Investment Outlook , Published Jan 18, 2018
Investors are reasonably deployed into equities, but we sense a fair bit of concern in our conversations with them. All institutional investors – domestic and foreign – seem to have a consensus bullish view on India. It seemed easier last year but frankly, it was not. We said in late 2016, when the markets were in a steep sell-off, that “India remains in a structural bull market… equities are the most attractive asset class for investments with a three-year horizon”. We also said, “A case exists for an allocation increase in equities… the last time an equivalent valuation opportunity in favour of equities arose was June 2013, which was a great time to enter equities.” Today, the risks are higher, and the call tougher, as we sit on attractive returns in equity portfolios.
The global economy is in a strong phase of synchronized growth as Japan, Europe and emerging markets join the U.S. on an upward growth path. Corporate spending and capital expenditure are on an uptrend globally, inflation is benign, but crude’s rise is a cause for concern. The consensus view remains bullish that this strong environment will continue into 2018, with calls for a correction along the way.
This is the third longest expansion cycle on record for the U.S., with persistent low growth and lagging industrial production. But a recession does not look imminent. Government and central bank actions staved off a great depression, but they left the U.S. and the global economy hobbled with excess liquidity, dismantled free market mechanisms such as bankruptcy and restructuring that supported economic rebalancing. Overcapacity remains a major problem across most industries because firms have been kept afloat by artificially low borrowing costs. Global indebtedness remains at historically peak levels.
As investors, two rationales confront us. On the one hand, contours of an impending turn in the business cycle are slowly coming into place. Interest rates are rising, inflation too, is set to rise around the world and in India as well.
Crude oil prices could continue to rise. Valuations are at extremes. The economy has not delivered earnings growth. It is a risky time to be invested in equities, and fixed income, for that matter. IPOs are overheated, and the small investor appears to be late to the party.
On the other hand, a growth shift is occurring. Developed economies are cheering 2-3% growth, while India is focused on breaching 7.5%. India remains in a structural bull cycle, earnings are about to come through next year at double-digit teens; stimulus is coming, and the sectors that have been slacking are repairing themselves, such as Telecom, PSUs, Materials and Real Estate. Finally, domestic flows remain resilient and rising, the rural consumer is getting healthier, bank recapitalization has addressed system default risk, borrowing costs are lower, and a large infrastructure stimulus appears to be on the way.
A major factor that has changed is that the domestic buyer now sets market prices. Domestic mutual funds bought equities worth $15.3 billion against $8 billion by foreign investors in 2017. The government’s ongoing push in infrastructure will continue to support investment growth with 80,000 km of roads across the country over the next 5 years, and a total investment of $106 billion or 0.8% of GDP.
Our models continue to suggest that prospective returns for equities are much higher than the 6-8% that one would look at from fixed income. Technical indicators remain positive and supportive. Should inflation or rates rise, we should not expect further gains. Crude remains a concern. Earnings growth is now critical to sustaining the bull market. Should earnings continue to not come through, stocks would be vulnerable to a correction. We remain of the view that we are not yet near the turn in the business cycle, but that could change during 2018 and it is likely that there will be greater volatility in equities in 2018 than 2017.
Inflation has picked up as has crude and interest rates. Most RBI MPC members have sounded cautious notes on inflation, believing the growth slowdown has troughed and a recovery may be underway. Yields have risen in recent weeks on fears of increased market borrowing and rising crude. On the positive side, FDI remains robust and rising. A stable currency driven by high real interest rates and improving macros have fuelled buying interest in debt with foreign institutional investors. Other domestic macros remain comfortable, with rising FDI flows, and rising forex reserves. The liquidity situation is almost back to normal.
Globally, the sustained rise in commodities has put pressure on inflation, but those trends also appear to be moderating. The fiscal deficits of the states are also a cause for concern, as is the consistently negative news coming out of PSUs on losses. Further complicating the issue will be the level of financing requirements put forward in the Union Budget. With the government on the back foot in the Gujarat elections, a pro-populist rural budget could mean further pressure on rates. To summarize, rising rates, rising inflation and rising commodity prices create a fairly unpleasant cocktail for debt investors. However, we remain of the view that fiscal worries are generally priced in, and at some point this year, debt is likely to look attractive for an increased allocation.
We have been underweight in Gold all of 2016 and 2017. With inflation rising, one could make the case that Gold will remain an inflation hedge. Firstly, we are not fully convinced that inflation will spike meaningfully. Crude oil still remains within manageable territory, with the large producers – Russia and U.S. – incented to keep crude at a sweet spot where a spike does not unravel the global economy.
Despite expectations of a spike in inflation by many watchers, we are also mindful of technological disinflation, improving agri productivity, and better supply chain management. The worrisome factor for investors is a spike in crude, but that is not a call we are prepared to make now. With much of the global economy in a synchronized upswing, investing for the black swan event is not a high probability decision.
From the lows of 2011 to the end of 2016, the U.S. dollar has appreciated an impressive 40% versus major currencies. Over the past few weeks though, the greenback has given back a fair bit of those gains. While rising interest rates are positive for the dollar, vis-a-vis the Rupee, structural reforms and rising attractiveness of India as an investment destination, along with the rising attractiveness of Indian debt act as offsets.
Much will be determined by the trajectory of domestic fiscal borrowing, the economy’s performance, earnings, inflation, and crude oil. Gold in our opinion will remain muted, and the final determinant will be the performance of crude oil.
With rising rates in India and the U.S., the Rupee remains an attractive currency. We expect the RBI to step in to stabilize the Rupee above 65. Furthermore, we think that the long term direction of the Rupee is now stable, rather than appreciating or depreciating ahead. With the growth in emerging markets outpacing U.S. growth, the U.S. dollar should remain stable to slightly weaker, in relation to emerging markets.
The year 2017 has been a watershed year for the real estate industry with a triple impact starting with demonetisation, implementation of RERA and finally the rolling out of GST. All this was felt in an environment of lower demand for residential units and supply overhang of five years inventory in some markets. We have witnessed a decisive change in investor preference away from real assets to financial assets. On the other hand, significant institutional flows have found their way into commercial yield assets and many Tier I and II cities have seen the emergence of SEZs, swanky retail malls, top hospitality operators, new educational institutes and warehousing parks.
We believe that 2018 would witness the start of a slow and painful recovery process for the residential sector driven by end-user demand and depletion of unsold inventory. Evolving regulatory landscape, improvement in macroeconomic environment, and stable interest rates may act as a catalyst to boost demand for property. RERA will drive consolidation in 2018 where smaller or highly leveraged companies will likely resort to asset sales to shore up liquidity, and coupled with consumer activism, it will continue to reduce the pace of new launches in 2018, as developers focus on completing existing projects. Sales in the secondary residential market, especially in the luxury segment, will continue to remain tepid. However, the transactions in mid-segment and affordable housing will remain strong. Due to the continuous support of the government, the affordable housing segment should pick up, and more developers and investors will try to invest in this segment. We should see the first REIT launch in 2018 and many yield asset classes will continue to see a strong institutional interest.
Investment Outlook 2018