The consensus growth estimates points to a moderate recovery in economic
growth in 2014. From sub 5% level in FY14, real GDP growth is expected to be in
the range of 5 to 5.5%.
In our view, much more than the below potential quantity of the
growth, it is qualitative aspects of the growth which are matter of serious concern.
The structure of the growth as partly manifested in direction and constitution
of growth remains weak and is expected to remain so for better part of 2014.
The recent RBI policy statement succinctly explained this aspect
as follows
“the pick-up in real GDP growth in Q2 of 2013-14, albeit modest,
was driven largely by robust growth of agricultural activity, supported by an
improvement in net exports. However, the weakness in industrial activity
persisting into Q3, still lackluster lead indicators of services and subdued
domestic consumption demand suggest continuing headwinds to growth. Tightening
government spending in Q4 to meet budget projections will add to these
headwinds. In this context, the revival of stalled investment, especially in
the projects cleared by the Cabinet Committee on Investment, will be critical”.
The current estimates of the modest recovery in growth are
overwhelmingly dependent on the steady global growth environment and nature’s
largesse in the form of favorable weather conditions.
In our view, for a structural improvement in the economy we need
our manufacturing and construction sectors to grow at a much faster rate.
Expected industrial growth of ~3% and service sector growth of ~6% cannot and
will not lead to any material improvement in the structural weaknesses of the
economy, e.g., high level of unemployment/underemployment, poor physical and
social infrastructure, low tax to GDP ratio, lower social sector spending,
especially education and health, declining private sector investment,
persistent high burden of entitlements on the fiscal, etc.
All the indicators are highlighting that the modest recovery in
growth will probably come from micro adjustments, like correction in inventory
levels, higher capacity utilization, higher exports, and improvement in project
execution etc.
This will not lead to any material improvement in employment
conditions. On the contrary there are sufficient indications that many
employers may actually further rationalize their work force to protect their
margins. Historically, the work force rationalization in India, especially in
manufacturing and construction sectors, has been more permanent in nature.
Private consumption growth may therefore
remain constrained during 2014 also.
The investment environment is not likely to improve in any
substantive measures. As with economic growth still much below potential, the
output gap will continue to remain high; persistent high inflation will keep
rates at elevated level; producers are not likely to gain much pricing power as
the demand domestic environment continues to remain weak; balance stress will
likely rise further unless lending rates come down materially.
In our view, it is pertinent to keep a watch on the periodic
macro data. But it is often not appropriate to let these data lead a
substantial change in the direction of investment strategy. A profitable
investment strategy, in our view, needs to be based on medium to long term
growth magnitude and direction.
Insofar as the current medium to long term growth trend in India
is concerned, in our view, the trend growth decline that began from FY09 may
not bottom before end of FY16, even if we accept the rather bullish estimates
of government agencies.
The resumption of up move in medium term trend growth would only
lead to a stable growth environment in the country and sustainable gain in
equity prices, because a sustained growth over medium term would only-
(a)
bridge the output gap and create demand for
investment;
(b)
lead to creation of productive employment
opportunities;
(c)
provide fiscal leverage to government for
increasing social sector spending and thus increasing the sustainability of
growth;
(d)
lead to stability in prices as more capacities
are added;
(e)
lead to sustainable monetary easing as fiscal condition
improves; and
(f)
lead to rise in private income and savings, thus
providing impetus to private consumption;
In our view, the potential growth of India under current
circumstances is not more than 6%. Growing at 5-6% in the current direction
would not lead to enough employment opportunities and strong consumption story
will not remain sustainable. Agriculture, as we have seen in past couple of
years is still “God” driven. Basing an investment strategy on God’s alone is
not advisable in our view.
Both WPI and CPI have shown tendency to rise in recent past. It is
more likely to exacerbate in 1H2014 as high base effect wanes, INR vs. USD
bottoms out at elevated 60-61/USD levels; more administrative prices move
closure to market price and wage inflation rises at faster pace led by rise in
rural and public sector wages.
In our view therefore the current stagflation like conditions
will persist for better part of 2014 with inflationary expectation persisting
at higher level.
However, the lagged impact of RBI’s measures and further
tightening, lack of pricing power in manufacturing sector and high output gap
due to lower capacity utilization and somewhat lower food inflation would keep
the inflation under check from running away in unmanageable territory.
The interesting factor to watch would be cereal inflation post implementation
of National Food Security Act. In our view, the Food Security Bill, if
implemented in right earnest could transform Indian agriculture from a mere
self sustenance activity into a truly commercial activity thereby marking a
meaningful shift of small and marginal farmers from cereal to cash crops or
even non-agriculture activity.
With real yields to household persisting in negative
territory household savings may deteriorate further. This may keep hurting the
growth by further widening the savings – investment gap.
In our view, higher risk, higher demand and lower supply
should keep interest rates in Indian context relatively higher for next couple
of years at the least.
Interest rates or cost/reward for capital is primarily a
function of demand and supply of capital. The default risk associated with the
demand for capital plays an important role in determination of rates. The
benchmark or policy rates established by the regulators or central bankers
theoretically play a critical role in determination of interest rate structure
in an economy under normal economic conditions. However, in extreme cases
policy rates may fail to transmit to the ultimate provider or user of capital.
Indian economy presently is passing through such extreme
conditions. Therefore, policy rates established by RBI are not as effective as
these should be under normal circumstances. The reason for this failure in
transmitting the policy rates are varied and multiple. For example:
(a) The default risk
and therefore credit cost for banks has risen substantially in this period.
Most of the credit demand is for re-financing of existing stressed loans or
working capital loans. Thus increasing the risk premium.
(b) Fiscal profligacy
has kept demand for government borrowing higher whereas higher inflation and
higher administered small savings rates have led to lower deposits growth
(supply of funds).
(c) Precarious BoP
conditions have probably prevented the regulator from aggressively enforcing
transmission, as lower rate could impact inflow of much needed foreign capital.
This read with (a) firming yields globally (b) persisting higher
inflationary expectations and (c) constant need to defend INR by augmenting
reserves through higher flows – implies that we may likely see the rates
persisting at elevated level during 2014 also.
Benchmark 10yr yields currently at ~8.75% are therefore not
likely to come down in any significant proportion next year. For all, these may
actually firm up a little during later part of the year, if US Federal Reserve
indeed indicates prospects of some tightening from 2015 onwards. Moreover, in
recent times currency movement has become a key factor in determination of
rates. With Fed already in “taper mode’, the tighter liquidity may potentially
reverse the normalization of yield curve in 2Q2014.
The Indian government and RBI successfully averted a disaster
last summer by stemming the slide in INR by using some emergency measures.
Keeping public sector oil marketing companies out of forex market for some
time, attracting over $32bn through a temporary swap window, and most
importantly curbing gold imports through official channels were the key
measures taken.
Delay in QE tapering by Fed, better export demand due to better
economic conditions & weaker INR, fall in fuel consumption due to higher
prices, and fall in non-fuel imports due to poor domestic demand conditions
also helped the government’s endeavor.
Consequently, the CAD conditions look much healthier as compared
to a quarter ago. INR is also stable around 61-62/USD level.
In our view, the stability in INR and improvement in CAD is
welcome; even though there is little evidence to suggest any structural
improvement in the external balance of the country (Also
see here). This temporary relief gives the government and RBI a window of
opportunity to introduce structural adjustments in the economy. Given that QE
tapering has already begun, the window is much smaller and warrants swift
action.
In our view, given the political environment and impending
elections, there are decent chances that we may again slip to face another
crisis in summer of 2014. Tighter global liquidity, strong USD, removal of
curbs on gold imports, and higher consumer demand and purchase of USD by RBI to
augment the reserves and smaller inflows due to policy uncertainties ahead of
elections may add to the pressure.
We believe that the current account deficit rise again to over
3.5% in FY15 and consequently USDINR equilibrium may shift upwards to INR65/USD
level by the end of 2014.
Through a mix of deft accounting (postponing fuel &
fertilizer subsidies and delayed IT/excise refunds), austerity (cut in public expenditure)
and strict enforcement (tax collections) the incumbent finance minister may
achieve the 4.8% fiscal deficit target for FY14.
Substantial rationalization of fuel subsidy is a major
achievement. However, a strong government would be needed to sustain it. The
incremental fiscal burden due to implementation of food security law is not
clear yet, but on aggregate level it may not be unmanageable given most states
are already providing food security.
A pickup in growth shall lead to better tax collections and
better market conditions could enable sale of stakes in PSUs and capital
raising by public sector banks.
Standing here at dusk of 2013, assuming noon of 2014 will see a
stable government taking over, fiscal condition look stable though not as good
as one would desire it to be. However, the assumptions are too many and
somewhat optimistic.
In our view, in next few quarters investors should closely watch
three factors in corporate performance – (a) improvement in capacity
utilization; (b) leverage reduction; and (c) operating margin improvement.
Revenue growth through higher sales rather than price hikes;
deleveraging by better working capital management and sale of non-core and
stressed assets rather than debt restructuring and accounting jugglery, and
cost optimization through automation and technology innovation rather than
lower taxes and wage cuts would indicate sustainable improvement in corporate
performance.
We believe that the bipolarity seen in earnings growth during
FY13-FY14 should continue in FY15 also. Large corporates with global operations
would continue to outperform the businesses totally focused on domestic market.
The earnings profile of large corporates with geographically
diversified global business profile could help aggregate earnings numbers to
show a better picture in FY15. Though, mid and small enterprise should continue
to struggle and post sub-par performance. The financials therefore may not
witness any marked improvement in asset quality. Besides, the urgency to kick
start the stalled investment cycle may warrant the lenders to play a larger
role in balance sheet cleansing process.
We feel consensus earnings growth of 16-18% for FY15 may not
materialize due to still higher rates and constricted public spending. In our
view, earnings growth should mirror the nominal GDP growth of 12-13%; mostly
driven by large global corporates, consumers and energy companies benefitting
from fuel price deregulation and other recent reforms.
As stated earlier, global businesses and energy may contribute
bulk of the earnings, while domestic businesses especially SME continue to
suffer under the twin pressure of lower margin and lower demand.
As on aggregate level margins in large corporates are close to
lowest level in post crisis period and small businesses are incurring operating
losses, 2014 could be a critical year. Given the high level of operating
leverage, a slight improvement in the operating environment could provide a
major boost to earnings and relieve financial stress. However, any further
deterioration in economy due to whatever reason could lead to exponential rise
in the stress level in financial system.
2014 being an election year, politics will dominant the business
and investors’ sentiment for most part of the year. However, given that the new
government will be in saddle only in June, any meaningful changes in economic
policy may take effect only from 2HFY15. Therefore, any optimism in business
confidence and therefore investment climate would be largely sentimental and
may not reflect in data for FY15.
Overall, we see gradual
improvement in business environment that would pave way for resurrection of
investment cycle over next few years. Therefore hope and the numbers would
drive the investors in equity.
