An explosion in transmissibility of the Omicron variant, which leads to wider spreads of infections that also tend to be milder than Delta, questions the quality and breadth of economic recovery in India. Indeed, COVID-19 curveballs, inflation scares, and the pace of monetary policy normalisation are the three key vulnerabilities and risks for India’s economy, as we highlighted in our Outlook 2022.
While the country is more prepared for Omicron and the economy’s resilience to it than earlier coronavirus strains, this year is likely to be characterised by slower growth, higher inflation, and elevated market volatility.
Global commodity prices, especially in the agriculture, energy and metals sectors, have firmed, and pose the principal threat to the inflation outlook. Domestically, further upward pressure on prices looks on the cards, as industrial output strengthens and with capacity utilisation, economic expansion, and early signs of the capex cycle underway. Furthermore, firms continue to experience elevated input costs, adding to the inflation risk in an economy on the mend.
Rate hikes in the offing
The headline consumer price index should average 5.4% in the fiscal year 2021-2022, but moderate to 4.5% in the following fiscal year, supported by cooling core price pressures, contained household inflation expectations, and a pullback in commodity prices.
Overall, headline inflation may continue to stay close to the top of the Reserve Bank of India (RBI)’s target range for inflation, setting the stage for tighter monetary policy in coming months. That said, the central bank may provide a more calibrated path to rate rises. We see scope for 50 basis points of repo rate hikes between April and September.
Fiscal focus on growth
In the budget for fiscal year 2022-2023, the finance minister, Nirmala Sitharaman, continued to prioritise sustainable growth with modest consolidation to support the economy. The 2021-22 fiscal deficit target, at 6.9% of gross domestic product (GDP), is very close to the budgetary estimate, and the 2022-23 fiscal deficit budgeted at 6.4% of GDP.
The government maintained its intention to meet the medium-term fiscal deficit consolidation glide path, targeting to reduce the fiscal deficit to 4.5% of GDP by end of fiscal year 2025-26. Tax revenues are expected to grow by 9.6% year on year. Meanwhile, total expenditure is projected to increase by 4.6% year on year, with capital expenditure being the key priority, and growing by 35.4% over prior budget estimates for fiscal year 2021-22.
Given the strong economic growth recovery underway, the revenue and fiscal targets look achievable.
The budget spends are clearly tilted in favour of capital expenditure, with a focus across infrastructure sectors, furthering the “Make in India” and “Atmanirbhar Bharat” (self-reliance) initiatives. Such spending also points to a multi-year move to “sunrise” areas, such as the country’s digital, green, and the burgeoning start-up ecosystems.
This encouraging revival in the economy, corporate earnings, business, and investor sentiment indicates that the demand-led recovery cycle is likely to widen. So far, recent growth has been polarised around a few sectors, but there are signs that this is also broadening.
Volatility to persist
We expect higher market volatility to persist, given the economic transitions underway, anticipated policy normalisation, rich market valuations, and elevated investor expectations. Additionally, continual rotations in sectors, investment themes, and between small, medium, and large market capitalisations will add to market risk.
Overall, though, even with lower absolute returns than witnessed in the recent past, the outperformance of equities over bonds in Indian markets appears set to continue. Being prepared for periods of elevated volatility, will help discerning investors take advantage of the opportunities that will emerge in the markets.
Corporate earnings are one of the key drivers of local equity markets. The so-called Nifty50 earnings, those from the 50 largest companies by market capitalisation, are forecast to rise by compounded average growth rate of more than 20% between fiscal years 2021 and 2024. Such expectations, and plentiful liquidity, provide ample support, feeding into corrections in equity markets that have been shallow and short-lived.
The resilience of equity markets to negative surprises may be further aided by strong domestic inflows, progressive government policies (such as the prime minister’s Atmanirbhar Bharat vision for the country and the PLI schemes), and improving economic indicators (such as GST collections and e-way bills).
The recent market corrections tempted us to raise our tactical stance on Indian equities to an overweight from a 12-month perspective. Near-term risks persist, in terms of upcoming state assembly elections, inflation, and the US Federal Reserve’s policy tightening, which could continue to hike volatility. That said, we believe that a period of such uncertainty will provide ample opportunities to use tactical budgets to top up investments.
In light of the recent elevated volatility levels, sector rotations, and bottom-up investment opportunities, we continue to prefer active management with a focus on quality, and sustainable businesses with strong earnings growth momentum.
Among our preferred sectors and themes, the inflation outlook favours real estate, infrastructure, industrials, manufacturing (capex play), and select banking and financial stocks. As the earnings recovery spreads to more sectors, we remain constructive on small- and mid-cap stocks too.
This year is likely to be of two halves, with the first set to be one of stable reference rates (like the repo rate), but with high levels of volatility.
The second period should see more clarity on the monetary and fiscal policy fronts. The RBI may harden rates, and take baby steps to normalising policy.
We anticipate that the peak Indian 10-year sovereign benchmark rate will be around 7%. Any overshoots to this estimate may create good entry points to add duration to portfolios.
Our twofold strategy of conservative duration positioning in liquid assets and roll-down strategy, remains appropriate, for now. In the preferred 1- to 5-year maturity segment, we favour a barbell strategy, keeping the average portfolio maturity to around three years.
At a portfolio level, increasing exposure to select credit remains an option for discerning investors. Once rate policy is normalised, the competitive environment within sectors may change, so relatively lower-credit bond investments need careful analysis.
We remain biased to sectors that should 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 vital opportunity in Indian markets. As such, active management is key.
High yield and structured private credits
We see merit in allocating high yield and structured private credits at this stage of the economic recovery. This stance is supported by credit spreads trading at historically tight levels and demand far outweighing supply in the public debt markets.
With the latest set of RBI restrictions on banks and non-banking financial companies, and enhanced guidelines on credit mutual funds, more opportunities are available in private debt markets, especially in the mid-market and real-estate backed credit segments. With risk appetite in this area of the market still muted, while traditional participants abstain, opportunities to build portfolios with an attractive risk premium in 2022 look likely.
High yield private debt has traditionally been less affected by rate-hiking cycles than public bonds. Prudent selection, diversification, and monitoring remain key when investing in private credits. As such, delegating these to active managers can help to navigate any new hidden stresses in markets, as the central bank reduces liquidity and starts raising rates.
Global exposure broadens opportunity set
The different growth profile of the largest economies, especially in recent quarters, highlights the importance of global equity exposure (both across public and private markets) for Indian investors.
We remain constructive on global equities despite concerns related to higher inflation, expected rate hikes, and elevated valuations. Our sector preferences point to a cyclical (value tilt) stocks, particularly in China and Europe. We also believe that equities in Asian emerging markets should be on investors’ radar.
We expect that in the next three to six months, some of the above risks may subside. For instance, price increases in the US are expected to peak in the first half of the year. This could lead to fresh opportunities in the high-quality, growth-based themes.