Domestic growth rates are seen improving following recent fiscal policy action. The slew of measures include moves to cut the fiscal deficit, curtail government spending, restructure state electricity boards and liberalise certain foreign investment limits. As such, the measures should help alleviate investor concerns, stabilise markets and help economic growth rates.
In addition to the reforms already undertaken, we would like to see some other measures to help put the economy on a more sustainable growth path. In order to speed the growth of the infrastructure sector, the government needs to more closely look at the issue of the domestic allocation of coal and land. Quicker approval mechanisms for large projects (i.e. through a single window application process) are needed. In addition, the government needs to push key reforms in the areas of goods and services taxes (GST), the direct taxes code and push through the land acquisition bill and increase clarity on the tax treatment of foreign investors. The implementation of direct cash subsidy transfers on a fully-fledged basis will also be important to address fiscal deficit meaningfully. A reform of GST alone, for example, is expected to add 150-200 bps to GDP growth.
The non-agricultural components in the 2012 third quarter GDP figures, as well as data from eight core industries over the past few months and the recent manufacturing PMI indicate economic growth has bottomed out in the current quarter. However, we expect GDP growth to remain below 6% for the next two-three quarters and recover in the second half of next year backed by domestic consumption, if inflation declines. This would also be supported by a meaningful recovery in investment demand and market stability globally. If all these conditions prevail, we expect GDP growth of around 7% in 2014.
Although the government has aimed to keep fiscal deficit below 5% of GDP in the next fiscal year, any reversal in recent policy actions or expansive measures during upcoming budget ahead of general elections could derail the fiscal deficit targets.
Earnings to recover
We expect corporate earnings to recover in 2013, revived by fiscal and monetary policy. We expect returns to be in line with earnings growth and are maintaining our overweight stance (versus bonds). This year, Indian equities outperformed most of its emerging market peers as global investor risk appetite increased, attracting $20 bn in the market. Indian equities are trading at 13.4x (vs historical average of 13.8x on one-year forward earnings basis (ten-year average).
Earnings growth is expected to be 15% between 2012 and 2014. Our preferred sectors for investing are consumer staples, healthcare and IT, although companies with high interest rate earnings components (such as banks and insurance companies) should benefit from any changes in monetary policy. CY13 is expected to be better for the banking sector as recent reforms support a recovery in growth and an upturn in the capex cycle in turn driving stronger pickup in credit growth from the current levels of 17%.
Bond yields to ease
Bond yields are expected to fall, as monetary conditions ease and liquidity improves in 2013. Shorter duration bonds will be driven by liquidity flows, with longer duration bonds directed by policy and action and government borrowing activity in the second half. Liquid funds returns should start falling in 2013, with lower rates seen at the very short-end. Accrual funds still have some room to rise and it currently is a good time to lock in these funds. Medium-term funds look attractive as they offer high accruals and have the ability to generate capital gains along with softening yields. With our expectation of a further monetary easing, recent fiscal reform measures and the RBIs continuing support for system liquidity, we suggest investors should opportunistically consider long duration funds or bonds as a part of their allocation quotient.
Gold prices could soften
The global economic recovery is still sluggish, but it now appears to be increasingly less fragile. The slowdown in China has turned a corner, and we believe the so-called US fiscal cliff will now have less of an impact. Correlations have been shifting with the change in the investment environment, which is why gold underperformed in 2012 in US dollar terms. Gold, however, still has an important role in investor portfolios as a hedge against global macro-economic risk and general inflationary trends. The extensive quantitative easing efforts in the developed world by a large number of central banks will provide support for gold in the medium-term.
The author is chief investment officer, RBS Private Banking