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A global recession is necessary to pull back inflation. How should you invest then?

The new global regime needs a new investing approach, now that a multi-decade period of stable growth and inflation is over. The conventional playbook of “buy the dip” or “time rallies” that worked during the sustained bull markets of the Great Moderation needs a re-watch ahead

November 24, 2022 / 01:38 PM IST
Representative image.

Representative image.

The markets are itching to see the aggressive global interest-rate hiking cycle peaking. While inflation globally has peaked, the cooling is not sufficiently large or broad-based enough to bring the rate cycle to a convincing conclusion.

But this has not prevented a dovish turn from a number of central banks in both developed and emerging markets amid growing concerns that policy tightening will hurt growth. The minutes of the Federal Open Markets Committee meeting showed a substantial majority of participants judging that a slowing in the pace of rate increases is appropriate.

To be fair, apart from the energy-led headline inflation easing, we are seeing the pace of core inflation, which excludes food and fuel, moderating, albeit to levels still uncomfortably elevated versus the target.

On the other hand, super-aggressive hikes have resulted in significant reduction in both demand and supply across various loan categories.

The constant upside surprises in inflation and rate repricing underscore that we are in a new regime of greater macro and market volatility.

Underlying shift in inflation 

We believe an underlying shift in the inflation process is underway that will likely require a recession to return inflation back to policy targets. However, the magnitude of this shift remains uncertain.

While disinflationary impulse is still non-linear, largely reflecting unwinding of adverse supply shocks and goods demand, it’s a matter of time that the inflation trend reversal gets acute — especially as current inflation is more a product of higher profit margins than the conventional wage-inflation spiral.

More prominently, a recession is a reliable disinflationary agent, especially when engineered by monetary policy. While peak hikes have gotten markets excited, a substantive central bank pivot is the one that signals a different regime (like a move from hikes to a pause or from a pause to cuts). The signs of that are yet to emerge.

This higher inflationary regime is not about to change and may see structural shifts ahead such as:

(1) Threat of fiscal dominance
(2) Dissipating long-term global disinflationary forces such as (i) Globalization – reversing with now persistent geopolitical risk premium, exemplified by rewiring global supply chains and strategic competition, and
(ii) Demographics, with ageing placing pressure on public finances,

(3) Emergence of ‘greenflation’ emanating from climate change transition and extreme weather events, reshaping energy demand and supply over time.

A new investing approach ahead?

This new global regime needs a new investing approach. A multi-decade period of stable growth and inflation is over now. The conventional playbook of “buy the dip” or “time rallies” which worked during the sustained bull markets of the Great Moderation, needs a re-watch ahead.

For near-term investing, we think duration (in rates market) is worth assuming the pause comes in late first quarter of calendar year 2023, while attractive yields on short-term credit make it somewhat appealing as we wait out a recession. We don’t think equities have fully priced risks of recession— and earnings forecasts still look too optimistic.

recession 2411_001

Rate cuts won't come until late 2023/early 2024, which is why it’s early to own equities over a three-six month period for those managing drawdowns, albeit such a strategy being positive on a 12-month basis.

We think the 2023 macro regime will likely follow 2022’s stagflation, getting into a recession of unclear duration and depth, with a decent growth sacrifice to manage inflation imbalance. To own anything more cyclical, investors need high risk premia (not in evidence yet) or high-conviction answers to three, interrelated macro questions:

(1) how quickly does core inflation decline;
(2) how much unemployment is required to reduce wage inflation; and

(3) what terminal rate delivers a soft labour market.

The answers to these are not clear yet.

Will the outperformance continue? 

Even as Indian equities in 2022 seem to be on track to deliver their poorest returns in recent times, they look good in comparison to peers — MSCI India has seen among the least earnings cuts, implying that India’s price-earnings multiple relative to that of emerging markets/emerging markets ex-China indices is now close to an all-time high. But will this outperformance continue?

While growth differentials with peers have historically been a good lead indicator for flows and returns, the China reopening theme early next year could also lead to flow diversification/re-allocation to China.

recession 2411_002

Besides, India’s relative outperformance will reflect in a prolonged external imbalance, in the form of higher current account deficit and external vulnerabilities.

While one can be relatively positive on India in the EM context, India, in absolute terms as a macro trade needs caution, as:

(1) global and domestic financial conditions are tightening, with the Reserve Bank of India (RBI) having rapidly withdrawn liquidity, while also losing forex reserves;
(2) no meaningful fiscal impulse;
(3) earnings likely to deteriorate into H2FY23, as the base effect turns challenging;

(4) stretched valuations against peers.

Besides, our recent channel checks depict mixed demand trends during the recent festive season. India still lacks a broad-based capex and infra cycle revival for a secular leg of growth, which again is endogenous in nature, contingent on private consumption – which we think will still linger amid moderating income growth ahead.

How to play India, and what within India? 

However, to be fair, the RBI is likely to reach a neutral real-rate by end-FY23 and pause and take stock, instead of becoming too restrictive. Our calculations suggest a likely hike of another 50-60bps, keeping forward inflation as a benchmark. This should be viewed in contrast to most developed markets that are likely to stay restrictive on the rates front and meaningfully impinge on growth.

As such, we prefer a moderate risk appetite for India, owning mostly large-caps over mid and small-caps; financials remain a relatively better bet (but are incrementally cautious on significantly adding these to our portfolio), healthcare, auto, select staples, and select discretionary, and are tactically UW (underweight) on information technology (with select buying opportunities).

We argue the lines are getting blurred between staples and discretionary, and cherry-picking works best. Historically, predictable and resilient staples and staples-like discretionary categories have proven to be a good defensive plays in times of slower income growth across income segments. Discretionary food services categories (such as quick service restaurants or QSRs) should also weather the environment better on rising distribution footprint.

Lastly, raw material inflation seems to have peaked, which should be a positive for margins for the entire sector ahead. Thus, playing select staples and select discretionary stocks seems a better bet.

Madhavi Arora is the Lead Economist at Emkay Global Financial Services. Views are personal, and do not represent the stand of this publication.
Madhavi Arora is the Lead Economist at Emkay Global Financial Services.
first published: Nov 24, 2022 12:53 pm