CY22 has turned out to be a bruising year for financial markets in general, as the settled template of benign inflation, lower/ near zero interest rates as well as a tranquil Geopolitical landscape gave way. What has replaced that is the new reality of persistent above target inflation, higher interest rates as well as geopolitical flashpoints. In line with the changing realities, as the year has progressed, less has been heard of exotic terms such as MMT (Modern Monetary Theory), SPAC’s (specialpurpose acquisition companies) and speculative assets such as Bitcoins and other Cryptos. What has replaced that is the reality of a tough battle against inflation that necessitates higher rates and lesser accommodation of financial markets through liquidity injections. The result has been a drawdown in most asset classes globally with even the traditional 60/40 portfolios of equities and debt providing no hedge as both asset classes bore the brunt of rising rates.Commodities, helped by the geopolitical developments have been an outlier.

Source: SBIMF Research, Bloomberg

While the Russian invasion of Ukraine has been touted as the proximate cause of higher inflation, the genesis of this can be traced back to the extraordinarily large and synchronous monetary and fiscal loosening provided in the aftermath of the pandemic in 2020. While the immediate support was warranted, the role played by the delayed adjustment/ unwinding by key Central Banks will need to be debated. Perhaps that may continue to shape central bank actions going forward. Nowhere is this more apparent than the current divergence between market expectations of Central Bank pivots and the reality of continuing hawkish policy stances even as growth concerns start to emerge.

As markets hope for a pivot and dovish guidance, the year has ended with hawkish commentary from key global Central banks. This is perhaps likely to persist in the near term with the experience of “ transitory inflation” narrative likely to incrementally result in realised inflation outcomes being assigned larger weightage as Central banks grapple with above target inflation alongside slowdown in growth. The recent emphasis on core inflation by most central banks attests to the worry on persistence as well as generalisation in price pressures.

Source: SBIMF Research, Bloomberg

Equity:

2022 ended up being an eventful year for investors.The year began with the Omicron scare which thankfully proved to be short-lived. However, just when Covid risks appeared to be fading, geopolitics flared up and aggravated the already grave inflation challenge. For equities,while frontline indices largely consolidated through CY2022 (gains of 5.8% each for the Nifty and the Sensex),the intermittent volatility was high. On one hand global macro uncertainty weighed on earnings outlook, on the other high bond yields continued to put pressure on equity valuations. Broader market performance was weaker with Midand Small caps underperforming-Nifty MidSmall Cap 400 Index was up less than 1%for the year.Yet relative to global equities, India was a strong outperformer. Sectorally,economically linked sectors such as Banks, Power, Automobiles and Capital Goods did well while Information Technology and Healthcare were the worst performers. Similarly, value stocks had a much better outing versus quality and growth, which is typical of an inflationary, rising interest rate environment.

Indian equities were significant outperformers in CY22

Source: Bloomberg, SBIFM research

Cyclicals and Value did well in 2022

Source: Bloomberg, SBIFM research

As we enter 2023, there is reason to believe that the aggressive policy response should help tame inflation if it has not already done so. The lagged impact of tightening will however also mean growth sacrifice for the global economy. A sharp deceleration in global money supply growth and a sharply inverted yield curve in the US point to potential growth headwinds. While India’s fundamentals are in much better shape, directionally global growth challenges will likely feed their way into weak exports and investment activity and hence lead to a slowdown in Indian economy as well.Therefore, growth concerns outweighing inflation challenges should be a dominant theme in the new year.

A related theme that we believe will likely play out in 2023 is a correction in the K-shape of the recovery. The recovery so far has been two-pronged. While exports and related themes as well as high ticket, urban consumption did well, mass consumption suffered owing to high inflation eating into real disposable incomes. Consumption recovery in India has lagged other components of demand since the Covid shock. In 2023, consumption is likely to stand as a relatively resilient factor amidst growthheadwinds, aided by improving jobs in the low-end segment and ebbing out inflationary pressures which will help to boost real spending. Overall, amidst slower growth the silver lining is that the K -shape should correct or normalize making the economy more balanced and hence growth more sustainable on the other side of the near-term sluggishness.

These themes will have several investment implications. On equity valuations,even as the worst of rate increase may be behind, macro uncertainty may limit valuation upside through a rise in equity risk premium. 2023 may therefore continue to be a year of volatility for equities, at least in the first half. Pockets such as mass consumption that benefit from cooling inflation and where demand is domestically driven may be better off in this environment. Asset class diversification beyond equities (into bonds, and to some extent Gold) should help. Within equities, diversification beyond pro-cyclical pockets such as value stocks and cyclical sectors should help too.

That said, once global headwinds fade, India can potentially post a strong rebound. India’s corporate and bank balance-sheets are in a much better shape than the pains of last decade. Corporate debt to GDP has come off significantly from 71% in 2013 to 52% now. Banking sector has ironed out the stressed asset issues, with net NPA under 2% and capital adequacy ratio at a multi-year high of 16%.Corporate capex witnessed a modest expansion in 2022. While the corporate capex cycle could take a mild breather in 2023, once the global headwinds subside, strong balance-sheets coupled with production linked incentives, a decade long of minimal capex activity in India, mushrooming new age industries make a case for a strong medium term corporate capex cycle in India. China + 1 is a durable reality today as global firms diversify their production in other countries. India is also on the cusp of revival in real estate construction after a decade long dormancy.

We therefore think of 2023 as a year of adjustment, where growth slows down but at the same time becomes more balanced setting stage for a more sustainable recovery on the other side. Beyond the near-term adjustment, India appears ripe for a multi-year uptrend in economic growth and earnings driven by manufacturing and investment revival. Navigating this interim phase will require a diversified strategy across assets as well asacross styles, market caps and sectors within the equity portfolio.

Fixed Income:

Central bank policy announcements in Dec 22 had a broader common messaging even as the anticipated downshift in rate actions happened. Even as most central banks incrementally dial down the pace of tightening, the guidance from financial market perspective continues to be hawkish. While the FED reiterated the message around rates likely to stay “higher for a bit longer”, the ECB guidance emphasized that “interest rates will still have to rise significantly at a steady pace to reach levels thatare sufficiently restrictive”. The bigger and completely unanticipated directional shift came from the Bank of Japan which readjusted the upper end of the yield curve control target on the 10y Government security by 25bps to 0.50%.

The RBI MPC statement was similarly perceived as hawkish even as the rate hike was scaled down to 35bps increment as expected. References to elevated core inflation, the midpoint target of 4% as well as the still surplus system liquidity clearly points to the near-term policy preferences within the Flexible Inflation Targeting regime. For a fixed income investor with a medium-term horizon, a conservative Central Bank that assigns higher weightage to inflation outcomes alongside the visible improvement in Tax compliance/ tax buoyancy on the fiscal side are meaningful positives.

Source: Bloomberg, SBIFM research

Even as the wider external cues remained negative, with uptick in global yields, domestic rates were more sanguine in Dec 22 even as there was some retracement post the policy. While at a broader level, the divergence could be attributed to the relative better dynamics from a policy rate perspective, shallow market conditions in terms of liquidity towards the year end could also have been at play. Overall,over the last year, domestic bond markets witnessed an effective policy tightening of around 300bps with the change in the overnight settings (policy operating target) helped by the unwinding of surplus liquidity. A significant flattening of the curve, apart from still tight credit spreads remains the other key outcome.

Source: Bloomberg, SBIFM research

Over the last quarter of the year, issuance pressure in the bond markets increased with a large volume of issuances from banks, both in Basel 3 instruments as well as Infrastructure bonds. This has been alongside the issuances in the Money market through CD’s and the upward repricing seen in deposits. Alongside the unwinding of surplus liquidity,the issuance schedule could set the stage for a reasonable repricing in credit spreads over the coming months. EBP issuances in Q3 FY23 at Rs 2.38 trillion grew by 67% y-o-y as compared to the Q3 FY22 issuance size of Rs 1.42 trillion. Cumulative issuances in 9mFY23 have been Rs 4.88 trillion as against the corresponding 9mFY22 issuance of Rs 3.71 trillion, growing at 31% y-o-y. Within this, the issuances from Banks in just Q3FY23 was at Rs 61,194 crs as against full year FY22 issuance size of Rs 76,309 crs.

As we head into CY23, the outlook towards Fixed Income as an asset class in India continues to remain positive as we have been emphasising in the recent past. However, this does not imply a view on any immediate shift in stance or any near-term easing. Considering the evolving dynamics, Monetary policy making in India clearly has reached a stage where subjective assessments would come into play, unlike the case a year back when all indicators pointed to a shift in the stance towards tightening aggressively. After a material shift in both the policy rates and more importantly liquidity dynamicsover the last 7 months, the argument towards assessing lag effects of earlieractions is compelling. This alongside the forward-looking estimates on growth and inflation would warrant a pause in the near term. At the same time, the focus on the midpoint of the inflation target, alongside likely spill over volatility from external developments would necessitate that policy stance continues to focus on withdrawal of accommodation.

The navigation of challenges including the external spill overs and the persistence of inflation would necessitate adjustments across policy rates, currency markets as well as liquidity dynamics. With the policy rate adjustments having broadly been accomplished and the recent adjustment in the currency, ongoing adjustments to further modulate liquidity would be essential. This may entail a period where market rates stay elevated for a while longer. With respect to navigating the same within portfolios, a flexible approachand focus on liquidity continues to be key guiding factors in the near term.

The medium-term positive view on domestic fixed income continues to be based on the following assessment.

Even as challenges persist in the near term, the above positives should provide a high degree of resilience. Fixed income products across categories provideattractivevaluecurrently.At the same time, itis essential that the same bealigned with specific risk tolerance and investment tenors.

• The emerging growth –inflation outlook as well as cumulative effects of earlier rate actions, alongside a forward looking real neutral rate range of around 1% should enable policy rate actions to pause at close to 6.5%.

• Market yields provide a positive real rate across most tenors both on realised and anticipated forward measures of inflation. This is unlike the scenario prevalent over the last few years.

• Fixed income yields remain attractive both on relative and absolute basis, notwithstanding near-term volatility.

• Inspite of challenges arising from the larger stock of Public debt/GDP, fiscal consolidation outlook is promising as tax buoyancy is improving led by better compliance.

• Interest rate sensitive flows within the capital account are far less even as the outstanding stock held by debt FPI’s is very marginal. This is a crucial variable within the external sector account that provides a high resilience to external pressures.

Even as challenges persist in the near term, the above positives should provide a high degree of resilience. Fixed income products across categories provide attractive value currently. At the same time, it is essential that the same be aligned with specific risk tolerance and investment tenors.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.

CY22 has turned out to be a bruising year for financial markets in general, as the settled template of benign inflation, lower/ near zero interest rates as well as a tranquil Geopolitical landscape gave way. What has replaced that is the new reality of persistent above target inflation, higher interest rates as well as geopolitical flashpoints. In line with the changing realities, as the year has progressed, less has been heard of exotic terms such as MMT (Modern Monetary Theory), SPAC’s (specialpurpose acquisition companies) and speculative assets such as Bitcoins and other Cryptos. What has replaced that is the reality of a tough battle against inflation that necessitates higher rates and lesser accommodation of financial markets through liquidity injections. The result has been a drawdown in most asset classes globally with even the traditional 60/40 portfolios of equities and debt providing no hedge as both asset classes bore the brunt of rising rates.Commodities, helped by the geopolitical developments have been an outlier.

Source: SBIMF Research, Bloomberg

While the Russian invasion of Ukraine has been touted as the proximate cause of higher inflation, the genesis of this can be traced back to the extraordinarily large and synchronous monetary and fiscal loosening provided in the aftermath of the pandemic in 2020. While the immediate support was warranted, the role played by the delayed adjustment/ unwinding by key Central Banks will need to be debated. Perhaps that may continue to shape central bank actions going forward. Nowhere is this more apparent than the current divergence between market expectations of Central Bank pivots and the reality of continuing hawkish policy stances even as growth concerns start to emerge.

As markets hope for a pivot and dovish guidance, the year has ended with hawkish commentary from key global Central banks. This is perhaps likely to persist in the near term with the experience of “ transitory inflation” narrative likely to incrementally result in realised inflation outcomes being assigned larger weightage as Central banks grapple with above target inflation alongside slowdown in growth. The recent emphasis on core inflation by most central banks attests to the worry on persistence as well as generalisation in price pressures.

Source: SBIMF Research, Bloomberg

Equity:

2022 ended up being an eventful year for investors.The year began with the Omicron scare which thankfully proved to be short-lived. However, just when Covid risks appeared to be fading, geopolitics flared up and aggravated the already grave inflation challenge. For equities,while frontline indices largely consolidated through CY2022 (gains of 5.8% each for the Nifty and the Sensex),the intermittent volatility was high. On one hand global macro uncertainty weighed on earnings outlook, on the other high bond yields continued to put pressure on equity valuations. Broader market performance was weaker with Midand Small caps underperforming-Nifty MidSmall Cap 400 Index was up less than 1%for the year.Yet relative to global equities, India was a strong outperformer. Sectorally,economically linked sectors such as Banks, Power, Automobiles and Capital Goods did well while Information Technology and Healthcare were the worst performers. Similarly, value stocks had a much better outing versus quality and growth, which is typical of an inflationary, rising interest rate environment.

Indian equities were significant outperformers in CY22

Source: Bloomberg, SBIFM research

Cyclicals and Value did well in 2022

Source: Bloomberg, SBIFM research

As we enter 2023, there is reason to believe that the aggressive policy response should help tame inflation if it has not already done so. The lagged impact of tightening will however also mean growth sacrifice for the global economy. A sharp deceleration in global money supply growth and a sharply inverted yield curve in the US point to potential growth headwinds. While India’s fundamentals are in much better shape, directionally global growth challenges will likely feed their way into weak exports and investment activity and hence lead to a slowdown in Indian economy as well.Therefore, growth concerns outweighing inflation challenges should be a dominant theme in the new year.

A related theme that we believe will likely play out in 2023 is a correction in the K-shape of the recovery. The recovery so far has been two-pronged. While exports and related themes as well as high ticket, urban consumption did well, mass consumption suffered owing to high inflation eating into real disposable incomes. Consumption recovery in India has lagged other components of demand since the Covid shock. In 2023, consumption is likely to stand as a relatively resilient factor amidst growthheadwinds, aided by improving jobs in the low-end segment and ebbing out inflationary pressures which will help to boost real spending. Overall, amidst slower growth the silver lining is that the K -shape should correct or normalize making the economy more balanced and hence growth more sustainable on the other side of the near-term sluggishness.

These themes will have several investment implications. On equity valuations,even as the worst of rate increase may be behind, macro uncertainty may limit valuation upside through a rise in equity risk premium. 2023 may therefore continue to be a year of volatility for equities, at least in the first half. Pockets such as mass consumption that benefit from cooling inflation and where demand is domestically driven may be better off in this environment. Asset class diversification beyond equities (into bonds, and to some extent Gold) should help. Within equities, diversification beyond pro-cyclical pockets such as value stocks and cyclical sectors should help too.

That said, once global headwinds fade, India can potentially post a strong rebound. India’s corporate and bank balance-sheets are in a much better shape than the pains of last decade. Corporate debt to GDP has come off significantly from 71% in 2013 to 52% now. Banking sector has ironed out the stressed asset issues, with net NPA under 2% and capital adequacy ratio at a multi-year high of 16%.Corporate capex witnessed a modest expansion in 2022. While the corporate capex cycle could take a mild breather in 2023, once the global headwinds subside, strong balance-sheets coupled with production linked incentives, a decade long of minimal capex activity in India, mushrooming new age industries make a case for a strong medium term corporate capex cycle in India. China + 1 is a durable reality today as global firms diversify their production in other countries. India is also on the cusp of revival in real estate construction after a decade long dormancy.

We therefore think of 2023 as a year of adjustment, where growth slows down but at the same time becomes more balanced setting stage for a more sustainable recovery on the other side. Beyond the near-term adjustment, India appears ripe for a multi-year uptrend in economic growth and earnings driven by manufacturing and investment revival. Navigating this interim phase will require a diversified strategy across assets as well asacross styles, market caps and sectors within the equity portfolio.

Fixed Income:

Central bank policy announcements in Dec 22 had a broader common messaging even as the anticipated downshift in rate actions happened. Even as most central banks incrementally dial down the pace of tightening, the guidance from financial market perspective continues to be hawkish. While the FED reiterated the message around rates likely to stay “higher for a bit longer”, the ECB guidance emphasized that “interest rates will still have to rise significantly at a steady pace to reach levels thatare sufficiently restrictive”. The bigger and completely unanticipated directional shift came from the Bank of Japan which readjusted the upper end of the yield curve control target on the 10y Government security by 25bps to 0.50%.

The RBI MPC statement was similarly perceived as hawkish even as the rate hike was scaled down to 35bps increment as expected. References to elevated core inflation, the midpoint target of 4% as well as the still surplus system liquidity clearly points to the near-term policy preferences within the Flexible Inflation Targeting regime. For a fixed income investor with a medium-term horizon, a conservative Central Bank that assigns higher weightage to inflation outcomes alongside the visible improvement in Tax compliance/ tax buoyancy on the fiscal side are meaningful positives.

Source: Bloomberg, SBIFM research

Even as the wider external cues remained negative, with uptick in global yields, domestic rates were more sanguine in Dec 22 even as there was some retracement post the policy. While at a broader level, the divergence could be attributed to the relative better dynamics from a policy rate perspective, shallow market conditions in terms of liquidity towards the year end could also have been at play. Overall,over the last year, domestic bond markets witnessed an effective policy tightening of around 300bps with the change in the overnight settings (policy operating target) helped by the unwinding of surplus liquidity. A significant flattening of the curve, apart from still tight credit spreads remains the other key outcome.

Source: Bloomberg, SBIFM research

Over the last quarter of the year, issuance pressure in the bond markets increased with a large volume of issuances from banks, both in Basel 3 instruments as well as Infrastructure bonds. This has been alongside the issuances in the Money market through CD’s and the upward repricing seen in deposits. Alongside the unwinding of surplus liquidity,the issuance schedule could set the stage for a reasonable repricing in credit spreads over the coming months. EBP issuances in Q3 FY23 at Rs 2.38 trillion grew by 67% y-o-y as compared to the Q3 FY22 issuance size of Rs 1.42 trillion. Cumulative issuances in 9mFY23 have been Rs 4.88 trillion as against the corresponding 9mFY22 issuance of Rs 3.71 trillion, growing at 31% y-o-y. Within this, the issuances from Banks in just Q3FY23 was at Rs 61,194 crs as against full year FY22 issuance size of Rs 76,309 crs.

As we head into CY23, the outlook towards Fixed Income as an asset class in India continues to remain positive as we have been emphasising in the recent past. However, this does not imply a view on any immediate shift in stance or any near-term easing. Considering the evolving dynamics, Monetary policy making in India clearly has reached a stage where subjective assessments would come into play, unlike the case a year back when all indicators pointed to a shift in the stance towards tightening aggressively. After a material shift in both the policy rates and more importantly liquidity dynamicsover the last 7 months, the argument towards assessing lag effects of earlieractions is compelling. This alongside the forward-looking estimates on growth and inflation would warrant a pause in the near term. At the same time, the focus on the midpoint of the inflation target, alongside likely spill over volatility from external developments would necessitate that policy stance continues to focus on withdrawal of accommodation.

The navigation of challenges including the external spill overs and the persistence of inflation would necessitate adjustments across policy rates, currency markets as well as liquidity dynamics. With the policy rate adjustments having broadly been accomplished and the recent adjustment in the currency, ongoing adjustments to further modulate liquidity would be essential. This may entail a period where market rates stay elevated for a while longer. With respect to navigating the same within portfolios, a flexible approachand focus on liquidity continues to be key guiding factors in the near term.

The medium-term positive view on domestic fixed income continues to be based on the following assessment.

Even as challenges persist in the near term, the above positives should provide a high degree of resilience. Fixed income products across categories provideattractivevaluecurrently.At the same time, itis essential that the same bealigned with specific risk tolerance and investment tenors.

• The emerging growth –inflation outlook as well as cumulative effects of earlier rate actions, alongside a forward looking real neutral rate range of around 1% should enable policy rate actions to pause at close to 6.5%.

• Market yields provide a positive real rate across most tenors both on realised and anticipated forward measures of inflation. This is unlike the scenario prevalent over the last few years.

• Fixed income yields remain attractive both on relative and absolute basis, notwithstanding near-term volatility.

• Inspite of challenges arising from the larger stock of Public debt/GDP, fiscal consolidation outlook is promising as tax buoyancy is improving led by better compliance.

• Interest rate sensitive flows within the capital account are far less even as the outstanding stock held by debt FPI’s is very marginal. This is a crucial variable within the external sector account that provides a high resilience to external pressures.

Even as challenges persist in the near term, the above positives should provide a high degree of resilience. Fixed income products across categories provide attractive value currently. At the same time, it is essential that the same be aligned with specific risk tolerance and investment tenors.

Mutual Fund investments are subject to market risks, read all scheme related documents carefully.