Private Clients multi-asset portfolio allocation

A year on from COVID-19 rearing its head and it remains the main driver of financial markets and influencer of much Indian policy. As public commitments to mitigate the impact of the pandemic rise, fiscal authorities are witnessing revenue shortfalls. The resulting expansion in the Indian government’s market borrowing programme is placing additional pressures on domestic banks.

Managing business

India’s borrowing programme in the shadow of the virus seems to have been managed smoothly so far, with the lowest borrowing costs in 16 years and an elongated maturity. Companies have also raised substantial funds from financial markets in accommodative financing conditions. The funds have been mainly used for deleveraging balance sheets and building precautionary buffers.

As growth takes root, the private sector’s capital expenditure cycle is likely to revive as existing capacity is utilised and new capacity is added. This will add pressure on the financial system to help growth among Indian businesses.

Meanwhile, the disconnect between certain segments of financial markets and the economy is being accentuated, both globally and domestically. The seemingly stretched valuations of some financial assets pose risks to financial stability. Banks and financial intermediaries need to be cognisant of these risks and potential spillover effects in an interconnected financial system.

Financial stability report

The governor of the Reserve Bank of India’s (RBI) financial stability report presented on 11 January looked at the opportunities and uncertainties that are likely to face investors this year. The key macro factors, like historically low interest rates, a stable external account and some room for more fiscal stimulus, would appear to be a tailwind for growth.

Gross domestic product (GDP) is expected to grow by 9.2% this year, compared with a contraction of 7.2% in 2020. The more positive growth backdrop also stems from the benefits of various reforms seen in recent years, like implementing goods and services tax, the Insolvency and Bankruptcy Code, lower of corporate tax rates and performance-linked incentive schemes for select industries, such as electronics. The benefits of these reforms are yet to be fully realised.

Economic indicators looking hopeful

High frequency indicators like mobility, purchasing managers’ indices, industrial activity and auto sales have steadily improved since June 2020. Meanwhile, government spending, which was lagging in the first half of financial year 2021, showed some pick up as lockdown restrictions were removed. Spending on construction is picking up and heading quickly towards pre-pandemic levels, aided by government spending.

Exports have slowed as re-stocking needs slow. Consumption spending is improving on the back of pent up demand, despite weak employment numbers. These trends seem likely to continue this year, potentially supported by lower interest rates. The vaccine rollout being seen in many countries is encouraging, though a fresh sharp acceleration in COVID-19 infections remains a key concern and could dent recovery hopes.

Union budget: spot on, execution is key

India’s Union budget 2021 stood out for its bold focus on growth through increased outlays on capital expenditure even at the cost of deviating from the prescribed fiscal glide path for five years. An estimated fiscal deficit of 9.5% of GDP in financial year (FY) 2021 and 6.8% in FY 2022 is higher than consensus, though look achievable. The capital expenditure outlay for FY 2022 has been increased by 35% year on year with ambitious plans across Infrastructure, Healthcare, Agriculture, Manufacturing and allied sectors.

Big plans have been announced on divestments and privatisation of key public sector undertakings and also large-scale asset monetisation of operating public assets. Reforms include attempts to attract foreign and domestic funding, including setting up of a Development Finance Institution, further reforms for real estate investment trusts and infrastructure investment trusts and plans to allow infrastructure development funds to issue tax efficient zero coupon bonds.

There are also plans to create an Asset Reconstruction Company and Asset Management Company (ARC - AMC) akin to a “Bad Bank”, which can help speed up the resolution process and free up lenders to focus on taking new credit risk exposures. Again, execution remains key.

Quality equities remain preferred

Equity markets have, to some extent, discounted the economic recovery, the Sensex having almost doubled from its March lows. The outlook for equities seems positive, on hopes of a stronger reflationary impulse, with policy rates likely to be “lower for longer” globally, and the seemingly improving demand environment.

Indian equity markets continue to receive more foreign inflows. This trend will probably persist given the strength of the revival in the economic activity and corporate earnings. We are, however, wary of valuations that seem to be expensive. It may be worth considering taking some profits. This prompted a move mid-January in our tactical stance on Indian equities to neutral from overweight.

We continue to prefer “quality”, sustainable businesses with strong earnings growth momentum. While the gap in valuation between large capitalised (cap) and small or mid-cap equities has narrowed in recent months, small and mid-cap stocks seem preferable as the recovery in equity markets continues to broaden.

Currency and inflation considerations

The RBI continues to purchase US dollars to defend the rupee amid a deluge of dollar inflows. This led to record levels of surplus liquidity in the system and saw money market rates fall sharply and distort the yield curve. The central bank’s 14-day reverse repo of 2tn rupees seems to be oriented towards managing overnight liquidity and normalising short-term rates.

Turning to inflation, this seems likely to trend lower in coming months. For now liquidity should remain ample. The RBI will probably remain accommodative and keep rates unchanged in coming months as the economic revival will require continued policy support now.

Bond markets turn cautious

The increase in fiscal deficit targets, higher government borrowing and fears of crowding out will weigh on bond market sentiment, despite the RBI’s accommodative stance. While flows from foreign institutional investors into bonds have been negative in recent months, domestic flows should remain buoyant, keeping demand-supply dynamics on an even keel.

For now, we expect the RBI to “do what it takes” to support the economic recovery with low rates and retain our preference for quality bonds, preferably in the 3 to 6-year maturity bucket. As short-term rates flatten, the yield curve is expected to flatten. The key risk remains that the fiscal trajectory, as outlined in the Union budget, disappoints.

Asset allocation

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

At such a time, an allocation to global equities and gold with a preference for alpha opportunities over beta seems to make 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. Some of the themes will occur in areas like pharmaceuticals and healthcare, technology, chemicals and consumer goods. Also, the nascent Indian REITs and infrastructure investment trust market should continue to perform well.

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