When we started the year 2022, we had a constructive view on the equity market and moderate expectations of returns. However, this outlook turned murky during the year as inflation skyrocketed, triggered by the unexpected war and China’s zero Covid policy. Supply constraints slowed the global economy, resulting in a shift in investment pattern driven by global risk-off. Drop in liquidity affected the performance of many Indian sectors, especially mid and small caps.
Despite the fear of looming recession, the equity outlook for the global stock market has improved compared to 2022. The improvement is due to better global supplies, lower energy cost along with moderating inflation, implying that the central banks’ aggressive policy will be curtailed in the future.
However, the cautious monetary policy is expected to continue in H1CY23, and for India, the broad valuation persists at premium levels, which is a hindrance in the short to medium-term. India’s valuation will reduce to long-term average due to shuffling by foreign investors and slowdown in domestic earnings growth. We can expect a modest positive average return, on an annual basis, as developed and other emerging markets are expected to perform well, because they are relatively cheap and recessionary factors have been adequately accounted for. India, being an essential part of the emerging markets, will benefit, though we can underperform on a comparative basis.
India is the most expensive stock market in the world. Dollar-based index, MSCI India, is trading at a premium of 41% and 86% to MSCI-World and MSCI-Emerging Markets, respectively. Other stock markets are trading so cheap, kindling a risk of India’s underperformance compared to the rest of the world. Since the pandemic, India has been trading at a premium level, which will moderate.
Foreign investors have the option to deploy additional or shift funds into developed or emerging markets (EM), according to the country wise outlook. The valuation gap between India and others is widening while the domestic economy is forecasted to slowdown in FY24. India’s GDP is expected to grow by 6% in FY24, compared to 6.8% and 8.7% in FY23 and FY22. Similarly, earnings growth is expected to moderate to 12% from 15% in FY24, suggesting that the premium valuations garnered by India will reduce in the future. Other important local factors to be considered are events like the Union Budget of 2023 and the General Election of 2024.
Stock markets in a rising interest rate cycle
Interest rates can rapidly rise in India as the transmission of RBI hikes in FY23 has been below average. During FY23, the RBI increased repo rate by 225bps, while the rise in bank rate is substantially low.
Average lending rate of private banks has increased by 90bps from a low of 9.6% in April 2022 to 10.5% in December 2022. This can increase to 12% by December 2024. This is expected to affect the performance of economy and stock market in 2023.
The most detrimental effect will be for the companies and sectors which are heavily indebted. Generally, companies with more than 0.5x D/E have a negative effect depending on the trend of future cash-flows. Sectors which depend on high amount of working and capex requirement are infrastructure, capital goods, metals, mining, cement, banks, and other industries.
Broadly, Indian corporates have de-leveraged in the last three to five years, suggesting that no immediate negative effect will follow. Companies with strong cash generation and light balance sheets will do well in 2023 due to steady cash flow and low private capex.
Generally, a high-interest rate has an impact on the broad valuation of the stock market because earning yields and interest yields have a reverse relationship on a long-term basis. The debt market is becoming an attractive segment as interest yields are rising. In 2023, we can expect a decent interest income in a range of 8% to +10%, depending on the category from government to corporate bonds, by undertaking extremely low risk.
Equity investment strategy for 2023
- Importantly, have a balanced portfolio. The universal ratio of 60:40 in equity and debt will be comprehensive for the average risk-averse investor. For a highly risk-averse investor, 40% in equity and for a risk-taker 75% in equity are advised. Investors should increase the weightage on equity during a correction in the year.
- In equities, the crux should be on value buying as the performance of highly valued stocks and sectors is likely to be vulnerable in 2023 because the overall valuation of the broad market is expected to moderate. It will be better to invest in stocks which are trading below the long-term averages. Example: Price to Earnings (P/E) and Market Capitalisation to Sales (Mcap/Sales) can be used as ratios for historic and future trend analysis.
- Sectors that are stable and rely on the strength of the domestic market are likely to be safe to invest even in a volatile market. Accordingly, sectors like FMCG, telecom, non- durable consumption, and cement are interesting and secure to invest. Within that group, highly valued and heavy balance sheet (high D/E) companies can be avoided.
- Invest in pockets which are likely to benefit from a drop in international commodity prices. India is likely to benefit as EBITDA margins will improve due to the fall in costs. Extra benefit will accrue to companies and sectors where the demand outlook is consistently positive. As a result, industries which directly supply goods and services to domestic consumers, such as energy distribution companies in gas and consumer durables, will benefit the most.
- Industries which are highly oriented to global demand will be volatile in 2023, like IT, Pharma, Chemicals, Metals, Mining, Textiles, Energy, and Auto, as global demand reduces. However, the IT, Pharma and Chemicals sectors have a solid outlook on a long-term basis. Valuations have moderated in 2022 due to price correction suggesting a buy on dip strategy for long-term gains.
- In the banking sector, we cut our rating from positive to neutral due to high valuation, a rise in interest rates, and a cut in lending growth. The industry is trading at a price-to-book value ratio of 2.2x, which is marginally above the long-term average. We are stock-specific and positive on A-group private banks.
- We have a long-term positive outlook on renewable energy sectors like electric, solar, hydrogen and biofuel. This sector is in a nascent stage of high growth. Availability of such stocks is inadequate, leading to an overwhelming valuation. Stock-to-Stock analysis is a suitable approach to identify companies. Loss making companies with low capacity are better avoided in this segment. Currently, we have a wait-and-watch approach on the auto 2-wheeler and 4-wheeler electric vehicle segments due to high competition and a lack of clarity on future winners.
- We have a mixed view on the new generation Fintech and Consumer Tech, which were recently listed. We are pessimistic on highly valued and negative cashflow generators. While we are accommodating to those showing the ability to overhaul their business model and increase net cash generation from operations in the medium to long-term.
- Some of the other sectors in which we have a positive view are hospitality, entertainment, and media. Due to increased activities in international and domestic tourism, travel, trade, media consolidation, and a rise in online subscriptions and offline footfalls.
Bottom line is that we should have a modest expectation for the stock market in the short to medium-term. We can expect a return of 5% to 15% in the broad market, on an annual basis, depending on the performance of the development and emerging markets, which is dodging against a recession. The current view is that the recession will be short-lived and not structural in nature. Similarly, the aggressive monetary policy will be short-term in nature, but it will lead to a recession around the globe, bringing volatility in 2023. At the same time, the job market will remain healthy due to a lack of labor availability and an increase in the world’s operational capacity as supply constraints reduce. Consequently, the monetary policy is likely to reverse in the latter part of 2023 and the global economy will stabilize as the ongoing imbalances correct. This will ignite positivity in the future stock market. Holding a balanced portfolio, value buying, focusing on domestic oriented sectors, and buying on dips should be the strategy ahead.
