Some random thoughts

 The preamble to the Constitution of India declares India to be a sovereign socialist (emphasis added) secular democratic republic. The Supreme Court of India has held in Kesavananda Bharati vs State of Kerala Case (1973) and S R Bommai vs Union of India (1994), that the Preamble is an integral part of the Constitution. The Court held that the Preamble is not the supreme power or source of any restriction or prohibition but it plays an important role in the interpretation of statutes and provisions of the Constitution.

The question is “whether, in the normal course, every legislation, policy, programs and practices framed and pursued by the Parliament and Executive ought to be congruent with the Preamble, to be constitutionally legitimate? Is it unreasonable to expect that the legislature and policymakers put all legislation, policies, programs and practices framed by them through the test of this declaration, before these are implemented? To clarify, these questions need to be examined considering the present status of the Constitutional mandate, without going into to the merits of this declaration in the Preamble.

As an investor, I find it relevant to examine the suitability of investments in public sector enterprises in light of the constitutional mandate for the government to be ‘socialist”.

From various sources, I gather the following three objectives of setting up commercial public sector enterprises in India.

·         Provide basic goods and services to the citizens; provide employment opportunities; and promote economic development.

·         Play a key role in the development of infrastructure; promote exports and encourage private investment.

·         Protect the interests of weaker sections of society.

Profiteering is definitely not one of the key objectives of the public sector enterprises. So, when we read the following headlines in newspapers, questions about sustainability, desirability and constitutional ethics are natural to arise.

“At Rs 16,884 crore, SBI posts highest quarterly profit”

“Minimum Balance Penalties: Public Sector Banks Collect Around Rs 8,500 Crore in Five Years”

“Railways earned ₹1,230 crore from cancelled waiting list tickets in span of 3 years”

The objective of the nationalization of banks in 1970 was “to control the heights of the economy and to meet progressively, and serve better, the needs of development of the economy in conformity with national policy and objectives”. To my knowledge it has not been changed so far. Making profit from poor depositors who are unable to maintain minimum deposit is ultra vires the primary objective of bank nationalization. Similarly, charging a fee on automatic cancellation of waitlisted rail tickets is untenable.

If the government wants the public sector enterprises to be as profitable as their private sector counterparts, it should either privatize these enterprises or make necessary changes in the constitution and other related legislations clearly outlining the change in the legislative intent. Till this happens, I shall continue to avoid investing in PSEs.

CPI – do not get excited as yet

The Consumer Price Index (CPI) inflation for the month of July came at 3.54%, the lowest in five years and below the RBI tolerance band of 4-6%. This has excited some market participants as their hopes of an earlier rate cut by RBI have been rekindled.

I am however not sensing any imminent rate cut, for the following simple reasons.

(i)      The headline inflation number is significantly impacted by a strong base effect, as the CPI inflation in the base period (July 2023) was 7.4%. Sequentially, the inflation has risen 1.42% MoM in July 2024 against 1.33% MoM rise in June 2024. As of now, there is no indication of a sustainable decline in inflation trajectory.

(ii)     Core CPI inflation in July 2024 was 3.3% against 3.1% in the preceding two months. This is the first rise in core CPI after twelve months of consistent decline.

(iii)   Food inflation remained sticky, rising 2.47% in July 2024 after a 2.69% rise in June 2024. Vegetable prices were higher by 14% MoM in July 2024. It is pertinent to recall that the RBI governor laid significant emphasis on food inflation in his bi-monthly monetary policy statement.

The governor stated, “our target is the headline inflation wherein food inflation has a weight of about 46 per cent. With this high share of food in the consumption basket, food inflation pressures cannot be ignored. Further, the public at large understands inflation more in terms of food inflation than the other components of headline inflation. Therefore, we cannot and should not become complacent merely because core inflation has fallen considerably”.

He further added, “high food inflation adversely affects household inflation expectations, which have a significant impact on future trajectory of inflation. Household inflation expectations, after witnessing a moderating trend between May 2022 and September 2023, have edged up on the back of high food inflation since November 2023.35 Persistently high food inflation and unanchored inflation expectations – if they materialise – could lead to spillovers to core inflation through pick-up in wages on cost-of-living considerations. This, in turn, could be passed on by firms in the form of higher prices for services as well as goods, especially in a scenario of strong aggregate demand. Third, these behavioural changes can then result in overall inflation becoming sticky, even after food inflation recedes.”

He categorically admitted that “The MPC may look through high food inflation if it is transitory; but in an environment of persisting high food inflation, as we are experiencing now, the MPC cannot afford to do so. It has to remain vigilant to prevent spillovers or second round effects from persistent food inflation and preserve the gains made so far in monetary policy credibility.”

(iv)    As per the latest Households’ Inflation Expectation Survey (August 2024), A larger share of households expects higher general prices and inflation as compared to the previous survey round. Households’ median perception of current inflation rose by 20bps to 8.2% in the latest survey round; their inflation expectations for the three months and one year ahead periods also increased by 20bps each.

The market trends in August indicate that vegetable prices have recorded material rise in the month of August also due to crop damage by excess rains and logistic issues. It is therefor likely that August food inflation may come even higher. Expecting any rate cut on 9^th October may therefore not be reasonable; unless the US Fed cuts dramatically in September, raising the
specter of recession.

 

Manage the change; not fear it

In the past few months, the RBI governor has repeatedly spoken about “diversion” of household money from the bank deposits to stock markets. He has in particular mentioned rising household (retail) participation in the derivative trading, as a cause of concern for the financial stability. The securities market regulator (SEBI) has also cited high retail participation in the derivative segment as a systemic risk to the financial markets.

For a common man like me, it is difficult to understand how option buying by retail investors possess any challenge or risk to the financial system and markets.

My understanding of the securities markets is very elementary. Whatever little I understand, it works like this.

Registered and/or authorized market intermediaries are not allowed to receive from or give cash to their respective clients. This implies that all legal transactions in the stock markets are settled through the banking system.

When someone buys a security, there is necessarily a counterpart seller. The seller could be an existing owner of thy security or the company that is issuing new shares. The transaction is mandatorily settled through the banking system. Which means, the money used for transacting in the securities market never leaves the banking system. It is reasonable to say that the stock market transactions do not adversely affect the banking system liquidity.

Moreover, the money used for the securities market transactions is mostly held in low-cost savings or current accounts, enabling banks to earn higher margins. In case of derivative trades most of the money involved is held in the current accounts, as margin money or otherwise, helping the banking system most.

The problem is that the money in savings and current accounts (demand deposits) can be withdrawn anytime. Therefore, the banks cannot use all of this to give longer duration loans, lest it will cause an asset liability mismatch (ALM) in their books. This is what the governor Das hinted in his statement on monetary policy last week.

The solution to this problem may not lie in discouraging households to invest/trade in securities. The solution should be found in reviewing the banking regulations and practices to factor in the structural shift in household finances. For example, (i) banks may be told to offer competitive rates on deposits; (ii) saving deposit rates may be linked to weighted average call market rates and revised quarterly; (iii) rules for maintaining reserves by banks may be reformed. E.g., the RBI may consider prescribing lower reserve ratios for the current account balances of market intermediaries like stocks exchanges, clearing corporations, stock brokers, mutual funds, PMS, AIF, etc.; (iv) create specialized development institutions for project lending, which can raise money at competitive rates from local and overseas markets; and (v) develop a vibrant retail debt market to enable companies to raise money at market driven rates for projects.

Insofar as derivative trading by retail traders is concerned, the regulators should be more concerned about systemic risk management and not get into the morality of the practice. Hike margins and prevent market manipulation. Creating additional entry barriers (higher contract size etc.) will only push the traders towards unauthorized/illegal markets, that will not only cause them bigger losses but also take the cash out of the banking system.

Is a bear market setting in?

“Bear market” is perhaps one of the most prominent phrases being used on social media, in the context of global stock markets. Several of the major global indices are down over 10% from their recent high levels. Japan (Nikkei 225 -17%), US Tech (NASDAQ -12%), France (CAC40 -14%), China/Hong Kong (Hang Seng -14%), and South Korea (KOSPI -11%) are some of the most talked about markets on social media.

The Indian indices have not fallen materially from their recent highs. The benchmark Nifty is barely down three odd percent from the highs it recorded last week. Obviously, in India, the household investors are not yet worrying about the possibilities of a bear market, as for them the sky is still bright blue with few scattered cumulus clouds. Nonetheless, this phrase is gaining frequency in the personal discussions.

From my various interactions with the market participants, I gather that many of them may have a different, and often misplaced, understanding of the concept of bear market.

The most widely accepted explanation of a bear market is “a 20% or more decline in the benchmark index for a sustained period of time.” This decline in market indices is usually accompanied by growth pessimism and change in the asset allocation in favor of less risky assets. Capital preservation takes precedence over wealth maximization, as the primary investment objective.

The key elements of a bear market, therefore, are growth pessimism; and wider asset allocation shifts towards less risky assets to preserve capital by sacrificing potential gains from equity. Fall in market indices is the most common consequence of a bear market. 20% fall in indices is just an indicative number based on empirical studies of previous bear markets. It is however not a precondition for a bear market.

Bear markets can, at times, last for many years. Japanese equities witnessed the longest bear market running for more than two decades. Chinese equities are in a bear market for over 15 years for now. Bear market in the US tech stock lasted for almost a decade after the bursting of the dotcom bubble in the year 2000. In India, bear markets have usually not lasted for more than 3 years.

It is important to understand that ‘bear market’ is a fundamental concept. It is not related to technical analysis or trend analysis of the market. For technical analysts the markets are defined on the basis of the current trend in the indices. These trends (uptrend, downtrend, sideways) can change in a couple of days. At times these trends could be incongruent to the fundamental trends, thereby causing irrationalities (extreme buoyancy or pessimism) in the markets. These irrational market conditions should normally be not considered bull or bear markets.

Where do we stand?

In my view, in strict technical terms the current uptrend in Nifty50 that started from October-November 2023 has terminated earlier this week. Nifty may move in a 5 +/- band (23100-25500) for a few weeks before a new trend emerges. At present the probability of a downtrend is higher than the uptrend. In case of a downtrend Nifty50 may yield 80% to 100% of the upmove from 19080 level. In case of extreme pessimism, Nifty50 may even fall to 17800 level for a few days. This downtrend may last anywhere between 9 to 17 months.

Fundamentally, currently there is no evidence of growth pessimism, or asset allocation shift. In fact, the growth estimates are getting revised upwards, earnings buoyancy has slowed down a bit buy still a long distance from material deceleration. Allocation to equities remains strong. I shall be closely watching these trends over the next 6 months for any indication of worsening, to bother about a bear market in Indian equities.

No escape!

The legendary Warren Buffet has been on an equity portfolio selling spree in recent weeks. His fund, Berkshire Hathaway, has reportedly raised over US$275bn in cash; which is over 20% of total assets under management. His selling in the stocks of Apple Inc and Bank of America have been reported the most. Apparently, either his team is not comfortable with the present market conditions (valuation, growth, macro, geopolitics etc.) or believes that they can get much better buying opportunities in near to short term, or both. They may be looking for better buying opportunities in terms of better stocks or better price points in the same stocks.

It may be pertinent to note that it is not Berkshire Hathaway alone. A number of reputable investors have taken note of the conspicuous warning signs flashing on billboards for the past few months in particular.

Yen carry-trade

Hike in the policy rates by the Bank of Japan (BoJ) and strengthening of Japan is perhaps the most talked about event in the market space. Young traders in their twenties, with one or two years of trading experience are confidently talking about the disastrous impact unwinding of “JPY carry trade” will have on the global markets, almost trivializing this important event.

World War III

The older and more mature investors on the other hand are preferring to discuss the impending World War (WWIII). They are worrying that (i) the countries producing about 60% of the global energy resources may be on the one side of this war; (ii) most NATO members may not be fully committed to the cause, due to economic and demographic constraints; (iii) many western countries may implode due to a strong internal resistance to the war at Israel’s behest; and last but most important (iv) the war this time will involve the fragile and totally intertwined digital world, which could be more debilitating.

US recession

A sharp rise in unemployment indicators; a marked slow-down in real estate market; the Federal Reserve hinting a rate cut on the table and the markets extrapolating it to full one percentage point cut in 2024 leading to sharp fall in bond yields; hedge funds raising their short position in commodities to the highest in over a decade; etc. have triggered a wave of concerns over sustainability of stock market euphoria in the US; especially the high valuations for a few technology stocks that have been at the core of the US equity bull market in the Post-Covid period.

Is a 2008 like collapse coming

In my view, there are genuine concerns for the market at present. However, the present narrative, which is revolving around the yield curves (and whether the central bankers are running much behind the curve) and geopolitics, may not be enough to cause a market collapse like 2008-09. We may need something bigger to break.

My worries

Notwithstanding, my worries are as follows:

·         Unlike 2008-09, the global economic growth is not strong. China and India were growing 8-11% 15 years ago. Now both are struggling in the 5-7% band; more so China.

·         In 2008-2013 the peripheral Europe faced problems that caused a lot of volatility and concerns in the global markets. A US$32bn bailout of Greece made headlines for many weeks. Sovereign debts Portugal, Iceland, Greece and Spain (PIGS) totalling less than US$120bn were primary talks of the table. But this time it is in Europe. Germany, France, and the UK are facing problems – economic, demographic, social and political. The primary talk of the table now is US$35trn debt of the US, ~US$10 trillion debt of Japan and mammoth but unknown amount of bad loans in the Chinese banking system.

·         In 2008-09, most countries had adequate financial leverage to stimulate their respective economies and mitigate the impact of the crisis. Today, not many global economies enjoy that kind of fiscal leverage. The recovery this time therefore could be a slow and long-drawn process.

·         2008-09 was more of a financial market crisis than an economic crisis. This time it might be an economic crisis driving the financial markets into a deep abyss. Moreover, the treasury bonds of many large global economies are technically junk (dipropionate to their respective GDP and debt servicing capabilities). Selling more of this to bail out struggling markets and economies may not be feasible.

·         A large number of developed and developing countries are facing internal social and political unrest. Besides, the mutual trust that characterized the globally coordinated action in 2008-09 may not be prevalent today. The efforts of various global powers may be focused on sinking the larger ships rather than bailing out the smaller boats.

Insofar as India is concerned, there are not much macro concerns at present; though the fiscal leverage to provide meaningful stimulus in case of a wider crisis may be limited. On the market valuation side, few pockets are clearly in bubble territory and need to retrace a long way back to the realm of sanity. Otherwise, a large part of the market is fairly valued. Maybe a 10% correction would make it look attractive again.

Nonetheless, when a global tide comes, it will also take the Indian markets along. No escape from higher volatility and jittery trades.

Interesting time ahead, for sure!

Pause! see left, see right

 Last week the benchmark Nifty50 crossed the 25000 level for the first time ever. Statistically speaking, it’s just a number and does not mean much in the broader picture. Nonetheless, it is noteworthy in the current context, because this milestone was crossed amidst a flurry of news flow which calls for closer attention of investors.

BoJ rattled the markets by deepening commitment to normalization

First of all, the Bank of Japan hiked the policy rates by 15bps to 0.25%. Governor Kazuo Ueda committed that if the economy and prices move in line with our projection, we will continue to raise interest rates. BoJ does not see 0.5% as any key barrier when raising rates; clearly indicating that the shift in BoJ’s monetary policy is definite.

A steeper hike by the BoJ, than currently estimated, could present several short-term challenges for the global markets. A stronger yen on rising JGB yields could (i) adversely impact Japanese exports; (ii) worry the JPY borrowers who may have assumed a secularly weak JPY; (iii) affect Japanese flow of investments to other markets besides unwinding of JPY carry trade. Through a weaker JPY, Japan, along with China, has been one of the primary exporters of deflation to the western world, especially since the global financial crisis (GFC 2008-2009). With Japanese exports becoming dearer this could change.

Japanese equities are correcting sharply.

…so did the US Federal Reserve

The Federal Open Market Committee (FOMC) kept its key interest rate at 5.25% to 5.5%. Commenting on the decision, the Fed Chairman said, “unemployment has inched higher, while the path of inflation has come down significantly.” Chairman Powell described the current economy as both “historically unusual” and “completely different economy from a year ago.” He indicated that “The broad sense of the committee is that the economy is moving closer to the point at which it would be appropriate to reduce our policy rate”. The market is reading his statement as a strong signal for the beginning of an accelerated rate cut path commencing from Sep’24.

Immediately after Chairman Powell’s comments, the US bond yields fell sharply and market expectations rose from 0.25bps cut in 2024 to 75-100bps cut in 2024. Equities have been correcting for three weeks now, and the Tech benchmark NASDAQ has corrected over 10% from the July 2024 top.

A much below US unemployment data released last week is widely seen as a strong indicator for impending recession.

Chinese economy not responding to stimulus

China’s PMI data last week showed an unexpected contraction in the manufacturing sector. The widely followed Caixin PMI reading brought up concerns over a broader slowdown in the sector. Slowdown in Chinese economy despite multiple efforts to stimulate growth may not be a healthy sign for the global economy.

German economy shrank in 2Q2024

Germany, the eurozone's largest economy, unexpectedly shrank by 0.1% on a quarterly basis in the second quarter of 2024 against the expectations of a 0.1% increase. Investment in equipment and buildings dropped significantly as the industrial sector continued to be pressured by high interest rates. Growth for the entire European Union stood at 0.3% in the second quarter, maintaining the same pace as the first quarter.

The Employment Expectations Indicator (EEI) saw a significant drop (EU: -1.6 points to 98.7, euro area: -1.8 points to 97.8), falling below its long-term average for the first time since April 2021 in both regions.

India core sector growth at 20 months low

India's core sector growth eased to 20-month low of 4 percent in June, from 6.4 percent in the previous month, owing to a slowdown in five of eight industries and an unfavourable base. The first quarter growth was also lower at 5.7 percent compared with 6 percent in the first quarter of the previous year. Sequentially, the eight core industries contracted 3.1 percent.

These all may be seasonal trends and may not be indicative of a major problem for the economies of India and the world. The markets are trying to assimilate these trends by pausing a little. Investors may also be better off pausing a bit, in my view.

Government vs corporate sector

One thing that the prime minister Narendra Modi is well known for is his business friendliness. At the core of the famous Gujarat Model, that shot Mr. Modi to the national and international scene, was his claim of making Gujarat the most business-friendly state in India. He is also often accused by the opposition parties for unduly favoring the large corporate at the expense of micro and small enterprises and middle-class households.

In the past ten years, the policies followed by the PM Modi led central governments have stayed true to his reputation. For example—

·         The effective tax rates of the corporate sector have been reduced. This has resulted in the aggregate tax collection from individual taxpayers to rise higher than the tax paid by corporations.

·         It is widely believed that the demonetization of high value currency notes and the implementation of GST have also adversely affected the micro small businesses and favored the large business in the organized sector.

·         The schemes launched to incentivize the businesses to increase local manufacturing and exports, e.g., production linked incentive (PLI) scheme, also appear to be focused on medium and large enterprises.

·         The government has allowed the large domestic businesses to freely grow inorganically by acquiring smaller and medium sized businesses. Large global players are also encouraged to set up their local units and avail concessions. This budget also lowered the tax rates for the local businesses of the global companies.

·         The bankruptcy resolution process also allegedly favors large businesses subsuming the troubled small and medium businesses rather than making efforts for revival of the troubled business.

However, in recent months there are some indications that the government might be considering to reorient its policy direction. It might have something to do with the results of the recently concluded general election in which the performance of Mr. Modi’s party, the BJP, was much below expectations. But to me it mostly appears to be waning mutual trust between the government and the corporate sector.

The language used in the latest edition of the Economic Survey for the corporate sector indicates that all may not be well. For example, consider the following excerpts from the Economic Survey 2024.

·         Hiring not commensurate with the profit growth: In terms of financial performance, the corporate sector has never had it so good. Results of a sample of over 33,000 companies show that, in the three years between FY20 and FY23, the profit before taxes of the Indian corporate sector nearly quadrupled. Further, newspaper headlines told us that the corporate profits-to-GDP ratio rose to a 15-year high in FY24. BusinessLine reported, “The corporate profit for the Nifty-500 universe was up 30 per cent last fiscal to ₹14.11-lakh crore against ₹10.88 lakh crore in FY23. The nominal GDP grew 9.6 per cent y-o-y to ₹295-lakh crore (₹269-lakh crore)1”. Hiring and compensation growth hardly kept up with it. But it is in the interest of the companies to step up hiring and worker compensation.

·         Private sector capex lacking: The Union government cut taxes in September 2019 to facilitate capital formation. Has the corporate sector responded? Between FY19 and FY23, the cumulative growth in private sector non-financial Gross Fixed Capital Formation (GFCF) is 52% at current prices. During the same period, the cumulative growth in general government (which includes states) is 64%.

Private sector GFCF in machinery and equipment and intellectual property products has grown cumulatively by only 35% in the four years to FY23. Meanwhile, its GFCF in ‘Dwellings, other buildings and structures’ has increased by 105%. This is not a healthy mix. Second, the slow pace of investment in M&E and IP Products will delay India’s quest to raise the manufacturing share of GDP, delay the improvement in India’s manufacturing competitiveness, and create only a smaller number of higher-quality formal jobs than otherwise.

·         Low employment density of capex: In a recent article the Economist cites independent research that predicted a slow demise of India’s services exports over the next decade. While the boom in telecommunications and the rise of the internet facilitated business process outsourcing, the next wave of technological evolution might bring the curtains down on it. In this milieu, the corporate sector has a responsibility, as much to itself as it is to society, to think harder about ways AI will augment labour rather than displace workers. Hiring in the IT sector has slowed significantly in the last two years. We do not have a full picture of overall corporate hiring in the country on a regular basis. In any case, deploying capital-intensive and energy-intensive AI is probably one of the last things a growing, lower-middle-income economy needs.

…the enlightened self-interest of the Indian corporate sector, swimming in excess profits, to take its responsibility to create jobs seriously.

…another article4 in The Economist that hails the arrival of China as a superpower in science should be sufficient inspiration for the corporate sector and academia to get their act together on scientific research and development.

·         Nudge to banks: …just as corporate profits are booming, the net interest margin of Indian banks has risen to a multi-year high. It is a good thing. Profitable banks lend more. To sustain the good times, it is important not to forget the lessons of the last financial cycle downturn. The banking industry must aim to lengthen the gap between two NPA cycles. It should also resist the temptation to pursue short-term profits at the expense of the customer. Product misselling is too rampant to be dismissed as an aberration of a few overenthusiastic sales personnel.

·         On pushing unhealthy food and bad habits: Social media, screen time, sedentary habits, and unhealthy food are a lethal mix that can undermine public health and productivity and diminish India’s economic potential. The private sector’s contribution to this toxic mix of habits is substantial, and that is myopic. The emerging food consumption habits of Indians are not only unhealthy but also environmentally unsustainable.

·         Final word: The tripartite compact that this country needs to become a developed nation amidst emerging unprecedented global challenges is for governments to trust and let go, for the private sector to reciprocate the trust with long-term thinking and fair conduct and for the public to take responsibility for their finances and their physical and mental health.

It would be interesting to see how the situation evolves in the next five years. Whether the government changes policy direction to promote MSME and impose additional taxes, duties and conditions on the large corporations or the corporations obey the government dictate and compromise their profitability to generate new employment and do CSR activities.

The capex “nudge”

Capital expenditure (capex) has been one of the primary focus areas of the government in the past one decade. As per the Economic Survey 2024, “The focus of capex has been broad-based. Spending in sectors such as road transport and highways, railways, defense services, and telecommunications delivers higher and longer impetuses to growth by addressing logistical bottlenecks and expanding productive capacities. Government capex has also begun to crowd in private investment, as discussed earlier in this chapter. Additionally, the Government continues to disburse grants-in-aid for the creation of capital assets to the states, thereby incentivizing them to increase their productive spending.”

Accordingly, “capex” has emerged as an important driver of growth, as indicated in its rising share of nominal GDP. As per the provisional actual (PA) figures for the FY24, capex for FY24 stood at ₹9.5 lakh crore, an increase of 28.2 per cent on a YoY basis, and was 2.8 times the level of FY20.

However, despite the sharp rise in the government capex in building the enabling infrastructure and incentivizing enterprises, the private capex has not responded adequately. Lamenting the private entrepreneurs, the Economic Survey stated, “while it remains the government’s responsibility to facilitate the development of infrastructure and address logistical challenges, it is incumbent upon the private sector to take forward the momentum in capital formation on its own and in partnership with the Government. Between FY19 and FY23, the share of private non-financial corporations in overall GFCF increased only by 0.8 percentage points from 34.1 per cent to 34.9 per cent. This was mostly driven by their fast-increasing share in the additional stock of dwellings, other buildings and structures. Their share in addition to the capital stock in terms of machinery and equipment, started growing robustly only since FY22, a trend that needs to be sustained on the strength of their improving bottom-line and balance sheets in order to generate high-quality jobs.”

In the recently concluded general elections, lack of adequate job generation emerged as one of the key agenda points. The experts have held the prevalence of high unemployment rates amongst educated youth as one of the factors responsible for below par performance of the BJP.

Obviously, the government is concerned about the employment situation. The problem is that commitment to fiscal discipline and structural reform in the public sector may not permit the government to create many new employment opportunities in the public sector. The employment generation would thus be the responsibility of the private sector.

In the recent budget for FY25, the government announced some measures to encourage private enterprises to invest in building new manufacturing capacities and generate employment for the youth entering the job market. The budget adopts a carrot and stick approach for that. On one hand, it provides support for hiring more fresher employees and skill them, and on the other hand it makes outflow of funds from companies difficult. After dividends, now buybacks are also made tax inefficient. The idea seems to “encourage” companies to invest in growing their businesses and reward shareholders through share price appreciation only. Abolition of Angel Tax on startups is also a measure to encourage more new businesses to be set up and offer employment opportunities.

How much of these efforts will yield in terms of new employment and growth is to be seen, but the intent seems clear.

Did you plan success or were just lucky?

One of my close friends bought a plot of land in the outskirts of the city of Dehradun in Uttarakhand, a decade ago. The reason, he outlined, for this investment was that Dehradun is a good place to retire. It is peaceful & clean and has a much lower cost of living. Considering the rising level of pollution (air, noise and water) in larger cities, people would want to move to such places in future. The property prices would therefore appreciate considerably.

After a decade, the price of his plot is up by some 300%. He is happy that he made a very good investment decision.

When I pointed out to him that Dehradun is no longer the peaceful, clean and cheap city it used to be ten years ago. Therefore, his investment premise has mostly failed. Besides, the land prices in many areas of the NCR have risen equal to or more than Dehradun in the past one decade.

The point to ponder over is if you earn a good return on your investment in spite of your assumptions behind making such investment proving to be wrong or inadequate – would you consider yourself to be an astute investor, even eligible to advise others, or just plain lucky!

To emphasize my point further, let me give you some more pertinent examples.

In December of 2023, many investment advisors advised their clients to invest in long duration bond funds. The primary premise underlying their advice was that the US Fed shall start cutting rates from February and the RBI shall follow the suit.

However, seven months later, neither the US Fed nor RBI have cut rates. The visibility of a material rate cut in 2024 has diminished considerably. The US benchmark 10yr yields are higher by 15bps YTD. Regardless, the benchmark yields in India are lower by 20bps. Long duration bond funds have, on average, yielded a very good return of ~7% YTD.

You tell me, if the investors who invested money in long duration bonds were smart or plain lucky?

Extrapolating this to equities, at the beginning of the year 2024, most brokerages projected an earnings growth of 17-20% for FY25-FY26. They expected buoyancy in capex, especially private capex. Massive growth was projected for the sectors like Railways, Defense, Power, Banks and Construction (especially roads). IT Services was forecasted to be the worst sector for 2024, in terms of earnings growth. Commensurate with these projections, ambitious price targets were set for industrials and infra builders.

After six months, the actual performance earnings and order flows are at divergence from the analysts’ projections. The 300 odd companies that have declared results for the 1QFY25 so far, have reported an average profit growth of less than 5% and sales growth of ~10%. IT Services companies have performed reasonably well. New project awards for roads and other infrastructure projects are much below projections. Power, Defense and railways sector companies have reported below par results. The Economic Survey has expressed concern over the private sector’s muted response to the government incentives and not doing enough capex in manufacturing capacities. Regardless, the stocks of these companies have recorded stupendous gains.

One defense sector fund has yielded return in excess of 115% in the past one year. My point again is whether these investors are plain lucky to have earned good return on their investments or they planned their success?

Also, the advisors, fund managers and analysts who made wrong assumptions but nonetheless performed well on returns deserve the credit for their performance or need to be questioned for their poor analysis?

In my view, Luck cannot be the primary factor in an investment plan. A good investment plan shall focus more on the process, fundamentals and accuracy of the assumptions rather than the price action, in the near term.

Remember, when the “experts” run out of luck, they would hide behind the excuse of “mean reversion” for their poor performance. As an investor you may not have that luxury.

The morning after

The union budget for the fiscal year 2024-2025 has been read, analyzed, criticized, and apparently brushed aside by the markets. Changes in the taxation of capital gains; changes in the custom duty and capital gain tax structure for gold; and higher rate of STT on derivative transactions are three points that have attracted the maximum attention, especially from the market participants.

I had posted my first impression of the Union Budget FY25 on Tuesday. On a second reading of the budget documents and listening to the views of a variety of experts, I have gathered some more inputs that I would like to share with the readers.

Impact of capital gain tax changes on equity markets

The long-term capital gain tax (LTCG) on sale of listed shares has been increased from 10% to 12.5% and the short-term capital gain tax (STCG) has been increased from 15% to 20%. The market reacted negatively to the announcement initially. However, all the losses were recouped within an hour. This has surprised many market participants who believed that any hike in capital gain tax would be detrimental for the markets.

My thoughts on this are as follows:

(a)   Tax is a function of actual profit gained or loss incurred by an investor. Stock price of a stock is a function of the demand and supply of such stock at a given point in time. Demand and supply in turn are determined by the future price expectations. If a larger number of buyers expect the stock price to rise in future, the demand will stay higher, and vice versa. Thus, if the "return expectations" of investors stay high, stock prices may not correct regardless of the cost of transaction and/or taxation of gains. The market correction may need a bigger reset for a meaningful correction. Tax or STT alone would not do much.

(b)   The capital gain tax structure has not only been simplified, on an average, the effective rates of taxation may be actually lower for many investors. For example, tax rates for STCG on listed bonds, Equity FoF, Gold/Silver ETF, have been reduced and holding periods are also aligned with listed shares. Similarly, tax rates for LTCG on Equity FoF, Overseas FoF, Gold/Silver FoF, Gold Funds, physical gold, unlisted stocks and foreign equity have been materially reduced.

(c)   Contrary to first impression, the budget may be positive for the real estate sector. The effective LTCG on sale of properties may be lower, despite lack of indexation benefit, in a majority of cases. Besides, the likely reduction in stamp duty may benefit the buyers.

(d)   By bringing taxation of listed bonds at par with equities, while keeping bond funds taxable at a much higher rate, the government wants to kick start the growth of the retail debt market, especially after inclusion of Indian government bonds in the JP Morgan bond index.

Gold

The finance minister has cut effective import duty on gold from 15% to 6% in this budget. Besides, the capital gains tax on physical gold, gold funds and gold/silver ETFs has been reduced materially.

These proposals have baffled my market participants. They have argued that this may lead to undue rise in import of gold, this adversely affecting the trade balance. Secondly, bringing LTCG taxation of gold at par with equities and bonds is against the spirit of financialization of domestic savings. It is pertinent to note that the NDA government has strived to financialize gold holdings through Sovereign Gold Bonds and other measures in the past 8 years.

In my view, there could be three reasons behind the proposal to cut tax and duties on gold.

(a)   RBI has been the largest importer of gold in India for the past couple of years. It is likely that RBI wants to further enhance its gold holdings, like the central banks of China and Russia, amidst rising global uncertainties over USD supremacy. Lower duties may help RBI to import gold cheaper.

(b)   The first series of SGBs is coming up for redemption next month. The government wants to redeem these bonds at a 9-10% lower price.

(c)   The policy makers have recently raised the issue of “excessive financialization” of the Indian economy. For example, the latest Economic Survey highlighted, “the financial sector should expand at a pace that is in lockstep with economic growth. In particular, India can ill-afford the economy's over-financing at its current development stage.” Cheaper gold prices may be an effort to set the clock back.

STT

The budget proposes to increase the securities transaction tax on sale of an option in securities from 0.0625% to 0.1% of the option premium, and on sale of futures in securities from 0.0125 per cent to 0.02 per cent of the price at which such “futures” are traded. This is an effective hike of 60%.

This is obviously supposed to act as a deterrent to excessive speculation in derivative trades by retail investors. The finance minister, the SEBI Chairperson and other policymakers have categorically expressed their displeasure over the rising retail participation in the derivative trading.

It is pertinent to note that as per a study conducted by NSE/SEBI over 90% retail traders lose money in their derivative trades.

It is interesting to note that the finance minister has assumed a ~16% rise in STT collection in her budget calculations. This implies that the government does not believe any material reduction in trading volumes at stock exchanges.

Besides, the hike in STT may not serve its stated purpose, as the retail traders treat option trades as lottery tickets. A small absolute hike in transaction cost may not deter them from trying their luck. It is the high frequency traders (HFT or Algo driven traders) who will be affected the most. If this affects their volumes, it may actually have detrimental impact on the entire market. For example, some of the HFTs may shift their base to overseas; the liquidity may diminish materially affecting the returns on arbitrage funds and hedging function.