Indian private markets appeal with economic recovery on track

• Indian economic revival secure despite COVID-19 infection levels picking up and hit to global growth by the Delta variant
• With commodity prices cooling and a relatively stable Indian currency, concerns over “imported” inflation are easing
• Indian equities seem to be fairly pricing in expected earnings revival, but stock selection remains key
• Allocating to mid-yield, high-yield and structured credits appeals at this stage of the economic recovery.

Despite being buffeted by the Delta variant, India’s economic recovery looks secure. Indian equities are fairly valued with the revival in earnings largely priced in. It may be time to seek fresh sources of return and bottom-up stock selection, private assets and credit markets might be the answer. Security selection is key.

India’s economic recovery seems to be on track, especially with the onset of the festive season and despite rising COVID-19 infection levels, and the overall threat to global growth of the Delta variant and Chinese crackdowns. As the current pace of recovery continues, we upgrade our gross domestic product growth projection for financial year 2021-22 to 10.2% in the India.

The manufacturing, construction and mining sectors are leading the recovery, with consumption of steel and cement remaining robust, driven by higher government spending and exports. Demand for utilities also remains strong, with power consumption above pre-pandemic levels.

In services, fuel demand and financial services seem to be rebounding quickly and are likely to boost growth more meaningfully in coming months. Uneven monsoon rainfall and the spread of the virus deep into rural areas are likely to weigh on farm output, and consequently the agriculture sector.

Learning to live with COVID-19

Around 35% of the Indian population are likely to be fully vaccinated by the end of October. Furthermore, rising vaccine supply is expected to cover 52% of the population by the end of the year.

Encouragingly, the chief scientist of the World Health Organisation, Dr Soumya Swaminathan, has indicated that India may be entering the stage when the population learns to live with the virus. A time when the spread of it would be limited to particular areas and with predictable rates.

Much inflation already priced in

With commodity prices cooling of late and a relatively stable Indian currency, concerns over “imported” inflation are abating.

Additionally, any input price pressures from imported inflation may not result in higher output or retail prices as demand and pricing power in the economy remain weak.

Much inflation risk seems to be already priced in. With supply constraints likely to ease in the coming months, inflation may undershoot forecasts in the near term.

Of course, any supply shocks resulting from a potential spike in COVID-19 cases or a significant pick-up in demand, putting pressure on output prices and retail inflation, are key risks.

Accommodative monetary policy to stay

The Reserve Bank of India (RBI) continues to maintain its accommodative monetary policy until it has more clarity on sustainable growth prospects. Given the central bank’s recent policy statements, policymakers may be looking at inoculation rates, the global growth outlook and signs of growth in credit and investments.

The RBI’s stance to build up foreign currency reserves seems to support keeping Indian rates low, relative to other emerging markets, and help to defend any potential external pressures on the rupee.

The earliest we think the RBI might start hiking the reverse repo rate is December, though repo rate hikes do not appear likely until early next fiscal year. Indeed, only two repo hikes appear to be on the cards at most in 2022, if the rate of inflation slows by then.

Eye on RBI liquidity management

Additionally, the Indian central bank seems unlikely to aggressively remove liquidity from the system. Indeed, the RBI may prefer to let liquidity naturally reduce as the demand for currency and credit increases.

Any early significant policy move designed to drain liquidity may mean that the operating rate starts moving towards the repo rate from the reverse repo rate. This might indicate that policymakers are more confident about growth persisting.

Tax revenues

On the fiscal side, the government’s capacity to spend remains healthy as tax revenues perk up and plans for more privatisations and asset monetisation are executed. Any correction in crude oil prices and relatively stable rupee may also reduce any pressure to reduce oil taxes.

Beyond a point, a period of broader, better-quality, growth depends on the private sector participating more. With several reforms already announced by the government to boost private investment and the economy opening up, stronger consumer and business sentiment, capital expenditure, and thereby employment and disposable income in the country, seem more likely.

Indian equities: earnings revival largely priced in; stock selection key

Following a stronger period and higher Indian equity valuations across the broader market, the scope for significant upside has faded. Furthermore, much of the expected earnings revival in stocks due to pent-up demand has likely been priced into valuations.

The benchmark blue chip equity indices may deliver returns more in line with the realised corporate earnings growth trajectory. Given the limited room available for margin expansion due to high commodity prices and wage inflation, perhaps from salary hikes in technology services, this may depend more on the sales growth (credit growth in case of lenders).

Rotations across sectors, themes and market capitalisations are adding to volatility. As such, bottom-up stock selection, active management and appropriate portfolio diversification look key to maximising returns. Any market correction is likely to be short and shallow and to mitigate the potential volatility, staggering allocations and buying on dips might help.

We have more conviction in quality companies across market caps and themes. Mid and small-cap stocks appear favourably priced, with opportunities to build on longer term positions in any corrections. Late-recovery themes, such as in the mobility, travel and tourism sectors, also offer opportunities.

Unlisted opportunities

Unlisted securities are in demand, especially in late-stage venture capital, private equity and the pre-listing markets. Primary markets look likely to be abuzz for some time, following the progress made by domestic technology and technology-driven businesses in the coronavirus era.

Global exposure broadens opportunity set

Outside of Indian equities, we continue to see opportunities in US equities through quality companies and active management. Additionally, recent Chinese regulatory crackdowns and equity falls may present an attractive entry point for a medium-term play.

High-grade Indian corporate bonds to the fore

We continue to recommend keeping core portfolios invested in high-grade corporate bonds of up to 5-year maturities, 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. Also, the term premia available in bonds with maturities of at least six years provides unattractive risk-weighted reward.

High-yield, structured and private credit

Allocating to mid-yield, high-yield and structured credits at this stage of the broader economic recovery appeals. Among bond segments, the non-AAA one seems preferable at the moment, with a focus on upgrade candidates.

In public debt, we target sectors likely to profit from government policies and the domestic economic revival. This includes infrastructure and residential real estate-backed debt and select non-banking financial companies that focus on housing finance and micro, small and medium-sized enterprise lenders.

Also, 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 for private debt managers in the mid-market performing credit. With risk appetite in this segment still muted and traditional participants abstaining, this credit market offers opportunities to build portfolios with an attractive risk premium.

Prudent selection, diversification and monitoring is key when investing in private credit.