By now it has become fashionable—and indeed commonplace—to describe India’s evolution over 2016 as ‘short-term pain, long-term gain.’ This is a truthful, but naive and limited description. This year, investors would do well to recognise the structural and sustainable changes that are being wrought via bold and far-sighted public policy. These changes will irreversibly alter the economic—and hence investment—climate of the nation in a few quarters. Long-term economic gain is the consensus view, but what needs finer appreciation is that this gain is premised on deep and lasting changes in the rules of business and economic engagement in India.
This change is our best guiding light for 2017 and beyond. Why? Simply because India—for all its opportunities, promise, talent and resources—has repeatedly failed at delivering sustained growth. It is, for example, yet to enrol large swathes of its people into the formal, organised and rule-based networks of modern commerce. Astonishingly, only about 15% of the labour force works with appointment letters and 3% pays income tax. Many businesses and self-employed professionals routinely under-declare business volumes to save on taxes and to avoid cumbersome processes and harassment by the authorities.
The government is rightly focusing on business enablers and removing administrative and procedural hurdles—GST, digital money, transparent and market-driven allocation of resources, simpler labour laws, easier tax compliance, faster credit recovery and bankruptcy resolution are likely to kick in.
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We expect lower income tax rates in the Union Budget, which, coupled with punitive measures for evaders, will increase the relative cost of tax non-compliance. Budgetary allocations for physical and social infrastructure as well as rural development (roads, healthcare, water supply and housing) and agriculture support (market access, irrigation and rural credit) should rise.
The net result of these measures can only be described as climate change. Confidence in the system, which lurched from cynicism to resignation for decades, is now reviving. This is especially true at those socio-economic levels that have borne the brunt of poor governance—unorganised labour, micro/small businesses and farmers. This rising confidence will unleash a transformation in consumption and savings habits in a granular and sustainable way.
Meanwhile, markets are swaying to domestic flows. In the last calendar year, domestic institutional investors’ (DII) net inflows in the cash market were well over 2X foreign institutional investors’ (FII) net inflows. While FII ownership remains high, the net selling by FIIs of over $4.5 billion over the last quarter of CY2016 was more than matched by DIIs. This is driven mostly by strong retail investor inflows into domestic funds and insurance portfolios. Monthly mutual fund SIPs are poised to cross the $1 billion-mark sometime this calendar year.
We foresee rising financial savings, formal credit penetration, steady and low inflation, lower real estate prices, increased tax compliance, a large infrastructure push, lower interest rates, aggressive capex at PSUs and higher business confidence. These will drive sectors such as financial/banks, automobiles, housing and construction/infra, despite the hiccups over late CY2016. Several listed companies are poised to benefit as unorganised competition recedes. A recovery in large cap cement stocks, however, looks back-ended, given rich valuations and low demand growth. Here it is the midcaps that offer value.
However, we need to closely watch how do state election results pan out. Whether post these we would have smoother conduct of Parliament and/or smoother passage of Bills? From when and in what diluted form the GST regulations get implemented? The intensity and spread of monsoons in 2017?
Globally, central banks have realised the ineffectiveness of monetary stimulus beyond a point and now the governments will rely more on fiscal policies. This will also help quell the impression that the monetary stimulus helped the rich get richer, leaving a vast majority of people untouched or worse than before. This means interest rates globally may not fall, and if at all, will seek higher levels. In India, however, given the relatively high levels of interest rates, we may see one or two rounds of interest rate cuts. We may also witness downward revision in saving account interest rates this year.
The inverse correlation between the dollar and commodity prices seems to have ceased to act, possibly due to improving US and China growth expectations and recent supply discipline among commodity suppliers. The correlation between the strength of the dollar and falling emerging market equity flows may also cease to work, going forward.
Commodity and crude prices could trend up—with some correction in between. The world will have to adjust to this against the backdrop of rising interest rates and hence an uppish inflation trajectory.
We are poised for a multi-year healing process, even as near-term earnings trajectory looks challenged. We are accustomed to FIIs seeing the longer-term potential in India’s macros, despite an anti-business regulatory framework, corrupt governance and weak institutions of policy creation, law enforcement and dispute resolution. Indian citizens were cognisant of these failures and were, hence, under-invested in their own stock markets.
This has changed over the last two years and, ironically, it is the far-sighted foreign investors who have been selling in the recent quarter. We believe this is more of a global reallocation, in line with the strength of the dollar, and it is only a matter of time before FII inflows resume, responding to the structural changes in India’s policy and governance framework. We are in the dark phase before a bright, new dawn.
The author, Dhiraj Relli is MD & CEO, HDFC Securities. Views are personal