After a tough year for the Indian economy, as a nascent recovery took hold, 2021 looks like being a better year for financial markets. A focus on opportunities in long-term investment themes, in a diversified portfolio, seems one way to manage the next twelve months. A period when spikes in market volatility, higher interest rates and elevated inflation seem likely.
Post the pandemic lockdowns, 2021 seems to be ending strongly for India. An encouraging recovery in the economy, corporate earnings, business and investor sentiment and market valuations seem to be heading beyond a pent-up demand-led recovery cycle. The polarisation of the recovery also seems to be broadening to more sectors.
India’s economic vulnerabilities and risks
However, there are economic vulnerabilities and risks, including:
COVID-19 curveballs – Variants, mutations, restrictions and vaccine inefficacies.
- With higher vaccination rates, reinforced resilience and medical infrastructure, the world seems to be entering an endemic state
- More than the threat of another wave of infections in India, the impact on global exports and imports or investment flows to India, due to any COVID-19 curveballs, poses a greater risk to India’s economic recovery. Having said that, the pandemic has boosted Indian exports, with increasing demand for digital solutions and services as well as global manufacturing supply-chain alternatives.
|Inflation scare – India is mainly a price taker for industrial metals, energy and semiconductor chips. Imported inflation, therefore, remains a concern.
- To some extent, the record forex reserves1 that the Reserve Bank of India (RBI) has built are likely to help allay any fears of sharp Indian rupee depreciation, that otherwise may have had a multiplier effect on imported inflation
- With activities picking up across the world, supply-side issues are expected to ease in the coming year
- It is fiscally difficult for the government to reduce taxes, such as on oil, that are funding higher infrastructure spending
- Any persisting inflationary pressures, however, may impact profit margins as well as business and consumer savings, consumption and investment. Unless, of course, income levels go up faster than inflation, the big hope in a high-growth country like India.
|Monetary policy normalisation – Removing the coronavirus economic medicine.
- Liquidity taper (or the availability of capital) – Reducing central bank asset purchases and other measures to absorb excess liquidity in the system has already started. This is forecast to continue into the first half of 2022, at which point the systemic liquidity may be reduced to a level conducive with a tighter monetary policy cycle. The RBI has emphasised making a gradual, measured and non-disruptive transition, keeping in mind the targeted relief being made to the more vulnerable sectors of the economy
- However, some vulnerabilities, both in the real economy and financial markets, may only come to light once targeted relief is removed. Vulnerabilities include any new stresses emerging in the system that were shielded during the forbearance framework in play during the pandemic
- We believe that the tolerance for inflation in India’s broad policy settings has increased. As the economy finds a more stable footing, we expect monetary policy to tighten, though not by much
- The availability of risk capital for the government, corporates and households, from both local and global equity or debt, has shot up over the last couple of years. This momentum is expected to continue to pick up pace in 2022
- Interest rate hikes (or the cost of capital) – It is now about the timing, pace and peak of the rate-hiking cycle. This is important for a smooth transition across rate curves, asset liability management (ALM) adjustments and for funding long-term growth, especially for critical private sector capex plans
- In terms of timing, we anticipate that the RBI will keep managing liquidity in the system. In this respect, we believe that reverse repo rate hikes may be initiated at the December MPC meeting. We also think that the central bank can consider hiking the repo rate from April. But the rate is likely to only go up by around 50 basis points (bp) in 2022, and maybe another 50bp in 2023
- Overall, our sense is that in a post-pandemic world, India’s terminal “R-star” (ie the terminal repo rate minus inflation) will probably go down to around 0-0.5% from the traditional 1-1.5% level, implying that the terminal policy rates on a nominal term are around 5%. Any more aggressive move than this may exacerbate vulnerabilities, introduce extra risks and open up opportunities for investors.
Not a house of cards
There are interlinkages between the previously mentioned risks. For example, surprise COVID-19 developments can exacerbate supply-side inflation concerns. On the other hand, the same surprises may delay policy normalisation timelines if the RBI sees risks to recovery targets for sustainable economic growth. Similarly, while persistent elevated inflation may speed up policy normalisation, any such policy actions might risk the nascent recovery in business and consumer sentiment.
Overall, though, we consider that India’s economic recovery can withstand these winds of change. A lot of these risks have occurred, and the government, corporates, households and investors have learnt to live with them.
Prepare for more volatility
Next year is likely to experience higher market volatility, given the transitions in the economy underway, prospect of policy normalisation, rich market valuations, cash flow discounting rates set to rise and continual rotations in sectors, themes and market capitalisations.
Indian regulatory attempts to mitigate market risks, such as the recent stricter norms for non-banking financial companies, initial public offering (IPO) funding limits, increased margin requirements for cash equity trading, and restrictions on retail participation in AT-1 bonds, may also add to volatility.
As such, having an appropriate asset allocation plan with adequate portfolio diversification and a portfolio rebalancing plan is critical. Also, bottom-up security selection and active management appear key to maximising returns. Any market correction should be short and shallow, and to mitigate the potential volatility, staggering allocations and buying on dips would help.
For more discerning investors, buying a portfolio hedge to expand the portfolio carry of overweight Indian equities, may be a more efficient way of reducing systemic risk, while benefiting from active management alpha. Selective beta neutral strategies, and/or locking into participation structures, when volatility pricing corrects intermittently, can also be explored.
Focus on long-term investment themes
Investing, especially during such volatile transition periods, requires looking to long-term emerging investment themes. Some themes that look poised to deliver high growth over time, irrespective of the near-term volatility, include:
- Formalisation of the economy favouring larger organised players (post demonetisation, goods and service tax implementation, Infrastructure Leasing & Financial Services-led credit crisis, pandemic-led stress and disruptions)
- Consolidation in and across sectors, especially with deleveraged balance sheets and access to cheaper risk capital
- Increased product development and marketing spends, market share gains, cost efficiencies and pricing power to maintain and increase profitability.
- Government policies and emphasis on digitisation and financialisation
- Digital infrastructure, including low cost of hardware, software and data
- Digital adoption (fast-tracked during the pandemic) Booming start-up ecosystem
- Global demand (and an established track record of Indian companies)
- Large, established supply of resources.
- Private capex cycles turning around (with capacity utilisation picking up)
- Performance-linked incentive schemes to attract greenfield investments
- Lower corporate tax rates (attracting investments and increasing earnings)
- Global supply-chain diversification and China+1 strategy driving both export demand and import substitution
- Stable rupee is likely to keep aiding flows into the country
- Asset monetisation virtuous cycle – both public and private yielding assets.
|Real estate (a potential inflation hedge)
- Residential – After facing serial blows over the last five years, the outlook looks encouraging with a strong end-user demand-recovery backed by increased affordability and work-from-home needs, a weak supply overhang, repaired balance sheets and consolidation in the sector, as well as stronger consumer protection with regulations, such as the Real Estate Regulatory Authority, and better operational and cost efficiencies. More investor demand and lender appetite is expected to follow soon, that may trigger a five-to-six year upcycle in the sector.
- Healthcare, industrials and logistics – There is a significant supply gap in these segments. Also a growing market for Indian real estate investment trusts and infrastructure investment trusts with established global players joining local institutional and retail investors.
- Construction materials and home building – These sectors are expected to benefit on the back of the growth in real estate and infrastructure.
- Green energy (production, storage and transmission, efficiencies and technology)
- E-mobility and the ecosystem around it
- Waste management and recycling, including e-waste.
|Banking and financial services
- Banks and larger non-banks: economic growth proxies; credit growth pick-up on the back of a deleveraging cycle and revival in private capex; pick-up in corporate profitability and real asset values; more established bankruptcy and debt restructuring norms; drop in non-performing assets and better capital adequacy ratios may lead to increased risk appetite from lenders. Larger players are likely to benefit from the lower cost of funds, ability to fund larger loans, digitisation and process efficiencies
- Growing financialisation of the economy is likely to benefit businesses like insurance, asset management, wealth management and transaction
|Late recovery themes
- As mobility restrictions ease fully, spending on leisure, travel and entertainment is likely to increase. This may provide opportunities to invest in resilient quality leaders in the travel, hotels, restaurants, retailing, shopping malls and multiplexes operators
- Investors may have to stomach more volatility in this space on any COVID-19 curveballs.
Global exposure broadens opportunity set
Besides the opportunity to invest in non-domestic markets, a more diversified approach can allow investment in opportunities expected to prosper in coming years.
While we continue to see bottom-up opportunities in quality US equities, based on regional market sector composition, our global sector preferences point to increased support for non-US equities in the first half of 2022. More specifically, this points to Europe, including the UK, followed by Japan and emerging markets. To that end, a truly global unconstrained, opportunistic equity portfolio may be a better fit for Indian investors in the coming years.
Flows into unlisted assets
Opportunities in unlisted Indian securities continue to attract flows, especially in late-stage venture capital, private equity and the pre-listing markets. Primary markets are likely to be abuzz for years yet following the progress made by domestic technology and technology-driven businesses in the coronavirus era. Having said that, investors should apply good diligence and caution and weigh in all the risks (including potential illiquidity risks) when investing in the pre-IPO market.
High-grade Indian corporate bonds
Keeping core portfolios invested in high grade corporate bonds, of up to five years, still makes sense. Ideally, this should be through a mix of roll down strategies and actively managed portfolios. The steep rate curve appears to offer enough carry to compensate for any residual duration risk in such portfolios. That said, the policy normalisation journey is likely to be fraught with high volatility. As mentioned above, any market overreactions beyond our base case on the timing, pace and/or peak of the rate hiking cycle can throw up tactical investment opportunities for the investors.
High-yield, structured and private credits
Allocating to mid yield, high yield and structured credit at this stage of broad economic recovery seem to have merits. Although with the credit spreads trading at historically tight levels and demand far outweighing supply in this segment, there is little room for error, especially in the public debt markets.
With the latest set of RBI restrictions on banks and non-banking financial companies and enhanced guidelines on credit mutual funds, more opportunities are available in private debt markets in the mid-market performing credit segment. With risk appetite in this segment still muted, and traditional participants abstaining, this credit market may still offer opportunities to build portfolios with an attractive risk premium in 2022.
High yield private debt markets have traditionally been less impacted by rate-hike cycles than public bond markets.
Prudent selection, diversification and monitoring remains key when investing in private credits. Delegating these to curated active managers can help to navigate any “kicked cans” or new hidden stresses, as the central bank reduces liquidity and starts raising rates.