At a volatile moment for financial markets and with surging rates and a global economy on the ropes, India stands head-and-shoulders above many peers, with an economy that is recovering well and relatively subdued interest rates. With positive earnings growth in the pipeline and many companies well-placed to profit from long-term structural trends, Indian equities offer a happy hunting ground.
India’s economy stands out from the pack as global economic prospects weaken and central banks hike rates aggressively. The economy’s relative outperformance is at least partly fuelled by chunky fiscal (including tax cuts and subsidies) and monetary support, helping consumer spending and corporate investment.
In comparison with other Asian emerging markets, India has more food security (turned food exporter), deleveraged private sector balance sheets, and a more domestically-oriented economy. In addition, the government has more room to use fiscal tools to mitigate the price shocks being seen across Asia, such as elevated inflation and soaring interest rates.
Central bank keeps its foot on the accelerator
With its latest hike of 50 basis points (bp), the Reserve Bank of India (RBI) has effectively tightened policy by 240bp (including a 50bp rate corridor reduction). The central bank may now look to let the effects of the hikes work their way into the economy, review the domestic growth-inflation dynamic, and keep an eye on commodity prices (especially crude oil prices) and global monetary actions (especially in the US and Europe).
The changing domestic macro debate around rates is also likely to be driven by the current account deficit, which we expect to remain elevated through fiscal year 2022-23.
Following a dip in forex reserves, the rupee may remain under downward pressure. The pass-through from lower commodity prices will be moderated by the recent currency depreciation. That said, we expect forex weakness to only reduce, not fully offset, the favourable effects of lower commodity prices, thus keeping imported inflation firmly on a downward trajectory.
This may give the government some room to claw back some fiscal space, which shrank after it cut taxes and introduced subsidies to manage inflation. Fiscal policy could also blunt the eventual pass-through from softer global prices into retail prices.
More room for macro outperformance
We expect Indian economic output, as measured by gross domestic product, to be close to 7% for this fiscal year, then at least 6% in the following two years. This is backed by strong consumption and continued fiscal 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.
That said, tighter financial conditions, domestically and globally, may dampen sentiment, especially as liquidity is drained. Compared with many other major economies, the tightening in India has been more restrained. This bodes well for capex.
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% (CPI) in fiscal year 2022-23.
Base case looks secure despite economic risks
While strong growth statistics do feed optimism about India’s macro outlook, rapid growth brings its own issues. Risks to the country’s macro stability mainly come in three forms: a higher current account deficit, stickier fiscal deficits, and elevated price pressures (especially as the room for wiggle narrows). These three indicators are not particularly kind for India at the moment. That said, our base case remains of a continuing favourable overall macro backdrop in India.
Upbeat prospects for Indian equities
We are overweight Indian equities. We believe that, at least in the near term, macro risks like surging inflation, rate hikes, and recession fears will overhang market sentiment. These may influence foreign flows and in turn drive valuation metrics. However, over the medium- to longer-term, corporate earnings growth is likely to remain the leading driver for equity markets.
We believe that there has 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 fiscal reforms seen in recent years. We expect this trend to continue in the medium- to long-term.
Sector winners
The banking sector, while a high beta play on the Indian economy, is in fine fettle after recovering from the impact of low credit growth, high corporate bad debts, and the crisis in the non-banking financial companies sector. Indeed, banks’ non-performing assets are at the lowest level since 2016, laying the foundation for more risk-taking capacity.
We remain positive on the information technology sector, supported by the long-term trends around digitisation, artificial intelligence, the Internet of Things, and cloud computing. In the near term, we believe that concerns around margins in the sector are overdone.
Companies targeting domestic consumption are also likely to perform well, given that the country has strong demographics, increasing purchasing power, and low household debt, across both consumer discretionary and non-discretionary businesses.
Finally, in terms of transitioning to a low-carbon world, we are upbeat on prospects for those companies profiting from trends around electric vehicles, recharging infrastructure, ethanol blending, and green power, which have government support, and should continue to attract capital at lower cost.
Maintain an overweight stance on debt
We are overweight domestic debt primarily to take advantage of the high accruals in the three- to five-year segment of the yield curve. Given our constructive view on the economy, we have upped exposure to certain high yield segments to enhance portfolio accruals.
We believe that the terminal repo rates may be in the range of 6.25-6.40%. While acknowledging the risks of more rate hikes based on more details on economic data and inflation needed to support the case, our base case remains for the RBI to be on hold for now.
However, even if we assume a terminal repo rate of 6.50%, a blended portfolio of 3-year sovereign bonds and high-quality corporate assets, with an investment horizon of at least a year, looks attractive tactically. Especially with the spreads over the terminal repo rate at around 100bp.
It may also be worthwhile considering blending 5-year sovereign bonds and high-quality corporate assets with a more strategic three-year investment horizon. While this strategy has a similar spread over the terminal repo rate (flattish rate curve), it could produce gains if the eventual rate path is more benign, due to the roll-down benefit over the three-year investment horizon.
Asset allocation and diversification key
Especially volatile markets seem to be the only constant at the moment. It might be tough, but investors should stay invested, stick to their asset allocation strategy, and use any sell-offs as an opportunity to rebalance portfolios. Staggering allocations may also help in sailing through this period of short-term volatility.
In real assets, exposure to real estate investment trusts and infrastructure investment trusts can provide an inflation hedge, while gold exchange-traded funds act as both an inflation hedge and a safe-haven in volatile times, plus helping to diversify portfolios.
