Market Outlook 2022: Transition to Mid-Cycle From Early-Cycle

Indian equity markets were the standout global market in 2021, with the Nifty index up 25.6 per cent. The rally was stronger for broader markets with the Nifty Mid-cap 100 index and Nifty Small-cap 100 index up 47.5 per cent and 60.7 per cent, respectively. Bonds had a challenging year, registering their lowest returns in over five years, with the Crisil Composite Bond Index up only 3.4 per cent. Gold (in rupee terms) ended 2021 lower by 6 per cent.

The calendar year 2022 is likely to see markets transitioning from ‘early-cycle’ to ‘mid-cycle’. A withdrawal of monetary policy stimulus defines the transition to ‘mid-cycle’, similar to 2003 and 2009 market cycles. Volatility rises during the period of transition, with equity returns being more modest during this phase, mirroring earnings growth. India’s macro fundamentals remain strong, with economic growth expected to remain well above its long-term trend, with the likelihood of further upgrades to consensus GDP growth for FY23. The overall policy environment is likely to remain supportive as fiscal policy takes over the mantle from monetary policy.

Given the above macro backdrop, the key investment takeaways for 2022 are:

Equity

Equities are expected to outperform bonds and cash in 2022, but at a more modest pace than 2020-2021 and with higher volatility. This is not unusual; it is characteristic of a ‘mid-cycle’ environment for equities. Equity earnings growth, the main driver of returns in a mid-cycle environment, remains robust with the current earnings cycle to be better than the last one. Consensus expects a compounded annual growth rate (CAGR) of 16 per cent in the Nifty index earnings per share (EPS) for FY19-FY23E compared to the near decade-long earnings lull of FY12-FY19, when Nifty Index EPS CAGR grew only 4 per cent. The current earnings cycle has many positive drivers–stronger GDP growth, better asset quality, corporate balance sheet repair, improving margins and a revival of investment cycle–which is likely to drive further EPS upgrades over the coming years.

Strategies within equities will be critical to drive equity allocation performance. We prefer large-cap equities over mid-cap and small-cap equities driven by three factors. First, large-cap equities provide a greater margin of safety during periods of high volatility, a characteristic of mid-cycle transition. Second, large-cap equities’ earnings growth and, more importantly, positive EPS revisions continue to outpace those of mid-cap and small-cap equities. Third, the strong outperformance of mid-cap and small-cap equities in 2021 has taken relative valuations of large-cap equities close to historic highs.

We also believe that conditions remain conducive for a deepening of rotation to value strategies. IT and materials were the major drivers of value outperformance in 2021. Reflationary macro environment, favourable valuations and better earnings are likely to broaden the value rally to sectors like financials, industrials and public sector enterprises (PSEs).

Bonds

A diversified bond allocation can help investors tide through an environment of rising interest rates. Our first preference is for corporate bonds over government bonds, given better corporate fundamentals compared to weak fiscal dynamics. We prefer high-yield corporate bonds, given a likely reduction in credit default risk amid improving corporate profitability and inexpensive valuations of AA or A corporate bonds relative to AAA corporate bonds. Our second preference is for short-maturity bonds, given lower price sensitivity to rising yields compared to medium and long-maturity bonds. Further, the rise in short-term yields over 2021 reflects RBI’s normalisation of excess liquidity and expectations of a rising interest rate trajectory.

Gold

Lastly, we continue to believe that gold plays an important role in diversified investment allocations. History suggests gold does well in periods of high inflation. If inflation proves to be higher, or longer-lasting, than our expectations, gold can act as a portfolio hedge. Also, we expect higher bouts of equity market volatility in 2022 given the transition to mid-cycle. This can be partially mitigated by gold.

Expectations In 2022

Our baseline scenario remains positive for growth and risk assets but we would watch how the following risks evolve over 2022.

1) Inflation is the biggest risk to the positive outlook. While we expect inflation to moderate over the course of 2022, a persistent rise in inflation could turn macro conditions unfavourable for risk assets.

2) We expect bond yields to rise on normalisation of monetary policy, but an over-tightening policy error by central banks could drive volatility significantly higher for risk assets.

3) Covid-19’s evolution could still see some hiccups as seen with the emergence of the new variant lately. A third wave and vaccine-evading Covid-19 variant remain risks for sustainable economic growth recovery.

Overall, we expect equity markets to do well in 2022, albeit at a more modest pace and with greater volatility as monetary policy becomes less supportive, while still strong growth and inflation means bond and cash returns will continue to face headwinds.

The author is Chief Investment Strategist, Standard Chartered Wealth, India