Volatile Year Likely in 2023 – Kotak Economic Outlook

Global Economy :The recent headlines in the US hint that we are in for a hard time. Technology companies are experiencing the greatest volume of layoffs in the last two decades, credit card debt is rising by 15 per cent to almost a trillion dollars, small businesses are not able to pay their rent, cryptocurrency has dropped and now crypto exchanges are failing, and most business owners are discussing a recession. In order to partially manage out-of-control inflation (which is currently in the high single digits) and to gain back respect, the Federal Reserve has been increasing interest rates at the fastest rate in history. However, even with the Fed’s aggressive tightening, inflation is still high and not reducing as expected. Interestingly, corporate profitability has surprisingly been quite solid. Companies have been transferring the increased costs of inflation to their customers, thus sustaining their profits. During this period, the US kept providing economic aid and thus the public debt has been rising at a faster speed. As a result, the difference between the 10-year and two-year US treasury has become inverted, which is a warning sign for a possible recession. The predicament of the US Fed perfectly reflects the proverb “caught between the devil and the deep sea”. If the Fed hikes up the interest rates, it could cause a major recession. On the other hand, if interest rates remain the same, inflation turns unmanageable. The Fed has to strike a delicate balance, and one reason why their attempts to control inflation have not been successful is because they have kept relatively high liquidity for a while now. Liquidity has been declining lately, with about 95 billion dollars being taken out each month. Although the Federal Reserve injected 4.8 trillion dollars from the subprime crisis to the Covid crisis, they only withdrew 400 billion dollars. They’ll need to take out more in the future. Will the Federal Reserve (Fed) keep interest rates higher for a long period? The written statement released by Fed said no, but the Fed chair said yes. It’s likely they’re doing this to keep the market and expectations under control. In the past, when the U.S. has increased rates, it hasn’t lasted very long – it’s been similar to climbing a mountain and only staying at the top for a short while. Before the subprime crisis, the Federal Reserve rate stayed at its highest level for around 63 weeks, roughly for one year. In general, the Fed has acted like a mountaineer, climbing and staying on Mount Everest, then going back down. This on-and-off stance of the Fed and its economic data has been confusing as well as perturbing the investors, making them hold less in stocks and more in cash to protect their portfolios against the fluctuations and volatility. The primary concern is whether inflation will slow down as anticipated. Will it drop sharply as the cost of goods has gone down due to the removal of fiscal stimulus, or will the inflation rate not decrease as much due to the leftover liquidity in the system?

Today when the state of world economy has deteriorated, India stands out like an oasis in the desert. If you look at the headlines today, many are positive; like Railway earnings up 16% YoY, direct tax collection up 31 %, foreign exchange reserves crossing 550 billion dollars after a gap, 97% of mobile used in India today are Made in India compared to just about 8% in 2014. There are certain worries alongside. The September quarter earnings were impacted quite badly by inflation. Manufacturing actually de-grew in the second quarter which impacted the overall growth rate. The trade deficit continues to remain excessively high as exports have dropped. We do have chinks in our armour but compared to the world, we look better. Capacity utilization now is at 17 quarter high, quite comparable to the pre-pandemic levels. The farm income is expected to grow higher based on good Rabi crops. Rural spending by the government is increasing and that should bode well for the Rural economy. GST collection of Rs 140,000 Crs is becoming the norm for almost the last nine months.

High inflation is impacting Growth. The trade deficit continues to remain excessively high as exports have come down. High trade deficit is likely to put pressure on the rupee as well as on growth. Oil as well as non-oil Imports continue to remain above our affordability range. One culprit for the high trade deficit is our trade with China. This year our Imports will cross probably 100 billion dollars and our trade deficit with China is likely to exceed 87 billion dollars which is more than our defence budget. One more concern for India is that our recovering manufacturing sector is fuelled by Imports.

For India to grow on a sustainable basis we need our exports to accelerate as the export share (as a percentage of the globe) is very low at 1.8%. It’s much lower than our Global share in GDP which is roughly about 3.4%. For exports to grow, the government has launched Production Linked Incentive schemes (PLIs). It has worked well in electronics and mobile phone sectors. Will it work in semiconductors, automobiles, solar modules, batteries, Pharma, etc.? If yes, exports can bounce back and help improve India’s market share in exports and support GDP growth further.

Debt is an important part of an individual’s portfolio as it brings stability. We believe over the next one year, the gap in return differences between Debt and Equity is likely to be far narrower. Inflation expectations globally seems to have peaked and falling commodity prices, withdrawal of liquidity and increasing rates by global central banks indicate that the trajectory of inflation is now down. The yield curve across Global markets has been inverted first time since 2000. An inverted curve invariably signals recession. The Fed as per Market expectation is supposed to raise interest rates by March to April 23 to about 5 per cent. The market is also expecting the Fed to start cutting rates somewhere between August to September 23 by 25 basis points. The five to seven-year segment provides a better opportunity for investment in fixed-income funds. If we talk about the funds, investors should ensure that their time horizon and the funds’ investment horizon is aligned. If you are looking to park money for a shorter period of time money market funds, savings funds and lowduration funds will be more appropriate. If you are looking at the medium-term to long-term view then there funds like Corporate bond funds, floating rate funds, short-term bond funds, mediumterm funds and Banking and PSU debt funds, Bond Funds and Dynamic Bond Funds.

Despite four rate hikes by the Fed this year, Indian Equity has continued to rise. India has delivered almost four times more returns than MSCI emerging market between 2014 and 2022. If you look at it on a 10-year or a 20-year basis, we have delivered about one and a half times more return than MSCI Emerging Market peers. India has made money for Global Investors, unlike most other markets. Partly this performance is driven by our sustained valuation. Historically, we have traded at a premium to Emerging Markets but right now the premium of Indian equities over other Emerging Market is almost high at 139 per cent. This is partly because of the massive outperformance of Indian markets over Emerging Market peers. As our performances improved, our weight in MSCI Emerging Market has also increased from 7% cent in 2020 to 14.8 % in November 2022. While markets are near all-time highs the rally is not broad-based as only 5 % of Sensex stocks are at a lifetime high level, which means the rest of these stocks are still languishing at lower levels despite a rise in the Sensex. The other interesting thing about the Market is participation by retail investors thanks to mutual fund distributors who took the message of SIP to every pin code of India. Retail investors now send about Rs 14,000 crores a month for participation in equity mutual funds through SIP. This has created a counterbalance to Foreign flows and more importantly reduced volatility.

In the near term, some investors may shift money to China on technical basis because of the very cheap valuation and potential opening up of the Chinese economy in the longer term. We believe India will be preferred by Global Investors because this is the country where rule of law and democracy is visible and Global Investors can take longer-term calls of becoming an investor in India rather than the technical call of becoming a trader in China. From a valuation point of view Indian Equity provides an interesting observation. Currently, we are trading at a marginal premium to our historical Leverage, average historical PE is 18.5, we are trading at about 20 times. The Price to Book historically is about 2.6 currently we are trading at about 3.2. Undoubtedly from a valuation point of view, we are somewhere near our historical average the same thing looked from the Market Capital to GDP ratio, we are now trading at a reasonable premium to our long-term average.

If you look at foreigners’ flow into Indian equity they did sell between October 2021 to June 2022.

But post-July 2022 they have emerged as a net buyer in the Indian Equity Market.

It is likely to be a volatile year with a roller coaster ride and hence having allocation between Debt, Equity, Real Estate & Commodity is extremely important. This is not the time to be leveraged in equity. This is the time to maintain a neutral allocation to equity and use any correction as an opportunity to enter. We suggest marginal overweight to large cap, and marginal underweight small and mid-caps. An equal allocation to equities as an asset class.

India Is at the Cusp of a Multi-year Capex Cycle. India is entering a big capex upcycle which would provide a leg-up to the overall economy. Capacity utilization now is now at 17 quarter high comparable to the pre-pandemic levels. Capex to depreciation ratio for all non-financial listed firms is almost at a historically low level. The next phase of the recovery in domestic demand in India will involve a pickup in private capex, aided by healthy private balance sheets and a prudent policy mix.

Budgetary capex allocation of both at a Central and State level has gone up considerably. The Centre’s allocation to Roads, Railways, Defence has gone up in double digits. India’s defence exports stood at a record ₹14,000 crore in 2021-22. As per media reports, the government plans to sharpen its focus on infrastructure growth in the coming Union budget by allocating 30% more funds for the roads ministry to speed up construction to more than 50 km of highways daily.

The next theme which we believe is the real estate and home improvement theme. In order to ride this revival in residential real estate we are quite positive on the home improvement space. We believe in the demand momentum revival. Real estate and home improvement sector will benefit from both primary and secondary market demand.

The Indian financial services space seems to be in a sweet spot as foreign investors have made a net investment of Rs 14,205 crore (USD 2.1 billion) in the sector in November amid strong credit growth and a manageable non-performing loan portfolio.

The push for infra development and local manufacturing are going to directly help the rural income levels. Be it the development of roadways or setting up of new plants and expansion of manufacturing capacities, these projects are set to happen in rural areas only. This will not only create jobs but will also boost consumption.

The higher MSP allocation would go a long way in helping drive consumption of FMCG products in the hinterland. This would be highly beneficial for companies with a strong rural footprint and would help drive growth for the consumer products industry.

We are in an era where consolidation is happening across industries. A decade ago there were dozen plus telecom operators now there are four. Across Industries such as Banks, Steel, Cement, NBFC and Aviation we are seeing consolidation resulting into big companies becoming bigger and strong companies becoming stronger. Survival of the fittest is the law of nature. It’s equally applicable in the corporate world.

We see a structural push to manufacturing coming from the China+1 strategy (a strategy in which companies diversify their businesses to alternative destinations other than China), and PLI schemes and the next decade may probably see the rise of India’s manufacturing sector, filling the missing piece in India’s growth puzzle. The emergence of Europe +1 theme due to the looming energy crisis in Europe would bode well for India as it becomes an attractive investment destination given its lower cost advantage and macro stability of the country.