Mar 9, 2023
• Global markets reassessed the Fed’s policy path and corrected last month.
• Fed may keep rates higher for longer, which could impact US growth later this year.
• US bond yields are attractive, but volatility could continue.
• US equity valuations are still not cheap, leaving room for further downside.
• Indian equity valuations are also not cheap, but with better earnings prospects, we remain neutral.
Fed-1 Market-0
The last few months have seen a tug-of-war between Fed action and market reaction. Either party had to blink, and the market did. Last month, data from the US showed that growth in some parts of the economy is still strong, the labour market is tight, and inflation is sticky, suggesting that the Fed may continue tightening a bit more and keep rates higher for longer. We have been highlighting how the market had been getting ahead of itself, exposing itself to downside risks. As the market reassessed the Fed’s policy path, it corrected last month. The US 10-year bond yield touched 4% last week from a recent low of ~3.4% in January. The equity market rally from Oct 2022 lows has also fizzled out.
Source: Bloomberg, Sanctum Wealth,
All data are in local currency and are price returns.
Global Macro | A tightrope
At this point, all eyes are focused on – whether the Fed can engineer a soft landing for the US economy, i.e., bring down inflation towards its target of 2% without causing a deep recession. Recent strong US economic data have only made the Fed’s task more difficult. The jobs number for January was much higher than estimated, and unemployment fell to multi-decade lows. This was followed by the personal consumption expenditures (PCE) index, the Fed’s preferred measure of inflation, rising more than expected to 0.6% month-on-month in January. Retail sales in January jumped up 1.8% month-on-month, and, finally, the Services sector is not showing any signs of a slowdown, as indicated by January and February ISM services PMIs of 55.2 and 55.1, respectively.
In the last monetary policy meeting, the Fed looked determined to continue raising rates and appeared comfortable with risking doing too much rather than too little. With the recent data, Fed funds futures are indicating more than an 80% probability of terminal rates being 5.5% or higher versus less than a 15% probability last month, and rate cut expectations by the end of this year have almost disappeared. While US recession expectations have also been pushed out further, the lag impact of these rate hikes and higher- for-longer rates could lead to a sharper recession than currently envisaged.
Market pricing in higher terminal rates
Source: CME Group
In Europe, one of the worries was a shortfall in energy supply over the winter. However, higher-than-usual temperatures across Europe have helped avoid widespread energy shortages. This led to a rebound in consumer and services business confidence. The ECB has been equally determined to stay on the path of monetary tightening but could be less hawkish than the Fed, given the cooling off in energy prices. The tight Euro-job-market and the Ukraine-war remain key risks for the region.
Meanwhile, China is seeing a faster-than-expected normalisation of economic activity as visible in the surge in domestic Lunar New Year holiday trips, the highest since 2020. In addition, still low inflation in China means the central bank can continue providing policy support, unlike the rest of the world.
Global Markets Outlook
US bond yields at 4% are attractive from a historical point of view. However, at this level, real bond yields
are negative and below the Fed rate of 4.75%, where they usually tend to trade at least 100bps more than
the Fed rate. This is because the market is expecting rate cuts by early next year. However, given sticky
inflation, Fed policy action and any delay in the rate cut timeline could lead to volatility.
In the US, the first quarter marked the largest decline in EPS estimates during the first two months of a quarter since Q2 2020. CY 2023 EPS estimates declined by 3.4% to a full-year growth target of 2.1%. With US equities hardly correcting, the 12-month forward PE is now slightly higher than the 10-year average and somewhat expensive relative to the rest of the world. This leaves US equities with significant downside risks, given the expectation of an economic slowdown. In Europe, valuations are much better, which has led to its outperformance versus US equities. The same could continue in the near future.
Changes in S&P 500 quarterly EPS- First two months of the quarter
Source: Factset
Emerging markets, led by China, have rallied sharply over the last few months. Chinese equities have now rallied more than 50% since their October lows. Despite this rally, valuations are still lower than the historical average. With strong recovery amid reopening and policy support, momentum in Chinese equities may continue. Emerging market currencies have so far held up despite the rebound in the US dollar. However, if the US dollar strengthens significantly amid prospects of higher interest rates, it could be a risk to EM currencies and, thus EM equities.
Indian Markets Update
Indian equities also corrected last month in line with global markets. Given the higher exposure of Adani in the Nifty Next 50, it corrected more than the Nifty 50. PSU Banks also corrected due to their exposure to the Adani group of companies. Metal stocks saw significant correction given the global demand slowdown expectation. IT was among the few sectors that held up.
Source: Bloomberg, Sanctum Wealth
Above returns are total returns
Tactical Asset Allocation | Quarterly Asset Pairs Review
As a framework for action, the Sanctum Investment Committee discusses the output of our proprietary asset pair model to cut through the noise and focus on what the data is saying every quarter. These insights serve as input for our tactical asset allocation decisions and, eventually, our model portfolios. Running the model this quarter, we found that our relative position vis-à-vis most asset pairs remained neutral. The only changes we saw were a move in favour of midcaps versus largecaps and in favour of gold versus cash.
Equities vs Bonds
Valuations are still not cheap
A sequential decline in India’s growth momentum was expected amid global growth headwinds. However, whilst India’s GDP growth in Q3FY22 moderated to 4.4% y/y, slightly below market expectations, it was in line with RBI expectations. Weaker-than-expected private consumption growth led to moderation in GDP growth, and de-growth in non-oil imports and exports also pointed towards slowing consumption. However, other indicators such as PMIs, non-food credit growth, passenger vehicle volumes, and core industry growth remained robust, suggesting the economy’s overall strength.
The impact of the global growth slowdown was also visible in corporate earnings for Q3FY22, especially in sectors exposed to global demand. Overall, the earnings growth numbers were slightly tepid. However, while input cost pressures continued to impact year-on-year profitability, we saw some improvement on a sequential basis.
Non-Oil imports declined
Q3 FY22 earnings have been a mixed bag
Source: Bloomberg, Sanctum Wealth
Despite somewhat mixed data, it all boils down to valuation. While Indian equity valuations on some parameters have moderated, they are still relatively expensive on others. Indian equities are trading close to the long-term average on 12M trailing P/E and P/B. However, 12M forward P/E is above average and, despite moderation, MSCI India continues to trade at a premium to MSCI EM. More importantly, equities are expensive relative to bonds, as the bond yield to earnings yields ratio suggests. As bond yields have inched higher, investors have the option to get slightly higher returns in fixed income without having to take too much equity risk, and this makes a case for equities that much weaker.
Nifty trailing P/E close to historic averages
Equity expensive relative to bonds
Source: Bloomberg, Sanctum Wealth
The asset-pair model suggested a marginal decline in macro fundamentals, offset by a marginal improvement in valuations, and an improvement in earnings was offset by weaker technical momentum. Overall, the scores remained neutral for equities versus bonds.
Largecaps vs Midcaps
Midcap valuations and earnings momentum have improved
The 12-month trailing earnings of midcap equities have turned flattish over the last few months. However, the consensus is that mid-caps are expected to grow by 23% over the next two years vs large-cap earnings by 15%. Additionally, the valuations of midcaps have also moderated on a 12-month trailing basis.
Midcap trailing valuations are lower than historical average; Nifty close to average
Source: Bloomberg, Sanctum Wealth
While the scores have moved in favour of midcap equities, global headwinds could impact midcaps more than largecaps, given the high-beta nature of those stocks. Hence, we will wait for more data in favour of midcaps before adding more midcap exposure to our model portfolios. Also, as highlighted in our previous commentaries, this year is likely to be a stock picker’s market, and a tilt towards either mid or largecap may add little incremental value.
Fixed Income | Corporate vs Government | Short-term vs Long-term
Yield curve flat, credit environment favourable
There are several factors at play in the bond markets. Global and local bond markets have seen some volatility, which could continue as markets speculate on future Fed action. Also, the yield curve is very flat, thus reducing the opportunity cost of not being in long-maturity bonds. On the other hand, we believe we are towards the end of the RBI rate hike cycle, and the absolute level of bond yields is attractive.
Additionally, the government is sticking to its fiscal consolidation path where, while the overall borrowing number is still high, it is in line with expectations. The market also expects the RBI to step in with OMOs if liquidity becomes tight.
On balance, we believe investors should start adding duration amid the expectations of volatility ahead. Investors with a fixed time horizon can lock in yield via target maturity funds.
Yield curve is very flat
Borrowing in line with market expectations
Source: Bloomberg, Sanctum Wealth
Corporate credit spreads have remained low for a while. Also, the rise in corporate bond issuance has offset credit demand growth. Thus, adding AAA or AA to the portfolio will unlikely provide a meaningful yield pick. With the change in the taxation of market-linked debentures (MLDs), investors looking for yield pick- up can no longer rely on tax arbitrage. Investors need to look at going down the credit curve. Since the overall corporate leverage is low and upgrades continue to outnumber downgrades, we believe investors can selectively invest in high-yield bonds or structured credit risk funds.
Corporate spreads remain low
Strong credit growth offset by Corp bond issuance
Source: Bloomberg, Sanctum Wealth
Gold vs Cash
Many factors in favour of gold
Gold had rallied hard since Nov 2022 before taking a breather in February. We have remained overweight gold for most of 2022, which has worked out well. Even now, many factors remain in favour of gold. US inflation, despite some moderation, is high, which means bond yields as well as real interest rates are still negative. ETF selling has slowed down, and open interest has increased. The stagflation environment and expectations of financial market volatility also augur well for gold. Most importantly, global central banks have been buying gold. In 2022 central banks bought close to 1,100 tonnes of gold, the highest in 55 years.
Hence, despite slowing technical momentum, we believe investors should remain overweight gold in the current environment. The only risk is the US dollar’s strength. With expectations of a hawkish Fed, the US dollar has strengthened, which is negative for gold. However, given that we are in the last leg of the Fed rate hike cycle, the dollar may not strengthen significantly from here to impact gold severely.
US inflation still elevated
A resurgence in USD could be negative for gold
Source: Bloomberg, Sanctum Wealth
Sanctum Multi-Asset Portfolios
To guide investors in creating optimal portfolios, we have been maintaining model portfolios called the Wealth Profiles since our inception. In December 2021, we launched our multi-asset PMSs called Sanctum Multi Asset Portfolios (S-MAPS) to allow investors to invest directly in our model portfolios. They are the best reflection of our tactical asset allocation views. The Asset pair model is a key input in constructing these portfolios. We run three portfolios under SMAPS, a conservative, balanced and aggressive portfolio called Shield, Enhancement and Generation, respectively.
As highlighted above, we are neutral equities versus bonds, underweight cash, and overweight gold. Post the budget, we exited our exposure to REITs amid a change in taxation and added that weight to target maturity funds. The drawdown seen in REITs post the budget has impacted our short-term performance, especially in Shield. Our overweight in gold, value-focused mutual funds and exposure to EM equities have added to our performance.
Here is a performance update of our three multi-asset portfolio strategies:
Corporate spreads remain low
Performance is calculated using Time Weighted Returns, net of fees and expenses. Returns over one year are compounded annually; returns for less than one year are absolute. Please note that SEBI does not verify the performance information provided above. Please note that past performance is not a guarantee of future performance.