Embrace Volatility In New Year

OH, 2023, what a snooze fest, right? The Grinch ‘stole’ the U.S. recession, and, shockingly, there was no grand re-enactment of the ‘Lehman’ crisis or a geo-political ‘apocalypse’ moment. Instead, stocks were high on dope, not just in India but in the U.S. as well, with tech shares staying frothy. Fixed income, real estate, gold and, yes, Bitcoin, too, couldn’t stop acing the price charts. Just your average, run-of-the-mill year in finance, ain’t it?

Amid a backdrop of paradoxical stability and chaos, the wealth landscape saw a significant milestone with India’s market cap surpassing $4 trillion, rising 26% through the year. The cumulative wealth of the country’s dollar billionaires, as per Fortune India’s Rich List 2023, was equivalent to 25.39% of India’s FY23 GDP of ₹273 lakh crore ($3.4 trillion). The collective wealth of India’s uber rich swelled from ₹66.35 lakh crore ($832 billion) in 2022 to ₹69.30 lakh crore ($843 billion), even as the club of billionaires expanded from 142 to 157. Beyond the billionaire listing, which was as of July 2023, a financial bonanza unfolded with the wealthy getting wealthier as the year drew to a close. Savour this: Promoters and associates of 4,741 listed companies were worth ₹174 lakh crore. Among non-promoters, 5.38 lakh high-net-worth individuals (HNIs — individuals holding nominal share capital more than ₹2 lakh) sat on a treasure trove worth ₹7.56 lakh crore, while 28.47 crore retail investors (individuals holding nominal share capital up to ₹2 lakh), amassed a staggering ₹26.22 lakh crore. Notional wealth apart, promoters of 46 companies pocketed a cool ₹12,607 crore by selling their stakes through IPOs. The icing on the cake was the dividend flow in FY23 with 1,388 companies paying out a record cumulative payout of ₹4.43 lakh crore, up 25%. Of this, promoters took home ₹2.32 lakh crore, 80,156 HNIs pocketed ₹6,226 crore, while 17.84 crore retail investors shared ₹31,122 crore among themselves. Not surprising that the Sensex total return (TRI) index zoomed past 100,000 for the first time in July, a gain of 18% vs 16% on the Sensex which is flirting at 71,300 levels (See: In an orbit of its own).

Notably, the indices hit new highs even as foreign ownership of stocks hit a decadal low — 16.6% in November 2023 — the lowest since 2012. But the tide is changing. The 10-year US Treasury yield, after hitting a 16-year high of 5.02% in October, fell to 3.943%, following the U.S. central bank leaving rates unchanged at 5.25-5.5% and backing it up with a surprise announcement of a likely 75 basis point (bps) cut in the New Year with consumer inflation easing to 3.1% in November. The Fed’s dovish stance is rubbing off on flows with FPIs pumping in nearly ₹57,000 crore into Indian equities (as of December 26th), 6x higher over their November investments. In fact, over the past decade, the AUM of passive funds tracking Nifty indices has increased to about $70 billion (as of November 2023) from about $1 billion in November 2013, an annualised rate of 53% even as seven funds were launched during the year in Japan and Korea. Signalling a shift in preference away from the safety of the dollar, FPI flows during the year have touched ₹1.61 lakh crore. The dollar index, which measures the greenback against six major peers, has slid from a 20-year high of 114 in September 2022 to 101 at present.

India Ahoy!

The heightened foreign interest, as reflected in the FPI flows, is also mirrored in the increasing engagement and enthusiasm at major financial forums, like the one held recently in India by CLSA, one of the earliest foreign brokerage firms to have entered the country in 1994. “This is our 26th annual conference and there seems to be palpable interest in India. We have had about 84 companies showcasing their growth plans, and almost 400 foreign clients coming down to India to meet companies and government officials. In just two days, 80 foreign investors met several companies and government officials across the country,” Indranil Sengupta, economist and head of research, CLSA India, tells Fortune India. Whether it was the biggest-ever turnout in the history of CLSA in India is not clear as the old guards, barring a few analysts, have moved on post the 2013 takeover of the Crédit Agricole-owned brokerage by Citic Securities, China’s leading brokerage and investment bank. But what is evident is that the largest underwriter of Chinese debt and equity now wants a larger slice of India’s growing pie for its international clients. Previously 40% underweight compared to India’s position in the MSCI All Country Asia Pacific ex-Japan Index, the brokerage house has now assigned the country an impressive 18.2% weight, a substantial 301 bps increase from the earlier 15.1%. CLSA candidly acknowledged in a report titled, Incredible India: Raising Exposure, that its prolonged negative outlook, effective from late October 2022, persisted “for too long.”

The title ‘Incredible India’, though, bears an intriguing, somewhat ominous resonance with ‘India Shining’ campaign, coined by the then-ruling BJP-led NDA government for the 2004 elections that resulted in an unexpected electoral defeat. Yet, the current wave of exuberance is partly fuelled by BJP’s recent successes in the assembly elections, bolstering foreign investors’ optimism in India’s economic trajectory. “India’s economy will surpass that of Japan by 2027. By 2052 we will be $45 trillion and $88 trillion by 2072. Now, this is pretty much on business-as-usual lines, assuming 6% GDP growth, 5.5% inflation and 2.5% currency depreciation. Our base case assumes India, by 2052, should move from being a middle-class economy to an upper middle-class country, which most of Eastern Europe is right now,” says Sengupta.

Though India’s GDP is expected to grow around 6.2-6.3%, positioning it as the fastest-growing economy in FY24, former RBI governor Raghuram Rajan feels headwinds are in store next year. “We will have to wait and see how much India will be impacted,” Rajan tells Fortune India. One big concern is that net household financial savings has fallen to a multi-decade low of 5.1% of GDP in FY23. The decline will result in a shortfall in investment capital, potentially hurting economic growth. Further, lower savings mean reduced financial buffers for families, making them more vulnerable to economic shocks, such as job losses and acute inflation. The fact that the BJP government has extended by five years the Pradhan Mantri Garib Kalyan Anna Yojana, which provides 5 kg of free food ration every month to 80 crore poor Indians, shows growing income disparity even if one sees it as a sop ahead of the general elections.

Though there is a disconnect between the real economy and the market, a couple of factors are keeping equities on the boil. In FY23, 1,388 dividend-paying companies’ cumulative profits hit ₹11.73 lakh crore, of which a common set of 820 companies’ cumulative profits surged from ₹5.64 lakh crore in FY19 to ₹8.23 lakh crore in FY23, reflecting the robustness and quality of India Inc.’s growth over the years (See: The big bounty). “We believe we are only halfway through a profit cycle, with profit share in GDP rising from a low of 2% in 2020 to about 5% currently, and likely heading to 8% in the coming four to five years. This implies about 20% compounding of earnings growth,” says Ridham Desai, equity strategist, Morgan Stanley India. Besides, at 20x estimated FY25 earnings, valuations are not out of whack in comparison to the 10-year average of 20.08x.

What should also keep the momentum going is that Indian households’ exposure to equities (4.8%), relative to other asset classes, is expected to increase in the coming years. In FY23, systematic investment plans saw a record inflow of ₹1.56 lakh crore — the highest in the history of Indian mutual funds and a 62.3% increase from the pandemic-affected FY21 (See: Ready, steady, flow). Desai draws a parallel with the U.S. market, where allowing 401(k) plans to invest in stocks significantly benefited the market. Similarly, India has seen positive changes since retirement funds were permitted to invest in equities from 2015. “With reducing dependence on FPI equity flows, India’s beta (volatility) is now down to around 0.4, making it a quintessential defensive market among emerging markets,” says Desai.

Even as equity remains a favourite asset class, Alternative Investment Funds (AIFs) have emerged as the new game in town.

The Rising Alternative

AIFs, across asset classes such as equity, debt, private equity and hybrids, have come of age coinciding with the rise of high-net-worth investors. According to a study by Crisil, AIFs have delivered 13.5% internal rate of return (IRR) alpha over Sensex during 2013-2023. AIFs are expected to remain one of the fastest-growing managed product categories over the next few years as more and more HNIs and ultra-HNIs seek higher alpha generating investments.

As many as two-thirds of the current lot of 1,096 AIFs were registered in just the past five years as of March 2023 with commitments surging 580x from ₹1,437 crore in 2013 to ₹833,774 crore in March 2023. Moreover, about 58% of the AIFs have been registered as Category II AIFs (largely comprising real estate funds, private equity funds and funds for distressed assets) as of March 2023. Interestingly, the 13.5% alpha over the Sensex TRI was driven by more than 75% of the funds. Crisil’s analysis of 217 funds reveals that the Indian private markets (category I venture capital funds and category II equity funds investing in unlisted securities combined) outperformed public market equivalent (Sensex TRI).

Interestingly, Sebi is keen on introducing an asset class between PMS and mutual funds. Chairperson Madhabi Puri Buch recently said the proposed category will likely have a higher minimum investment and relaxed norms to generate high returns.

But what’s pertinent to note is that while the IRR for the aggregated AIF benchmark stands at 25.76% as of March 2023, the ratio of total distributions to paid-in capital — which denotes realised gains — remains low. Though public markets have been on a roll, private market valuations have had to grapple with write-downs. Not surprising, the study states that the ability of fund managers to make timely exits from their portfolio companies at favourable valuations will determine the investor experience with these products. With private funding pools drying up, there are opportunities for some AIFs to offer an exit to vintage capital invested in these companies. “If you’re not able to exit or float an IPO, or if the company has not reached a stage where it can raise further growth capital, then those companies or funds are forced to sell their holdings and you are getting a huge discount in some of these secondary transactions. So, the whole space from a valuation perspective is very attractive,” mentions Yatin Shah, co-founder of 360 One, a leading wealth management firm.

Credit Blues

Among AIFs, credit funds, too, have been gaining traction. Since 2018, there has been a staggering $23 billion deployed across more than 190 deals, with the real estate sector, especially, witnessing substantial utilisation of private credit, as per the Indian Venture and Alternate Capital Association. “Real estate equity funds that started in the early years did not deliver as per what was committed. Against a targeted 20%-plus kind of return, the funds barely managed 10-11%. But after the clean-up (RERA, demonetisation and GST), most funds are focusing on mezzanine kind of structures, with funds delivering 18-19% gross return with quarterly payouts,” says Rajesh Saluja, CEO & MD, ASK Wealth Advisors.

While the run for private credit AIFs has been good, there is a growing concern that the risk-return trade-off may not be as attractive in the coming year. “Since the tax change for debt mutual funds, a lot of money has flowed into private credit even as equity allocations have continued to be robust. Thus, there is a risk that many investors may have over-allocated to pro-cyclical risk assets when compared with their underlying risk appetites,” says Suyash Choudhary, head, fixed income, Bandhan AMC. Pro-cyclical assets tend to do well when the economy is on a roll and counter-cyclical assets, in theory at least, do well during an economic or a cyclical downturn. Equity and private credit are pro-cyclical assets, whereas quality fixed income (government securities, quasi-gilt and AAA papers) comprise counter-cyclical assets. If the return profile of private credit is similar to that of equities over the medium term, it implies that associated risks are more akin to those of equities rather than fixed income. “There are no perpetual arbitrages in the marketplace. So, by definition, if there is an asset class that seems to have an expected return profile which is closer to equity rather than quality fixed income, then the risk profile also should be closer to equity rather than quality fixed income. Our view is that allocations to private credit, AIF, etc. should be carved out from your equity allocation and not your quality fixed income allocation,” says Choudhary. Gilts are sensitive to interest rate changes but provide diversification benefits because of their low or negative correlation with equities.

In FY23, debt fund returns were dismal with 10-year Gilt Index up 3.41% and the Nifty 10-year Benchmark G-Sec up 3.17% as central banks across the globe went on a monetary tightening spree to contain inflation. Year-to-date returns on benchmark gilt have been range bound around 30-40 bps. “The bulk of the yield readjustment on account of the change in monetary policy stance and the subsequent rate hikes in India played out between March and June 2022. While near term fluctuations have continued, the bond market hasn’t seen any further large adjustments over the past year thereby allowing funds to largely earn carry income from investments,” says Choudhary. Carry is the income you make basis yield at which investments are made. When interest rates fall, the value (price) of debt securities held will go up, leading to a mark-to-market gain and yields fall, and when interest rates rise, the value will go down (as yields go up), leading to a mark-to–market loss.

Of late, investors are focusing more on this stable income (carry) rather than taking risks with interest rate changes (duration risk). For example, many people have parked their money in bank deposits because interest rates were high last year. If these rates fall when the deposit matures, investors might have to reinvest at a lower rate. Therefore, it’s important to choose new investments with longer tenure to increase the overall maturity of the portfolio. To put it simply, of an investment of ₹100, if ₹90 is locked away in relatively short-tenor instruments, the remainder (₹10) should be invested in medium-to-long-term investments to balance out the average maturity on the overall ₹100. “We have seen over multiple cycles that in the growth phase of a cycle when price performance is robust, investors tend to overstretch their risk appetite. Hence, it’s high time to rebalance in favour of high-quality fixed income especially as valuations on high quality relative to credit have cheapened,” says Choudhary. Saluja, too, mentions that in the coming year, fixed income will be in vogue over equities. “There’s a very good play on capital gains because our view is that 2024 will be the first year of rate cuts, both in the U.S. and in India,” says Saluja.

That should work in favour of gold as well since the declining dollar and treasury yields have pushed up bullion prices given that lower interest rates reduce the opportunity cost of holding non-yielding bullion. Besides, given the fresh geo-political skirmish and central banks loading up on the yellow metal, gold will retain its allure. Yet, the case for investing in equities remains compelling.

On A Wing & Prayer

In the coming year, India will be in focus as, in June 2024, the country will join the global bond index, prompting $30 billion inflows into gilts. From an initial 1%, the weightage will increase by 1% each month until it reaches 10% in April 2025, mentions Morgan Stanley in its report. The move could also trigger other index inclusions which could attract another $10 billion in inflows.

Even as the bond market finds favour with investors, equity, too, will be in vogue, In November, index provider MSCI raised India’s weightage in its Global Standard (Emerging Markets) index to 16.3% from 15.9%, the second highest after China’s near-30% weightage. The inclusion could trigger inflows of around $1.5 billion, according to domestic brokerage Nuvama. Further, an additional inflow of ₹30,000 crore from 2024 onwards is expected from a major U.S. pension fund. The Federal Retirement Thrift Investment Board with assets of around $600 billion was thus far investing through the MSCI EAFE, which comprises 21 developed markets, ex-India, will now switch over to MSCI ACWI ex USA and ex-China index, wherein India’s weightage is higher. The changing narrative is also driven by the fact that Indian corporates’ deleveraging spree has improved the debt ratio from 78% of GDP a decade back to 54% of GDP as against China’s 165%.

While the equity market looks promising as ever, one cannot ignore the broader global context that could introduce volatility. Consider this: general elections will be due in 40 countries, including the U.S. and India. Further, the tension in the Suez Canal, where Yemen’s Iran-linked Houthi rebels are attacking ships, might result in an oil price flare-up. However, one can take heart from the fact that despite all the crisis and negative macro developments, equity as an asset class has outperformed over a longer period (See: Reasons to sell). So, let’s raise a toast for a year that was and prayers for a New Beginning.