Mar 11, 2024
• Market expectations of rate cuts by the Fed has moderated amid spike in January inflation numbers.
• While headline numbers point to a resilient US economy, there are signs of stress under the surface.
• We are close to neutral on Indian equity as valuations turn expensive even as macro and earnings are supportive.
• Bond index inclusion, prudent fiscal policy supportive of duration and Indian government bonds.
Inflation Back in Focus
Global Macro Update
After years of being a non-issue, US inflation has played truant since the covid supply chain disruption. Initially dismissed as ‘transitory’, the situation prompted a swift cycle of rate hikes. However, inflation over the past year started moderating and fading from commentaries. Until last month, when super core inflation saw one of the largest spikes in decades, with a month-on-month increase of 0.8%. Just days before this, the Fed had cautioned against the risks of premature easing. Consequently, market expectations of rate cuts readjusted from six rate cuts this year to a more modest four rate cuts.
Headline numbers point to a resilient US economy, but there are signs of stress under the surface. Consumer spending is robust, but credit card outstandings and delinquencies, are rising. BNPL (buy-now- pay-later) data, which was not a part of the credit scoring system earlier, is now being incorporated, resulting in lower credit availability for some.
Total outstanding credit card balance in the US
Source: New York Fed Consumer Credit Panel, Lending Tree
Another concerning signal arises from the strain on the commercial real estate sector in the US. New York Community Bancorp, a regional US bank, experienced substantial sell-offs due to pressures on its commercial real estate portfolio. The scope of the banking sector’s exposure and its repercussions on the markets will become clearer with time.
Unemployment levels continue to be low, but W.A.R.N. notices (US law requires employers to provide 60 days’ notice before a plant closing or mass layoff) are piling up, indicating rising layoffs in the upcoming days. The apparent contradiction can be easily addressed: Unemployment levels are a combination of survey responses and imputations, while the WARN notices are given by employers.
There are several such data points that paint a contrasting picture of the world’s largest economy. It is the lag effect that is taking time to percolate. For example, in the technology sector (a proxy for well-paying Investment Strategy 07 March 2024 sectors), layoffs don’t immediately impact, as typically, the severance packages by several companies span anywhere between 3 to 12 months. This creates a buffer and extends the lag between event and effect.
In the meantime, the S&P 500 has just crossed its previous all-time high, and bitcoin is 3% away as we write this piece. Additionally, an NFT sold for the second highest price ever (USD 16 million). Risk assets continue to be in vogue, it appears. On the other hand, gold is beginning to move up again and is only 1% away from its previous all-time high. The Magnificent seven now look like the Magnificent four.
The contrast is stark. We are cautious.
India Market Update
India posted a higher-than-expected GDP number at 8.4%, but Gross Value Added (GVA), a proxy of growth, was at 6.5%, in line with expectations. Our commentaries have emphasised that India is not insulated from a global slowdown, although we are likely to be less affected. We will closely monitor any further indications of moderation in the domestic economy.
The Monetary Policy Committee (M.P.C.) chose to maintain rates and its stance in its meeting in February, which was in line with expectations. Most of the M.P.C. members expressed a cautious approach to monetary easing, given uncertainties in the inflation outlook. We don’t anticipate rate cuts for another few months.
Indian equities posted roughly 1% gains for the month but underperformed global peers. FIIs sold for the second consecutive month. Domestic flows continue to be supportive.
Source: Bloomberg, Sanctum Wealth
Tactical Asset Allocation | Quarterly Asset Pairs Review
As the corporate earnings season ended, the Sanctum Investment Committee convened to deliberate on the outcomes of our asset pair model, which guides our tactical asset allocation decisions and model portfolios. Score in favour of equities moderated due to the rise in valuation following the recent equity rally. Within equities, the model maintained its preference for large-caps over mid-caps. Additionally, there was a shift in favour of long-term bonds and government bonds, while the stance on gold turned neutral.
Equities vs Bonds
Macro earnings are supportive but valuations are expensive.
Enough has already been said regarding the resilience of the Indian economy. Nearly all high-frequency indicators, including PMI, GST collection, and credit growth, consistently indicate economic strength. While concerns existed about a potential populist budget before the election, the interim budget displayed considerable restraint and stayed committed to fiscal consolidation. This bodes positively for India’s macro stability, especially when fiscal policy remains loose in many major economies. However, as mentioned above the recent GVA reading does create some concern and needs to be closely watched.
PMI indicates sustained economic growth
Q3FY24 earnings largely in line with expectation
Source: Bloomberg, Sanctum Wealth
Corporate earnings for Q3FY24 (the quarter ending December 2023) met expectations. While profit growth was robust, supported by margin tailwinds, revenue growth remained modest, staying in single digits. Strong earnings growth was observed in the auto, capital goods, and pharmaceutical sectors. The auto sector benefited from decreasing commodity prices, stable currency rates, and the normalization of supply chains. Banks saw strong credit growth propelled by retail credit demand, but deposit growth lagged, and NIM pressures persisted. Overall, companies remained optimistic about the near-term outlook.
Indian equities expensive
Net equity inflows have been strong
Source: Bloomberg, Sanctum Wealth
Flows have been a key driver of equities. Even though foreign investors have been in and out of Indian equities, domestic investors, both institutional and retail, have remained consistent buyers. Since August 2023, domestic institutional investors have been net buyers of equities every month. Similarly, mutual fund SIP contributions have shown consistent monthly increases throughout the financial year.
With the November and December rallies, Indian equities are now expensive on most metrics. Relative to emerging markets, Indian equities are currently close to being the most expensive they have ever been. Higher valuations do not provide the margin of safety needed against a global growth shock or surprise surge in global inflation. Hence, we remain close to neutral equities in our model portfolios.
Large-caps vs Mid-caps
Midcaps more expensive
Following the asset pair review in August, we reduced our mid-cap allocations and overweighted largecaps. Since then, mid and small-cap stocks have continued to rally. Both mid and smallcaps are currently trading at significant premiums compared to historical averages, both in trailing and forward P/E terms. Additionally, they are trading at substantial premiums relative to largecaps. While midcap earnings have been strong in recent quarters, the 12-month forward PE reflects an EPS growth expectation of over 35%, which is very high. This leaves room for potential negative surprises. Moreover, the midcap index to large cap index ratio, historically a good indicator of relative attractiveness, also suggests that the midcap rally may have extended beyond reasonable levels.
Midcaps relatively more expensive than large caps
Net equity inflows have been strong
Source: Bloomberg, Sanctum Wealth
Midcap to large cap ratio most extended
Source: Bloomberg, Sanctum Wealth
While we acknowledge that momentum in mid- and small-cap stocks can persist despite underlying fundamentals, we are content with maintaining an underweight position in these stocks, even if it means enduring some near-term underperformance.
Fixed Income | Corporate vs Government | Short-term vs Long-term
Index inclusion, prudent fiscal policy supportive of duration and government bonds
As we approach the inclusion of Indian bonds in global bond indices, we have witnessed an increase in foreign inflows into Indian bonds. We view the bond index inclusion as a long-term structural positive for Indian bonds. A more near-term positive is the fiscal prudence displayed by the interim budget. Not only were the revised fiscal deficit target for FY24 and the budget target for FY25 lower than expected, but the gross borrowing target for FY25 was also lower than expected. These developments are positive for Indian bonds in general but more so for government bonds. Furthermore, corporate spreads remain low despite the favourable credit environment indicated by the upgrade-to-downgrade ratio. Therefore, we maintain a preference for government bonds over corporate bonds.
Foreign flows into Indian bonds rising
Upgrade-to-downgrade ratio has moderated
Source: Bloomberg, Sanctum Wealth
The criteria for inclusion in JP Morgan’s emerging market bond index require Indian government bonds to be issued under the fully accessible route (FAR), have a total face value outstanding of over USD 1bn, and have at least 2.5 years left until maturity. Therefore, the bond index inclusion and prudent budget argue in favour of preferring long-term bonds over short-term bonds. While we do not anticipate the RBI to cut rates this year aggressively, it’s evident that rates have peaked and are set to decline. This further strengthens the case for adding duration to portfolios.
Government gross borrowing to decline
Yield curve is still flat
Source: Bloomberg, Sanctum Wealth
While investing in higher-duration government bonds is the preferred option, it entails higher volatility and requires careful consideration for both entry and exit timing. We believe that active trading strategies could potentially generate additional returns, so allocating some funds to actively managed corporate bond funds could also be considered. Finally, as we have emphasised multiple times before, it is crucial for investors seeking higher yield opportunities to be selective in the current environment.
Gold vs Cash
Gold as an insurance
Many of the factors that previously supported gold prices have diminished. With a correction in commodity prices, gold is relatively more expensive. US inflation has moderated, and equity volatility remains low. ETF holdings of gold and net gold contracts do not support gold prices, and technical momentum is lacking as gold remains range bound. Additionally, cash offers good yield. However, geopolitical risks such as the war in Europe and tensions in the Middle East suggest that some allocation to gold may still be warranted. Furthermore, inflation is a key risk to global equities and debt, and gold is an inflation hedge. Therefore, gold functions more like a put option, potentially expiring worthless or serving as your desired insurance.
ETF Gold holdings declining
USD Gold close to all-time highs
Source: Bloomberg, Sanctum Wealth
INR vs USD
India’s fundamentals to support INR
Over recent months, the INR has traded within a narrow range, mirroring the stability of the US dollar against other currencies, as indicated by the Dollar Index (DXY). Seizing this opportunity, the RBI has bolstered its FX reserves. We anticipate the INR to maintain its range-bound trajectory in the future as well. The INR is fairly valued, crude oil prices pose no immediate concerns and foreign inflows, particularly into Indian bonds, are expected to be supportive.
USDINR has been range bound
USD Gold close to all-time highs
Source: Bloomberg, Sanctum Wealth
Sanctum Multi-Asset Portfolios
We manage our multi-asset portfolios known as SMAPs, representing our tactical asset allocation decisions across three profiles: Shield (conservative), Enhancement (balanced), and Generation (aggressive)
In the previous quarter, mid and small-cap stocks maintained outperformance over largecaps, albeit not as significantly as previously observed. Furthermore, as our recent monthly report highlighted, most mid-cap equity mutual funds have underperformed over the past year. This underperformance can be attributed to the substantial contribution of public sector enterprises to mid-cap index returns, a segment to which these funds have relatively lower exposure. Our underweight in midcaps and the underperformance of midcap mutual funds impacted the performance of our portfolios.
In largecaps, our allocation to smart beta funds such as Nifty Alpha Low Vol 30 and Nifty Equal Weight has significantly outperformed the Nifty index. Given the extent of this outperformance, we are considering some profit booking in these trades.
Our allocation to REITs and INVITs has also proven fruitful. Embassy REIT, benefiting from the resolution of SEZ denotification issues, strong leasing activities, and a robust development pipeline, has delivered strong returns in recent months. We are contemplating profit booking here as well.
We do not anticipate making significant changes to the portfolios beyond those mentioned above. We believe our portfolios are well positioned to achieve their investment objectives.
Overall, the portfolios have performed in line with expectations. Here is an update on the performance 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