On 24th February 2023, the United States Commerce Department released the inflation data, which reported the Personal Consumption Expenditure (PCE) for Jan 2023 rising to 5.4% from the year earlier, which stood higher than expectations. The PCE is the US Federal Reserve’s favourite parameter to gauge inflation, continuing to point towards the sticky nature of inflation, which means that various supply-side constraints are the primary factors responsible for it.
Nonetheless, the current scenario is not new but a relic of the past that has emerged strongly with new challenges in the globalized world.
Before the age of unlimited government stimulus and ultra-lenient monetary policy, the world was not very different. The era of strong monetary stimulus transformed investing in many ways. Investors across the globe reached an assumption that interest rates would remain closer to zero, which in turn, led to unlimited flows into the equity asset classes. Critical financial terms, such as valuation, lost their meaning, and only buzzwords like compounding growth took precedence, as access to capital was practically unlimited.
While it is vital to acknowledge the crucial role of monetary easing in achieving quantum leaps in technology over the last few years, monetary easing has also led to several severe challenges on other fronts. For instance, much-needed investments in tangible assets such as factories and infrastructure took a back seat as forces of globalization outsourced everything to China and Asia. This led to years of under-investment and disruption in supply chains, now wreaking havoc on equity markets. And while this new paradigm is not new altogether, it’s not the same as before.
On a positive note, there is enough learning from the past to guide us through these challenges. New challenges bring new opportunities, and one needs to carefully look into past paradigms to find these answers. Against this backdrop, we believe that the current equity market is courageous as return expectations have increased, but so have the accompanying risks that need to be taken to generate above-market returns.
History rhymes, but rarely repeats itself
Periods of high inflation are not rare but a common phenomenon. However, the western world has not experienced inflationary pressures recently, and interest rates closer to zero were assumed to be the new normal. On the other hand, India has seen significant inflationary pressures in the not so distant past.
Even after the demonetization of Rs 500 and Rs 1000 notes, core inflation remains quite sticky. In this context, India has been significantly different from the western world. However, the world continues to think in dollar-denominated returns, and the actions of the Federal Reserve have a more significant impact than any other central bank.
Courses of high inflation have occurred in history, and the current phase is similar, at least in terms of its implications on the markets. However, the world has changed in the last 40 years, with the western world experiencing hyperinflation. It is much more globalized now, with significantly improved capital availability and a much deeper proliferation of technology. Additionally, central banks have a firmer grip on understanding recessions and are equipped with an array of monetary tools to manage them.
Risk-taking to be rewarded
It is clear that the world has changed post-pandemic, and new paradigms have emerged, but there are substantial similarities to past challenges. The implications of higher interest rates will be broadly the same. Equity markets will de-rate from the current levels, which could either be in the form of multiple compression or time correction. In the scenario where multiples are likely to see compression, stocks with high growth rates would make up for the compression or bottom out in terms of valuation.
Stocks exhibiting both will be the best bet. However, such instances are difficult to spot as stocks exhibiting these attributes display high-risk and high-reward characteristics (For example – PSU banks). While these stocks are certainly not for the faint-hearted, adequate portfolio diversification will help manage risk. Thus, we believe this is a market where valuations might see compression and stocks will become cheaper. Hence, taking high-conviction bets will yield results.
We believe equities worldwide have entered a new phase through higher expectations of returns, and generating such returns entails a higher risk-taking capacity. This is the market for the brave, and we have embarked on this new world.
Naveen Kulkarni – Chief Investment Officer, Axis Securities P