At a time of conflict between Ukraine and Russia and inflation hitting multi-decade highs in leading economies, investor sentiment is poor. However, as the Indian economic recovery broadens, prospects for the country are encouraging. Furthermore, with the fiscal room available for authorities to act to limit the effects of higher prices, the country’s equities appear better placed to weather the anticipated storms from elevated inflation and higher rates than many other markets.
Financial markets are in volatile mood in the face of the conflict between Ukraine and Russia, growing inflationary pressures and expectations, and rate rises by several central banks across the globe. A resurgence of COVID-19 cases in China also adds to the gloom.
While the above risks are global, in India the immediate concern is on imports, especially energy, edible oils, and fertilisers. More so, as the economy returns to normal levels of production, and imports pick up after the latest wave of infections, from a more infectious Omicron, seen in January. If higher prices persist, the second-order impact on services, such as transport, may add to inflationary pressures in particular, with India being a net-importer of oil.
However, we expect the effects of the above price rises to be contained when it comes to inflation in India. Retail prices can be shielded somewhat through fiscal measures. For example, fertiliser subsidies could be increased, excise duties on gasoline cut, and subsidies on cooking oil, or reducing import taxes on them, could be contemplated by the government.
Earlier this year the budget for the fiscal year (FY) 2022-23 factored in a lower fertiliser subsidy bill of 1.5 trillion rupees. However, Barclays’ economists believe that the bill is likely to be closer to 1.89 trillion rupees, equating to almost 0.32% of gross domestic product (GDP) more than the original estimate, eating into the limited fiscal space available to the government. Also, direct price support for edible oils cannot be ruled out. The authorities may need to raise food subsidies, adding perhaps another 10-20 basis points to India’s subsidy bill.
Limited room for manoeuvre
While the room to cut excise duties on crude oil is limited, we would not rule out such changes. If the price of oil remains at around the $110 per barrel, domestic pump prices may need to increase by at least 20% in coming months, though some of this has already happened in recent weeks. The government could ease this potential increase by reducing excise duties. We estimate that for every five rupees per litre cut in excise taxes, the government loses 700 billion rupees (or 0.27% of GDP) in fiscal revenue.
In such a scenario, while we do not see the government raising its fiscal deficit target soon, fiscal pressures are likely to stay elevated. Though the gap between India’s wholesale price index and consumer price index indicates that the producers are yet to pass on much of their input price pressures to consumers, this is likely to happen, eventually.
Growth set to be hit by higher energy prices
The impact of the conflict in Ukraine, and the surge in prices of goods on consumer and business confidence, and therefore on domestic demand, need to be watched closely.
For now, a robust economic recovery seems to be overshadowing such concerns. The headwinds to growth have, however, increased. Although the direct effects of the Russia-Ukraine conflict, and the magnitude of the hit to growth, are likely to depend on how long the war lasts, slower global growth, especially in Europe, will weigh on the local economy somewhat.
Updated economic forecasts
Based on an oil price of around $105 per barrel, Barclays’ economists see India’s consumer price index (CPI) rising to 5.1% for FY22-23, with risk biased to the upside. For the calendar years 2022 and 2023 respectively, our economists have changed the CPI forecast to 5.4% (from 4.8%) and 4.4% (from 5.0%), and GDP to 7.2% (from 7.8%) and 6.7% (from 6.8%).
The lower growth, higher inflation backdrop will likely complicate policy decisions for the Reserve Bank of India (RBI), especially as it also faces a more hawkish monetary policy environment globally. As it supports a nascent recovery in the economy, we think vigilance on inflation will increase without the policy path changing materially. Specifically, we do not expect the central bank to switch gears and start hiking the repo rate immediately, to counter more inflationary pressures driven by supply-side factors. We continue to expect the RBI to increase rates from the third quarter.
However, the Indian bond market keenly awaits some guidance on how the RBI plans to manage a high supply of government bonds in the current fiscal year, especially with the bond-buying programme through Open Market Operations being a contradictory tool to a liquidity reduction mode.
In India’s union budget for FY2022-23, the government prioritised sustainable growth with a modest fiscal consolidation to support the economy. However, as discussed above, the room for the government to speed up fiscal capital spending, in order to crowd in private investments, may be constrained due to the selective tax and price subsidies that may be needed for some imported commodities.
Recovery base likely to widen
The encouraging revival in the Indian economy, corporate earnings, business, and investor sentiment indicates that the demand-led recovery cycle may widen. So far, growth has been polarised around a few sectors, but there are signs that this is also broadening.
We reiterate the importance of diversification, time-in-the market (rather than timing the market) and active management, especially in such volatile markets. It may also help to refresh some of the medium-term themes that we highlighted in our Outlook 2022. The themes continue to look attractive and may help navigate through the noise in the markets at the moment:
- Quality leaders – Formalisation of the economy; business resilience; stronger balance sheets; industry consolidation; lower cost of capital; and pricing power
- Banking and financial services – Economic (nominal) growth proxies; stronger balance sheets; credit pick-up; rates pick-up; and growing financialisation and digitisation in India
- Technology/Digital 2.0 – Increasing adoption and global demand; new economy technology and tech-enabled businesses; strong policy support; and growing start-up and tech-savvy environment
- Real estate, infrastructure and allied industries – Favourable demand-supply mix; better regulations; increased affordability; industry consolidation; institutional participation, and growing real estate investment trust (REITs) and infrastructure investment trust (InvITs) market
- Manufacturing – Government reforms, focus, and incentives; favourable capex cycle; global supply-chain substitution benefits; cost competitiveness; and strong domestic market alongside exports
- Late recovery themes – As mobility restrictions ease fully, spending on contact-intensive leisure, travel, hospitality, retail and entertainment is likely to increase
- Green economy – Energy price spikes; global net-zero aims; green energy production, storage and transmission; greener production technology and efficiencies; e-mobility solutions; and waste management and recycling, including e-waste
- High yield and structured credit – Broader economic recovery; risk appetite still muted; demand far outweighing supply; attractive risk premiums; traditionally less affected by rate-hiking (normalisation) cycles; but prudent selection, diversification, and monitoring remain key.
While in the near term, pressures from rising input costs and interest rates remain in most of these themes, the medium-term trends point to a good investment case for them. Investment opportunities in these themes are available across asset classes, as well as across both public and private markets.
The current volatility in the Indian equity market seems more due to geopolitical tensions rather than any concerns with growth over the medium to long term. So, in the short term, the market is moving in line with global markets. However, over the medium to long term, we believe that the country is in a better position, given the positive earnings growth trajectory being seen and that is likely to last.
The so-called Nifty50 earnings, representing the 50 largest companies by market capitalisation, are forecast to rise by a compounded average growth rate of 21% between fiscal years 2021 and 2024. It will be illuminating to see the impact of inflationary pressures on the corporate profit margins, and subsequent guidance on the same from companies, especially in the consumer sector, during the quarterly earnings season set to unfold from early April.
Even though the earnings forecast may be revised down in the coming months, most of the expected growth is almost a given, considering the increase in profitability already captured in sectors such as banking and financial services, commodities, technology, and select manufacturing, such as chemicals.
The resilience of equity markets to negative surprises may continue to be aided by strong domestic inflows, progressive government policies, and improving economic indicators. We believe that the cyclical growth that is returning to the economy has legs.
The recent market corrections tempted us to overweight Indian equities on a 12-month perspective. Near-term risks persist and could continue to lead to more volatility, which may provide opportunities to use tactical budgets to top-up investments.
This year is likely to be one of two halves, with the first set to be one of stable reference rates (like the repo rate), but with high levels of volatility. In the second half, more clarity on the monetary and fiscal policy fronts should emerge. The RBI might lift rates, and take baby steps to normalise policy. That said, geopolitical events, elevated commodity prices (especially oil), and the rates trajectory in the developed markets are likely to add volatility to domestic Indian bond markets throughout the year.
Assuming that we see a normal monsoon season and the inflation trajectory remains manageable (as discussed above), we anticipate that the peak Indian 10-year sovereign benchmark rate will be around 7%. Any overshoots to this estimate may create opportunities to add duration to portfolios.
For now, we continue to favour our twofold strategy of conservative duration positioning in liquid assets and roll-down strategy. In the preferred 1- to 5-year maturity segment, we prefer a barbell strategy, keeping the average portfolio maturity to around three years.
We are biased to sectors set to benefit from government policy and budgetary initiatives, such as power, financing for micro, small, and medium enterprises, rural housing, and rural infrastructure. That said, a bottom-up approach remains critical while adding names. In that context, identifying rating upgrade candidates, or “rising stars”, remains a key opportunity in Indian markets. As such, active management will remain key.
Gold as a diversifier
Gold is known for its safe-haven characteristics, and ability to act as an inflation hedge. That makes it a welcome portfolio diversifier at the moment.
Gold is more likely to preserve wealth during periods of turbulence, diversifying rather than growing portfolios. For Indian investors, a weaker rupee against the US dollar should add to the attraction of this strategy, the gold price in the country being derived by converting the US dollar price to Indian rupee prices.