A year of caution

Liquidity tightening will affect financial assets

The investment outlook for 2022 is mixed. Global growth could plateau as base effects from the recessionary 2020 wear off, inflation is sticky, and the pandemic continues. The Federal Reserve has said it will accelerate the pace of its ongoing taper and hike policy rates. Other major central banks are likely to adopt similar policy measures, cutting down liquidity and triggering higher bond yields. While the US could see strong growth rates driven by its infrastructure development plans, China is expected to deliver lower growth as it focuses on emission control and tightens the regulatory grip on real estate and tech. There are fears of defaults by Chinese real estate giant Evergrande triggering a wider financial meltdown. India is also expected to see slower growth in 2022-23.

Globally equity valuations could see “risk-off” corrections, as hard currency liquidity tightens. This is especially relevant for India since it is the most highly-valued of emerging markets. Foreign portfolio investors (FPIs) may be cautious about India exposures through calendar 2022. Several major global investment banks have announced cutbacks on India allocation, and the first nine months of FY22 saw net equity sales by FPIs. The Reserve Bank of India is expected to continue the policy normalisation process, and that may lead to a “risk-off” attitude from domestic investors as well. In 2021, equities across the world produced strong returns, as did gold. Debt instruments did well early in the year but plateaued towards year-end, as it became apparent that inflation was rising. The benchmark Indian market index, the Nifty 50, returned about 24 per cent in calendar 2021. This was justified to some extent by a strong revival in profitability across listed companies and many firms took advantage of the benign interest rate regime and higher profits to deleverage and strengthen balance sheets.

The higher profits have come from tax cuts and cost-reduction measures forced by the pandemic. If we discount base effects, revenues have not risen by commensurate amounts, indicating consumption is still weak and there has been little increase in corporate investment, or expansion in bank credit. Hence the likelihood that earnings growth rates will plateau. It’s interesting to consider asset classes in this scenario of plateauing growth and higher interest rates. Equity may take a bit of a back seat, given the current elevated valuation levels. Debt in general does not give good returns in an inflationary scenario. Gold is a traditional haven against inflation but it may be hurt by a stronger dollar after delivering an excellent performance in 2021. Alternative assets like cryptocurrencies (the best performing class of 2020 and 2021) are surrounded by regulatory uncertainty apart from inherent volatility.

Industrial commodities present an intriguing investment case and may be a focus area for speculation. Crude oil will be in supply surplus by February 2022 as production ramps up in the US and Canada. Lower growth in China spells lower demand for metals and energy. But it also means lower metal production since China is the dominant player in steel, copper, aluminium, zinc, and tin and it is consciously cutting back on the high-carbon processes required to produce metals. At the same time, the Joe Biden administration’s infrastructure thrust (and India’s to a lesser extent) could drive demand for metals. Hence, metals demand could exceed supply. Investors will need to weigh the pros and cons of this evolving scenario, and, of course, there is the threat of yet another high-mortality wave of the pandemic. But 2022 looks to be a year when caution trumps optimism when it comes to asset allocation.