Markets India podcast July 2023

Narayan Shroff (NS):  Hello, and welcome, everyone, to our periodic podcast for Barclays Private Clients India. I’m Narayan Shroff, part of the India Investments team, and I will be your host for this podcast.

For this podcast, I have invited two of my colleagues for short interviews. I will start with quizzing Srutaban Mukhopadhyay, Director, Investments, at Barclays Private Clients India, on our asset allocation strategy and views. This will be followed by a brief interview on bottom up strategy and themes with Kartik Soral, Vice President in our equities investment management team.

Hi, Srutaban, welcome to our podcast. The equity markets have scaled new highs. What have you been telling investors?

Srutaban Mukhopadhyay (SM):        Hi, Narayan. Thanks for having me. Not just returns, we also find interesting the relatively low volatility exhibited by the Indian indexes. It is easy to get carried away with these returns. Best to stick to an investing discipline and anchored around the target asset allocation is what we’re telling our clients.

NS:      Yeah, that makes sense, Srutaban. Let us move to the larger picture. We have recently refreshed our Strategic Asset Allocation. Can you throw some interesting insights on the process you use and latest outcomes?

SM:      Definitely, happy to do so.

For the Strategic Asset Allocation or SAA process, we actually look at the long term, say five years or 10 years, and maybe even as long as 15 years outlook rather than the near term outlook. We address the near term outlook as part of our Tactical Asset Allocation or the TAA framework.

Coming back to the SAA, when you look at such long periods, it is important to adopt a step by step process, enumerate all the assumptions. These assumptions are actually a part of our Capital Market Assumptions or CMA. The CMA is an input to our portfolio optimisation process. For our CMA, we first estimate expectations around growth and inflation.

Let’s start with growth. We look at the factors of production, that is capital formation, labour, knowledge. If you look at each, one by one, first, India’s demographic dividend, the working age population as a percentage of the total population, this is expected to achieve a peak of 69% around 2030. That’s a good seven years to go.

Second, there is robust growth in capital infrastructure like road and transport networks. In fact, India now has the second largest road network in the world, ahead of China and only behind the US. About 140 airports, that’s nearly double of what it was a decade ago. Port and railway infrastructure is also growing. And all of this is yet to be monetised.

By the way, we are not only talking about the public sector. The production linked incentive scheme under the Make in India strategy has also generated significant participation from the private sector.

Third, we have seen a significant increase in institutes of higher education, such as engineering, medical, and management. India’s growth outlook looks robust indeed. Actually, estimating inflation expectations was the tricky one. While the credibility of the RBI, unlike some other central banks, remains high, the impact of nondomestic factors are higher when we talk about domestic inflation.

Narayan, we spoke about growth prospects. We expect significant FX capital flows. Relative interest rates and carry trade are likely to play a significant role. Structurally, given the fiscal discipline and RBI’s MPC’s inflation targeting mandate, inflation in India, we believe, should be trending lower than historical averages.

Interesting fact, just before COVID, India was in a positive real interest rate scenario and we are currently also in the same scenario. Definitely, an anomaly for a growth economy. We expect it to normalise sooner than later. Overall, cash returns are likely to trend lower than inflation, and we would be underweight cash from a longer term outlook.

Narayan, for our listeners, we have a publication around the CMA, and would definitely recommend reading it.

NS:      Yeah, thanks, Srutaban. You mentioned cash. What about the outlook for other asset classes?

SM:     Yes. The next step in our SAA process, let’s get to that, we actually estimate returns for each of the asset classes. In India, we broadly look at public market debt and equities, and separately estimate for private markets. For public market, we break up the return expectation into three components. One, income, two, growth, three, valuations.

For debt, the income or the coupon component is expected to trend in line with the long term average. Growth and valuation are likely to counterbalance each other. We, therefore, are neutral on debt.

Moving to public market equities, income is a relatively negligible component. This is expected for a high growth economy like India. India has traditionally traded at higher valuation multiples compared to other emerging economies, basically reflecting its higher growth potential. We do not see a change in that. However, for reasons we just discussed, we expect growth to be higher than expectations. We are, therefore, positive on Indian equities over the medium to long term. Our underweight cash position funds the additional allocation towards equities.

NS:      So, now you have covered cash, debt and equities, what about other asset classes, and how do we go about arriving at the appropriate mix of all the asset classes?

SM: Yes. This is where mathematics comes in. This is the third step in our process. We estimate asset class volatilities and cross asset class correlations. Volatility and correlations are not stationary, they are not static, and change over time. As an example, the three year return correlation between Indian debt and Indian equities have ranged between a positive 0.8 to a negative 0.2 over the last 10 years or so. To analyse, we actually break down the periods into risk on and risk off periods and study these patterns.

We expect a risk on period for Indian markets in the medium to long term. We, therefore, assume a mildly correlated relationship between Indian debt and Indian equities. Interestingly, this contrasts with our global SAA where the assumption is a stagflationary economic environment and, therefore, have a risk off scenario. This means a higher degree of correlation between debt and equities globally.

Other asset classes in India, like commodities, alternative trading strategies, REITs and InvITs are not as developed as yet. As far as the modelling goes, we cap or constrain out our allocation to these investments. We prefer to play these investments through our Tactical Asset Allocation framework. So, once we have the estimates for volatilities and correlations, it is a matter of running a series of simulations to arrive at the overall asset allocation. We then adjust for drawdown risk budgets for various risk profiles. That’s how we arrive at our SAA.

NS:      Well explained, Srutaban. You referenced our Tactical Asset Allocation framework quite a few times. Can you expand a bit on that?

SM:      Yes. The SAA is the long term asset allocation process. In the shorter term, markets can deviate from long term expectations and averages. Various factors like liquidity, short term demand, supply factors, market sentiment, valuations, you name it. Our TAA framework attempts to capture some of these shorter term moves. We tilt the asset allocation accordingly and, of course, within risk budgets. For example, and very interestingly, our current TAA calls are overweight Indian debt and neutral Indian equities, in contrast with our longer term expectation on neutral Indian debt and overweight Indian equities.

NS:      Thanks, Srutaban. Within public equity markets, there are opportunities to generate alpha through bottom up themes, sectors, and ideas. This would be the right time to bring in our colleague Kartik Soral from our Indian equities team into the conversation.

NS:      So, hi, Kartik. Welcome to our podcast. From a bottom up perspective, what have been the key drivers for Indian equity markets?

Kartik Soral (KS):        Hi, Narayan. Thanks for having me. So, in the period since the pandemic, there have been several cyclical factors that have been driving the Indian economy. These are the factors like availability and growth of credit, well capitalised banks, strong corporate balance sheets, and even a very strong rebound in the private consumption from the lows of the pandemic.

What is interesting is that these cyclical factors have been somewhat supported by the structural factors as well. There are structural factors like the focus on capital expenditure by the central government. There is an improving efficiency of payments through the GST, the direct benefit transfers, and also the UPI payments. And lastly, as Srutaban mentioned, there is an increased focus on Make in India through the production linked incentive schemes to boosting manufacturing output.

So, as a result, what we have seen is that over the last three year period, the Nifty 50, which is the benchmark for the largest and the most liquid 50 companies in India, it has registered an EPS growth of 19% on an annualised basis. Now, this compares quite well with the mid single digit number that was seen in the run up to the pandemic. What is even more interesting and heartening to know is that this EPS growth is not limited to the large cap companies. If we were to look at the EPS growth of the midcap index, it’s grown at a three year CAGR, of 29.6%.

So, among the sectors that have done well over this period expectedly are consumption. If you look at the EPS, which is the earnings per share growth of NSE consumption index, it’s grown at a 33% CAGR over the last three year period.

Banking has done very well. If we were to look at the EPS growth of NSE banking index that’s gone up almost 29% on an annualised basis over this period. And the infrastructure has done well. If we were look at the NSE infrastructure EPS, it’s grown at a 20% three year CAGR.

While these sectors have done well, there are very divergent undercurrents at play within each of these sectors. For example, within the consumption basket, the large ticket consumer discretionary segments like autos and real estate have done much better than the smaller ticket consumer nondiscretionary segment. As an example, you know, NSE FMCG EPS has only grown at 8% CAGR over the last three year period, which is almost one third of what was seen of the overall consumption basket.

Even within the banking sector, even though the private sector banks have grown their loan book at a much higher rate, it is the public sector banks which have displayed a higher EPS growth, primarily coming from the reduction in the nonperforming assets and the provisioning thereof.

NS:      There was a great set of numbers there, Kartik. So, what are the key themes and sectors that we like at the current juncture?

KS:       So, Narayan, from a cyclical perspective, we believe India is in a phase where we should see private sector capex picking up on the back of strong corporate balance sheets and high capacity utilisation numbers, rural demand bouncing back as inflation cools down, and disposable income in the hands of the population improves on the back of good seasonal harvests. High MSP for key crops and pre-election spending should also aid the rural demand bouncing back. Finally, the flow of credit remains relatively unconstrained as banks and NBFCs are adequately capitalised and large bad debt creation remains distant.

With this background, some of the themes that we really like at the moment are, number one, the nonbanking financial companies. Historically, we have seen, when the credit growth in the economy remains healthy and the bad debt formation remains low, the well capitalised NBFCs are able to grow at a much faster rate than the banking sector. This is because of their agile business models and quicker turnaround times. As we find ourselves in such an environment, we believe NBFCs offer a good investment opportunity.

The second theme that we really like at the moment is the two wheeler autos and auto ancillaries. If we look at the last five years, the two wheelers in India have borne the brunt of many factors, including COVID, price increases on the back of BS6 transition. There have been steep raw material price increases. There have been semiconductor shortages, and also the prices have gone up because of the logistics cost increase.

As a result, the two wheeler industry sales in India are at a level seen eight years ago. During the same period, the per capita income in India has grown by approximately 50%. However, as the entry level motorcycles form the majority of the Indian market, the sales have suffered due to affordability issues. We believe that the majority of supply side problems seem to be behind us and that rural consumption is on the cusp of an uptrend. Therefore, the sector offers a compelling investment opportunity.

Finally, the third theme that we really like at the moment is the capex and the industrial basket. Capex oriented spending has escalated post the pandemic with central government doing much of the heavy lifting till now. For example, the capex spend for the current fiscal year is budgeted to be 22% of the central government’s total annual budgetary expenditure. It was just 12% three years ago. It now totals to INR 1 trillion, which is substantial. Further, we also now also expect the private sector to start participating in the capex as the demand environment remains supportive and the corporate leverage remains at a 15 years low.

From a structural perspective, however, the themes that we really like are the electrification trend in autos and the indigenisation of the Indian defence industry. Both these trends are at their inception in India, and we see a long runway ahead for each. However, as the earnings consistency for these companies in the sector are yet to be fully established, we aim to be highly selective in our approach while investing in these themes.

NS:      Thanks, Kartik. My last one to balance the perspectives. Which sectors are we cautious on?

KS:       So, Narayan, from a growth perspective, any hard landing in the United States, although not our base case, and a sharp reduction in discretionary technology spends by clients is a key risk for the Indian IT sector. We would wait for this risk to pass through fully before moving in to be overweight on the sector.

However, many stocks in the sector have undergone a reasonable correction in anticipation of a sharp slowdown. Given the strong cash generating ability of these companies, we would be tracking the cashflow yields generated by the industry leaders to increase our position in the sector. As of today, the cash flow yields for majority of the Indian IT players are in line with the historical averages and they do not offer any great margin of safety.

NS:      Yeah, thanks, Kartik. With this, we come to an end of our podcast but, before you log off, just a reminder to check out India’s Growth Drivers, our new series in partnership with Forbes India, discussing the catalysts of growth behind achieving a USD 5 trillion economy in India. You can visit our global Barclays Private Bank LinkedIn page to find out more, including access to the full video recording, or buy the magazine which is on newsstands until 27^th July.

Once again, thank you for listening to us. Stay healthy and invested and wish you a great second half of the calendar year ahead.