Lehman Fears Loom: Is India Insulated?

The failure of Silicon Valley Bank (SVB), Signature Bank and Silvergate Bank in the US and the crisis at Swiss bank Credit Suisse (later acquired by UBS) in March 2023 has raised concerns about a contagion. Markets around the world are witnessing higher volatility, and India is no exception. The benchmark Sensex index, which peaked on December 10, 2022, has fallen by over 10 per cent since. The Nifty Banking index is also down by nearly 11 per cent from its peak in December 2022.

In India, the collapse of US banks added to the blow the Adani saga rendered to the market earlier this year. It also brought painful memories from 2008, when the US-based Lehman Brothers collapse left ripples across the world and India suffered deep losses as well.

Continued Trouble

The Indian market was upbeat till the second week of January 2023. To encash that, Adani Enterprises announced a `20,000 crore follow-up public offering (FPO) to expand their shareholder base on January 25. But soon enough, a report by US-based research firm Hindenburg accused Adani Group of “engaging in blatant stock manipulation and accounting fraud over decades”.

The shares of the Adani Group companies fell dramatically, leaving the market in a foul mood. The market didn’t just turn its ire towards the stocks of the Adani Group, but also singed those of the financial institutions that had either given loans or invested in them. The shares of State Bank of India (SBI), India’s largest commercial bank, which was trading near an all-time high of `600 before the allegations, fell by over 10 per cent within a week. The shares of Life Insurance Corp. (LIC) Of India also fell because of their investment exposure in the Adani Group. Both SBI and LIC were forced to assuage investors by clarifying on their exposure to Adani Group shares.

Is The Lehman Moment Back?

The market hadn't even gathered its breath from the Adani blow, when news of the banking crisis in the US and Europe started seeping in. That brought back the unsavoury and morbid sentiments of the 2008 crisis.

Back then, people had initially felt that India would not be affected as much being a fundamentally strong country. The reality was different: the Indian markets tanked 63 per cent, while the US markets fell 55 per cent from their peak in 2008. It took five-and-a-half years, till 2013, for the Indian market to reach the January 2008 peak.

Given this past track record, investors are now worried about what lies in store for them. But is the situation in 2023 similar to what it was in 2008?

Says Neelesh Surana, chief investment officer, Mirae Asset Investment Managers: “Lehman was different given the underlying assets were subprime loans with synthetic products. Also, large banks were involved then. The current developed market crisis started with large bond losses and surveillance failure, and is now impacting credit flows.”

In both cases, however, the real culprit is interest rates, but for opposite reasons. Let’s understand how interest rates gave way to the 2008 crisis. After the dot-com bubble in 2000 and the 9/11 attacks of 2001, central banks across the globe pumped capital into the market to create higher liquidity through lower interest rates. That spiralled into a crisis as banks took a hit.

In the present scenario though, the cause of the failure of US banks is the rise in interest rates that translated into an asset-liability mismatch.

Banks invest and/or lend the money received from depositors to other entities to earn higher returns. When SVB’s deposits grew multifold from $55 billion in January 2020 to $186 billion by the end of 2022, it invested this money in long-term fixed-rate treasuries to earn higher returns. This investment call turned out to be wrong because they had to sell the bonds prematurely to meet depositors’ obligation, and booked hefty losses due to rise in interest rates (bond prices are inversely related to interest rates).

Is India Insulated?

Not from the point of volatility. Investors usually attribute market decline to “global cues” and rebounds to “decoupling”. In 2022, when the Indian market outperformed global peers, pundits gave the latter logic. But now the market has proved that decoupling is just a myth. Sharp selling by foreign institutional investors (FIIs) will keep the market volatile until the dust of uncertainty settles. In terms of banking stability, Indian banks are resilient in comparison to their global peers.

“In case of crisis and spread of balance sheet contagion, countries with limited direct and indirect exposure will remain resilient. Foreign claims on India are $104.2 billion on immediate counterparty basis, and $81.5 billion as guarantor basis. When compared to other major countries, India has the least foreign claims, both on counterparty and guarantor basis,” writes Soumya Kanti Ghosh, group chief economic adviser, SBI, in a report. He further says that “our ratio of foreign claims to domestic claims is also least among countries, signifying that our banking and financial system is very disciplined, and no international balance sheet contagion can start from India”.

The other factor that will play a major role will be monetary policy action. The market will keenly look forward to the next policy rate announcement and guidance. In terms of rate hike, experts are divided. Some believe the Reserve Bank of India (RBI) will take a pause, while others believe that there will be another rate hike of 25 basis points (bps).

RBI has hiked the policy rates by 250 bps since May 2022. The impact of the rate hike would be seen in the corporate results of this quarter due for release in the next few days. A further rate hike will hit the profit margins because of higher interest.

What Should You Do?

Market valuation plays a key role in attracting investors. The fear of over-valuation has been thrown out of the window now as the Indian markets are trading at 20.41 times FY23 earnings, compared to 40-plus times two years ago in March 2021. These positive valuations are, however, not providing comfort, due to the fear of FII selling. This is evident from rising gold prices.

Experts, however, see this lower valuation as an opportunity. “Post the correction over the last 18 months, the valuations are reasonably attractive and will yield good returns over the next 3-5 years,” says Surana.

In a bleak environment like this, you need to build a portfolio by way of diversification that will not only beat inflation but offer stability as well.

Equity: Equity has historically performed over the long term. On a year-to-date (YTD) basis, the BSE Sensex is down by around 6 per cent, but over a 10-year period, its compounded annual growth rate (CAGR) is at 11.73 per cent as on March 21, 2023. Similarly, on a YTD basis, the BSE Small Cap index is down by 7.01 per cent, but over 10 years, the CAGR is 16.11 per cent.

Says Surana: “India remains strong from the long-term view with significant improvement in trade balance, and strong balance sheet of banks and corporates, but capital linkage will have an impact in the near term. The next few decades belong to India.”  

Within equity, it may be safer to stick with large-caps in terms of stability. In the current market scenario, where volatility is at its peak, it is better to stay away from mid-, small-cap and under-researched stocks.

If you are a mutual fund investor, continue with your systematic investment plans (SIPs). They work best in volatile markets, as they average out the buying cost over time. Says Surana: “Investors should stick to SIP and have equal weight in equities. Once the global chaos settles, Indian markets will stand out in terms of long-term growth potential and stability.”

Hybrid funds could also be an alternative for risk- averse investors as they give the best of equity and debt. They are less volatile, and do not fall as much as pure equity funds when the market is in a downtrend.

Bonds: Though inflation is down, it is still not within RBI’s comfort zone. With interest rates at its peak now, investing into long-term bond funds for 3-5 years would be a great investment idea. “We expect the 10-year benchmark bond yield to keep trading in a range of 7.30-7.50 per cent till the fiscal year-end,” says Puneet Pal, head fixed income, PGIM, Mutual Fund.

Investors with medium- to long-term investment horizon can look at funds with a duration of 3-4 years and having predominant sovereign holdings as they offer better risk-reward currently, adds Pal.

You may also allocate a certain portion of your portfolio to short-term bond funds, as they are less volatile. “Investors having an investment horizon of 6-12 months can consider money market funds as yields are attractive in the 1-year segment,” adds Pal.

Gold: For the sake of diversification, have 5-10 per cent of your investment in gold because of its negative correlation to equity. Gold exchange-traded funds (ETFs) are the best, as they are cost efficient, liquid, and eliminate the perils of owning physical gold.

kundan@outlookindia.com