Daily Voice | Softening demand environment a key challenge for Indian economy, says Unmesh Kulkarni of Julius Baer India

He sees increasing global opportunities for some sectors such as IT, chemicals and engineering products.

Do you see any possibility of a spike in CPI inflation in India? Also, will it be sticky for the next year?

The spike in inflation in January (6.52 percent) certainly caught everyone by surprise, as the consensus expectation being built was that inflation has peaked and entered a downward trajectory after the CPI printed below 6 percent for two consecutive months.

The broader theme remains intact, that the massive rate hikes by the RBI (250 bps cumulative so far in the current rate hike cycle) will cause the economy to slow down and therefore have a lagged impact on inflation. On the one hand, the global supply bottlenecks have been easing, taking the pressure off the CPI, in most countries. However, in the domestic economy, food inflation (primarily high vegetable prices) is delaying the disinflationary process that RBI would ideally like to see. Core inflation remains quite sticky, at 6 percent+.

Going forward, we do expect the headline CPI inflation to fall back again into RBI's 2-6 percent target range, as the interest rate hikes start having a more meaningful impact on demand. Besides, global commodity and oil prices have also softened considerably, and this augurs well for the inflation cool-off in India. While the CPI could print close to 6 percent for the next couple of months, the subsequent path should be heading lower. RBI itself has projected CPI inflation at 5.4 percent in Q3FY24.

Do you think India will see more correction in the coming weeks before showing a major upmove?

From a market performance perspective, CY23 is likely to be a year of two halves, with the markets expected to see some correction/consolidation in the first half, followed by some improvement as we progress in the second half.

In the near term, Indian markets need to contend with some key headwinds – a likely extension of the rate hike cycle in the US, an overall slowing economic environment globally, tactical shifts in global flows happening away from India due to the strong outperformance in CY22, which resulted in a much higher valuation premium compared to historical averages, and softening domestic demand, especially with rural demand still remaining weak impaired by inflationary pressures.

The Q3FY23 earnings season was a mixed bag, with small cuts to the overall earnings estimates. FPIs continue to remain sellers, while domestic flows (especially from HNIs) also seem to be slowing down. The domestic equity markets may therefore continue to see some softness in the near term, and volatility could remain high.

However, as we progress towards the second half of the year, we could start getting more clarity on several fronts: (a) Fed positioning - we should mostly have seen the peak of the rate cycle and there could be increasing rhetoric of an easing policy stance, resulting in a risk-on environment, (b) rainfall activity – whether there is any impact from El Nino; domestic demand – with rural India hopefully starting to recover, (c) FPI activity – which is expected to recover after the tactical shifts, with India displaying one of the fastest economic/earnings growth, and (d) valuations – which would have seen a meaningful correction with markets having consolidated for almost two years along with earnings catching up.

Are the banking stocks looking attractive now, after the recent fall due to events unfolding in the last few weeks?

We have been quite positive about the banking sector for some time, and we continue to remain sanguine in the sector. The overall credit growth is expected to pick up with steady retail demand and an expected improvement in the investment/capex cycle, thereby providing impetus to the topline growth for the banks. The bottom-line growth is expected to be faster, considering lower credit costs and sufficient provisioning buffer by the banks.

In fact, the balance sheets of a number of banks are among the best that we have seen in the past few years. Some of the banks have recently seen some correction due to the adverse sentiment related to one of the leading corporate houses. However, we are not overly alarmed about the situation, as the borrowings of the group seem to be well supported by cash flow generating assets. Considering our overall constructive view on the economy, we remain positive on the banking sector.

What is the real challenge for the Indian equity markets and economy, now?

The key challenge currently for the Indian economy is the softening demand environment, especially with persistent weakness in rural demand. The rising interest rates and any adverse development related to monsoon can further add pressure on the economy. In terms of the equity markets, the key challenges are in the form of FPI flows, as we have seen huge outflows over the past 15 months due to dollar strengthening and a risk-off environment.

Additionally, any weakness in corporate earnings growth due to softer economic activity can also emerge as a challenge for the market, especially when valuations are slightly higher than historical averages.

What are the key themes to focus on in FY24?

We continue to remain positive on domestic cyclicals – BFSI, industrials & infra, auto, building materials, etc., in line with our constructive view on economic activity and a pick-up in capex/investment cycle amidst rising utilization levels, thrust on domestic manufacturing and healthy corporate balance sheets.

We also expect a recovery in domestic/rural demand, and hence are positive on the consumption space.

We see increasing global opportunities for some sectors such as IT, chemicals and engineering products. Lastly, healthcare has been a big underperformer since 2015 with the sector facing multiple challenges; however, some of these challenges seem to be abating and hence we could see some mean reversion for the sector over a period of time.

Do you expect a rally in oil prices given China re-opening?

China’s tourism industry has been one of the most affected segments of the economy during the past two years, heavily impacting travel and tourism. The easing of travel restrictions is indeed expected to release huge pent-up demand for both domestic business and leisure travellers in China.

Indeed, China’s reopening boosts oil demand, especially related to air travel. However, the property and construction segments are likely to witness persisting softness, while other parts of the economy relevant for oil demand, including road travel and chemicals did not really show major activity setbacks last year (and hence there’s not much catch-up to do there). The catch-up potential seems more limited than perceived and China’s oil supplies anecdotally are ample.

China’s reopening is therefore unlikely to derail the oil markets' slow normalisation, and hence we are neutral and see oil prices heading lower in the long run.

Do you see any concerns in the Chinese market with respect to political uncertainties?

While it is difficult to provide a succinct view of the Chinese market with respect to political uncertainties, the experience of investors has not been too encouraging, especially in some specific cases where government interventions have weighed heavily on the valuations of the companies.

Moreover, there have been apprehensions related to the banking system, real estate, etc. in China. So, while China is a tactical investment opportunity with the re-opening trade, it is a less preferred market now from a structural investment perspective.

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