Good Morning Toasters!

In today’s issue of the Morning Toast, we discuss:

• Yield curves are hinting at an upcoming recession
• HDFC Limited + HDFC Bank merger to create deep synergistic value
• News around the world
• An educational concept to keep you learning every day 🙂

Market Watch

Nifty: 18,053.40 | +382.95 (+2.17%)
FII Net Bought: INR 1,152.21 crore

Sensex: 60,611.74 | +1,335.05 (+2.25%)
DII Net Bought: INR 1,675.01 crore

Global Economy News

Yield curves are hinting at an upcoming recession; what’s up and what do you need to know?

• Long known as a signal for a recession, yields on two-year Treasury notes moved above yields on 10-year notes (a phenomenon known as an inverted yield curve)
• On Friday, the yield on two-year Treasury notes hit 2.44% while 10-year notes lagged behind at 2.38%

Can you break down the economics for us?

• Think about it intuitively, the longer a loan the higher the interest rate one has to pay (since it entails more risk)
• The expected chronology is that the Fed increased interest rates to fight off inflation -> credit squeeze in the economy due to high cost of capital -> recession -> interest rate cuts to stabilise the situation
• History too agrees – 2006 saw the Fed raise short term interest rates at 5% while long term rates remained below that level and a recession followed in 2008
• Similar instances have taken place in the early and mid 2000s and on average yield inversion in the US has happened about 16 months ahead of the recession and 10/12 months ahead of the peak in equity markets

What’s the way out?

• In the past (1998 and 2019) the Fed has changed course mid-cycle of interest rate increases, and averted recessions
• Chairman Powell believes in the theory that looks at yields for even shorter maturity periods (3 months & 18 months) and those numbers don’t look as alarming
• There’s also hope that inflation subdues on its own as supply chain bottlenecks easen + geopolitical outlooks become better and that none of this story will have to take place

And in the Indian context?

• India’s economic growth is predicted to be hurt by 80-90 bps due to oil crossing the $100 mark with the risk of inflation increasing by 80 bps too (especially if there is full pass through to freight rates)
• Nifty earnings are not expected to be impacted greatly as earnings from benefitting industries like commodities/energy/software mostly off-sets a rather sharp slump in autos/cement and consumer staples
• With a downside looking more likely, stocks like Hindalco/ONGC seem to be saving grace!

A great thread on yield curves, via a bottoms up analysis on the Economic Principle. Click here to know more.

Around the World 🌎

• Crypto world beware – Major investment firms like Fir Tree Partners and Viceroy Research LLC have placed short sell bets on stablecoin Tether which is the most popular currency for trading bitcoin and is supposed to have a fixed value pegged to the U.S. dollar. Tether has not given in to world pressures in the past with price remaining solid. Firms are being accused of defrauding the less informed and raising capital with the end goal of collecting a management fee. Shorting tether costs about 6-8% a year with a very low probability but high upside that it falls
• Not the best quarter for Tesla – Even though Tesla vehicle deliveries rose in the last quarter to stand at 310,000 units globally, they were well below investor expectations of 317,000 vehicles. Supply chain interruptions and China’s zero-covid policy made it an “‘exceptionally’ difficult quarter” acc to CEO Musk. Tesla has tried to maintain a growth rate of 50% and has expanded production on a huge scale but operating restrictions in its biggest factory in Shanghai are spoiling its plans. Inflation too is a cause of concern with many key models seeing a 30% price increase
• Old is Gold, for Starbucks at least – Starbucks ex-CEO Howard Schultz will be returning to the CEO’s chair for the third time (but as interim CEO) after Kevin Johnson retires till the company finds a permanent fit for the role. Major challenges include improving work culture and employee retention, pivoting to a model that focuses on to-go deliveries, battling increasing costs and competition, and giving investors value for their buck. Adding to the pressure is the geopolitical situation that is sure to hamper their expansion plans, inflation and an uncooperative China

Company News

HDFC Limited + HDFC Bank merger to create deep synergistic value; what’s up and what do you need to know?

What’s up?

• Housing Development Finance Corporation (HDFC) Limited announced that its board has approved a composite scheme of amalgamation for the merger of HDFC LImited into HDFC Bank
• As a part of the merger between the group entities, 42 shares of HDFC Bank of Re1 would be given for every 25 shares of HDFC Limited of the face value of Re2;
• Post the above, HDFC will be 100% owned by public shareholders, and existing shareholders of HDFC will own 41% of HDFC Bank
• All non-lending subsidiaries will be merged in the bank as per RBI norms, which might result in the Bank having to dilute its stake in the Insurance business to 30% or 50%, depending on the outcome of discussions with RBI (current stake stands at 48%)
• The merger is expected to be completed by Q2 / Q3FY24, subject to shareholder & regulatory approvals

Why?

• The merger will likely to beneficial for HDFC Limited, as the mortgage business leverage will increase, leading to better business RoEs, adjusted for regulatory cost, and thus be valued higher in the Bank
• The Bank (via its press release) also mentioned benefits to be accrued from a larger balance sheet & net worth, which would allow underwriting of larger ticket loans and also enabled a greater flow of credit within the ecosystem
• Likewise, HDFC Limited’s rural housing network & affordable housing lending is likely to quality for HDFC Bank as Priority Sector Lending (PSL), which will assist in enabling higher credit flow into PSL linked sectors (think: Agri)
• HDFC Bank expects the current low cost of funds (CASA), coupled with a large base of existing capabilities to act as a lever in offering flexible & innovative mortgage offerings in a cost-effective & effective trade manner
• HDFC Bank has struggled to build out its home loan portfolio in the last 12 months, while key competitor ICICI Bank has grown its book >20% during the same period

Anything else?

• There has been a consistent decrease in regulatory arbitrage b/w NBFCs and Banks in the recent past, accentuated primarily on account of crises including IL&FS and DHFL, resulting in –
  • Asset classification norms for NBFCs and Banks on-par
  • Increased supervision of large NBFCs
  • Expectation that RBI may move to a CRR and SLR type regime for NBFCs soon
• The above has made owning & operating an NBFC and building on the perceived lack of regulatory oversight less attractive, with merging/combining with banks a recurring route going forward (think: Capital First & IDFC Bank)
• Also to consider is the apparent need to successfully execute leadership & succession planning at HDFC Limited, with key top management personnel (CEO / CFO) all nearing their retirement age; by being a part of the Bank, the ability to replace/create funnels would be far easier (we believe)

Okay! Final thoughts?

• The combined entity will likely be the third largest company (after RIL & TCS) in the country (basis MCAP), while also becoming part of the Top 10 (including China) and Top 5 (excluding China) banks globally
• With ~18 Lakh crore book, the size & scale provide the Bank with every opportunity to grow, and yet there also remain multiple challenges (regulatory & business)
  • Post the merger, the combined entity will hold stakes in multiple external & internal subsidies including HDFC Life, AMC, Bandhan Bank, RBL Bank, HDFC Ergo, HDB Financial, HDFC Credila, which will require regulatory approval to continue
  • Leveraging technology to maintain processes, asset quality, growth and operations will be key to watch out for, as size & scale look unprecedented in the Indian context
  • The approval process, via multiple different regulatory bodies, is likely going to be a long journey, with road bumps along the way
• Mr. Parekh spoke about finding a home for HDFC Limited; getting one within a group company, this merger seems a synergistic fit from the off (stocks were up ~10% during the market), creating value for shareholders
• That being said, leveraging technology to successfully cross-sell, while maintaining book quality will be key to judging the effective amalgamation of the two businesses

What else caught our eye? 👀

India getting more responsible fiscally

• Direct taxes reached an all-time high of Rs. 13.81 trillion in FY22, an increase of 49% from the previous year (34% and 23% higher than pre-pandemic FY19 and FY20)
• Gross GST revenue also peaked in March touching Rs 1.42 lakh crore (a 15% increase from March last year) and breached the last high of Rs 1,40,986 crore collected in Jan’22
• India performed on the global front too with merchandise exports touching a record $40.38 billion while imports rose to $59 billion

India’s GDP numbers looking good

• A survey by FICCI (Federation of Indian Chambers of Commerce and Industry) has stated India’s annual median GDP growth forecast at 7.4 percent for 2022-23 (with a range of 6-7.8%)
• Sector-wise, agriculture is expected to grow at 3.3% followed by industry and services at 5.9% and 8.5% respectively with a CPI inflation of 5.3% for FY23
• Downside risks to growth including Russia-Ukraine and resulting commodity price rise + the Covid pandemic may continue to remain escalated

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Educational Topic of the day

Golden Cross

A Golden Cross is a basic technical indicator that occurs in the market when a short-term moving average (50-day) of an asset rises above a long-term moving average (200-day).

When traders see a Golden Cross occur, they view this chart pattern as indicative of a strong bull market.