The year 2022 has been an entire bag of surprises. The bulls and the bears caught unaware way down and the ferocious way up.

In retrospect, the Fed rate hike of more than 400bps, the never-ending Russia -Ukraine war, and the ongoing political and economic slugfest have made us believe India would have an extremely tough ride the past year. Well, the Santa rally for India had begun since July, and we saw a turn of FII flows leading to a near 20%+ rally from Nifty lows on June 22. The reasons range from the resilience of Indian consumers to the TINA factor that plagues the world.

Fundamental, Sentiments and Liquidity: Key Variables 

• Fundamentals:PLI policy reforms to target global sourcing, Need for China +1, Favourable demography, Improving fiscal led by tax compliance and spending discipline
• Sentiments:Visible road map of moving towards 3rd largest economy in the next 4-5 years)
• Liquidity:Active participation by domestic investors along with global strategic investors that offset the FPI outflows.

While fundamentals create the base for long-term returns, liquidity matters for short-term performance. 

Globally the “Santa (Dec) rally” for risk assets failed on the US Fed’s rate guidance of higher for longer on equities. Global financial markets are gradually adjusting to the US Fed’s hawkish messaging on the economy and inflation. Before the December Fed meeting outcome, not many market participants were anticipating 12 months of no rate cut by the US Fed. Inflation is yet to settle down to a more straightforward trajectory. Re-opening the Chinese economy offers some hope for supply but also creates domestic demand and a revival of demand for global commodities & hence prices of these commodities. A policy surprise for the month came from the Bank of Japan by raising the yield curve range from (+/-)25 bps to (+/-)50 bps, and This led to a sharp jump in Japanese bond yields and appreciation in JPY. Over the past 15-20 years, Japan has been a significant ‘financier’ of the global economy & financial markets as ‘carry trade’ emanated from low rates. Any increase in Japanese bond yields would reduce this ‘carry trade’ attractiveness and volatility in global markets.

Indian markets, too, closed negative for the month. Sector, Metals, Financials (led by Banks) & FMCG outperformed, while IT, Auto, Pharma & Energy underperformed Nifty. Globally, Metals rallied on the expectations that China will stick to its guidance of easing the covid restrictions from January.

Looking from a yearly perspective

India continues to remain in a sweet spot as a bottom-up stock idea over the medium to long term. The near-term directions are likely to be driven by investors' asset allocation adjustment vis a vis new monetary policy norms of higher for more extended, relative country valuations and India's domestic policy action in the run-up towards elections.

As global central banks are signalling a higher rate environment for a longer time, hopes of a rate cut in CY23 have softened. The past decade of ultra-low rates created a preference for risk assets like equities for investors (choice over dent) and speculators (cheap cost of leverage). We need to monitor whether a new environment of higher rates can lead to a change in investor behaviour on either front. Any shift in asset allocation globally, as well as domestically, can influence markets.

Indian equities are at a marginal premium to the long-term average, in line with growth expectations. This may resonate with reforms led by PLI & tax compliance, favourable demography and healthy balance sheets (government, corporates & household). However, from a relative outperformance potential, an eye on the valuations vis a vis the global equity markets matter. Indian markets are trading at a substantial premium to other markets. Hence, from a worldwide investor perspective, risk-reward in India may look weaker than it was a year ago. This is significant as global expectations are moving towards the potential re-opening of the Chinese economy. Any surge in growth there can attract more flows towards China and other markets connected with the Chinese economy.

Indian policy environment needs to be monitored for policy actions in CY23, ahead of the state & union elections in the next 12-18 months. While the long-term direction of the reformist agenda is not likely to change much, near-term populist policies can offer attractive opportunities as an incremental flow of money may create a new set of beneficiaries, more in rural & infrastructure areas.

As usual, the economy and financial markets offer multiple data points to navigate in the short term; the Union budget and US Fed & RBI meet in early February, global commodity prices post China re-open and Q3FY23 result season for Indian corporates. The result season may likely remain soft, as seen by GST collection trends and weaker H2FY23 GDP growth expectations.

• Humility:

"We understand better how little we understand about inflation.": coming from the US Fed Governor, Jerome Powell it could easily have passed of as the quote of the year . Yet in those words rings the hints of humility.

• We Got it wrong:


Source: Bloomberg; Data as on December 31^st, 2022.

The above chart shows the Fed Dot plot: the dots represent what the US FOMC members target for the Fed Fund rates on December 2022, on different FOMC meeting dates . On December 15, 2021, most of the FOMC participants expected the target Fed fund rates on December 2022 to be around 1 % . The Fed Fund rates ended the calendar year at a range of 4.25% to 4.50% . A miss of around 350 basis points! Humbling again!

• Not for the faint hearted

The trader of the year, for us, was the Yen currency trader. The USD Yen saw a movement from a high of around 113 to an almost all time low of 150 in October 2022 , before settling at 131 for the year . And if you are a currency buff; the 150 on the Yen was last seen in 1990.

• The Conundrum

The Rupee had one of its worst performances against a bunch of currencies as it depreciated around 11 % against the USD and was amongst the weakest currency in Asia on a nominal basis.

There is a measure for currency performance called the REER (Real Effective Exchange Rate ) which also takes into account inflation of the other economies . Turns out that on available REER indices , the Rupee INR has remained quite stable !

The Conundrum of comparing Nominal versus Real continues!

• The Local Boy – India 10 year Gilt

The New Calendar year of 2022 started at around 6.50% : low , benign and comfortable . In June 2022 , 6 months into the year the 10 year moved up to a high of 7.60%.

Could we ever fathom that? The Mind thinks linearly; the markets don’t!

• Quo Vadis- What Next

The usual caveats to forecasting: our investment process thinks in terms of probabilities and not in terms certainties.

• "Trends that can’t continue, won’t"

Herbert Stein had famously expressed "If something cannot go on forever, it will stop".
We look at some trends which "may not go on forever"

• The Inverted US sovereign yield curve

The Current US yield curve is inverted: the 2 year around 4.43% and the 10 year around 3.87% . Its been almost 6 months the US yield curve assumed the inverted /flat structure. This represents an extreme outlier; a 5 percentile event occurrence over Five decades ..this inversion may not go on forever

• Global Central Bankers action

2022 was a year of Global Central Bankers on an increasing rate spree . 2023 could be a slowing down process, of possible pause and reflection.

• Oil and Commodities: Enfant Terrible

Oil and Commodities have been historically a difficult asset to predict. As China resumes normalcy, and with metal inventories at London Metal exchange at historic lows, there exists a healthy chance of higher metal prices and crude prices. However, we believe the commodities, including farm commodities and metals should consolidate or move lower through the year, helping a softer inflation bias.

• The Local Boy again – India 10 year Gilt

We always remind ourselves of a fact on market volatility; the median difference between the High and low of the India 10-year gilt (disregarding the direction of the market) for the last 10 years has been close to 75 basis points. As a soft reminder , the difference between the High and Low of the benchmark 10-year Gsec was close to 125 basis points in 2022.

We believe that the RBI is close to the terminal repo rate policy. And with RBI projecting an inflation of 5 % in June 2023, the probability of the 10-year heading lower exists. Fixed income indices which measure the Gilt returns show that a 5-year monthly returns (XIRR) is around 4% with the average return around 8%. We believe that returns broadly mean reverse and thus there exists a probability of the 10 year to deliver a positive surprise in this calendar year.

• Generally speaking, we believe that investors could move up the Risk continuum. We believe the carry and possibility of a RBI pause merit investments in fixed income funds.
• We believe that the investors with a shorter time horizon of less than one year may continue investments in ultra-short term and low duration funds. Both funds have a carry of around 7% and look comfortable on a risk adjusted basis.
• Short term fund category may be suitable for investors looking to stay for a time horizon beyond one year with a lower risk volatility.
• For a long investment horizon and with a suitable risk appetite, an allocation to Dynamic Bond fund merits attention.