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Happy 2023!!! Themes to Look Out For

- Vikram Kotak

Dear Investors,

At the outset let me wish you a very Happy 2023!!!

The world economy was both shaken and stirred during the year 2022. A series of challenging phenomena which include clingy inflation, high-interest rates, de-rating of private markets, geopolitical uncertainties led by the fallout of the Russia-Ukraine war, headwinds in China both on account of the country's covid breakout and political tension with Taiwan; all of which have led to tighter financial conditions and weakened economic activity across the world.

India too hasn't remained insulated from these macro developments and the country is likely to be impacted further in 2023, albeit to a lesser extent.

India is always known to react when it's pushed against the wall. It is analogous to a Bollywood movie wherein the police arrive after the hero has managed the crisis. But this time India has been more proactive, kudos to the Government and regulators. It will be wrong on my part if I don't thank the Indian heroes (i.e., in the language of the Bollywood audience) who have shown confidence throughout Indian equities, and it was well supported by under-investment in equities for years. SIP flows have increased to the highest-ever levels and guarded Indian Markets against heavy selling by FII till mid-2022. SIP inflows are up from a monthly avg. of Rs.80 bn in 2020 to over 133 bn in Nov 2022.

This brings me to the first theme of this note, Investing in Bonds. The new way of living with higher inflation brings good times for bonds. Higher yields are a gift to bond investors who have starved longer for income. Despite fundamentals being supported, liquidity has played against bonds. And investors don't have to go far up the risk spectrum to receive it. With US fed rates increasing interest rates by whopping 425-450 bps in last 12 months. We believe the rate hike cycle will likely end in the first quarter or early second quarter of 2023. This gives a good chance for an investor to lock their allocation in high-quality bonds across the spectrum, but I believe that the 3-5-year segment will be most attractive and can be a great play against any unforeseen geopolitical uncertainties in 2023. Finally, the time has arrived for investors to get higher yields as the central banks are in the mood to hike rates. We firmly believe this opportunity will be for the very short- term as we will see a shift of incremental and existing flows from underperforming asset classes such as crypto, private equity, and commodities. We believe the rate hike cycle is coming to an end in the next 6 months in India too after 225 bps hike. Over the next couple of months, it is a good time for investors to lock their allocations in high-quality bonds.

The second theme of this note is Inflation. High inflation has sparked a cost-of-living crisis, putting pressure on central banks to tame inflation -whatever it takes. Yet there has been little debate about the damage to growth and jobs. We think the “politics of inflation” narrative is on the cusp for a change. In our view, the cycle of outsized rate hikes will stop without inflation being back on track to return fully to 2% targets. As the damage becomes clear, the “politics of recession” will take over. Plus, central banks may be forced to stop tightening to prevent financial cracks from becoming floodgates, as seen in the UK and Europe.

Back in India, inflation is relatively a lesser headache and RBI has been proactive in increasing rates here. With global slowdown and stable oil & commodities, inflation will move southward quicker than anticipated.

The old playbook principle that recession drives below-target inflation and an easy monetary policy doesn't hold true anymore. I believe that the principle might be adjusted towards balancing inflation and growth more than what has been prescribed in the rule book.

Geopolitical fragmentation is likely to foster a permanent risk premium across asset classes, rather than have only a fleeting effect on markets as in the past. Market attention is likely to stay fixated on geopolitical risks. All this will likely contribute to the new regime of greater macro and market volatility -and persistently sticky inflation.

We must start living with relatively high inflation and attractive interest rates in the medium to long -term. But in the short-term, inflation will likely come off and lead to a peak out rate.

The third theme of 2023... is the likely liquidity squeeze in private markets, As an outcome negative returns are expected, and many business models become unviable with the free tap of money going dry.

As it is well said, “Volatility is the price one pays for Listed equity. Liquidity is the price one pays for Private equity. Liquidity does play a significant role when you want money, but you can't sell".

The Global Private market has gone to the size of $10 Tn before correcting itself last year. Most money raised and invested has a long-term lock in say 10 years starting with the advantage that you don't need to publish NAV and statements on a daily/monthly basis. Unfortunately, everything in this market is long-term. Now look at the scenario in today's world when yields and inflation have shot up and the money supply is tight. It will not only be challenging to raise money, but it would be difficult to fund the growth of private markets across the board. This will result in weaker players getting hammered. I believe over the next 2 years we will see many skeletons; in Indian and global private equity markets. There was a big FOMO of investing in private markets which have suddenly converted into HOGE (hope to get exit).

The vicious circle of private markets is buying low in the private market where price discovery is non-existent and selling high in the public market. This chain must end somewhere because people have started buying high at absurd valuations and foolishly find buyers at much higher valuations. This cycle seems to be ending for all other than a small per centage of those whose businesses are rock solid. If you look at the debt-equity ratio of the average private company vs a publicly listed company, it's more than double. With the inability to raise more money, we will see a rush for exit from such deals in the next 2 years, which can shiver global financial markets.

We all know even Indian regulators have been worried about the funding and reporting mechanism of private companies. I will remain extremely cautious and careful in selecting the right business models at right prices.

My theme 4 for the big boom in the Capex cycle is not only restricted to India but there will be a big wave in MENA countries particularly Saudi (previously seen in Qatar). Saudi is looking forward to growing at 6% for the next 2 years, which is a remarkable value. The region is investing a large amount of oil money to build world-class infrastructure spending billions on transforming metro centers into smart cities and promising a futuristic car-free version of urban life. The US hasn't spent a lot on Capex over the last many years and is expected to have a big boom in defence, transmission, and building many essential supplies such as food, pharma, and healthcare factories within the US and other countries post covid.

India is on the cusp of starting a new Capex cycle well initiated and supported by public sector enterprises. The Modi govt has done a fabulous job in carrying out “Make in India” and we are seeing benefits of that across various sectors. The cherry on the top is quick clearances and Performance Linked Incentive (PLI) schemes and there is a race to chase capital between many states. I believe that in the next 5 years, there is a great opportunity to make money from high-quality Capex-related companies in India.

Also, there is a great opportunity to build a semiconductor hub in India as we are the 2nd largest smartphone market, the 5th largest automobile market, among the top 5 in consumer durables, and the top 3 in laptops and tablet consumptions. With rising demand, we need to build in-house capabilities to manufacture chips. Govt. has announced a $10 bn PLI scheme for this industry. With abundant talent and innovation in India, we can surely have our mind share in the $ 500 bn global industry. We need to be hungry to build mega infrastructure like China to propel growth. Currently, people are using more hours on travel and freight costs because of underdeveloped infrastructure.

To summarise, I believe 4 themes will ride 2023 in a big way namely:

    1. Great time to invest in bonds

    2. Staying with high inflation for longer time

    3. Bubble to burst in private markets more

    4. Recovery in Capex cycle in many parts of the world

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    a) Ace Lansdowne Absolute Return Strategy: The objective is to generate positive absolute returns in all market conditions across time cycle, while managing portfolio risk

    b) Ace Lansdowne Multicap Strategy: The objective is to generate sustained capital appreciation through superior risk-adjusted returns across the time cycles and seeks to generate better return than benchmark (Nifty 500)

    c) Ace Focused 10 Strategy: The objective is to generate long term returns across the market cycles by investing in maximum 10 high conviction stocks across sectors and market cap.