Jan 14, 2023
• Global markets ended the last quarter on a positive note after a tough first nine months of the year
• Global growth is likely to moderate in 2023 amid tighter financial conditions
• Slower growth will weigh on global equities; Indian equities may underperform global peers as the divergence of 2022 narrows
• Domestic bond yields may have peaked. Investors should lock in yields over the next few months
• Gold could outperform in 2023 also, as dollar strength reverses. It is a hedge against recession risks.
Muddling through
After what seemed like an eternity, 2022 allowed us to finally get back to the small things we had taken for granted pre-pandemic. However, the resurgence of global inflation meant that the world was not going back to where it was pre-pandemic, at least from an economic point of view. Global central banks, after initially underestimating inflation, acted swiftly by tightening monetary policy at a record pace. Also, for the first time since World War II, we saw a war in Europe which caused supply-side disruptions adding to inflationary pressures. Both global equities and bonds closed the year in red- only for the fourth time in 150 years.
However, we ended the year on an optimistic note. Global equities bounced back in the last quarter of 2022 to recover some losses. The US 10-year bond yields have eased from the October 2022 peak, and Gold has rallied more than 10% in the last few months.
Source: Bloomberg, Sanctum Wealth
Global macro
Throughout 2023 markets did not believe Fed-speak, yet the Fed defied them by raising rates higher and swifter than expected. Even today, the markets expect Fed to cut rates closer to Q3 CY2023 but the Fed is indicating that they will hold throughout the year.
Market expectation of Fed rate cuts
Source: Morgan Stanley, 2023 Outlook Survey
This is despite economic data turning weaker. A recent Fed paper indicated that considering the compressed pace of rate hikes, its impact would percolate into the economy in about 12 months rather than the usual 18-24 months. We hit the one-year mark in a couple of months. We are already getting data showing business closures are higher; unemployment insurance claims are up a whopping 30% since May 2022 lows. US consumers are ratcheting credit card debt when commercial banks’ rates on credit card plans are over 19% – a multi-decade high. This, in turn, implies that US consumer spending is at an inflexion point and will quickly roll over. Recession is barely even a debate now.
The debate has moved to whether the recession will be short or long and deep or shallow. Fed appears committed not to easing rates till inflation is back to below 3%. But something in the credit markets could break before that, forcing the Fed to reconsider its stance. Either way, the world needs to brace for pain emanating from the US.
China finally relented on its zero covid policy, although not before people took to the streets in protest. While under lockdown, households have amassed huge savings a chunk of which may be spent as the economy opens. This expansion of consumption would result in an economic bump-up. However, if one is to consider a slightly longer horizon, the debt de-leveraging cycle would continue to limit GDP growth.
US and EU are entering a recession but partially counterbalanced by reopening related bounce in Chinese GDP, and this implies global GDP growth for the year could average lower than 2022.
Global markets
Corporate earnings downgrade in the US has begun in line with the expectation of moderating economic growth. Earnings downgrade will worsen valuations unless prices correct further. We expect US equities to continue to underperform global markets in the first half of 2023.
S&P 500 earnings change during the quarter
Source: Factset
Data depicts the change in EPS estimates from the start to the end of the respective quarter
While recession risks are most prominent in Europe, markets seem to have priced in the worst. Therefore, attractive valuations partly offset poor macro fundamentals.
Recovery in emerging market equities is linked to China’s reopening. While a surge in Covid cases this winter is a risk, economic reopening, attractive valuations, and policy stimulus could support a bounce in Chinese equities in the short term. Additionally, dollar strength in 2023 has also weighed on EM equities, and if the dollar weakens, it could support equity flows into emerging markets. However, deleveraging and property market meltdown suggest widespread pain in the Chinese economy, which will require some doing before long-term recovery can be achieved.
MSCI China trading at discount to MSCI Asia ex Japan
Source: Bloomberg, Sanctum Wealth
Japan may turn out to be the surprise element in 2023. The front runner in the race to succeed the retiring incumbent central bank governor is known to be a hawk. A departure from the ultra-loose monetary policy that Japan has followed for over a decade should be a key development to watch.
Dollar strength amid Fed rate hikes has helped US export inflation. The dollar could weaken in 2023 as valuation relative to other currencies has turned unfavourable, and Fed rate hikes are expected to moderate.
Dollar strength could reverse this year
Source: Bloomberg, Sanctum Wealth
Indian Macro
Stronger Indian macroeconomic fundamentals relative to the rest of the world have been well articulated throughout the last year. The real question is whether India can remain resilient even as the world slows in 2023. Recent data reiterates India’s relative strength. According to first advance estimates, India’s GDP is expected to grow at 7% in FY2023, higher than RBI’s growth estimate of 6.8%. A robust agriculture sector on the back of a good monsoon, a strong services sector and private consumption led by discretionary spending is likely to support GDP growth. On the other hand, a slowdown in export and still muted private sector capex could negatively impact the numbers.
Source: IMF, World Economic Outlook October 2022
High-frequency data like PMIs. GST collections, credit growth and car sales are also showing strength. Both manufacturing and services PMI in December increased further to touch 58, one of the highest in the world. GST collections from April through December averaged INR 1.49 lakh crores, higher than budget estimates of INR 1.45 lakh crores.
Strong PMI data
Source: Bloomberg, Sanctum Wealth
However, a few things need to be watched closely. As highlighted above, the global slowdown has impacted exports and is likely to continue. Also, real wages in rural sectors are declining even as urban sector wages grow. Private capex has been restricted to industries which have received sops. A silver lining here is the high levels of capacity utilisation and low corporate leverage, which could allow industries to do capex if demand sustains.
Overall, while there could be some momentum slowdown going forward, given global growth worries and the lag effect of domestic rate hikes, India seems to be on a structural growth trajectory.
Indian Equities
Indian equities were one of the top-performing global equity markets in 2022, as the Nifty ended the year in green. However, investors saw some pain in the domestic equity portfolios as smallcap, and smaller midcaps underperformed headline indices. Strong macro tailwinds, buying by domestic institutional investors and robust earnings growth supported Indian equities.
Source: Bloomberg, Sanctum Wealth
As India did not correct in 2022, valuations are expensive in absolute terms relative to its history and peers. Strong earnings have supported the markets; hence, they are pivotal if India has to sustain higher multiples. Additionally, as mentioned in our last month’s note, Indian equities could underperform the rest of the world as the divergence in performance seen last year normalises. India is likely to be a beneficiary of EM inflows, however, rebalancing away from India into China, given the valuations disparity, may impact the inflows.
India is expensive relative to its peers
Source: Bloomberg, Sanctum Wealth
Given the likely economic slowdown globally in 2023, a tilt towards domestic cyclicals could be beneficial. The tailwinds like lower commodities, improving manufacturing competitiveness, and infrastructure investments will continue to benefit India in 2023 as well.
One of the largest beneficiaries of the ensuing investment and consumption will be the financial sector, which is witnessing decadal-high credit growth. High double-digit credit growth is likely to continue, given that we are just getting started after years of lull in the sector. The non-frontline banks will continue to deliver as the growth will be higher in those names because of their low earnings base. We wrote about this in detail in our portfolio commentary last month.
Apart from banks, the auto sector is witnessing earnings growth as easing production bottlenecks led by waning chip shortages, and correction in commodity prices bodes well for margin expansion.
Indian Fixed Income
Since the rate cut cycle in India wasn’t very steep, the rate hike cycle has also been less steep relative to the rest of the world. RBI raised a cumulative 1.9% in 2022 vs. a 4.25% hike by the Fed. Also, since inflation in India is largely due to global factors, most rate hikes were aimed at defending the currency. With initial signs of inflation rolling over and signs of global central banks coming to the end of their rate hike cycles, the RBI may not be required to act further. Hence, the RBI could pause going forward.
Generally, January to March is the time when liquidity is tight. Additionally, demand and supply are evenly matched. Higher tax collections suggest the government may be able stay within its fiscal deficit target; however, high levels of SLR and credit growth suggest Banks may not be very active buyers in current markets. Thus, there could be some pressure on yields in the short term.
Over the last few years, investors have had to look at alternatives to boost yields amid a low-yield environment. Investors shouldn’t wait long and lock in yields with yields turning attractive. We prefer the 3-4 years yield bucket as the yield curve is very flat. Investors with longer time horizons can match duration with their time horizon. As corporate spreads remain low, we prefer the more liquid government bonds. Investors looking for some yield pickup could look at well-managed credit opportunity funds.
The Indian yield curve has turned flat
Source: Bloomberg, Sanctum Wealth
Gold
Gold frustrated investors most of the last year before rallying more than 10% in the last quarter. Overall, it outperformed equities and bonds, and Gold could do well in 2023 as well. The world is entering an environment of low growth and high inflation (stagflation). The chart below shows Gold as the best- performing asset class in a stagflation environment. Additionally, dollar strength weighed heavily on gold prices last year. As mentioned above, the dollar could weaken, which is positive gold. Also, in case of recession risks materialize in 2023, gold can act as a haven. Historically gold has done well in past recessions. Finally, technical momentum is also in favour of gold. Hence, we remain overweight gold in our model portfolios.
Gold outperforms in a stagflation environment
Source: Bloomberg, Sanctum Wealth
Annualised average return. Data from 1973 to June 2021
Conclusion
As we enter 2023, our views haven’t changed materially in the last few months. We remain neutral on equities and neutral between large and midcap. We continue to be overweight gold. We think the current yield levels are attractive however, we prefer matching duration to the investment horizon and for now would not like to take duration calls. Overall, we believe at least the first half of 2023 is likely to be just an extension of 2022 where we all are muddling through.