The year 2017 was a year of splendid returns. Small caps led the charge with more than half a century. Mid cap and large caps also scored more than a quarter of a century. There was absence of volatility. This came on the back of subdued earnings as valuations kept expanding.
But 2018 is unlikely to match 2017 on returns as well as volatility or risk parameter. It is likely to be more volatile and yet deliver lower returns.
We expect 2018 to be more volatile as there are couple of risks on the horizon which can impact market.
The first risk is the political risk. India is going to face state elections in crucial states in the calendar year and general elections in May 2019 as per schedule. State election of Karnataka in May and Rajasthan, Madhya Pradesh and Chhattisgarh in the second half of the year are likely to impact the market because the results will determine how market will asses the stability of the next government.
The general election itself will start getting discounted by the market in the fag end of the year based on various factors. In 2004, markets soared ahead of election, based on the India Shining campaign and crashed post election on seeing a Left front-supported government. In 2009, the markets had corrected to price de to a khichadi sarkar and moved up on seeing a stable government.
In 2014, the market continue to rise on expectations of a stable government. Elections have played an important role in the market in the past and 2018 and 2019 are unlikely to be different.The second Risk for the market is rising interest rates globally led by the US and withdrawal of liquidity by central
banks around the world. India has been a beneficiary of global flows partly due to low to negative interest rates and liquidity pumped in by central banks of the developed world.
The US Fed is looking to raise interest rates three-four times this calendar year. If that pushes the US 10-year yield to above 4%, flows to the emerging market debt as well as equity will certainly slow, impacting India. We expect central bankers to be calibrated and gradual in their approach.We don’t expect them to be cavalier to disrupt markets but it is worth remembering the risk of liquidity disappearing.
The other risks are usual suspects like oil prices and monsoon etc.
Fortunately, oil prices look to remain elevated for a short period of time and monsoon is likely to be normal with advent of La Niña. It is safe to to say that in 2017, India enjoyed a good macro environment with lower inflation, lower fiscal deficit, lower current account deficit, lower NPAs etc.
Year of Deterioration
But this year is going to be a year of deterioration. The fiscal deficit is budgeted to be wider and in an election bound year, is likely to exceed the budgeted estimate. The current account deficit on account of higher oil prices is likely to deteriorate. Inflation has picked up, though within the comfort zone of the RBI. This deteriorating macro situation is likely to keep market volatile.
For markets to move upwards, fundamentals and flows are required. Last year, flows pushed market upwards whereas fundamentals were lagging behind. In 2018, fundamentals are likely to be better whereas flows could take a breather.
In 2017, mutual funds absorbed huge flows. Their work over the last two decades resulted in an inflection point. Their flows are outpacing FII flows. In the budget of FY2019, a non- level playing field was created by taxing mutual funds but by exempting Insurance companies ULIPS. This can adversely impact flows in mutual funds.
We expect the finance minister will restore level playing field for the benefit for Indian markets. FII flows can be adversely impacted if MSCI carries out its threat of reducing India’s weightage in the Emerging Market Index. We have to work hard to educate MSCI in not doing the same.
The flows in 2018 will be driven by events like restoration of level playing field between Mutual Fund and ULIPs and MSCI weightage apart from how investors price in the political risk and withdrawals of liquidity / rising interest rates in global markets.
This year, the fundamentals are good despite some strong head winds. India Inc is doing a marvellous job despite the burden of high real interest rates and overvalued currency.
They are also doing well to absorb the lesser availability of credit especially at lower end of the rating curve. The combination of high real rates, low credit availability and overvalued currency has subdued demand and kept capacity utilisation of India Inc at lower levels.
There is Optimism in the Air
India Inc was cautiously optimistic for the bulk of the last three years as apart from rates, currency and credit, they had to tackle disruptive reforms like demonetisation and GST. Now they are becoming optimistic shedding cautious stance. They are becoming optimistic as demand seems to be picking up and an election bound government is likely to keep the spending tap open to boost demand. This will help improving capacity utilisation, leading to better margins.
If rates, currency and credit normalise, the recovery will be more broader and more faster. The investments in 2018 are likely to be led by the government and PSUs.
But I can see support from private sector post formation of the new government. Sectors such as agriculture, rural and infrastructure are likely to see higher growth due to focus of the election bound government.
In a lighter vein, 2018 can be described as “ Liquid Oxygen”, a joke made famous by Bollywood villain Ajit. Liquid will not allow a person to live and oxygen will not allow a person to die.
The markets upside will be capped by political uncertainty and rising interest rates and down side will be protected by the improving corporate bottom line.
For investors, 2018 is a year when they need to focus on asset allocation rather than market momentum. It will be a year of volatility rather than steady rise. It will be year of stock picking rather than sector picking. It will be a year of large caps rather than micro and mini caps. It will be a year of playing contrast rather than chasing momentum.
Nilesh Shah is chief executive officer and managing director at Kotak Mahindra Asset Management Company