Big-bang Budget unlikely due to limited fiscal headroom: Gautam Chhaochharia

The fiscal headroom is very narrow for the government to make big-bang announcements in the Budget, says Gautam Chhaochharia, head of India Research, UBS. In an interview with Devangi Gandhi, he says whether the government actually makes a push for public spending will matter for the earnings trajectory, and a significant recovery in crude oil prices may add to market volatility.

What are the key issues that may be covered in the Budget?

I think  the government will talk about increasing capital spending and cutting subsidies, as we have seen in the last couple of years. There is a serious commitment to fiscal consolidation from their side, so how they look at a trade-off is critical. The fiscal room is still very narrow to make big-bang announcements. As per FRBM, the fiscal deficit target may be moved from 4.1% to 3.6% of the GDP, which is a big number. But that also means they will have less room to spend on capex. The government will to do a balancing act, maybe by moderating the fiscal deficit to, say, 3.9%. As for the Make-in-India theme, it would be interesting to see whether they give tax breaks despite the lack of fiscal headroom. But they may announce a roadmap to bring down taxes over the next few years.

What about taxation reforms like GST?

GST is on track, it will be passed even as its application may get delayed to April 2017 from April 2016. It is a long-term reform, so even if it gets rolled out in FY16, the impact on tax revenues and fiscal is still couple of years away. So, if we are talking about its impact over a period of 3-5 years, then a one-year delay on its rollout is not that worrying. The bigger issue from the market’s perspective is whether they are able to get the main legislation passed as soon as possible.

What do you think of the sectors that have led the dismal Q3 results ?

Sectorally, wherever there were expectations around high growth rates, we have seen disappointments. For commodity-linked companies, the impact of fall in global prices was reflected in quarterly numbers. In fact, if crude stabilises here, we could see a positive surprise in the earnings of oil & gas companies next year.

As for banks, there are two drivers for earnings. The credit growth has disappointed, which may still be the case next year, but the NPL recognition can surprise positively although we have seen contradictory signs this quarter.

Our view is that the extent of interest rate cuts may yet be a positive surprise, and this will be a key driver for lower NPLs. We have a very aggressive view on interest rates. We are forecasting 10-year bond yield to touch 6.5% early next year, which will be a big for bank earnings as they will lead to higher bond book gains and add to reported profits. We expect another 100 basis points of reduction in rates by March 2016.
How do you see the earnings cycle panning out now?

I think a more credible assessment of cycle can only happen post the Budget. Whether the government actually starts or makes a push for public spending, that will matter for the earnings trajectory. Having said that, I believe that the overall earnings trajectory should still be healthy as the pace of economic growth is seen improving. It should support earnings growth back into double digits.

Are the current market valuations justified after the disappointing results season?

Overall, the markets are not cheap anymore; they are trading above long-term fair valuation multiples. But they are not expensive in absolute terms, and in terms of the outlook. If the economic trajectory follows through and policy expectations are met, then the market can sustain the current valuations and will deliver returns in line with the earnings growth. There are sectors that are expensive and holding up overall valuations. Despite disappointing volume growth in the last two quarters, FMCG companies continue to trade at high multiples. But this shows that investors are not completely ready to take big bets on the cyclical recovery of India and they still want to buy these high quality names.

Do you see any downside risk to the market currently?

We don’t see a significant downside from the current levels even as volatility may remain high. If crude prices shoot up significantly, the Indian market may turn volatile even in a relatively stable global macro environment. This is because the positioning in the market is not light as a lot of money is coming even through the ETF route. In the bond market as well, investment limits are near-full in most categories. So, there is room for money to flow out, which can cause volatility.