Greetings from Team Carnelian!
Hope you had a wonderful festive season.
A new Samvat is a good time to take stock of how things went by last year, delve over important learnings and chalk the path ahead.
Last Samvat, we wrote “Focus on Risk and BRICs” and highlighted the potential inflationary risk and volatile environment. We also said Banking, Real Estate, IT and Capital goods will do well. While Banking, Real Estate and Capital Goods have done exceptionally well, IT has disappointed due to fear of a demand slowdown and high attrition. We re-iterated our stance on volatility through our July 2022 letter (‘Embrace volatility and build this vintage’) outlining plenty of speed bumps along the way YET providing a great vintage to build portfolios amid volatility – “2022, year of portfolio building” .
As we move into a new Samvat, we share below our views/thoughts for the year ahead.
“Optimism often sounds like a sales pitch; pessimism sounds like someone trying to help you”- Morgan Housel
Our apologies if this sounds like a sales pitch, but we are unable to hide our optimism despite being in the minority. The current wide-spread view is one of pessimism given the global macro environment and uncertainties prevailing.
We believe that the Sensex will inch up to 70,000-72000 mark by the next Samvat (~16-18% upside)
And why/how so?
1. 3 Peaks in sight – Inflation, Interest rate & USD
We see Inflation peaking out. Inflation started getting out of control from the start of this calendar year and rose until June 2022. Higher base effect will start kicking in by end of this year and most commodity prices (energy, metal, food) are at pre Covid levels and falling. This combination will bring Inflation down and within comfortable zone.
Interest rates have already peaked out in expectations and in reality, will peak out in the next few months with actual action by central banks. Central banks turned hawkish in the last few quarters and showed great resolve to tame inflation through aggressive hikes. We see central banks across the board driving comfort from the falling commodity prices, logistics costs and moderation in demand.
The Bank of Canada announced a smaller-than-expected interest rate hike and said it was getting closer to the end of its historic tightening campaign. The central bank increased its policy rate by half a percentage point to 3.75%, coming up short on expectations of 75 basis points move. It has lifted rates by 350 basis points since March, one of its fastest tightening cycles ever. (link)
"This tightening phase will draw to a close. We are getting closer, but we are not there yet," Governor – Bank of Canada
These two factors will lead to third Peak - USD
In times of crisis/global meltdown, usually the USD strengthens, and money moves towards safety. As calm returns, USD starts weakening. We saw similar patterns in 1987, 2000, 2008 and now.
Dollar index is at 20 years high and we are already seeing initial signs of it retracing. FII flows and emerging markets returns have an inverse correlation with the same. Dollar index starting to cool acts as good lead indicator for FII flows.
2. Strong Liquidity from FPIs & domestic – Twin Engines
It is clear from past trends that whenever the Fed starts raising interest rates and focuses on quantitative tightening, USD strengths due to risk off, and Emerging Markets (EMs) market currency weakens. EMs mostly being Current Account Deficit, import inflation and deliver negative returns. Due to this standard play book, whenever Fed raises rates, foreign investors pull out money from EMs. As and when this trend reverses (USD and interest rates peak) they come back and invest in EMs.
Post US Fed hinted rate hikes and a balance sheet reduction, flows from FPIs turned negative. From October 21 to July 22 FIIs have been sellers to the tune of INR. 3,900 bn - a massive outflow! Thankfully domestic investors saved the day absorbing such a huge supply.
Similar trends have been observed in previous cycles as well, where FPIs withdrew in anticipation of fed raising rates.
We anticipate that the FPI should invest between INR 1,200- 1,600 bn in Indian equities over the next 12 months for reasons mentioned above and the fact that India remains one of the most promising markets across the globe.
Domestic SIP flow continues to be remain strong and still Equity exposure to household saving is still around 4-5% levels.
Twin Liquidity engines of Strong FPI flows coupled with continued domestic flows can create a huge positive liquidity situation in the markets.
3. Earnings growth to remain robust
Corporate earnings are likely to remain robust as visible from many lead indicators such as GST collections and Advance Tax, cooling commodity prices improving margins, capex picking up as visible in growth in order book of capital goods companies, credit picking up slowly and gradually across SME’s, corporate houses, and sectors etc.
Consensus estimates across sectors for Nifty from FY 22 to FY 25 looks very robust as well:
Nifty earnings in conjunction with flows:
Markets always delivers great return whenever there is a combination of earnings growth along with liquidity flow. Between FY2012-2015 (witnessed strong FII inflows), Nifty earnings grew by 5.4% CAGR and returned ~17% CAGR, whereas for the period FY2015-2018, while Nifty earnings grew 6.4% CAGR, nifty grew only 5.6% CAGR.
Nifty earnings consensus for FY2022-2025 is ~17% CAGR and we believe FII flows in this period would be very similar to the period FY 2012-2015. This time around DIIs have also been continuous buyers - to the tune of INR 3,140 bn for the period October 2021 – September 2022 which should continue as well.
To support the above data points, we build conviction from the underpinning strong domestic economic indicators as well.
Now comes the important question – what do we look at?? We believe that the next leg of growth will come from BAM!!!
The credit cycle so far has been led by personal credit; however green shoots across corporate lending are well visible as reflected in the recent numbers of large banks. Whenever economic growth starts, it has been preceded and accompanied by credit growth and we believe this time will be no different. There could be intermittent hick-ups as loan growth will be higher than the deposit growth, but eventually yields will also be priced accordingly leading to overall good profit growth for banks.
(A)uto and Auto Ancillary stocks (~50% of India’s Manufacturing GDP):
Revival of the auto sector has just begun! Domestic auto sales volumes across major categories are still below the peak of last cycle and gradually picking up. Festive season sales show the continued momentum in auto volumes. Historical issues of higher commodity cost and semiconductor related chip issues are slowly starting to wade. Additionally, several auto ancillary companies are seeing strong traction on the export front. Exports aided by strong domestic markets will augur well for the sector.
Manufacturing post pandemic has acquired a new decadal growth driven by Import substation and Export opportunity. Government of india has led several initiatives to take manufacturing GDP from 16% to 25% over time. China+1, cost competitiveness and strong demand are additional growth drivers.
Companies involved in manufacturing across sectors will be the biggest beneficiaries of the evolving global situation on account of export opportunities opening up. Exports of merchandise goods have already started to see and uptick. Capital goods companies have a robust order book driven by:
Industrial capex - new manufacturing units across steel, cement, sugar, chemicals, refineries, pet-chem & data centres
Railways – green field lines + electrification
Pipes – water + sewage network
Urban Mobility – metros, road infrastructure
Consumptions stocks of course will continue to do well in economy like India where aspirations and income are rising.
As discussed in our previous letters to you, several structural and other reforms are already initiated, which will go a long way in boosting our economy.
Twin engine of strong economy driving the Nifty earnings by 17% CAGR over the next 3 years, and end of global tightening regime driving FPI flows will keep market strong.
The risk to our hypothesis could be further escalation of any geopolitical situation, any systemic failure/cascading effect due to poor macros and huge wealth destruction across most asset classes.
Markets are discounting machines, pricing events long before they have occurred - recent most example being markets being at lows when covid cases were the lowest and vice versa at highs when covid cases were at peak. Similarly, we think markets have already factored in a lot of negative macros and set for good run.