India offers reasons for optimism

Key Points 

• With many western economies at risk of recession, India is expected to be one of the world’s fastest-growing economies in 2023  
• Backed by a government keen to support growth, the recent budget revealed plans to boost capital spending in the short term – as well as fighting inflation and reducing government debt in the medium term 
• A better-than-expected earnings season has reinforced the positive mood in Indian equities, after a short period of profit-taking 
• In the bond market, despite inflation trending down of late, geopolitical and economic uncertainty continues to ripple through markets  

With prospects of much faster growth than most major economies this year, backed by a government committed to supporting cautious expansion, Indian equities can help to diversify portfolios in what seems set to be another tough year for investors.

While the rest of the world experiences sluggish growth and high inflation, India has been an outpost of relative economic stability. 

Even as growth in many other leading economies slows, India is forecast to expand by at least 6% in FY-23-24. That said, managing its current-account and fiscal deficits will be a challenge, given the amount of government spending designed to shield the economy from the economic effects of recent global economic volatility. 

India faces making trade-offs between growth and its external balance on trade in goods and services, inflation and fiscal policy. However, monetary policy is likely to help to balance these competing forces. The Reserve Bank of India (RBI) also needs to strike a delicate balance between achieving reasonable levels of growth and minimising deviations from its 4% inflation target, cognisant of maintaining rupee stability.

Competing forces shaping the budget

After three years of government spending aimed at dealing with the economic effects of the COVID-19 pandemic and recent geopolitical tensions, February’s budget for the fiscal year (FY) 2023/24 highlights the administration’s attempts to achieve fiscal prudence while supporting economic expansion. With growth in revenue holding up, the government plans to gradually reduce the deficit while lifting public spending. 

The budget followed a turbulent year for India’s fiscal dynamics, with a surge in subsidies being offset by higher tax collections. As expected, spending on subsidies is to be reduced significantly, affecting those directed at food while moderating fertilizer subsidies. In addition, the government has gradually been withdrawing pandemic-related emergency measures, which should help to keep finances in check in the medium term.

Capital spending remains a key priority for the government, with expenditure likely to be broadly stable and facilitate further fiscal consolidation in FY2023/24. Coupled with softening global commodity prices, the stoppage of the pandemic food distribution scheme should help to create some breathing space. That said, in a pre-election year, there is unlikely to be much desire to increase the pace of fiscal consolidation, with pressure to spend any fiscal surplus to target economic growth. 

The need for more caution on government spending seems critical to debt sustainability in the next fiscal year, given expectations for gross domestic product to ease in FY23/24. This means that fiscal policy will need to be tightened in the medium term, which could add to upward inflationary pressures or push down growth. In turn, this should aid achieving  macro stability in the medium term.

Indian equities offering better value  

Indian equity markets have seen a good bout of profit taking over last two months, while the rest of the emerging market pack has bounced back. Much of this can be attributed to the premium valuation of the domestic market versus the other emerging markets and the expectation of a revival in Chinese growth following the removal in the country’s zero-COVID policy. Foreign institutional investors have sold more than 250 billion rupees-worth of equities, net, in the domestic market during January 2023. 

Fundamentally, the Indian economy has been showing signs of considerable strength, with the consumer price index falling to 5.72% in December and the purchasing managers’ index for each of the manufacturing and service sectors remaining comfortably in expansionary territory. Furthermore, domestic consumption has picked up during the festive season.

Positive earnings season

The latest quarterly earnings from Indian companies have been better than expected for many so far, with growth remaining strong and cost pressures easing. 

Bank earnings outperformed as they benefited from higher credit growth and lower provisions and non-performing assets than seen for several years. Many banks delivered higher-than-expected net interest margins after a period of rising interest rates. However, deposit growth still lags credit growth across the sector and may pose a threat of margins.  

Another sector with earnings that beat expectations was information technology. Despite the pessimism, and job cuts, pervading the industry, especially in the US and Europe as revenue growth slowed sharply, growth remains in the high teens on a year-on-year basis. Moreover, there are signs that the worst of the slowdown may be behind the industry, which should aid margin recovery. 

Infrastructure boon

Given the push by the Indian government to boost spending on infrastructure projects, companies in construction and capital goods remain flush with orders, and execution for these companies remains strong. Further, with buoyant tax receipts, the government has been prompt to pay its bills, leading to good cash generation for organisations in these sectors. Indeed, company expectations of their future performance remain optimistic. February’s budget provided another boost to infrastructure spending. 

Companies with a more domestic focus appear more appealing than those with more international exposure, at this juncture. At the sector level, defence and infrastructure groups, along with those in the capital goods industry, look well placed to benefit from additional capital expenditure. 

Among exporters, information technology groups are benefiting from strong cash generation and deep customer relationships. In the mid- and small-cap universe, companies with a history of generating, and redeploying, capital prudently appear attractive.  

Mixed signals for bond investors

The RBI continues to prioritise fighting inflation, with lowering sticky core inflation, which excludes volatile components like fuel and food prices, being a key challenge.  

Inflation data have trended down in recent months, along with expectations for future inflation levels. Despite the better news on prices, bond investors are likely to remain concerned for some time given the volatile geopolitical outlook and potential for recession in many leading economies this year.

On the monetary side, the RBI has reiterated its commitment to provide timely and appropriate support to bond markets, in terms of boosting liquidity and policy flexibility, as and when is deemed appropriate. 

Given the flattish yield curve, it appears to be a good time to lock in yields. That said, a more cautious approach may be needed, given uncertainties over how much longer the central bank will keep hiking rates for.

Rate outlook

In the short term, a blended portfolio of 3-year sovereign and high-quality corporate assets seems attractive. 

However, over a longer three-year investing horizon, we prefer a blend of 5-year to 7-year sovereign bonds and high-quality corporate assets. While this strategy commands a similar spread over the terminal repo rate, as available on 3-year debt, there is also the potential for capital gains if the rate path is more benign than expected and due to the roll-down benefit over the three-year investment horizon. However, investors should have appropriate risk appetite to remain invested through bouts of volatility.

Asset allocation and diversification key to navigate volatility

After a tough year for investors, 2023 is likely to be another volatile one given the level of uncertainty over inflation, growth and central bank policy. While it may be a struggle, investors should stick to their asset allocation strategy and use any sell-offs as opportunities to rebalance portfolios. Staggering investments into the market could also help during periods of short-term volatility. 

Foreign equity markets appear to be discounting a mild recession, in line with our base case scenario. For investors to look beyond heightened levels of volatility, sustained indications of a pick-up in economic activity will be needed, along with signs that the hiking cycle in interest rates is coming to an end. 

Developed market equities have outperformed emerging markets recently. In the US, earnings are expected to support the markets without providing much surprise on either side of consensus. That said, valuations remain on the high side. Europe, after being engulfed in pessimism, has surprised the most. But, as forecasts are being revised higher, so is the likelihood of disappointments in the future. There seems every chance that the next few months will remain equally as bumpy, until more clarity emerges on interest rate policy, inflation and growth.  

As a revival in the Chinese economy gets underway following the removal of the country’s zero-COVID policy, equities have been quick to bounce, closing the underperformance gap that emerged against other major equity markets in the final three months of last year. That said, the virus was only one of a host of challenges facing China’s growth prospects in 2022. A deeper property market contraction, slowing exports and restrictions on the imports of US semiconductors remain among the potential brakes on growth.

Alternative assets

Private markets look like continuing to offer good opportunities in the coming year to diversify portfolios across both private equity and private credit.

In addition to opportunities in private markets, investing in real estate investment trusts (REITs) and infrastructure investment trusts (INVITs) could help to provide a hedge against higher inflation, both asset classes tending to perform relatively well in inflationary periods. However, investments in such areas should be considered as long-term in nature. 

Gold can also act as an inflation hedge while also usually being a “safe-haven” in volatile times and helping to diversify portfolios. In the current environment, any recession or weaker earnings is likely to dampen investor sentiment and, in turn, be a positive for gold. Furthermore, any weakening of the US dollar, as inflation recedes and interest rates are cut, could act as a support. Lastly, buoyant demand for jewellery also remains a positive for the yellow metal.