How to position your investments amid shifting growth-inflation dynamics

A four-pronged investment strategy to tide over market volatility

Saurabh Jain and Ravi Kumar Singh

Indian equities fell into correction zone after scaling several new all-time highs till mid-September 2024 with the Nifty index down 11 percent from its recent peak. The pullback has been much sharper in certain pockets of the market (materials, energy, PSUs, autos and FMCG) with expensive valuations and lacklustre earnings.

Shifting growth-inflation dynamics

While the initial outflows could be driven by reallocation to relatively better-valued markets, we observe that other drivers too have dampened risk sentiment. First, high-frequency indicators over the last few months indicate a normalisation of economic activity from the strong pace in FY2024. The impact of this slowdown is visible in corporate earnings delivery, with the Nifty index Q2 FY2025 earnings being the weakest in nearly four years, leading to downgrades of full-year EPS growth estimates for FY2025: 8 percent (11 percent earlier) and FY2026: 14 percent (16 percent).

Earnings estimates are trending lower than the actual earnings growth delivery of about 20 percent during the FY2020-2024 period. Second, domestic consumer price inflation has risen above the Reserve Bank of India’s upper-bound target of 6 percent, driven by a sharp surge in food article prices. High inflation has resulted in markets pricing in delayed policy easing driving bond yields higher. Third, the shifts in domestic macro fundamentals and weak earnings have made it difficult to justify stretched valuations for Indian equities, as they trade at a premium to both their own long-term average and emerging market peers.

Finally, the uncertainty surrounding the potential impact of US President-elect Donald Trump’s policies on global trade and financial markets has driven a surge in US bond yields and strengthened the US dollar, triggering outflows from EM assets and putting pressure on EM currencies, including the INR.

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What should an investor do?

While pullbacks are normal for equity markets, sharp drawdowns can make equity focused portfolios too volatile for many investors. We expect volatility to remain elevated over the next 1-3 months as investors adjust to normalisation of growth and corporate earnings delivery, evolving monetary policy outlook and US President-elect Trump’s policies. We believe investors can adopt the below four-step approach to navigate the near-term uncertainty:

Build a strong foundation portfolio

A diversified asset allocation remains a prudent strategy to tide through the near-term uncertainty. For investors, this means having a neutral allocation to main asset classes – equity, bonds, cash and gold, aligned to one’s risk appetite. Diversification across asset classes by having low correlated assets helps dampen the impact of sharp drawdowns in risk assets, improving risk-adjusted returns.

Stay selective in risk-taking

Within equities, we prefer large-caps over mid-caps and small-caps, given a better margin of safety in terms of earnings and valuations. Historically, large-cap equities have withstood market transitions better than broader markets, given stronger balance sheets and liquidity buffers. Within bonds, we prefer the medium-and-long maturity bonds given attractive absolute yields. We expect bond yields to decline over the next 6-12 months, driven by positive government bond demand-supply balance and central bank easing led by US Fed rate cuts and the RBI commencing rate cuts in Q1 2025.

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Bullish on AAA-rated corporate bonds

We buffer our foundation allocations with opportunistic ideas that offer a favourable risk-reward. We like the investment sectors – manufacturing and infrastructure. We find multiple structural drivers still in place for these sectors – sustained investment cycle, continuity of past policy reforms, governments’ focus on infrastructure delivery and incentive schemes to boost the domestic manufacturing ecosystem. Within fixed income, we see improved risk-reward in high-quality corporate bonds (AAA), given their attractive spreads over government bonds (3YAAA-3YG-Sec spread currently at 75-80 bps versus the ten-year average of 70 bps).

Gold a hedge against geopolitical tensions

We prefer gold as a key portfolio hedge against escalating geopolitical tensions, commodity price shocks and global growth slowdown risks. We see scope for further price rise for the yellow metal, supported by declining US bond yields, central bank purchases and strong domestic demand ahead of the marriage season. Finally, keeping some cash in the portfolio can serve as dry powder for opportunistic allocations should volatility rise in the coming months.

Overall, we remain constructive on Indian assets over the medium term supported by robust domestic growth, better than peers’ macro stability, strong corporate earnings delivery and policy continuity. Over the near term, the above investment approach could help investors tide through a period of uncertainty.

(Saurabh Jain is the Managing Director and Head, Wealth Solutions, Standard Chartered Bank, India and Ravi Kumar Singh is the Chief Investment Strategist at Standard Chartered Bank, India)

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