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Investment Strategy

Jun 7, 2023

• Debt markets have finally aligned themselves with the Fed’s stance of higher-for-longer rates.
• Mega-cap stocks in the US have led the rally but look vulnerable again.
• We are neutral on equities, with a slight positive bias, as still-not-cheap valuations offset strong economic and earnings growth.
• We remain overweight on Gold as we believe several factors favour the yellow metal.

Cut Through the Clutter

The world can finally breathe a sigh of relief as President Biden signed the deal that suspends the US debt ceiling for two years, preventing a potential US default. Investors can now return to the basics and base their investment decisions on sound fundamentals. In this report, we cut through the clutter and use our asset pair model to help our investors with their tactical investment positioning.

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

Global Macro

After much hue and cry, the US debt ceiling deal was reached last week. Goldman Sachs describes the deal as a significant reduction in uncertainty but a small reduction in spending. The deal suspends the debt limit until January 2025, going beyond the next US Presidential election, and enforces a cap on non-military discretionary spending for the next two years. The US treasury will now have to borrow to restore cash balances, potentially draining market liquidity. Moreover, considering the anticipated US recession in the coming quarters, the spending cap could exacerbate the situation. Nevertheless, given the initial deadlock between Democrats and Republicans, the deal probably represents the best possible outcome, with a longer duration of limit suspension and lower-than-expected spending cuts. With the reduction in uncertainty, the focus will return to the economy and the central banks.

The latest US jobs report showed that the US economic data remained mixed. In May, the number of jobs added and the unemployment rate exceeded expectations, giving contradictory indications about the labour market. Similarly, while the US CPI inflation in April 2023 slowed to 4.9% vs 5% in March 2023, core PCE inflation increased more than expected.

The ambiguity in the economic outlook is also reflected in the May FOMC meeting minutes, which revealed a divided Fed. The Fed chair signalled a possible rate pause, highlighting the need for the central bank to rely on incoming data before making further policy moves. Several other Fed officials supported this stance, although some felt further rate hikes might be warranted. Amid still-tight labour markets and elevated inflation in the US, the market’s expectations, as reflected by Fed funds futures, have shifted, as visible in the chart below, and are finally aligning with the Fed’s stance of higher-for-longer policy rates. From expecting three rate cuts a month back, the market now anticipates only one rate cut by the end of the year.

Market pricing of rates by the end of the year

Source: CME Group
Please note that the current Fed fund rates are at 5.00-5.25%

Even as policy rates in the US are closer to the peak, concerns around sticky inflation in the UK and Europe could prompt the BoE and ECB to continue hiking rates in June and beyond. In the UK, core CPI accelerated to 6.8% YoY in April, surpassing the consensus expectations, while headline inflation hit 8.7%. Similarly, in Europe, although the headline inflation fell to 6.1% in May from 7% in April, it remains way above the ECB’s target of 2%.

Turning to China, recent data suggest a patchy yet growing economy. On the one hand, retail sales were up 18.4% YoY in April; however, on the other hand, industrial production rose only 5.6% falling short of market expectations of 10.9%. The market expects the Chinese government to intervene to support the economy; however, the government has been circumspect in this regard thus far.

Global Markets Outlook

The US 10-year government bond yield has moved close to 3.7% from May lows of 3.3%, reflecting the market’s adjustment of expectations regarding future Federal Reserve policy actions. If the terminal policy rates were to settle in the range of 2.5% to 3%, as anticipated by many economists and indicated by the Fed dot plot, a yield closer to 4% for the 10-year US government bond seems reasonable. Historically, the 10-year US government bond yield has traded at around 1% spread above the Fed fund rates.

US 10-year Bond Yield Chart

Source: Bloomberg, Sanctum Wealth

Unlike the bond markets, the US equity markets have continued to move higher. Year to date (as of 30 th May 2023), the technology sector-heavy Nasdaq is up more than 30%, significantly outperforming the S&P 500. Almost all gains have come from the Mega-cap stocks, which collectively outperformed S&P 500 by approximately 35%. Strong earnings, demand boost from the application of AI and the possible peaking of interest rates have been the prime drivers of the rally. With expectations of higher-for-longer rates, likely US recession, and elevated valuations, these mega-cap stocks could be vulnerable again.

Performance of US Mega-cap Stocks vs Others

Source: GS Global Investment Research and GS Asset Management

Last week the Japanese equities, represented by the Nikkei 225 index, reached levels not seen in over 30 years. However, a weak Japanese Yen (JPY) eroded some of the returns for foreign investors. Improving corporate governance as firms work towards increasing return on capital and cheap valuations have increased foreign investor interest. The rally in Japanese equities could have a solid foundation due to the ongoing structural shift in corporate Japan. Additionally, analysts expect the Bank of Japan to shift from an extremely dovish policy so far to a more hawkish stance, which could support the JPY going forward.

Indian Markets Update

Indian equities ended the month with gains. Broader markets outperformed the Nifty index. The IT sector gained the most in line with global technology stocks. PSU banks and Metals, the leaders in 2022, have lagged so far this year.

Source: Bloomberg, Sanctum Wealth
The above returns are total returns

Tactical Asset Allocation | Quarterly Asset Pairs Review

Amid the global macroeconomic uncertainty, our asset allocation model helps us cut through the clutter and focus on sound fundamentals to arrive at our tactical asset allocation calls. This quarter, the asset pairs model suggests a slight preference for equities over bonds and continues to favour gold over cash. The sub-asset class scores, such as large-caps vs mid-caps, corporate bonds vs G-Sec, and short-term vs long-term bonds, are all neutral. Additionally, the model indicates relative INR strength compared to the USD.

Equities vs Bonds

Global growth slowdown, valuations still a concern

India’s recent GDP data showcased its relatively strong economic growth. In Q4 FY23, the GDP growth stood at 6.1%, surpassing consensus estimates. For the full year FY23, India achieved a robust GDP growth of 7.2%, one of the highest rates globally. This growth was driven by strong performances in agriculture, government capital expenditure, manufacturing, and services, while private capital expenditure remained subdued. Moreover, high-frequency indicators such as PMIs, GST collection, credit growth, steel and cement demand, and auto sales indicate sustained economic strength in India.

India’s GDP growth bounces back

Strong PMI data suggest resilient economy

Source: Bloomberg, Sanctum Wealth

India’s earnings growth is also relatively better placed, and in Q4 FY23, Indian equities, represented by Nifty Index, delivered 13% YoY growth. The banking and auto sectors displayed strong growth, while the metals, cement, and healthcare sectors weighed down the overall figures. More companies surpassed analyst expectations compared to those that missed estimates. Management commentary was optimistic, particularly regarding domestic demand prospects, with signs of recovery in the rural economy. Also, managements highlighted lower cost pressure, contributing to a healthy margin outlook.

Nifty trailing P/E close to historic averages

Net equity flows positive

Source: Bloomberg, Sanctum Wealth

Furthermore, Indian equities are supported by net equity inflows, driven by foreign flows and the anticipation of the end of rate hikes by both the Fed and the RBI. However, it’s important to note that valuations are not cheap yet. Although the Nifty forward and trailing price-to-earnings (P/E) ratios are close to their historical averages, Indian equities are still relatively expensive in terms of price-to-book (P/B) and price-to-sales (P/S) ratios and when compared to other emerging markets.

While economic growth, earnings growth, and positive flows support Indian equities, still-not-cheap valuations, global-slowdown concerns and global macroeconomic uncertainty exert downward pressure. As a result, despite the slight improvement in favour

Large-caps vs Mid-caps

No valuations gap between large and mid-caps

Mid-caps have outperformed large-caps over the last couple of months and continue to show strong technical momentum. Additionally, the earnings outlook for mid-caps appears brighter than large-caps, even as incremental earning revisions for mid-caps have moderated more than large-caps. However, with the recent rally, mid-cap valuations have again increased and now trade close to historical valuations. Hence, the overall score is neutral.

Both mid-cap and Nifty valuations close to historical averages

Source: Bloomberg, Sanctum Wealth

Along with mid-caps, small-caps have also rallied in the last two months. The rally in small-caps comes after a sharp correction in the preceding two months, bringing their valuations to more reasonable levels. While we are neutral on small-caps, those under-exposed to small-caps should look at additional exposure.

Fixed Income | Corporate vs Government | Short-term vs Long-term

Yields have peaked, credit environment favourable

Unlike most of the world, India’s inflation rate is in a comfortable zone, with CPI inflation at 4.7% in April, the lowest since October 2021. This is due to a favourable base effect and lower food inflation. The inflation outlook also remains positive, supported by falling commodity prices and a continuation of the favourable base effect. A critical risk is that El Nino could disrupt the forecasted normal monsoon, potentially impacting food inflation.

Hence, the RBI will likely keep monetary policy unchanged in June and potentially throughout the year, suggesting that bond yields may have already peaked. While the yield curve is flat and long-duration investments may not fully compensate for the additional duration risk, some duration exposure is advisable to avoid timing issues. However, as seen recently, higher-duration investments may experience increased volatility and may not be suitable for all investors.

Inflation moderating in India

Yield Curve is still flat

Source: Bloomberg, Sanctum Wealth

India’s credit environment remains favourable, driven by robust corporate earnings and significant deleveraging in the previous few years. However, the credit spread between high-quality corporate bonds and government bonds is still below the historical average. To enhance yield, investors may need to explore lower-rated bonds. The recent tax changes for debt mutual funds and market-linked debentures further emphasize the importance of adding exposure to carefully selected higher-yielding bonds.

Corporate spreads remain low

Source: Bloomberg, Sanctum Wealth

Gold vs Cash

Several factors support the yellow metal

After a strong rally, gold prices have been range-bound in the last couple of months. However, several factors continue to support our positive view of gold. Central bank buying, strong physical gold demand, and positive flows in gold ETFs could continue supporting gold prices. The moderation of the US dollar and persistently negative real yields also favour gold. Moreover, historical trends indicate that gold tends to perform well before, during, and after recessions, making it a potentially attractive asset class amid an expectation of a US recession.

Flows into gold ETFs have turned positive

Moderation in USD could be positive for Gold

Source: Bloomberg, Sanctum Wealth


Dollar could face headwinds

The recent rebound in the US Dollar index (DXY) is likely linked to rising bond yields and safe-haven demand due to delayed debt ceiling negotiations. However, we expect headwinds for the USD as the Fed pauses and European central banks raise rates, potentially weakening the USD against the Euro and Pound. With the debt ceiling uncertainty resolved, safe-haven demand for the USD may also diminish.

In contrast, multiple factors are supportive of the INR. As indicated by the real effective exchange rate, valuations are currently favourable. The RBI has also rebuilt its foreign exchange reserves, and crude oil prices and other commodities have moderated. Moreover, FIIs have turned into net buyers of Indian equities.

RBI has been able to rebuild FX reserves

Moderations in Dollar to support INR

Source: Bloomberg, Sanctum Wealth

Sanctum Multi-Asset Portfolios

Our tactical asset allocation calls based on the asset pair model are utilized in our Sanctum Multi-Asset Portfolios (SMAPs). We offer three distinct portfolios catering to different risk profiles: Shield (conservative), Enhancement (balanced), and Generation (aggressive).

Following the tax amendment for non-equity mutual funds in March 2023, we have optimized for tax in our SMAPs. A significant change involves excluding international equities and gold as strategic allocations in the portfolios. The tax implications for gold funds and funds investing in international equities have become unfavourable. Moreover, considering restrictions on new subscriptions due to SEBI limits, the availability of market routes for international equity allocation is also an issue. However, we still have the flexibility to allocate tactically to gold and international equities as required. We also believe REITs and INVITs again are viable alternatives to debt mutual fund allocations. Additionally, in our conservative portfolio, Shield, we may take some allocation to equity savings funds.

Looking at our current tactical positioning, we have kept the portfolio largely unchanged. We remain overweight gold and hence have some allocation from a tactical point of view. We maintain strategic weights to equities and within equities to large-caps and mid-caps across portfolios. We have allocations to a few roll-down funds as routes to taking higher duration within the fixed income allocation.

Here is a performance update of our three multi-asset portfolio strategies:

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.

NSE Multi Asset Index 2 composition is 50% Nifty 500, 20% Nifty 50 Arbitrage, 20% Nifty Medium Duration Debt Index, 10% Nifty REITs and InVITs

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