‘Investors should expect moderate risk premium of 3-5% per annum over fixed income returns’

By Urvashi Valecha

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In the new normal, investors need to reset returns expectations from markets. Investors should expect a moderate risk premium of about 3% to 5% per annum over fixed income returns, says Sampath Reddy, chief investment officer, Bajaj Allianz Life. In an interview with Urvashi Valecha, he also explains why mid and small-cap stocks should do well going forward. Excerpts:

The markets are at their life-time highs because of positives such as the Covid-19 vaccine and robust FPI flows. Is this likely to sustain?

In November, we have seen the highest monthly foreign portfolio equity inflows at over Rs 60,000 crore. However, after such a strong FPI inflow, we may see some moderation in flows, especially those driven by MSCI India Index weight increase, in the near term. The long-term structural growth story for India remains intact, and the country remains favourably placed in terms of fundamentals within the emerging markets pack.

Your interpretation of the market returns in the last 5 to 10 years? With valuations soaring, what is your outlook for market returns going forward? Should investors expect lower returns given that bond yields are down?

Investors in the equity markets were not compensated well in the past few years for the risk that they took. Equity market returns have been quite similar to debt market returns over the past 5 to 10 years. With the strong market rally, and with valuations, especially based on FY21 earnings, being above long-term average, investors should expect a moderate risk premium of about 3-5% per annum (over fixed income returns).

What is your outlook for the mid and smallcap stocks for the next year? Has the time finally come for their outperformance?

The broader markets (mid and smallcap indices) have actually fared better since March 2020, helping them to outperform large-cap peers CYTD in 2020. Mid-caps and especially small-caps are still away from their 2018 peak, although the Nifty is at all-time highs. The valuation of the mid-caps segment is also looking relatively more moderate. Small and mid-caps stocks would usually outperform in an economic recovery phase and when risk appetite is higher, but they also tend to generally be more volatile. As we believe the worst of the economic slowdown is behind and FY22 is likely to be a good year of growth recovery, mid and small cap stocks should do well.

What is your outlook for the Indian economy in 2021?

Economic activity in India has recovered faster than expected, and various economic trackers show that economic and business activity is now back to 85-95% of pre-Covid-19 level at an aggregate level. Most economists are already upgrading the GDP growth forecast. The Q2 GDP contracted by 7.5% year-on-year, which was better than consensus expectations of above 8% contraction. Positive surprise was gross fixed capital formation (investments), which Y-o-Y contracted less than expected, and saw a healthy recovery sequentially. Personal consumption also witnessed recovery sequentially. Even though government expenditure registered a record year-on-year contraction in Q2, we feel that the contraction in GDP growth during FY21 may not be as sharp as projected earlier, if the momentum continues.

Sectors such as IT and pharma have been participating in the rally that started in March. Of late, banks have been participating too. Should investors continue to hold on to these sectors?

Yes. With the economy recovering, some of the cyclical sectors like banking and financials, capital goods (which have relatively underperformed earlier) and metals have started to outperform in the past few months, and they have managed to close the performance gap to some extent. Within the banking sector, we have been preferring well-capitalised private sector banks, and we have also been adding to the metals sector. We also like the domestic manufacturing theme, with the government trying to promote it through the PLI schemes. Besides, we continue to like export-oriented sectors like IT and pharma.