Understanding how much India’s economic recovery is priced into investments

• As the Indian economy recovers from the latest wave of COVID-19, a tepid recovery seems to be taking hold – but a more sustained pick-up in activity cannot be ruled out
• Equity valuations do not appear expensive and market corrections may present buying opportunities – especially small and mid-cap stocks, as well as sectors or themes underpresented in blue-chip indices
• Unlisted equity opportunities continue to attract attention and significant flows – notably in the late-stage venture capital, private equity and pre-listing markets
• In fixed income, it seems preferable to keep core portfolios invested in high-grade corporate bonds of up to 5-year maturities
• In the ”satellite” part of bond portfolios, we see value in non-AAA investment-grade bonds, high yield and structured credit.

As India’s economy shows signs of recovery from the impact of the Delta variant, the question is whether the revival is sustainable. Given the uncertainties over inflation, central bank policy and how much of the recovery is priced into equity valuations, a review of portfolio allocations and risk budgets may be called for.

As the first major economy to be affected by the Delta variant, India is also the first to emerge from its impact on economic growth. We see more signs of a tepid recovery taking hold, though whether a sustained pickup in activity is occurring is open to question.

Given that much of India’s inflation comes via its imports, and the exchange rate effect on prices has been limited, there seems little that domestic monetary policy can do to address the issue. Also, the output gap remains negative, pricing power appears relatively weak and fiscal revenues constrained.

The key risk in the short term is an uptick in medium-term inflation expectations, which would create a policy dilemma for the Reserve Bank of India (RBI). If higher price expectations became generalised, this could add to the risk of the consumer price index.

RBI drains liquidity

While rate hikes may be unlikely soon, the RBI is taking small steps to cut the liquidity provided during the pandemic. From a high of 6.8tn rupees in December, liquidity was 4.3tn rupees by the end of May. It has since hit 5.5tn rupees. This was driven by draining currency in circulation and capital flows to reduce the surplus.

We expect the RBI to keep channelling liquidity into the system, especially at the grass roots level. The central bank is likely to maintain its purchases of government bonds, while retaining its passive liquidity strategy and reducing more excess liquidity in the banking system during the rest of the current fiscal year.

Timing when to start tightening policy

Through the past 18 months the RBI has consistently been surprisingly dovish. In particular, governor Shaktikanta Das has intervened at key moments to temper market pricing of an early policy exit. The governor is committed to maintain the central bank’s growth supporting bias, even at the expense of temporarily higher inflation, in our view.

Credit outlook is key

According to RBI published data, Indian deposit growth has consistently outpaced credit growth. The excess liquidity is being parked with the central bank under the reverse-repo window, earning just above 3%, close to the savings deposit rate for banks.

Bank credit growth remains subdued, probably due to risk aversion. The recent additional measures taken by the government to mitigate pandemic-related stresses in the economy are expected to improve credit flows. That said, the downside risks on credit growth include limited capital expenditure plans, partial COVID-19-related restrictions in key states and concerns over another acceleration in infection levels.

Weak corporate bond issuance

Turning to Indian bond markets, while so-called G-Sec supply remains high, with the RBI managing the absorption through the G-Sec acquisition programme (G-SAP), primary issuances of corporate bonds in the domestic market is very low. This is likely due to volatile markets. Overall, local primary issuance between April and June was around 70% lower than last year.

However, we need to factor in the changing sources of funding, especially for stronger Indian corporates, with record international bond issuance this year, a growing REITs and InvITs market as well as booming IPO and private equity markets.

Keeping core portfolios invested in high-grade corporate bonds of up to 5-year maturities seems preferable, ideally through a mix of roll-down strategies and actively managed portfolios in this segment. The steep rates curve appears to offer enough carry to compensate for any residual duration risk in these portfolios. However, the term premia available on longer maturity bonds offers unattractive risk- weighted reward.

High-yield and structured credits offer value

In a “core/satellite” strategy, it may be worth building a satellite fixed income portfolio across mid-yield, high-yield and structured credits at this stage of the broader economic recovery. Among bond segments, the non-AAA one seems preferable at the moment with a focus on credit/perception upgrade candidates.

The credit migration ratio (upgrades-over-downgrades) in India has seen steady improvement over the last year. This ratio improved to 2.08 times for the quarter ending June 2021, compared to 0.36 times for same quarter last year, according to the Prime Acuite Credit Rating Migrations database.

We target sectors likely to profit from government policies and the economic revival, including infrastructure and residential real estate-backed debt and select non-banking financial companies that focus on housing finance and micro, small and medium-enterprise lenders. Prudent selection, diversification and monitoring is key in this sector.

Time to review equity allocations

With the recovery in Indian equities this year, it may be time to review asset allocation and to consider rebalancing portfolios. It might also be worth weighting more to Indian equities using a core/satellite approach, with the satellite portion representing higher risk strategies. To mitigate the potential volatility in satellite portfolios, especially from any risk-off triggers globally or domestic difficulties, staggering allocations and maintaining appropriate portfolio diversification may be advisable.

Active management remains key due to richer valuations and the low margin for errors when pricing in longer projections and also to monitor and timely exit, rotate or book profits across a wider universe of stocks.

Equity corrections may provide buying opportunities While inflationary pressures persist and have helped top-line growth in many sectors, margin compression does not look a significant threat in the near term. Having said that, operating margins seem to be peaking and further earnings growth will probably be driven more by continued sales growth. Superior-quality businesses with a resilience bias, pricing power and ability to acquire market share are well positioned in this respect.

Valuations of Indian equity indexes do not appear to be at exuberant levels. But neither do they seem cheap. Much of the expected earnings revival in stocks due to pent-up demand has likely been priced into valuations. As such, the room for rerating of Nifty50 companies, or the 50 largest quoted Indian groups by capitalisation, may be limited in the near term.

That said, with the lack of alternatives available to investors, as well as supportive liquidity conditions, any market corrections will probably be short and shallow and offer good buying opportunities.

Don’t get blinded by benchmarks

As the broader economic recovery solidifies, an exciting set of opportunities for satellite strategies in portfolios can be found in the wider equity market. Such investments seem likely to outperform the large-cap stocks over the next 12-18 months. This seems to be especially the case in the small and mid-cap space and in sectors and themes underrepresented in blue-chip indices, like the Nifty50 or Sensex.

Some of the sectors and themes that look particularly attractive include:

• Engineering and capital goods – Benefit from revival in capex cycle, credit offtake and infrastructure spends
• Housing – Including not just the plays in home building, but also in household goods and decorations
• Industrial metals – Benefit from the cyclical revival
• Manufacturing – Including chemicals, textiles (the China effect), sugar and paper
• Financialisation and formalisation – Especially small and mid-cap companies that have shown resilience and look well placed to take advantage of these key themes
• Late recoveries – Travel and tourism

Unlisted opportunities and the surging Indian IPO market Apart from the small and mid-cap opportunities in the listed universe, unlisted opportunities continue to attract attention and significant flows, especially in the late-stage venture capital, private equity and the pre-listing market. The acceleration in the progress made by domestic technology and technology-driven businesses during the pandemic is expected to keep the primary markets abuzz for years to come.

Global exposure broadens opportunity set

The different growth profile of the largest economies, especially in recent quarters, highlights the importance of global equity exposure (both across public and private markets) for Indian investors.

Besides the opportunity to invest in non-domestic markets, like China or US equities, a more diversified approach can allow investment in opportunities expected to prosper in coming years, such as in the technology spectrum. In this respect, China’s regulatory crackdown on some technology and education companies and fall in its equities may present a good entry point as a medium-term play.

Although not our base case in the short term, more international exposure may profit from any rupee depreciation, perhaps caused by worsening inflationary risks.