, SAIF Partners
Source: Company, IIFL Research
China shows the possible growth path 1,170
1,000 734
Indian players are witnessing signs of consolidation, with Swiggy 96
and Zomato growing ahead of peers. This is similar to what is seen 0
CY13 CY14 CY15 CY16 CY17 CY23e
in China. Further, an analysis of China’s industry highlights the large
potential for growth in the online food delivery in India. China’s Source: Company, IIFL Research*includes restaurant as well as non-restaurant food consumption
market stands at ~12x the size of the Indian market, despite China’s
GDP being 5x that of India.

China points to high growth potential in online food delivery

Aided by a robust payments infrastructure and increasing internet
penetration, the online food delivery market in China has clocked

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Institutional Equities Disruptors

Figure 15: Share of online channel likely to increase to 30% vs. 13% in CY13 Figure 17: Per-order break even reached in CY17
(%) Food Consumption - Share of online channel (%)* Revenue per order Cost per order Gross profit per order
35.0% 8.0
29.5% (RMB) 6.0
30.0% 6.0 5.1

25.0% 4.0 3.3

20.0% 2.0 0.4 0.8

15.0% 13.4% 0.0
9.2% (0.3)
10.0% 6.2% (2.0) (0.6) (0.3)
3.6% (4.0)
5.0% 1.8%
0.0% (6.0) (4.7) (5.1)
CY13 CY14 CY15 CY16 CY17 CY23e CY15 CY16 CY17 CY18
Source: Company, IIFL Research
Source: IIFL Research; *includes restaurant as well as non-restaurant food consumption

India market has seen signs of consolidation, like China

Figure 16: Meituan has seen 116% order Cagr over CY15-18
Swiggy and Zomato have substantially outgrown peers,
Gross Transaction volume (RMB bn) No. of transactions (m) consolidating the market in their favour. Media reports indicate that
(RMB bn) (m) Swiggy is the lead contender for a possible stake sale by Uber in its
300 6,393 7,000 food delivery business, Uber Eats. We have witnessed a similar trend
250 6,000 in the past in China, where market share of top-two players
4,090 5,000 increased from 69% in CY15 to 92% in CY17.
100 1,585
50 637
171 283 1,000
0 16 0
CY15 59
CY16 CY17 CY18

Source: Company, IIFL Research

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Figure 18:Top-2 players in China have cornered most of the online food delivery market Figure 19: Menu innovations to become an important factor
Others Ele.me (acquired by Alibaba) Meituan Dianping
(Market share in China)
100% 8%
80% 32%
60% 35%
47% 56%
20% 32%
CY15 CY16 CY17

Source: Company, IIFL Research

Restaurant players would need to adapt

Online aggregators have driven a massive disruption in the Indian
food services industry in the last three years. Backed by large
venture capital funding and through heavy discounting, aggregators
have expanded the food delivery market.

We expect food delivery players to help increase customer eating-

out frequency. This would help growth across the food restaurant
space. However, we believe that the benefit would be primarily
across chained restaurants, where consumers are aware of the

Further, home delivery, earlier a competitive moat for organised

QSR players, is getting increasingly democratised. In such a
situation, players would increasingly need to enhance focus on menu
innovations to sustain user interest. The ability to manage supply-
chain complexity that such constant menu innovation imposes would
become the differentiator among chained restaurants, in our view.
Source: Company, IIFL Research

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Institutional Equities Disruptors

Further, the ability to ensure that food is not tampered with during
delivery is crucial and gaining significance; hence, secure packaging
Annexure A: India food industry
would become an important aspect.
The size of the Indian food services industry stood at Rs3.4trn, as of
As food delivery players expand into new cities, it would become CY17, and is expected to register 10% Cagr over the next five years
important for players to have presence in these cities. However, this aided by higher urbanisation, growing affluence, increasing share of
would entail a measured addition, to ensure that store capex is women in the workforce, etc. Further, the industry records 60bn
commensurate with the level of demand possible in that region. annual transactions, as of CY17, and is expected to clock ~5% Cagr
Also, the cost of servicing the store and the pricing it can afford to ~77bn by CY22.
becomes the other essential factor.
To put this in perspective, at the current monthly run-rate of 75m
Companies would also need to invest in brand development and orders, food aggregators would cater 0.9bn orders annually, which
customer experience for differentiation among peer chains/ implies a mere ~1.5% volume market share. Thus, online players
restaurants. have an opportunity to expand share in a growing market. Increase
in internet penetration (32% in CY18 vs. 14% in CY14) and
proliferation to tier 2/3 towns would act as key growth drivers.

Figure 20: The Indian food services industry likely to see healthy growth; aggregators
currently account for only ~1.5% of transactions
(Rs bn) Food delivery market size (Rs bn) No of transactions (bn) (bn)
6,000 10% Cagr in value; 5% Cagr in no. of 90
transactions 69.8 73.3 80
5,000 63.1 66.4
59.9 70
4,000 60
2,000 30
3,375 3,710 4,090 4,505 4,985 5,520 10
0 0
CY17 CY18 CY19 CY20 CY21 CY22
Source: Company, IIFL Research

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Annexure B: Swiggy − Shareholding pattern

Figure 21: Swiggy’s shareholding pattern post the US$1bn fund raise
Equity Preference
Entity shares shares
Sriharsha Majety (Co-Founder) 55,000 -
Lakshmi Nandan Reddy Obul (Co-Founder) 25,000 -
Rahul Jaimini (Co-Founder) 20,000 -
Naspers (through Naspers Ventures & MIH India Food Holdings) 10 275,568
SAIF Partners 1,000 88,983
Accel India 1,000 81,753
Tencent Cloud Europe B.V. 10 40,342
Nowest Venture partners 10 77,835
Apoletto Asia 10 15,525
Harmony Partners 10 12,228
RB Investments 10 9,290
DST Global (through DST Euroasia and DST Investments Asia I) 10 15,629
Bessemer India Capital 10 27,371
Inspired Elite Investments 10 44,029
HH BTPL Holdings II 10 14,384
Wellington (through Hadley Harbour Masters Investors
10 7,979
(Cayman) II LLP)
Coatue PE Asia Xi LLC - 7,278
Total 102,110 718,194
Source: Company, IIFL Research

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Covering the pledge
The case for assessing promoter pledge transactions
based on entire promoter debt than a specific deal

Executive summary .................................................................................................................................................... 4

Pledge-based debt is exposed to equity risk as underlying cash flows do not support promoter debt .......... 5

The equity market has seen sharp corrections ....................................................................................................... 5

Typical transaction cover levels do not provide sufficient cushion to absorb equity risk ................................ 6

Market does not have the depth to ensure orderly exit by lenders in case of liquidation of shares ................. 7

Legal and practical risks may impede the effectiveness of pledge-based transactions .................................... 8

Credit profiles of such debt instruments should be assessed based on the overall cover available –
whether it is enough to withstand market stress .................................................................................................... 9

Strength of underlying company and management profile should be centrally factored in ............................ 10

Conclusion ................................................................................................................................................................ 10

Executive summary
Recent market events have put the practice of lending against shares pledged by promoters under the scanner and
sent market participants on a frantic search for ways to gauge the risks in such deals.

“What are the risks in these transactions?

What should be the cover commensurate with the risks?”

Such are the questions flying thick and fast.

To be sure, borrowing based on the value of the underlying listed shares is an easy way of monetising a promoter’s
ownership without ceding control. According to Bombay Stock Exchange data, the total value of shares pledged by
promoters is more than Rs 2 lakh crore, involving 800 companies1 and Rs 1-1.3 lakh crore of pledge debt.

This has implications for the lending community, for such debt is backed by collateral of equity shares, which are
inherently volatile, rather than by cash flows. Hence, pledge debt is exposed to high levels of equity risk, and the
cover through pledged shares is usually small to absorb these risks.

The typical transaction cover for ~Rs 38,000 crore of rated debt in the market analysed by CRISIL 2 – accounting for
30-40% of the total pledge debt of promoters – is less than 2 times.

In case of a breach of covenants, lenders usually have less than a month to liquidate the shares. However, the
domestic equity markets may not have the depth and liquidity to absorb the flood of promoter shares dumped by
multiple lenders. Therefore, ensuring an orderly exit without a drastic impact on share prices is easier said than done.

Besides, enforceability of pledge has been called into question in the past because of legal and practical challenges.

CRISIL believes debt raised through pledge of promoter shares should be assessed based on the overall cover
available through promoter holdings – both pledged and unencumbered – on the overall debt that the promoter has
raised in various holding/ investment companies, and not on the pledge and structure of a specific transaction alone.

The overall cover acts as the first line of defence, determines refinancing ability, and provides the flexibility to pledge
additional unencumbered shares to maintain the minimum pledge cover requirements and prevent a breach of
covenants in any specific transaction.

CRISIL’s overall cover requirement for assessing debt of a promoter’s holding companies depends on the rating
category, an auto-correcting factor that adjusts based on the state of the market and sensitivity of the specific stock
to overall market movement. CRISIL also factors centrally the credit profile of the company whose shares are pledged
and the management quality.

As on February 27, 2019
Data related to rated ‘pledge’ debt as of January 15, 2019. CRISIL has not rated any of these transactions.

Quantifying pledge-based rated debt in India

 An estimated Rs 38,000 crore of rated debt (accounting for 30-40% of total pledge debt of promoters), backed
by pledge of shares, has been raised from the market to date. More than 60% of this is rated in the ‘AA’
category or above, and almost 90% is in the ‘A’ category or above

 ~90% of the rated pledge debt has transaction cover of less than 2 times. This is in sharp contrast to the
Reserve Bank of India’s (RBI’s) prescription of a minimum collateral cover of 2 times for lending against shares
by banks and non-banking financial companies (NBFCs)

 ~10% has transaction cover of 1.3 times or lower, and provides for additional illiquid collateral (unlisted shares,
real estate mortgage) to compensate for the lower cover

 For ~30% of the rated pledge debt, the pledged shares have to be liquidated within 10 days in order to recover
debt and avoid a payment default following invocation

 The rated pledge debt transactions are backed by shares of 32 listed companies, of which, 13 are rated in the
‘A’ category or below, or are unrated

Pledge-based debt is exposed to equity risk as underlying

cash flows do not support promoter debt
Pledge-based debt is usually issued by promoter holding/investment companies that have limited operations of their
own. Their cash flows are limited to dividend payments from the underlying companies in which they hold stakes.
Such dividend payments (dividend yield at less than ~2%) are typically insufficient to ensure repayment of the pledge-
based debt (interest cost at ~10%).

Also, promoters would be reluctant to dilute their stake in the listed group companies to generate funds for debt
repayment. The debt is, therefore, expected to be refinanced, backed by the strength of the market value of promoter
holdings in listed companies. Any significant fall in value of the shares during the tenure may lead to high refinancing
risk and eventual default.

The equity market has seen sharp corrections

In order to understand the kind of share price drops in the Indian market, CRISIL analysed companies in the Nifty
500 index. The price drop in a one-month horizon was chosen considering the typical time period prescribed in most
transactions for liquidating shares following a pledge invocation. The periods chosen included 2005-18 and 2009-18.
The period 2005-18 was considered as it included the Lehman crisis, a black swan event.

As the following chart shows, during 2005-18, 90% of companies analysed witnessed market cap declines of more
than 23% within a month. A 23% price drop implies that if a shares-backed transaction had an overall cover3 (includes
both pledge and unencumbered shares) of 1.3 times4 to start with, in 9 out 10 cases, the market value of the shares

Overall cover indicates both pledged and unencumbered shares on the overall promoter debt raised through holding or investment companies
1.3 times = 1/(1-23%)=1/77%

could have dropped below the debt contracted within a month, leading to losses for debt holders. During the same
period, half of companies having such transactions witnessed market capitalisation fall of more than 45%, i.e., even
a cover of 1.8 times could have been fully depleted within a month in the case of 50% of companies.

Chart 1: During 2005-18, 90% of companies analysed witnessed peak market cap drops of more than 23%
within a month (translating to a cover of 1.3 times)

Peak market cap drop within 30 days

60% 57% 55%

45% 45%

40% 34%

10% 25% 50% 75% 90%
Percentage of companies

2005-18 (including Lehman crisis) 2009-18 (post Lehman crisis)

Typical transaction cover levels do not provide sufficient

cushion to absorb equity risk
For loan exposures backed by pledge of shares, RBI regulations require NBFCs and banks to maintain a minimum
cover of 2 times (or a loan-to-value ratio of less than 50%) 5. This is a bare minimum and lenders are free to seek
higher cover depending on the quality of the collateral.

However, certain pledge-backed debt, especially capital market instruments, may be raised at transaction covers
lower than 2 times as well. Indeed, around 90% of the rated pledge debt of ~Rs 38,000 crore had cover less than 2
times – even as low as 1.2 or 1.3 times. Considering high equity volatilities as shown in Chart 1, low covers of 1.2 or
1.3 times may not be able to provide adequate cushion and avert a default on the debt. While NBFCs and banks
have capital cushion to absorb risks as per regulatory capital adequacy norms, others do not have any such leeway.

For RBI guidelines on NBFCs, please refer to RBI notification titled ‘NBFCs – Lending against Shares’ dated August 21, 2014 at
https://rbi.org.in/scripts/NotificationUser.aspx?Id=9180&Mode=0; For RBI guidelines on banks, please refer to ‘Master Circular- Loans and
Advances – Statutory and Other Restrictions’ dated July 01, 2015, at https://m.rbi.org.in/Scripts/BS_ViewMasCirculardetails.aspx?id=9902#231

Chart 2: Approximately 90% of rated pledge debt had a cover of less than 2 times 6

11% 12%


1.50 - 1.74

33% 1.75 - 1.99

44% >= 2.00

Given that the transaction cover requirements may not suffice to cover the equity risks, lenders create “structures” to
protect against the market-related risks.

The structure requires promoters to top up the cover in case it falls below the minimum levels. For this, a promoter
needs to have sufficient headroom with a reserve of unpledged shares. However, ~25% of over Rs 2 lakh crore worth
of listed shares pledged by promoters in the market belong to companies whose promoters have pledged 60% or
more of their holdings, which limits their ability to pledge additional shares.

Market does not have the depth to ensure orderly exit by

lenders in case of liquidation of shares
In case the promoters do not have the ability to top up, the structures envisage certain timelines to avoid a payment
default through sale of shares in the market. The typical timelines are less than 30 days. Around 90% of the rated
pledge debt analysed provided less than 30 days to liquidate the shares, with ~30% envisaging less than 10 days.
The timelines envisaged in the structure should be a function of the liquidity in the market to ensure orderly exit
without any steep impact cost. However, the liquidity in the Indian market is insufficient to provide an orderly exit in
less than 30 days.

As shown in Chart 3 below, it would take more than 30 days to sell Rs 500 crore worth of shares of 50% of companies
in the Nifty 500 index and more than 90 days for 30% of companies in the index, if shares worth the average daily
turnover of the respective shares in 2018 were liquidated every day.

The chart only highlights the timelines for liquidation of Rs 500 crore worth of shares. The actual quantum of pledged
shares that can come up for liquidation may be much higher. This is because pledge transactions of a promoter
group are not restricted to just one lender. While it is possible that lenders can dump these shares and exit in a
shorter time span, such a hasty act may lead to a dramatic fall in share prices, due to which they may not be able to
cover the value of debt.

Pertains to Rs 36,679 crore of rated debt, for which, information on cover was available; minimum cover below which promoters have to top up
the pledge considered

Chart 3: Orderly liquidation of Rs 500 crore of shares would take more than 30 days for 50% of companies
in the Nifty 500 index

30% 29% < = 10 days

11 - 30 days

31 - 60 days

61- 90 days
9% > 90 days

Legal and practical risks may impede the effectiveness of

pledge-based transactions7
The enforceability of the pledge of shares has been called into question in the past due to both legal and practical
challenges. A case in point is Unitech Ltd, where the promoters stalled the move by the debenture trustee to sell
pledged shares by securing an injunction from the court on the ground that the company would suffer irreparable
loss if the stay was not granted. Such actions raise doubts about the ability of the trustee to liquidate the collateral
when triggers are breached.

Promoters typically indulge in multiple pledge transactions with several lenders to raise the desired quantum of debt.
For example, in one promoter group, 12 promoter holding companies had issued rated pledge debt worth more than
Rs 6,000 crore. The huge supply of pledged shares following invocation by multiple lenders can potentially lead to
dramatic share price declines, further accentuating the risks.

There have also been instances of promoters losing control of their operating company due to invocation of pledge
of shares, as was the case in Great Offshore Ltd. In many other cases, the promoters are on the brink of losing

To steer clear of such episodes, lenders may, in consultation with the promoters, arrange for a standstill agreement
and stay the share sale on the breach of covenants. If the practical enforceability of the structure is ambiguous, and
only limited protection can be provided by the cover, then how should the credit profile of promoter debt be assessed?
The following section provides the answers.

The RBI notes in its Financial Stability Report issue no. 10: “In some instances, the shares pledged by unscrupulous promoters could go down
in value and the promoters may not mind losing control of the company as there is a possibility of diversion of funds before the share prices

Credit profiles of such debt instruments should be
assessed based on the overall cover available – whether it
is enough to withstand market stress
The overall cover available through promoter holdings (both pledged and unencumbered) on the overall debt that the
promoter has raised in various companies should be the determinant of the credit profile of the promoter debt, rather
than the pledged shares and the structure of a specific transaction alone.

The overall cover acts as the first line of defence, determines refinancing ability, and provides the flexibility to pledge
additional unencumbered shares to maintain the minimum pledge cover requirements and prevent a breach of
covenants in any specific transaction. The higher the overall cover, the higher the availability of shares that can be
used for topping up the pledge, enabling the transaction to withstand higher share price drops before covenants are
breached and pledge is invoked by the lenders.

The overall cover should be high enough ab initio to ensure that the transaction is able to withstand medium-term
share price drops during its tenure.

CRISIL takes into account not only the cover on the debt being raised as on the date of the rating, but also the future
debt-raising plan. CRISIL typically considers a base cover of 4 times for a promoter holding company to be rated in
the ‘A’ category. The exact cover requirements would depend on the rating category, the state of the equity market,
and stock-specific volatility.

As the following chart shows, CRISIL’s cover requirements are built from a base cover, alpha cover and beta cover.
This helps segregate the risks and address the cover requirements for each risk bucket.

Chart 4: Cover requirement compartmentalised based on rating category, market conditions and stock type
• Calibrated for each rating category, based on peak market
High beta stock drops of companies
Overall cover requirements for promoter debt

• Cushions against medium-term equity volatilities during

Agitated market debt tenure
Base cover
• Higher the rating, higher the base cover requirement
Low beta stock

• Auto-correcting countercyclical buffer, based on state of

equity market
• Cushions against short-term equity volatilities
Alpha cover
Depressed market

• Stock-specific cover, based on volatility (beta) of stock

• Cushions against stock-specific risks with respect to
overall equity market
Beta cover

Base cover Alpha cover Beta cover

Strength of underlying company and management profile
should be centrally factored in
The strength of the underlying company whose shares are pledged, in terms of its business and financial profile,
cash flow stability, and market capitalisation, influences its share-price volatility and liquidity. Any stress in the
operating company can lead to a drop in its share price, thereby affecting the cover available.

Credit stress in the underlying company can further amplify the stress on pledge debt if the pledge debt at the
promoter level was used to infuse funds into the underlying company, leading to double leverage. This is a sign of
serious stress both at the company and promoter level.

The management quality of the promoter group factors their adherence to prudent debt levels and ability to preserve
the value of the operating company.

Clearly, for pledged shares-based transactions of promoters, risks are commensurate only at appropriate
cover levels – a cover that is adequate enough to withstand the equity market risks should be maintained.

The cover should be assessed on the basis of the overall cover available through promoter holdings – both pledged
and unencumbered – on all of the debt that the promoter has raised in various holding/ investment companies, and
not just on the basis of pledge and structure of a specific transaction alone.

Other factors such as strength of the underlying company and management profile should also be considered.

Christopher Wood christopher.wood@clsa.com +852 2600 8516

FONGO Down Under

The Federal Reserve has now given the markets what they had been led to expect, namely a
schedule for ending balance sheet contraction. The Fed will slow the reduction of its holdings of
Treasury securities by reducing the cap on monthly redemptions from the current level of US$30bn
to US$15bn beginning in May. While the reduction of the Fed’s aggregate securities holdings will be
concluded at the end of September. As a consequence, the Fed balance sheet contraction will end at
the end of September at US$3.7tn, or 6.8% below the current level of US$3.97tn.

That, and the dovish tone in yesterday’s FOMC statement, means the “Powell pivot” is now

GREED & fear encountered a new acronym in Sydney this week in an article in the Australian
Financial Review. It is FONGO, or “fear of not getting out” which was the subject addressed in the
newspaper in an article on falling home prices in Australia (see Australian Financial Review article:
“‘Fear of not getting out’ worry for house prices”, 19 March 2019 by Matthew Cranston).

The article noted that while transaction activity has slowed as house prices have fallen, with Sydney
already down 14% from the peak and Melbourne down 10% (see Figure 1), there was a growing risk
of increased selling pressure should buy-to-let investors start selling. While most investors GREED &
fear met in Australia this week do not expect such an outcome, the risk is clearly not zero. There is a
lot of residential property owned by investors, encouraged by the tax deduction on the negative
carry on investment properties, and this looks a much less attractive proposition when prices are
falling, most particularly as the Labor opposition is still campaigning on removing for new purchases
the negative gearing tax deduction on investment properties, as previously discussed here (see
GREED & fear - Equivocating central bankers, 7 February 2019). Labor is still expected to win the
general election due to be held no later than 18 May. A poll conducted on 6-11 March by Essential
Research shows Labor with a two-party lead of 53-47 against the ruling Coalition.

Figure 1
CoreLogic Australia Hedonic Home Value Index

180 (Index) Sydney Melbourne

160 Perth 5 capital cities









Note: Data as of 21 March 2019. Source: CoreLogic

Thursday, 21 March 2019 Page 1

For important disclosures please refer to page 18.
Christopher Wood christopher.wood@clsa.com +852 2600 8516

Meanwhile, one point is very clear to GREED & fear. Australian housing loan commitments are likely
to keep plunging so long as banks keep assessing a borrower’s ability to service a mortgage on an
assumed 7.25% borrowing rate even though it is now possible to get a mortgage at a market rate of
3.55%. This tough “serviceability calculation”, combined with much tougher scrutiny by banks of
what a household spends a month, means the number of people who can qualify for a home loan is
collapsing, most particularly as banks also now want to see 25% equity in a home loan. As a result,
Australian housing loan commitments declined by 20.6% YoY in January, the biggest decline since
November 2008 (see Figure 2). And so long as lending keeps declining, house prices are likely to
keep falling.

Figure 2
Australia housing loan commitments

40 (%YoY)
Australia housing loan commitments






Jul 03

Jul 04

Jul 05

Jul 06

Jul 07

Jul 08

Jul 09

Jul 10

Jul 11

Jul 12

Jul 13

Jul 14

Jul 15

Jul 16

Jul 17

Jul 18
Jan 04

Jan 05

Jan 06

Jan 07

Jan 08

Jan 09

Jan 10

Jan 11

Jan 12

Jan 13

Jan 14

Jan 15

Jan 16

Jan 17

Jan 18

Jan 19

Note: Total dwellings excluding refinancing, value of commitments. Source: Reserve Bank of Australia, Australian Bureau of Statistics

If the banks have now gone into classic risk aversion mode, GREED & fear heard this week that the
Reserve Bank of Australia is pushing for the minimum 7% stressed borrowing rate to be lowered.
However, the Australian Prudential Regulation Authority (APRA), the banking regulator, is resisting
because its mandate is less about boosting the economy than preserving the health of the banking
system, and never forget that the four major Australian banks have an average net loan loss
provision of only 12bps.

Figure 3
RBA cash rate target and Australia 3-year government bond yield

8 (%)
RBA Cash Rate Target
7 Australia 3-year government bond yield














Source: Bloomberg

Thursday, 21 March 2019 Page 2

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Still one way the central bank could get that assessment rate for the serviceability calculation lower
would be to cut the policy cash rate from the current all-time low of 1.5%. The RBA again missed a
chance to cut at its monetary policy meeting on 5 March, while the three-year government bond
yield has this week fallen below the cash rate (see Figure 3). But policy rate cuts are coming sooner
rather than later as the RBA will inevitably panic even it is true, as has been highlighted by CLSA’s
Australian bank analyst Brian Johnson, that rate cuts will not be fully passed on to home borrowers
(see CLSA research Australian Banks – Bank snippets 11 March 2019).

Certainly the money markets now understand that more rate cuts are coming, even though the RBA
is still officially on “neutral”. Money market futures are now discounting 50bp easing by 1Q20 (see
Figure 4) whereas when GREED & fear was last in Australia (see GREED & fear – Vietnam revisited and
Aussie banks, 15 March 2018), the money markets were assuming the next move in monetary policy
would be a tightening. As for the view here, GREED & fear repeats the forecast first made here in
March 2015 that Aussie short-term rates will go to zero in this cycle (see GREED & fear - Lower for
longer “Down Under”, 19 March 2015). Meanwhile, there is a lot of room for the Aussie 10-year
government bond yield to decline further even it is now only 9bps above the record low of 1.82%
reached in August 2016 (see Figure 5).

Figure 4
Australia cash rate futures implied rate and RBA cash rate target

Cash Rate Futures Implied Yield RBA Official Cash Rate



Apr 19

May 19

Jul 19

Aug 19

Sep 19

Oct 19

Jan 20

Apr 20

May 20

Jul 20

Aug 20
Mar 19

Nov 19

Dec 19

Feb 20

Mar 20
Jun 19

Jun 20

Source: Australian Securities Exchange, RBA

Figure 5
Australia 10-year government bond yield

8 (%) Australia 10-year government bond yield





















Source: Bloomberg

Thursday, 21 March 2019 Page 3

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Consequently, GREED & fear continues to recommend domestic Australian equity investors to
remain overweight resources stocks and bond proxies excluding banks, as has been the
recommendation here for several years (see Figure 6). Aussie banks remain a big underweight or a
zero weight in GREED & fear’s relative-return Asia Pacific ex-Japan asset allocation. The risk of a cut
in Australian banks’ massive dividends remains material. On this latter point, one underappreciated
risk, from an asset-quality perspective, is SME loans collateralised by residential property.

Figure 6
Australian banks and resources indices relative to ASX 200 Index (total-return basis)

120 (1/1/10=100) ASX200 Resources Index relative to ASX200 (1/1/10=100) 150

110 ASX200 Banks Index relative to ASX200 (RHS)
90 130
60 110
30 90
Sep 10

Sep 11

Sep 12

Sep 13

Sep 14

Sep 15

Sep 16

Sep 17

Sep 18
May 10

May 11

May 12

May 13

May 14

May 15

May 16

May 17

May 18
Jan 10

Jan 11

Jan 12

Jan 13

Jan 14

Jan 15

Jan 16

Jan 17

Jan 18

Jan 19
Source: Datastream, CLSA

Figure 7
Australia annualised net overseas migration and population growth

500 (000s, annualised)

YoY change in resident population
Net overseas migration (annualised)

Source: Australian Bureau of Statistics

As for the Australian economy, a recession is not inevitable since net migration continues while
employment and wage data look, for now at least, far from disastrous. Net overseas migration
totalled 240,057 in the twelve months to September 2018, accounting for 61% of the increase in
the population over the same period (see Figure 7). Wage growth was 2.3% YoY in 4Q18 (see Figure
8), while total employment increased by 284,100 in the twelve months to February, with full-time
employment increasing by 210,000 (see Figure 9).

Thursday, 21 March 2019 Page 4

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Figure 8
Australia wage growth

4.4 (%YoY)
Sep 98
Mar 99
Sep 99
Mar 00
Sep 00
Mar 01
Sep 01
Mar 02
Sep 02
Mar 03
Sep 03
Mar 04
Sep 04
Mar 05
Sep 05
Mar 06
Sep 06
Mar 07
Sep 07
Mar 08
Sep 08
Mar 09
Sep 09
Mar 10
Sep 10
Mar 11
Sep 11
Mar 12
Sep 12
Mar 13
Sep 13
Mar 14
Sep 14
Mar 15
Sep 15
Mar 16
Sep 16
Mar 17
Sep 17
Mar 18
Sep 18
Note: Total Hourly Rates of Pay Excluding Bonuses. Seasonally adjusted data. Source: Australian Bureau of Statistics

Figure 9
YoY change in full-time and part-time employment

500 (thousand, sa) Full-time employment Part-time employment






Sep 09

Sep 10

Sep 11

Sep 12

Sep 13

Sep 14

Sep 15

Sep 16

Sep 17

Sep 18
May 09

May 10

May 11

May 12

May 13

May 14

May 15

May 16

May 17

May 18
Jan 09

Jan 10

Jan 11

Jan 12

Jan 13

Jan 14

Jan 15

Jan 16

Jan 17

Jan 18

Jan 19

Source: Australian Bureau of Statistics

There is also an expectation of fiscal easing at the forthcoming budget due to be announced on 2
April. Still the risk of a recession is clear from the fact that the household savings rate has barely
risen as yet. The savings rate has declined from 10.9% of disposable income at the end of 2008 to
2.3% in 3Q18 and was 2.5% in 4Q18 (see Figure 10). Real household consumption growth remains
at a healthy 2% YoY in 4Q18, though real household disposable income growth has slowed to only
0.4% YoY (see Figure 11). The household debt and mortgage debt to disposable income ratios are
now 189% and 140% respectively.

With such high household debt levels concentrated on mortgage debt, there has to be a growing
likelihood that falling home prices lead to a spike in the savings rate. Such an outcome would,
ultimately, be extremely healthy even though it would also mean the first recession in Australia
since 1991. It would also create a long-term buying opportunity in Australian residential property.
But it would only be after a further decline in house prices and interest rates and, in GREED & fear’s
view, a further decline in bank share prices.

Thursday, 21 March 2019 Page 5

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Figure 10
Australia household savings as % of disposable income

22 (%, sa.) Australia household savings as % of disposable income

Source: RBA, Australian Bureau of Statistics

Figure 11
Australia real household consumption growth and disposable income growth

10 (%YoY)

(2) Real household disposable income growth

Real household consumption growth

Source: RBA

In Bangkok last week for CLSA’s 16 Asean Forum, the lack of noise on the pending general election,
the first to be held for eight years (2014 one was invalidated), was almost as marked as what GREED
& fear observed a week before as regards the also pending Indonesian presidential and
parliamentary elections (see GREED & fear - Eurozone revisited and Jokowi ascendant, 14 March 2019).

Still the atmosphere in Thailand politically is less surreal than it has been for years. Political parties
are allowed to campaign and the media is allowed to report the election news.

The base case remains what it was the last time GREED & fear visited Thailand four months ago (see
GREED & fear – South Asia focus, 8 November 2018). That is that the current Prime Minister General
Prayut Chan-o-cha will remain in power in a coalition government with some representation in
government by the Democrat Party, which essentially represents the Bangkok middle class. This
assumption is maintained despite news reports last week quoting Democrat leader and former prime
minister Abhisit Vejjajiva saying that he does not want General Prayut to be prime minister (see The
Nation article: “Doubt greets Abhisit’s shunning of Prayut’s continued leadership”, 11 March 2019).

If this is the base case, and the one the stock market would most probably like to see given any
other outcome represents increased uncertainty, GREED & fear would still prefer to wait and see

Thursday, 21 March 2019 Page 6

Christopher Wood christopher.wood@clsa.com +852 2600 8516

before making an increased allocation to Thailand in the Asia Pacific ex-Japan relative-return
portfolio. It is not as if Thailand is super cheap since valuations have continued to be supported,
Malaysian-style, by continuing inflows into the domestic mutual funds even as foreigners have
remained net sellers. Domestic institutions have bought a net Bt29bn worth of Thai stocks so far
this year, after buying a net Bt184bn in 2018, while foreigners have sold a net Bt13bn year to date
after selling a net Bt287bn last year (see Figure 12). CLSA’s Thailand universe of 49 companies
under coverage now trades at 13.3x forecast 2019 earnings, assuming 8% earnings growth.

Figure 12
Cumulative net buying of Thai stocks by foreigners and domestic institutions
600 (Bt bn) Domestic institutions Foreigners
Sep 07

Sep 08

Sep 09

Sep 10

Sep 11

Sep 12

Sep 13

Sep 14

Sep 15

Sep 16

Sep 17

Sep 18
May 07

May 08

May 09

May 10

May 11

May 12

May 13

May 14

May 15

May 16

May 17

May 18
Jan 07

Jan 08

Jan 09

Jan 10

Jan 11

Jan 12

Jan 13

Jan 14

Jan 15

Jan 16

Jan 17

Jan 18

Jan 19
Source: CLSA, Bloomberg

The other point about the pending Thai election is that, while the base case discussed above is
indeed the most likely outcome, the outcome is binary. That is that if the base case does not occur,
the consequences become potentially highly volatile in terms of how the opposition parties react
and how the military responds. Still the election has become more difficult for the pro-Thaksin
opposition since the Thai Raksa Chart party was expelled from the campaign for nominating the
king’s sister, Princess Ubolratana Rajakanya, as its prime ministerial candidate. The Constitutional
Court dissolved the Thai Raksa Chart party on 7 March and banned all its senior executives from
politics for 10 years.

The result is that the Pheu Thai Party of the still exiled Thaksin Shinawatra is only campaigning in
250 of the 350 constituency-based seats. The Pheu Thai Party’s plan was to have its spinoff Thai
Raksa Chart contest in areas where the Pheu Thai cannot win but hopes to take some votes for
better allocation of Party-list seats. Remember that under the new Constitution, implemented in
April 2017, seats will be allocated by proportional representation, not by first-past-the-post. This
leads to an incentive to create smaller parties, which is essentially what has happened in terms of
the specially created pro-junta parties as well as pro-Thaksin parties.

Still it remains the case that the Thaksin vote, combined with the new political opposition force, the
Future Forward Party, led by the charismatic 40-year-old Thanathorn Juangroongruangkit, could
potentially garner 50% of the vote. That could set up a difficult situation where Prayut is only
returned to power because of the votes provided by the 250 junta-appointed members of the Upper
House or Senate. It is this kind of result which has the potential to trigger manifestations of public
discontent. Note that the Future Forward Party is running candidates in each of the 350
constituencies, though it only seems to be popular among first-time voters aged 25 or below who
account for 10% of the total eligible voters.

Thursday, 21 March 2019 Page 7

Christopher Wood christopher.wood@clsa.com +852 2600 8516

The other issue is that officially the result of the election is not meant to be announced until after
the king’s coronation scheduled for 4-6 May, or six weeks after the actual voting takes place. This
would suggest an extremely tricky public relations exercise to manage the resulting information
vacuum as to the outcome of the vote. But presumably the powers that be will seek to fill the
vacuum as quickly as possible if the result is viewed as acceptable.

From a macroeconomic perspective, the hope remains that Thailand will become more domestic
demand driven, after the huge tourist-driven boom of recent years, most particularly Chinese
tourists. Tourism revenue has risen from 5.3% of GDP in 2009 to 12.3% of GDP in 2018, with
Chinese tourists’ share of total tourism revenue rising from 4.5% to 29% over the same period (see
Figure 13).

Figure 13
Thailand tourism revenue as % of GDP

14 (%GDP) China Others
























Source: CLSA, CEIC Data

Figure 14
Thailand share of Japanese outward FDI

8 % share 7.3
5 GFC takeover
4.0 4.2
4 3.4 3.6
2.8 2.9 2.8
3 2.7

1 0.6

2006 2008 2010 2012 2014 2016 2018
Source: CLSA, CEIC Data

Still for these hopes to be properly fulfilled will require the much heralded Eastern Economic
Corridor (EEC) to be a success. For now the EEC is still being constructed, a process in itself which
should lead to a pickup in economic growth and which should be completed by 2024. CLSA’s Asean
economist Anthony Nafte noted in his forum presentation last week recent announcements that
Japan would support the EEC project. Thus, the Japan Bank of International Cooperation (JBIC)
confirmed earlier this month soft loan financing at Bt225bn (US$7bn or 1.3% of GDP) for a high-

Thursday, 21 March 2019 Page 8

Christopher Wood christopher.wood@clsa.com +852 2600 8516

speed railway linking Thailand’s three main airports with the EEC. He also noted that after a
relatively “patchy” period, Japanese FDI into Thailand rose significantly last year to US$6.7bn or
4.2% of total Japanese outward FDI, up from US$4.7bn or 2.8% of total Japanese outward FDI in
2017 (see Figure 14). This was 61% of the Japanese FDI into China last year (see Figure 15). For
more on this read Nafte’s recent report (Gallop to glory: Thailand and Vietnam, 8 March 2019).

Figure 15
Share of Japanese outward FDI: 2018 vs 2017

China 6.8 11.3

Thailand 4.2

Korea 3.0

Indonesia 2.0

India 2.0
2018 2017
Hong Kong 1.4

Vietnam 1.1

Taiwan 1.0

Philippines 0.6

Malaysia 0.5 % share

0 2 4 6 8
Note: Japan total outbound FDI was US$160bn in 2018. Source: CLSA, CEIC Data

But what would really be bullish for Thailand is if both China and Japan supported the EEC project.
This has now become a distinct possibility in GREED & fear’s view given the significant improvement
in relations between Beijing and Tokyo in the past year and more, though obviously the improved
relations will have to be maintained. As regards China’s interest in the EEC, GREED & fear noticed an
encouraging article in the Thai press last Friday (see Bangkok Post article: “China wants EEC estate
land”, 15 March 2019). In this article Somchint Pilouk, the governor of the Industrial Estate
Authority of Thailand (IEAT), was quoted as saying, following a recent visit by potential mainland
investors, that the Chinese government wants to bring in more than 500 businesses into the EEC.

The above means it is wrong to be too cynical about the prospects for the EEC. The ambitious
project can certainly be complementary to China’s ambition as regards to One Belt One Road
(OBOR). It is also the case, as argued in Nafte’s report, that Thailand, along of course with Vietnam,
are the two countries most likely to benefit from relocation of production out of China in terms of a
realignment of Asian supply chains.

Meanwhile, from a monetary policy standpoint the rate hike by the Bank of Thailand, implemented
last December after remaining on hold at 1.5% since April 2015, is likely to be the last with the 1-
day repurchase rate at 1.75% (see Figure 16). Nafte expects no change in the policy rate this year
and next.

The sustained low rate environment, combined with the relatively unexciting stock market, is leading
to a rush to set up private banking operations in Thailand to attract Thailand’s traditionally domestic
focused wealthy to invest internationally where returns look more interesting. Certainly with import
growth slowing of late, there is little evidence as yet of the cyclical upswing which would trigger a
material decline in Thailand’s current account surplus which is the reason for its stable currency and
depressed interest rates.

Thursday, 21 March 2019 Page 9

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Figure 16
Bank of Thailand policy rate and Thailand CPI inflation

5 (%) BOT policy 1-day repo rate

Headline CPI inflation (%YoY)
4 Core CPI inflation (%YoY)


2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
Source: CLSA, Bank of Thailand, CEIC Data

Figure 17
Thailand 10-year government bond yield spread over US 10-year Treasury bond yield

2.5 (ppt) Thailand-US 10-year government bond yield spread





















Source: CLSA, Bloomberg

Figure 18
Thai baht./US$ (inverted scale)

28 Thai baht/US$ (inverted scale)

Apr 10
Jul 10
Oct 10

Apr 11
Jul 11
Oct 11
Jan 12
Apr 12
Jul 12
Oct 12

Apr 13
Jul 13
Oct 13

Apr 14
Jul 14
Oct 14

Apr 15
Jul 15
Oct 15

Apr 16
Jul 16
Oct 16

Apr 17
Jul 17
Oct 17

Apr 18
Jul 18
Oct 18
Jan 19
Jan 10

Jan 11

Jan 13

Jan 14

Jan 15

Jan 16

Jan 17

Jan 18

Source: Bloomberg

The ten-year government bond yield is still only 5bps above the 10-year US Treasury bond yield, at
2.58% (see Figure 17), while the Thai baht has appreciated by 2.2% against the US dollar so far this
year and is up 13% since the beginning of 2017 (see Figure 18). As for import growth, it slowed from

Thursday, 21 March 2019 Page 10

Christopher Wood christopher.wood@clsa.com +852 2600 8516

17.3% YoY in US dollar terms in the three months to October to 4.4% YoY in the three months to
January, while exports declined by 2% YoY in the three months to January (see Figure 19). As a
result, the current account surplus remains large at 7.4% of GDP in 2018, though down from 11.7%
in 2016 (see Figure 20).

Figure 19
Thailand export growth and import growth in US dollar terms (BOP basis)

80 (%YoY 3mma)
Export growth Import growth
May 10
Sep 10

May 11
Sep 11

May 12
Sep 12
Jan 13
May 13
Sep 13

May 14
Sep 14

May 15
Sep 15
Jan 16
May 16
Sep 16

May 17
Sep 17

May 18
Sep 18
Jan 10

Jan 11

Jan 12

Jan 14

Jan 15

Jan 17

Jan 18

Jan 19
Source: CLSA, CEIC Data

Figure 20
Thailand current account as % of GDP

15 (%GDP)
Thai current account as % of GDP




Source: CLSA, CEIC Data

There has been US$3.3bn of net buying of Indian equities by foreign investors since an opinion poll
was released on 4 March by India TV-CNX (see Figure 21) showing a big increase in support for the
BJP following the airstrikes on 26 February in Balakot in Pakistan. The BJP is now expected to get
41 of the 80 seats in India’s most populous state of Uttar Pradesh, compared with the 29 seats
expected by the same opinion poll in January. For more on this read a recent research report by
CLSA’s Indian strategist Mahesh Nandurkar (Market Mantra - Investor sentiment improves, 6 March

GREED & fear has always thought BJP would win the forthcoming general election due to be held
between 11 April and 19 May. But there is no doubt that concerns had been growing in recent
months. It is the case that Modi’s structural reforms, such as demonetisation and GST, have caused
economic pain in the first instance. This is why the recent military skirmish with Pakistan could well

Thursday, 21 March 2019 Page 11

Christopher Wood christopher.wood@clsa.com +852 2600 8516

prove the equivalent for Modi of what the Falklands War was for the late and great Margaret
Thatcher in 1982. For prior to that event, and the related surge in jingoism, Thatcher was looking far
from guaranteed for re-election as the media and the masses attacked “the cuts”. As for Modi, he is
reaping the rewards of a robust response to the killing of more than 40 Indian soldiers in Indian-
administered Kashmir on 14 February.

Figure 21
Cumulative foreign net buying of India equities
16 Cumulative FII net equity investment 39,000
14 BSE Sensex (RHS) 37,000
8 33,000

6 31,000
4 29,000
-2 25,000

-4 23,000














Source: CLSA, Bloomberg, SEBI

To remain effective Modi’s style of government, which is highly centralised government by the
Prime Minister’s office, requires a big majority for the BJP. This is why it is also a positive that the
BJP has formed pre-poll alliances in the large states of Maharashtra and Tamil Nadu, as well as in
Assam and North East. Opinion polls published last week also indicate a gain of 30-40 seats
nationwide for the BJP compared to polls in early February (see CLSA research India Market Mantra -
The positive trend can persist, 15 March 2019).

Figure 22
Net inflows into Indian domestic equity mutual funds adjusted for Arbitrage funds
4.5 (US$bn) Net inflows in equity funds adjusted for Arbitrage funds



















Note: Include 65% of flows into balanced funds. Source: CLSA, AMFI, Bloomberg

Meanwhile if the risk in India from a fund flow perspective remains that inflows into local equity
mutual funds slow further, at least such flows remain positive. Domestic equity mutual funds’
monthly net inflow, excluding arbitrage funds, has declined from an average of US$2.5bn (Rs160bn)
in January-February 2018 to US$0.7bn (Rs50bn) in the first two months of 2019 (see Figure 22). It
is also the case that there is definitely room for foreigners to increase weightings as they have not

Thursday, 21 March 2019 Page 12

Christopher Wood christopher.wood@clsa.com +852 2600 8516

added to their holdings in Indian equities for three years. Thus, net foreign portfolio investor equity
inflows into India, adjusted for dividends paid on their holdings, were almost zero over the past
three calendar years. Foreign portfolio investors have recorded net inflows into Indian equities of
US$6.4bn over the past three years (see Figure 23), equivalent to about 4% of their outstanding
investment at the end of 2015. This is almost the same as the aggregate dividend yield for the Indian
stock market over the past three years, which has been running at around 1.3-1.5%. Still foreigners
have bought a net US$5.9bn worth of Indian equities so far in 2019, equivalent to about 3% of their
estimated holdings at the end of 2018. Meanwhile, CLSA’s India office estimates that foreigners’
India overweight had reduced from 5-6ppts in 2015 to about 0-0.5ppt by the end of 2018 due to
tepid FII inflows of around US$2bn/year over the past three years. As for the asset allocation in the
Asia Pacific ex-Japan relative-return portfolio, GREED & fear remains double overweight India (see
Figure 28).

Figure 23
India net foreign portfolio investors’ equity inflows (calendar year)

30 (US$bn)




















Note: Calendar years. Data up to 19 March 2019. Source: Bloomberg

Figure 24
India real GDP growth and real gross fixed capital formation growth

10 (%YoY) India real GDP growth (%YoY) 16

Real gross fixed capital formation growth (RHS)
8 10
6 4
4 -2
Sep 12
Dec 12

Sep 13

Sep 14

Sep 15

Sep 16

Sep 17

Sep 18
Dec 13

Dec 14

Dec 15

Dec 16

Dec 17

Jun 18

Dec 18
Jun 12

Mar 13
Jun 13

Mar 14
Jun 14

Mar 15
Jun 15

Mar 16
Jun 16

Mar 17
Jun 17

Mar 18

Source: CLSA, CEIC Data, MOSPI

As regards to the latest Indian economic data the most encouraging has been a pickup in fixed
capital formation. Real gross fixed capital formation rose by 10.6% YoY in 4Q18, up from 10.2% YoY
in 3Q18 and a recent low of 3.9% YoY in 2Q17 (see Figure 24). As a result, annualised gross fixed

Thursday, 21 March 2019 Page 13

Christopher Wood christopher.wood@clsa.com +852 2600 8516

capital formation declined from 34.5% of nominal GDP in 2Q12 to a low of 28% of GDP in 2Q17
and has since risen to 28.9% in 4Q18, the highest level since 4Q15 (see Figure 25).

Still the forthcoming general election will be held in the absence of clear cut evidence of an
economic upturn. Indeed real GDP growth for 4Q18, at 6.6% YoY, was the weakest in 16 quarters
aside from when GST was implemented on 1 July 2017 (see Figure 25). While total tax revenue
growth slowed from 18% in FY17 to 12% in FY18 and 7.3% YoY in the first ten months of FY19
ended January, compared with 11.8% YoY growth in nominal GDP in April-December 2018 (see
Figure 26).

Figure 25
India gross fixed capital formation as % of nominal GDP

36 (%GDP) India gross fixed capital formation as % of nominal GDP






Sep 11

Sep 12

Sep 13
Dec 13

Sep 14

Sep 15

Sep 16

Sep 17

Sep 18
Dec 11

Dec 12

Dec 14

Dec 15

Dec 16

Dec 17

Dec 18
Jun 11

Mar 12
Jun 12

Mar 13
Jun 13

Mar 14
Jun 14

Mar 15
Jun 15

Mar 16
Jun 16

Mar 17
Jun 17

Mar 18
Jun 18

Source: CLSA, CEIC Data, MOSPI

Figure 26
India gross tax revenue growth and nominal GDP growth

20 (%YoY) Gross tax revenue Nominal GDP

FY12 FY13 FY14 FY15 FY16 FY17 FY18 10MFY19
Note: GDP data up to April-December 2018. Source: CLSA, MOSPI, CEIC Data

Staying on the subject of India, two points need to be noted regarding two stocks in the Asia ex-
Japan long-only portfolio. The investment in Dalmia Bharat will now be temporarily renamed to
Odisha Cement following the recent completion of the merger between the two companies. Dalmia
Bharat has now been delisted while Odisha Cement will subsequently be renamed Dalmia Bharat.
While the investment in Arvind Limited will be switched to Arvind Fashions, the branded apparel
business of Arvind, following the demerger and the listing of Arvind Fashions on 8 March (see Figure
29). The investment case for Arvind Fashions can be found in a recent research report by CLSA’s
Indian consumer analyst Chirag Shah (Arvind Fashions - Diversified play on branded apparel, 12 March

Thursday, 21 March 2019 Page 14

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Finally, the existing investment in Woodside Petroleum will be removed and replaced by an
investment in Thai energy stock PTT Exploration & Production (PTTEP). The investment case for
PTTEP can be found in a recent sector report by CLSA’s deputy head of Thailand research
Narongpand Lisahapanya (Thailand energy – Road to recovery, 7 March 2019).

Moving away from Asia, the investment wisdom has it that the middle ground is always the sensible
approach in politics. This can be seen, for example, in a series of articles triggered by the US
Democratic presidential candidates’ recent efforts to paint themselves as socialists. Most of these
articles make the point that it is possible to have capitalism in the context of modern welfare states.
See, for example, an article by former Federal Reserve vice chairman Alan Blinder in last Friday’s
Wall Street Journal (“Democrats, stop pretending to be socialists”, 15 March 2019).

May be this is the case but GREED & fear has significant reservations in the sense that income tax
levied above a certain percentage of income massively distorts the incentives provided by capitalism.
It is also the case that “capitalism” has long ceased being practised in the banking sector with the
distortions provided by taxpayer-funded bailouts and regulatory imposed “risk-based” capital
adequacy models. This is why, in GREED & fear’s view, the Democrat left and the Republican free
market right were correct when they both called for nationalisation of the US banks requiring
taxpayer bailouts during the 2008 crisis.

But GREED & fear’s point this week is not to dwell on history. Rather it is to observe that the
Democrat left and the free market Republican right are both converging on the same view as
regards the long overdue regulation of “Big Tech”.

One and a half years ago, GREED & fear referenced an excellent book which highlighted both the
insidious “echo chamber” dynamic of social media as well as Big Tech’s commercial exploitation of
individual data and its successful capture of Washington via lobbying (see GREED & fear – Creepy
geeks, 5 October 2017). The author of that book (“Move Fast and Break Things”, Little, Brown and
Company, 18 April 2017), Jonathan Taplin, also spoke at CLSA’s last Hong Kong Forum.

Figure 27
Facebook share price

230 (US$) Facebook share price








Jul 15
Sep 15

Jul 16
Sep 16

Jul 17
Sep 17

Jul 18
Sep 18
Jan 15
Mar 15
May 15

Nov 15
Jan 16
Mar 16
May 16

Nov 16
Jan 17
Mar 17
May 17

Nov 17
Jan 18
Mar 18
May 18

Nov 18
Jan 19
Mar 19

Source: Datastream

The arguments in that book have since become much more widely accepted, though GREED & fear
will admit that baby boomers like Taplin and GREED & fear seem much more concerned about the
privacy issue than millennials. GREED & fear was reminded of all this reading that Democratic

Thursday, 21 March 2019 Page 15

Christopher Wood christopher.wood@clsa.com +852 2600 8516

presidential candidate, Senator Elizabeth Warren, has now publicly called for a break up of “Big Tech”
on the anti-trust angle and also called for an unwinding of acquisitions where “Big Tech” has
successfully identified potential threats to its winner-takes-all models and purchased them. The
most obvious examples here are Facebook acquisitions of Instagram in 2012 for US$1bn and of
WhatsApp in 2014 for US$19bn.

GREED & fear has to admit to not sharing Senator Warren’s views on most economic issues. But
GREED & fear is in complete agreement on “Big Tech”, and from a more Republican right-wing
perspective GREED & fear was also interested to see Republican Senator Ted Cruz making approving
comments. The policies she is proposing are almost exactly what is proposed in Taplin’s book or a
more recent book looked at Facebook (“Zucked: Waking Up to the Facebook Catastrophe”, Penguin
Press, 5 February 2019) by Roger McNamee who, interestingly, was an initial investor in Facebook.
And Facebook and Google are the main companies in the immediate line of fire with Amazon and
Apple, in that order, not so far behind.

The Warren call is also topical at a time when Facebook is seeking to start monetising Instagram and
WhatsApp, and when Mark Zuckerberg has put on record that he is fundamentally aiming to shift
Facebook’s core strategy from the advertising driven “public sharing” model to an encrypted system
based on privacy where only people sending and receiving messages will be able to see them. This,
in GREED & fear’s view, is a smart decision if Facebook wants to survive, and also complements the
recent news reports of Facebook’s plan to develop a digital currency discussed by CLSA’s global
head of thematic research Shaun Cochran in his daily Theorality email bulletin on 1 March. Thus,
Facebook is reportedly planning to roll out a cryptocurrency over the next year which will allow
users to send money to their WhatsApp contacts across international borders (see New York Times
article: “Facebook and Telegram are hoping to succeed where Bitcoin failed”, 28 February 2019).

Meanwhile, if Zuckerberg does not succeed in implementing the change, the likelihood is that the
current model will hit a brick wall, either because it becomes “uncool” or because it is heavily
regulated or, perhaps most likely, a combination of both. Meanwhile, the disruption of traditional
media by the grotesque “news feeds” has long been obvious. GREED & fear remains amazed why
major media ever allowed “Big Tech” to display their content free of charge. But for a long time the
Big Tech companies were able to have the best of both worlds by claiming they were not media
companies but only utilities. That is no longer the case. The editorial obligation of social media to try
and monitor what is on the platform means soaring costs as they try to perform an editing function
in terms of which they have no competence. Meanwhile, the latest outcome of the insidious
feedback loop, encouraged by the obnoxious “algos”, was a Facebook live stream of a gunman
attacking worshippers in two mosques in, of all placesfear, New Zealand last Friday.

Still Zuckerberg is obviously very smart, and presumably understanding the old model has passed its
“sell-by” date, he is clearly switching direction. May be he can pull it off.

Thursday, 21 March 2019 Page 16

Christopher Wood christopher.wood@clsa.com +852 2600 8516

Figure 28
CLSA Asia Pacific ex-Japan asset allocation
MSCI AC Asia CLSA Mismatch Current
Pacific ex-Japan recommended from MSCI benchmark
weightings weightings benchmark weightings
23-Jan-19 24-Jan-19 (20-Mar-19)

Australia 17.1% 5.0% -12.1% 16.6%

China 29.3% 35.0% 5.7% 31.1%
Hong Kong 9.7% 8.0% -1.7% 9.8%
India 8.4% 17.0% 8.6% 8.5%
Indonesia 2.2% 4.0% 1.8% 2.0%
Korea 13.0% 12.0% -1.0% 12.4%
Malaysia 2.2% 1.0% -1.2% 2.1%
New Zealand 0.6% 0.0% -0.6% 0.6%
Pakistan 0.04% 2.0% 2.0% 0.03%
Philippines 1.1% 1.0% -0.1% 1.0%
Singapore 3.4% 2.0% -1.4% 3.2%
Taiwan 10.4% 7.0% -3.4% 10.5%
Thailand 2.4% 3.0% 0.6% 2.2%
Vietnam -- 2.0% 2.0% --
Bangladesh -- 1.0% 1.0% --
Total 100.0% 100.0% -- 100.0%
Source: CLSA, MSCI

Figure 29
Asia ex-Japan thematic equity portfolio for long-only absolute-return investors

Australia gold mining 4% Regis Resources

China e-commerce 5% Alibaba
China online marketplace 5% 58.com Inc
China financial services 3% Ping An Insurance (Group)
China oil & gas 6% CNOOC
Hong Kong insurance 5% AIA Group
Macau gaming 4% Galaxy Entertainment
India internet 5% Reliance Industries
India private sector banks 16% HDFC Bank (5%), IndusInd Bank (3%), ICICI Bank (5%), Axis Bank (3%)
India housing finance 9% HDFC (5%), GRUH Finance (4%)
India non-bank finance 5% Bajaj Finance
India cement 4% Odisha Cement
India property 6% Godrej Properties
India consumer 4% Arvind Fashions
Indonesia banks 4% Bank Rakyat Indonesia
Indonesia cement 3% Indocement
Korea property 4% HDC Hyundai Development
Korea tech 5% Samsung Electronics Pref
Thailand oil & gas 3% PTT Exploration & Production
Note: Readers should refer to the relevant CLSA research reports for detailed analysis & disclosures. Source: CLSA

Thursday, 21 March 2019 Page 17

March 21, 2019 12:37 AM GMT


US Economics & Fixed Income Strategy | North Ellen Zentner
America Ellen.Zentner@morganstanley.com +1 212 296-4882
Matthew Hornbach
FOMC Reaction: The Doves Are Matthew.Hornbach@morganstanley.com
Jeremy J Nalewaik
+1 212 761-1837

Back in DC Jeremy.Nalewaik@morganstanley.com
Robert Rosener
+1 212 761-3892

Robert.Rosener@morganstanley.com +1 212 296-5614

While the Fed sees strong underlying fundamentals, Molly Wharton
policymakers no longer feel the urge to tighten policy anytime ECONOMIST
Molly.Wharton@morganstanley.com +1 212 296-8054
soon, nor do they see the need to move into restrictive Guneet Dhingra, CFA
territory. Our strategists stay long US duration via real and Guneet.Dhingra@morganstanley.com +1 212 761-1445
nominal rates, long UST 5y vs. OIS, and short the US dollar. Sam Elprince
Sam.Elprince@morganstanley.com +1 212 761-9491
Jay Bacow
The FOMC's forecast materials were more dovish than expected: even STRATEGIST
Jay.Bacow@morganstanley.com +1 212 761-2647
with a shallower path for policy over the projection horizon, less David S. Adams, CFA
restrictive monetary policy, and easier financial conditions, STRATEGIST
David.S.Adams@morganstanley.com +1 212 761-1481
policymakers expect growth will decelerate and inflation will remain Andrew M Watrous
anchored at 2%. STRATEGIST
Andrew.Watrous@morganstanley.com +1-212-761-5287

The Committee finally announced the details of its plans to end

balance sheet normalization in September, largely in line with our
expectations. Details on the longer-run framework are still to come.

Based on these rather benign projections from the FOMC, our

outlook for accelerating core inflation at the end of this year and into
next year will likely catch policymakers by surprise, and should push
them back into hiking mode, in our view. We expect the Fed to hike
next in December.

We continue to suggest notional neutral UST 2s5s flatteners, long 5

TIPS outright, overweighting duration in the US and Canada against
Germany and the UK, and we add a new suggestion: Go long UST 5y Ellen Zentner, Jeremy J Nalewaik, Robert Rosener and
vs. OIS. Molly Wharton are economists and are not opining on any
securities. Their views are clearly delineated.
Due to the nature of the fixed income market, the issuers or
Increased prepay risk from the rally along with faster seasonals and bonds of the issuers recommended or discussed in this
report may not be continuously followed. Accordingly,
more issuance will be supportive of specified pools, though they are investors must regard this report as providing stand-alone
already well bid. We don't expect the Fed to exceed the $20bn MBS analysis and should not expect continuing analysis or
additional reports relating to such issuers or bonds of the
caps at this rate level; we estimate reinvestments wouldn't stay issuers.
above the cap for the entire year unless we see a rally close to 2% on Morgan Stanley does and seeks to do business with
10s. companies covered in Morgan Stanley Research. As a
result, investors should be aware that the firm may have a
conflict of interest that could affect the objectivity of
We suggest buying risk- and rate-sensitive currencies against the USD. Morgan Stanley Research. Investors should consider
Morgan Stanley Research as only a single factor in making
Emerging market currencies including IDR, RUB, PLN, and CLP look their investment decision.
especially attractive. For analyst certification and other important disclosures,
refer to the Disclosure Section, located at the end of this

US Economics
MORGAN STANLEY & CO. LLC Ellen Zentner +1 212 296-4882
Jeremy Nalewaik +1 212 761-3892
Robert Rosener +1 212 296-5614
Molly Wharton +1 212 296-8054
Molly. Wharton@morganstanley.com

The FOMC kept the federal funds target range unchanged at 2.25-2.50% at its March
meeting, leaving all the action for the accompanying materials where policymakers
indicated no plans for rate hikes this year, and a more dovish policy path over the next
couple of years, alongside plans to wind down balance sheet normalization beginning in
May, with the program concluding at the end of September 2019.

Economic Projections & The Dot Plot

The March projection materials showed a much more dovish and uncertain outlook for
monetary policy against a backdrop of an economy that the Fed expects will gradually
converge toward its dual mandates. Eleven policymakers expect no rate hikes this year
(Exhibit 1), a solid consensus that likely includes both Chair Powell and the core of the

The outlook for 2020 and 2021 looks more uncertain as well. Seven policymakers
expect the fed funds rate will remain unchanged all the way through the end of 2020.
That compares with just one policymaker in December (St. Louis Fed President Bullard)
who saw the fed funds rate at 2.375% at the end of 2020. Moreover, five policymakers
now expect policy will remain on hold all the way through the end of 2021. Importantly,
no policymakers have penciled in rate cuts from current levels over the forecast

Those changes in the dots over the next few years are interesting in the context of the
long-run dots that moved very little. The median long-run dot remained unchanged at
2.75%, although there were some minor underlying shifts in the individual projections,
with a couple more participants now seeing the long-run neutral rate as low as 2.50%.
But importantly, 10 policymakers see the fed funds rate at 2.625% or lower at the end
of 2021, meaning that the majority of policymakers expect policy to just butt up against
neutral at the end of the projection horizon. That's a meaningful departure from the
December dot plot and the general picture seen in most of the dot plots of the last
year that consistently showed a large majority of policymakers favoring moving policy
into restrictive territory.

Exhibit 1: The March Dot Plot

5.0% Fed's Summary of Economic Projections (March) March Median

4.5% Fed Funds Futures MS Outlook
4.0% December Median
2019 2019 2020 2020 2021 2021 2022 Longer
2022Run 2023

Source: FOMC March 2019 Summary of Economic Projections, Bloomberg, Morgan Stanley Research

While there are fewer rate hikes in the pipeline in the Fed's view, policymakers'
projections for growth and inflation were somewhat more sober (Exhibit 2). Median
growth projections for 2019 and 2020 were marked lower – the median projection for
2019 was marked down to 2.1% from 2.3% and the projection for 2020 was marked
down to 1.9% from 2.0%. By 2021, the median projection sees growth running slightly
below potential at 1.8%. So the Fed now expects the economy will be more self-bridling
and should slow toward potential even with less planned monetary policy tightening
than it previously imagined and without rates moving into restrictive territory. Are they
telling us that we're not getting any bang for our buck out of this "patient" period for
monetary policy and subsequent easing of financial conditions?

With slower growth, the Fed also now expects a slightly higher unemployment rate over
the projection horizon. The unemployment rate is now seen at 3.7% at year end, up from
3.5% previously; the unemployment rate is then projected to tick higher in 2020 and
2021, ending the projection horizon at 3.9%, 40bp below where the Committee sees the
longer-run unemployment rate.

Inflationary pressures are also few and far between in the Fed's projections, with core
PCE inflation expected to remain level at 2.0% over the entire projection horizon.
Indeed, that dynamic may explain why so many policymakers anticipate leaving policy
on hold for so long. As Chair Powell indicated in his press conference, not achieving the
2% inflation target in a symmetrical way is one of the reasons policymakers are being
patient, and will "not move until we see that our target goals are being achieved."

Exhibit 2: March FOMC Economic Projections
2019 2020 2021 Longer Run
Real GDP (Q4/Q4)
March 2019 2.1 1.9 1.8 1.9
December 2018 2.3 2.0 1.8 1.9
Unemployment Rate (Avg. 4Q)
March 2019 3.7 3.8 3.9 4.3
December 2018 3.5 3.6 3.8 4.4
Core PCE Inflation (% change)
March 2019 2.0 2.0 2.0 -
December 2018 2.0 2.0 2.0 -
Federal Funds Rate
March 2019 2.375 2.625 2.625 2.75
December 2018 2.875 3.125 3.125 2.75
Source: March 2019 FOMC Summary of Economic Projections, Morgan Stanley Research

Balance Sheet
After policymakers have provided coordinated signals since the beginning of the year
indicating plans to end balance sheet normalization, the Committee finally announced
the details of those plans. Beginning in May, the Fed will slow the pace at which
Treasury securities roll off the balance sheet by "reducing the cap on monthly
redemptions from the current level of $30 billion to $15 billion".

Policymakers will conclude the reduction in its securities holdings altogether at the end
of September 2019, after which the Committee will continue to allow MBS to roll off
the balance sheet but will reinvest MBS roll-offs into Treasuries.

For now, policymakers will reinvest maturing securities across the curve to match the
maturity composition of Treasury securities outstanding, but the accompanying policy
statement and Chair Powell's press conference indicated that decisions about long-run
securities holdings are still ongoing. As Chair Powell confirmed, the FOMC has not taken
up the issue of the long-run maturity composition of the SOMA portfolio and implied
that it may take several meetings for policymakers to come to a decision on this
important issue.

Concluding Thoughts
Importantly, on the back of the FOMC meeting, financial conditions eased markedly. By
our estimates, financial conditions eased about the equivalent of half a rate cut, and are
now about 25bp easier from where they stood at the end of September. That means not
only have markets more than fully reversed the tightening of financial conditions seen
at the end of last year, the net easing in financial conditions has also now amounted to
the equivalent of a full Fed rate cut.

Much of this easing has come from the depreciation in the dollar (see FX Strategy),
which if sustained provides support for the outlook for growth and inflation over the
medium term.

As for our outlook, Exhibit 1 charts our expected policy path against the Fed and current
market pricing. Whereas the market is pricing a decent chance of rate cuts over the
horizon, the Fed sees policy a bit more steady, while we expect the Fed to deliver a hike
in December this year followed by a lengthy pause and three more hikes in June,
September, and December of 2020. Inflation outcomes will be the key here. We're
looking for core PCE to accelerate to 2.5% in 2020, versus the Fed at 2.0%. Such an
outcome would catch policymakers by surprise, and push them back into hiking mode,
in our view.

US Rates Strategy
MORGAN STANLEY & CO. LLC Matthew Hornbach
Matthew.Hornbach@morganstanley.com +1 212 761-1837
Guneet Dhingra
Guneet.Dhingra@morganstanley.com +1 212 761-1445
Sam Elprince
Sam.Elprince@morganstanley.com +1 212 761-9491

A balance sheet update with Bayesian inference

The FOMC meeting came in line with our expectations on certain fronts (lower median
2020/2021 dots, ending balance sheet normalization in September), and surprised
dovishly on others (no hikes appropriate in 2019). In particular, we were surprised that
the Fed opined this early on how it would redirect agency MBS principal into Treasuries,
at least at first, after the Treasury reinvestment caps fell to zero in September. We had
assumed that the decision on agency MBS-into-Treasuries would come in May or in June.
The final decision, of course, still may.

However, for those updating probabilities via Bayesian inference, the probability that the
Fed redirects all agency MBS principal into T-bills (or T-bills, 2s, and 3s) has gone down.
Why? Because the Fed announced that the default option will be reinvesting in Treasury
securities across a range of maturities to roughly match the maturity composition of
outstanding Treasuries. In our view, the Fed didn't have to announce a default option.
Rather, it could have suggested a decision would be forthcoming before September.

Principal payments from agency debt and agency MBS below the $20 billion
maximum will initially be invested in Treasury securities across a range of maturities
to roughly match the maturity composition of Treasury securities outstanding; the
Committee will revisit this reinvestment plan in connection with its deliberations
regarding the longer-run composition of the SOMA portfolio.

We last discussed our thoughts on the duration of the Fed's balance sheet in Dissenting
from Dudley. In summary:

1. Active vs. passive tools: Reducing the duration of the SOMA portfolio is
inconsistent with the Fed's desire to have investors view the balance sheet as a
passive tool. Ceasing the normalization of the balance sheet size only to begin to
normalize the balance sheet duration sounds like an active use of a passive tool,
especially if the federal funds target rate range – the active policy tool – is inactive
(which it may very well be when the Fed ceases balance sheet normalization in
September). The most passive approach the Fed could take with its balance sheet
is to let someone else (the Treasury) determine what it holds until the time when
the Fed wants to use the balance sheet actively (presumably with rates at the
effective lower bound).

2. Uncertain impact: The Fed is uncertain about the impact of balance sheet
normalization on the economy and financial conditions. We don't think the Fed
would feel comfortable reducing the duration of its portfolio until it has a better
handle on the effect of reducing its size. We don't expect the Fed to have an
understanding of this for some time to come, just as it took the Fed years to
understand how quantitative easing impacted the economy and markets.

3. MEP vs. QE: Research from the FRB San Francisco suggested the MEP had the
smallest impact on Treasury yields among the first 3 large-scale asset purchase
(LSAP) programs. And research from the FRB Kansas City suggested the MEP had
the lowest implied signaling effect of the first 3 LSAPs. Why would the Fed see
another MEP as a preferred option to another QE program? We don't see a
reasonable case.

Given the Fed's initial decision to redirect agency MBS principal into Treasuries across
the curve, market participants should put higher probabilities on the same policy
continuing after the Fed's final decision. As this process plays out, the intermediate
sector of the yield should benefit the most (5- to 10-year maturities).

The third mandate: Keep the party going

In A Framework for This Fed: It's My Party and I'll Cut If I Want To, we discussed our
view that the current FOMC is really about keeping the party going. We pointed to two
quotes from Chairman Powell that suggested this to us. The earliest quote came from
Powell's conversation with Dallas Fed President Kaplan on November 14, 2018.

So the best thing we can do it to try to sustain this expansion for as long as possible,
and that’s really what our policy is designed to do.

The later quote was from the January 2019 FOMC press conference. As it turns out,
Chairman Powell repeated the same line verbatim at the March 2019 FOMC press

My colleagues and I have one overarching goal: to sustain the economic expansion
with a strong job market and stable prices, for the benefit of the American people.

The goal of keeping the economic expansion – the party – going certainly sounds like
another mandate for monetary policy. In practical terms today, the Fed is waiting,
patiently, to see if current guests stay and previous guests return (growth to rebound
back above potential, the unemployment rate to fall further, and inflation to move
above target for a period).

In practical terms tomorrow, if current party guests start leaving and previous guests
don't return, then the FOMC may turn up the music volume (cut rates) even though the
party is still going (the economy is not yet in recession). By turning up the music volume,
the Fed will (1) encourage people to return to the party and (2) prevent people already
at the party from getting bored and leaving.

In this sense, the view of most FOMC participants, expressed in the March 2019 dot-plot,
that appropriate policy means no rate changes this year is important. As Powell
described in his opening statement, there are risks around those views of appropriate
policy that are not captured by the median dots (or any dots for that matter).

The SEP includes participants’ individual projections of the most likely economic
scenario along with their views of the appropriate path of the federal funds rate in
that scenario. Views about the most likely scenario form one input into our policy
discussions. We also discuss other plausible scenarios, including the risk of more
worrisome outcomes. These and other scenarios and many other considerations go
into policy, but are not reflected in projections of the most likely case.

As long as US data remain lackluster, market participants should feel more comfortable
with the rate cut priced in to 2020 (a full 25bp cut is priced by July 2020). If the data
worsen (more people leave the party), market participants should feel comfortable with
the market pricing an even earlier rate cut in 2020 or more rate cuts in 2020 than what
is priced in.

Higher probabilities of more rate cuts in 2020 and beyond should support intermediate-
sector Treasuries. As a result, we continue to suggest notional neutral UST 2s5s
flatteners, giving investors exposure to the 2y forward 3y Treasury yield via a duration
neutral 2s5s flattener and an outright long in 5y Treasuries.

Finally, from a charting perspective, we suggested that the low from early January at
2.54% was the next resistance level, but we broke it after the FOMC meeting. Now, it's
open sailing from there down to 2.34/2.37%, then at the 38.2% Fibonacci projection of
major waves 1 to 3 at 2.27% (see Exhibit 3).

Exhibit 3: UST 10-year on-the-run yield - Daily

Source: Morgan Stanley Research, Bloomberg

Trade idea: Maintain long US (TY) and Canada (CN) futures vs. short Germany
(RX) and gilt (G) futures
Trade idea: Maintain short 2y notes vs. long 5y notes, notional neutral

The fruits of patience: Long real yields

In 2018, with the Fed having hiked 4 times in a straight line, and perhaps predictable
fashion, one of the best trades was to be short 5-year real yields. In 2019, the story has
reversed. Exhibit 4 shows how 5-year real yields are within spitting distance of their
starting point in early 2018 – the levels consistent with the pre-tax reform level for 5-
year real yields. With a Fed that has turned significantly dovish, by guiding to a pause in
2019, we continue to suggest being long 5-year real yields.

How much more can real yields rally? As Exhibit 4 shows, real yields have been rising in
straight line for the last two years before coming into 2019, and were in negative
territory in early 2017. We have noted in the past that real rates tend to peak and
trough with the fed funds rate (see Exhibit 5), and therefore, current real yield levels are
nowhere close to how low they can get. Additionally, as we note in the section above,
the Fed's implicit third mandate, keeping the party going – will keep this downward drift
in real yields.

Exhibit 4: Moves in 5-year real yields and breakevens since Exhibit 5: 5-year real rates vs. fed funds target rate over the
the start of 2018 last two decades
% % % %
2.4 1.2 7.0 Real rates peak as fed 5.0
funds rate peaks
2.3 4.0
1.0 6.0
0.8 5.0 3.0
2.0 2.0
0.6 4.0
1.9 1.0
1.8 0.4 3.0
1.7 0.2 2.0 -1.0
0.0 1.0 -2.0
1.4 -0.2 0.0 -3.0
Aug-17 Dec-17 Apr-18 Aug-18 Dec-18 Jul-97 Jul-01 Jul-05 Jul-09 Jul-13 Jul-17
5-year breakevens 5-year real yields (rhs) Fed funnds rate 5-year real yields (rhs)
Source: Bloomberg, Morgan Stanley Research Source: Bloomberg, Morgan Stanley Research

Real yields vs. breakevens: willingness vs. ability... While 5-year real yields dropped by
12bp as a reaction to the March FOMC, 5-year breakevens widened by only 2bp. We
think this muted reaction in breakevens is a testament to how the market thinks about
the ability of the Fed to generate inflation. In other words, the market can more
confidently price in lower real rates on the back of a dovish Fed, but does not feel
confident that such a shift is worth much in terms of inflation expectations.

We think this distinction is particularly relevant in a year where the average inflation
targeting and price level targeting framework will be discussed by the Fed. We think as
the debate continues on through 2019 (the Fed is expected to make updates on their
conclusions in 2020), we expect real yields remain under pressure, as the market prices
in the Fed's willingness to keep real rates lower for longer.

On the other hand, we do not think the market will give much credence to the Fed's
ability to generate inflation, even though it may be willing to keep rates lower. This is
essentially a reflection of the lack of inflation pressures we have seen even with the
easiest policy from the Fed over a decade. As a result, we think breakevens will face
resistance in widening, even as real yields could continue to march lower.

The inflation pessimism from the Fed doesn't help. It is also notable that the Fed has
lowered its headline PCE projections for 2020 and 2021, while moving its projections for
the unemployment rate higher. Additionally, Powell called low inflation "a major
challenge of our time" without offering any countering narratives. Such comments along
with downbeat inflation projections paint a picture where the Fed does not feel very
confident about prospects for inflation.

The unmistakable focus on unit labor costs: We found it notable that when Fed chair
when asked about wage inflation simply did not refer to average hourly earnings. In fact,
he simply mentioned unit labor costs, as if that's the variable he has been looking at all
along. As we have noted before, unit labor costs is indeed the right metric to look at as it
has a much stronger relationship with CPI than average hourly earnings – a relationship
that has stood the test of time (see Exhibit 6).

Average hourly earnings does not adjust for productivity gains embedded into wage
increases, and therefore unit labor costs, which adjust for productivity gains, are a better
gauge into how wages might be rising vis-a-vis the supply side of the economy.

Exhibit 6: Unit labor costs vs. headline CPI over the last fifty years
% %
16.0 14
14.0 12
12.0 10
10.0 8
8.0 6
6.0 4
4.0 2
2.0 0
0.0 -2
-2.0 -4
-4.0 -6
Feb-69 Feb-74 Feb-79 Feb-84 Feb-89 Feb-94 Feb-99 Feb-04 Feb-09 Feb-14 Feb-19
CPI Unit Labor costs
Source: Bloomberg, Morgan Stanley Research

Trade idea: Long 5-year real yields at 42bp

Trade idea: Long 10-year real yields vs. EDZ9 at 212bp
Trade Idea: Long Jul19s TIPS vs. May19 CPI fixing

Fed to return to the secondary market

With today's announcement that, starting in October 2019, the Fed will be reinvesting
MBS prepays under the $20 billion cap into USTs, the Fed effectively announced that it
will be back to the secondary market buying USTs. That is because only reinvestments
of USTs can be conducted as an add-on to UST auctions. Exhibit 8 illustrates the total
amount of UST buying we expect the Fed will have to do over the coming years to
reinvest MBS prepays.

The Fed will also have to start buying USTs in the secondary market to compensate for
physical currency growth that organically drains reserves from the system. When this
intervention will be necessary remains an open question. Our current base case is that
the Fed will start buying $110 billion in USTs per year from 1Q2020 onwards to
compensate for currency growth. Under that base case, the total size of the Fed's
balance will start expanding in 2020 as shown in Exhibit 7 to maintain a stable level of
reserves at around $1.2 trillion.

In reality, the Fed will only start compensating for the impact of currency growth on
reserves when it judges that reserves have shrunk by "enough" (recall that reserves are
simply electronic cash held by banks with the Fed). The main metric the Fed will
probably be watching to make that judgment is how the effective fed funds rate reacts
(i.e., EFFR; the price for borrowing cash rises vs. IOER, the interest paid by the Fed on
reserves) as total reserves in the system continue shrinking.

Exhibit 7: Projections for the Fed's balance sheet and Exhibit 8: Estimated impact on net UST supply from the end
reserves under our base case scenario to balance sheet normalization compared to the
counterfactual where the balance sheet continued shrinking
$bn $3,766bn by Sep 2019 (green highlights indicate Fed buying in the secondary
5,000 market)
Factor 2019 2020 2021
USTs not rolling off -97 -199 -190
3,000 MBS -52 -168 -147
$1,200bn reserves Currency 0 -110 -110
2,000 Total -149 -477 -447
Source: Morgan Stanley Research

Dec-06 Dec-10 Dec-14 Dec-18 Dec-22
Total Reserves Projection Fed B/S Projection
Source: Morgan Stanley Research, Federal Reserve

The regression in Exhibit 10 illustrates how the correlation between the level of
reserves and moves in EFFR has been strong over the past year. A $1 trillion drop in the
level of reserves correlated with (or caused) a 17bp rise in EFFR vs. IOER. Since we
expect the correlation between reserve levels and EFFR to remain strong, we project
that the $500 billion drop in reserve levels from the current $1.7 trillion to the $1.2
trillion we project for reserves by September 2019 (when the Fed intends to stop
normalization fully) would lead to a 5-8bp rise in EFFR. We think this will motivate the
Fed to take two actions:

1. Cut IOER by 5bp at the June FOMC meeting and potentially another 5bp in
September to keep EFFR far enough from the upper bound of their target range.

2. Decide that $1.2 trillion in reserves is an appropriate level for the long run, which
would require the Fed to start expanding its balance sheet in 1Q2020.

Exhibit 9: Recent history of reserves vs. their projected Exhibit 10: Correlation between reserve levels and the
levels by the time normalization ends effective fed funds rate
EFFR - IOER Spread (bp)


1.5 2.0 2.5 3.0
Reserves ($tn)
Source: Morgan Stanley Research, Federal Reserve

Source: Morgan Stanley Research, Federal Reserve

So far this year, EFFR has been very well behaved and remained at 2.40%, which was a
break in the consistent rising trend seen last year. We think this is simply a result of two

1. Reserves have not shrunk since the beginning of the year as highlighted in Exhibit 9.
This was mainly due to the drop in the Treasury's cash balance that is held with the
Fed due to debt ceiling technicalities.

2. FHLBs (the primary lender in the fed funds market) have increased lending in the
fed funds market over the past couple of months. This increased lending is
seasonal and as Exhibit 11 illustrates is driven by a reduction in the total amount of
advances they offer to banks.

However, as those temporary factors reverse, EFFR is likely to accelerate back higher
and signal a sufficient level of reserve "scarcity," which incentivizes the Fed to start
expanding its balance sheet sooner rather than later.

Exhibit 11: Fluctuations in FHLB lending in the fed funds Exhibit 12: T-bill and UST spreads vs. OIS
market vs. fluctuations in their advances
$bn 30
10 0
0 -10
-10 -20
-20 -30
-50 Mar-15 Mar-16 Mar-17 Mar-18 Mar-19
2013 2014 2015 2016 2017 2018
Advance Volume Drop from Dec to March 3m OIS-UST 2y OIS-UST 5y OIS-UST
FF Lending Increase from Dec to March Source: Morgan Stanley Research
Source: Morgan Stanley Research, FHLBanks

Given our outlook for reduced UST supply to the market, we expect the cheapness in T-
bills and more broadly USTs that occurred over the course of 2018 as the Treasury
increased auction sizes to start reversing (see Exhibit 12). Thus we like 5y UST-OIS
wideners. We have liked that trade for a while, but tactically took it off last week since
we believed the market was overoptimistic about the prospects of the Fed announcing a
repo facility at the March meeting. However, two factors currently encourage us to scale
back into the trade:

1. The Fed's mention that MBS reinvestments into USTs will (at least initially) be
spread across the UST curve as opposed to simply going into T-bills as market
consensus has been assuming. Since the WAM of outstanding USTs is around 6
years, we think this factor is likely most supportive of the belly of the curve.

2. There seems to be a lot of pessimism around funding conditions at quarter-end,

with the March quarter-end turn repo pricing at 3.80%. This pessimism is likely
driven by the outsized moves in repo rates seen at year end. However, we think the
extent of funding stresses seen at year end is unlikely to repeat since dealer
balance sheets are now much more available and inflows into money market funds
YTD have been extremely strong (strongest YTD inflows since at least 2008). If
indeed we reach the year-end turn and repo rates don't realize the current high
implied levels, we expect investors to feel more comfortable entering spread
wideners, which would be very supportive of the trade.

Our current target for 5y UST-OIS is -10bp to -5bp (i.e., 10 to 15bp richening) over the
next 6 months to 1 year.

Trade Idea: Enter 5y UST-OIS spread widener at -20bp

FX Strategy
MORGAN STANLEY & CO. LLC David Adams +1 212 761-1481
Andrew Watrous +1 212 761-5287

The USD bear appears. Our call last week that it is time to sell USD has received
support from the FOMC. The decline in nominal and real yields should offer the USD
little support while the improvement in risk sentiment and more benign financial
conditions should buoy risk- and rate-sensitive currencies against the USD. In particular,
emerging markets look attractive under this scenario – we like IDR, RUB, PLN, and CLP.
The market remaining long USD suggests further room to run as positioning unwinds.
We should watch CAD, AUD, and EUR closely in this regard as sentiment in these
currencies is the least bullish.

The dovish Fed may lead to carry trades unwinding. We should watch US flow of funds
data closely. 2018 saw material inflows into US assets – not only long-term assets like
equities, credit, and rates, but also short-term assets like money markets. These latter
flows in particular were a key driver of last year’s USD strength. We have previously
argued, though, that flows into money markets are “low conviction” flows and are easily
liquidated. Recent months’ flow data have borne that thesis out. As market volatility
rose and the Fed turned more dovish since December, reducing the expected path of
future rates, the US saw $200 billion in outflows from short-term investments.

Watch low-yielders closely. This additional dovish shift from the FOMC may further
drive outflows. Since short-term investments are rarely FX hedged, these are likely to be
USD negative. USDJPY, USDCHF, and EURUSD should be watched closely as these are
classic funding currencies for carry trades.

Exhibit 13: USD Carry Trades Have Begun to Unwind

Net flows into US assets (12-month sum)
1250 Long Term
1000 Short Term
-750 USD carry trades
beginning to unwind
05 06 07 08 09 10 11 12 13 14 15 16 17 18 19
Source: TIC, Morgan Stanley Research

Agency MBS Strategy
Jay.Bacow@morganstanley.com +1 212 761-2647
Zuri.Zhao@morganstanley.com +1 212 761-5429

Today's announcement provided no new information to the mortgage market

specifically, but the mortgage basis will likely react to the rates market. The more
dovish-than-expected forecast along with details about the balance sheet reduction will
likely be a slight negative in our view. With the 10-year note now down around 2.53%,
we have to increase our expectations of the Fed's balance sheet reduction. With thanks
to Zhi-Guo Huang and his modeling team (not a member of the Agency MBS Research
team), we have updated our projections for paydowns at various rate levels in Exhibit 14.
We want to point out that the Fed's portfolio is still well out of the money given that
the average WAC on their portfolio is 3.95 vs a prevailing mortgage rate of about 4.25%.

Exhibit 14: Projections of Fed Balance Sheet Reduction in MBS

Fed MBS Balance Reduction Projection ($Bil), spotting tens at 2.53%
Year/Rate 2019Q2 2019Q3 2019Q4 2020Q1 2020Q2 2020Q3 2020Q4 2021Q1 2021Q2 2021Q3 2021Q4
FWD-50 56 60 60 59 60 60 58 52 56 56 46
FWD-25 55 60 56 53 57 59 51 44 49 50 40
FWD 54 58 49 44 51 54 43 37 43 45 36
FWD+25 53 53 43 38 44 48 39 33 39 42 34
FWD+50 51 49 40 35 41 44 36 31 37 40 32

Fed MBS Reinvestment Projection ($Bil), spotting tens at 2.53%

Year/Rate 2019Q2 2019Q3 2019Q4 2020Q1 2020Q2 2020Q3 2020Q4 2021Q1 2021Q2 2021Q3 2021Q4
FWD-50 3 29 16 9 14 16 1 0 0 0 0
FWD-25 0 12 0 0 0 3 0 0 0 0 0
FWD 0 1 0 0 0 0 0 0 0 0 0
FWD+25 0 0 0 0 0 0 0 0 0 0 0
FWD+50 0 0 0 0 0 0 0 0 0 0 0
Source: Morgan Stanley Modeling team, not a member of Research

We note that, at these rate levels, we won't really see the Fed reinvesting back into the
mortgage market. If it were to reinvest, that would be good, as it would mean the Fed
would be taking some of the cheapest to deliver out of the market if its paydowns were
above $20bn/month. However, this impact should be somewhat dominated by the
impact of higher overall prepayment levels, and the increase in supply. Note that
reinvestments come the month after the Fed sees its prepayments, which is about two
months after the gross origination hit the market. Thus, we would expect the mortgage
basis to trade to slightly shorter durations if we rally further, as the Fed buying would
come in a bit later than the origination in a rally, but would be more than origination into
a selloff based on the lag.

As the Fed wind-down of the mortgage portfolio increases, there needs to be

incremental marginal buyers. We want to point out that mortgage performance right
now is going to depend a lot on the the marginal buyer's choice of hedging styles. We
believe that over the life of the investment period, excess returns will equal the OAS of
a mortgage, and prefer to look at OAS as a measure of fundamental value. On that
metric, if you look at Exhibit 15, you can see that as of yesterday's close, we were about
6bp above the long-term time average OAS, and just 5bp tight to average level when

the Fed wasn't buying. Given that the Fed has taken about $1.7Tn mortgages out of the
market, OAS levels seem reasonable to us.

Exhibit 15: Current Coupon* Treasury OAS History

TOAS (bp) Treasury OAS History





2003 2004 2005 2006 2007 2008 2009 2010 2011 2012 2013 2014 2015 2016 2017 2018 2019
TOAS LT Ave Post-2009 ave No-Fed-Buying Ave
Source: Morgan Stanley Research, Yield Book
*Note: Uses FNCL 3 OAS if current coupon below 3%

However, it's not just the OAS that matters. Many investors look at MBS as a way to
either sell vol or just look at the nominal spreads as way to clip carry. Today's
announcement should be a negative for vol, and selling vol at the all-time lows has
been a good trade recently. However, we're not sure how much further room there is for
vol to fall (Exhibit 16), and consequently are not sure whether ZV can fall that much
more either. In looking at mortgage ZV post-crisis (Exhibit 17), the only times that it was
much lower than it is now were when rates were substantially lower, as the shift of
current coupon from 3.0s at lower rates to 3.5s now involves a bit of widening in ZV.

Exhibit 16: 2yr10yr Vol Is at Multi-decade Lows Exhibit 17: Current Coupon* Mortgage ZV Post-Crisis
nVol T ZV
2yr10yr vol 100
180 90
160 80
60 40

40 30
Nov-13 Nov-14 Nov-15 Nov-16 Nov-17 Nov-18

Source:: Morgan Stanley Research, Yield Book

Source: Morgan Stanley Research, Bloomberg *Note: Uses FNCL 3 OAS if current coupon below 3%

Of course, it's not just the basis that matters to mortgage investors; spec performance,
coupon performance, and G2/FN, among many other things, are also relevant. At this
rate level, we'd expect our Total Refinanceable Index to approach 30%, which in
conjunction with the seasonal pickup in refinance activity as we head toward the
summer will likely cause specified pools to be well bid. Rolls will likely struggle as
origination increases both due to higher refinance activity and higher purchase activity

while the slightly seasoned,high WAC bonds head up the WALA ramp. Of course, at this
rate level we'd expect issuance to be more focused in 3.5s and 4.0s, while 4.5 and 5.0
issuance should be muted. G2 4.0s and 4.5s will easily pass the net tangible benefit test,
while 3.5 prepays in Ginnies should still stay rather subdued.

Exhibit 18: Change in Duration of the ex-Fed Market Across Different Rate Moves
Duration Sensitivity of Mtg Universe Net of Fed in 10yr equivalents ($bn)
Change in ten year yield -100 -75 -50 -25 0 25 50 75
UST 10 yield 1.61 1.86 2.11 2.36 2.61 2.86 3.11 3.36
Duration of ex-fed
universe (bn ten year
equivalents) 857 1,040 1,330 1,662 1,971 2,251 2,499 2,709
Change in selloff 128 183 290 331 309 281 248 210
Change/bp 5.1 7.3 11.6 13.2 12.4 11.2 9.9 8.4
MSR -113 -113 -105 -91 -76 -61 -47 -35
Change in selloff -4 0 8 14 15 15 14 13
Change/bp -0.2 0.0 0.3 0.6 0.6 0.6 0.5 0.5
Source: Morgan Stanley Research, Yield book

Finally, from a convexity perspective, if you look at Exhibit 18, you'll see that we are near
the peak convexity point, but we want to caveat that we don't think all of these
investors are delta hedging. We look at the duration of the ex-Fed universe because we
know that the Fed is not delta-hedging, but when we make some assumptions about
other investors proclivities for delta hedging. For instance, while we know the Fed
doesn't delta hedge, we also think that money managers are positively convex vs their
indices, and the GSEs and REITs own a much smaller percent of the market now than
they used to. We then look at the delta-hedging amounts as a function of the
outstanding Treasury universe, and find that convexity needs right now should not
impact rates and swap spreads like they did in the past, as we show in Exhibit 19.

Exhibit 19: After adjusting for the growth in the Treasury market and ownership of MBS market
(less delta-hedgers) the impact of MBS convexity needs on the rate market should be relatively low

8,000 40%
Holdings by Account Type (bn)

Convexity Needs as % of Tsy Market

6,000 30%

4,000 20%

2,000 10%

0 0%

Banks Fed MMs / Others

Overseas Treasury GSE
REITs MBS Hedged MBS Hedging/Tsy Market (RHS)
Source: Morgan Stanley Research estimates

Chemicals Practice

China’s chemical
industry: New strategies
for a new era
China looks set to remain the fastest-growing major chemical market,
but important changes are under way. To succeed in this next stage of
development, players will need to embrace a new set of strategies.

by Sheng Hong, Yifan Jie, Xiaosong Li, and Nathan Liu

© ViewStock/Getty Images

March 2019
China's chemical industry: New
strategies for a new era
Exhibit 1 of 6

China’s fast-growing chemical industry has been Exhibit 1

the largest in the world by revenue since 2011, and
its growth rate continues to outpace by far other China’s chemical-market growth has
major chemical-producing regions. But this colossal slowed as the country’s GDP growth
size should not be seen as a sign of stability. On the has decelerated, and the trend is
contrary, China’s chemical industry is in the midst of projected to continue.
a profound, rapid transition.
China’s chemical-market growth and GDP
growth compared, %
China’s growth in chemicals over the past two
decades has been characterized by rapid
investment and intense competition and
Chemical-market growth
fragmentation across large numbers of segments.
This has particularly been the case where 20
production technology has been widely available
and where access to raw materials and financing
has been easy to obtain. This combination has led to
rampant overcapacity in many sectors.

But the market and the industry are now moving into
a new phase of development. There’s a shift toward
specialty-chemical growth, reflecting consumer-
GDP growth
demand trends and the rising sophistication of
China’s industrial output, while consolidation has
started to take a grip in certain sectors. These
trends are all helping the value-pool growth
prospects for parts of the industry. In the meantime, 0
money for investment is harder to come by, and the 2005 2010 2015 2020 2025

government is imposing new, stricter environmental Source: Asian Development Bank; China Petroleum and Chemical
regulations on the industry. To succeed in this next Industry Federation; Citigroup; Deutsche Bank; Economist
Intelligence Unit; Goldman Sachs; IHS Markit; JPMorgan Chase;
stage of China’s chemical-market development, Merrill Lynch; UBS; World Bank; McKinsey analysis
players will need to embrace a new set of strategies.

The enormous base that China’s chemical industry

China’s new chemical-market dynamics now constitutes—around $1.5 trillion of sales in 2017,
China’s chemical market has contributed half of amounting to nearly 40 percent of global chemical-
the growth of the world chemical market over the industry revenue—means that, even at lower overall
past two decades. Increasing economic turbulence growth rates, the growth of absolute volume is still
since mid-2018, related to China’s economic very large. To get a sense of that potential, consider
slowdown and US–China trade relations, adds that, at 5 percent growth per year, China will be
new uncertainties to the short-term outlook. While adding the equivalent of the annual sales of Brazil’s
the chemical market’s growth rate is expected to or Spain’s chemical industries. Projections suggest
slow as the country’s overall economy matures, we that China will provide over half of the global
expect that, in the medium term, the growth rate will chemical industry’s growth over the coming decade,
remain significantly positive (Exhibit 1). underlining its importance.

2 China’s chemical industry: New strategies for a new era

Five trends are spurring the changes in China’s with its “In science we trust” slogan, to start-up
chemical-market dynamics. Three are fueling the companies working in a wide array of leading-edge
industry’s expansion and diversification, and two are areas, such as enzymes, catalysis, nanomaterials,
imposing new constraints. and battery materials. China’s chemical-R&D
spending is now among the world’s leaders. The
Industrial policy and consumer trends structure of China’s chemical-industry R&D has also
stimulating demand for more specialty products changed, moving from one in which initiatives were
As China’s economic policy shifts more to under government direction to one primarily driven
consumption-driven growth from that of by individual companies within an ecosystem of
investment—and, within that consumption, toward collaboration with government research institutions
more sophisticated products—the result is likely and universities—and that has a strengthened
to lead to additional growth in specialty-chemical regime to protect intellectual property.
demand. For example, as markets for higher-end
personal-care products grow, they are likely to bring China’s chemical-technology capabilities are rapidly
with them demand for more sophisticated specialty advancing. There are many examples of Chinese
surfactants and additives, as well as more expensive companies gaining technological parity with
fragrances. Similarly, Chinese consumer trends Western companies. One in the petrochemical field
will offer new opportunities. For example, the rapid has been Wanhua Chemical, which has developed
growth in online ordering of food is likely to increase its own methylene-diphenyl-diisocyanate (MDI)
demand for packaging materials, potentially technology. Wanhua is now the world’s largest
raising demand for innovative products such as MDI producer in what had historically been a
biodegradable polymers. close-knit sector dominated by a handful of
Western companies due to isocyanates chemistry’s
At the same time, the Chinese government’s Made challenging technology-entry barriers. Another
in China 2025 policy is prioritizing a number of example is Kingfa Science & Technology, which
high-tech industries for development. The strategic started out as a supplier of lower-end products,
directions it indicates could stimulate certain end such as plastics for TV-set cases, but has now
markets, such as aerospace, electronics, electric become an engineering-resin supplier to the
vehicles (EVs), and batteries, which could, in turn, top auto OEMs. Kingfa is also one of the small
create opportunities for expanding production in group of producers in the world making high-tech
China of a range of more sophisticated chemical engineering resins, such as polyether ether ketone
products. Take EVs: electric-car sales in China and polyamide 10T. In the fast-growing lithium-ion-
are projected to rise at a 25 percent compound battery area, Shanshan Technology has established
annual growth rate through 2030. By that date, 12 a leading presence in cationic- and anionic-anode
percent of all cars running in China would be EVs, materials, electrolytes, and separation membranes,
and the country would account for more than half with a top three position in all segments.
of worldwide electric-car sales. Other examples
include coatings and new materials for high-speed There are some segments in which the Chinese
trains, and advanced composites for use by the chemical industry is starting to get a technology
country’s expanding aerospace industry. edge over multinational companies (MNCs). This
has been the case in a number of fermentation-
Upgrading innovation and technological based products, including monosodium glutamate,
capabilities to strengthen the industry vitamin C, and xanthan gum. In all of these, Chinese
An embrace of R&D is under way across the chemical companies are now the leading producers in the
industry, from sector giants, such as Sinochem world, based on better-performing technology, and

China’s chemical industry: New strategies for a new era 3

they have continued to achieve process and quality Bank loans are harder to get: China’s main bank
improvements. Development of new materials is supervisor decreed in 2014 it would control
another example of Chinese players being well- investment in oversupplied industries, including
placed. Cathay Industrial Biotech, for example, parts of the chemical industry, and this led banks
has established a leading position in bio-based in 2015 to tighten rules governing eligibility to
nylon 5,6, a polymer with wide potential application. loans in oversupplied sectors. Banks have shifted
over the past year to demand more collateral,
As a general statement, there is now a huge array terminate loans prematurely, and refuse to renew
of Chinese companies that have access to many of loans, putting chemical companies at a further
the most up-to-date technologies (or at least the disadvantage for borrowing. Chemical enterprises
almost most up-to-date technology) with which they also get charged an above-market-average interest
can be very competitive with MNCs, backed up with rate. Further limiting options has been the stricter
concerted application-development efforts. monitoring of companies using mutual-guarantee
borrowing—a mechanism used in some provinces
Opening the industry up to new investors whereby groups of companies could guarantee each
Prior to 2015, petroleum refining in China had other’s loans while, in effect, putting them all at risk
been treated as a strategic national industry to be should one go bankrupt.
controlled by state-owned oil companies. Naphtha
crackers had also been under their control, and At the same time, the Chinese government is
MNCs could only have a 50 percent stake. Since that restricting the releases of new bonds—traditionally,
date, however, refining and upstream petrochemical a major source of funds for POEs—and private
investments have been opened up to MNCs and lending is becoming more regulated. Equity
more broadly to Chinese privately owned enterprises financing remains out of reach for most chemical
(POEs) to establish wholly owned operations. companies: domestic investors are increasingly
selective, while chemical companies are not seen
Several POEs are aggressively investing upstream as sufficiently attractive to be candidates for IPOs
into building-block petrochemical production, outside China. The Chinese government’s policy to
reshaping China’s petrochemical industry. Our continue to rein in debt suggests that the financing
analysis shows there are nine POE-backed projects outlook for the chemical industry will remain
accounting for over half the 20 million metric tons challenging in the coming years.
per year of new ethylene capacity being planned in
China. For example, Hengli Petrochemical is moving This has already had significant consequences.
upstream into oil refining to source raw materials Annual chemical capital expenditures had risen
for its purified terephthalic acid and polyester rapidly in the 2010 to 2015 period, when China’s
production. At the same time, a number of MNCs chemical demand was growing at more than 10
are planning wholly owned investments, including percent a year, more than doubling to reach 1.61
an integrated petrochemical complex by BASF and trillion renminbi in 2015. Spending peaked in 2015
a refinery–petrochemical complex by ExxonMobil, and fell back 7 percent, to 1.5 trillion renminbi, by
both announced for Guangdong province. 2017 (Exhibit 2).

Tightening of financing availability New environmental regulations leading

The industry is also operating under new constraints. to restructuring
The Chinese government’s policy to tighten credit China’s chemical buildup over the past two decades
across the country’s economy has been a particular had prioritized growth over environmental quality.
handicap for the capital-intensive chemical indus- The 13th Five-Year Plan for environmental protection
try that has in the past benefited from low-cost published in 2016 enshrining “clear waters and lush
capital to expand capacity. mountains” as a national policy has marked a sharp

4 China’s chemical industry: New strategies for a new era

GES 2019
China's chemical industry: New
strategies for a new era
Exhibit 1 of 6

Exhibit 2 production zones where wastewater- and hazardous-

waste-treatment infrastructure can be centralized
Pressure on financing has led the and shared. While a number of regions—for example,
chemical industry to pull back on Shanghai—have long enforced tight standards, most
capital expenditures. of the country’s industrialized regions have been
facing serious chemical-pollution issues.
Total capital expenditures of the Chinese
chemical industry, trillion RMB, % change
The new environmental regulations are having only
2 limited impact on the big upstream petrochemical
and chemical intermediates and polymer plants,
1% most of which are built with appropriate emissions
14% –5% controls and waste-treatment facilities. The severe
impact is on the thousands of smaller plants that
make all the specialty chemicals, from coatings and
dyestuffs and pesticides to food ingredients and
surfactants, used by Chinese manufacturing and
1 agriculture and by Chinese consumers. These are
typically privately owned operations often lacking
appropriate waste-management capabilities and
located in urban areas. The moves to shut down out-
of-compliance plants have affected large numbers
of these small operations, but the impact on overall
chemical output has been less severe. In Shandong
province, for example, the government closed
0 25 percent of all the chemical companies operating
2010 2011 2012 2013 2014 2015 2016 2017 in the province during 2018, but this affected only
5 percent of output.
Source: China Petroleum and Chemical Industry Federation; Wind

Looking ahead over the next three to five years,

we expect China’s environmental authorities to
shift, as China’s authorities have started to address continue to push enforcement energetically in
environmental degradation. the designated “radical change” regions, which
account for nearly 50 percent of China’s chemical
New national pollution-control standards are production, as well as push for improvements in
being enforced by a system of requirements for the “moderately strengthened” enforcement
production permits and a push to relocate chemical regions (Exhibit 3).
production to special chemical parks. The 2018 ban
on imports of plastics waste, which has disrupted This is likely to cause continuing disruptions in
Western countries that had relied on exporting to specialty-chemical markets. The impact can be
China, is part of the same new policy. substantial: environmental enforcement during 2017
and 2018 shut down 30 to 40 percent of all Chinese
The environmental policy aims to move chemical production capacity for monosodium glutamate
production from its current configuration, in which and certain dyestuffs and pesticides. This supply
many tens of thousands of plants are scattered curtailment led to significant price increases in these
across mixed urban industrial and residential sectors in China—for disperse dyes and glyphosate
areas, to a new one based on specialized chemical- pesticide, a near 50 percent price increase.

China’s chemical industry: New strategies for a new era 5

China's chemical industry: New strategies for a new era
Exhibit 3 of 6

Exhibit 3

Three levels of environmental rules and enforcement are emerging across China—with an
overall trend to much higher standards for the chemical industry.
Share of China’s chemical-industry output1 represented by regions under each category of rules and enforcement, %

49 Radical change
Aggressive performance
targets and strict enforcement
(all along the Yangtze River
and in a. Hebei, b. Shandong,
c. Northern Jiangsu, and
d. Henan)

Moderately strengthened Yangtze River2
Moderate increases in targets d c
and enforcement (most of China’s f
regions, excluding “radical change”
and “always strict” regions) g

21 Always strict
Stable targets and strict enforcement h
(in e. Beijing, f. Shanghai, g. Zhejiang,
and h. Guangdong)

Total GDP created by chemical industry in 2015.
China Petrochemical Yearbook 2016, China Petrochemical Consulting, November 2016; expert interviews; press search; McKinsey analysis.
Source: McKinsey analysis

While the new regulations are likely to force China? Our analysis suggests that the evolution of
restructuring across significant portions of the the country’s different chemical-industry segments
industry, they could also present the potential for is likely to continue to follow broadly the pattern
higher profitability for the companies that are able it has shown over the past two decades. This
to manage under them and can absorb the higher consists of a phase of massive overinvestment and
operating costs that compliance will entail. Even oversupply as state-owned enterprises (SOEs)—
after making the environmental investments, they often with MNC partners—and POEs rush to move in
can continue to have a highly competitive global cost and produce chemicals that have historically been in
position and then compete in a less-crowded field. short supply in China due to either lack of feedstock
or lack of access to process technology. This phase
is eventually followed by a shakeout and subsequent
Survival of the fittest, China style consolidation. In that latter stage, profit margins
What do these new dynamics mean for the chemical and investment returns for participants stabilize at a
industry’s evolution and future value-pool growth in sustainable level.

6 China’s chemical industry: New strategies for a new era

A number of segments—ranging from commodities, Exhibit 4. The segment’s value pool is below
such as soda ash, to specialties, such as vitamin its previous peak, but the top ten companies’
C and monosodium glutamate—have reached consolidation moves have already improved their
that phase. However, there is an impressive list profitability over other participants and continued
of chemicals for which the battle to ascertain the to grow their profits. Our projections suggest that
winner is still very much under way (Exhibit 4). consolidation is likely to continue and polyester-
fiber demand will expand further. This could lift the
The polyester-fiber market provides a good example value pool to new heights, and the leading players
of this pattern of market evolution and how it affects would continue to take the largest share of it. As
a segment’s value pool over time (Exhibit 5). Our similar market dynamics play out in many other
analysis suggests that the long-term trend for chemical segments, there is clearly scope for their
the polyester-fiber value pool is one of growth as value pools to evolve in a similar way.
China’s demand continues to expand, but the trend
line includes downs as well as ups. Demand that It’s important to underline that there are still
outstripped supply in the early 2000s generated important segments of the chemical industry—
high margins and attracted many new entrants. notably ethylene and propylene—for which China’s
GES 2019
Severe overcapacity resulted, and a shakeout demand continues to outstrip domestic production
China's chemical industry: New strategies for a new era
ensued. Our analysis suggests that polyester fiber capacity. Our projections suggest that even with the
Exhibit 4 of 6 investments that have been announced, ethylene
has entered the rebalancing phase shown in

Exhibit 4

While many chemicals in China are currently in oversupply or soon will be, the trend toward
consolidation is likely to prevail.
Over- In short supply Rapid expansion Severe oversupply Rebalancing

 Significant barriers exist  Barriers removed  Severe oversupply  Consolidation of players

(including regulatory and  New investment rushes is created makes it possible to manage
access to technology and into market  Competition on price overcapacity
resources)  Capacity grows leads to low margins,  Sector profit margins recover
 Demand exceeds supply rapidly, but supply and weak players are to reasonable levels, achieving
is still less than demand squeezed out stable investment returns

 MDI¹  Ethylene  PVC⁴  Vitamin C
 HMDA²  Propylene  Methanol  MSG⁶
 Potash  Polycarbonate  PTA⁵  Soda ash
 PEEK³  Acrylic acid

Methylene diphenyl diisocyanate. 2 Hexamethylenediamine. 3 Polyether ether ketone. 4 Polyvinyl chloride. 5 Purified terephthalic acid. 6 Monosodium glutamate.
Source: IHS Markit; McKinsey analysis

China’s chemical industry: New strategies for a new era 7

China's chemical industry: New strategies for a new era
Exhibit 5 of 6

Exhibit 5

Value pools in China’s chemical industry: In polyester, the top ten players have consistently
increased their profits, outpacing the rest of the field.
Phases in the development of the Chinese polyester-fiber sector

 A. 2000: Demand outstrips supply  D. 2017: Getting supply and demand in balance
 B. 2005: Rapid capacity buildup, with many new entrants  E. 2023: Market projection assumes scenario of
 C. 2012: Consolidation gets under way continued demand growth1

Total value Average EBIT² margin of Top 10 players’ value pool, Top 10 average EBIT Top 10 players’ share of
pool, billion RMB sector, % billion RMB margin, % total value pool, %

30 10 30 10 100

8 8 80

20 20
6 6 60

4 4 40
10 10

2 2 20

0 0 0 0 0

Market projection assumes scenario of continued demand growth in China’s polyester-fiber market supporting increased production of fiber, accompanied by further
consolidation among producers, which might lead to top 10 producers achieving higher profitability.
Earnings before interest and taxes.
Source: IHS Markit; press search; McKinsey analysis

production will continue to lag demand in 2023. situation in China. Polycarbonate is an example
However, the rules opening the petrochemical of a market segment that, until recently, had been
segment to new players means that capacity is likely undersupplied domestically, but investments in
to continue to build up, which suggests that these new plants using China-developed technology are
segments will also head for a consolidation stage. tripling capacity and could push polycarbonate into
severe overcapacity by 2022.
It remains to be seen how long chemical segments
for which proprietary technology has so far limited How will the new environmental regulation and
the number of entrants, such as certain nylon more limited availability of finance affect the
intermediates and isocyanates, will remain in this industry’s evolution in China? Paradoxically, the
state: the extremely entrepreneurial character of the new constraints may be a blessing in disguise for an
Chinese chemical industry and the inventiveness industry that is grappling with how to adapt to the
of its process engineers may challenge this new market dynamics.

8 China’s chemical industry: New strategies for a new era

This is an industry in which demand-growth rates now has impressive profitability and aggressive
had been so high that building a new plant every expansion plans, including a world-scale MDI
two years had often been a key to success, but it project on the US Gulf Coast.
now confronts growth rates at half these levels.
There is not going to be the same need for new Another company, Shanghai Huayi, diversified
plants, and so limited funding will present less of from producing chlor-alkali and fine chemicals to
a challenge and even help restrain some overly production of tires and entry into fluorochemical
enthusiastic companies from contributing to more manufacturing. It has a slate of projects, including
overcapacity. Meanwhile, capacity closures forced a coal–chemical complex in Qinzhou, to sustain its
by environmental regulations will be less disruptive growth in the medium term. Another successful
in a moderately growing market than in one growing player is SDIC Xinjiang Luobupo Potash, which
at more than 10 percent a year. is developing a high-quality and low-cost potash
resource in Xinjiang province. This new output will
At the same time—and perhaps most important— help reduce the country’s large potash imports,
this change in the growth climate will help to push typifying the opportunities that continue to present
chemical-company-management teams to ensure themselves in meeting the chemical needs of
that their operations are truly profitable. Instead China’s huge market.
of being able to hide behind new borrowing,
companies will need to set a course toward high- The major central SOEs, meanwhile, are continuing
quality, profitable growth. with their historic mandate from the Chinese state
to provide a stable supply of basic chemicals. They
are participating in the current wave of investments
How players in China’s chemical to double China’s ethylene capacity, with Sinopec’s
industry can position themselves for four cracker projects making it the biggest investor
the new era overall. With the central SOEs’ large sizes, they
Faced with the changes in China’s market, are also well equipped to fulfill another part of
how should the major groups of players their mandate from the government: maintaining
position themselves? steady employment.

State-owned enterprises: Diverging fortunes— At the same time, however, new challenges are
and roles? emerging for these companies. Maintaining the
SOEs have led China’s chemical-industry scale of their operations will need to be balanced
development over the past two decades, but it is with pressure to improve profitability by starting to
important to look at this group more closely to see retire their less-competitive older production assets.
how future developments may unfold. Best known They must navigate this while facing increasing
are the central SOEs, while the group of SOEs competition for their refining and petrochemical
owned by provincial governments are sometimes business from aggressive new-entrant POEs.
overlooked. A number of players in this latter
group have, in fact, followed a more dynamic and Some of these companies also face underlying
entrepreneurial trajectory than has the central- questions about their long-term strategies. While
SOE group. they have been successful in the goal of providing
basic-chemical supply, that focus may have left
One example is the previously mentioned MDI maker some of these companies less well positioned in the
Wanhua, of which the majority owner is Shandong kinds of specialty-chemical businesses needed to
province. Wanhua’s path to MDI leadership started serve China’s next stage of economic development.
40 years ago making synthetic leather, and it Unlike in basic chemicals, these kinds of
technologies are not usually available for licensing.

China’s chemical industry: New strategies for a new era 9

Some SOEs struggle with centralization, siloed take regulatory and environmental compliance
organizational structure, and layers of bureaucracy and government relations in stride, will be best
that may handicap them in developing a strong placed to seize opportunities and move to dominate
specialties segment. Such specialties businesses their sectors.
typically move at a fast pace and depend on cross-
functional collaboration among R&D, manufacturing, The differing fortunes of POEs, central SOEs, and
and sales functions to succeed. Should the SOEs provincial SOEs highlight the dynamics that are
be able, however, to overcome these organizational playing out in the market. A number of POEs and
challenges and develop the necessary functional provincial SOEs are continuing to find very-high-
excellence, their scale would represent a strength growth opportunities, while most of the central
to draw on. SOEs are achieving lower growth rates, at under
10 percent per year (Exhibit 6).
Privately owned enterprises: A drive to
professionalize business International companies: Facing an
Chinese private-sector chemical companies are uphill struggle
also on the cusp of an important shift. They are It’s not easy to find an example of a chemical MNC
moving from the buccaneering days of China’s that has managed to gain a market share in China
peak chemical-market growth to ones of more that is the same as its market share in the global
discipline—a shift enforced by new financial and market, a fact that encapsulates the challenges that
environmental constraints and the evolution toward MNCs have consistently encountered as China’s
a higher level of maturity in the market. chemical market has ballooned.

The challenge facing the many companies in this Historically, MNCs have often entered new
group is to professionalize their operations in all geographical markets by making acquisitions,
dimensions. Large numbers of these companies are but this has not been feasible in China. This was
still run by their founders, who are still very much because SOEs couldn’t be acquired by foreign
in the driver’s seat as executive chairs, even if they companies, while Chinese POEs were either too
have public shareholders. At the biggest of these ambitious to be acquired or too small to be worth
companies, the founders are now billionaires. acquiring. Instead, MNCs have had to rely on direct
investment, but they have run into challenges there.
This drive to professionalize covers business
processes, for which they need to embrace best In the first round of large investments by MNCs in
business practices on decision making, strategy China starting 20 years ago, their entry was through
selection and execution, as well as hiring and joint ventures with Chinese SOEs, allowed on the
training. It also includes building up their innovation condition that the MNCs brought chemical-process
and technology capabilities. technologies needed in China. The lack of majority
control tended to put a cap on the scale of moves.
There is a consciousness among POE leaders In addition, where MNCs have been able to own
that the stakes here are high. Companies are fully their Chinese subsidiaries in more downstream
increasingly engaging in strategies to roll up and chemicals, MNCs’ conservative decision-making
consolidate major sectors of the chemical industry— processes designed to avoid high-risk moves have
as is being seen, for example, in sectors such as made it difficult to make the aggressive capacity
dyestuffs and polyester fiber. In this new phase of expansions typical of the entrepreneurs leading
the industry’s development, the players that have Chinese POEs. As a result, MNCs have been, in
already professionalized their operations, are used effect, shielded from making big mistakes in China—
to working with banks to secure financing, and can but also from capturing fast growth.

10 China’s chemical industry: New strategies for a new era

China's chemical industry: New strategies for a new era
Exhibit 6 of 6

Exhibit 6

Leading players in China’s chemical market fall into two main categories: Fast growers and
central giants.
Compound annual growth rate (CAGR)1 compared with revenue2

 Private-owned enterprises  Provincial state-owned enterprises  Central state-owned enterprises



Fast growers

ChemChina Central giants

Sinochem Sinopec
0 50 100 0 500 1,000 1,500 2,000 2,500

Revenue, billion RMB Revenue, billion RMB

CAGR calculated as 2008–17 10-year average, except for Hengli (2016–17), Qixiang (2008–16), and Yuntianhua (2013–17).
For the central giants, revenues cover all activities of the companies, not just chemical activities.
Source: Wind; McKinsey analysis

Since the change in rules in 2015, MNCs have been consideration, such as Invista’s proposed $1 billion
able to make wholly owned investments in upstream adiponitrile investment at an as yet undetermined
petrochemical plants. The size and importance location in China, are part of the same pattern.
of the Chinese market means that it cannot be
ignored by MNCs that want to continue to be leading A further challenge is that some MNCs are failing
players in the world chemical market. This has to undertake product development tailored to the
been clearly reflected in recent announcements of Chinese market’s needs. As a result, they are finding
major investments by MNCs that see opportunities themselves relying on their original offerings, which
in China. These include the large investments that were developed for Western markets. Chinese
BASF and ExxonMobil are considering in wholly competitors, meanwhile, are increasingly making
owned petrochemical complexes in Guangdong inroads, resulting in a narrowing area of opportunity.
in southern China. By building ethylene crackers, On top of that, MNCs are still contending with the
they should be able to establish a base in C2 and basic cultural barriers to doing business in China,
C3 chemistry—just in time, before that window notably in hiring and keeping hold of the best local
of opportunity closes as domestic companies Chinese employees. The Chinese government’s
expand operations. Other major investments under decision to open up the petrochemical market can

China’s chemical industry: New strategies for a new era 11

be interpreted as a sign of its confidence that local
companies have gained strong-enough positions
against international ones and will maintain a lead. The shifts under way in China’s chemical industry are
on a massive scale that mirrors that of the industry
To summarize, MNCs need to be ready to deal with itself. Players in the world’s largest chemical market
further headwinds in the coming years and build into must make the adaptations necessary to ensure
their expectations the idea that future chemical- success at growth rates that are less than half of
market growth is likely to be more incremental, as what they have been seeing in the recent past. At
they fight to maintain market share against Chinese the same time, they must adjust to a world of scarcer
players and to win scraps of market share from other financing and tighter environmental regulation. The
MNCs. But MNCs that have the flexibility to make factors driving success will vary among the different
the necessary moves—such as tailoring solutions for groups of players in the industry, but in all cases,
the local market and participating in the industry’s they will need to be informed by a readiness to
consolidation trend—should be better placed. adapt rapidly and innovate to meet the needs of
the market.

Sheng Hong and Nathan Liu are partners in McKinsey’s Shanghai office, where Yifan Jie and Xiaosong Li are specialists.

The authors wish to thank Florian Budde, Yuan Tian, Minyu Xiao, Fengfeng Xu, and Philip Zheng for their contributions to
this article.

Designed by Global Editorial Services

Copyright © 2019 McKinsey & Company. All rights reserved.

12 China’s chemical industry: New strategies for a new era

3/26/2019 The Twenty Craziest Investing Facts Ever - The Irrelevant Investor

The Irrelevant Investor 

The Twenty Craziest Investing

Facts Ever
Posted March 13, 2019 by Michael Batnick

1. Since 1916, the Dow has made new all-time highs less than 5% of all days,
but over that time it’s up 25,568%.
95% of the time you’re underwater. The less you look the better off you’ll be.

2. The Dow has compounded at less than 3 basis points a day since 1970.
Since then its up more than 3,000%.
Compounding really is magic.

3. The Dow has only been positive 52% of all days. The average daily return
is 0.73% when it’s up and -0.76% when it’s down.
See above.

4. The Dow has spent more time 40% or more below the highs than within 2%
of the highs (20.6% of days vs. 18.4% of days)
No pain no gain.

5. The Dow gained 38 points in the 1970s

See above.

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3/26/2019 The Twenty Craziest Investing Facts Ever - The Irrelevant Investor

The Irrelevant Investor 

6. Why am I using the Dow instead of the S&P 500? They’re effectively the
same thing. The rolling one-year correlation since 1970 is .95.
Stop wasting your time on this.

7. At the low in 2009, U.S. stocks were back to where they were in 1996.
Stocks for the long-run. The very long-run. Usually. Sometimes.

8. At the low in 2009, Japanese stocks were back to where they were in 1980.
See above.

9. U.S. one-month treasury bills went 68 years with a negative real return.
What’s safe in the short-run can be risky in the long-run.

10. At the bottom in 2009, long-term U.S. government bonds outperformed

the stock market over the previous 40 years
Stocks generally outperform bonds, but there are no guarantees.

11. Gold and the Dow were both 800 in 1980. Today Gold is $1,300/ounce, the
Dow is near 26k.
Cash flows > commodities.

12. Over the last twenty years, Gold is up 340%. Stocks are up 208%, with
You can support any argument by changing the start and end dates.

13. Since 1980, Gold is up 153%. Inflation is up 230%.

See above.

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3/26/2019 The Twenty Craziest Investing Facts Ever - The Irrelevant Investor

The Irrelevant Investor 

14. CTAs gained 14% in 2008 when stocks lost 37%. Since 2009 they’re up 2.5%.
Stocks are up 282%.
Non-correlation cuts both ways.

15. If you had invested from 1960-1980 and beaten the market by 5% each
year, you would have made less money than if you had invested from 1980-
2000 and underperformed the market by 5% a year (A Nicky Numbers
When you were born > almost everything else.

16. The Dow lost 17% in 1929, 34% in 1930, 53% in 1931 and 23% in 1932.
Be grateful.

17. Warren Buffett is the greatest investor of all-time. In the 20 months

leading up to the dotcom peak, Berkshire Hathaway lost 45% of its value.
The NASDAQ 100 gained 225% over the same time.
No pain no premium.

18. Only 47.7% of stocks generated a life-time return that match one-month
treasury bills.
The reason why so many mutual funds fail to beat the market is because so many
stocks fail to beat the market.

19. Dow earnings were cut in half in 1908. The index gained 46%.
The stock market ≠ the economy.

20. In 1949 the stock market was trading at 6.8x earnings and had a 7.5%
dividend yield. 50 years later it reached a high of 30x earnings and carried
just a 1% dividend yield. ×
You can calculate everything yet still not know how investors are going to feel
https://theirrelevantinvestor.com/2019/03/13/the-twenty-craziest-investing-facts-ever/ 3/8
3/28/2019 Good enough to eat? The toxic truth about modern food | Books | The Guardian

Good enough to eat? The toxic truth

bout modern food
We are now producing and consuming more food than ever, and yet our modern diet is killing us. How can we solve
this bittersweet dilemma?

by Bee Wilson
Main image: Grapes have become a piece of engineering designed to please modern eaters. Illustration: Colin Campbell/The Guardian

Sat 16 Mar 2019 09.00 GMT

ick a bunch of green grapes, wash it, and put one in your mouth. Feel the grape with your tongue, observe how cold
and refreshing it is: the crisp flesh, and the jellylike interior with its mild, sweet flavour.

Eating grapes can feel like an old pleasure, untouched by change. The ancient Greeks and Romans loved to eat them,
as well as to drink them in the form of wine. The Odyssey describes “a ripe and luscious vine, hung thick with grapes”.
As you pull the next delicious piece of fruit from its stalk, you could easily be plucking it from a Dutch still life of the
17th century, where grapes are tumbled on a metal platter with oysters and half-peeled lemons.

But look closer at this bunch of green grapes, cold from the fridge, and you see that they are not unchanged after all. Like so many
other foods, grapes have become a piece of engineering designed to please modern eaters. First of all, there are almost certainly no
seeds for you to chew or spit out (unless you are in certain places such as Spain where seeded grapes are still part of the culture).
Strains of seedless varieties have been cultivated for centuries, but it is only in the past two decades that seedless has become the
norm, to spare us the dreadful inconvenience of pips.

Here is another strange new thing about grapes: the ones in the supermarket such as Thompson Seedless and Crimson Flame are
always sweet. Not bitter, not acidic, not foxy like a Concord grape, not excitingly aromatic like one of the Muscat varieties, but just
plain sweet, like sugar. On biting into a grape, the ancients did not know if it would be ripe or sour. The same was true, in my
experience, as late as the 1990s. It was like grape roulette: a truly sweet one was rare and therefore special. These days, the
sweetness of grapes is a sure bet, because in common with other modern fruits such as red grapefruit and Pink Lady apples, our
grapes have been carefully bred and ripened to appeal to consumers reared on sugary foods. Fruit bred for sweetness does not have
to be less nutritious, but modern de-bittered fruits tend to contain fewer of the phytonutrients that give fruits and vegetables many
of their protective health benefits. Such fruit still gives us energy, but not necessarily the health benefits we would expect.

The very fact that you are nibbling seedless grapes so casually is also new. I am old enough to remember a time when grapes –
unless you were living in a grape-producing country – were a special and expensive treat. But now, millions of people on average
incomes can afford to behave like the reclining Roman emperor of film cliche, popping grapes into our mouths one by one. Globally,
we both produce and consume twice as many as we did in the year 2000. They are an edible sign of rising prosperity, because fruit
is one of the first little extras that people spend money on when they start to have disposable income. Their year-round availability
also speaks to huge changes in global agriculture. Fifty years ago, table grapes were a seasonal fruit, grown in just a few countries
and only eaten at certain times of year. Today, they are cultivated globally and never out of season.

Almost everything about grapes has changed, and fast. And yet they are the least of our worries when it comes to food, just one tiny
element in a much larger series of kaleidoscopic transformations in how and what we eat that have happened in recent years. These
changes are written on the land, on our bodies and on our plates (insofar as we even eat off plates any more).

For most people across the world, life is getting better but diets are getting worse. This is the bittersweet dilemma of eating in our
times. Unhealthy food, eaten in a hurry, seems to be the price we pay for living in liberated modern societies. Even grapes are
symptoms of a food supply that is out of control. Millions of us enjoy a freer and more comfortable existence than that of our
grandparents, a freedom underpinned by an amazing decline in global hunger. You can measure this life improvement in many
ways, whether by the growth of literacy and smartphone ownership, or the rising number of countries where gay couples have the
right to marry. Yet our free and comfortable lifestyles are undermined by the fact that our food is killing us, not through lack of it
but through its abundance – a hollow kind of abundance.

• • •

With Brexit, food worries in the UK have become political, with panicked discussions of stockpiling and the spectre of US imports of
chlorine-treated chicken on the horizon. Woody Johnson, the US ambassador to the UK, has dismissed these worries, suggesting
that US food standards are nothing to be concerned about. But the bigger question is not whether American standards are lower
than those in Britain, but why food standards across the world have been allowed to sink so dramatically.

What we eat now is a greater cause of disease and death in the world than either tobacco or alcohol. In 2015 around 7 million people
died from tobacco smoke, and 2.75 million from causes related to alcohol, but 12m deaths could be attributed to “dietary risks” such
as diets low in vegetables, nuts and seafood or diets high in processed meats and sugary drinks. This is paradoxical and sad,
because good food – good in every sense, from flavour to nutrition – used to be the test by which we judged the quality of life. A
good life without good food should be a logical impossibility.

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3/28/2019 Good enough to eat? The toxic truth about modern food | Books | The Guardian
Where humans used to live in fear of plague or tuberculosis, now the leading cause of mortality worldwide is diet. Most of our
problems with eating come down to the fact that we have not yet adapted to the new realities of plenty, either biologically or
psychologically. Many of the old ways of thinking about diet no longer apply, but it isn’t clear yet what it would mean to adapt our
appetites and routines to the new rhythms of life. We take our cues about what to eat from the world around us, which becomes a
problem when our food supply starts to send us crazy signals about what is normal. “Everything in moderation” doesn’t quite cut it
in a world where the “everything” for sale in the average supermarket has become so sugary and so immoderate.

At no point in history have edible items been so easy to obtain, and in many ways this is a glorious thing. Humans have always gone
out and gathered food, but never before has it been so simple for us to gather anything we want, whenever we want it, from sachets
of black squid ink to strawberries in winter. We can get sushi in Buenos Aires, sandwiches in Tokyo and Italian food everywhere.
Not so long ago, to eat genuine Neapolitan pizza, a swollen-edged disc of dough cooked in a blistering oven, you had to go to
Naples. Now, you can find Neapolitan pizza – made using the right dough blasted in an authentic pizza oven – as far afield as Seoul
and Dubai.

Talking about what has gone wrong with modern eating is delicate, because food is a touchy subject. No one likes to feel judged
about their food choices, which is one of the reasons why so many healthy eating initiatives fail. The rise of obesity and diet-related
disease around the world has happened hand in hand with the marketing of fast food and sugary sodas, of processed meats and
branded snack foods. As things stand, our culture is far too critical of the individuals who eat junk foods and not critical enough of
the corporations who profit from selling them. A survey of more than 300 international policymakers found that 90% of them still
believed that personal motivation – AKA willpower – was a very strong cause of obesity. This is absurd.

It makes no sense to presume that there has been a sudden collapse in willpower across all ages and ethnic groups since the 1960s.
What has changed most since the 60s is not our collective willpower but the marketing and availability of energy-dense, nutrient-
poor foods. Some of these changes are happening so rapidly it’s almost impossible to keep track. Sales of fast food grew by 30%
worldwide from 2011 to 2016 and sales of packaged food grew by 25%. Somewhere in the world, a new branch of Domino’s Pizza
opened every seven hours in 2016.

Zhongshan Snack Street, a market in Nanning, Guangxi province, China. Photograph:

Aleksandar Tomic/Alamy Stock Photo/Alamy Stock Photo

But this story isn’t just about one kind of food or one set of people. Across the board, across all social classes, most of us eat and
drink more than our grandparents did, whether we are cooking a leisurely dinner at home from fresh ingredients or grabbing a
takeaway from a fast food chain. Plates are bigger than they were 50 years ago, our idea of a portion is inflated and wine glasses are
vast. It has become normal to punctuate the day with snacks and to quench our thirst with calorific liquids, from green juice and
detox shots to craft sodas (which are just like any other soda, only more expensive). As the example of grapes shows, we don’t just
eat more burgers and fries than our grandparents, we also eat more fruit and avocado toast and frozen yoghurt, more salad dressing
and many, many more “guilt-free” kale crisps.

Barry Popkin, a professor of nutrition at University of North Carolina, Chapel Hill can identify the year when snacking took off in
China. It was 2004. Before that, the Chinese consumed very little between meals except green tea and hot water. In 2004, Popkin
suddenly noticed a marked transition from the old Chinese ways of two or three meals a day towards a new pattern of eating. In
collaboration with a team of Chinese nutritionists, he has been following the Chinese diet in snapshots of data every two or three
years, conducting regular surveys of around 10,000-12,000 people. Back in 1991, Popkin found that at certain fixed times of year,
there were treats to supplement the daily diet. During the mid-autumn festival, for example, people would eat moon cakes made
from lard-enriched pastry stuffed with sweetened bean paste. But such feasting foods were ritualised and rare, nothing like a casual
cereal bar.

In 2004, out of nowhere, as incomes rose, Chinese habits of snacking spread dramatically. The number of Chinese adults between
19 and 44 describing themselves as eating snacks over a three-day period nearly doubled, while the number of children between
two and six eating snacks rose almost as much. Based on the most recent data, more than two-thirds of Chinese children now report
snacking during the day. This is an eating revolution.

The curious thing about snacking in China is that to start with it actually made people healthier, because they were snacking on
fruit: fresh tangerines and kumquats, bayberries and lychees, pineapple and pomelo. These were the foods that people had always
aspired to eat, but couldn’t afford in the past. Phase two of snacking in China has been very different. “The marketing comes in,”
Popkin tells me, “and boom! boom! boom! the snacks are not healthy any more.” As of 2015, the commercial savoury snack food
market in China was worth more than $7bn. When I travelled to Nanjing last year, I saw people consuming the same Starbucks
Frappuccinos and blueberry muffins as in London.

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3/28/2019 Good enough to eat? The toxic truth about modern food | Books | The Guardian
China is not alone. Almost every country in the world has experienced radical changes to its patterns of eating over the past five, 10
and 50 years. For a long time, nutritionists have held up the “Mediterranean diet” as a healthy model for people in all countries to
follow. But recent reports from the World Health Organisation suggest that even in Spain, Italy and Crete, most children no longer
eat anything like a “Mediterranean diet” rich in olive oil and fish and tomatoes. These Mediterranean children, who are, as of 2017,
among the most overweight in Europe, now drink sugary colas and eat packaged snack foods and have lost the taste for fish and
olive oil. In every continent, there has been a common set of changes from savoury foods to sweet ones, from meals to snacks,
dinners cooked at home to meals eaten out, or takeaways.

In Spain, Italy and Crete, most children no longer eat anything like a ‘Mediterranean diet’.
Photograph: Alamy Stock Photo

The nutrient content of our meals is one thing that has radically changed; the psychology of eating is another. Much of our eating
takes place in a new chaotic atmosphere in which we no longer have many rules to fall back on. On an early evening train journey
recently, I looked up at my fellow travellers and noticed, first, that almost everyone was eating or drinking and second, that they
were all doing so in ways that might once have been considered deeply eccentric. One man had both a cappuccino and a can of fizzy
drink from which he was taking alternate sips. A woman with headphones on was nibbling an apricot tart, produced from a
cardboard patisserie box. She followed it with a high-protein snackpot of two hard-boiled eggs and some raw spinach. Sitting across
from her was a man carrying a worn leather briefcase. He reached inside and produced a bottle of strawberry milkshake and a half-
finished packet of chocolate-caramel sweets.

We are often told in a slightly hectoring way that we should make “better” or “smarter” food choices, yet the way we eat now is the
product of vast impersonal forces that none of us asked for. The choices we make about food are largely predetermined by what’s
available and by the limitations of our busy lives. If you go into the average western out-of-town supermarket, you can choose from
thousands of different sugary snack bars (many of them protein enhanced in some way) but only one variety of banana, the bland

It might be possible to eat in a more balanced way, if only we didn’t have to work, or go to school, or save money, or travel by car,
bus or train, or shop at a supermarket, or live in a city, or share a meal with children, or look at a screen, or get up early, or stay up
late, or walk past a vending machine, or feel depressed, or be on medication, or have a food intolerance, or own an imperfectly
stocked fridge. Who knows what wonders we might then eat for breakfast?

A line of fast-food restaurants in Los Angeles, US. Photograph: David McNew/Getty Images

Our culture’s obsessive focus on a perfect physique has blinded us to the bigger question, which is what anyone of any size should
eat to avoid being sickened by our unbalanced food supply. No one can eat themselves to perfect health, nor can we ward off death
indefinitely, and the attempt to do so can drive a person crazy. Life is deeply unfair and some people may eat every dark green leafy
vegetable going and still get cancer. But even if food cannot cure or forestall every illness, it does not have to be the thing that kills
us. The greatest thing that we have lost from our eating today is a sense of balance, whether it’s the balance of meals across the day
or the balance of nutrients on our plate.

“There are so many myths about food,” says Fumiaki Imamura, an epidemiologist who has spent the past 16 years in the west,
studying the links between diet and health. One of the food myths Imamura refers to is the notion that there is such a thing as a
perfectly healthy diet. He offers himself as an example. Like many Japanese people, he eats a diet rich in fish and vegetables, but he

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also eats a fair amount of supposedly “unhealthy” refined white rice and high-salt soy sauce. But Imamura is conscious that no
population in the world eats exactly the combination of healthy foods that a nutritionist might prescribe.

Every human community across the globe eats a mixture of the “healthy” and the “unhealthy”, but the salient question is where
the balance falls. Take ultra-processed foods. The occasional bowl of instant ramen noodles or frosted cereal is no cause for panic.
But when ultra-processed foods start to form the bulk of what whole populations eat on any given day, we are in new and
disturbing territory for human nutrition. More than half of the calorie intake in the US – 57.9% – now consists of ultra-processed
food, and the UK is not far behind, with a diet that is around 50.4% ultra-processed. The fastest growing ingredient in global diets is
not sugar, as I’d always presumed, but refined vegetable oils such as soybean oil, which are a common ingredient in many fast and
processed foods, and which have added more calories to what we eat over the past 50 years than any other food group, by a wide

In 2015, Imamura was the lead author on a paper in the medical journal the Lancet, which caused a stir in the world of nutrition
science. This team of epidemiologists – based at Tufts University and led by Professor Dariush Mozaffarian – has been seeking to
map the healthiness, or otherwise, of how people eat across the entire world, and how this changed in the 20 years between 1990
and 2010. The biggest surprise to come out of the data was that the highest-quality overall diets in the world are mostly to be found
not in rich countries but in Africa, mostly in the sub-Saharan regions. The 10 countries with the healthiest diet patterns, listed in
order with the healthiest first, came out as: Chad, Mali, Cameroon, Guyana, Tunisia, Sierra Leone, Laos, Nigeria, Guatemala, French

Meanwhile, the 10 countries with the least healthy diet patterns, listed in order with the unhealthiest first, were: Armenia, Hungary,
Belgium, USA, Russia, Iceland, Latvia, Brazil, Colombia, Australia.

The idea that healthy diets can only be attained by rich countries is one of the food myths, Imamura says. He found that the
populations of Sierra Leone, Mali and Chad have diets that are closer to what is specified in health guidelines than those of
Germany or Russia. Diets in sub-Saharan Africa are unusually low in unhealthy items and high in healthy ones. If you want to find
the people who eat the most wholegrains, you will either have to look to the affluent Nordic countries where they still eat rye bread
or to the poor countries of sub-Saharan Africa, where nourishing grains such as sorghum, maize, millet and teff are made into
healthy main dishes usually accompanied by some kind of stew, soup or relish.

It was Imamura’s conclusion about the high quality of African diets that ruffled feathers in the world of public health. What about
African hunger and scarcity? If the people of Cameroon consume low amounts of sugar and processed meat, it is partly because
they are consuming low amounts of food all round.

Amsterdam has been the first rich city in the world to bring down child obesity. Photograph:
Alamy Stock Photo

Imamura does not deny, he tells me, that the quantity of food available is very low in some of the African countries, but adds:
“That’s not the point of our study. We were looking at quality.” His paper was predicated on the assumption that everyone in the
world was consuming 2,000 calories a day. Imamura was well aware that is far from the case in sub-Saharan Africa, where the
prevalence of malnourishment is around 24% according to the Food and Agriculture Organisation. But he and his colleagues wanted
to isolate the question of food quality from that of quantity.

For 50 years or more, our food system has been blindly fixated on the question of quantity. Since the end of rationing after the
second world war, our agricultural systems have been focused on supplying populations with enough food, without considering
whether that “food” was beneficial for human health. But now there are glimmers of a return to quality, with an acknowledgement
in public health circles that food is more than just a question of calories in and calories out. With Brexit, there has been belated
recognition in the UK that the quality of the food we eat is not something we can just take for granted. At a meeting in Westminster
Hall earlier this month, Sharon Hodgson, the shadow minister for public health, warned that a no-deal Brexit would be disastrous
for the quality of food served by public caterers in schools, hospitals and prisons.

Brexit or no Brexit, it’s becoming abundantly clear that the way most of us currently eat is not sustainable – either for the planet or
for human health. The hope is that some governments and cities around the world are already taking action to create environments
in which it is easier to feed ourselves in a manner that is both healthy and joyous.

Amsterdam has been the first rich city in the world to bring down child obesity, through the Amsterdam healthy weight programme
(AHWP). From 2012 to 2015 the percentage of children there who are overweight or obese declined by 12%. The AHWP worked on
many fronts at once, from banning junk-food marketing at sporting events to increasing water fountains in the city. But the guiding
philosophy behind all the actions was to change collective ideas about what is normal when it comes to food and health. Now, when
a child celebrates a birthday in an Amsterdam school, he or she cannot bring in packs of cookies or Haribos. Instead, a popular
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option is a selection of vegetable skewers to share with friends, consisting of tomatoes, cubes of cheese and green olives. Celebrate
with olives!

Here in the land of The Great British Bake Off, celebrating a child’s birthday with olives instead of sugar might sound weird. If
schools tried to enact such a plan in the UK, you can be sure that the usual chorus of critics would denounce it as “middle-class”.
But there is nothing middle-class about the desire to eat food that brings us both health and happiness.

To reverse the worst of modern diets and save the best would require many other things to change about the world today, from the
way we organise agriculture to the way we talk about vegetables. A smart and effective food policy would seek to create an
environment in which a love of healthy food was easier to adopt, and it would also reduce the barriers to people actually buying
and eating that food. None of this looks easy at present, but nor is such change impossible. If the transformations we are living
through now teach us anything, it is that humans are capable of altering almost everything about our eating in a single generation.

• This article was amended on 19 March 2019 to more correctly order the name of the University of North Carolina at Chapel Hill.

• Bee Wilson’s The Way We Eat Now is published by 4th Estate on Thursday.

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