In such a situation, it will be a challenging six months to deliver positive, if not good, returns. Being cognizant of the risks, we have made strategic changes to our portfolios.
“Market participants with less than 12 years of experience have never been burned and have no idea how hot the stove can get” — Seth Klarman
The last 18-24 months have been a one-way street for markets. Almost anything that one bought has been a winner. The intoxicating returns have somewhat numbed investors, advisors and portfolio managers to impending risks, as every correction in hindsight has been an opportunity to buy into and compound returns. Hence, at this juncture, it makes a lot of sense to highlight the risks to not just investors and advisors, but also to oneself, so that when we read this, we can at least try and register the risks in our mind.
Globally, supply-side shocks and increased money supply have led to inflationary pressures — to such an extent that the US Federal Reserve has withdrawn the term “transitory”. From being behind the curve, the Fed is not only looking to withdraw quantitative easing (QE) by the end of March, but it is also looking at interest rate hikes and balance sheet tapering. All the three coming together is an ominous sign for increased volatility.
Clearly, 2022 can be expected to be a far more challenging year than 2021 in terms of generating returns. Returns have two components, earnings growth and P/E expansions. Earnings growth may not be a challenge, as the demand across sectors will continue to drive decent earnings growth. The challenge will be P/E expansion in a scenario where cost of capital will move up due to higher interest rates.
Higher cost of capital should ideally compress P/E valuations. The Fed is already talking of 3-4 rate increases this calendar year, and foreign brokerages are all of the view that it could be even up to 7 rate hikes. In such a scenario, there is a likelihood of P/E compressions happening. So, instead of earnings growth and P/E expansions moving in the same direction, which was the case in the last 2 years, one might see them move in opposite directions, tempering return expectations.
Rising crude oil prices have an impact on the country’s current account deficit (CAD) and inflation. A $10 move in crude oil has an impact of approximately 0.4% to CAD. Higher current account deficits might impact the currency also. Hence, one will have to closely track crude oil prices, as they have a major bearing on the macros.
The Covid situation has had a negative impact on earnings on rural and the urban poor. The income levels of these people have gone down and there have been widespread job losses. Consumer companies have reported volume degrowth, a clear reflection of the slowdown. It becomes pertinent for the government to push policies that will support the urban poor and rural India through direct transfers, which again will have an impact on the fiscal deficit.
Finally, geopolitical risks like the Russia-Ukraine situation will keep the world markets tense.
In such a situation, it will be a challenging six months to deliver positive, if not good, returns. Being cognizant of the risks, we have made strategic changes to our portfolios.
