Indian economy looks to keep calm and carry on

Key Points

• India’s economy seems on track to grow more than other leading economies this year, aided by a growth-focused government with commitment to boost capital spending, falling commodity prices, especially oil, improving external balances and robust domestic services and consumption
• India’s central bank is expected to join others in continuing to hike rates at its next meeting, in April. Beyond that increase, and with inflation pressures appearing to ease, the focus will next be on how long rates are kept on hold
• Despite the recent sell-off in Indian equities, long-term prospects are promising, supported by powerful earnings growth and a dynamic economy. Domestically oriented commodity consuming companies seem well placed, with the potential to expand their margins further
• Leaving aside bond market volatility and inflation concerns, positive real interest rates are an encouraging sign for bond investors. A blended mix of 3- to 7-year corporate bonds and sovereign debt seems preferable at the moment, with the window to lock in rates expected to close in sooner.

In the year or so since Russia invaded Ukraine, geopolitical risk uncertainty has been more of an issue, adding to the general heightened uncertainty seen around the path for interest rates, inflation and economic growth around the world. The collapse of tech-focused Silicon Valley Bank in the US and Credit Suisse in Switzerland has added to the malaise, as volatility spiked across financial markets.

Despite the cocktail of troubles facing policymakers, the US Federal Reserve and other leading central banks continue to stay the course in delivering rate hikes to fight inflation. That said, given the recent troubles in the banking sector and subsequent tighter monetary conditions, this may lead to a lower peak in the hiking cycle. Either way, a higher-for-longer rate pause cycle remains the base case for most central banks.

Although the reopening of China’s economy should boost global economic growth this year, the International Monetary Fund (IMF) has trimmed its global growth expectations to 2.9% in 2023, from 3.4% last year¹. That said, India remains a bright spot. The country is expected to grow more quickly than any other leading economy this year and next, according to the IMF.

Domestic economic prospects

India’s domestic financial system has weak global linkages, and the recent fall in commodity prices, especially for oil, if sustained, should be positive for the economy. Expanding export capacity, backed by an improving goods and services deficit, bodes well for the country’s growth prospects.

On the fiscal side, the need to manage inflation through fiscal measures has diminished and the government seems to be focusing more on upping capital spending.

Economic indicators, particularly those linked to domestic services and consumption, are holding up well, given the tough conditions facing the global economy. While there is scope for further pass-through of recent rate hikes to borrowers, the domestic growth outlook remains encouraging. India is expected to grow by 6.3% in fiscal year 2023-24 (up from 6%) and 6.5% in FY 2024-25 (unchanged).

Indian equities offer shelter, as storms brew

Indian indices have corrected by around 8% since their all-time high in December, largely driven by the equity markets’ reaction to stubbornly high inflation, domestically and elsewhere, despite central banks lifting rates in efforts to dampen demand.

The collapse of banks in the US, along with Credit Suisse’s takeover by UBS, further added to the general turn in sentiment among investors. That said, the Nifty50 index, of the highest capitalised stocks in the country, still trades very close to its ten-year average of 18.6-times one-year forward earnings, according to Bloomberg.

At these valuations, and considering the attractive local bond yields available, the equity risk premium available seems insufficient to compensate for any further pressure on global flows into Indian stocks.

Having said that, Indian equities offer investors refuge from troubles seen in many other markets. Earnings growth for Nifty50 constituents is expected to be a healthy 14% in fiscal year 2023-2024, powered by better macroeconomic stability, strong domestic demand, high infrastructure and capital spending, encouraging credit growth and cleaner bank balance sheets.

Better placed than others

Despite the sell-off in local markets this year, Indian equities offer promising long-term prospects. Domestically oriented commodity consumers, like infrastructure, capital goods, consumer goods and consumer discretionary sectors seem well placed, with the potential to expand their margins further.

By contrast, non-Indian equities may struggle in the short term. Given the heightened uncertainty in the banking sector, inflation outlook and central bank policy, non-Indian equities have been downgraded to underweight (within India-specific tactical asset allocation), with a preference for US equities over those in Europe and China.

Debt maintained at overweight, despite inflation concerns

Despite facing opposing pressures across persistent and above tolerance inflation prints, as well as the risks to growth from global financial stress events, the Reserve Bank of India (RBI) may hike the policy rate by 25bp to 6.75% in April.

Beyond that, further hikes seem unlikely as lower commodity and input prices should help nudge Indian inflation lower. That said, the prospect of the RBI making any rate cuts this year seems limited, not least given the need for central banks to remain vigilant. Meanwhile, market liquidity should remain healthy, and the fiscal deficit seems to be on track to meet budgeted estimates.

Bond markets, as with equities, have been particularly volatile this year, though the supply of sovereign, state and corporate bonds are well supported by demand for debt investments. While elevated inflation remains a concern, positive real interest rates are an encouraging sign.

The term curve has been little moved over recent months and remains relatively flat. This provides an excellent backdrop for locking in rates while it remains an option.

Also, spreads between AAA-rated corporate bonds and government debt have been stable, aiding the appeal for a balanced allocation. A blend of 3- to 7-year corporate bonds and sovereign debt seems preferable. For investors with the appropriate risk appetite, the non-AAA segment has started to look more attractive from an accrual perspective. With the yield curve relatively flat, even at the front end, cash and ultra- short term debt yields seem relatively attractive.

Alternative assets

The volatility seen in markets around the world in March, and in India for much of the year, highlights the importance of diversifying portfolios to reduce long-term investment risk. As such, private markets provide opportunities to make portfolios more diversified.

With inflation stubbornly remaining high, investing in real estate investment trusts (REITs) and infrastructure investment trusts (INVITs) should provide opportunities to hedge against higher inflation. Indeed, both asset classes might offer shelter should a period of low growth and high inflation emerge (known as stagflation). Furthermore, a recent sell-off in REITs and INVITs makes their valuations more reasonable. That said, recent taxation changes may act as a short-term drag on performance.

March highlighted that this may be a particularly volatile year, given the level of uncertainty over the outlook for global growth, inflation and interest rates. And as exemplified in March, gold generally provides a “safe-haven” for investors at such times, while also acting as a portfolio diversifier or inflation hedge.