After a tough year for the Indian economy, as a nascent recovery took hold, 2022 is likely to bring with it spikes in market volatility, higher interest rates, and elevated inflation. A focus on opportunities in long-term investment themes, in a diversified portfolio, seems one way to manage the next twelve months.

India’s economic vulnerabilities and risks

Below are some of the potential economic vulnerabilities and risks;

• COVID-19 curveballs – Variants, mutations, restrictions, and vaccine inefficacies.
  • With higher vaccination rates, reinforced resilience, and medical infrastructure, the world seems to be entering an endemic state
  • More than the threat of another wave of infections in India, the impact on global exports and imports or investment flows to India, due to any COVID-19 curveballs, poses a greater risk to India’s economic recovery. The pandemic, however, has boosted Indian exports with increasing demand for digital solutions and services as well as global manufacturing supply-chain alternatives.

• Inflation scare – India is mainly a price taker for industrial metals, energy, and semiconductor chips. Imported inflation, therefore, remains a concern.
  • To some extent, the record forex reserves that the Reserve Bank of India (RBI) has built are likely to help allay any fears of sharp Indian rupee depreciation, that otherwise may have had a multiplier effect on imported inflation
  • With activities picking up across the world, supply-side issues are expected to ease in the coming year
  • It is fiscally difficult for the government to reduce taxes, such as on oil, that is funding higher infrastructure spending
  • Any persisting inflationary pressures, however, may impact profit margins as well as business and consumer savings, consumption, and investment.

• Monetary Policy Normalisation
  • The RBI has emphasised on making a gradual, measured, and non-disruptive transition from the easy liquidity environment, keeping in mind the targeted relief being made to the more vulnerable sectors of the economy
  • Some vulnerabilities, however, both in the real economy and financial markets, may only come to light once targeted relief is removed. Vulnerabilities include any new stresses emerging in the system that was shielded during the forbearance framework in play during the pandemic
  • The Reserve Bank of India may consider hiking the repo rate from April. But the rate is likely to only go up by around 50 basis points in 2022, and maybe another 50bp in 2023.

Prepare for more volatility

Next year is likely to experience higher market volatility, given the transitions in the economy underway, the prospect of policy normalisation, rich market valuations, cash flow discounting rates set to rise, and continual rotations in sectors, themes, and market capitalisations.

As such, having an appropriate asset allocation plan with adequate portfolio diversification and a portfolio rebalancing plan is critical. Also, bottom-up security selection and active management appear to be key to maximising returns. Staggering allocations and buying on dips would help.

Fixed Income Outlook

Keeping core portfolios invested in high-grade corporate bonds, of up to five years, still makes sense. The steep rate curve appears to offer enough carry to compensate for any residual duration risk in such portfolios. The policy normalisation journey, however, is likely to be fraught with high volatility. Any market overreactions beyond the expected case on the timing, pace, and/or peak of the rate hiking cycle can throw up tactical investment opportunities for the investors.

Currency Outlook

It has been seen that, after a year of low volatility, volatility tends to pick up. Therefore, the question remains what can cause volatility to rise in 2022.

• Historically, when US Fed goes for a rate hike, volatility picks up in the emerging markets.
• In India, real rates are negative. At a time when the U.S. is looking to normalize interest rates, negative real rates can become a headwind for the Rupee.
• 2022 is also the year of major state elections in India, which are critical from the perspective of 2024 LS polls. The focus will be on Gujarat, Punjab, and UP state assemblies.