Asset classes – Indian multi-asset portfolio allocation

Can Indian equities keep outperforming emerging market peers as rates rise?

13 June 2022

By Narayan Shroff, India, Director-Investments

  • The Indian central bank surprised financial markets in May with an inter-meeting interest rate hike. Together with fresh fiscal measures directed at easing the pain of the recent surge in inflation on consumers and industry, the country’s authorities are flexing their inflation-fighting muscles
  • The local economy continues to perform relatively healthily, with local equity markets outpacing their emerging market peers, in the face of the recent acceleration in prices. Indeed, with additional government spending on capital expenditure projects and a normal monsoon season forecast, we are upbeat on prospects for domestic equities
  • As overseas investors sell off predominantly large-cap quality and growth stocks, local demand for smaller-cap equities is helping to buoy markets. Furthermore, with fundamentals for quality and growth securities seemingly little altered this year, additional sharp falls in their share price could present attractive entry points
  • The Reserve Bank of India’s decision to raise rates in May could make bond investors more nervous of their intentions. We prefer local debt with a three-year to seven-year maturity in the short-to medium-term. In addition, given the supply-demand dynamics and a rate-hiking cycle that is likely to see the largest moves in the early phase, opportunities look likely in corporate bonds as spreads widen

As global equity and bond financial markets struggle in the face of central bank rate hikes targeted at tackling rampant inflation, Indian equities appear well placed to keep outperforming other emerging markets, backed by a government focused on easing the effects of price rises on consumers and supporting the economy.

With little sign of a peace deal being reached between Russia and Ukraine soon, supply-chain, inflation, and growth pressures are likely to remain elevated. Meanwhile, tighter monetary and financial conditions add to slowing momentum in growth globally, and growing fears of a recession in the not too distant future.

Despite the international economic malaise, Indian financial markets have shown remarkable buoyancy, and resilience, since their pandemic lows in 2020. That said, domestic equity and debt markets saw heightened volatility in May.

Central bank in shock rate hike

In a surprise move, the reserve bank of India (RBI) raised the repo rate by 40 basis points (bp) in an intra-policy meeting in May. Further, at June’s meeting, it hiked the rate by 50bp, taking it to 4.90%.

While the central bank tightened monetary policy, the government announced steps to lessen the impact of the surge in commodity prices. Chief among the fiscal measures was lower excise duties on the cost of petrol and diesel. In addition, subsidies were boosted on liquefied petroleum gas cylinders and fertilisers, while customs duties were cut on some materials used in plastic and steel production. Finally, in an effort to protect Indian manufacturing, export duties are being strengthened on items like pellets, iron ore, and several steel products.

The above measures also display the inflation-fighting credentials of the authorities. Fiscal initiatives tackle demand by keeping inflation in check, helping real incomes, while monetary actions coordinate domestic policy with their international peers.

Indian equities remain appealing

Domestic equities saw more volatility and a sell-off from foreign investors. After rallying for over two years, the markets seem to be in the consolidation phase. Although valuations are lower, they continue to outperform other emerging markets.

The pessimism in local markets is largely focused on the implications of rising global interest rates and inflation for the Indian economy. We believe that these factors will contribute to prolonged volatility.

High equity valuations have been fuelled by the low bond yields experienced since the global financial crisis. With the US Federal Reserve and other central banks unleashing a hiking cycle this year, earnings growth will be vital to sustain valuations.

So far, many companies have reported margin pressure, in all sectors, due to climbing wage bills, raw material expenses, and oil prices. Luckily, the government is keeping the accelerator on, with spending on capital expenditure (capex) projects. As such, the hit to demand in India may not be as bad as initially thought.

Investors seem to be moving capital away from emerging market assets. However, domestic flows have helped to protect the effect of this shift on small-cap companies, whereas large caps have suffered considerable outflows, given that overseas investors have typically favoured quality and growth stocks. The recent sell-off in these stocks has borne the brunt of the market correction over this period. As the fundamentals for quality and growth companies are largely unchanged, the resulting subdued prices suggest that they offer attractive entry points.

One sector where valuations have been hit hard is information technology (IT) services, on concerns that a possible slowdown in the US may reduce IT budgets. However, with fairer valuations for the sector now and a strong earnings outlook over medium term, in our view, share prices in the sector may bounce back over the rest of 2022.

While there may be some earning downgrades in coming weeks, hints of sustainability in underlying demand and predictions of a normal monsoon season should support markets. Hence, we maintain our overweight stance on Indian equities.

Sector rotation and elevated volatility create opportunities

We believe that this period of elevated volatility and sector rotation has further to run. As such, we anticipate more scope for bottom-up stock selection. Beyond the near-term turbulence, we may be at the beginning of a capex-driven economic and earnings cycle. Any sharp fall in quality, sustainable businesses with the potential for strong long-term earnings growth should present investment opportunities. We prefer active management and have no bias towards large- or mid-cap stocks.

Neutral stance on debt

Indian bond yields climbed in May and prior to June’s policy meeting, supported by well-received fiscal and monetary measures from the government and central bank. However, with the RBI increasingly focusing on inflation, bond investors are likely to remain anxious. On the other hand, policymakers may want to keep managing the shape of the yield curve, with the aim of changing the market dynamics for demand and supply while providing intermittent support to bonds.

The global geopolitical and macroeconomic situation remains a source of volatility and adds uncertainty to prospects for growth and inflation in the country. Moreover, the market will likely have to price in a larger bond-supply premium given the uncertainties unleashed by the recent fiscal measures. This is expected to keep pressure on yields in the near term.

With increased inflation projections for the current fiscal year (up 100bp to 6.7% at June’s policy meeting) alongside more entrenched and broadening growth, the RBI is expected to keep inflation management its key priority. Over the next three meetings, finishing in December, we now expect rates to reach 5.75%, which may mark the end of this cycle. A term spread (10-year government debt rate over repo rate) of 175-200bp or higher would be well above its long-term norm, at a time when rates are on pause, offering opportunities to add duration to a debt portfolio.

Prefer bond yields in the 3-year to 7-year segment

In the short- to medium-term, we prefer bonds with maturities of between three and seven years, with the flexibility to add duration as the yield curve changes. Again, assuming a medium-term peak repo rate of say 5.75-6.00%, a term spread of more than 100bp would be above its long-term average with rates on hold, in turn providing an attractive opportunity at current levels of government bonds in this segment. With a bond supply overhang and in a front-loaded rate-hiking cycle, this means that opportunities may also occur in corporate bonds as spreads widen.

However, investors should have appropriate risk appetite to remain invested through periods of intermittent spikes in volatility. Staggering allocations could help to manage portfolio performance at such times. In that context, our tactical outlook for domestic debt remains neutral.

Foreign equities still appeal

We believe that global equities remain relatively more appealing than bonds, for now. Yet, we are highly selective in allocations, and our portfolios are geared towards high-quality businesses. As the market tries to find a bottom, investors will keep an eye on earnings releases and any guidance from management about their ability to pass on higher input costs to customers. We believe that a lot of bad news is already reflected in asset prices.

More attractive opportunities appear to reside in developed market equities compared to their emerging peers. While the Chinese authorities have attempted to calm markets by striking a more reassuring tone of late, a combination of lighter restrictions, especially in respect of technology groups, and economic support could be enough to turn around sentiment and remove a key overhang weighing on markets. As such, we believe that Chinese assets could perform better than many expect in the second half of this year.

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