Jan 02, 2017
Nilesh Shetty - Associate Fund Manager - Equity
The year gone by..
The Year started off on a pessimistic note with equity markets moving sharply lower as weak corporate earnings belied lofty valuations. Rural India was particularly struggling on the back of two successive droughts. The government, albeit a bit late, realised the same and tilted the orientation of its budget to address the concerns of rural India. After the clouds came the silver lining. The weatherman forecasted above normal monsoons, so equity markets cheered and started moving higher. FII Flows, which had been negative till February, quickly reversed and India again became the standout emerging market poised to show strong economic growth while others were struggling.
Despite the strong growth suggested by the new GDP series, the fact remains that for the last three years, most companies have faced weak consumer demand. Hopes of an economic recovery were belied each year as company after company delivered weak earnings growth. This year a combination of economic factors meant the story of a possible economic recovery had real credibility. Rural income was poised to pick up after two successive droughts. Lower interest rates, the seventh pay commission, and “one rank one pension” payouts suggested a positive outlook. Government finances as well as India’s external account looked well under control. All these factors pointed to an economy on the cusp of a leap in consumer discretionary spend. Equity markets reacted appropriately and continued to rally in anticipation of the same. But then the Government launched what may eventually become one of the most ill-planned and executed schemes in the history of modern India. On Nov 8 the government launched a currency exchange scheme which delegitimised 85% of the cash in circulation. Cash available for transactions suddenly disappeared, while new cash with limited printing capacity was not even close to filling the gap. FII’s staring at rising international yields and an uncertain economic impact of the policy decided to bail, reversing the prior strong flows.
The government’s launch of the demonetisation scheme has now become a textbook case of how not to execute a currency exchange program. No sooner was the announcement made to replace old currency notes than immediately a parallel economy to convert ill-gotten cash sprung up. What ensued was a race between economic agents – taking advantage of the situation with ingenious avenues to convert cash – and the RBI, as it introduced a flurry of rules every day to stem this conversion. The pace at which cash came gushing back into the banking system belied any hopes of major recovery of black money held in cash. After the first few days most people gave up on trying to keep up with the daily rule changes and just wanted to get some cash out of the bank to get back to their daily lives. The government finally threw in the towel by launching the Income declaration scheme which now ensures all the money will come back into the system. Looking at the economic costs involved with loss of productivity, lower revenues, loss of taxes, and stalling of the consumption cycle, the payoffs could never justify whatever the government was trying to achieve. Given that the upcoming implementation of the GST will make it increasingly difficult for the informal sector to under-declare revenues, one wonders why this scheme was even necessary.
Internationally two major events marked the calendar year, both unexpected and misforecasted by pundits: Britain voted to leave the European Union and Donald Trump won the US presidential election. Both events were a result of populations reacting to years of stalled economic activity and negligible wage growth, trying to find avenues to change the status quo. The worrying aspect remains how disconnected the mainstream media has become with ground realities. Both outcomes were originally thought to be low probability by the media and ended up being a major shock when the actual results were declared. They signify that we may over the next few years see a world which is a lot more insular and protectionist in policymaking. One may also see economic costs being imposed on businesses which thrive on the free movement of goods and labour.
Demonetisation has come at a crucial time for the Indian economy. Companies that were looking at a strong economic revival – especially the ones linked to consumer discretionary spend – are now staring at a sharp drop in revenues in H2FY17. Our channel check with companies suggests that even a full month after demonetisation, demand remains ~30%-50% below normal. The popular expectation that consumer demand will come rushing back once cash in the system normalises is looking more and more like wishful thinking. Lower demand leads to lower income leads to lower wage growth/job losses; the exact opposite of a virtuous economic cycle. The government may be forced to launch a stimulus program to break out of this descent, putting pressure on its finances.
The next few months could be testing for India as the population waits for a normalisation to take hold and becomes increasingly restless, potentially triggering a political backlash. Weak corporate performance coupled with rising international yields may test flows into India as FII’s look at other commodity-linked economies delivering stronger corporate performance. Rising government expenditures and increasing commodity prices internationally could let the inflation genie out of the bottle – a genie which has been tamed as of late. But India has never been a story for the near-sighted. The India story remains: 6.2% average GDP growth for the last 36 years! It is a story of skilful managements trying to meet the requirements of an underpenetrated 1.2 billion-person-market despite constrained infrastructure and erratic government policy. Any major correction would be a great opportunity for long term investors to solidify their equity portfolios by buying India low.
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