Indian assets: investing in an inflationary world

• India’s deadly second COVID-19 wave has slowed its economic recovery – but with cases falling, there is expected to be a sharp pick-up in business activity and financial market sentiment
• Investor concerns over growing inflationary pressures in India may be overplayed – at least in the short term
• A mix of investment strategies – ideas that benefit from low interest rates or protect against inflation – are likely to perform well in the current transition period
• In equities, we prefer to focus on resilient, high-quality companies with pricing power that give them a competitive edge. While India’s real estate sector also offers potential. 

As investors prepare for a pick-up in Indian economic activity and sentiment, growing inflationary pressures, even if transitory, are firmly in view. Upping exposure to cyclical equities, corporate debt and real estate may be one way to prepare for this transitory period.

The impact of the second wave of coronavirus on India and the prolonged restrictive measures taken by the state authorities may delay the country’s economic recovery. However, the focus on vaccinating the population increases our hope that this may mark the beginning of the end. The second half of the year is likely to see a sharp pick up in business activity and (financial) market sentiment. 

Such transition periods are usually difficult to navigate. That said, they often can be rewarding for investors willing to take advantage of the available, fear-led risk premiums. As fears of vaccine availability and efficacy, elongated regional lockdowns, a potential third-wave, smaller business stresses, credit concerns and delays in a sustainable revival in demand linger, opportunities remain in play.

Policy support (both monetary and fiscal), including the recent positive surprise on dividends from the Reserve Bank of India (RBI), as well as systemic liquidity should remain conducive in this period.

With global and local liquidity remaining high, and inflation inching up, getting positive real returns may require increasing risk exposures. Reinvestment risk also remains high with structurally low cash and short-term rates in the country.

Inflation worries may be overplayed

Fuel prices have moderated somewhat recently, but should remain sticky. Food prices are still low and with good monsoons, as forecast, may remain range-bound. The rupee has also held up well during this period and cushioned the effect of imported inflation. However, rising global commodity prices may pose challenges.

As recent purchasing managers’ index prints also indicated, surging input costs and wholesale price inflation remains a worry. However, the weak employment and demand conditions through the second wave of COVID-19, and an economy operating below full capacity, should reduce the pass through of input price inflation to retail prices.

Inflation may not be as much of an evil as it is thought, at least in the near term. The Indian central bank, like most others, is likely to look through the coming prints as “transitory” at best. The effects may rather be addressed through counterbalancing factors in the short term and supply-side catch-ups in the medium term. For Indian companies too, reflation has helped top-line growth without much impact on margins, at least for ones with more pricing power.

Keep investing during the transition period

A good mix of investment strategies and ideas that benefit from low rates, and the fiscal and monetary support on one hand and inflation risk on the other, should perform well in the current transition period.

In Indian equities, a selection of quality companies with resilience and pricing power and cyclicals seems to make sense. Similarly, in Indian debt, it may be worth considering a mix of high quality corporate bonds of up to 5-year maturity and select high-yield credits, especially credits collateralised by real assets that generally hold well during high-inflation periods.

Active management to the fore

Active management seems key, especially during this transition period, with sharp sector rotations a regular occurrence. Bottom-up stock selection remains the key driver of alpha amid rich equity valuations.

Exploring the less researched stocks in the small and mid-cap space can be another path to generating alpha. Similarly, credit selection and monitoring is likely to be critical during this transition period. As the economy recovers, potential ratings and/or perception upgrades are likely.

Target global exposure

The different growth profile of the largest economies in the recovery, especially in recent quarters, again 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 China or US equities, one can also take advantage of opportunities benefiting from the new normal across the entire 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.

Real estate approaches “goldilocks” situation

Indian real estate, especially residential property, seems well positioned to recover, supported by many of the right ingredients for growth. These include: a growing and younger working age population; expanding urbanisation; historically low home loan rates; local tax breaks in the sector during the pandemic; better availability of loans to developers supported by the RBI’s targeted longer term refinancing operations; preference for bigger and better organised residential premises; and proliferation of home working.

The corrections and consolidation in Indian real estate seen since the credit crisis, additional real estate regulations and the effects of the pandemic have helped to put a cap on a supply glut. With the employment conditions, income and affordability, demand picking up again and amid less oversupply, Indian residential real estate looks poised to gain its share back in the economy over the coming years. Growing expectations of a period of higher inflation may further raise investor interest in the sector.

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

Resilient Indian equities

The resilience displayed by Indian equities, the participation of the broader market in recent up moves and rotations across sectors are not surprising in the context of:

• falling active COVID-19 cases in the country; and
• anticipated gradual easing of restrictions across states over the next few weeks.

Investors are also surprised about the disconnect between the human tragedy of this second wave and the equity market’s resilience – the more forward-looking approach taken by the markets may help explain this, with strong earnings growth expected over the next couple of years.

Banks provided more comfort to the market by indicating much less stress in the retail and micro, small and medium enterprise (MSME) segments than some thought. Cyclical recovery should gradually see sectors like automobiles, retail, leisure, travel and tourism participate once more visibility is seen on easing lockdown restrictions.

Our equity portfolio strategy remains largely intact with a mix of quality stocks across market capitalisations and sectors, including cyclicals.

Debt – discretion is warranted

This year is proving trickier than last for Indian bond investors. Our debt investment strategy during this period is oriented towards the right blend of credit and duration positioning with the flexibility to change the mix when needed by maintaining adequate liquidity in the portfolio.

In a lower-for-longer interest rate environment, the search for carry naturally leads to on-boarding more duration and/or credit risk in the portfolio. But there is a distinct slowdown in market interest towards adding credit and/or duration due to the second wave and associated lockdowns, compared with previous quarters.

For now, this sits well with the duration and quality positioning of our debt portfolio strategy. We remain open to judiciously adding credit, but will look for leading indicators to signal that the economic impact of the lockdown is reducing before taking additional credit risk.

Our preferences in the non-AAA segment remains towards credit/perception upgrade candidates and in sectors that stand to benefit from government policies and economic revival such as roadways, infrastructure, power and select non-banking financial companies with a focus on housing finance and MSME lenders.