Time to reconsider risk budgets and buckle up for the ride

• With a fast economic recovery in sight, the road ahead is expected to be bumpy for India’s financial markets
• A core-satellite investment approach may be worth considering – by maintaining a steady "core", but adopting higher risk strategies in the "satellite" section of your portfolio
• We also suggest investing in high-quality equities and high-grade corporate bonds as the economic recovery enters its next phase
• For Indian investors, the different growth rates of other major economies around the world highlight the importance of global stock market exposure.

As the economic recovery evolves and inflation rears its ugly head, investors might consider rebalancing portfolios to match their risk appetite and budgets. A core/satellite approach may help portfolios to weather periods of likely turbulence ahead.

The unprecedented monetary and fiscal support, high liquidity and structurally lower rates have supported the financial market performance in India. However, the constrained economic environment through the waves and ensuing lockdowns and the general risk aversion through this period led to more of a K-shaped recovery. Parts of the market trade at rich valuations while others struggle through the pandemic.

With a sharp economic recovery in sight in the second half of the year, a broader bounce in each asset class may occur.

Also, while inflationary pressures are building, in a structurally lower rates environment, investors may need to take more risk to earn long-term real returns.

Aligned on inflation expectations

The Reserve Bank of India (RBI) may be channelling liquidity and targeting stable interest rates across the curve that are also conducive to sustainable domestic growth. That said, financial markets are likely to remain on a tightrope depending on inflation data and inflationary expectations.

In the near term, the market and policymakers seem to be aligned that inflation is likely to be transient and addressable through counterbalancing factors such as unemployment, stabilising pent-up demand and supply-side catch-ups.

Time to review asset allocation

With the recovery and run-up in Indian equities over the last year or so, it may be time to review asset allocation and rebalance as required. Also, within this allocation, it may be worth increasing the risk allocations in each asset class using a “core/satellite” strategy, 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 headwinds, we suggest staggering allocations over coming months and maintaining appropriate portfolio diversification.

As an example, an investor who invested at the then peak of India’s S&P BSE 500 index of listed companies on 7 January 2008, earned around 6.9% a year compound annual growth rate (CAGR) by 15 June 2021. Instead, investing at the following bottom of the market on 9 March 2009, in the aftermath of the global financial crisis, delivered around 17.5% CAGR over the same period.

While catching the top or bottom of the market may only be possible in the hindsight, staggering investments monthly starting from the top of the market in 2008 until the bottom of it in 2009 produced a CAGR of around 12.5% over the same period.

Active management is key

Active management remains key for core portfolios, due to high valuations and the low margin for errors when pricing in longer projections. For satellite portfolios, the same holds with a large bottom-up universe to select from and a relatively fragile, and evolving, environment, limited visibility, early versus late cyclicals, supply-side catch-ups versus the demand-pull ones and cost pressures among other factors.

Active management in such portfolios is advisable not just for diligence and when selecting how to allocate, but also to monitor and timely exit, rotate or book profits.

Quality in vogue

In Indian equities, we continue to suggest sticking to quality businesses and a resilience bias in the core portfolio. It includes companies that may thrive using their pricing power and adding to market share, even when their margins might come under pressure from:

• Inflation/input costs (such as labour cost) pressures; and
• Financing cost pressures (rates increase as well as spreads widening)

These companies also tend to have a long-term, stable investor base (that is, are well placed to withstand money outflows due to general market risk-off events).

Satellite equity portfolios might comprise of small and mid- cap portfolios and cyclicals (including the pandemic-led late-cyclical sectors like automobiles, retail, leisure, travel and tourism).

Capex cycle

We expect the Capex cycle to kick in faster than some forecast due to formalisation of the economy. While this process had started post demonetisation in 2016, the goods and services tax (GST) implementation in 2017 and India’s credit crisis in 2018, the pandemic seems to be accelerating it.

The weaker and vulnerable businesses are giving way to more “organised” ones. This has led to a faster Capex cycle as these organised players need to scale up supplies quickly. Vulnerable companies’ idle capacity may not be fully acquired/utilised by stronger peers that would rather create capacity on their “cleaner” books.

Unlisted opportunities

Apart from the small and mid-cap opportunities in the listed universe, opportunities in the unlisted space continue to attract attention, especially in late-stage venture capital, private equity and the pre-listing market. The acceleration in the progress made by domestic technology and tech-enabled businesses during the coronavirus era is expected to keep the primary markets abuzz for years to come.

High-grade corporate debt appeals

In Indian debt, we continue to suggest keeping core portfolios invested in high-grade corporate bonds of up to 5-year maturities, through a mix of actively managed and roll-down strategies. The still steep rates curve seems to offer enough carry to compensate for any residual duration risk in roll-downs.

We reiterate our stance that the RBI will support the bond markets through its policy stance, liquidity and rate stability across yield curves. With the inflation prints and higher bond supply in the market, however, portfolio volatility may remain elevated.

Time to nibble at mid-yield, high-yield and structured credits

With the broader economic recovery, it may be worth building a satellite fixed income portfolio across mid-yield, high-yield and structured credits. Our preference in the non-AAA segment remains towards credit/perception upgrade candidates and in sectors standing to profit from government policies and economic revival. Such sectors include roadways, infrastructure, power and select non-banking financial companies with a focus on housing finance and micro, small and medium enterprise lenders.

Residential real estate-backed debt, by marrying high yields with appreciating collateral values, looks well positioned to profit in the transition phase. Once again, selection, diversification and monitoring remains key.

Global exposure broadens the 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 participate in external markets, like US equities or Asian emerging markets, the approach can allow you to consider investing in opportunities expected to prosper from the new normal across the technology spectrum. Although not our base case in the short term, such exposures would profit from any rupee depreciation, perhaps caused by worsening inflationary risks.