Looking back, most of the themes we outlined for 2021 namely, (i) big rebound in global GDP growth, (ii) post vaccine spending spree being unleashed (iii) Governments around the world raising infrastructure spending and (iv) a more broad-based rally, have largely played out. Our other themes around Asia being the engine of growth (led by India and China) over the next 5 years remains a medium-term goal. The one theme that really didn’t work was our call for a weaker dollar albeit that despite this India was still one of the best performing markets globally in 2021.
It seems odd that this time last year we were full of optimism regarding the new vaccine only to find a new “Delta” variant would hit us all so badly and now “Omicron” hangs over us like a sword. That said, Omicron whilst more transmissible, seems to lead to only mild symptoms (as of now) and hopefully vaccine “booster” shots being rolled out will help avert another medical crisis. Governments around the world have acted quickly with borders being virtually closed leading again to problems for the hospitality/travel industries. We think it will be some time before people start holidaying outside their own country as the risks to “being stuck” somewhere due to travel or quarantine rules changing seem quite high. As a result, local travel and hospitality may recover quite quickly once restrictions on people’s movement are relaxed.
Our big theme for 2022 is continued volatility for global markets particularly given our view that we think the Federal Reserve may have or is going to make a policy misstep. Throughout most of the year the FED Chairman Powell told and reiterated that the rise in inflation was “transitory” only for us to be told to forget the word in November and that in fact inflation was much worse than their expectations. Perhaps with mid-term elections due later this year in the US, this was more due to political pressure to at least show action will be taken.
We still believe that Inflation will prove to be transitory and as consumer demand wanes and supply side chain problems ease that in fact we may be talking more of deflation going ahead. Also, the FED is expecting US GDP growth of 4% next year which in our view seems very optimistic and could be nearer to 3-3.5%. Given this we believe tapering will likely end March 2022, but the interest rate hikes, starting as early as June 2022, may not happen. So, the policy mistake would be to try to “tame” inflation with interest rate hikes leading to a market and economic collapse. In our view, the FED mistakenly believed that the “supply” side shortage was temporary, and this (with hindsight) has proved terribly wrong. Also, with unemployment high the belief was that wage growth would be slow to pick up and again this has not been the case. In a recent visit to London, it was noticeable from hotels to restaurants to bars that there was a staff shortage (perhaps Brexit related) and those people were in demand and not surprisingly were naming their own wage hikes to move or stay. These are big misses in our view and as a result the FED has lost some of its credibility. So, we think the market will continue to grapple with this over the first quarter of 2022 and hence volatility will remain high.
Interesting to us is that bond yields in the US maybe telling us the real story. The 10-year bond yield has remained around the 1.45% mark despite all this hawkish talk by the FED and in our view indicates that an economic slowdown or something else may be coming. The 2-year bond yield hovers around 0.7% and if due to interest rate hikes the yield rises above the 10 year (inverted) then as in the past it would be a clear indicator of a recession in the making. Alternatively, given the massive amounts of debt both in the US and globally maybe tightening and interest rates will lead to a credit problem. Still these are early days to conclude, hence we will stay data dependent to firm our view on the same.
Maybe the experience of China is a good guide as to what next! China was the first to enter and exit Covid, tightened when the rest of the world was adding liquidity and is now starting to ease again. In the tightening phase it has caused problems particularly in the property segment with some well-known property companies facing liquidity problems. This scenario may well play out globally as central banks rush to rein in inflation through hiking rates.
So overall it may be a year of two halves, the first half witnessing high levels of volatility, sharp fall in markets especially in “growth” stocks. The second half maybe more constructive particularly if a significant slowdown in economic activity leads to a halt or reverse course in interest rate hikes/expectations.
India
2022 growth drivers: Activity levels are back to pre-COVID level except in some pockets of consumption. A narrow set of growth drivers have helped in lifting activity to pre-COVID levels, such as 1) spending by high income households and 2) market share gains in exports of chemicals, electronics and IT services. However volume growth hereon can be hindered by a) COVID variants and b) weak consumer sentiment owing to scarring in broader households and the real income pinch from high inflation. The current sequential pace of real GDP growth is equal to ~8% annualized which is strong and likely to normalize ~ 7% as pent-up demand wears off.
External risk emerging: Exports were comfortably above imports through the early part of 2021, but now we have seen reversal due to improvement of domestic demand and worsening in terms of trade (commodity price inflation). If external demand is impacted by the pandemic while domestic demand remains resilient, the trade deficit could remain elevated. Balance of Payments financing is likely to get trickier in 2022. To safeguard Rupee and long-term rates, both RBI and the government will have to signal exit from crisis level policy, showcase fiscal consolidation and take actions to manage inflation (tax cuts). Trade deficit remaining stubbornly near USD 20bn in coming months and an expansionary union budget are potential trigger points for rupee and rates outlook.
Inflation concerns can flare up again if Omnicorn and any such other future variants keep impacting global supply chain. In our opinion while Covid is a health scare but incrementally it is becoming more of a supply chain and inflation scare. Assuming a normalised scenario we do not see inflation breaching RBI target range of 2-6%. Inflation at upper end of RBI tolerance level accompanied by broad based GDP growth could be the best outcome for India.
Government focus to continue on localisation and environment (clean energy) over medium term and this should be key theme around budget as well. Push towards consumption for lower and mid income consumers is also anticipated which could come in form of fertiliser subsidies, lower fuel taxes. Hence we believe, in ensuing budget government will begin its fiscal consolidation by further normalising revenue expenditure and buoyant tax revenue. From reform perspective, we are looking forward for privatisation of PSU Bank. One real example can transform Indian Financial System over next decade.
Market
India and US equity risk premium (ERP) is currently at a discount to its long term average which is likely to inch up with rising inflation and liquidity tightening. Along with this we expect discount rates to gradually increase from current levels. Nifty valuations are at record high both in absolute and relative terms. Considering normalisation of liquidity, ERP and discount rate we expect volatility to stay high in next few months.
Earnings so far has been very strong and is largely led by reflation trade, credit cost normalisation and reduction in fixed cost. Sectors which performed well in 2021 are Metal and Mining, Real Estate, Auto (exports) . One common thread across all sector is global growth and high income consumption. Underperforming sector were BFSI, FMCG (ex of ITC) and Domestic Auto. Again common thread is broader/ mid to low income economy
We are starting 2022 with high valuation, liquidity getting tighter, reasonable earnings expectation, risk of slowing global growth but pick up in domestic growth. In light of this we believe high quality stocks with better earning visibility and reasonable valuations should be preferred.