Dalal Street Voice: FY23 will be a challenging year for equity markets, says Darshan Engineer of Karma Capital Advisors

Darshan Engineer, Portfolio Manager, Karma Capital Advisors said that FY23 will be a challenging year for equity markets, investors and money managers as they navigate uncertain times.

In an interview with Zeebiz's Kshitij Anand, Engineer said that demat accounts have reached around 6 per cent of total population in December 2021, from 2.7 per cent in March 2019, and 2 per cent in March 2016. More demat accounts were added in 2019-22 than in 2016-19, both on absolute and relative basis. Edited excerpts:

Q) The Nifty50 will close FY22 on a strong note with double digit gains seen (so far). How do you sum up FY22 and what are your expectations for FY23?

A) I would like to lay down some background and context. Equity markets generally tend to follow earnings growth at an aggregate level.

The past 5 years had been full of disruptive events for the Indian economy such as demonetization, introduction of GST, IL&FS crisis, introduction of various structural reforms such as RERA, IBC, etc.

Hence, in terms of earnings growth for the economy, it has been muted for several years. Things were finally falling in place for a strong earnings growth cycle on a low base.

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In fact, till February 2020, Indian markets were in a strong uptrend and economic indicators were also broadly improving.

The other aspect is that markets don’t like uncertainty and de-rate to account for the same till the time they can get a good hold on future growth trajectory.

At the same time, information dissemination and related analysis has become quick, in today’s globalized world and age of social media.

Hence, after a few days of high volatility, markets are able to get a good hold on the impact of near- and medium-term events and risks and price them accordingly.

So, with these factors in mind, you would observe that, the past few years have seen short periods of high volatility, followed by extended periods of a trending market, either with an upward or downward bias.

The covid pandemic hit world equity markets in March 2020 and India was no exception. Markets corrected significantly even before the 1st serious covid wave began, as too much conflicting information was coming in from various directions.

Hence, there was a significant correction in a short period with the bottom made in last week of March 2020.

As understanding of the pandemic improved, markets understood the impact on economy and rebounded to an extent, with defensive sectors like consumer staples and pharma and large caps leading the way.

Once there was a realization that the pandemic could be managed even through lockdowns and without hurting the economic engine drastically through economic support from government for distressed parts of the economy, FY21 turned out to be a strong year for equities as valuations had become cheap in most parts of the market.

FY22 continued this trend with the difference being that the recovery spread to the broader markets including the small and midcap space. The Nifty50 will broadly deliver 15-16% return for FY22, if it remains range bound for the last few days of FY22.

If you go a bit granular, you will observe that FY22 was a story of 2 halves. H1FY22 was strong and delivered a strong 24-25% with the top being at 18450 levels on 18 October 2021.

From there on, it has been range bound with a downward bias, giving a negative 7 per cent return.

H1FY22 was strong primarily due to a few factors –

(1) strong quarterly results by most companies as they managed to meet the strong pent-up demand, cut down on costs to maintain or even improve margins, and restructure their balance sheets to reduce debt through either capital raises or using cash flows to reduce debt and improve their financial profile, and

(2) the expectation that this recovery would continue into H2FY22 and FY23. Of course, there was the 2nd covid wave which extracted a tragic and huge human cost, but because of the learnings from 1st wave, economic costs were managed to a large extent.

This can be explained by the fact that the market was sideways in H1CY21 (from Jan 2021 to Jun 2021), with an upward bias, during the height of 2nd covid wave.

However, what no one was really prepared for, was the huge disruption in supply chain in various parts of today’s globalized supply chains and its inflationary impact on world economy.

Apart from supply chain issues, there is also the aspect of significant under-investment in traditional old economy sectors such as oil and gas, coal, other basic commodities, due to concerns relating to environment.

The on-going war between Russia and Ukraine only complicates matters more, as Russia and Ukraine together, are large suppliers of various basic and intermediate commodities across sectors.

All of these have come together to create huge inflationary pressures in most parts of the economy in the past 6 months and changed the discussion from a virtuous economic recovery cycle to a vicious self-fulfilling inflation cycle.

While consumption of essential basic goods and services will continue, high inflation reduces savings at an aggregate level, especially for the bottom section of the society, and consequently, they have to reduce spends, especially in discretionary areas.

There is now a sense of demand slowdown and possible stagflation which makes it even more challenging for decision makers at government (who want growth) and central banks (who want to control and bring down inflation).

A stagflation is most challenging as it puts the 2 arms of government at opposite ends. While central banks have already started to raise rates, they also know that it is going to cause a slowdown which will not be liked by politicians and government who also borrow to fund their social programs.

Higher inflation and interest rates will cause higher cost of funding leading to possible deferment of expansion and capex plans.

At the same time, it brings down valuation multiples while demand slowdown and high inflation will also cause high probability of another earnings downgrade across the board.

This is what is being observed in the past 6 months and caused the downward drift in Nifty50 and correction from the top.

Thus, FY23 will be a challenging year for equity markets, for investors and money managers as they navigate uncertain times. In case of money managers, managing client’s expectations would be an important aspect as the past 2 years have brought a sense of entitlement of strong and easy money among large swathes of the investing population.

Q) At a time when leaders are discussing tougher action against Russia, markets have remained relatively stable. Trading on Russian bourses also started. Do you think the worst is factored in by equity markets?

A) As I explained earlier, in the first few days of an event, markets become more volatile and correct significantly to account for uncertainties and then as more information is gathered, they recover and settle at particular levels.

This is what happened in the highly volatile month of Feb 2022 when the news of invasion first came in and the western world responded with a series of sanctions.

As the war completes 1 month, markets have broadly understood the implications of the war on various areas of world economy. Hence, despite incremental sanctions, markets have broadly settled in a range.

There are many second and third order derivative impacts of the war which we have very little idea about. As an example, we have seen how semi-conductor supply chain disruption impacted the auto industry production in CY21.

Just as it was recovering from the initial disruption, the recent war puts the spotlight on neon gas used in the production of semi-conductors with Ukraine accounting for ~ 50% of supply.

While experts indicate that neon gas inventory is available for the next few months, what if the war continues for long or if neon produced in Ukraine is simply unable to move out of Ukraine. There are many such imponderables which may come out of the blue in future.

Hence, it would be wrong to say that the worst is factored in. It is quite possible that new events or risks emerge which can cause another leg of downtrend trend or correction.

Alternatively, it is possible that the market remains in a range bound sideways market for a long period as they process new information and hope to see signs of new earnings growth cycle.

Q) We are approaching financial year end – which sectors are likely to be in focus in FY23 and why?

A) The challenges thrown by the recent macro environment puts the spotlight firmly on inflation and its deleterious impact on profitability and demand in many sectors. As explained earlier, most of the near-term events and risks are already priced in.

Some sectors which seem relatively less impacted by current environment, such as IT Services, are accordingly valued at higher multiples compared to their historical averages, apart from other drivers such as a strong demand led growth cycle.

However, they also face challenges relating to higher wage costs, higher attrition, etc. Interestingly, traditionally defensive sectors like consumer staples which normally do well in a challenging macro environment are facing the double whammy of poor demand and lower margins in coming quarters.

Manufacturing as a broad sector seems to be back in interest due to multiple factors relating to Make in India, China+1, import substitution, etc.

Some sectors such as Auto and related sectors have been beaten down due to multiple external challenges such as demand, shift in technology, higher inflation, etc.

Commodity and old economy sectors, including some traditional bulk commodity chemicals, are currently in focus due to shortages of certain products and commodities globally.

However, it is difficult to predict when and how the cycle turns in such sectors. The key learning for us, over the years, is that markets are ever evolving, with different sectors, market caps, and investing styles, doing well over various time periods.

It is best to follow your investing process and not get influenced by the latest fads and trends, even if it leads to periodic underperformance.

In today’s age, there are multiple linkages across sectors and economies. Indian market is anyways blessed to have a huge diversity in terms of sectoral exposure, especially at the small and midcap level.

Hence, it is best to track companies across sectors, have a good understanding of the same over time, and be ready to invest in them for the long term based on valuation multiples that you are comfortable with.

Q) Anything which investors should do differently in the new financial year?

A) No two investors are the same. Each one has his/her personal goals, capital base, and risk-taking ability. Hence, depending on goals, risk appetite, and investing horizon, investing style will differ.

Regardless of the same, my suggestion would be to stick with an investing style that works best for him/her, over a longer time frame.

Of course, you should learn from own and other’s mistakes and try to ensure that those mistakes are not repeated over time. It is a difficult process and not easy to avoid in the short term.

Q) In the precious metal space, we saw 17% rally in Gold, and over 70% upside seen in the Silver. What is your view on precious metal space in the new year? How should investors go about investing – digital or physical route?

A) Gold is the ultimate hedge against inflation and has been a store of value for thousands of years, way before the fiat currency system that forms the backbone of the current economic system.

Indians have always had a love for precious metals as reflected in the huge household precious metal reserves in the form of jewelry and coins.

I consider Gold and related precious metals like Silver as an independent asset class, which need to have a certain minimum allocation in your wealth.

I would consider Silver as a high beta version of Gold as it also has many industrial uses apart from being a store of value.

The recent war has brought forward a renewed focus on precious metals as an investible asset class. Sanctions by western nations against Russia include actions such as freezing forex reserves and removal from international monetary payment systems like SWIFT.

While no nation has publicly said anything, I am sure governments across the world would have taken note of these actions and be planning to diversify their forex reserves away from currencies and into Gold or other precious metals.

In a way, this gives a strong floor to Gold prices. I see a sustained long period of various central banks increasing the share of Gold in their forex reserves. Hence, I expect Gold and other precious metal prices to remain firm in future. 

Coming to the question of physical or digital, it depends on the government and economic conditions of a country. Large holdings of Gold and other metals would be difficult to handle in physical form.

However, we now also know the perils of relying on digital assets which can be froze in a second at the whim of government and central banks. Hence, I would recommend a combination of physical and digital approach to investing in precious metals.

Q) At Zeebiz we celebrated March 24 as Wealth creation day as it was a day when the Nifty50 made a bottom in 2020 and since then it has been a wealth creation opportunity for investors. What were your key learnings?

A) The past 2 years have been an eye-opener for all of us, including the experienced market veterans as well as newbie investors.

While the 2 years have been rewarding for those who remained invested in the market, it has tested the patience of investors.

We saw wild swings from the top, say a 52W high, to the bottom 52W low, in a matter of few weeks, especially during Mar 2020.

For me, the most important learning was to stay put and not touch your portfolio at all, even if you are not sure of the future. I have now observed this at least 3-4 times in the past 10-12 years of my working career.

If you are in a decent company backed by fair promoters and management and if it is not saddled with any financial problems, it is very likely to not only recover the deep drawdown from time to time but also generate healthy long term compounded returns.

There are opportunities across the length and breadth of the market in every market cycle. There is no need to shun or avoid any sector or company.

For instance, last 2 years have seen strong returns from old economy sectors and they were mostly available at dirt cheap valuations, which brings me to the point about starting valuations as they make a difference to the eventual returns that you make on any stock.

Too high a starting valuation and you can be saddled with sub-optimal returns if not held for a really long-time frame. While everyone professes being long term investor, I am not sure if they really have that much patience in real life.

Q) Some global rating agencies have downgraded GDP forecast for India – will that impact markets and earnings trajectory? What are your views?

A) As I explained earlier, markets are always real time and forward looking in nature and price-in near- and medium-term risks and expectations.

This is amply reflected in the bond and equity markets through movements in yields and stock prices. By the time Rating Agencies come out with their ratings and forecasts, markets, have already factored the same.

Hence, downgrade of growth estimates by Rating Agencies is just a confirmation of what the market already thinks. At the same time, sell side estimates have built in a strong earnings recovery starting from FY22 and continuing into FY23/24.

However, with the high inflation and expected interest rate upcycle, there will be a gradual downward revision to future estimates. Interestingly, you may not see much downward revision at the index level since it also has higher share from some commodity sectors which will benefit from the current macro environment. Hence, FY23 will be one more year of middling earnings growth.

According to me, the more important thing to observe is that Nifty50 has now been in a muted earnings growth cycle for almost 10 years now (~ 5% as per MOSL) whereas the previous decade from 2001-2011 saw a healthy 16% CAGR. Most of the returns in the past decade has been due to re-rating of valuation multiples.

At some point, we should see a mean reversion to higher earnings trajectory and valuations normalizing. When it happens, we will be in for a strong bull market as well.

However, timing of the same is difficult to predict. Individual stocks and sectors can do much better depending on various internal and external factors. For instance, in the past 10 years, there have been several wealth creators who grew at a strong pace and were rewarded amply through gradual re-rating over the years.

Hence, it is better to stay invested by allocating a part of your savings to equity markets, directly in case of seasoned mature investors, or through regular lumpsum and SIPs to MF/AIF/PMS for normal investors.

Q) BSE has now 10 cr registered investors on website – what does it say about the investment climate which has evolved over the past 2 years?

A) Covid-19 accelerated several structural trends which otherwise would have taken longer to materialize in case of India. The biggest was the acceptance of digital as a way of life.

In all areas, digital was heavily adopted –shopping, communication, work, etc. The financial markets were no different. Consumers adopted to digital mediums to avail their financial services relating to investing, loans, payments, savings, etc.

Demat accounts have reached around 6% of total population in Dec 2021, from 2.7% in Mar 2019, and 2% in Mar 2016. More demat accounts were added in 2019-22 than in 2016-19, both on absolute and relative basis.

Secondly, average age of an investor has also come down as most new clients are being added in the age group of 18-35 years. Thus, most brokers have seen a reduction in their median client age to ~ 30 years.

Thirdly, most new client additions have been in Tier-2/3 and beyond towns. Apart from direct investing, we have also seen SIP flows growing every month and quarter to touch new all-time highs in recent months.

This increasing participation of domestic savings in equity markets has helped India cushion the strong FII outflows in recent quarters.

These data points only highlight that the spread of equity culture across India, an improving and stable investment climate, and an increasing realization among the working population about the benefits of being invested in equity markets from an early age.

All these was possible due to government efforts in encouraging use of technology in various areas of functioning (JAM trinity), and heavy investments by telecom companies in creating a low cost digital infrastructure.

These were aptly used by the strong ecosystem of discount digital brokers, AMCs, regulators, market infrastructure players (exchanges, RTA, depository participants, etc.), advisory community, etc. to create awareness and benefits of being invested in the equity market through a variety of media channels.

It has been easier for new investors to learn the tricks of trade and avoid certain pitfalls such as leverage (enforced by regulator). Fortunately, supportive markets have increased the wealth of most market participants in last 2 years, which gives them the much-needed confidence to continue and remain invested.

Interestingly, even after this strong 2 years, India remains way below other emerging and developed markets in terms of penetration. Even now, there is a lot of sceptism among the general population when it comes to investing in equities.

In terms of demat accounts, China and Korea are in early teens while USA is at a whopping 32%. Thus, India still has a long way to go in terms of penetration of equity culture.

(Disclaimer: The views/suggestions/advices expressed here in this article is solely by investment experts. Zee Business suggests its readers to consult with their investment advisers before making any financial decision.)