Do you think that sooner or later the RBI will also have to bite the bullet and raise rates to combat inflation?
Yes, we are in a world where inflation has taken center stage and the normalization of monetary policy in response to higher inflation is going to be the order of the day. Until now, RBI has focused more on growth versus inflation because inflation in India in CPI terms has been largely within the range that RBI is actually targeting, which is plus 4% minus 2% on both sides. Now, in the current situation, given the conflict between Russia and Ukraine, world oil prices are going up. We don’t know how long oil prices will stay at current levels and that will be a key factor driving RBI monetary policy going forward.
Now, with every 10% increase in oil prices, the impact on CPI inflation is about 35-40 bps on a direct level, and therefore, at current prices, it is possible that inflation will exceed the upper limit of the RBI in terms of the tolerance band. However, the key to keep in mind is how sustainable the current level of oil prices is and that is what RBI will really look at.
In the short term, we believe that normalizing monetary policy as RBI has been doing so far will be a gradual step. We don’t expect the next policy to be a rate hike, but possibly a move in terms of changing our stance from dovish to a more neutral stance and then as the inflation trajectory develops, possibly the RBI will consider raising rates rates.
So yes, rates will go up this year, but the pace of rate increases will be more measured and moderate, considering that the kind of growth improvement that we were seeing in India was still quite nascent even before the conflict and after conflict. the focus will be in terms of balancing growth and inflation. We expect RBI to embark on a rate hike journey as well, but it will be a calibrated decision and action will be taken in the coming quarters.
How did you make your portfolio inflation proof?
Keeping the portfolio inflation-proof is a really difficult task. We have to deal with inflation across the board. What we are really seeing and especially when it comes to the markets this year, unlike last year where the market movement was quite broad, we believe that this year the market movement will be very stock specific in nature. So bottom-up stock picking will be the way to go.
In a scenario where inflation is a concern and rates are likely to move, we should also look at companies that have strong earnings, balance sheets and cash flows; companies that are gaining market share in the sectors in which they operate and also companies where valuations are not overly stretched and therefore valuations need to be reasonable in this type of environment.
The construction of our portfolio has not really changed significantly. On the one hand, we have exposure to the domestic cyclicals that include infrastructure, capital goods and industrial play because we believe that while in the short term there could be some headwinds and there could be some delay in terms of the revival of the capital cycle private, is clearly on track and public capex remains strong and the government’s policy to make growth lead over investment is something that will continue. Therefore, our exposures in the capital goods, industrials and infrastructure sectors remain.
The second way to play in the current kind of environment where interest rates are going to go up, but possibly gradually increase from a political perspective, is the banking sector. The sector has underperformed in the recent past. However, we think the time is right in terms of how some of the big banks are positioning themselves given that they have a very strong low-cost deposit franchise today and therefore are likely to be better placed in this cycle as interest rates begin to rise. , capital is also well above regulatory requirements. So that’s the second area of focus.
The third area of focus is possibly the export market and specifically sectors such as pharmaceuticals, where we have stock-specific exposures in the domestic formulations business as well as specialty pharmaceuticals.
Finally, we are analyzing the longer-term structural thesis of the real estate recovery, which is something that we have also been playing in recent quarters and where we believe that the improvement in the real estate cycle is here to stay.
Therefore, although the real estate sector and home construction in the short term would face pressures due to inflation and the structural increase in the costs of raw materials, the cycle remains quite intact.
What is your opinion regarding the insurance space? How would fate change once LIC’s initial public offering enters the picture?
What has clearly happened in the insurance sector has been twofold; one, the impact of Covid that affected profitability last year has resulted in the underperformance of the sector and there is also the fear that with the IPO of LIC, there will be more competition, especially in the non-party segment, which is the segment with the highest margin.
Actually there is also a third reason due to Covid and mortality experience being unfavourable, there has been an increase in the reinsurance rate which has caused the price to go up for protection products as well. Incrementally from here on out, it seems the worst is behind us. The Covid situation seems to be improving and therefore the fear that we will have another wave is also diminishing.
The second is that the sector’s growth prospects should improve from now on. There is an inherent structural demand for protection due to the lack of penetration that exists throughout the country and although there have been some price increases due to higher reinsurance charges, the structural demand remains intact. And so we think that both in terms of traditional products such as participating, non-participating or ULIP, as well as protection, the prospects for gradual growth should start to improve. However, it will be a gradual improvement towards the second half of the year.
Last year’s margins, especially in terms of VNB margins, for most companies performed quite well. We saw margins stay the same or improve primarily due to changes in the product mix. Going forward, we expect margins to hold, especially as retail APE growth returns to the sector as a whole.
Also, in terms of valuations, most of these companies; Reported rates of return in terms of return on embedded value are quite healthy in the range of, say, 15-18%, and so given the type of rate-of-return profile, growth may return. valuations at the moment appear to be quite attractive. However, patience is needed because the growth trajectory will not accelerate immediately.
What is your calling in the car space as a whole? Tata Motors has been flagging concerns about supply chain and logistics issues. Does that mean a rough road for cars?
Auto as a sector in the last four and five has had a rough ride. It has been quite difficult for the sector in several aspects and just before the conflict broke out, we were seeing the first signs of revival in the sector, especially on the four-wheeler side. We believe that in the short term there will be challenges. Due to the conflict, the supply chain problem and the shortage of chips could drag on. We don’t know how long or when the conflict will be clearly resolved, so it’s a big question mark right now. The short-term recovery that we were seeing in the sector has been postponed.
The other factor to take into account would be the elasticity of demand to higher fuel prices, as well as the input cost pressures that some of these companies face and whether they would need to transfer it as well, and therefore in the short term. , possibly there is a push in terms of the recovery that we were seeing.
Structurally though, over the last four or five years, as the industry has gone through considerable turmoil, especially in the four-wheeler space, we believe that as things start to stabilize towards the second half of the year , part of this replacement demand would begin to pass. Inventory levels in the system, especially when it comes to four-wheelers, are quite low. When consumer sentiment has also improved thanks to wage growth, we believe that all of this together will translate into better trends for the automotive space, but clearly with a delay.
Valuations in this space are quite attractive. Within the automobile segment, our preference has been for four-wheelers over two-wheelers, and that preference remains. Of course, we are aware of the short-term challenges that the sector will face. We are also looking for companies within the sector that have major product launches that have lined up and companies that are also investing in conversations about future technologies.
Are power supplies a pocket you would put money in?
Our approach to power supplies has been quite specific in nature. We have exposure in certain segments of the entire PSU basket. For example, among the larger PSU banks, we believe there are opportunities among the few major banks in the PSU banking space. Where liabilities play a significant role, banks that have had the ability to build a strong liability retail franchise and where banks are showing signs of improving growth and may be growing slightly faster than industry-level growth.
In the industrials package, we have looked at some of the public sector names where we believe there are growth opportunities and also where valuations are again attractive. Our approach to the entire public sector has been quite bottom-up in nature. Companies that show signs of improvement in terms of earnings growth, companies that show signs of growing faster than the industry in which they operate, and finally companies that also show signs of improvement in performance ratios in the next two years, which could be a catalyst for multiples to rise as well. These are some of the segments within the PSU basket to which we currently have exposure