Will FY22 be the year for cyclical or defensives?

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Stellar run in FY21

The year FY21 has been a one-way streak for the markets having registered one of its best gains in any given financial year. The re-opening of the economy coupled with continuous government support, low interest rates and overwhelming liquidity has led to a monstrous rally in equity markets worldwide. Supported by global cues, even Indian markets have witnessed a sharp recovery having registered ~93% returns in last one year.  

Given the high economic uncertainty, at first, the defensives (IT, Pharma and FMCG) led the charge for the markets but, as the economy re-opened, we saw cyclical too joining the party. The sentiments became stronger for cyclical on the back of better-than-expected demand recovery (both pent up and festive season) and then a growth-focused budget presented by the government this year. In terms of returns, if we take one-year performance both cyclical and defensives have yielded strong returns but as we said it’s the timing that has differed. This has happened in the past as well that whenever economic uncertainty is high, within equities defensives are preferred over cyclical as the wide expectations is that defensives would be least affected.

If you wish to read more on Cyclical v/s Defensive sectors – Here is the link.

1 Year Returns (%)

Remember the period between 2011-14 when the Indian economy was dwindling with high inflation and global cues weren’t that supportive, it was the Pharma index (BSE Healthcare index) that outperformed. It nearly doubled in that period. If we check the returns from 2009 lows to 2015 highs the index has yielded 6x returns. Yes 6x.

Not all looks well for equity markets

Back to the present, as we speak, all is not looking hunky-dory for equity markets in India or even worldwide as all the positives seem to be priced in and the negatives are looming over. Firstly, let’s address the bond yields. Rising bond yields are theoretically bad for equities as when calculating the discount rate in DCF valuation, it takes into account the risk-free rate which is typically the 10-year bond yields. And now when the yields are rising the discount rate would increase leading to lower terminal value and eventually lower prices.

Moreover, investors were working with an inherent assumption that interest rates would remain at low levels for at least the next 2-3 years and that’s one of the reasons why equities got re-rated recently. But that premise is under serious threat currently, as commodity prices are witnessing strong traction not only due to better-than-expected demand recovery but also due to supply-side issues. This would sooner or later show its way into inflation which would prompt central banks to raise interest rates. Again, not good for equities especially cyclical (Banks, NBFCs, Autos, Industrials, etc.) as they are more rate sensitives.

Central banks continues to support

Let’s not be a pessimist as past cycles have shown us that on many occasions rising bond yields are positively correlated to equities. But in most cases, growth was picking up and inflation was steady. This time around the growth is picking up, that’s true, but even inflation has started to inch upwards. The only silver lining is that the central bank continues to overlook the recent pick-up in inflation and focuses more on economic recovery which means interest rates would remain where they are even if inflation goes beyond the limit temporarily. The keyword here is temporary.

Another factor to worry about for Indian equities is the emerging second-wave of infections which can potentially put brakes on India’s on-going economic recovery and cyclical sectors would get hit the most. But again, our Prime Minister has made it clear that the focus should be on micro-containments. This has somewhat alleviated concerns of a lockdown but nonetheless, the risk still persists.

Therefore, to be honest, as we stand, things are in the balance for cyclical and defensives. Cyclicals have all the ingredients of growth at present with strong government support, low-interest rates, and buoyant demand. But if yields continue to harden, firstly the premium gained by equities due to low yields would start to shave off and second, if inflation is persistently higher than the comfort zone, then central banks would be forced to tighten monetary policy and defensives would gain limelight

On the other hand, if infections surge considerably then too, we would see defensives gaining limelight due to increased economic uncertainty. As an investor it would not be prudent for an equity investor to go all guns blazing on either one of them but rather take a more balanced approach.

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Monergise helps you learn and stay updated with the current market and investment trends which would enable you to make better investment decisions. Our team of finance professionals publishes articles on latest market trends, industry reports, stock analysis, investment planning, and personal finance. Our articles are also suitably designed to aid our readers towards better financial learning. We are a group of finance professionals having experience of more than 10 years in Indian markets.