Market Outlook-October 2019

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

The sharp economic slowdown of the past several months had necessitated policy action at a war scale. The Government responded with big bang reform on corporate taxes. The sharp cut essentially represents a huge transfer from the government to the corporate sector. In our view, this move underlines the government’s belief that it is the innovation, efficiency and enterprise of the private sector that will drive growth while the government plays the role of a facilitator in business.

While this move doesn’t directly address the near-term demand weakness beyond providing a sentiment boost, this is an important step towards reviving the investment cycle. Followed with appropriate regulatory realignment, this would also help in bringing in foreign manufacturing as global supply chains readjust. This in turn should create employment leading to sustained consumption and growth. In fact, the consumption driven growth of the past few years while investments struggled was unsustainable as incrementally this consumption was being financed through dipping savings and increasing leverage, as income growth severely lagged.

There are concerns around the implication on fiscal deficit. While the fiscal pressures are for real, the government has levers to address those. For one, the move should strengthen the government’s resolve to shore up its finances through asset monetization and strategic divestments. Similarly, there is room for significant increase in GST compliance as collections have run way below expectations so far. The time is also ripe to relook at subsidies. The experience with fuel subsidy was very encouraging. With better adaption of Direct Benefit Transfer (DBT), food and fertilizer subsidies can also be rationalized.

Given the global backdrop, the tax reform assumes greater significance. There is enormous uncertainty globally, from frail economies to rising geopolitical tensions: trade tensions between US-China and Japan-Korea, Brexit, Hong Kong, the middle east to name a few. India being integrated with the rest of the globe is bound to be impacted, yet this can be our opportunity to stand out and stand tall. Amidst all the chaos, India can carve out a position of strength for itself owing to several factors.

India for one is a large and stable democracy with a strong political leadership. At a time when the world continues to experiment with unconventional monetary policy, India has been relatively prudent on monetary and fiscal fronts. While the world is grappling with excess leverage, we have modest debt to GDP. When currency is increasingly being used by countries as a tool against economic challenges, India has largely left its currency to market forces. Globally while policy uncertainty has been on the rise, India has been cracking down on corruption and black economy and improving the ease of doing business. When climate change is emerging as the biggest risk, India is already taking a lead on environment (non-fossil fuel adoption, ban on single use plastic, water conservation to name a few) despite the stage of our economic development.

The common theme across all these, be it strong democracy, prudent fiscal and monetary policy, market determined currency, modest leverage, crackdown on black economy or environment and social security initiatives, is that we have ingrained sustainability in our development model. And in that context the fact that the government has sought to revive investments through corporate tax cuts rather than wasteful consumption emphasizes its focus on the structural rather than here and now. At a time when investment opportunities are scarce globally and money is abundant, India can be an oasis of hope for foreign capital. Yet, in spite of the inherent strengths of our model, we shouldn’t be counting our chickens before they hatch. There is a tremendous lot to be done before we hope to be a truly viable investment destination for the world.

Starting with sustainability, one remarkable achievement has been the empowering of masses as a way to sustainable development. The integration of the rural masses with the mainstream through road, electricity, financially, digitally and through improved social security should go a long way in rural India catching up with urban India. The resultant rise in their aspirations has to be positively channelized to move the large population employed in relatively unproductive agricultural activities away into more productive sectors by reskilling them. Within agriculture, reforms such as farmer education, land record digitization, investment in logistics and food parks and contract manufacturing to name a few have the potential to significantly improve productivity.

Being a country deficient in risk capital, we need to do more to channelize both domestic and foreign savings. A sovereign bond offering in local currency can do a lot of good to building credibility around Rupee as well as India. Effort should be made to get these local currency bonds included in international bond indexes. An associated outcome will be a better bargaining position with rating agencies. These are vital as we have humongous investment needs for infrastructure build up. Given the challenges faced by private sector in the previous cycle, asset recycling, by inviting long term investors in infrastructure assets to free up capital for further asset creation, has to be the dominant funding model.

While raising investment rate is a prerequisite to raising domestic savings, these savings have to be better incentivised to move to financial assets rather than physical. Especially flow into equity markets remains abysmal denying corporates the much-needed risk capital. Corporate tax cut is an important step; the government should evaluate following it up with removal of long-term capital gains tax to encourage equity flows. Jan Dhan has been a great success story on financial inclusion. How about Jan Nivesh to encourage more financial savings?

A direct tax code with a significant simplification and lowering of personal taxes will go a long way in channelizing savings. A radical simplification of tax filings, through measures such as Aadhar linkage, app-based interface or faceless pre-assessment, can be a significant boost to tax compliance and collections. And not to forget the behavioural aspects of it all, we wonder what changing the name of income tax to something like Swabhimaan Yogdaan and GST to Rashtra Nirmaan Yogdaan will do to willingness of Indians to pay their share of taxes!

Finally, investment cycle won’t revive without a revival in business sentiment. After a period of what many commentators believe to be regulatory and judicial overreach, the PM in his Independence Day speech acknowledged the need to respect wealth creators. The current tax reform is an important step in that direction. Regulatory environment needs to align with taxation now and soothe more nerves to unleash private sector’s enterprise. While these tax cuts help private sector deleveraging, focussed approach on NPA resolution and bank recapitalisation is needed to kickstart credit growth.

Financial sector is the life-blood of the economy and addressing challenges in that space is of utmost importance, especially given the role reflexivity plays in shaping the real economy. NCLT like framework to deal with stressed entities in the financial sector, refinance window for illiquid assets with appropriate haircut, steps to revive real estate and MSME sector, a scheme to provide priority debt to stalled but viable projects that are NPA are some of the steps needed. While ensuring abundant liquidity, a strong message that “we will do whatever it takes” along with swift and coordinated policy response are needed to alleviate the current stress and set in motion a virtuous cycle.

Bond yields have spiked on fears of fiscal slippage post tax cut announcement. Given the local growth-inflation dynamics, weak global growth and commodity prices, and given these tax cuts don’t do much to inflation expectations, we expect the RBI to remain accommodative. Given the already elevated term premium, expect yields to cool off as a result.

Equity markets aren’t discounting a new investment cycle yet given the concerns around financial sector stress. The recent up-move therefore has barely mimicked the upgrades to FY20 earnings owing to tax cuts. However, with corporate profits to GDP at multi-decade lows, mean reversion may be in order. Investors should take comfort that Government is intent on decisive structural reforms to fortify India’s position in the global arena.