Reviewing Asset Allocation Strategy for 2023

This is a review of last quarter’s asset allocation strategy note (posted on Substack and with details on LinkedIn). Questions are from media interviews. Hope you find it useful. Happy new financial year to all my friends!

“Corporate results have been muted for the past two quarters. Rather disappointing. Can you give a sense of the big picture of how the profit landscape has evolved through a top-down framework?”

Answer: Top-down approach predicted a bad fy23 for corporate earnings. The same approach will forecast better profit growth next year.

First a quick view of history. The previous peak of the profit cycle was in FY11, followed by a sluggish growth of less than 6% over the years (fy12-21). A very bad performance indeed. Contextualize it with a 10-year bond at 8%+ then. However, within this period, the past five years (FY19-23) have seen a profit boom, with a 14% growth rate for non-financial non-government (NFNG) firms, primarily driven by COVID cost cuts and corporate tax cuts. Many analysts believe it was due to a boom in nominal GDP growth or sales growth. Not true.

The average profit-to-GDP ratio for NFNG firms has averaged 1.5% for the past decade. This ratio increased sharply in FY22 but has been declining since. For FY23, sales and expenditure growth track nominal GDP, but net profit growth is shrinking for trailing four quarters. Why?

Two main factors contribute to this: a small fiscal consolidation (40bps) and a widening current account deficit (2%). The net effect is muted corporate profit performance, which many top-down analysts had anticipated for FY23. However, the stress is beginning to dissipate at the margin.

Another side point is that even sales grew by nearly 8% over the past 12 years even when nominal GDP grew by 11%. Typically, sales and GDP growth correlate. Research by Fed. Several opinions (Arvind Subramanyan etc) suggest that the actual GDP growth might have been weaker than the reported figures over the past decade. Researchers might want to consider the slow corporate sales growth as an additional factor in their analysis.

And the Future, for the rest of the year and fy24? Credit impulse will likely drop; Fiscal deficit too will see a small decline but CAD will improve. Besides this, the past year’s strong credit growth and resultant higher impulse will flow into the profits of the firm. This means it’s likely that profits grow at a nominal GDP growth run rate. Doing so will mean about 10-12% growth in the profits of nfng firms. Net net, profit growth won’t be the headwind for nfng stocks in fy24 (though there could be disappointments relative to lofty expectations of analysts)

"Will there be a crisis, given what is happening in US Banks? Is a Lehman moment around the corner?"

Answer: Likely no.

Notably, most crises in modern economies stem from excess money creation, which can lead to banking crises. Generally, these crises fall into two categories.

• Excess money created by lax banking practices: This scenario often results in higher inflation and thereafter, policy tightness, leading to an eventual slowdown and credit stress on corp/individual balance sheets that weren't initially equipped to handle it. If this stress becomes system-wide, it can evolve into a bank and credit crisis, as we saw with Lehman Brothers.

• Excess money due to fiscal transfers: In such a case too, inflation and rate hikes follow. However, rate hikes don't slow the economy quickly enough since the money spent was "free money" for private balance sheets. Central bankers end up tightening a lot more in such setups, leading to an interest rate or duration crisis. This affects assets with long durations, such as start-ups, tech companies, long bonds, and narrative investing. This is the crisis we've been in.

Interestingly, an interest rate crisis can evolve into a credit crisis if it persists for an extended period. The recent SVB fallout was due to excessive interest rate risk combined with leverage. It's possible that more entities are in the pipeline, but there's a nuance here. Many of these weaker entities are outside the US. The US economy and its banks remain strong. Net net, at this point, US is unlikely to face any major banking crisis.

"If profit growth is likely to be okay, there's no major banking crisis, and peak interest rate is behind us, then what's the problem for equities now?"

Answer: Central Bank's dual mandates and the change in reflex

To grasp the challenges facing equities, we must examine the dual mandates of central banks, particularly the Federal Reserve. These mandates involve price stability and maximum employment. In the past 20-25 years, price stability was rarely a concern, so the emphasis was on employment. Consequently, central banks tended to cut rates at the first sign of a slowdown, leading to the belief in the so-called "Fed put." This preemptive action helped avert deep economic downturns, established negative bond equity correlation, and offered support for equity markets.

Now in the current set up, with risk of sharp economic slowdown, the previous reflex would have likely prompted central banks to ease or at least be more cautious with rate hikes. However, given the persistent inflation and being late to react, price stability has become the primary focus for central banks. As I have argued for the past 18 months, this new reflex is why the macro environment remains 'not so good' for equity markets, leading to a higher bar for adding equities compared to the post-GFC setup.

Can we expect the Fed to maintain its recent hawkish stance? Probably not. Financial conditions have tightened rapidly, and current bank runs may lead to stricter lending standards. This situation effectively adds an extra 25-50bp worth of rate hikes, which is beneficial for fixed income as the tight policy is being achieved through the lending channel instead of the rate one. However, for equities, the crucial question is whether the Fed will implement policies that are easy enough to outweigh the cost of the ongoing slowdown by lowering discount yields. The answer is likely no.

“What about Indian equities for fy24? Having underperformed so sharply but is the case of o/p on the horizon now?”

Answer: We have two problems. The wedge between Perception vs Reality & depressed Equity risk premium.

The first one is about a wedge between Investor perception and economic realities- that has rarely been as large as it exists today. An average investor thinks that India is doing extraordinarily well, its economic growth is accelerating and its heft is rising. The reality is that India is simply muddling through a difficult environment, it’s grown at barely 4% in 5 years, and most economic indicators are suggestive of the fact that we may be slowing instead of accelerating. To be sure – this is despite reasonable governance, reforms and decent management of the Covid crisis. It’s just that the current setup isn’t conducive to acceleration. Story of a changed perception

Second is, even though current valuations have mean reverted – for given interest rates- risk premia remain small (there is an effect of taxes. But I will come to that in a while). I think that our corporate profit growth will be close to 10-11% over the next few years (=nominal growth). At that growth, for current valuations, only 10-11% returns are likely. That’s just 2-3% over FDs. This spread is lowly vs history.

How to bake in higher rates in equities valuation?

How to track historical risk premium

With valuations neither very cheap nor providing adequate returns, it may be wise for investors to maintain an underweight position in the market. However, as each month passes with unsatisfactory past performance, the risk of a sudden market shift increases. The small & mid-cap segment of the market continues to remain the most vulnerable one, which is likely to draw out losses gradually for an extended period before experiencing some sudden and significant ones. In some sense, my view is more or less the same on equities as was in July 2021. Though on a fixed income - it has turned constructive. Time to go underweight equities

“What is your asset allocation strategy now?”

Let me reflect on my previous asset allocation recommendations and macro forecasts, review outcomes over the past 90 days and explore the current outlook for various asset classes, including US tech, bonds, and Indian equities.

1. US Tech/NASDAQ: My allocation to US tech was timely, with returns of nearly 18%+ in this quarter alone. It remains an attractive investment even today in the equity space due to reasonable valuations, consistent earnings, cost reductions from layoffs, and the potential for significant productivity gains in the coming decade.

2. Short-dated bonds and US rates: I suggested investing in short-dated bonds in India and forecasted a rally in US rates. US rates are down sharply. Indian short-dated bonds are likely to do better in the coming weeks. I expect RBI to pivot on liquidity.

3. Indian Equities: I anticipated a lacklustre year for the Nifty and underperformance in small/mid-caps, which has largely come to fruition. I don’t expect Nifty to underperform now. But the first quarter underperformance won’t be undone for the rest of the year.

4. Sector Performance: I had expected banks and NBFCs to struggle and IT to perform well. While this played out relatively, Nifty IT didn't deliver significant returns in absolute terms. They did better than the markets whereas banks underperformed. I don’t expect BFSI’s underperformance to continue any more. But local IT firms should do well for the year.

5. Policy and Market Views: I argued that the Fed would end sooner than expected and that the RBI would raise the REPO rate to 7%. I also predicted higher crude prices, stronger growth in China and the US, and weaker growth elsewhere. Most of these predictions have materialized, except crude, where prices have fallen slightly. My view on all of these remains the same, though i think China’s growth may end up being weaker than what I had expected.

6. Flows: I anticipated lacklustre FII flows and potential weakness in local flows. While FII flows have been weak, mutual fund flows have remained strong despite a slowdown in direct retail investments. I still expect lower flows in 2023 compared to 2022.

“What is the impact of tax changes on various asset classes?”

Answer: Major impact depressing the demand for the risk premiums of local equities lower.

The new tax regime has made fixed-income investments less favourable for high-tax bracket investors, shrinking the risk premium requirement by nearly 1.5%. While this change might prompt some investors to consider shifting their asset allocation, it's essential to exercise caution, as the tax regime is not yet settled. The risk of an increase in capital gains tax on equities remains high over the next 2-3 years. Not just in India but also globally.

The tax changes have created a diverse incentive structure for different investor groups. For those in lower tax brackets, the case for entering the market remains weak, with better alternatives available in fixed deposits and various government schemes. On the other hand, high-tax bracket investors now face stronger incentives to invest in riskier assets to generate higher returns. This perhaps is the revenge of the proletariat! The impact of tax changes. impact (2)