Cautious optimism prevails

Key takeaways

• Despite recent spikes, India seems to be successfully managing the pandemic
• Will the nation have similar success in sustaining the economic recovery?
• Government support may add meaningful depth to the financial response
• Can inflation be kept within reasonable parameters?
• Investors might consider the attraction of quality equities and private assets.

Active cases of COVID-19 have sharply spiked since mid-February, after declining since November. While the increased incidence of the virus is concentrated in few states, like Maharashtra, the risks of a wider second wave seem to be rising in other states. Local authorities seem better prepared to handle the situation, aided by better medical infrastructure and the pace and widening of the vaccination drive.

From a financial markets perspective, fear of missing out again should continue to provide a strong support to the market.

Gross domestic product (GDP) growth in the quarter ending December was positive after two negative quarters. The Reserve Bank of India (RBI) expects India’s GDP to grow by 10.5% in fiscal year 2022.

The Union budget for financial year 2022 suggests that the government will support the economic recovery with expenditure, aimed at increased capex outlays, especially in infrastructure sectors.

Inflation, as measured by the consumer price index, rose to 5% year-on-year in February, from 4.1% in January. This uptick was largely driven by core inflation of 5.9%. However, it is expected to remain in the RBI’s comfort range of 4% to 6% in the medium term.

The outlook for equities remains positive, the asset class benefiting from the cyclical rebound being seen in the economy. We continue to prefer “quality”, sustainable businesses with strong earnings growth momentum in the medium term as they provide strong resilience, including using their pricing power to pass on any major inflationary pressures. As such, quality companies should continue to be part of the core equity portfolio, while the satellite equity portfolio can have allocation to sectors witnessing cyclical recovery.

As we prepare for a post-pandemic world, private assets may offer ways to diversify portfolios while accessing many investment themes set to play out in this period. Such themes may include increased interest in pharmaceuticals and healthcare, technology, consumption, chemicals, supply chain and logistics, asset leasing, receivables financing and structured private debt.

Barclays Private Bank discusses asset allocation views within the context of a multi-asset class portfolio. Our views elsewhere in the publication are absolute and within the context of each asset class.

Active cases of COVID-19 have sharply spiked since mid-February, after declining since November. While the increased incidence of the virus is concentrated in few states, like Maharashtra, the risks of a wider second wave seem to be rising in other states.

Considering the severity of the localised restrictions being benign, especially compared to the complete lockdowns seen early last year, it appears unlikely to hit growth materially. Also, local authorities seem better prepared to handle the situation, aided by better medical infrastructure and the pace and widening of the vaccination drive.

From a financial markets perspective, investors having seen the light at the end of the tunnel, fear of missing out again should continue to provide a strong support to the market on any retracements.

Sustaining growth beyond pent-up demand

Gross domestic product (GDP) growth in the quarter ending December was positive after two negative quarters. The Reserve Bank of India (RBI) expects India’s GDP to grow by 10.5% in fiscal year 2022, aided by a resumption in domestic and global economic activities and by expanded fiscal budgets for the next five years. The recovery is led by both private consumption spending and increased government spending.

The steady fall in COVID-19 cases last quarter gradually unlocked the economy, creating pent-up demand from consumers. Better employment and income visibility should continue to support more structural consumer demand beyond this initial pent-up demand.

While individual balance sheets have suffered, as seen by the large withdrawals from the government employee provident fund scheme, a drop in the household savings rate from the spike seen during lockdowns indicates a return to more discretionary spending.

Fiscal heavy lifting

The Union budget for financial year 2022 suggests that the government will support the economic recovery even at the cost of fiscal slippages. Indeed, much of the heavy lifting in encouraging growth will probably be done through government spending. Recent announcements related to privatisation of public sector undertakings, monetisation of public infrastructure assets and increased spending for infrastructure projects should be viewed in this context.

Government expenditure is aimed at increased capex outlays, especially in infrastructure sectors. Besides, spending is also focusing on additional infrastructure financing options by further relaxing fund-raising norms of infrastructure investment trusts (InvITs) and real estate investment trusts (REITs) and monetisation of operating public sector assets like roads, railways and airports. The government has also extended its performance-linked incentive scheme to 13 more sectors to support large-scale manufacturing of electronic equipment.

Inflation risk to upside

Inflation, as measured by the consumer price index, rose to 5% year-on-year in February, from 4.1% in January. This uptick was largely driven by core inflation of 5.9%. The impact of higher oil and commodity prices are expected to feed into inflation. However, it is expected to remain in the RBI’s comfort range of 4% to 6% in the medium term, though inflation may be sticky, with more upside to it.

Any significant increase in crude prices might hit fiscal policy as indirect taxes on oil may need to be cut to keep retail prices in check. Also, a higher oil import bill could worsen the current account and put pressure on the rupee. That said, with comfortable forex reserves, the RBI should still be able to provide stability. We expect crude to be range-bound and remain cautiously optimistic on the authorities’ ability to manage the imported inflation risk.

Stable inflationary expectations for the coming twelve months provide room for the RBI to support growth while keeping rates low and ensuring sufficient liquidity in the system. A continued cyclical rebound in growth and higher core inflation may eventually put pressure on the central bank to normalise policy.

Equities outlook positive

The outlook for equities remains positive, the asset class benefiting from the cyclical rebound being seen in the economy. Earnings momentum continues to improve, driven by sales growth (including reflationary growth), market share gains, a lower cost of financing and cost cuts.

Indian equities continue to attract more foreign inflows, a trend that will probably persist given the revival in activity and earnings. So far the market rally was supported by historically low rates and massive global liquidity. However, valuations are coming under pressure from higher global bond yields. Any corrections in the market continue to be shallow and short-lived though.

Quality still appeals

In recent months, companies with stable earnings and low leverage – especially from consumption-oriented sectors – have underperformed the broader markets. This is driven by an anticipated pick-up in earnings growth, after a hiatus of five years or so, in sectors such as real estate and cement and steel. Lenders with good corporate loan books and the capital goods sector should benefit from the resurgence in private capex and increased government spending in infrastructure-related sectors.

Despite underperforming of late, we continue to prefer “quality”, sustainable businesses with strong earnings growth momentum in the medium term as they provide strong resilience, including using their pricing power to pass on any major inflationary pressures. As such, quality companies should continue to be part of the core equity portfolio, while the satellite equity portfolio can have allocation to sectors witnessing cyclical recovery.

While the gap in valuation between large capitalised (cap) and small and mid-cap equities has narrowed in recent months, small and mid-cap stocks seem preferable as the recovery in equities broadens.

RBI holds the key

The complex themes impacting bond markets will likely keep markets volatile in coming months. Increased borrowings, economic revival and inflation may cause headwinds. However, the RBI’s commitment to maintain ample market liquidity and orderly moves in the yield curve is likely to support bonds. As the economy revives, the market’s dependence on the central bank’s actions to influence rates will probably increase, likely keeping sentiment subdued.

Tactically, bond yields may soften due to short-term market liquidity increases and any delay in the supply of corporate bonds. That said, this may be a short-lived phenomenon and the opportunity to profit from the recent hardening of rates may soon end.

In the medium to long term, a period of rising rates appears some way off. Economic revival should eventually normalise monetary and liquidity conditions. Under these conditions, a combination of active and passive bond strategies may be worth considering. On the passive side, allocating to roll-down strategies (with duration dependent on individual appetite for intermittent volatility) may be useful in locking in higher accruals expected to more than compensate for any adverse interest rate moves.

On the credit front, the outlook for Indian issuers seems to be improving. Credit spreads are significantly higher than long-term averages. With the economy recovering, these spreads should narrow. Judiciously, we continue to add issuers in sectors which stand to gain from the revival such as agriculture, roadways, power, select real estate and select non-banking finance companies (NBFCs).

Asset allocation

As the effects of, and uncertainty around, the pandemic linger and as the economy revives, allocating assets with appropriate diversification remains key. Like last year, this one is likely to experience periods of elevated volatility and sharp sector rotation too.

At such a time, an allocation to global equities and gold, while averaging-in purchases with a preference for active management, makes sense. While gold is traditionally held by Indian households, increasingly domestic investors are discovering the attractions of investing in global equities, with a bias to US and Chinese markets.

As we prepare for a post-pandemic world, private assets may offer ways to diversify portfolios while accessing many investment themes set to play out in this period. Such themes may include increased interest in pharmaceuticals and healthcare, technology, consumption, chemicals, supply chain and logistics, asset leasing, receivables financing and structured private debt. Additionally, the nascent Indian REITs and infrastructure investment trust market did well last year and should continue to grow for some time yet.