Edited excerpts:

The markets have discounted political continuity and domestic economic stability. What’s your base case?

The economy has been prudently managed and is well placed cyclically, i.e. demand is picking up and there is spare capacity available to meet that demand. This means output (gross domestic product) and, consequently earnings growth, is likely to be healthy over the next 2-3 years. So, we are fairly confident about the economy over the medium term. Since we are not experts in politics, we do not have any unique insights on what the electoral outcomes will be.

But our approach is that if the economy is healthy and even if the markets were to turn volatile (for whatever reason), then one should use that as an opportunity to increase investment levels. Having said this, we are concerned about the valuations in the small and midcap space, where we believe the risk-return trade-off is adverse.

Geopolitical tensions (Iran-Israel) can cause crude to flare to triple digits. What’s your estimation of when it will begin to hurt us (economy and markets) and for how long?

If one were to consider the economic impact, the current account is in very good shape—it might even be in surplus in Q4. Also, we hold significant reserves. Given this scenario, on a temporary basis, shocks can be easily managed from an economic perspective. However, if high oil prices persist for a prolonged period, then currency should be allowed to depreciate as part of the adjustment process to high oil prices.

There is a fundamental difference between the economy from the 90s and today. In the 90s, oil was our predominant import item and we did not export much, relying mostly on remittances to keep the current account in equilibrium. At such times when oil prices shot up, the only option was to cut oil purchases, translating into a sharp economic slowdown as less oil meant less output.

Our import basket is more diversified today.

Today, we have a diversified basket of imports and exports. While oil still remains a large part of the imports, imports of other items like electronics, tourism and education services are also substantial. Similarly, the export basket is also diversified. So today, even if we have an oil price shock, we do not have to cut back on oil imports. There are other items that can flex to keep the current account in equilibrium and flexing these items will not lead to a contraction in economic output. For example, domestic economic output will not drop if Indians did not holiday abroad. A rupee depreciation will be part of this adjustment—but that should not be seen as a cause of worry.

So the economy now can absorb fairly substantial oil price shocks given the level of reserves and the elasticity of the current account. This is the reason why Indian economy did not lose momentum when oil prices went into triple digits in the first half of 2022. In the initial phase, equity markets may react negatively, but over time they will follow the economy.

What are the expectations on Q4 earnings? What are your views on BFSI, IT, FMCG, industrials, pharma, etc.?

In general, we are positive on domestic cyclical sectors—auto, capital goods, financials and cement. These sectors are likely to see good volume growth. We continue to remain negative on the FMCG space where the problems are not related to the economy. The challenges show that companies are trying to hold margins at levels that are hurting the competitiveness of their products in the market place.

What’s the house view or outlook for FY25? If you could mention sectors…do you see earnings of small- and mid-caps outperforming large caps in case of cost of funds remaining high (viz. no rate cut in US or India) or if inflation remains a worry?

Given the strength of both the US economy and the Indian economy we do not expect aggressive rate cuts as there is no need to stimulate demand through rate cuts in either of the economies. In US, even if the Fed cuts short-term rates, one should not expect long-term bond yields to drop much. The yield curve is currently downward sloping and will revert to its normal upward sloping shape as and when short-term rates ease. From an equity market multiples perspective, it is the long-term yield that matters and not the short term rates. So, one should refrain from building an investment thesis around rate cuts leading to multiple expansion.

Large-cap returns have lagged mids and smalls for many years, particularly in the last four years. Do you see the trend continuing, given 7-8% economic growth and inflation at 4-5%, resulting in nominal GDP of 12% or so?

We are fairly concerned about the small and midcap space and would advise investors to be cautious in this space. In past cycles, we have seen that investors get drawn into stocks based on narratives or excitement around earnings over 1-2 quarters. But liquidity in these stocks tends to dry up when the performance mean reverts. We see the risk of a similar scenario playing out again.

What’s your advice to investors on how to approach the markets given the ambient domestic and global economic and geopolitical factors? Is it good to diversify a bit more towards gold (and/or INVITs/REITs) and fixed income especially if rates are expected to soften?

While the economic outlook is strong, market levels are not cheap. In such situations, one should focus on improving the quality of the portfolio—rather than being in the riskiest segments of the market. Given this framework, it is better to be invested in large-cap companies with long -term track records. Also, the risk-return trade-off is better in this part of the market. Investors should invest with at least a three-year horizon and should not enter market with the expectation of making short-term gains.

One constant refrain is private capex not picking up as desired albeit investment commitments for green energy, chip plants, etc. are top news. What’s your take?

Home building and construction are a very large part of private sector capex. There has been a clear and sharp uptick in this activity. Capex intensive sectors such as cement, power and steel are also seeing fresh investment activity. So, it would be incorrect to say private sector capex is not picking up.

What’s your view on rupee in the current fiscal?

Fairly large inflows on account of bond index inclusion are expected. So our base case is that the rupee is likely to remain relatively steady. In case there is a supply shock on the oil front, leading to a sharp and sustained increase in oil prices, then the rupee would be expected to depreciate to allow the economy to adjust.