The past five decades witnessed sea changes in the global financial landscape. In the 1970s, fiat currencies unhinged from the gold standard. The 1980s initiated the steady decline of sovereign bond yields. The 1990s witnessed the growth, and bursting, of the Internet bubble, while the 2000s saw the great financial crisis that led to quantitative easing with steady decline in interest rates, and the birth of the cryptocurrency ecosystem. Meanwhile, the 2010s prospered on low interest rates, and high sovereign debts.
The pandemic-hit 2020s may, however, be very different. Historic-high inflation is ushering in an era of rising interest rates. It is a challenging phase where high inflation clashes with high interest rates and causes low-growth or stagnant economy — a condition known as stagflation.
The past two decades of low interest rate have made equity markets the preferred asset class for growth investing. Market capitalisation of the BSE, for instance, grew from ₹90,836 crore in 1990-91 to ₹241 lakh crore on May 15, 2022. Hence, a generation of investors has mostly witnessed bull runs of the financial world propped up by benign interest rates. Out of the 9 crore demat accounts in India, only 2.1 crore existed in FY13, and 55% were opened after FY20 (See: Growth in demat accounts). When the bears emerge from hibernation due to anti-inflationary measures, nouveau investors are at risk of fleeing in droves.
In the past few weeks, bond, equity, and cryptocurrency have corrected severely globally. The start-up ecosystem is facing funding crunch, while new-age consumer tech companies are bearing the brunt of market pessimism. More than $11 trillion has been wiped out from the global stock market this year, and the cryptocurrency market lost $1 trillion in just one month, between April and May.
Billionaire investor and Berkshire Hathaway chairman Warren Buffet once said, “Be greedy when others are fearful.” Amassing wealth involves both wisdom and patience. Understanding of the geo-political events and macro-economic trends helps one identify investments suitable for particular goals in volatile times.
Soaring Commodities, Resurging Mercantilism
Liberalisation and globalisation, which have been trending for decades, are now being subdued by Mercantile Militarism — a scenario in which nations focus on controlling commodities and supply chains with the aid of a strong military. Indonesia, for instance, has banned palm oils exports, but has since started exports again. Back home, India has banned wheat export to feed its huge population and assist its neighbouring countries attain food security. Now there is balkanisation of the global world order where nations are divided into various camps. Food and commodities are being used as weapons. Russia and Ukraine, the principal supplier of wheat to African nations, are leveraging their positions to garner support. Russia is also using supply of gas and oil, as weapons, to keep European nations in check.
The pandemic, followed by the Ukraine War has reduced cross-border flows of goods, capital, and people, while increasing digital activities. Soaring commodity prices, and rising inflation, on the back of reduced import competition, are hinting at physical de-globalisation.
The most potent macro-economic change is the strengthening of the US dollar against all major currencies. The rupee hit an all-time low of 77.63 against the dollar in mid May. Yen plunged past 130 to the dollar, a 12% decline since early March, and a 20-year low. The yuan exchange rate has dropped sharply, by around 3.9% against the dollar, since mid April. The euro has slid around 8% since January, to a five-year low of around $1.05.
Impact On The Indian Market
A strong dollar is leading to asset re-allocation and portfolio realignment of global fund biggies. Foreign institutional investors (FIIs) have pulled out a record $20 billion from the Indian equity market in 2022, while resource-exporting nations such as Indonesia and Malaysia have seen an inflow of $5 billion and $1.7 billion, respectively. India’s weight in the MSCI Emerging Markets index currently stands at 13.64%, while China is at 30.57%, and Taiwan at 15.45% (See: The emerging market index).
The current earnings growth in India is primarily led by cyclical businesses such as metals and mining, while high-growth sectors, including consumer durables, consumer staples and two-wheelers, are facing earnings cuts, says Abhiram Eleswarapu, head of equities, BNP Paribas India.
A larger contribution in EPS growth is coming from cyclical businesses that have historically traded at low earning multiples while earnings cuts are coming from businesses which are trading at much higher earning multiples. So even if EPS stands at the same levels, the contribution from low PE multiples businesses have increased. Hence, more earning growth is required to attain the same level the index was quoting six months back, which is a big issue, adds Eleswarapu.
“India is slated to show 11-12% nominal growth for the next five years,” says Yogesh Kalwani, head of investment at InCred Wealth. “Do I have any other country in the world with a 10% growth for the next five years? I can’t think of many options,” he adds.
India’s growth story is primarily built on consumption, which has been dampened by inflation. Businesses dependent on raw materials such as palm oil, imported coal and petrochemicals face the double whammy of rising import costs and falling demand due to inflation. Hence, FMCG, cement, paint stocks are unlikely to perform well, say analysts. While Britannia, Asian Paints and Marico have seen a 4% decline in gross margins between FY21 and FY22, HUL saw a 3% drop.
High inflation has also led to reduction in discretionary spending, adversely impacting many sectors. Consumer staples and telecom companies have registered negligible volume growth, and have hiked prices to boost revenue. For consumer durable companies, topline growth is not getting translated into bottomline growth, as Ebitda (earnings before interest, taxes, depreciation, and amortisation) remains low due to high input cost.
However, as far the equity market is concerned, the Nifty may not be severely hit since the weightage of the consumption sector, which includes FMCG (7.75%) and consumer durables (3.32%), is a meagre 11%.
“The Indian consumer doesn’t really matter that much when you look at it from the index perspective,” says Kunal Vora, head of research, BNP Paribas Securities India. He believes inflation is primarily affecting companies which were trading at high PE multiples and new-age consumer tech firms which are currently not making profit but will be in the black 10 years down the line. “ The discretionary spending of the mass market will remain under pressure for a few quarters due to inflation,” he says.
According to Dhiraj Relli, CEO, HDFC Securities, inflation will impact all possible industries for the next three to four quarters. Citing the example of HUL which has cut cost by 2% by curtailing advertising spends, he says such strategies could be used by other companies too. “The earnings will be subdued for most companies for the next few quarters.”
Companies across the board are seeing margin pressures and are not able to pass on cost increases since incomes have not kept pace with retail inflation. “Currently we are seeing a tough position for India Inc. as companies try to push higher utilisation levels and volume growth, but are ending up seeing a reversal of it,” says Abhiram of BNP.
The key is to invest in companies or sectors unaffected by inflation. Service sectors such as IT will primarily remain insulated from the commodity crisis, while pharma and healthcare are unlikely to be impacted by discretionary spending cuts. Sectors closely aligned with the government’s agenda such as defence will get more business, while commodity and chemical-based sectors, including petroleum, coal, sugar etc. are at an advantage due to rising commodity prices.
Investors should focus on banking and finance as the sector has long underperformed and net interest margins of banks typically improve in an inflationary period, says Relli of HDFC securities. Around 45% of banks’ liabilities come from current account, savings account (CASA) deposits. Banks do not pay any interest on current accounts, and only 4% on saving accounts. In inflationary times, banks increase their lending rates quickly, but cost of funds do not rise much, adds Relli. On a one-year forward basis, banks are also trading at low earnings multiples of 13-14 when historic average is around 23-24, according to Relli. “We believe private banks have significant value.”
He suggests investors should focus on the oil and gas and metals sector where prices are moving up. Natural resources, metals and refining companies benefit in an inflationary regime. IT (which is leading the digital boom) and chemical companies are set to gain big as well. Chemical is an indispensable raw material for manufacturing companies, and till the time China is under lockdown, the sector will attract high premiums.
Kalwani of InCred Wealth says investors should park their money in companies that dominate their respective sectors (See: The sector leaders). “If India’s nominal GDP grows 10%, sector leaders normally register 14-15% growth in corporate earnings,” he adds.
But none of these is likely to dampen the India story. BNP Paribas is overweight on Indian equities since the country has several companies with a track record of strong earnings growth. “Our call may not be a call on India but one on 10-15 large bottom-up opportunities,” says Abhiram. “What interests investors most about India is the fact that they have a choice of high-quality companies that have demonstrated strong and consistent earnings growth.”
Interest rate hikes do not impact precious metals, especially gold, since the former is mostly used as a hedge against currency devaluation during inflation. Hence, investors can buy precious metals like gold and silver during dips and when currencies are losing sheen.
Another sector is real estate, especially domestic housing. Second-hand homes are ideal long-term, big-ticket investments as home-ownership comes with the added benefit of tax-savings, asset leverage for loans, passive income through rent, or saving on rental expenses.
While investing in cryptocurrency in India is subject to heavy taxation, the market for non-fungible tokens (NFTs) is steadily gaining traction. Indian companies that sell NFTs by accepting rupees are a legitimate investment. NFTs are like art investments. Enthusiasts can start by investing small sums periodically, and slowly build a portfolio.
The ecosystem of low interest rate and meagre inflation that led to the growth of FAANG-dominated investing is diminishing. FAANG stands for Facebook, Apple, Amazon, Netflix, Google. The investing world is now talking about FAANG 2.0, which stands for Fuels, Aerospace & Defence, Agriculture, Nuclear, Gold & Metals that provide anchor in a world of geo-political risks and volatility.
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