Apr 12, 2024
• The Fed dot plot continues to suggest three rate cuts in 2023, despite persistent inflation.
• Crude oil prices are inching higher, a key risk for India and the resurgence of global inflation.
• Global equity momentum persists, with Japanese and US equities leading the rally.
• The RBI maintained status quo across all fronts
• Valuations of Indian mid and small-cap equities are stretched; volatility seen in March.
Much The Same
The first quarter of 2024 mirrored 2023 in many ways. Global macroeconomic data remained mixed, with the US economy demonstrating resilience despite certain areas signalling potential risks. Inflation, which held the spotlight in 2023, once again took centre stage after a brief hiatus. Global equity momentum continued as many markets surged to new heights. Similarly, in India, equity momentum stayed strong throughout the first quarter, albeit with some turbulence in March. The standout difference was the subdued performance of global bonds, as US yields climbed amidst persistent inflation concerns.
Global Macro Update
The February CPI inflation data in the US indicated persistence. Month on month headline inflation showed a slight uptick compared to January, while inflation remained steady. Although the trend in inflation is downward, recent data suggests that it may take some time before inflation aligns with the Fed’s 2% target.
US inflation has been more persistent than expected
Source: Bloomberg, Sanctum Wealth
Nevertheless, during its most recent monetary policy meeting, the Fed chose to overlook this persistence in inflation and maintained its projection of three policy rate cuts for the year, in line with market expectation. Additionally, the Fed revised its economic forecasts, raising the US growth outlook for 2024 to 2.1% from 1.4%. While forecasts for headline inflation remained unchanged, the Fed slightly increased its projections for core PCE to 2.6% from 2.4%. This suggests that the Fed is willing to pursue rate cuts despite inflation running above its target.
In line with the US Fed, most economists now anticipate a very low probability of a US recession. Consumption has been a key driver of US economic resilience. While excess savings built during the pandemic have dwindled, a rise in household wealth amid the stock market rally, an increase in real income amidst disinflation, and an increase in immigration have sustained consumption so far. There are also signs of a nascent global manufacturing recovery. However, it might be premature for the Fed to claim victory. Elevated US fiscal deficit, tighter credit conditions, and weak commercial real estate sector are amongst few risks to watch out for.
US GDP growth driven by consumption
US 4Q23 nominal GDP components
Source: JPMorgan Asset Management
Another factor worth monitoring is the gradual increase in crude oil prices observed over the past few weeks. Tightening demand-supply dynamics have resulted due to a more resilient-than-anticipated global economy, declining US inventories, and disruptions in Russian oil production caused by Ukrainian drone attacks. Looking at the long-term perspective, the growth of Artificial Intelligence (AI) is expected to result in greater demand for energy. Although renewable energy sources are gaining traction, the share of oil and fossil fuels in energy consumption has not significantly decreased. Consequently, a surge in energy prices could potentially spark a resurgence of inflation.
Crude oil prices rising again
Source: Bloomberg, Sanctum Wealth
Finally, we cannot forget this is a US election year. As we approach election, volatility can be expected. Although the official US Presidential nominees have not been announced yet, we will see a rematch between Biden and Trump in November. Currently, Biden’s approval ratings are below expectations, but there is still time. As candidates announce their intended policies, we may observe volatility in the markets.
Meanwhile, the Swiss National Bank surprised the markets with a 25bps rate cut amid low inflation, becoming the first G10 central bank to ease policy in the current cycle.
In Japan, the Bank of Japan (BOJ) increased rates for the first time in 17 years, putting an end to its decade-long ‘negative interest rate policy’. It is crucial to note that the BOJ still maintains an accommodative stance, and the commentary remains cautious.
Sentiments in emerging markets are largely influenced by China. The Chinese economy seems to be slowly recovering, as evidenced by the rebound in PMIs, industrial production, and retail sales. Moreover, if the global manufacturing cycle rebounds, it should further benefit China. However, the recent National People’s Congress did not introduce any big bang stimulus measures for the economy. The growth target for the year was set at 5%. Without strong government support, the recovery is expected to be gradual.
Global Market Update
Global equities maintained their momentum from 2023 into the first quarter of 2024. Japanese equities led the pack, with US equities also posting strong returns. Bond markets remained relatively flat, while gold reached new all-time highs.
Source: Bloomberg, Sanctum Wealth
Above returns are price returns in local currency terms
Let us first look at US equities. Despite concerns about valuations, momentum remains robust. Overweight position in US equities have led to extreme global positioning.
Foreign holdings of US financial assets
Allocation to Equities
Source: Topdown Charts, Refinitiv, Federal Reserve FoF data
Furthermore, the top 10 names have been major drivers of the rally. While these top 10 companies contribute more than 25% of the earnings of the S&P 500, they now constitute over one-third of the index. These top 10 companies are trading at significant premiums compared to their historic averages. Valuations of rest of the stocks is still not as extreme. For instance, Nvidia is valued higher than the entire US energy sector, despite generating less than one-tenth of the cash flows of the energy sector. Diversifying away from these companies via something like an S&P 500 equal weight may allow investors to maintain exposure to US equities while reducing exposure to index heavy weights.
Turning to Japanese equities, despite the recent policy change by the BOJ, monetary conditions remain relatively accommodative. Structural reforms aimed at enhancing return on equity for Japanese companies are yielding positive outcomes, attracting strong inflows from both foreign and domestic investors. Furthermore, valuations are not expensive as Japanese equities trade at a discount compared to global equities and below their historical averages.
US bond markets appear more pessimistic than equity markets. US bond yields have risen this year as the market prices in three rate cuts instead of the seven anticipated at the beginning of the year. The yield on 10-year bonds has climbed from around 4% at the start of the year to nearly 4.35% currently. Investors with longer durations have experienced losses. Although the trend for bond yields over the next 2-3 years is expected to be lower, the journey down for higher duration investors may not be smooth.
Gold has reached all-time highs and breached a significant resistance levels. Momentum in gold in the near term could persist. As we have previously highlighted, gold serves as a valuable hedge against equity market volatility, geopolitical risks, and inflation resurgence from a longer-term perspective. We emphasize the importance of including gold in portfolios. Our technical view on gold is bullish from, however given the run up, we suggest adding fresh exposure on any pullbacks.
INR Gold touching new all-time highs
Source: Bloomberg, Sanctum Wealth
India Macro Update
The RBI’s recent monetary policy announcement met expectations, maintaining the status quo across all fronts, including inflation and growth projections. In his address, the RBI Governor highlighted global risks stemming from excessive global debt, geopolitical tensions, and the recent surge in oil prices. However, he acknowledged India’s contrasting position, noting the country’s adherence to fiscal consolidation, robust economic expansion, resilient external macroeconomics, and moderating inflation. The governor also reaffirmed the RBI’s commitment to actively managing liquidity. We believe the RBI may be guided by global central bank actions, given India’s robust growth, which may not necessitate a rate cut. Instead, the RBI may action to maintain INR stability once the Fed begins its rate-cutting cycle.
The dates for the Indian general election have been officially announced, with voting scheduled to take place between April 19, 2024, and June 01, 2024. The results will be declared on June 04, 2024. Unlike the closely contested US election, a continuation of the incumbent BJP government appears to be the most probable outcome. If the BJP secures a comfortable majority, we may witness policy continuity and potentially more structural reforms.
The structural reforms implemented over the last two terms have been instrumental in fostering the current resilience of the Indian economy. This resilience has led many to draw comparisons between the current economic cycle and the period from 2003 to 2007, during which India experienced robust economic growth, increased productivity, and rising incomes. However, there are several factors that need to align before we can anticipate celebrating.
In the 2003-2007 period, growth was primarily driven by robust private capital expenditure. Currently, while public capex has been robust in recent years, private capex has yet to show significant pick-up, although there are some promising signs. Additionally, rural demand has been sluggish thus far, impacted by successive shocks such as Covid-19 and elevated inflation. However, there are now indications that rural demand may also be recovering.
Central government capital expenditure as % of GDP has risen to 18-year high
Source:CEIC, Budget Documents, Morgan Stanley Research
If sustained signs of growth in private capex and rural demand emerge, the next few years, akin to 2003-07, could witness strong macroeconomic stability, robust economic growth, rapid income growth, and healthy corporate earnings growth.
India Market Outlook
Indian equities ended the month on a positive note, despite experiencing significant volatility. Following the SEBI chair’s expression of concern over stretched valuations of mid and small-cap stocks, they witnessed substantial volatility. However, after a sharp correction, mid and small-cap indices managed to recover most of the losses in the latter half of the month.
Source:Bloomberg, Sanctum Wealth
Above returns are price returns
Strong relative macro positioning and robust corporate earnings growth have supported the strong returns observed in Indian equities. Margins have played a crucial role in driving earnings, while revenue growth has remained relatively subdued. However, sustaining the current pace of earnings growth may be challenging, as further margin expansion is improbable. Revenue growth is essential for maintaining earnings growth over the long term.
Further valuations across most parameters are expensive. The valuations are more stretched for mid and small caps. It is to note market distortions can continue to longer time if flows are supportive. Currently flows are strong. However, in March we saw how quickly the sentiments in this space can change. Hence, we continue to suggest that investors exercise caution in this segment.
Fixed Income
In March, India bond yields remained largely unchanged, with no significant movement even after the RBI’s monetary policy announcement, which was largely as expected. However, yields in the AAA segment experienced a slight decrease, narrowing the credit spread once again. We anticipate yields to remain range-bound in the coming months until the RBI signals any potential rate actions.
Indian government bond yield has been range bound
Source:Bloomberg, Sanctum Wealth
We believe that duration remains an attractive option. However, substantial gains from duration will likely materialize only after the RBI indicates rate cuts. While we do not anticipate significant volatility in Indian bond yields, recent events in the US have shown how fluctuations in yields can result in negative returns if duration exposure is too high. Therefore, it’s essential to consider individual risk appetite before increasing duration exposure.