Dealing with probabilities, not certainties
The conflict in Ukraine continues to rage with tragic loss of lives and destruction of cities and towns. The markets have recouped all their losses from the sell off after the outbreak of hostilities in Ukraine. The Nifty 50 Index is in positive territory for the year (as of April 01, 2022). The same is true for the broader index Nifty 500 as well. There is a significant out performance of the MSCI EM Index and also the MSCI All Country World Index which are down to single digits for the year. Even adjusting for the drop in the value of the Indian Rupee YTD India is outperforming the above global and emerging benchmark indices.
The US Federal Reserve has kicked off the normalization process with a 25 bps rate hike and the forecasts suggest another 6-7 hikes in 2022. These forecasts account for the uncomfortably high consumer inflation in the US which scaled a new high at 7.9% in February 2022. In India, the CPI rose to 6.1% Y-o-Y in February 2022, but the number is slightly misleading as the increase in crude oil prices from December are only now being passed through to retail prices. A 10% increase in oil prices has a 30- 40 bps impact on inflation.
The concern about likely rate hikes weighs heavily on the minds of equity investors. After all, a rise in the cost of capital would ceteris paribus equal a fall in the present value of the cash flows accruing to the company. That would imply a decline in the value of the share price of the company. But a company may be able to offset that increase in cost of capital by way of price hikes, cost reductions or improving its capital efficiency. Bond instruments (with a fixed coupon) on the other hand enjoy no such flexibility of terms and therefore an increase in rates translates into a fall in the value of the bond. That is why long-term bonds are an extremely unattractive investment when faced with the likelihood of a sharp increase in interest rates. In fact, longer dated bonds are worse placed in the context of rising inflation and rising rate when compared to equities. In the US context, the Bloomberg Aggregate Bond Index is down 6.19% YTD (as of April 01, 2022). The S&P 500 is down 4.28% (total return) during the same period. In India, the CRISIL Composite Bond Fund Index has returned 0.51% as of April 01, 2022 CYTD while the Nifty 50, as mentioned earlier, has delivered +2% CYTD. The relative performance of Indian bonds vs US bonds likely reflects the bigger challenges confronting the US Federal Reserve in managing monetary policy. That is not to say that the RBI does not face challenges, but the overall dashboard of India’s macro indicators provides the RBI with greater maneuverability. This is very unlike past instances of US Fed tightening.
While we debate the attempt of the US Federal Reserve to tackle inflation in real time, it is instructive that the past track record of the US Fed in tackling inflation by tightening policy does not inspire confidence in a soft landing. From the ten episodes of Fed’s tightening in 60 years, only three episodes (1965, 1984 & 1994) had a soft-landing. The rest ended in recessions (Source: Edelweiss). In other words, orchestrating a recession is the high probability, albeit unhappy outcome based on the Fed’s track record. Further, in all three episodes of a soft landing the Fed backtracked mid-way, as things went awry on the macro front. On balance of probabilities, one might have to take the dot plot of the US Federal Reserve governors and the forecast of hikes with a pinch of salt. The yield curve has flattened and is now inverted to a large degree, i.e, the 10-year bond’s yield is less than the 2-year bond. A full inversion of the curve has normally been an effective harbinger of an economic downturn. Policy makers are operating with constraints in a difficult situation and the probability of a policy error is high.
There is a lesson for investors in the poor performance of Bonds vs Equities particularly in the US context. Diversification across asset classes such as Equity, Debt, Gold, Real assets is based on the premise that the assets behave differently and reduce the overall portfolio volatility. But choosing to emphasize an asset class solely because it has lower volatility (debt) or for that matter superior returns (equity) is not a sound strategy. The differences in risk and return are to be embraced, not avoided, to improve the risk -return outcomes in the aggregate portfolio. And it is always to be aligned with one’s financial goals.
At the worst point of the sell-off, Indian large caps, as indicated by the Nifty 50, were in the fair value zone. With recovery since then, the valuation argument is now muted. Further, the disruption of the commodity supply chains continues, and high prices persists for a large section of the commodity space. A fresh outbreak of Covid-19 in China does not help matters - it adds a new dimension to disruption in the global supply chain, though to the converse it could soften demand and thereby offset commodity price pressures if the outbreaks and lockdowns persist.
We are dealing with probabilities, not certainties. A staggered investment approach appears to be the most appropriate. We take comfort in India’s relatively healthy macroeconomic indicators in dealing with headwinds. The persistence of the headwinds of higher commodity prices and supply chain disruptions pose a risk to earnings estimates for FY23. The Reserve Bank of India (RBI) and Monetary Policy Committee (MPC) are likely to remain supportive of growth but may choose to narrow the policy corridor in their bi-monthly meeting. We expect bond markets to respond more to supply demand dynamics in the near-term, with investors preferring to remain at the short-end of the curve.
Above commentary is published in UTI Fund Watch (monthly factsheet) in the section of Update from CIO’s Desk, click here to refer to the factsheet.