India’s multi-asset portfolio allocation

• India’s economy is on track for fast growth, providing global uncertainties don’t weigh on demand in the near term
• Unlike the declines seen by many of its global peers, local equity markets have shown much resilience this year, boosted by the government’s growth agenda
• India’s growth story also remains intact, with many parts of its economy gathering momentum
• The biggest worry is high inflation, which may force the Reserve Bank of India to hike rates further

Indian equities: a bright spot in stormy times? 

As many countries skirt a recession, India is on track for strong growth in 2022. Similarly, domestic equity markets have been resilient in the face of persistently high inflation in much of the world and aggressive rate hikes. With the authorities supporting a growth agenda and inflation set to ease, the outlook for India and its financial markets looks bright.  

Geopolitical risks, elevated inflation, and the pace of rate hikes are likely to continue dominating the headlines and market sentiment. Any escalation of military conflict, or a new outbreak, does not seem to have been priced in by financial markets and is a key tail risk. 

Inflation appears to be peaking in many countries, but is likely to remain higher for longer. Structurally as well, inflation is likely to find support from increasing de-globalisation, more restrictive trade policies, and continuing sanctions of key commodity suppliers like Russia.  

In monetary policy, interest rate hikes are likely to cease at higher levels during 2023. The impact of interest rates on the economy is likely to kick in next year. In addition, liquidity tapering – across both monetary as well as fiscal fronts – and a global recession, especially across Europe and to lesser extent the US, looks probable.

Indian economy 

India has maintained a balanced geopolitical stance and is likely to profit from global trade diversification efforts by leading economies. We expect gross domestic product (GDP) growth to be close to 7% for the 2022-2023 fiscal year, then at least 6% in the following two fiscal years. This is backed by strong consumption and continued taxpayer support (especially with national elections due in 2024).  

While investment in the country has returned to pre-pandemic level, there still seems much scope for expansion, aided by stronger bank balance sheets, growing capital goods production, and more public investment. Lag indicators, such as credit off-take, employment, and wage growth, support the sustainability of growth. 

That said, tighter financial conditions, domestically and globally, may dampen sentiment, especially as the central bank drains liquidity. Compared with many other major economies, the tightening in India in 2022 was more restrained. This bodes well for companies’ capital expenditure (capex), including private investments. 

We believe that the worst is now behind us in terms of inflation, as the pace of price gains eases, and that it will average 6.5% (based on the consumer price index) in this fiscal year. 

Equities 

Backed by encouraging local GDP growth, Indian equities have shown much resilience this year, compared to the slumps in valuations seen among global peers. This trend is likely to continue in the coming twelve months. 

Although not our base case, a key risk remains of persistently higher imported inflation, especially if oil prices shoot up, or if the rupee suffers a sharp depreciation. 

Overall, liquidity tapering by leading central banks is expected to add to downward pressures, squeezing the availability of capital and increasing the cost of it.  

However, we anticipate that global and local investment risk allocations to keep supporting flows into Indian equity markets, albeit the quantum of domestic activity may not be enough to compensate for any sharp global outflows. This is especially the case as local bank deposit rates and bond yields now appear attractive for domestic retail investors. 

Fall in cost of capital 

There seems to have been a structural fall in the cost of capital for Indian companies, aided by its more competitive global status, prudent fiscal and monetary policies, and recent fiscal reforms. 

Thus, we expect domestic equities to keep outperforming local debt markets in 2023. That said, with valuations around their long-term averages, high volatility with frequent rotations across sectors and themes may be a theme of next year. 

Sector insight 

As covered above, after a long hiatus, a capex and manufacturing boom cycle appears likely in the country, well supported by positive reforms, policies, and incentives. A wide variety of segment leaders across cement, power, defence, industrial construction, chemicals, and energy transition are well positioned to provide superior earnings growth in coming years. 

Consumer sector 

With one of the largest and fastest growing consumer markets, we expect to see more focus from investors on the Indian consumer sector. Higher spending by the central and state governments, agricultural growth, as well as travel and leisure, retail, and construction activity are likely to support higher employment and wage growth, supporting high-street demand. Buttressed private capex flows should further accelerate this trend. 

Staples

Among consumer staples businesses, “premiumisation” is expected to drive demand in urban India. Meanwhile, sustained growth in rural India, coupled with price easing in key commodities such as crude and palm oil, could lead to margin expansion for fast-moving consumer goods area. Quality companies will likely benefit from a shift to the “organised” sector from the “unorganized” one. 

Durables

Consumer durables will likely be backed by growth in disposable income as the number of middle-class members and per capita income expands, a relatively young population, more urbanisation, and a boost in female employment numbers. This should play out across white goods, fashion and accessories, and home improvement, amongst others. 

Auto manufacturers

The auto sector should benefit from an ongoing easing in the shortage of chips seen this year, along with increased demand for passenger vehicles and two-wheeler volumes. A nascent switch to electric vehicles from fossil-fuel-powered alternatives should also provide opportunities for manufacturers. 

E-commerce 

Improving digital infrastructure and adoption should keep fuelling growth for goods and services delivery e-commerce platforms. Investor sentiment towards this segment and rising valuation discounting rates will probably keep valuations under pressure, especially for the loss-making companies. 

Financials 

The banking and financial services sector is expected to benefit from the surge in interest rates seen in 2022. It remains a high-beta play on the Indian economy. In addition, the banking sector is stronger financially after the recent consolidation activity seen among banks.  

The amount of non-performing assets is at its lowest levels since 2016¹. Large lenders should continue to benefit from higher lending rates, a lower cost of liabilities, more cost-saving measures, and enhanced market share, aided by better digital infrastructure and digital adoption. 

Other sectors offering select plays 

IT services, domestic-oriented pharmaceuticals and healthcare, real estate, infrastructure, and logistics sectors are expected to perform in line with the market next year. However, those with the biggest market share should continue to boost this share and command premium valuations. 

Active management 

We believe that active fund managers will continue to struggle to beat benchmarks in the first half of the year, but if more clarity emerges around inflation and recessionary impulses, along with geopolitical and currency uncertainties, the second half of the year may be a better hunting ground for “bottom-up” stock pickers. 

Debt markets 

Domestic fixed income assets will likely keep offering high accruals in the 3-7-year segment of the yield curve. Given our constructive view on the economy, certain high yield segments are expected to offer attractive opportunities to enhance portfolio yield. 

We believe that the terminal repo rate will lie in the range of 6.25-6.5%. However, even if we assume a terminal repo rate of 6.5%, a blended portfolio of 3-year sovereign bonds and high-quality corporate assets, with an investment horizon of at least twelve months, looks appealing tactically. Indeed, that view appears stronger with the spreads over terminal repo rate at around 100 basis points. 

Blending 5-year sovereign bonds and high-quality corporate assets with a more strategic three-year investment horizon may be another way to play the above view. While this strategy has a similar spread over the terminal repo rate (flattish rate curve), it could produce gains should the rate path be more benign, due to the roll-down benefit over the investment horizon. 

Rate pause anticipated 

We expect to see a long pause for interest rates in 2023, but would keep an eagle-eye on any growth-led inflationary impulses that may push the central bank to hike rates again.  

The interest rate curve may “bear steepen” towards the middle of the year, with longer-end rates still under pressure from increased bond supply (persistent government spending ahead of elections in 2024 and increased private credit demand) and the central bank’s draining of liquidity stance not supporting the case for the Reserve Bank of India to conduct much of its open market operations purchases.  

Global listing and/or inclusion in global bond indices of Indian government securities may also boost sentiment in the bond markets in the second half of 2023. 

We expect credit spreads to widen and create occasional opportunities to increase exposure to the sector. 

Asset allocation and diversification key to navigate volatility 

After a tough year for investors, sticking to your long-term asset allocation strategy is key, while keeping an eye on opportunities to rebalance portfolios in market sell-offs.  

Foreign equities, especially in developed markets, have seen sharp corrections in 2022. With the markets priced for worst case scenarios, this may amplify opportunities to capture appealing risk-adjusted returns and diversification opportunities. 

Private markets have cooled off from the frenzy seen in 2021 and early 2022. However, they should continue to offer opportunities to diversify portfolios in private equity and private credits. 

In real assets, exposure to real estate investment trusts and infrastructure investment trusts can act as an inflation hedge, while gold backed securities can act as both an inflation hedge and a safe-haven in volatile times, while also helping to diversify portfolios. 

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