Market Outlook – Feb 2019

By: Navneet Munot, CFA, CIO, SBI Funds Management Pvt Ltd and Chairman, CFA Society India, IAIP

Union budget for FY 2019-20 was staged against the backdrop of compulsions of pre-election spending but a challenging revenue situation, primarily emanating from the shortfall in GST collection. Deflation in food prices and mounting agriculture debt have highlighted the accentuating farm distress. Further, the thrust on infrastructure spending over the last few years (particularly on road, railways, housing, urban development) had just started to bear some result. The capacity utilization for some of the sectors had started to improve and it appeared that private sector was mulling capex on the expectation of continued order inflow from the government and growth improvement in the economy. These developments further complicated the difficult choice between fiscal rectitude and a pause to enable the process of stimulating the economy.

Against this backdrop, the government had eventually sided with marginal glide path on fiscal consolidation. Fiscal slippage in 2018-19 was limited to 10bps and revised deficit estimate is pegged at 3.4% of GDP. As per the revised FY19 numbers, the fiscal slippage gets primarily explained by the higher expenditure (Rs. 200 billion of allocation towards income support for small and marginal farmers).

The shortfall in GST, telecom receipts, non-financial PSU’s dividend is expected to be offset by higher direct taxes. Prima-facie, it appears that government also aims to utilize the undistributed compensation cess fund in FY19 and ask for Rs. 200-300 billion of interim dividend from the RBI.

Fiscal deficit for FY20 has been kept at 3.4% of GDP and thus frayed from the Fiscal Responsibility and Budgetary Management (FRBM) Framework which mandates the government to reduce the fiscal deficit by at least 0.1% of GDP every year till the deficit reaches 3% of GDP. In any case, another FRBM target of reducing central government debt to 40% of GDP by FY25 could also be challenging as the recapitalization of public sector banks and increasing issuances of government guaranteed/serviced debt are adding to the debt burden.

Tax assumptions for FY-20 (14.8% growth and 12.1% as percentage of GDP) are a bit on the optimistic side but not completely out of line if one assumes better enforcement of GST compliance post the general election. Dividend from RBI has been scaled up. In the current year, RBI has built its balance-sheet with G-sec as opposed to foreign securities and has stayed in Net Repo mode through most part of the year. Both the factors will ensure higher interest income. Disinvestment targets have been scaled up marginally (by Rs. 100 billion). It can be achieved if some of the long pending strategic asset sale were to materialize. A large part of the expenditure side (salaries, pensions, defense, and interest payment) is sticky. Hence, it is imperative that tax-to-GDP ratio increase substantially to enable higher spending on social and physical infrastructure.

Some relief could come to the fiscal if a windfall gain is obtained from RBI’s excess capital being transferred to the government. A committee with a 3-month timeframe (Jan-Mar) has been set up to evaluate this issue. The base case we expect at this stage is that the committee may direct the central bank to suspend the build-up of contingency fund for several years and transfer the entire surplus to the government each year (just as done during the year FY14-FY16).

As expected, the budget kept its focus on rural, small and medium enterprises and middle-class households. While this is an interim budget and the actual realization of the visions (such as the changes in direct taxes in favour of the middle-class) will have to wait till the roll-out of the full budget post the general election, it does set a narrative. Some of the rural oriented schemes such as PM Kissan Samman Nidhi and Mega pension scheme are expected to be rolled out in FY19 itself and have seen the provision in FY19 revised estimates figure. The scale of the programs was at the lower end of market expectations (market feared a fiscal stimulus to the tune of Rs. 2-3 trillion) enabling the government to stay close to fiscal targets. These measures entail an income stimulus of ~0.5% of GDP primarily for the low-income strata but if the government were to go stricter on tax compliance (both income tax and GST), a parallel amount could be ploughed back from relatively higher income class.

The earlier years of the current government were focused on addressing the bottle-necks of growth. Consequently, we saw the taxation reforms, banking sector reform, real-estate reforms, e-auction of natural resources, reduced time-lines in obtaining the business clearances, bringing the parallel economy into the mainstream, a drive towards implementation of Aadhar and financial inclusion. These reforms yielded visible gains in terms of formalization, digitization, financial inclusion and lower inflation. Yet, for a variety of reasons, the reforms are yet to translate into a higher income gains. The rising inequality and the unique nature of a large un-organized sector in the Indian economy make it imperative for a government to not only worry about the overall growth and reforms but the distributional aspects of growth i.e. a more equitable growth.

So far, India has already seen its own version of Universal Basic Income with the implementation of MGNREGA, free LPG, Free LED, Free Toilet, Free debit and credit card, Free health Insurance, cheaper housing, various interest subventions, benefits for girl child and so forth. Guaranteed income for small and marginal farmers and pension for workers in unorganized sector have got added today. Robust social security net is a must for leveraging demographic dividend and creating a sustainable, equitable growth to preserve our democratic and liberal society. JAM trinity (Financial inclusion, Aadhar and mobility) should be made best use of to prevent leakages in such schemes. Effective execution will be the key.

The gross borrowing target for FY20 had been scaled up to Rs. 7.1 trillion, even as the net borrowing was kept unchanged at Rs. 4.2 trillion (net of buy-backs). Further, the borrowing for FY19 has also been revised up by Rs. 360 billion to Rs. 5.7 trillion (borrowing calendar penciled Rs. 5.35 trillion). Consequently, 10-year bond yield jumped up by 15bps post the budget release. The bond market is faced with a mix of push and pull factors. While the extremely muted headline inflation, stable external account dynamics, dovish bias in key global central banks and continued OMOs by RBI augur well for the Indian debt market, the high gross market borrowing and the large emphasis on off-budget borrowing requirement would prevent a material rally in the yields. With the fiscal stimulus being limited, we continue to build in the probability of a rate cut by RBI in February.

The relatively sticky revenue and expenditure status at the center is leading the government to look for off balance sheet sources of funding as meeting the FRBM targets is becoming difficult. The importance of Internal and Extra Budgetary Resources (IEBR) of the Public Sector Undertakings is increasing as the budgetary support is lowered for them. In turn, there has been an increased supply of bonds from the Public Sector entities. And this is reflected in elevated corporate spreads.

From equity market perspective, budget would be seen as a positive event given the continued focus on income enhancing measures. Structural reforms undertaken over the last few years should start yielding returns over a medium term. As the event is behind us, market’s focus will shift back to global cues, political developments and earnings trajectory. Improved earnings prospects with correction in valuation should lead to a double-digit return in equities. However, brace for an extremely high volatility in the near term.

-NM