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Investment Strategy

May 5, 2023

• Continued macro ambiguity as both growth and inflation remain elevated.
• US corporate earnings have surprised positively but could enter an earnings recession.
• Indian corporate earnings have been mixed so far.
• In uncertain times, revisiting overall strategic asset allocation may be prudent.
• A slowdown in private market deal velocity suggests more reasonable valuations.

The Chinese Puzzle
Despite increasing noise around the US recession, global equity markets have remained surprisingly resilient throughout the year, emphasising the high levels of ambiguity we are seeing. Economic data, while slowing down, is still very strong and is in no way close to recession levels. Similarly, there are divergent views on inflation. Similarly, there are divergent views on inflation; some believe inflation is likely to stay higher for longer, while others expect it to roll over swiftly. Additionally, there is no consensus on the Fed’s future course of action, with the market anticipating sharp rate cuts in the second half of 2023 and the Fed looking to hold rates higher to fight inflation.

Source: Bloomberg, Sanctum Wealth
All data are in local currency and are price returns.

Global Macro Update
US GDP for the first quarter of calendar 2023 grew at 1.1% vs the consensus Bloomberg estimate of 1.9%. However, a closer look at the data indicates that consumer spending remained strong, growing at 3.7%, the fastest in nearly two years. The GDP growth decline was primarily due to a fall in inventories, which suggests that corporates are anticipating weaker demand in the future. A slowdown in housing and business investments also contributed to the decline in GDP growth.

A tight labour market, characterised by a 3.5% unemployment rate and a sharp fall in jobless claims, supports robust consumer spending and fuelling concerns of sticky inflation. The core personal consumption expenditure (PCE), a measure of inflation tracked by the Fed, was recorded at 4.9% in Q1 CY 2023 against consensus estimates of 4.7% and the prior quarter number of 4.4%.

US Quarterly Real GDP Growth (YoY%)

Source: Bloomberg, Sanctum Wealth

Another near-term risk factor for the US is the debt ceiling showdown. The Republicans seem unwilling to consider raising the debt ceiling without substantial spending cuts. With Presidential elections in 2024, the debt ceiling is likely to be a political tussle more than anything. The US has never defaulted on its debt, and a last-minute deal will likely be achieved. However, spending cuts would further exacerbate the impact of rate hikes.

As we enter a stagflation-like environment (slowing growth and elevated inflation), the Fed may continue focusing on bringing down inflation before looking to support growth. Hence, while the market may expect rate cuts by the Fed later this year, the Fed may remain on hold unless inflation falls below 3% and unemployment jumps to 4.5%, or there is a significant collapse in growth, or the financial market/system experiences substantial stress.

The situation in Europe is no different. Growth has slowed, but there are pockets of resilience. Inflation remains elevated, and central banks continue to remain hawkish. However, China is different. Unlike the rest of the world, inflation in China in March 2023 grew at just 1.1%, providing room for the central bank and the government to implement policies supporting economic growth. Additionally, China’s economic growth rate at 4.5% in Q1 CY2023 was higher than most of its peers and surpassed analysts’ forecasts of 4.0%.

China Quarterly Real GDP Growth (YoY%)

Source: Bloomberg, Sanctum Wealth

Global Markets Outlook
More than half of S&P 500 companies have reported their earnings for Q1 CY 2023. 79% of these companies have reported higher-than-expected EPS, beating analyst expectations by an impressive 6.9% aggregate, comfortably one of the best performances relative to analyst estimates since Q4 2021. However, despite this positive earnings surprise, the index is still expected to report a second straight quarter of decline in earnings, pushing the US into an earnings recession.

Analysts expect earnings to decline by 5% in Q2 before growing at 1.7% and 8.8% in Q3 and Q4, respectively. However, there is significant scope for a downward earnings revision in Q3 and Q4 as the lag impact of rate hikes is felt in the economy. Furthermore, the S&P 500’s 12- month forward price-to-earnings (P/E) ratio of 18.1 is above the 10-year average of 17.3, suggesting that US equities are not cheap.

S&P 500 Earnings Growth: Quarterly growth (YoY%)

Source: FactSet Earnings Insights as of 28 April 2023

Two factors that could have contributed to market resilience in the face of macroeconomic headwinds include positive earnings surprises and bearish sentiments amongst market participants, as highlighted by fund manager surveys conducted by institutions like Bank of America. Eventually, the market will have to align with the reality of a possible stagflation environment.

The US dollar is also likely under pressure amid weak US economic data, concerns around the debt ceiling deadlock, and expensive valuations relative to peers. Additionally, the dollar could face greater headwinds if the Fed is comparatively more dovish than its European counterparts, which is likely to support emerging markets. Emerging markets have generally performed well in environments where the dollar has weakened.

Indian Macro Update
Overall, Indian macroeconomic data remains mixed. While PMI numbers remained above 55 in March and GST collections touched a new all-time high of INR 1.87 lakh crores in April, core industry growth in March declined to 3.6%, the slowest pace in five months. Additionally, CPI inflation dropped to a 15-month low of 5.6% in March vs. 6.4% in February, and WPI inflation continued its downward trajectory declining to 1.3% in March.

Almost as if expecting the inflation decline, the RBI decided to keep the policy rate unchanged in its April policy, which was a surprise given the market expectations of a 25bps hike. However, the RBI has kept the door open for further hikes if the data demands it. The RBI is likely to remain on hold through the rest of this year.

Crude oil price is one thing that the RBI would be closely watching. The OPEC+ countries decided to cut production in a surprise move to push the crude market output to a deficit in Q2 CY 2023 vs earlier expectations of a surplus. A weaker oil demand from a slowing global economy and the build-up of inventories amid warmer winters could offset the output cut and keep crude oil close to current levels. However, further output cuts could push prices higher and thus impact the Indian economy subsequently.

Indian Market Outlook
The earnings season for Q4 FY 2023 (quarter ended March 2023) in India has just begun. Only about one-fifth of Nifty 500 companies have declared their results so far. As expected, banks have delivered strong results, with the larger private banks delivering in-line or better results. On the other hand, IT heavyweights disappointed markets with lower-than-expected numbers for the quarter and muted guidance for FY 2024. While it is still too early to conclude, results have been mixed and largely aligned with expectations. At an aggregate level, Nifty EPS is expected to grow at close to 14% yoy in Q4 FY 2023 and about 12-13% in FY 2023. However, a large part of this is from the Financial and Auto sectors, and Nifty EPS is likely to be flat if we exclude these two sectors.

Nifty Quarterly EPS Growth (YoY %)

Source: Motilal Oswal Research

Comparative valuations of Indian equities have improved due to their underperformance relative to other emerging markets. In addition, the earnings delivery in India at double-digit growth is strong relative to the rest of the world. However, global macro headwinds will likely affect India, as seen in the muted IT sector results. We await the full quarter earnings results before reviewing our neutral stance on equities.

Fixed income
With the RBI deciding to keep rates on hold, we believe bond yields are headed lower over the next few quarters. If not already done, adding duration to portfolios could be prudent. However, it is essential also to consider the potential risks associated with global headwinds and the uncertain rate trajectory of the Fed.

Debt mutual funds offer advantages such as higher liquidity, the possibility of mark-to-market gains in a declining interest rate environment, and diversification. Despite recent tax amendments, they remain a viable option for investors. For those with limited risk-taking capabilities, some allocation to equity savings funds taxed as equity may also be a suitable option. For others, selecting structured credit funds or absolute return strategies may improve post-tax returns. In addition, allocating some funds to REITs and INVITs at current levels may also help improve the overall portfolio return profile.

We have highlighted the importance of staying invested in gold in an environment where growth is slowing, and inflation remains elevated. Despite it touching new all-time highs, there is merit to gold allocation. Amid the expectation of a weak dollar, gold can act as a haven. Demand for gold from central banks, speculators, and investors has also increased.

Overall, uncertain times like these warrant a look at asset allocation. Rebalancing in line with risk profiles and allowing minor tactical asset allocation deviations as and when opportunities present themselves could lead to a much smoother ride through this volatility and optimal portfolio outcomes.

India Private Markets
Over the last few years, the private market allocation has started representing a more meaningful proportion of HNI investment portfolios. With the noise around the funding winter, we evaluate the private market opportunity in today’s environment.

Private market deal velocity was the highest ever in 2021, with most investors flushed with liquidity. As financial conditions tightened in the second half of 2022, we saw a global decline in deal-making, commonly termed the funding winter. According to Venture Intelligence, PEs and VCs invested nearly USD 5.6bn across 184 deals in the quarter ending March 2023. In 2019, before the liquidity gush, the average quarterly amount invested by PE and VC was USD 9.2bn across about 240 deals. Hence, the deal value has dropped by about 40%, and the deal count by about 25%. While these declines may seem significant, it is essential to note that high-quality companies continue to receive funding.

Av. Quarterly PE and VC Deal Count and Value

Source: Venture Intelligence, Sanctum Wealth

Our discussion with industry participants highlighted that in 2021 and 2022 when liquidity was abundant, deal velocity led to the loosening of deal terms and even somewhat inferior companies were getting unjustifiable valuations. As investors exercise greater caution, deal terms have become more prudent and valuations more rational. Thus, in the near term, companies need to improve their profitability path and reduce cash burn.

Structurally, the need to solve problems with very big eventual outcomes is a key fundamental factor for the long-term growth of private markets in India. The development of digital and physical infrastructure has also enabled the emergence of startups catering to the vast middle India rather than the overcrowded top of the pyramid. Moreover, India has emerged as one of the top three destinations for foreign flow into private markets. Furthermore, some of the local PE and VC managers have been able to raise some of the largest funds ever, even in current times.

Along with PE and VC, the Indian venture debt ecosystem has grown significantly over the last few years. However, it is still highly under-penetrated. Only some of the best startups have access to venture debt. Venture debt sits at the top of the capital structure and typically has some assets like current assets, inventory, and IP as collateral. Also, in most cases, the debt is a tiny portion of the overall firm valuations, and hence even in a distress sale, venture debt investors can come out unscathed. Thus, while it may appear that investors are capping returns when investing in venture debt, a regular cash outflow at a very healthy IRR could eventually lead to a superior return for the risk taken.

Despite the noise around the funding winter, we recommend investors with the risk appetite, investment horizon, and patience required for these investments to evaluate opportunities in the PE, VC, and venture debt space if currently under-allocated.

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