The prospects for Indian equities seem to be improving, aided by healthier prospects for the manufacturing sector, and a relatively accommodative central bank. They appear better placed to weather the anticipated storms from elevated inflation and higher rates than many other markets. Staggering investments, appropriate diversification and active management should help to add to risk budgets through satellite allocations.
Markets seem to be behaving to the playbook we laid out in our Outlook 2022. Indeed, COVID-19 curveballs, inflation scares, and the pace at which monetary policy is normalised are the three key vulnerabilities and risks which we highlighted for India’s economy. The country has demonstrated strong resilience to the spread of the Omicron variant, and we continue to believe that this year is likely to be characterised by slower growth, higher inflation, and elevated volatility.
While it is difficult to predict so-called black swan events, such as Russia’s conflict with Ukraine, the risks to the Indian economy, and markets, emanate more from any impact of high oil prices and from other imported inflation components. Imported items have a 10% weighting in India’s consumer inflation index (CPI), according to Barclays economists. But they contribute to almost half of the headline retail inflation numbers.
On the other hand, the remaining 90% of the CPI basket continues to generate little additional upward inflationary pressure. The latest forecast of a normal monsoon from Skymet, an Indian weather-forecasting company, points to favourable guidance on food prices in the country.
All eyes on the speed of rate hikes
We expect headline inflation prints in many leading economies to moderate in the second half of the year. But whether this would be fast enough to deter central banks from aggressively lifting interest rates and reducing systemic liquidity is a moot point. This may create further pressure on economic growth in developed markets, although an imminent recession appears a remote possibility for now.
In India, we believe that the market is pricing in too many rate hikes. The Reserve Bank of India (RBI) left rates on hold at its last policy meeting, seemingly reinforcing its accommodative credentials. However, local bond investors keenly await some guidance on how the RBI, as a banker to the government, plans to manage a high supply of government bonds due in the coming fiscal year, especially with the bond-buying programme, through Open Market Operations, being contradictory to reducing liquidity.
In February’s budget for the fiscal year 2022-23, the government continued to prioritise sustainable growth, with modest fiscal consolidation to support the economy. The 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.
The current volatility in the Indian equity market is probably more down to geopolitical tensions, rather than any, fundamental, growth concerns over medium to long term. In the short term, the Indian equity market is likely to move in line with global ones. However, over the medium- to long-term, local stocks appear to be in a better position, given the positive earnings growth being seen and that is likely to persist.
The so-called Nifty50 earnings, those from the 50 largest Indian companies by market capitalisation, are forecast to rise by compounded average growth rate of 21% between fiscal years 2021 and 2024. Such expectations, and plentiful liquidity, provide ample support.
The resilience of equity markets to negative surprises may be further aided by strong domestic inflows, progressive government policies, and improving economic indicators. We believe that the cyclical growth returning to the Indian economy has some legs to go. The government’s thrust to offer the production-linked incentive scheme (PLI) to various sectors has improved confidence among entrepreneurs, helping to underpin growth prospects. Additional capacity can be seen being created in most sectors too, helping create a manufacturing-led recovery in India.
Outlook for manufacturing sector improves
Banks with strong corporate loan books, non-banking financial companies, domestic cyclicals, like utilities, commercial vehicle manufactures and some lenders to them, along with real estate, look well positioned to benefit from a resurgence in manufacturing. Similarly, attractive businesses in the capital goods and engineering sector may also see premium valuations, irrespective of whether inflation stays elevated or not.
Manufacturing related to the defence sector may present a long-term growth opportunity as more defence equipment is made locally rather than being imported. Similarly, there are openings in the green and sustainability themes in the country.
Businesses that benefit from themes such as formalisation, financialisation, and digitisation in the economy continue to attract investor interest. Similarly, businesses benefiting from innovative business models and global supply chains diversification continue to appeal.
Local equities raised to overweight allocation on a 12-month view
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 continue, in terms of geopolitical risks, upcoming state assembly elections, near-term inflationary pressures, and the US central bank’s more hawkish stance on interest rates. In turn, any of these risks could prompt spikes in volatility, potentially providing 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.
This year is likely to be of two halves, with the first being one of stable reference rates (like the repo rate), but 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.
Indian bond markets are expected to remain volatile throughout this year. Geopolitical events, elevated commodity prices (especially crude oil) and the US rates trajectory are likely to add volatility to domestic bond markets.
Assuming that we see a normal monsoon season and that the inflation trajectory is manageable, 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.
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 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. Post-normalisation of rate policy, the competitive environment within sectors may change, so relatively lower-credit bond investments need careful analysis.
We remain biased to sectors that stand 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.
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.