"When I had all the answers, the questions changed."
– Paul Coelho, Author

This is the fate of every investor — just when you think you’ve finally understood the market, the issue of concern changes. If having to cope with the raging pandemic or the trajectory of inflation and Central Bank policies were not enough, investors had to shift focus to the military conflict in Ukraine this last month.

With questions of humanitarian crisis looming large, investors are now having to ponder over the implications of this exogeneous shock or the shock caused by outside influences. But, as before, there can be no easy answers. The military conflict and subsequent economic sanctions have added yet another dimension to the supply chain disruption, thereby providing a further impetus to inflationary pressures. This shock is likely to dampen both global growth and output. The repercussions, on the Indian and the global economy, will depend on how long the conflict drags on.

For investors, it is important to understand that Russia and Ukraine are significant suppliers in global supply chains, spanning natural gas, crude oil, coal, steel, nickel and agricultural products such as wheat, corn and edible oil. In this interconnected world, a critical link in the chain has now been broken and there are likely to be further surprises as the situation unfurls.

The weaponisation of the financial system and how sanctions and restrictions are being used during this conflict will be the subject matter of much analysis, since these will have repercussions on how sovereign nations view the safety provided by their Foreign Exchange reserves.

Central bank reserves, not held in gold in the vaults of central banks, are claims on balances held with other participants of the global financial system. However, a central bank that has been disconnected from the financial system can no longer access those reserves. Think of it like having money in your bank account, which you access through your mobile phone. And, suddenly you no longer have a mobile network signal or the app does not let you log in. Although the money is still in your bank account, you can no longer access it or use it for transactions. The Foreign Exchange reserves that you built, for days of crisis, are no longer available to you.

As of March 2 of this year, the Bloomberg commodity index had already spiked higher by 22.6% YTD, while Brent crude oil prices spiked higher by 45% YTD. Current prices are higher by nearly US $40 per barrel, compared to the price during the Oct-Dec 21 quarter.

In the last 12 months, India’s net imports amount to 1.25 billion barrels of crude oil. At current prices that would add US $50 billion to India’s import bill over the course of the next 12 months if prices remain at this elevated level. Further higher cost for gas, coal, edible oil and fertiliser could potentially add another US $35 billion to India’s import bill as per estimates (Credit Suisse).

However, these numbers come to bear only if prices remain unchanged for a full year. In other words, the longer the conflict persists the more pain it would inflict economically. If, on the other hand, the disruption is resolved within a few weeks, then the negative impact would be significantly lower.

... because as we know, there are known knowns; there are things we know we know. We also know there are known unknowns; that is to say there are some things we do not know. But there are also unknown unknowns — the ones we don’t know we don’t know.
– Donald Rumsfeld, US Secretary of Defense

As an investor, the playing field is almost always full of unexpected events. Risks arise from occurrences that are beyond one’s vision or expectation. And, the risks that one can see and estimate are discounted by markets quite efficiently. It is the unknown unknowns that create both ‘upside risk and downside risk’.

Since they are not discounted in market prices, unforeseen developments can change perceptions and modify the assumed trajectory of the economy and associated variables. The risk is even higher when valuations are rich, because rich valuations imply a benign and cheery view of the future. Cheaper valuations, on the other hand, suggest that the implied expectations of the market price are muted, ensuring these valuations are less vulnerable to shocks and that they do not discount potential positive surprises in the future.

The correction in the market has finally pulled large cap valuation on a Trailing P/E & Forward P/E basis into the fair value territory (March 7, 2022). In this case, fair value being considered as the zone of valuations within one standard deviation of the long-term average. However, mid and small cap indices are yet to do the same.

Most investors may recollect the 2013 taper tantrum, when India was significantly negatively impacted. Back, then, India’s macro-economic variables were vulnerable even before the event. This time around, India’s macro-economic variables are in a healthy condition. Real long-term yields in India, adjusted for inflation, compare favorably to yields in the US, which suggests that the degree of normalisation required in the US is higher than that required in India.

The trajectory of the current account deficit in India was well within the comfort zone of the RBI as of the quarter ended December 21. Further, bank balance sheets (Net NPAs) are in their best health in more than a decade, as is corporate leverage. The realistic budget math provides a degree of flexibility for the government to use tax cuts to offset the pressure from the increase in crude oil prices. However, if the conflict in Ukraine persists, the stress will increase. For both fiscal and monetary policies, this requires a delicate balancing act and calls for flexibility and agility in responses from policy makers.

It's not what happens to you but how you react to it that matters.
– Epictetus, Greek philosopher

The Greek stoic philosopher may not have had investment in mind when he made his statement over 2000 years ago, but investors would do well to follow his guidance.

Stick to your asset allocation plan, since it was designed to meet your financial goals keeping in mind there would be bumps in the road. Systematic investment was designed to help you navigate the volatility inherent in equities — buying more units when prices are lower and less units when prices are higher. Your outcomes as an investor will be determined not by events but by how you react to such events.

Above commentary is published in UTI Fund Watch (monthly factsheet) in the section of Update from CIO’s Desk, click here to refer to the factsheet.