The first of the current financial year progressed on the predicted lines. There were no remarkable surprises either in the global macroeconomic developments or market performance. The focus of market participants and policymakers remained mostly on the macroeconomic parameters. Economic growth and trade moderated worldwide with a few exceptions like India. Inflation remained elevated but under control. Monetary policy continued to tighten resulting in higher bond yields, tighter liquidity, and rising cost of capital. Geopolitical conditions remained mostly unchanged.

Commodity prices moved in tandem with the macroeconomic, geopolitical, and environmental conditions. Clouded growth outlook led the industrial metals down; higher bond yields and stronger USD weighed the precious metals lower, depleted strategic reserves and larger output cut by OPEC+ led the energy prices higher, and better crop and improvement in shipments from war zones led the agri produce prices lower.

Chinese equities (especially in Hong Kong) performed the worst amongst peers; whereas Indian equities were amongst the best performing assets.

India did well on most parameters; domestic flows ex-SIP negative

The Indian economy grew ~8% in 1QFY24 and is expected to log an average growth of 7.25% in 1HFY24. The benchmark bond yields (10yr G-Sec) withstood the pressures of rising global yields and potential fiscal pressures due to rising crude prices amidst a heavy election schedule, and eased 5bps. Despite the cloudy CAD outlook, INR remained one of the strongest emerging market currencies. It weakened ~1% against USD, but recorded decent gains against EUR, JPY and GBP.

The consumer price inflation remained elevated, within the RBI tolerance band, primarily due to vegetable and fruit prices; whereas wholesale prices entered the deflation zone. RBI has maintained a status quo on the benchmark rates since the last 25bps hike in February 2023; and continued with the withdrawal of accommodation provided during the Covid period. At the end of 1HFY24, the banking system liquidity was in negative territory vs the peak surplus of Rs12trn during 2022.

Corporate earnings trajectory continued to improve, with NIFTY50 RoE breaching the 15% mark for the first time after 2015. The breadth of earning also improved with a larger number of companies and sectors participating.

The benchmark Nifty50 gained ~13% during 1HFY24. The broader markets however did extremely well with small cap (~42%), midcap (+35%), and Nifty 500 (+19%) registering strong gains. The gains were led by rate-sensitive sectors like Realty, Auto (especially ancillaries), and PSU Banks. Infrastructure, Capex and healthcare themes also outperformed the benchmark indices. Non-PSU financials and services were notable underperformers.

Within the capex and infra theme, defense production, power utilities & equipment, railways ancillaries, and engineering design services were the most notable gainers. Chemicals and consumer durables were some of the notable underperformers.

Foreign investors were net buyers in five out of six months during 1HFY24. Net FPI flows in the secondary market exceeded Rs1.24trn. Domestic institutions on the other hand were not as enthusiastic. The net domestic flows were a meager Rs141bn during 1HFY24. However, adjusted for the strong SIP flows (appx Rs140bn/month), the domestic flows have been strongly negative.

While equity markets do enjoy better attention of investors, it is the bond market that usually guides the direction of financial markets, including equity and currency markets.

The following recent signals from the bond market are worth noting:

US Junk Bond Yields fall below inflation

Investment demand for speculative-grade debt and high-yield bond exchange traded funds has been so high that yields on the riskiest U.S. companies are now below that of inflation. The rally in corporate debt rated below investment grade has also pushed yields down to record lows around 4.54%, compared to consumer prices that rose 5% in May year-over-year.

The head of equity research at Julius Bär, summarized the situation as “Inflation has risen to record-high levels in recent months, and the 10-year US bond yield has fallen to a fresh five-month low. What is the reason for the rally in US Treasuries? Obviously, investors believe that peak growth and peak expectations are already behind us. The US Federal Reserve’s (Fed) shift towards earlier-than-expected rate hikes has removed fears that inflation may run out of control, and falling purchasing managers’ indices from record-high levels support the case for decelerating economic growth. This is a normal mid-cyclical consolidation driven by base effects and most likely set to continue at least until Q1 2022.”

India: Credit risk category outperforming

In India also in past one year, the riskier corporate bonds have yielded best return as compared to the highly rated corporate and Sovereign bonds. The five year return on credit risk funds was less than half of highly rated corporate bonds and gilt.

These trends clearly indicate that bond market is not buying the theories of immediate full recovery to pre Covid level; sustainable higher growth, hyperinflation and imminent rise in borrowing cost.

After FY09, the current financial year (FY21) has been the most eventful year in most respects – social, economic, financial, ecological, science, and geopolitical.

Socio-economic disaster: The spread of SARS-CoV-2 (Covid-19) virus that started sometime in last quarter of 2019 was declared a global pandemic in March 2020. The pandemic engulfed the entire world in no time, causing tremendous loss to human life and global economy. The mobility of people was restricted in most countries substantially. The economic activities were also curtailed only to the “essential” activities. Consequently, the global economy faced a technical global recession as most major economies recorded negative growth during 1HFY21.

The pandemic this had disastrous socio-economic consequences. Millions of jobs were lost and workers displaced; smaller businesses which could not bear the cost of lockdown faced closure or were further scaled down; loss of lives traumatized families; and millions of poor children who could not afford cost technology access were rendered out of schools. The inequalities rose sharply, further widening the social, economic and technology divide that has been hindering the global growth since the global financial crisis (GFC, 2008-09). It is estimated that millions of families across Latin America, Eastern Europe, Asia, Africa, and Indian subcontinent, that were brought out of poverty in past couple of decades face the specter of slipping back into the abyss.

Financial profligacy of gargantuan proportion: The pandemic and consequent economic lockdowns evoked unprecedented response from governments and central bankers across the world. The amount of fiscal and monetary stimulus created is unprecedented; even much higher than the quantitative easing done post GFC. This has certainly put question marks over sustainability of global debt (over $15trn still yielding negative return); ability of governments to support the poverty alleviation efforts.

Ecological awareness: One of the positive outcomes of the pandemic has been the rise in awareness about the ecological conservation. The partial lockdown of commercial activities demonstrated how the mother nature could heal itself within few weeks. The urban population which was moving away from the nature was reconnected with roots. This awareness may certainly accelerate the execution of global climate change action plans, saving the planet from imminent disaster.

Scientific advancement: The pandemic prompted a vaccine development program at unprecedented scale and speed. The scientists world over worked to develop an effective vaccine for the SARS-CoV-2 infection in no time. Never in the human history an effective antidote to a potent virus has been developed at such alarming speed. It is estimated that in next 3-5years the entire global population could be inoculated against this virus. The experience gained in development and administration of Covid-19 vaccine may be extremely useful in fast tracking the efforts for development of vaccines for other major infections like HIV and H1N1 etc. It shall also help in eradicating or controlling many deadly diseases in African continent, thus bringing the most endowed and most poor continent in the global economic mainstream.

Trade and Geopolitical tension: An intense trade war between the two major trade partners, viz., USA and China, had started couple of years ago. Besides, trade tensions were also rising between China-Japan, India and China and US and EU. The conspiracy theories behind origination of SARS-CoV-2 virus from Wuhan province of China, further deteriorated the trade conflicts into geopolitical tension. Some major economies and global corporations decided to reduce their dependence on imports from China; and use of Chinese technological firm’s services and equipment. India and China also had a material buildup at Northern borders. China intensified the efforts to build strategic block with allies like Iran, Sri Lanka, Pakistan, North Korea etc. These developments shall have a far reaching impact on the global economic and geopolitical situation. The full impact of this may be known in next decade or so only.

Indian markets

The initial reaction of Indian markets to the pandemic was that of panic. The prices of equities and bonds crashed precipitously. The panic however subsided soon as the government took some strong measures to control the spread and mitigate the damage due to economic slowdown. The FY21 journey of Indian markets could be summarized as follows:

Nifty rallied hard, catching the participants by surprise

Nifty is ending FY21 (all Nifty data till 29 March 2021) about 20% higher than its December 2019 closing level. Nifty rallied hard in October –December 2020 quarter as the unlock exercise started and earnings upgrade cycle kicked in. By November 2020 all Covid-19 related losses were erased.

The strong market rally in fact caught many participants by surprise as the divergences from the real economy became too evident. The rally was apparently supported by the fact that the large organized players have not only survived the lockdown well but gained material market share from the smaller unorganized players. Multiple stimulus packages announced by the government and consequent abundant liquidity also have helped the rally.

The rally however appears to have tired in 4QFY21, for lack of triggers.

India with over 75% (Nifty TRI) gains is the second best market (after South Korea 78%) amongst all global major markets. It outperformed peers like Brazil (21%), China (25%), and Indonesia (40%); and developed markets like UK (21%), US (48%), France (37%) and Europe (36%), .

The momentum however has slowed down considerably in 4QFY21. In the current quarter, India (up 4%) is sharply underperforming US (8%), Japan (7%). Germany (8%). Even though it is still outperforming its emerging market peers like Brazil, China, Indonesia etc.

Consumption lags, cyclicals, IT & Pharma shine, smallcap outperform; FPIs’ big buyer

Metals, IT, Auto, Realty and Pharma have been the top performing sectors in FY21. Consumers have underperformed massively. Financials performed in line with the benchmark indices.

Broader markets (small and midcaps) and Alpha strategies sharply outperformed the benchmark indices. The market breadth has been mostly good (8 out of 12 months).

Net institutional flows were not great (less than $9trn) considering the abundance of liquidity and lower rates. FPIs though poured over $27bn in secondary equity market alone.

Gold disappointed; broader markets underperform on 3yr basis

Despite the huge rally in benchmark indices and broader markets, the household investors continue to be disappointed. One of their favorite asset class ‘gold” has underperformed majorly. Intuitively, gold ought to have done well in a crisis marred year. Gold ETFs have returned almost nothing in FY21 and are down over 10% in the current quarter.

Mid and small cap stocks have given superlative return in FY21. However, if we account for the massive underperformance of preceding two financial years, the performance of broader markets continues to remain below par.

Debt market jittery about large borrowing program

The government has managed the FY21 borrowing program well without any noticeable damage to bond markets or private credit. The bond market returns for FY21 have therefore been more than decent. However, in past 3months, rising global yields and huge Rs12trn borrowing for FY22 has kept the debt market on the tenterhook. A steeper yield curve due to abundant liquidity and RBI’s efforts has further queered the pitch for bond investors.

The Reserve Bank of India managed the markets well. It avoided direct monetisation of government borrowings and supported the government borrowing by all means available to it. At end of the day, RBI may close FY21 with a ballooned balance sheet equal to the size of 30% of GDP.

INR recovers from panic fall, stable around Rs73/USD

On announcement of lockdown, INR had a panic fall upto RS78/USD. It however recovered the entire lost ground within 5 months, and has been mostly stable around Rs73/USD in 2HFY21.

India’s macro conditions remain challenging despite the complete recovery from recession. Pre pandemic, Indian economy was growing at the long term rate of ~6% (5yr rolling CAGR). Due to collapse of growth in FY21 (-8%), the trajectory has slipped to ~4%. Recovering back to even subpar ~6% trajectory may take upto 5 years (FY26). Considering that India’s demographic needs require consistent 8-9% growth, led by high job creating construction and manufacturing sectors, the growth challenges may not abate anytime soon.

To make the matter worse, the inflation has become sticky and persisting close to upper bound of RBI’s tolerance range. Though RBI has made it abundantly clear that Indian economy cannot tolerate rise in interest rates at this point in time, any further easing of policy rates is virtually ruled out.

Quasi stagflation (for lack of a better term), has therefore emerged as a major policy challenge in FY21.

Conclusion

To sum up, FY21 had been a challenging year. It has dented the core of global as well Indian economy. The markets have come out from it mostly unscathed. It would be interesting to see how FY22 unfolds. I will share my investment strategy for FY22 tomorrow.