Narayan Shroff (NS): Hello, and welcome everyone to our monthly podcast for Barclays Private Clients India. I am Narayan Shroff, part of the India Investments team, and I will be your host for this podcast.
In this month’s podcast I will share with you a broad synopsis of our India outlook for 2022, followed by a short interview with our guest Julien Lafargue, Chief Market Strategist at Barclays Private Bank. Julien will share some of the relevant insights from our global outlook for the year ahead.
Post the pandemic lockdowns, 2021 seems to be ending strongly for India. An encouraging recovery in the economy, corporate earnings, business and investor sentiment seems to be heading beyond the pent up demand led recovery cycle. The polarisation of the recovery also seems to be broadening to more sectors. However, there are economic vulnerabilities and risks, including any COVID-19 curveballs, inflation scare or monetary policy normalisation.
First on the virus, 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 renewed restrictions poses a greater risk to India’s economic recovery. Having said that, these scares should continue to reinforce the pandemic led boost to Indian exports.
Inflation scare in India largely pertains to imported inflation, mainly as a price taker for energy and industrial commodities. With activities picking up across the world supply side issues are expected to ease in the coming year.
Also, to some extent, the record forex reserves that the 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.
The government’s recent steps to reduce taxes on oil may also reduce the impact somewhat. 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.
On the monetary policy normalisation, our views are more sanguine than the market. Absorption of 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 clearly indicated making a gradual, measured and non disruptive transition.
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. It is now about the timing, pace and peak of the rate hiking cycle. This is important for a smooth transition across the rate curves, asset liability management and for funding long term growth, especially the critical private sector capex plans.
In terms of timing, we believe that the reverse repo rate hikes may be initiated at the December MPC meeting. We also think that the central bank could consider hiking the repo rate from April, but the rate is likely to only go up by around 50 basis points in 2022 and maybe another 50 basis points in 2023.
Overall though, we consider that India’s economic recovery can withstand these winds of change. A lot of these risks have already shown their heads earlier as well and the government, corporates, households and investors have all learnt to live with them.
Next year is likely to experience higher market volatility given the transitions in the economy underway, prospects of policy normalisation, rich market valuations, cashflow discounting rates expected to rise, and continual rotations in sectors, themes and market capitalisation.
As such, having an appropriate asset allocation plan and adequate portfolio diversification and a portfolio rebalancing plan is critical. Also, bottom up security selection and active management appears 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.
Investing, especially during such volatile transition periods, requires looking to long term emerging investment themes. Some of these themes that look poised to deliver higher growth over time, irrespective of the near term volatility, includes:
Quality growth leaders: Demonetisation, GST implementation, IL&FS led credit crisis, pandemic led stress and disruptions have all led to formalisation of the economy that should continue to favour larger organised players. Consolidation in and across sectors, especially with deleveraged balance sheets and access to cheaper risk capital, should also help. Increased product development and marketing spends should also help market share gains. Again, from cost efficiencies and margin expansion we are back to input price pressures on margins and, hence, pricing power of these companies should help them to maintain and increase profitability with sales growth.
The next theme is technology or the Digital 2.0: Government policies and emphasis on digitisation and financialisaton; digital infrastructure, including low cost of hardware, software and data; digital adoption fast tracked during the pandemic; booming start up ecosystem in the country; global demand and an established track record of Indian companies in this space; large established supply of resources and skills in the country should all help this theme.
The next one is manufacturing or the capex cycle: Private capex cycle 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+One strategy driving both export demand and import substitution; stable rupee likely to keep aiding flows into the country; asset monetisation virtuous cycle, both public and private, yielding assets. All this should help.
The next big theme is real estate, which is not just a potential inflation hedge but a big theme. After facing serial blows over the last five years, the outlook for Indian residential real estate sector looks encouraging.
Strong end user demand recovery backed by increased affordability and work from home needs, weak supply overhang, repaired balance sheets and consolidation in this sector, stronger consumer protection with regulations like RERA, better operational and cost efficiencies alongside the end user demand, more investor demand and lender appetite is expected to follow, that may trigger a five to six year upcycle in the sector.
There is also a significant supply gap in the healthcare, industrials and logistics segments. A growing market for Indian REITs and InvITs with established global players joining local institutional and retail investors should continue to support these segments.
Needless to say that construction materials and home building sectors should benefit on the back of growth in real estate and infrastructure.
The next one is the green ecosystem in India: Green energy production, storage and transmission, efficiencies and technology; e-mobility and the ecosystem around it; waste management and recycling including e-waste.
The next big one would be the banking and financial services: Banking and larger non-banks have historically been the economic growth proxies. Credit growth pickup with revival in private capex should help. Pickup in corporate profitability and real estate value should also help the collateral. Better established bankruptcy and debt restructuring norms, drop in NPAs and better capital adequacy ratios may lead to increased risk appetite from lenders. Again, larger players are likely to benefit from the lower cost of funds, the ability to fund larger loans, digitisation and process efficiencies.
Growing financialisaton of the economy is likely to also benefit businesses like insurance, asset management, wealth management and transaction processing.
The next one would be 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 multiplex operators. Investors may have to stomach more volatility in this space on any COVID-19 curveballs.
In Indian debt markets, keeping core portfolios invested in high grade corporate bonds still makes sense. Ideally, this should be through a mix of rolldown strategies and actively managed portfolios. The policy normalisation journey is likely to be fraught with high volatility. Any market overreactions beyond our base case on the timing, pace and/or the peak of the rates hiking cycle can throw up tactical investment opportunities for investors.
Allocating to mid yield, high yield and structured credit at this stage of broad economic recovery seem to have merit. With the latest set of RBI restrictions on banks and NBFCs 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. Once again, prudent selection, diversification and monitoring remains key. 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.
We now have Julien Lafargue with us.
Hi, Julien. Thanks for joining us today.
Julien, before we get to our 2022 outlook, can you share some of the top notes from our five year forward capital market assumptions?
Julien Lafargue (JL): Hi, Narayan, and thanks very much for having me. Yeah, we’re very excited to be able to share with clients our five year views, and I think the key message here is that investors should prepare for lower returns from traditional asset classes and really look for opportunities outside the typical 60/40 portfolio.
Given the starting point here when it comes to valuations, we see minimal upside from fixed income markets and more muted upside from equities. On the other hand, we see potential for better risk adjusted returns in private markets, both equity and debt, as well as hedge funds, thanks to their ability to be less directional. And finally, with higher inflation likely to remain a feature of the macroeconomic landscape, we believe investors should diversify across real assets including real estate and select commodities.
NS: Thanks, Julien. Now coming to the year ahead, what is our outlook on global equities in 2022 and beyond?
JL: Well, after a very spectacular 2021 we believe 2022 will see more muted returns as I mentioned. This year all of the upside has come from strong earnings growth as valuations have started to normalise somewhat and we expect more of the same into next year with earnings delivering the bulk of the upside while valuations should remain under modest pressure driven by relatively less accommodative monetary policy.
However, earnings growth will slow on a combination of lower overall economic growth, unhelpful base effects and the lack of substantial margin expansion. The result is, therefore, likely to be high single digit returns, at least that’s our base case.
Now, the path to get there may also be more bumpy than usual and markets may continue to assess the outlook for inflation and, therefore, central bank policies. And this means in our view higher volatility, more frequent sector rotation and likely higher dispersion.
NS: Indeed, back to deep dives and hard work for our equity investors and managers. So, Julien, considering the valuations, where do the opportunities lie? I mean which market themes and sectors do we see outperforming going ahead?
JL: Well, we believe 2022 could be a year of two halves with cyclical sectors such as financials and industrials leading in the first part of the year as concern over high inflation persists pushing interest rates higher.
However, by the middle of next year we would expect inflationary pressure to start fading, paving the way for central banks to remain patient contrary to the market expectation. At this stage quality and growth companies could retake their leadership. This should be more supportive of the broad tech sector for example. So active management and diversification will be two important themes going into next year.
Outside of the short term noise and direction we also believe that circular trends will continue to provide attractive opportunities to investors. This is particularly true when it comes to the energy transition, but also the ongoing digitalisation and automation of the global economy.
Now, regionally these views translate into a preference for developed over emerging market equities and if cyclicals lead Europe could be best positioned in the first half of next year while the US could resume leadership in the second half. And with regards to emerging markets, we maintain a preference for Asia over the rest of the group.
NS: Thanks, Julien. Now, specifically coming to China which has been the talk of the town of late, what is our outlook on the economy and markets there and perhaps more around the region?
JL: We remain relatively cautious on China, in the short term at least. The macroeconomic situation is problematic with decelerating growth, weak domestic demand and very elevated inflationary pressures, at least from the production side.
This, combined with very poor investor sentiment driven by the recent crackdown on parts of the economy and the uncertainty around the health of the real estate sector, means that Chinese assets remain in what we would call a ‘penalty box’ for the time being. So it could become more constructive when the central bank starts easing monetary policy and when recent restrictions start being lifted. However, we believe this may not happen until after the winter Olympics.
NS: Coming to Indian markets now, where imported inflation in the form of global commodity prices, especially oil, remains a concern, do we see these price pressures to settle down at these elevated levels or we see higher risks of increased rate of inflation there?
JL: On commodities, we believe the bulk of the surge is now behind us. Oil prices, for example, have doubled in the last 12 months and it’s hard to imagine the same being repeated in the next 12 months. So by design, commodities driven inflation should recede. Now, we could continue to see spikes here and there across the commodity spectrum but, in our opinion, 2021 marked the peak in terms of inflationary pressures.
(NS): And finally, what is our outside in view on Indian equity markets?
(JL): Well, with China losing some of its appeal, India has emerged as a strong contender to be the favourite emerging market for foreign investors. The country’s demographic represents a significant growth tailwind and the policy backdrop now compares favourably versus the rest of the emerging market complex.
Domestic equity markets obviously have posted stellar performance in 2021 and so a period of consolidation is increasingly likely in the short term. But, if you’re a medium term or a long term investor we believe that India continues to be an attractive market, especially if the recent uptick in capex you mentioned earlier has legs and if companies can keep expanding earnings.
NS: Thank you again, Julien, for joining us today.
JL: Thank you, Narayan. Thank you very much for having me on this podcast.
NS: With this we come to an end of our podcast. Thank you for listening to us. Stay safe and healthy, and happy investing.