Will the World Head into a Recession, and Is It the Right Time to Invest in Equity Mutual Funds?

June 29, 2022 Mutual Fund

Bears seem to be tightening their grip on the global financial markets. The worries of investors are mounting with unprecedented global developments, thanks to the fallout effects of the Russia-Ukraine war, supply-chain disruptions, rising inflation, zero covid policy of China, and rising interest rates, amongst others.

The World Bank has clearly highlighted the risk of stagflation in its latest report, Global Economic Prospects. According to the report dated June 7, 2022, the world economy is likely to clock a 2.9% growth in 2022. This is a sharp downward revision from the World Bank’s January estimates of 4.1%.

On this backdrop, Federal Reserve (Fed) Chair, Jerome Powell’s latest comment that “recession is certainly a possibility”, has created jitters amongst global investors.

Are we really heading for a recession within two years from having one inflicted by the COVID-19 pandemic?

As you might be aware, in economics, a contraction in economic activities for two consecutive quarters is termed a recession. The United States (US) and European Union (EU) are the world’s largest economies, and they have been reeling under pressure at present.

While the EU is feeling the heat of rising energy prices in the aftermath of the Russia-Ukraine war, the on-ground data in the U.S. doesn’t look encouraging either.

According to S&P Global, the U.S. economy might have hit a rough patch already. At 49.6, Flash US Manufacturing Output Index (based on data collected between June 13 and 22) has fallen to a 24-month low. Flash PMI is a leading indicator of what the full-month final PMI numbers may look like.

Similarly, Flash US PMI Composite Output Index of 51.2 is at a 5-month low. Factors such as contraction in new orders, contraction in export orders, creation of fewer new jobs, falling work backlogs of the private sector and sinking business confidence, amongst others, don’t bode well for the GDP growth of the world’s largest economy.

Graph 1: S&P Global Flash US PMI Composite Output Index

(Source: S&P Global)  

As the Fed is increasing its target interest rate to fight inflation (which has touched a 41-year high of 8.60%), the International Monetary Fund (IMF) is of the view that the US economy would see a ‘very significant’ downside risk this year and particularly 2023 but will ‘narrowly avoid a recession. And if it does slip into a recession, the IMF expects it to be relatively short.

For now, the growth in the US and EU is underpinned by pent-up demand for consumer services, including travel and tourism. It remains crucial to see how rising inflation affects the performance of these sectors in the foreseeable future.

If stagflation risks are real and potent as feared by the World Bank, the hawkish policy response in terms of rising interest rates may continue, going by the experience of the 1970s. This might increasingly put pressure on global financial markets and equity markets in particular.

According to the World Bank estimates, inflation is expected to ease out next year but is unlikely to stay within the comfort zone of most central banks.

A disproportionate policy response might push the global economy into recession as higher interest rates may cause demand destruction. According to noted American economist, Nouriel Roubini, famously known as Dr. Doom, the US economy is ‘getting very close’ to a recession.

The experience in Indian markets is no different.

The World Bank has slashed India’s FY23 GDP growth estimates to 7.5%. This is a downward revision of 120 basis points (bps) from its January 2022 estimates. The RBI has issued an even more conservative estimate of 7.2% GDP growth in FY23. The RBI, too, has raised policy rates by 90 bps over the last few months. And the way inflationary pressures persist, it is likely that the RBI may hike rates further. How much and how quickly the repo rate would increase further remains crucial to be seen.

That said, history suggests that equity markets have adjusted quickly to rate hikes. When a rate hike is gradual (less disruptive), spread over a longer cycle (as seen during the period October 2005 to July 2008), the equity market fares well. Similarly, shorter interest rate cycles are less disruptive as well, though a bit aggressive (as seen during the period September 2013 to January 2014).

Table 1: Performance of Indian equity market during the rising interest rate scenario

Note: Returns for a period over a year expressed in CAGR, while for up to a year in absolute terms
(Source: ACE MF)  

But when rate hikes are done aggressively and not spread over a very longer period (as seen from March 2010 to October 2011), then the returns from your equity investments could be muted.

Hence, what matters is the quantum of the rate hikes and for how long the period of the upward interest rate cycle continues.

If the global economy remarkably slows down or slips into a recession, it is unlikely that the Indian economy will decouple. The impact of a recession in the developed world would be seen in India as well. How much will be the impact shall depend on how severe the recession is and for long it lasts.

Should you invest in equity markets during a recession?

In regards, follow the pearls of wisdom of legendary investor, Warren Buffett: Be fearful when others are greedy and be greedy when others are fearful.

Investing in a market selloff when there is panic around provides you with value-buying investment opportunities. Here’s what Buffett has to say:

"In the early 1980s, the time to buy stocks was when inflation raged, and the economy was in the tank… In short, bad news is an investor’s best friend."

Where are the Indian equity markets currently placed?

As you may know, volatility in the Indian equity market has intensified. The bellwether Nifty-50 Index is down about 15% from its October 2021 highs. As a result, the valuations have become reasonable at present. The Nifty-50 is trading at a Price-to-Earnings (PE) of 19 on FY22 earnings compared to the PE of 27 in October 2021. Similarly, the mid-cap and small-cap indices also have corrected significantly, and their valuations provide a decent margin of safety to clock attractive returns over the long term.

The collective performance of listed Indian companies has been quite encouraging in the last few quarters. In Q4FY22, too, the earnings were satisfactory, considering the inflationary pressures. A set of 4,083 companies tracked by Business Standard recorded operating profit growth of 14.3% in Q4FY22, which is fairly robust.

Unless Indian companies fare miserably over the coming quarters or markets rebound sharply, the valuations are likely to moderate further in future.

The history of the Indian equity market stands testimony to the fact that after negative events such as the downturn of 2002, the U.S. subprime mortgage crisis of 2008-09, the Dubai debt debacle of 2009-10, and later the debt crisis in Greece, the slowdown in China in 2016, and the crash at the onset of the COVID-19 pandemic in 2020, the Indian equity markets have well trounced supported by buying activity from investors.

As a retail investor, you must devise a sensible strategy to make the best of the beaten-down markets while investing in equity mutual funds. Don’t avoid equity as an asset class just because interest rates are moving up or the recessionary pressures are setting in.

If you have a high-risk appetite, the broader objective is capital appreciation, and have an investment horizon of at least 3 to 5 years; invest in equity funds following the ‘Core & Satellite Approach‘.

The term ‘Core’ applies to the more stable, long-term holdings of the portfolio, whereas the term ‘Satellite’ applies to the strategic portion that would help push up the overall returns of the portfolio across market conditions. This time-tested investment strategy is followed by some of the most successful equity investors, proving to be a wealth multiplier for them in the long run.

The ‘Core’ holdings should be 65%-70% of the portfolio and consist of equity funds such as Large-cap Fund, Flexi-cap Fund, and Value Fund/Contra Fund.

The ‘Satellite’ holdings, on the other hand, should make up 30%-35% and comprise of equity funds such as worthy Mid-cap Funds and an Aggressive Hybrid Fund. If your risk appetite is very high, maybe you could add a small-cap fund in the satellite portion.

When you construct an equity mutual fund portfolio based on the ‘Core & Satellite Approach’, you should ensure it does not contain more than 7 to 8 best equity mutual funds. There is no point in over-diversifying your equity mutual fund holdings.

It would be best to ensure that no more than two equity mutual fund schemes belonging to the same fund house are included in the portfolio.

Further, no more than two schemes in the portfolio should be managed by the same fund manager, all the schemes should have a strong track record of at least five years, they have outperformed over at least three market cycles, are among the top performers in their respective categories, and are abiding by the stated objectives, indicated asset allocation, and investment style.

Your objective as an investor should always be to try generating superior risk-adjusted returns higher than the risk-free rate. And to achieve this objective, make the most of weak market conditions that provide you with worthwhile opportunities to buy for the long term.

Happy Investing!

This article first appeared on PersonalFN here