The market does not know what is the true underlying quality of the book on which it is paying a multiple, says Neelkanth Mishra, India Equity Strategist.

What is your understanding of the way the shape of the Indian economy is moving? The optimists would say it is a V-shape recovery, a pessimistic would say that it is difficult to predict. What is the right way of looking at the new normal for India?
The situation we are in right now, we need to assume that the virus is still not under control. We are still seeing a doubling rate of cases and in many of the large cities, the medical infrastructure is starting to get overwhelmed. The government has now realised the challenges of enforcing a lockdown because in Mumbai, a lot of the police personnel are infected and several have unfortunately died. The ability to enforce a lockdown is also limited and therefore, the state is receding. The government is now realising that they need to rope in civil society. So societal structures are now going to enforce the lockdown or impose the social distancing. The optimal level at which the economy needs to operate is still undecided. We do not know at what level of fear and social distancing, we will be able to keep the infections in check.

So till we are certain on how actively the cases are growing, to assess whether the economy is going to have a W-shaped recovery or a V-shaped recovery or a phased recovery does not make a lot of sense. This is very different from what we have seen in China or South Korea. So it will not be a 0-100 type of lockdown. These countries were able to eliminate the virus to a large extent and then one fine day the economy started to gradually open up and over a period of 1-1.5 months, a fair degree of normalisation was achieved. In India as we are now relying on individuals and collectives to enforce this, it will be a much more gradual pace of normalisation. Therefore, one way of looking at it is that if you are running at 50% of normal, let us say cement volumes were running at 40-50% in April and they are at say 70-75% today, the pace of resumption from 50% to 75% and even to 85% is perhaps going to be reasonably rapid because all the people who were stopped from moving around are now moving around; a lot of activities are permitted. It is the last bit -- 85-90% and then 90-100% where the challenges will be most extreme and this is something that even countries like China, Vietnam and Korea who have managed the virus are struggling with. So we are in very early stages of figuring out where this goes economically.

Markets are giving step-motherly treatment to even best of the breed stocks like Bajaj Finance or HDFC Ltd. Keep the ownership patterns and the FII selling aside and talk about your understanding of the RBI moratorium and the credit. What do you think is the next trend or next big thing we should expect for Indian financials now?
If you see globally, after things like travel and tourism and movie halls where social aggregation is a nature of the service provided, it is the banks which have done the worst and this is not just for India. And what is the reason for that? So this is again a hypothetical example. If you take a Rs 20 lakh crore loss of economic income, a nominal GDP growth of 10% was the consensus three months back and suppose we take a 0% nominal GDP growth, which is the consensus now; of that Rs 20 trillion, say there is a loss of income, then who is bearing this loss? In general, in the record of GDP, about two-thirds goes to individuals, about 16-17% is budgeted, 18% goes to the government; this is tax to GDP, and the rest is retail profits of corporates.

Now when an income loss happens, the government and the corporates bear the larger share of loss as they have many costs that they are not able to postpone. That is what we call not being able to stop the clock. So the fixed cost on salaries, rents, interest cannot be stopped and therefore they book a higher share of loss than their normal share of income. So let us assume a 20% share of loss, say that is Rs 4 lakh crore of the total loss is Rs 20 trillion that is now being borne by the corporates is quite normal. What we should be more worried about from a potential GDP growth perspective is that this is a retained profit that could have been used for further investments. But assuming how is this going to be accounted for? Some of it is just loss of profit; say the company makes zero profit, there is no problem but this will be distributed among companies which have no buffers. Therefore, they quickly become NPA and then this very clearly starts to erode the tier-1 capital and therefore the potential for growth for many of the financial firms. We do not know if this Rs 20 trillion is going to be Rs 15 trillion or Rs 30 trillion; therefore, the quantum of loss that will percolate down to the financial system is actually unknown at this stage because of regulatory reasons.

I think that is perhaps the most obvious way to fight this uncertainty at this stage. If you allow firms to go bankrupt, you cannot un-bankrupt them. Therefore, the moratoriums have been provided so that in this period of really depressed cash flows, you do not have to service your loans. But what this does is it increases the opacity of the balance sheets of financial firms, whether they are public or private or NBFCs. Therefore, the market then does not know what is the true underlying quality of the book on which you are paying a multiple. Therefore, there is an automatic compression of the price to book multiple as well the price to earnings multiple and that is what you are looking at.

It is the combination of these two that has driven down the banking stocks all over the world. So they are among the worst performing stocks in any market that you look at because you do not know how much will be the loss as the economy has not normalised yet. In our particular case, we have not even seen a victory over the virus yet and therefore the uncertainty is that much higher. On top of that, because of the regulatory measures, the clarity with which you can value the book is also not there. So it is not surprising that the banks and the financial services firms have been the worst performing across holdings.