Asset classes – Indian multi-asset portfolio allocation
09 May 2022
By Narayan Shroff, India, Director-Investments
Global financial markets are in a volatile mood in the face of the Ukraine-Russia conflict, growing inflationary pressures and expectations, and rate rises by several central banks. A resurgence of COVID-19 cases in China adds to the gloom.
In a marked contrast from its February stance, the Reserve Bank of India (RBI) has changed gear and shifted its priority to managing inflation (over growth).
In April the central bank tightened policy by 40 basis points (bp) by making the Standing Deposit Facility (SDF) effectively the floor for the overnight rate. Then, in a surprise move in early May, the RBI tightened liquidity by raising the Cash Reserve Ratio (CRR) by 50bp and hiked the repo rate by 40bp to 4.4%.
While the policy stance remains accommodative, the latest adjustments show the RBI's intent to gradually tighten policy towards pre-COVID levels. The central bank has also reduced its gross domestic product growth projections and increased inflation expectations sharply.
The central bank's monetary policy continues to focus on the volatility and risk posed by global macro and geopolitical factors, the impact of supply-chain shocks, second order economic impacts, and the added costs being passed to consumers, while also recognising the resilient and broadening growth indicators being seen.
As elaborated in April’s Market Perspectives, we expect inflation to moderate later in the year, and policymakers may ease aggressive front-loaded rate hiking to target a soft landing for the economy.
In India, we believe that as the recovery broadens, prospects look promising. Furthermore, with the fiscal room available to mitigate the effects of higher prices, domestic equities appear better placed to weather a period of higher inflation and rates than many other markets. Even debt markets are starting to throw up opportunities, especially given the heightened uncertainty seen of late.
Indian equity markets have been performing in line with global markets on the back of Russia’s invasion of Ukraine, hitting demand-supply imbalances for many commodities (such as energy, metals, and food baskets) and thus worsening inflationary pressures around the world. Moreover, warnings from leading central banks of an aggressive rate hiking cycle, and with the latest set of actions of the RBI, have contributed to the volatility.
Corporate earnings continue to be a key trigger for sentiment in Indian equity markets. The latest quarterly earnings season seems to suggest that underlying demand remains vibrant, while cost pressures are worsening. While some downgrades are expected, positive hints on underlying demand, as also noted by the RBI governor in his off-cycle policy statement around improvements in consumption and investments activity, resilience in exports, and a strong balance of payments, would support markets. As such, we remain constructive on Indian equities from medium- to long-term perspective.
Given the heightened uncertainty seen in markets, volatility and sector rotation may be the order of the day. A diversified portfolio strategy balanced across both defensive growth sectors and structural growth sectors may help sail through near-term uncertainty. We continue to prefer active management with a focus on “quality” companies, or those with sustainable businesses and the potential for strong long-term earnings growth, with an equal preference for large caps and mid caps.
We retain our view that the peak policy rate in the current rate hiking cycle are likely to be lower than in the last one. The RBI may continue to hike rates and we expect the repo rate to reach around 5.25% in the medium term, when the central bank may look to reassess the macro conditions, especially from the demand-led inflation perspective.
We maintain our view that rates of around 7.25% for benchmark 10-year government bonds may be appealing in terms of adding duration. If we assume a medium-term peak repo rate of 5.25%, a term spread (10-year government bond rate over repo rate) of more than 200bp would be on the higher side of historical data in a rate pause environment, and might offer good accrual opportunity in the medium- to long-term.
In the short- to medium-term, we prefer bonds in maturities of 3-7 years with the flexibility to add duration as the yield curve changes. Again, assuming a medium-term peak repo rate of around 5.25%, a term spread (5-year rate over repo rate) of more than 100bp would seem high by historical standards in a rate pause environment, and appears appealing at current term spreads at 200-250bp.
With the bond supply overhang persisting alongside a front-loaded rate hiking cycle, opportunities may emerge in corporate bonds as the spreads widen.
However, investors should have appropriate risk appetite to remain invested through intermittent volatility. Staggering allocations may also help sail through this period.
We remain constructive on global equities and believe that they remain relatively more appealing than bonds for now. Yet, we are highly selective in allocations, and in line with our long-term investment philosophy, our portfolios remain geared towards high-quality businesses.
More opportunities seem to be available in developed market equities compared to their emerging peers. While Chinese authorities have attempted to calm markets by striking a more reassuring tone, much more will likely be required before investors’ confidence is restored. That said, Chinese assets may surprise on the upside in the second half of this year.
We reiterate the importance of diversification, time-in-the market (rather than timing the market) and active management, especially in such volatile markets. The medium-term themes highlighted in our Outlook 2022 in November still look attractive and offer one way to help navigate through all 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 – More adoption and demand for technology, aided by pandemic trends; 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 REITs/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, 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; traditionally less affected by rate-hiking (normalisation) cycles; but prudent selection, diversification, and monitoring remain key
While in 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.
Diversification is particularly important in riding out highly uncertain times while managing risk levels. Gold is known for its safe-haven credentials and as an inflation hedge. So it can be a welcome portfolio diversifier in troubled periods. The yellow metal is more likely to preserve wealth during periods of turbulence and act as a diversifier, rather than grow portfolios over time.
Welcome to the May edition of "Market Perspectives". This month we take a look at the implications of elevated inflation for equities and bonds, how private markets can help you navigate rising inflation expectations, and what investors can do to protect their portfolios in the face of stock market turbulence.