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Investment Strategy

Jan 19, 2024

• Global economy faces headwinds.
• India’s growth remains resilient despite global challenges
• Indian bonds are likely to be range-bound as the RBI counterbalances bond inclusion cheer.
• Better value in large-cap relative to mid and small-cap stocks in the medium term.

The Year of the Humble Pie

2023 will go down in history as ‘The year of the humble pie’. Battered by brutal corrections in both stocks and bonds in 2022 and the fear of looming rate hikes in the year ahead, there was an overwhelming consensus that the US would be in a recession in 2023. The Fed’s commentary was decidedly hawkish, warning of economic pain until a surprise pivot in December. Contrary to expectations, the US economy grew, and the markets rallied, albeit with support from the magnificent seven (Apple, Alphabet. Amazon, Meta Platforms, Microsoft, Nvidia and Tesla). A few months ago, the US Fed also dropped its recession forecast.

Source: Bloomberg, Sanctum Wealth
Above returns are price returns in local currency terms.

The most common range of the 2024 forecasts span from mild, steady growth to a mild recession – basically, predicting a scenario of muddling through.

Global Market Update

Our expectations were that after such a sharp hiking cycle a recession is imminent in the US. But the excesses from programs such as the Paycheck Protection Program and Employee Retention Credit program that gave sizeable sums directly to consumers, ensured that the effects of the hikes had a longer lag than anticipated. However, these effects now seem to be abating, as evidenced by the weakening of several leading indicators. The US Conference board’s Leading Economic Indicator Index, which as the name suggests, aggregates the top 10 leading economic indicators, is suggesting that a US recession is probably already underway. Historically, this indicator has exhibited 100% prediction accuracy whenever the readings are below 0 and persist at that level for 2-3 months.

Source: Datastream

Some of these trends, combined with lower inflation, are likely to have prompted the US Fed to pivot last month after a long hawkish spell. Various members of the FOMC are indicating three cuts in the current year, whereas the markets are expecting six of them. In the past couple of years, Fed has largely prevailed over market expectations, and we think this year won’t be any different.

The S&P 500 had delivered -19.5% in 2022. However, those losses were recouped in the past 12 months as the index rallied by 24.2%. Looking ahead, earnings expectations are lower, whereas the interest rates are up by almost 250bps. This combination does not support a raging rally. Even with some reduction in rates, medium term returns appear to be capped.

Despite expectations of some economic recovery in China, international sentiment toward Chinese stocks has remained lukewarm. The Xi-Biden meeting didn’t move the needle much in thawing of the relationship. Incidences like threats of persecution of anyone criticizing the government policies in their due diligence and ‘nationalization’ of Alibaba didn’t help either. Chinese stocks which were already cheap, only got cheaper.

Chinese equities getting cheaper

Change in global money supply

Source: Bloomberg, Sanctum Wealth

The devastating earthquake in Japan could be a short-term setback to the economy. Inflation could persist in wake of the disruptions on account of the earthquake and later as the rebuilding efforts increase demand.

Interestingly, after a disastrous few months, there seems to be an improvement in industrial confidence in Europe. The general view seems to suggest a bottoming out of the economy and a slow recovery.

Globally, views on inflation are mixed. There is no doubt that inflation has been trending lower the world over, but the question is whether it is low enough not to be harmful. The problems in the Red Sea need to be closely watched. Roughly 15% of the world’s trade traverses through the Red Sea, and the Houthi attacks are causing cargo ships to be re-routed via the Cape of Good Hope. If this continues for a few more weeks, port capacity constraints, longer trips, and missed delivery schedules could lead to another round of supply chain disruptions, and consequently, inflation could potentially rise. Of the several factors that influence economies and markets, this is the one to watch.

India Update and Outlook

Increasingly, global investors are taking note of India’s resilience. There is a growing acknowledgement that this resilience is more structural in nature. Much has been written about this being India’s decade. BJP wins in key states are being considered as a cementing factor of their victory in the upcoming central elections. The record SIP book signals deepening retail participation. We agree with most things – economic resilience, potential continuation of policy, a flourishing middle class, financialization of savings, and that makes us part of the herd. Where we step back is the expectation that this will result in a linear equity run up. Structural bull runs are punctuated with corrections. Entry valuations are important.

GST Collections have exceeded expectations indicating economic resilience

Source: Bloomberg, Sanctum Wealth

Source: AMFI

We are particularly cautious about the small cap segment. As per AMFI data, small-cap funds attracted a whopping Rs 41,035 crore in net inflows in 2023, while midcap funds witnessed net inflows of Rs 22,913 crores. The euphoria is spilling over to even SME IPOs. There were 164 SME IPOs in 2023; three times those in 2021. These IPOs raised a total of INR 4,425 crore. Some of the mid and small cap-oriented PMS managers have stopped accepting flows as deploying at reasonable valuations has been getting difficult. We urge investors to rebalance their portfolios and to be circumspect while deploying in mid and small caps. At this time, 2–3-year investment horizon in mid and small cap may leave investors disappointed. A staggered entry of 2-3 months might not help much either. It is entirely possible that in the pre-election rally, investors may average upwards. Our view on large caps is much more sanguine. Relatively more reasonable valuations, potential inflows from FPIs, earnings growth expectations of ~17% over the next 12 months suggest that large caps are not stretched.

Mid and Small-cap MFs saw significant inflows in 2023

Source: AMFI, Sanctum Wealth

In fixed income, we have been somewhat circumspect in adding duration. We prefer to match investment horizon and duration. The impact of the Red Sea attacks is slightly different for India than the West. These attacks are taking place on container ships and not oil tankers. Oil prices, therefore, may not be impacted. For India oil import prices are a big factor in building inflation expectations. If there is a knee jerk reaction in the markets, it could allow for good entry points to take some duration exposure and/or lock in yields. We continue to exercise caution in the high-yielding space.

We wish all our readers a very happy new year!

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