Budget and Markets

Ms Nirmala Sitaraman had presented her budget yesterday. The details of the Budget are all over the place. We will focus on the impact of the budget on the economy with special emphasis on stock markets.

The Story so far:

Over the last 5 years, these were the salient features and characteristics of our economy.

1. Low Inflation

Inflation’s back bone was broken due to increase in agri productivity as well as dismantling of supply cartels. Inflation hit a new low of 2.5% in last financial year.

2. Reducing Interest rate

The headline repo rate was reduced by a huge 250 BPS over the last 5 years. However, the prime lending rate, the rate at which we borrow has reduced only by 125 BPS. Monetary policy transmission was hampered by the pathetic state of the banks, a legacy left behind by earlier regimes as confessed by ex RBI Governor yesterday.

3. Moderate Growth

Capacity utilization in Economy was low. It oscillated between 70-80 % over the last 5 years. Low capacity utilization was a result of reckless expansion earlier. So, no fresh investments happened. Consumption was the sole driver of the economy. Both discretionary and non-discretionary consumption chugged along very well.

4. Government Focus

Government focus over the last 5 years was on increasing the tax revenues. Direct taxes alone almost doubled over the last 5 years with increase in tax base. And there was a windfall in Indirect taxes. Almost 8 lakh crore incremental tax was collected on excise duty on crude. Government also recapitalized the PSU banks to a larger extent. Demonetization and GST too happened. As private investment was not happening, public investment in infrastructure happened. As a result, we grew at 7% real GDP rate and experienced 3.5% inflation translating to a nominal GDP growth of 10-11%. The stock market which broadly reflects this nominal growth in GDP delivered a 60% return from 24300 in May 2014 and touched 39500 on the day Modi got re-elected.

This is the story so far.

What Next?

Consumption was the engine which was driving the economy. It grew at a faster pace over the last decade. Higher taxes in Government hand means less money in the hands of the consumer. Thanks to this high base of consumption growth and lesser money in end consumer’s hands, consumption has slowed down a bit now. Amidst this background, what was expected from Nirmala Sitaraman was a small stimulus to bring back this consumption engine back on track. However, from the contours of the budget, one can infer that Government is focused on rescuing the PSU banks and bring them back to shape as early as possible and maintain fiscal discipline. Once the banks are back in shape, there could be rapid transmission of the rate cuts, which in turn will boost consumption and take it back to higher trajectory. Government is committed to keep inflation under control. This is evident from the mild increase in farm gate price of agri produce by 2-3%, a day before the budget.

Government also made it clear that it is sticking to fiscal deficit target of 3.3%. Extrapolating all these, one can infer, that over the next few quarters,

1. Inflation will be lower, say 3-4%
2. Real GDP growth will hover around 6%
3. Currency will be in 67-71 range
4. Fiscal Deficit targets will be achieved.

These are the broad messages conveyed in the budget. From these messages, one can come to a conclusion that RBI has enough room to cut the repo rate by another 75-100 BPS over the next 12 months.

‘Nudge’ was one of the terms used by the minister often. One can expect the minister to nudge the banks to cut rates and pass on the cuts at a faster pace over a period of time. Once these cuts happen, real GDP growth will get boosted to 7.5% from current 6%. This is the game plan of the govt which one can make out from the speeches of the Minister, Niti Aayog and CEA.

In the base case, where there is no nudge and fiscal stimulus, one can expect 9% nominal GDP growth over the next 5 years. 9% nominal GDP will translate to a Sensex level of 60000 at the end of 5 years In case there is nudge and stimulus at an appropriate time, you can expect another 2% growth in nominal GDP which may take up the Index by another 10 to 15%.

What will happen in the shorter run?

Markets corrected yesterday on account of the following reasons.

1. Tax of super rich increased to 42%
2. Tax benefits in buy backs withdrawn
3. Mandatory public float increased to 35% from current 25%.

All the above 3 will have temporary negative impact on Stock market. The first one may lead to drop in inflows, the second one will increase the tax on buy backs, the third one may lead to supply of more stock. There is no roadmap for the third one. Once a roadmap is given, market will take it in its stride and move on. The buyback tax will actually be beneficial to minority investors as Dividends will be favored over buy backs going forward. Dividends are relatively stable and cash flows are assured unlike in buy backs.

Other Impacts

1. NBFC Crisis

GoI has extended a special facility for banks to refinance NBFC in trouble like, DHFL, IBulls. This will lead to resolution of NBFC crisis after a gap of 10 months.

2. EV Subsidies

Government has allowed a deduction of interest to the tune of 1.5 lakh for EV vehicles bought on credit. Details of the policies are awaited. The impact of this on Auto scrips will be studied in detail.

Sovereign Borrowings

Govt has made it clear that it will borrow abroad as External Borrowing to GDP ratio is very low and reduce its borrowings domestically in the Budget. Borrowing abroad means lesser crowding out in Indian Bond space translating to lower interest rates. However, the Govt s taking a currency risk here. Hence, the finance minister has harped on fiscal discipline to keep the currency stable. Govt is sure about keeping currency in a tight 67-71 range and is hoping weaker dollar will come to it’s rescue as well.

Conclusion

On the whole it was a SOP less, a bit taxing budget. The intentions of the Government is clear. 1. Low inflation 2. Stable currency. 3. Reducing interest rates through Nudge and overseas borrowing 4. Moderate Growth. Under these conditions, investors can expect 9-10 % growth from the stock market, which is almost the double of what one might get in fixed deposits and 2.5 times higher than inflation as long as Govt follows this path.

Higher growths from stock market are possible, once the gears shift from moderate growth to higher growth, which we think will happen in another 12-18 months once the interest rates come down and Govt resorts to tax cuts or other targeted fiscal stimulus.

In the shorter run, markets will be largely range bound say 37000-41000. Huge flows to emerging markets from developed markets are waiting on the side-line as FED has clearly moved to monetary easing again on account of recession fears and in a bid to avoid recession and sustain high growth in US. This augurs well for liquidity in Indian equity space thus limiting downside.

Investors in Indian Equity will be benefitted in the longer run. There should be no scope for disappointment if one buys with a 5-year time horizon and a Sensex target of 60000 and if growth accelerates to 7.5%, we may go back to the old higher 12-14% CAGR.

Our philosophy of sticking to quality names will continue. Sectoral exposures will be monitored closely and weights will increase or decrease based on number of variables which change dynamically.

Investors through SIP route can continue to invest to take best advantage of short - term volatility and avoid the risk of timing the market. Lumpsum Investments during sharp 5-10% corrective phases will go a long way in boosting CAGR meaningfully. Big corrections in markets are ruled out unless US slips into recession fast or a war breaking out and we don’t foresee a recession until US presidential elections are over which is Nov 2020.

Regards, R. Subash