Financialization trend is just getting started

Year 2017 was characterized by spirited equity markets driven by structural reforms, burgeoning domestic flows, and consumer-driven credit growth. However, given the negative rhetoric around some of the reforms, mainly due to the pain felt by consumers and businesses, we analysed policy actions across geographies and timelines to establish their likely long term impact.

Short-term pain for long-term gain

Findings suggest that a government interested in sustainable economic growth should focus on three policy priorities: structural reforms, fiscal prudence and private investment. And the Indian government’s approach indeed reflects these priorities. 

To begin with, when viewed collectively, the reforms reveal several interconnected measures that reinforce each other, and should serve to create multiplier effects. Take real estate as a straightforward example. Demonetization, together with regulatory reform and enforcement, should contribute to the normalization of prices in a sector which is currently distorted. Or non-performing assets (NPAs). Bankruptcy reform, alongside bank recapitalization, puts in place clearing procedures to restructure inefficient capital allocators. 

Aadhaar and account linkage is a similar measure. India is in the early stages of private credit expansion with total domestic credit to the private sector at roughly 50% of GDP, whereas it is at 170% in China and over 200% in the US. As India’s annual per capita income rises from its current $1,710, the government is putting in place an architecture for sustainable domestic credit expansion.

Over time, the totality of these reforms should result in a significant change in savings and investment behaviours towards more productive avenues. Today, there are only 30 million demat accounts in a country of 1.2 billion. The “financialization” trend is just getting started and has a long way to go. Further, despite the sometimes negative narrative, many people seem reasonably convinced of the constructive intent behind the policy actions. This bodes well for the continuity of these reforms and we expect them to be further buttressed by actual results as the resultant growth starts becoming visible.

Market positioning

Over this decade and the last, easy monetary policies globally have propelled asset prices higher and driven bond yields lower. This phase is now coming to an end, as central bank balance sheets are expected to contract in coming years and this will affect local markets too. That said, the centre of gravity for growth is shifting to emerging markets, and India's domestic economy in particular remains well positioned because of the multiple growth drivers available to it.

As we look ahead into 2018, it’s instructive to review our position at the same time last year. Markets were in a steep sell-off. It was felt equities were the most attractive asset class for the medium term, and the valuation opportunity was as attractive as at any time since June 2013. 

It’s a more difficult call this year, at least in the near term, with valuations stretched globally, unwinding central bank liquidity, and a hawkish US Federal Reserve intent on rate hikes. Crude oil could create further worries, though we expect it to stay within the current ranges. And then there are the ever-present geopolitical risks. Back home, a key systemic risk is in the process of being addressed through the recapitalization of the public banking system. Political risk remains a concern domestically and globally. Adverse election outcomes could lead to corrections in the equity markets albeit these should be short lived. Moreover, earnings and GDP appear to be recovering and the consumer is getting healthier at the rural level. Market earnings growth could reach the mid-teens next year, with several underperforming sectors repairing themselves. That said, high valuations leave little room for error, and the kicker from price-to-earnings expansion is largely over, so earnings will need to come through for the market to move higher. 

Outlook

Equities enjoy a favourable view based on reforms driving the hypothesis that India is in a structural bull market, and the feedback from on-ground checks is that sectors such as infrastructure, building materials and affordable housing are improving.

Prospective long-term returns for equities are considerably higher than the 6-8% expected in fixed income. If investing in equities, expect that there will likely be volatility and corrections along the way, and an element of tactical agility may come in handy. 

No change in forecast for gold: remains underweight. With respect to fixed income, the position is towards corporate bonds and short duration, noting that fixed income is a risky asset class in an environment with rising rate risk. 

In general, investors should determine their asset allocations based on an assessment of their risk appetites and time horizons. That said, it is worth noting that the Indian equity market (indeed most markets) has repeatedly demonstrated that long investing horizons are beneficial and the cost of adopting risk aversion is high. Even an index investment at the peak of the 2007 bull market would still have earned roughly 85%. Staying invested, being patient and embracing some amount of volatility has proven to be far more profitable and is likely to remain so. 

Shiv Gupta, chief executive officer, Sanctum Wealth Management