The Indian economy has witnessed a structural shift to lower inflation levels and investors need to realign their expectations accordingly. Manish Gunwani, chief information officer, equity, Reliance Nippon Life Asset Management, talks about why the primary debate for investors is whether to go with a growth strategy or look for value with a better risk-reward ratio.

What are the primary narratives that will drive the equity markets now that the impact of the general election is behind us?

From a medium-term perspective, there are a few trends that will be important. One factorthat is core to the economy, capital markets and life in India is the structural move from a high inflation country to a lower inflation one. For the last 30 years, the consumer inflation has been at 8-9%, which helped nominal gross domestic product (GDP) growth of 14-15%. This was mirrored in the Sensex returns of 15%. This also meant that there was a rupee depreciation of 4-5%, because over the long term, currency valuation is about the inflation differential. The structural movein consumer inflation to 4-5% essentially means that nominal GDP is likely to be in the 11-13% range, and equity market returns will also be in line with this.

Another factor is how India builds an alternative export engine. Our share in global trade grew 0.5% in the early 1990s to 2.5% by 2010, and we witnessed a growth of over 15% every year, primarily from the revenues of IT services, as well as pharma and auto ancillary industries. But today exports are a slow growth area and remittances have also slowed to 5-7%, leaving us vulnerable to a spike in energy prices. We have to target big global export industries like textiles and tourism. India has the opportunity to become a big agricultural exporter. It is a very sensitive trade item, and requires intelligentpolicymaking.

The third narrative is about how well the three levers of monetary policy, fiscal policy and exchange rate are used to manage the economy. In my opinion, we are overtly tight on all three levers. Easing monetary policy is the easiest case to make because real rates are high. Expansive fiscal actions come with their own limitations, particularly because they cannot be easily reversed. If you stimulate the economy, the fiscal deficit can actually come down. The third is exchange rate which may be the best stimulus because it encourages production and discourages consumption.

Are valuations in the Indian equity market high?

Equity valuation is a function of growth and cost of equity. While growth has slowed, cost of equity too has fallen just as fast. When nominal growth comes down, nominal EPS (earnings per share) growth drops as well. But this is countered by the cost of equity coming down, whichflows into financial assets, keeping valuations high. If cost of equity is low then Price Earnings ratio (PE) will not fall by much. The stickyflow into equities from SIPs, insurance, etc. is around 2,400 crore. There is a macro-economic context to these flows. Lower inflation means lower returns from fixed income products and lower currency depreciation, which means lower gold prices. Other physical assets are not generating historical returns either.

How should equity investors approach investing in equity market in today’s scenario?

The best approach to building wealth is to have a disciplined asset allocation that is counter cyclical. It is important for investors to rationalize return expectations. If you look at stocks bottom-up, it’s not easy to find ones that will be multi-baggers in a 2-3-year time frame, unlike the situation in 2009 or 2013. Neither is the scenario like it was in 2010 or the beginning of 2018, when things looked too frothy. In the last seven years, the Nifty earning compound annual growth rate (CAGR) has been 5-6%. A combination of low interest and an earnings cycle coming out of a long bearish trend means that you need not be bearish even if the PE is 10-20% higher. Different sectors will recover at different points over time. But for an investor, equity allocation should not be sector-focused but diversified.

Is the time right to invest in the mid- and small-cap segments of the equity markets?

The large-cap segment underwent a catch-up phase in 2018, to make up for the period between 2014 and 2017, when the mid- and small-cap segments had outperformed. The mid- and small-cap segments are not significantly distressed. We had capped lump sum investments in our small-cap fund in January 2018, and we haven’t opened it up yet. Some consumer-facing sectors in these segments have done well, so valuations are higher, while others that are asset heavy or cyclical in nature have not done much in in 4-5 years; so valuations are not high there. But on a 2-3-year basis, both the indices will broadly give the same return.

The bigger debate today is value versus growth. Any period of time when the economy slows down, growth stocks like technology stocks worldwide, and consumer sales and retail banking in India since 2010-11, tend to outperform, because they grow irrespective of the macros. This makes them more expensive than cyclical stocks which don’t see earning momentum. The decision to make is whether you want to take a call on the economy picking up a bit and buy intobeaten down sectors, where the demand has been weak or the supply has not been weak enough, to give them pricing power. The reward is conditional on growth reviving.That is not to say that we are not in the first bucket. The best balance sheet is still with the household in India and it is under-penetrated in terms of goods and credit. Consumption stocks will do well in absolute terms. Whether the valuation is high or not is a different question.