Market Outlook – October 2020

Written by Navneet Munot, CFA,
CIO, SBI Funds Management Pvt. Ltd. and Chairman, CFA Society India

Return of volatility characterised global financial markets in the month of September as the near vertical uptrend off March lows got tested. This was in line with our view that while things had materially improved, we were not quite as much in the clear as financial markets had appeared to suggest. Especially risks around global politics, geopolitics and the enduring impacts of the Covid-19 crisis were being ignored. With a sharp intra-month upmove off lows, Indian equities fared better amidst this volatility. The most significant domestic development was the continued intent to use the crisis to push through structural reform as the legislature passed farm bills and labour codes.

On Covid, cases in India are now stabilizing albeit at a high base. People appear to be adapting to the new normal of the virus staying with us for the foreseeable future. The economy continues to reopen and this along with pent-up demand has led to continued revival in the goods sector. On the services side of the economy, progress has been understandably slower but incrementally services are reopening too. Even if there indeed is a ‘V’ shaped recovery for a large part of the economy, there has been a massive output loss already, the second-round impacts of which will continue to play out. And finally, consumer and businesses will tread with caution and sentiment will only gradually revive.

Against this backdrop, the government will have to do a lot more to support the recovery. We think there are three planks to the government support specifically: one- ensuring capital availability through the crisis, two- pushing through structural reform, and three- stimulating aggregate demand. With monetary policy having done the heavy lifting on supporting the economy so far, the government on its part has complemented RBI’s efforts through moves such as credit guarantees for MSMEs. Sectors impacted severely by the current crisis will have to be supported. This ensures a multiplier effect to RBI actions with liquidity getting transmitted to those in need of capital. The second plank is to use the crisis as an opportunity to push through structural reform. On this front, the government has done a commendable job so far. The government has spent good amount of political capital in pushing through important supply side reforms with the passage of farm bills and labour reforms. However, to extract the maximum benefit execution will be key. This will also be a test of India’s cooperative federalism as states will have to play an important role in ensuring the success of these reforms.

Similarly, the recent moves on production linked incentives (PLI) along with a very competitive tax rate should help provide boost to local manufacturing and can be expanded to other sectors. The next piece that needs to be prioritized in our view is financial sector reforms. Here, we lack a grand design that matches our aspiration of a US$ 5 trillion economy. With the lowest proportion of wealth in financial assets amongst major economies, we need to address the scarcity of risk capital by incentivizing domestic savings into capital markets. Institutional capacity needs to be strengthened. Instead of stepwise tinkering, we need to holistically think through the financial sector policy and infrastructure. At a time when we are fiscally limited, we must make it up through decisive reforms.

The third plank of government support is to revive aggregate demand and for that a direct stimulus is the need of the hour. While India’s debt to GDP is higher than many emerging market peers and high versus our own history, the path towards debt sustainability is more nuanced than resorting to outright austerity. Sustainably improving the denominator of the ratio, i.e. a credible roadmap towards higher growth should automatically take care of the debt burden. Once we get growth back, tax buoyancy will ensure a more comfortable fiscal position. The government’s privatization and asset monetization efforts themselves will get a fillip from improving growth prospects. Fiscal policy must be counter-cyclical and at times like these it needs to be expansionary to avoid turning the ongoing P&L recession into a Balance Sheet one.

We must also not underestimate our ability to fund a judicious fiscal expansion through a mix of private sector savings and foreign capital. While our government debt is high, private sector debt is modest. However, with consumer and business sentiment adversely hit and with capacity utilization staying low, reviving aggregate demand is critical to crowd in the private sector. Similarly, at a time when global financial system is flush with liquidity with opportunity cost of that capital is nearing zero, a credible growth plan along with conducive policy environment should help attract this capital to fund our growth.

The RBI on its part should continue lending a helping hand even as things have gotten a little complicated recently. A combination of high inflation prints, appreciating rupee, and capital inflows amidst a balance of payments surplus has made the task of keeping yields low more challenging. However, to the extent that the rise in inflation is supply side driven while demand and employment stay weak and till the extent it does not become more generalised, it should not pose much challenge. In the long run, supply side reforms should help lower inflation trajectory. Agriculture, for example, has large contribution to CPI and there is room for innovation and improvement there. The RBI has and should continue to strongly signal its discomfort with higher yields. With measures such as higher HTM for banks, operation twists, and shifting some government borrowing to the short end temporarily, borrowings can go through without pressurizing yields.

There is therefore room for the government to stimulate, primarily through shovel-ready infrastructure spends as also through NREGA to boost consumption. Policy support for reviving real estate demand can be opportune given the negative real rates on one side and builders unable to hold inventories responding with price cuts on the other.
Preserving medium term growth potential of 7% plus is not just important but perhaps the only solution to our macro challenges and the best response to geopolitical tensions too. In a country where a large part of the population including many northern states and large parts of rural areas have a per capita GDP of less than US$ 1000, we should not fall for the ‘5% is the new normal’ narrative. Else, not only will macro problems get exacerbated, we will invite serious challenges with regards to social tensions as well.

Globally, a potential reflation could provide an important tailwind. The current crisis will entail a more expansionary fiscal policy by the US and other major economies, which should help an economic reflation. This should be positive for global growth and EMs like India. At a time when China is losing trust, the global geopolitical re-alignment should work in India’s favour. Our favourable demographics, large local market, strong democratic institutions, trust, and continued focus on structural reform augur well. But above all, our ambition for high growth and a credible roadmap towards it will be very critical to act as the magnet to keep the world interested in us.

Trend towards digitalization is coming at the opportune juncture for India. We missed the bus on manufacturing, but we may have natural advantages on digital owing to a large and diverse population which serves as source for rich data and allows scale benefit. Technology is also opening frontiers on public services, education, healthcare etc that may allow us to harvest our demographics better. In areas like social welfare, we have already seen the benefits including speedy direct benefit transfers during the Covid crisis. And now Health Stack opens up newer possibilities amongst many others. Separately, the recent California Fires and erratic weather events have once again brought the Climate Change issue to the fore. With significant infrastructure yet to be created, we can leapfrog into creating it in a climate-efficient manner without having to undo anything which several other countries would need to.

Eventually our success in the global economy will depend on creating absorption capacity through focus on scale, smart infrastructure, improving ease of doing business, ensuring contract sanctity, reforming factors of production and fostering innovation. Technology can help accelerate our transformation. The reforms undertaken so far have been encouraging and we need to keep at it and supplement them with judicious fiscal boost and speedy execution. This should help us break the pattern of capital flow driven booms and busts in favour of a sustained expansion. Equities have underperformed government bonds for over a decade now and yet valuations are expensive, thanks to the ever-dwindling corporate profitability which is at multi decade lows now. A sustained expansion on the back of right ambition and execution is critical for turning the tide in equities’ favour over the next decade. We must re-iterate, even with return of high structural growth, the winners will still be very different, just as they were post the reforms of early 1990s, with resilience and innovation even more vital now!