How ‘Cold War II’ Will Impact Indians’ Wealth

→ Given the likelihood of elevated inflation as Cold War II commences, the worst possible thing that investors can do is seek the safety of fixed deposits, government bonds, corporate bonds and other fixed-income investments – inflation will radically erode the real value of such investments. The most sensible method to deal with a scenario of healthy economic growth alongside elevated levels of inflation is to invest in high-quality companies which have the pricing power to pass on the rise in labour and raw material costs to their customers and thus significantly outperform the market..I would bet on globalization slowly being in abeyance. I think with the benefit of hindsight, we will realize that 2007 was not just the peak year of the finance boom, but also the peak year of globalization, like maybe 1913. Happily, it hasn't resulted in a world war, at least not yet, but I think we are in this period where globalization is steadily pulling back. And so, you want to be in places or industries that are levered to things other than globalization.Peter Thiel, Co-Founder - PayPal, Palantir Technologies.Over the past five years, we have grown accustomed to China and America squaring off on trade restrictions and Covid-19 even as the Americans had grown habituated to the Russians meddling in American elections. With Russia’s assault on Ukraine, these smouldering hostilities have now been escalated to what is effectively Cold War II. The sanctions on Russia which have followed the assault on Ukraine, and China’s support for Russia in the midst of all this is likely to reverse much of the globalisation dynamic which was set in motion after the fall of the Berlin Wall in 1989..India Impact.Given China’s increasingly menacing behaviour vis-a-vis Taiwan, India, and Australia, India is strategically inclined towards the democratic bloc led by the United States, along with the European Union, United Kingdom, Japan, and Australia..This could lead to the creation of a 21st-century strategic equivalent of an Asian version of NATO. In any case, an economic quid pro quo between the countries in the democratic bloc and India seems to be on hand. This essentially would be in the form of increased foreign direct investments, foreign portfolio investments, and trade inflows (largely in the form of the western world outsourcing much of its white-collar office work in information technology services, finance, human resources, payroll, and marketing to India) in return of continued allegiance with the democratic bloc.The implications of these capital and trade inflows for India’s economy are significant. Services currently account for $1.3 trillion of India’s $2.6 trillion economy. India’s total export of services currently stands at $250 billion trillion or around 9% of GDP. The combined services sectors of the U.S., E.U., and U.K. stood at nearly $30 trillion at the start of the pandemic. Even assumed to stay constant, if a mere 5% of this is assumed to get outsourced to India, India’s services exports to just this group say a decade hence could be around $1.5 trillion. To get to this number organically would imply a ten-year CAGR of 20%..All other things being equal, this would add approximately 1.2% points each year to India’s nominal GDP growth rate over the next ten years, making services almost 21% of GDP..Such a blast off in services exports in turn would become a strong driver of formal sector job creation in India. EPFO and CMIE data already point to a rapid surge in formal sector job creation over the past three years. The first chart shows that India added 33 million jobs in the formal sector over FY20 and FY22..Thanks to the surge in formal sector job creation in India alongside the boom in the services sector in India, wage inflation is likely to sustain in the mid-teens over much of the next ten years. This alongside: (a) China’s increasing reluctance to be the manufacturing centre of the world for cheap chemicals, cheap toys, electronics, low-end synthetic textiles, etc; and (b) the disruption of global supply chains as the democratic bloc brings stuff back home that was hitherto imported from China, is likely to result in CPI inflation in India staying well above 6% (i.e., the upper end of the RBI’s comfort range) for much of the next decade. In addition, Indian investors routinely fret over rising commodity prices and especially, rising oil prices. However, if we analyse the link between crude oil prices, the Indian economy, and the Sensex, a far less worrisome picture emerges..The next chart shows an initial positive relationship between the crude oil price change and the real GDP change for India. Understandably, however, once the oil price rise exceeds 100% year-on-year, the relationship becomes negative i.e., the rise in oil prices begins to hurt economic growth..Presently, according to the red dot in the chart, we are well within the rising phase of the chart, meaning that the surge in crude oil prices that we have seen so far is unlikely to materially impact economic growth. Interestingly, when it comes to the relationship between crude oil prices and the Indian stock market, the relationship is positive i.e., a rise in oil prices correlates with a rise in the Indian stock market – see the next chart..How Little Champs Become Cash Generation Machines.Investor Implications.Given the likelihood of elevated inflation as Cold War II commences, the worst possible thing that investors can do is seek the safety of fixed deposits, government bonds, corporate bonds, and other fixed-income investments – the odds are high that inflation will radically erode the real value of such investments. In fact, over the past twelve months, investors in the Indian government’s ten-year bonds have got a meagre 2% return on their investment, which does not even exceed the inflation rate, making people lose their money in real terms.As detailed in last month’s column, the most sensible method to deal with a scenario of healthy economic growth alongside elevated levels of inflation is to invest in high-quality companies which have the pricing power to pass on the rise in labour and raw material costs on to their customers and thus significantly outperform the market – both on fundamentals and on share prices..To illustrate the limited impact of rising crude prices and rising inflation on high-quality stocks, look at Asian Paints. If we try to identify periods of 2x rise in crude prices, three such episodes emerge – January 2007 to July 2008, May 2010 to March 2011, and March 2016 to September 2018. In a majority of such episodes, Asian Paints’ profit margin did not get compressed, making its average EBITDA margin stand way higher at 18% than its peers..The primary reason for such sustained EBITDA margins in Asian Paints is the high pricing power in its industry. The drivers of this pricing power are not price hikes but:.Playing the ‘volume’ game: due to modest price hikes leading to improved affordability and coupled with accelerated penetration among geographies (tier 3/4/5 cities), the company has improved its pricing power, thereby not letting its profitability get hit.Market share gains: incremental efficiencies in operations help capture markets, which competitors cannot do without any price hikes.Defence against price wars: the company’s competitive advantages are so well established that it doesn’t feel the need to get into price wars to eliminate competition and take a hit either on the product quality or their profit..Due to these three drivers, such companies are not impacted by short-term macroeconomic imbalances like oil price hikes. In fact, such circumstances help champion franchises to gain market share whilst their competition suffers..Note: Asian Paints and Berger Paints are part of many of Marcellus Investment Portfolios. The authors by dint of their investments in Marcellus’ portfolios also have investments in these stocks.Chart 2 Note: All data used is in real terms, i.e., tied to a base year. Brent USD per barrel has been deflated using US CPI data and then quarterly YoY change was calculated. The red dot signifies latest quarter’s datapoint (December 2021)Chart 3 Note: All data used is in nominal terms, i.e., in US dollar terms. Then monthly YoY change was calculated over it. The red dot signifies latest month end data available (February 2022).Saurabh Mukherjea and Nandita Rajhansa are part of the Investments team in Marcellus Investment Managers. Disclaimer: Read here..The views expressed here are those of the authors, and do not necessarily represent the views of BloombergQuint or its editorial team.

How ‘Cold War II’ Will Impact Indians’ Wealth

“The worst thing investors can do is seek safety of fixed deposits, g-secs, corporate bonds and other fixed-income investments.”

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