Investment Outlook , Published Feb 17, 2019
CIO at Sanctum Wealth Management.
In 2018, we were advising investors to cut back on equity allocations. In contrast, as we head into 2019, the macro picture looks favourable for equities.
Elections, fiscal stimulus, the Fed and U.S. China trade war are likely to garner short term focus, but lower crude, low inflation, accommodative central banks, structural reforms, a resurgent technology sector, rising consumption and rising domestic flows remain key underpinnings that will drive India’s economic growth.
Last year witnessed the largest FII selling since 2008, the BJP lost key bastion states, the RBI governor stepped down with immediate effect, the Fed raised rates, withdrew liquidity, the RBI raised rates, the IL&FS meltdown, NBFC funding crisis, painful global trade wars, a belligerent U.S. President, a slowdown in the global economy, the end of NAFTA, Italy debt and Brexit, and a massive SEBI mandated mutual fund re-organisation. Yet, the Nifty 50 ended the year up 2.8% and the annals will show this as an up year.
Greater access to information has not improved outcomes
We live in an age of privilege, where investors have access to large amounts of information. Despite this access to superior information, however, investor behavior has not changed demonstrably.
Euphoria in late 2017 reliably turned to fear and despair in 2018. An overabundance of data has not lead to better investment outcomes. Risk and reward continued to remain intrinsically linked.
High valuations remain a headwind
We are now in the third year of high valuations. Had investors followed single factor (e.g. P/E) investing, they’d have exited the market in early 2015 at around 8800, waiting for the P/E to drop to 16 times, and possibly been unable to re-enter the market, missing a strong 2017 rally.
While valuation remains sentiment driven to some extent, we are now entering the fifth year with limited contribution by earnings growth, and yet again, and more than ever, it will be critical for earnings growth to come through.
The other p/b ratio – price to brent
Over the past two decades, bottoms in crude oil have coincided with subsequently strong returns in Indian equities. With the news of a doubling of reserves in the Permian Basin, and expectations of meaningful supply coming on in late 2019, Brent crude prices have come down 26% from the peak. Longer term, the onset of EVs will further impede demand. Benign crude prices bode well for India’s fiscal situation. The Price to Brent ratio suggests a favourable environment for equities ahead.
Strong FII selling normally precedes good years
We experienced the largest FII selling in India since 2008 last year in equities. FIIs were big sellers in 2008, 2011, 2013, and 2015. In each instance, FIIs returned to the India market. What followed in each instance were good years in the markets.
Accommodative central bankers
A neutral Fed, a stabilising Fed Balance Sheet and an accommodative RBI add to our positive macro outlook. Accommodative RBI policy starting in late 2001, late 2008, early 2012, and early 2014 was a precursor to healthy equity markets. The track record during declining interest rate environments suggest a similarly favourable outlook. (See table)
Dominance, vulnerability and cap
Throughout the global economy, big companies keep getting bigger, more productive, more profitable, more innovative. Over time, we expect the largest four names in any sector to control 90% plus market share. We are not anywhere close to that situation in India.
Large caps enjoy increasingly dominant competitive positioning with the lower cost of capital, distribution leverage, reputation, and brand advantages. However, the dominance can be ephemeral, particularly in technology; witness Apple, Facebook, and Tesla. On the other hand, distribution, pricing power, and branding stand the test of time; hence Britannia and Hindustan Unilever sport premium valuations.
While the valuation mulitiples of mid caps and small caps have moved to a discount relative to large caps, the volatility of small and mid caps has appeared to have caused a lasting aversion amongst investors. Investors are increasingly preferring the steadier returns of larger caps. We note, however, that forward 3 year expected returns look attractive for small and mid caps.
The chatter around a yield curve inversion and U.S. slowdown may also be driving a preference towards large caps. We favour a portfolio tilted to large caps, with selective exposure to high-quality growth mid cap and small cap in investment portfolios.
Domestic over global growth
The shift of growth to Asia is unfolding along expected lines. Germany, France and the U.K. are making way for India and Indonesia in the top 10 economies list. EM countries will account for roughly 50% of global GDP by 2030. As emerging markets develop, the nature of growth will remain domestic and consumer driven. The growth of world population by 750 million, nearly all of it originating in emerging economies, will account for about one-quarter of the rise in GDP. Increased productivity will generate the rest. This bodes well for Asia, India and domestic- focused investments.
The macro picture looks fairly good heading into 2019 for Indian equities, buffeted by domestic flows, declining rates, low inflation, lower crude, and accommodative bank policy.
There remains an excess of capital chasing fewer attractive opportunities. The U.S. has $37 trillion in assets under management. India’s is a fraction of that, and India’s market cap is less than 2% of the global market cap. Domestically, substantial capital sits on the side-lines. Global economic growth slowing remains a risk to our outlook, as do elections and credit stress.
Interestingly, the data on equity performance during various political regimes clearly demonstrates that the equity markets have little if any direct correlation to the political party in power.
At some point, a divergence between our markets and developed markets is inevitable.
Source: IMF Data Mapper
Last year, we were advising investors to trim equity allocations and be weary of over-exuberance. Today, recognising year-end forecasts are fraught with risk, we are of the view that the macro environment for equities is favourable. In the final analysis, anything meaningful that one wants to accomplish in life and investing takes time and rarely is it easy. Extending time horizons and accepting volatility as the price of admission tilts the odds in one’s favour. Amazon built great wealth for investors, but along the way, there were 5 painful 25-30% corrections. There is likely to be volatility in the beginning of the year as uncertainties remain front and center.
Our advice remains simple: align with trusted, competent, service providers, outsource or automate as much as possible, because time is the only commodity that cannot be purchased. Despite their billions, none of us would trade places with Warren Buffett or Rupert Murdoch.
Global macro conditions remain fairly favourable, with low crude, low inflation and accommodative central bank policy favouring a downward bias on interest rates. Our forward expectation on crude pricing is close to current levels, but with a fairly wide range of deviation. Elections have brought forth populist announcements as expected. These represent a risk to the debt outlookand could exert upward pressure on rates.
Following in the wisdom of Winston Churchill, the IL&FS crisis is certainly a good crisis and does not appear to have gone to waste. It’s after-effects are resonating into the New Year. Governance, promoter integrity and those familiar enemies of business continuity – greed and leverage – have come to the fore. In the big picture, a healthy cleansing is underway and the system should emerge stronger.
In the shorter term, however, these players are facing challenges in rolling over maturities and this could potentially impact debt mutual fund returns. Traditionally, credit managers have a reputation for deep analysis and strong due diligence. It is however, becoming abundantly evident that many debt fund managers have not lived up to their fiduciary responsibilities as responsible allocators of capital that are supposed to prioritize the most fundamental notion of safety of principal. The market will exact a price from those found lacking, and separate the men from the boys.
An annual forecast on interest rates is fraught with a fair bit of risk and uncertainty, and this year is no exception. With benign longer term expectations on crude, global inflation and high domestic real rates, an argument can be made for a downward drift on interest rates longer term. However, uncertainties domestically need to play out, and worsening credit conditions remain a risk in the near term that must be acknowledged. In such a scenario, we favour the short end of the curve, higher rated, clean credit, short duration until risk is clearly priced in and clarified. We also prefer exposure via principal protected structured strategies with upside participation.
Gold has broken out of its trading range recently, and deserves an allocation in investor portfolios. Should the macro fundamental picture change, we would consider a review of our allocations.
Consumption remains our key focus area, poised to benefit from government largesse. We continue to like financials in the current stage of the business cycle, particularly private and corporate banks. The Technology sector appears to have successfully transitioned to digital transformation from the days of BPO, and technology remains fairly priced. We remain interested in automation and productivity improvement.
With 2008 fresh in the minds of most investors, risk-reducing behavioural changes may have made the system more stable and a severe crisis less likely. When everyone is too afraid to take big risks, it is hard to get a truly threatening bubble underway. As we move to $2000 per capita annual income, consumption is likely to grow. Of the next billion customers, a good-sized chunk will originate out of India.
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Investment Outlook 2019