Indian equities remain a high remorse asset that can cause pain during sell-offs and create a fair bit of volatility in portfolios.
2017 was a year that will be remembered for rising domestic equity inflows, strong rhetoric on the government’s reforms, and resilient consumer credit spends. As we head into 2018, we highlight key structural themes that will drive markets:
Structural reforms undertaken by the Government will deliver sustainable growth:
Given the heated debate around the topic of structural reforms, we did extensive research on the subject across geographic regions and over the past three decades. The research is clear: reforms invariably lead to growth and a more resilient economy. What’s also clear is a fair bit of pain is experienced in the short term.
Further, the government chose to undertake a wave of reforms in parallel and the inter-related benefits will create additional multiplier benefits. We expect the pro-growth benefits of these measures to unfold over the coming quarters of 2018 and beyond.
The Flattening U.S. Yield Curve Will Not Be a Cause for Concern:
Global growth is accelerating in a synchronized fashion and all developed regions are showing impressive growth momentum. There’s been a fair bit of hand-wringing around the flattening U.S. yield curve.
At a spread of 57 bps between the 10 years and 2 years, the U.S. yield curve is at a stage where the economic momentum could continue for another year or two. The last stage of a bull market can often be a profitable phase. Hand wringing over the yield curve is misplaced, for now, but bears watching in coming quarters.
Inflation Will Remain Contained:
With deflation in technology and crude, disruptive business models that automate and/or eliminate the middleman, inflation has consistently undershot global central bank’s expectations and will continue to do so in 2018.
Domestically, we are starting to see efforts on agri-technology, yield enhancement, and supply chain management. With near-record food grain production and a positive rabi sowing season, food inflation is likely to be contained and remain within the RBI’s glide path.
Contrasting Global Demographics Favor India and Emerging Markets:
Take India’s 425 million Millennials and contrast them with the millions of Baby Boomers. While Millennials are entering their peak spending and consumption years, Boomers are exiting the workforce and transitioning to dis-savings mode.
33 percent of India’s population are Millennials:
That’s the largest concentration of Millennials in the world. China is a close second with roughly a little over 400 million. The oldest Millennials are now 35 years old, and the youngest 13 years old. We don’t think Millennials are that different a generation.
They prefer to own their homes, aspire to leadership positions, wealth, travel, and healthy living. Entrepreneurship is something they’re passionate about, and they are entering the workforce. That translates to consumption and growth.
Unwinding Balance Sheets in Developed Markets Will Pose a Challenge:
Over the past couple of decades, the easy global monetary policy has propelled asset prices higher and driving bond yields lower. This phase is now coming to an end, as central bank balance sheets are stabilizing and are expected to contract in the coming years.
In contrast, the domestic economy remains well positioned with a healthy banking system in the process of repairing the public sector NPA issues.
Ironically, because of the reforms holding back economic growth last year, India remains quite early in terms of the stage in the business cycle relative to developed markets.
Developed markets will face the headwinds of liquidity being extracted from the system, and a hawkish Fed focused on raising rates. In contrast, India with 7.3 percent yields on the 10 year and real yields around 2.5 percent has sufficient headroom to lower interest rates.
Credit Growth: The Data-Driven Inclusive Economy:
Post demonetization and Aadhaar, India has in less than a year transformed the domestic economy into an Aadhaar driven economy. Information on investment accounts, bank accounts, credit cards, mobile phones, and bills will be available to credit agencies.
India has made a dramatic shift towards a data-driven, organized economy. With rising annual per capita income, $1710 currently, the platform is in place for a continued expansion of credit as a percentage of GDP.
Valuations and P/E Multiples:
The rise in equity markets in 2017 has led to concerns about inflated asset prices and high P/E multiples. With the expected pickup in earnings, these concerns will get alleviated.
The low cost of capital will likely continue to keep valuations elevated. However, the kicker from P/E expansion is all but done and it is essential that earnings growth come through for valuations to sustain.
Expected Returns:
As we look ahead into 2018, it’s instructive to review our position at the same time last year. Markets were in a steep sell-off. We felt equities were the most attractive asset class for investments with a three-year horizon and the valuation opportunity in favor of equities was as attractive as at any time since June 2013.
It’s a more difficult call this year, with valuations stretched, unwinding central bank liquidity, and a hawkish Fed intent on rate hikes.
Investors with a suitable level of risk appetite have benefitted strongly over the past few years. We remain of the opinion that India is early to middle stages of a business cycle recovery.
Taking into account the kicker we expect from structural reforms leads us to a favourable view on equities. In particular, well managed active funds have delivered returns far in excess of benchmark returns. We remain favourably disposed towards specialized investment managers.
In contrast, the last few months have demonstrated to debt investors that fixed income can be a risky asset class in a rising rates environment. With bond yields reflecting much of the uncertainty over the fiscal borrowing plans of the government, debt investments are likely to return somewhere between 6-9 percent over the year.
Portfolio Composition:
Our view on Gold remains underweight. We see a limited reason to change our forecast. On a fixed income, we remain positioned in corporate bonds and short-term debt until the rise in rates stabilizes.
Our relative valuation models continue to suggest that prospective returns for equities will be higher than debt over a longer investment time frame. We remain invested in equities and recommend that investors consider adding an appropriate degree of risk to their portfolio.
There is a reasonably strong likelihood of a correction along the way, and tactical asset allocation and protective strategies will be valuable in those periods.
Indian equities remain a high remorse asset that can cause pain during sell-offs and create a fair bit of volatility in portfolios. However, investors that have been willing to accept the risk of volatility have been handsomely rewarded over the past two decades. Staying invested in equities and embracing short-term volatility is likely to continue to prove to be profitable.
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