Reflections of a US trip

There is positive sentiment for India, but in the short-term foreign selling will continue

I had the opportunity to spend a couple of weeks in the US recently. While there on a family trip I had the chance to speak to a cross-section of market players: Asset allocators, hedge funds, long-only investors and long-term institutional capital providers. Every meeting had its own unique pattern, but there were two-three themes that came up in every interaction.

Firstly, all the really smart investors were incredibly cautious. Everybody thought the recent stability and uplift in markets was a dead cat bounce. Everyone talked about how in all the significant multi-year market breakdowns, you had two-three bear market bounces of 30-40 per cent. They did not think this was a simple market correction, where after a 20 per cent drop the market would stabilise and start moving up again. This was seen more as a cleansing event, huge excesses, value destruction on a massive scale and potential for some large blow-ups. Most thought that inflation was genuinely out of control; that Fed tightening will be more aggressive than anticipated and the consequences of simultaneous quantitative tightening with rising rates were unknown. The Federal Reserve will be forced to tighten into a slowing economy, and given how far behind the curve it is, its need to re-establish credibility will trump fears of causing a recession. The Fed put is gone and looking at history, chances of a soft landing for the economy are very low.

Most also felt that we had only seen the first wave of the correction, wherein multiples normalise. We have yet to see the next wave where earnings expectations adjust downward and then finally multiples correct once more and markets bottom with low multiples on below trend earnings. Many felt that the odds of a recession in the US, in 2023, were upwards of 60 per cent. Clearly, earnings expectations have not adjusted for a recession. Given where we are on inflation and the tight labour markets, corporate profitability in the US is simply too high. This adjustment will cause the next leg of the downtrend.

We have seen mayhem in high growth/no profit tech stocks, but ultimately even the tech titans will correct and then finally the market blue chips.

Illustration: Binay Sinha

A sombre outlook to say the least. Could it be already reflected in prices? Should we treat this view as a contrarian indicator and become more bullish? I don’t think so, as my sense is that the consensus is not as bearish. There is still too much hope and belief that this is just a bad dream, and will soon go away. Also, the folks I was speaking to are in my opinion the smart money, very seasoned and sophisticated investors, not people I would bet against. They have seen cycles.

The second clear takeaway was the coming nuclear winter in late-stage tech/growth investing. Late stage defined as the final private round before the company goes for an initial public offering (IPO). Crossover funds/ hedge funds are in intense pain and they were the major players in the late-stage game. Many of these funds had invested 20-25 per cent of their assets in late stage privates. The public book is down 50 per cent, thus taking the private weight to 40 per cent. These funds are now facing redemptions and thus will have to further sell down their public book, taking the private stock weight up even further. Suddenly, many of these funds will have a majority of their assets in private stock. This is not their mandate. The private exposure will have to be reduced. Expect to see a wave of secondary transactions and very limited appetite for incremental private investments from these funds. Late stage is where the pain will be maximum. A correction here will obviously pressurise the IPO markets. Only the best tech start-ups will be able go for an IPO and that too at much lower prices than currently envisaged. Many others will be stuck, neither able to raise money via IPO nor access new rounds at their last valuation. We are going to see down rounds. This will be messy, as down rounds bring into focus the tussle between funds not wanting to mark down and companies needing the money. Preferred return structures will also come into focus. Late stage companies will have to pivot towards profitability, the reality is that all business models will not be able to make this transition. Many founders have never had to worry about profits or cash flows, only growth. That environment is gone. Early stage venture capital funding has more dedicated capital and there is a lot of investor appetite even today. Here we will see a correction in valuations, but funding will happen, there will not be a lack of investment capital as is likely in the late-stage rounds.

It was also clear that valuations have not yet corrected in the private stock space, many founders have not seen the memo that the funding markets have changed, this typically happens with a six-nine months lag, but it will happen.

The third takeaway was on India. I have not seen investors this optimistic on the long-term outlook for India in years. A combination of geopolitics, erratic policy-making and the downside of extreme centralisation of power with no checks and balances has combined to cool sentiment towards China. The events and policies of the last 18 months in China have introduced an element of uncertainty and risk that investment committees and boards are uncomfortable with. A clear takeaway for me was that over the next few years the allocations to China will at the margin reduce. Not dramatically, but China’s weight has peaked for many. For India there was positive sentiment, both on the longer-term outlook as well as some element of a lack of choice within the emerging market (EM) universe. If you are going to cap China, expect Korea to move out of the EM universe, extinguish Russia, worry about Brazilian politics and are nervous around the geopolitics of Taiwan, there are limited alternatives. India is clearly benefiting from this dynamic.

To my mind if investors had one dollar in India, they had 5.5-6 in China. Over the coming years, that 1 will probably move to 1.5, while China will stagnate at 5. This is however a multi-year dynamic.

India is still seen as expensive, thus money flows will take time and most investors will wait for better entry points. In the short-term, foreign selling will continue.

An interesting trip. We are going to have a volatile and difficult few months ahead. This is the time to build out your portfolio and concentrate your holdings in the best businesses and your best ideas, so that you can deliver strong differential performance on the way out of this downturn.

The writer is with Amansa Capital