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Investment Strategy

Aug 11, 2023

• Global equity momentum continued in July amid supportive US data.
• However, several factors could impact the anticipated “soft-landing” scenario.
• Global slowdown may impact India’s services exports growth, but currently, India is showing resilience.
• Indian Q1 FY2024 earnings so far have slightly exceeded expectations.
• Nevertheless, the recent equity rally has further stretched valuations.
• The Indian bond market requires clear indications of rate cuts before it can experience a rally.

The Momentum Continues

Recent data indicates that the US economy may be more resilient than initially predicted, with economic growth, earnings, and inflation data pleasantly surprising the markets. Furthermore, despite a rate hike in July, the market is celebrating the potential end of the rate hike cycle. As a result, global equity markets once again delivered positive returns last month. However, a closer look suggests some headwinds for the US economy ahead.

While India is relatively better placed in terms of growth and inflation, it is unlikely to be immune to global equity market volatility.

Global Macro Update

According to the advance estimates, US Q2 2023 GDP grew at 2.4%, against an estimate of 1.8%. This has led analysts to revise their annual GDP forecasts higher. Although consumption growth remained strong, there are headwinds on the horizon, including a decline in excess savings from USD 2.1tn in August 2021 to USD 500bn, lower than historical levels. Additionally, US domestic banks have tightened their lending standards to small businesses and consumers. The net percentage tightening standards for commercial and industrial loans to small businesses has risen to 47% and for consumer credit cards and auto loans to 30%. Tighter lending standards and higher borrowing costs would put further pressure on consumption demand.

A surprise rebound in US GDP growth

Source: Bloomberg, Sanctum Wealth

Another positive surprise was the moderation in inflation. The core personal consumption expenditure (PCE) inflation, the Fed’s preferred measure of inflation, rose at its slowest pace in nearly two years at 4.1% year-on-year compared to estimates of 4.2%. Further headline inflation in June moderated to 3%. However, this is partly due to a favourable base effect, which is expected to wane in the coming months.

Moderating inflation raises the hopes that the 25bps policy hike in July may be the last one in the current cycle for the Fed. However, loose fiscal policy could undermine the impact of interest rate hikes. With the US Presidential election scheduled for next year, it is unlikely that the fiscal policy will turn prudent. Fitch Ratings estimates the US general government deficit will rise to 6.3% of GDP in 2023, up from 3.7% in 2022, due to cyclically weaker revenues, new spending initiatives and a higher interest burden. As a result, Fitch downgraded US credit ratings from AAA to AA+. While this credit rating downgrade may not have a material impact given the overall strength of the US economy, it highlights the growing fiscal challenges the government faces.

US fiscal deficit rising again

Source: OECD, General government deficit (indicator), Fitch Ratings
Data from 2018 to 2021 is from OECD, and 2022 and beyond is from Fitch Ratings

Meanwhile, in Europe, data suggests a weakening economic activity. The Eurozone composite PMI slipped into contraction in July. Germany, a key contributor to the Eurozone, is experiencing declining economic growth, with falling business confidence and slower construction and manufacturing activity. The only hope is the possible end of the ECB’s rate-hike cycle. Even though the ECB raised rates by 25bps in July, it has indicated that it may not hike rates in September.

The recent statement from the Chinese Politburo meeting highlighted the need for stimulus measures to bolster the struggling economic recovery post-easing of Covid restrictions. The politburo proposed adopting a “proactive” fiscal approach, “prudent” monetary policy, and ensuring the yuan's stability to boost confidence among businesses and consumers. While we eagerly await more details on the specific actions, it is crucial to recognize that while these measures may improve near-term sentiments, achieving long-term structural improvements in the Chinese economy will require significant effort.

As anticipated, the Bank of Japan (BoJ) finally decided to tweak its bond yield curve control (YCC) by increasing the cap on 10-year Japanese government bonds (JGB) to 1% from 0.5% earlier. The shift is in reaction to higher inflation which crossed US inflation for the first time in 8 years. The policy shift will allow BoJ to reduce its intervention in bond markets allowing the JGB yields to rise over time. 10 Year JGB yield shot up beyond 0.5% for the first time since 2014.

Japanese bond yields cross 0.5% after many years

Source: Bloomberg, Sanctum Wealth

Global Markets Outlook

US equities continue to outperform the rest of the world, supported by strong growth data and better-than- expected Q2 2023 earnings. Nearly 80% of S&P 500 companies that have announced results so far have reported positive earnings surprises, with technology and consumer discretionary sectors leading the way. However, despite better-than-expected results, S&P 500 EPS is expected to decline by 5.2% in Q2 2023. After a flattish third quarter, analysts expect a sharp rebound in earnings in quarter four and CY 2024. With the 12-month forward P/E for the S&P 500 at 19.2, compared to the 5-year average of 18.6 and the 10-year average of 17.4, US equities are already expensive. Any disappointment in earnings in upcoming quarters could impact stock prices.

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

Despite the Chinese government’s promise to support the economy, the Chinese equity market only delivered a modest rebound after poor performance year to date. However, the market remains hopeful of greater support from the government.

The US 10-year government bond yield has once again crossed 4% led by strong growth data and the credit rating downgrade. While interest may have peaked, the Fed is not expected to signal an imminent rate cut. This suggests that bond yields are unlikely to decline significantly in the near term. Nevertheless, a 4% yield will appeal to long-term investors. Additionally, investors with a shorter time horizon may find short-term yields exceeding 5% highly attractive.

Indian Macro Update

There are concerns about how the global growth slowdown will affect India's growth prospects. India's services exports have grown faster than its nominal GDP, and now contribute more than 1% to GDP growth. Hence, if there is a global slowdown, it is likely to impact India’s services growth and, thus, overall growth as well. Current indicators show steady growth in India. In July, India's services PMI reached its highest level in over 13 years at 62.3, while the manufacturing PMI was at a healthy 57.7. Other indicators such as e-way bills, GST collection, and consumer sentiment index also remained strong.

PMI data suggests resilient Indian economy

Source: Bloomberg, Sanctum Wealth

Additionally, the weakening dollar, strong foreign inflows, and decrease in trade deficit have alleviated external challenges. The RBI has also successfully increased its foreign exchange reserves, surpassing USD 600bn for the first time since May 2022, without causing a significant impact on the currency.

In terms of inflation, CPI inflation in June 2023 was 4.8%, higher than in May 2023 and consensus estimates, mainly due to a spike in food inflation, while core inflation remained changed from May. Since food inflation tends to be quite volatile and generally transitory, the RBI decided to overlook this spike and kept rate unchanged in its August policy. However, it did increase its FY24 inflation target to 5.4% from 5.1% thus indicating limited scope for a rate cut this fiscal year.

India Market Update

In line with the global markets, Indian equity markets also continued to deliver positive returns. Mid and Smallcaps outperformed largecaps for the fourth consecutive month. PSU banks led by PNB bounced back sharply on strong results after underperforming most of the market this year.

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

Corporate earnings for the quarter ended June 2023 so far have slightly exceeded expectations. Over two- thirds of companies have announced their results, with earnings beat outnumbering earnings misses. The 33 Nifty companies that have declared results have reported sales growth of 8% and PAT growth of 43% against an estimate of 5% and 41%, respectively. The IT sector has shown weak results, while the banking sector has demonstrated consistent earnings growth and improved asset quality.

Equity Outlook

The recent rally in Indian equities can be attributed to strong FPI inflows, positive global equity momentum and resilient corporate earnings in Q1 FY2024. India has received record inflows of USD 18bn in the current financial year (April to July 2023), the highest ever in any four months. This trend is expected to continue due to the expectation of a weaker dollar and relatively better prospects for India and the rest of Asia. Although there are long-term headwinds ahead, in the short-term global equity momentum may also persist. However, the growth in profit margins driven by banks, which has been a significant factor in earnings growth in Q1 FY2024, may not continue in the coming quarters. As we approach the end of earnings results, we will revisit our asset pair model this month to guide our tactical asset allocation decisions.

Debt Outlook

The India 10-year government yield has risen by another 9bps to 7.19%. This increase is in line with the rise in global bond yields due to strong economic data in the US. For Indian bond yields to decrease, we need to see indications of future rate cuts. Although the RBI had stopped raising rates before the Fed, it is unlikely to start cutting rates until rate cuts in the US become visible. Historically, the RBI has prioritized the stability of the INR over inflation.

Therefore, investors should focus on matching their investment horizon with the duration of their investments rather than adding excessive duration in hopes of capital gains. Those with a longer time horizon may take advantage of the yield spike to increase their duration.

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