The Nifty Index declined 3.6% in December, while the Mid-cap and small-cap indices did better than the large-cap indices and were down 2.5% and 2%, respectively. All sectoral indices closed negative, except for Metals, which was up 3% in the week on the news of China further easing the three-year border controls aimed at curbing Covid-19. Power, IT and Auto were the top losers, declining 6.8%, 6% and 4.8%. FPIs bought US$ 1.3 bn worth of Indian equities in the secondary market, while DIIs were net sellers.

Globally, all markets ended weak other than Hong Kong. Better-than-expected Q3 US GDP data further signalled more rate hikes by the US Fed. Other key developments in the month were (1) the RBI MPC hiked the repo rate by 35 bps to 6.25%, (2) BJP scored a resounding victory in Gujarat, whereas INC beat BJP in Himachal Pradesh, (3) the US Federal Reserve raised interest rates by 50 bps, (3) the Bank of Japan, in a surprise move, fine-tuned its ultra-accommodative monetary policy by widening the range for its 10-year government bond yield fluctuations.

Domestic high-frequency indicators, while healthy have moderated sequentially. Early data for Dec as indicated by GST collections and PMI manufacturing, indicates a sequential improvement. Indeed, PMI manufacturing rose to a 26-month high of 57.8 in December. However, external indicators remain weak, with export growth tracking at -2.2% in the three months ending November 2022 vs. 33.5% for the three months ending November 2021.

In a backdrop of increasing likelihood of slower global economic growth in 2023, resulting out of the aggressive rate hikes of 2022, India’s economic growth is likely to stay resilient but not without its own set of challenges. With the post-Covid opening up/pent-up demand recovery in the economy largely behind us, India’s economic indicators may take a breather in 2023 as it too re-adjusts to slowing global growth. Within domestic growth drivers too, India may take time for incremental levers like the resumption of rural demand and a fresh investment cycle to start making meaningful contributions. From an earnings standpoint as well, there is considerable dependency on recovery in profitability within many sectors from easing commodity prices as being an important factor. While this may play out to some degree, in our view, it has its own challenge, particularly in an environment of slowing growth and rising competitive intensity. Expecting a lagged rural recovery post-Covid is good in intent but relies on the probabilities of a strong crop season, higher food prices, and government support in a pre-election year.

Hence, while India’s economy is on a steady growth path relative to probably other global markets, this appears sufficiently baked when translated into corporate earnings expectations and with the earnings upgrade cycle of the last 5-6 quarters now levelling off, India’s valuations multiples may find it challenging to expand further. On current reckoning, we expect the next earnings upgrade cycle in India to commence in mid-2024 as the impact of the global slowdown wanes and India’s structural growth drivers assert themselves more meaningfully. For Indian equity markets, domestic flows have offered meaningful support in 2022, which may be at risk in 2023 in a scenario of high interest rates. Under such conditions, it is therefore, quite likely for headline returns in the market to be muted in 2023, much in the same way as in 2022. India, however, remains one of the best ‘buy on dips’ markets for investors focused on medium-term returns.

Our portfolio objectives remain firmly focused on medium-term returns without losing cognizance of short-term economic and market volatilities. Even though our preferred portfolio stance has been India-centric growth sectors for much of last year, but pockets of value may have started to emerge in some of the global-oriented sectors such as technology, pharmaceuticals and commodities. Taking a balanced approach at portfolio construction and ensuring adequate diversification appears to be the best way forward for 2023.

The Global backdrop turned less challenging with many Central banks already starting to moderate the rate hikes from the so-called jumbo ones as the inflation trajectory has reversed, indicating the return of market conditions to a more normal level. Nonetheless, global rates got elevated by 30 – 50 bps during the month as the Bank of Japan (BOJ) unexpectedly increased its yield curve control band from 0.25% to 0.50%, which created some volatility in global rates in second half of the month.

Domestic interest rates were more resilient to the global backdrop and moved in a narrow band, closing the month with 5-10 bps movement across the yield curve. Corporate bonds also moved in line with the G-Sec with a marginal flattening bias.

Domestic headline inflation softened more than expected and came in at 11-month low number at 5.9% from the previous month of 6.8%, largely due to the sharp easing of food inflation led by vegetables and fruits. Core inflation remained elevated and entrenched at 6.1% YoY, with most items at elevated levels. Nonetheless, headline inflation coming within the upper band of 6% was a welcome relief.

FPI flows remained negligible during the month with margin inflows in the debt segment and marginal outflows in the equity segment. CY2022 witnessed a huge outflow of ~ INR 1.57 trillion with global risk-off sentiments during the year. Fx reserves further surged by ~USD 12 bn to close the month at ~USD 562 bn. INR came under pressure by ~INR 1.5 to close the month at INR 82.73 against USD even as USD gave up some of its strength during the period as RBI intervened in the market to shore up its Forex reserves.

Outlook

2023 has commenced on a positive note, with many Central banks already starting to moderate the rate hikes, and now looks closer to the peaking of rates by early 2023. As the global growth slowdown / recession fears take centre stage during the year, a correction in global commodity prices, better resolution of supply chain bottlenecks, and most critically, relatively stable currency market points to a benign environment for interest rates, especially as the rates are already highly elevated.

Similarly, in India, the Monetary Policy Committee (MPC) has moderated the rate hike to 35 bps. At the same time; the MPC has continued to maintain its caution on inflation, highlighting the sticky core inflation, higher demand-pull factors, and global uncertainties that can pose upside risks to the inflation trajectory. MPC’s decision to continue with its “withdrawal of accommodation” stance indicates that the rate hike cycle is not over yet. Given the current global as well as domestic indicators, we expect the MPC to undertake one final rate hike of 25 bps in February 2023 to reach a peak policy rate of 6.5%. This may provide a safety cushion to absorb the global spillovers to some extent. India’s Foreign Exchange (Fx) reserve has also improved over the last few weeks, which has provided some relief. Any further rate hikes beyond a policy rate of 6.5% would be more determined by global factors than domestic factors. Post achieving the peak rate by early 2023, we expect policy rates to remain higher for longer as the inflation may remain elevated in FY24.

Another major event to be kept under watch is the fiscal deficit budgeted for FY24, and we expect the Central Government to continue with its infrastructure push, leading to yet another year of record fiscal supply.

As the global and domestic rate hike cycle reaches towards the end over next few months, interest rate volatility is also expected to reduce compared to the heightened volatility witnessed over past few months. At the same time, impact of future rate hikes has already been largely factored in specifically in the 1 – 5 years segment, while the long end may remain under pressure as the fiscal supply overhang is expected to continue for next year as well.

Credit environment remains healthy; however, current narrow spreads of AA / AA+ over AAA bonds do not provide favorable risk adjusted reward opportunities and we expect il-liquidity premium to increase sharply over a period of time thereby posing mark to market challenges for this segment.