Cautiously pushing the boundaries

The narrative around the pandemic in India remains the same: increasing numbers of coronavirus cases recorded, a seemingly good rate of recoveries and relatively low mortality rates. While fears of renewed regional lockdowns remain, this is being countered by a strong belief that the government cannot afford the economic impact of stricter containment measures.

Hopes remain high, however justified or not, that with a self-restraint culture, an evolving healthcare system and belief that a successful vaccine can be found and administered at a larger scale soon, revival should sustain. Sentiment is also being aided by signs of improving economic activity, as indicated by high frequency data sets, including mobility and employment figures, and a pick-up in sectors like auto, steel and cement.

Supply restored, but will demand follow?

While any supply side fears seem to have almost abated, including production, supply chains and labour migration, prospects for the recent rise and further revival in demand remain bleak.

Investments, both private and public, are unlikely to pick up significantly in the short term, with:

• demand (both business and consumer) sentiment remaining low,
• high inventory and capacity build up in the economy, and
• fiscal constraints limiting government capital expenditure, which is likely to be more pronounced across state governments and government agencies (while questions remain about the sustainability of increased fiscal support beyond fiscal year 2021).

Indian exports and trade balances are expected to improve over the next few years, especially with the benefits offered by global trade realignments and supply chain diversification, growing demand for technology, healthcare and pharmaceuticals and increased government support to promote exports of agriculture and rural produce. However, these may not be enough to offset the negative impact of an anticipated global slowdown on Indian exports.

Consumer sentiment remains key

Domestic consumption, at least for the next two years, remains the key driver for growth in India. However, a question that remains in many people’s mind is “what will support sustainable growth in consumption/demand?”. The following important clues may help answer this question:

• Disposable income: while the overall outlook for employment and income is weak, inflation seems to be well behaved and may reduce further
• Consumer sentiment: as sentiment weakens, any pick-up in disposable income could be directed more towards savings than immediate consumption
• Credit demand: higher consumer credit growth remains vital for sustainable domestic growth. Indeed, this factor has been a growth driver for the country with higher penetration levels seen over the last decade. Furthermore, a policy of ”lower for longer” interest rates should support a pick-up in credit.

As such, consumer sentiment (in turn dependent on the business, employment and income outlook) remains the most critical factor to watch out for in India. A recovery here can be sharp, considering the highly elastic levers of higher disposable income, increased savings (and with lower savings returns encouraging consumption) and a healthy credit culture. Considering the higher resilience seen in the rural economy, for now, demand may rise faster in rural segments and in discretionary consumption of low value items.

Indian equities

While valuations, especially at the larger, “blue chip” index levels, continue to remain uncomfortably rich, these might need to be evaluated using different lens now:

• The index composition has changed significantly over the years in favour of companies that have typically had higher price-to-earning (P/E) ratios. So, a comparison with historical P/E ratios using the respective historical index composition could be incorrect
• While it is difficult to establish a correlation between interest rates and equity valuations, historically low interest rates and a lower for longer outlook should affect the discount rates used by analysts in discounting future cash flows of companies
• If the composition of the current Nifty 50 or Sensex indices are broken down, any sharp sell-off in these Indian indices, even if also seen in the emerging markets more generally, remains unlikely as:
  
  • IT and pharma are global favourites, a trend amplified in the pandemic and that is expected to sustain after the COVID-19 crisis passes;
  • some sectors, especially in manufacturing, are expected to profit from a rebalancing of global trade;
  • the largest weighted companies in these indices continue to attract significant capital flows from foreign investors; and
  • financials continue to be the largest weighted sector and have already seen a sharp sell-off over the last few months, making valuations appear somewhat cheaper.

Market breadth expected to improve

We continue to prefer “quality” stocks and believe that this basket will be increasingly influential across various market capitalisations. The recent directive by the Securities and Exchange Board of India aimed at better aligning multi-cap mutual fund portfolios towards mid and small-cap stocks by January 2021, should continue to support smaller capitalised stocks.

Flows to Indian equities should continue to be supportive, both in the primary and secondary markets. With important geopolitical developments globally in coming months, both at home and overseas, investors may need to have a higher appetite for volatility per unit of risk premium. With sharp sector and cyclical rotations possible in equity markets before the year is out, active management and a staggered incremental investment approach appeals.

Fixed income

We expect the Reserve Bank of India (RBI) to continue with its accommodative stance and keep ample market liquidity. With over 115 basis points (bp) of rate cuts behind us, headroom for more rate cuts appears limited to 25-50bp at most. However, the RBI also has an extensive toolkit of measures at its disposal to influence market rates.

Expectations of continued government spending, in the face of lower public revenues is likely to result in fiscal slippage at a consolidated level. In turn, this will probably mean increased supply at the longer end of the yield curve, reinforcing our neutral stance on domestic debt and attractions of high-quality assets at the shorter end of the curve.

Banking on accruals and roll-downs

As India comes out of the debt moratorium, we are likely to see a relative normalisation in the credit environment. However, breaks in supply chains and some demand destruction may lead to increased corporate vulnerability. In line with our views, we prefer high-quality instruments and roll down strategies might be used to take advantage of the shape of the yield curve. Higher accruals and curve steepness can provide partial insulation to any adverse interest rate movements due to higher duration risk.

Quality and liquidity baskets expanding

In the post-moratorium environment, companies that have sound business policies, proven track records, ability to leverage at competitive levels and manage their assets efficiently are likely to be well placed to expand margins and gain market share.

Several such businesses have navigated stressed market conditions by successfully reducing their liabilities as balance sheet sizes shrink. In case of such issuers, an important distinction which emerges, is the relative lack of liquidity caused by lower supply coinciding with a lack of sellers (who prefer to hold on to instruments of these issuers rather than sell at higher yields). Such issuers remain part of our bottom-up approach towards credit, including issuers in sectors which are currently seen as stressed (such as non-banking financial companies).

In a lower for longer rate environment, it may be worth considering increasing the number of issuers that merit inclusion in the ”high quality-less liquidity” category and to search for opportunities in this expanded universe in the near future.

Investments can fall as well as rise in value. Your capital or the income generated from your investment may be at risk.

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