India's multi-asset portfolio

Can Indian equities and bonds offer investors some respite in highly uncertain times?

05 September 2022

By Narayan Shroff, India, Director-Investments

Key points

  • While Indian interest rates are back to pre-pandemic levels now to tackle surging inflation, the difference between inflation and real interest rates remains at a record high against developed markets – encouraging more flows into Indian assets
  • On this basis, we remain tactically overweight local equities, especially as we believe that the top in rates and inflation is near, supported by encouraging company earnings
  • Similarly, we are overweight local bonds, with the central bank hiking rates but retaining its economic forecasts. Corporate bonds rated below AAA appear particularly appealing
  • Feeding in allocations of Indian assets over a long period of time may also help to ease investors’ nerves through a period of anticipated near-term volatility for financial markets

This year has been a wild ride for investors, with an equity sell-off in the first half followed by a modest bounce. Persistently high inflation and aggressive interest rate hikes have largely set the tone for sentiment. Through all the twists and turns, heightened volatility looks guaranteed. However, with the economy in relatively fine fettle, can Indian equity and bond markets outperform other emerging markets?

Indian markets face more global, rather than local, issues. And while geopolitical events continue to have a profound influence on local markets, it’s worth keeping an eye on inflation and rate hike concerns over slowing demand and, indeed, the potential for recession.

In line with such worries, the Reserve Bank of India (RBI) is treading with more caution, while keeping its gross domestic product growth and inflation forecasts unchanged.

With prices remaining a key priority for the central bank, domestic interest rates are above their pre-pandemic levels, and appear to offer an increasingly attractive investment opportunity.

The difference between inflation and the real interest rate in India and western developed economies, especially the US, has never been so wide (with developed economies facing bigger inflationary headwinds). If this persists, it may encourage more flows into India, supporting the local currency while also leading to relatively less margin pressures on domestic corporates.

Upbeat signs

High-frequency economic indicators continue to remain robust in India and expectations of the rate cycle peaking, globally and locally, are priced in. The first-quarter earnings season for fiscal year 2023 was broadly in line with consensus and we believe that they should continue to remain supportive over the rest of the year.

While valuations for Indian equities are close to their long-term average, foreign flows into the market, which have rebounded since July, and domestic flows are likely to boost investor sentiment.

Indian equity prospects continue to look good

We maintain a tactically overweight stance towards domestic stocks and believe that inflation and the rate hiking cycle are peaking, a view that is being priced into current valuations. Key commodity prices appear to be softening from their recent peaks, including Brent crude (more Iranian oil could lift supply soon, supporting the downward pressure on prices) and industrial metals.

The latest corporate earnings results show little signs for worry, coming in largely as expected for most sectors. Furthermore, the risk of earnings downgrades does not seem strong. We expect earnings growth to remain supportive in the near term.

With the NIFTY 50 index of the largest 50 domestic companies trading at around 20-times its one-year forward price-to-earnings (P/E) ratio, it is not expensive relative to the long-term historical average (especially when factoring in the change in index constituents towards more high P/E companies over this period).

India’s NIFTY VIX (the volatility index for the NIFTY 50) has fallen in the last few months to 17-19%, from being in the 23-25% range for much of May, which points to less volatile times ahead.

Supportive broad-based flows

With healthy flows from international investors into Indian equities, after a period of outflows, they should help valuations. The key question is will such investors differentiate between generic emerging market allocations and Indian ones?

We continue to assign equal preference to both large-, mid-, and small-cap stocks. Our preferred sectors are banking and financial services, IT services, materials (such as specialty chemicals), and consumption (including consumer discretionary sectors like automakers).

Overweight stance on debt

The RBI hiked the repo rate by 50 basis points to 5.40% at August’s Monetary Policy Committee meeting in an attempt to rein in inflation and to anchor inflationary expectations. Both remain a concern, along with the broad-based nature of inflation across industries. The central bank also retained its growth and inflation forecasts for this fiscal year at the meeting.

We believe that the cycle may be a relatively short, but intense, one. We seem close to the end of this cycle. Given the RBI’s inflation concerns, the peak repo rate may be 5.90%. As such, market sentiment could improve as investors adjust to a “pause mode” in the cycle. In light of this, we have turned tactically overweight debt, up from neutral.

While the rate curve for government bonds has flattened as overnight rates increase, the mid- to long-end of the government bonds rate curve continues to offer an appealing term premium.

Corporate bonds increasingly appeal

The spreads between the AAA-rated corporate bonds and “G-secs”, or government bonds, have been volatile recently. While the 10-year and longer maturity bonds have seen spreads contract due to consistent demand from domestic institutional investors, the two-year to five-year maturity segment continues to provide good spreads over the G-secs of respective maturities.

As such, we believe that a blend of corporate bonds and sovereign instruments with a portfolio duration of around three to five years may be preferential over a medium- to long-term investment horizon.

For investors with the appropriate risk appetite, bonds rated below AAA are starting to look appealing. While the opportunity may improve in coming months, it may be more prudent to consider capturing the yield on such bonds, on a staggered basis. Feeding in allocations over time may also help ease investors’ nerves through a period of near-term volatility for financial markets.

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