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  1. Despite demonetisation, India is still a bright spot

Despite demonetisation, India is still a bright spot

India’s businesses are still trying to cope with the effects of demonetisation. The latest purchasing managers’ data point to the impact on supply chains across the manufacturing sector.

New Delhi | Published: January 27, 2017 2:25 AM
India’s foreign exchange reserves are at a multi-year high and its twin deficits (fiscal and current account) significantly curtailed. (Reuters) India’s foreign exchange reserves are at a multi-year high and its twin deficits (fiscal and current account) significantly curtailed. (Reuters)

India’s businesses are still trying to cope with the effects of demonetisation. The latest purchasing managers’ data point to the impact on supply chains across the manufacturing sector. Concern about the outlook for growth and corporate earnings drove the Sensex more than 11% lower from its recent peak at one stage. While short-term traders are focussed on the immediate impact, longer-term investors are likely to see this as an opportunity to position for the coming rebound.

Demonetisation has put a spotlight on how extensively the economy and businesses are dependent on cash (and the immense potential for going cash-less!). However, aided by accommodative monetary policy and robust consumption, India’s economy is likely to once again outperform other emerging markets (EMs), including China, in 2017—consensus estimates point to a 7.5% growth for FY18, after dipping to 6.9% in FY17.

The recovery is likely to be helped by a return of global business confidence, driven by a revival of growth and inflation expectations in the US and other major economies. Asia ex-Japan is likely to be the biggest contributor to global growth in 2017. Consensus estimates forecast 5.8% expansion for Asia ex-Japan in 2017, similar to 2016. The constructive outlook for Asia is not without risks—any protectionist or punitive trade measures adopted by the Trump administration or a stronger dollar could heighten uncertainty. Weighing opportunities against the risks, India’s domestic demand-driven economy stands out as a likely outperformer in Asia.

There’s little doubt that India’s macroeconomic fundamentals have improved significantly since 2013, the last time global concerns emerged around rising US rates and a stronger dollar. India’s foreign exchange reserves are at a multi-year high and its twin deficits (fiscal and current account) significantly curtailed. More significant, after years of joint effort, RBI and the government have been able to put a lid on inflation. Economic reforms have progressed considerably under the current regime, lest we forget the years of policy paralysis under the previous government. Notably, India is at the cusp of a once-in-a-generation tax reform, GST, which will turn India into a common market. One can expect a tax boost for the government, increased transparency and reduced red-tapism for businesses, and improved domestic demand over the coming years which could add significantly to India’s trend growth.

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The question then is how does an investor position to benefit from the opportunity? There is no ‘one size fits all’ approach, as each investor is unique, with distinct risk-tolerance, discrete goals, varied cash flows and divergent investment horizons. However, at a very broad level, the two key asset classes of local equities and rupee bonds are likely to fare well over the next few years. Our strategic asset allocation model for an investor with a ‘moderate’ risk profile suggests about 55% allocation to bonds and 25% to local equities, the rest going to commodities and cash. We believe local bonds and equities should outperform gold and cash in 2017.

2016 has not been too kind to Indian equities but, looking ahead, India is our top equity market in Asia for 2017. After a strong run-up in the first three quarters last year, two key events saw Indian equities give up most of their early-year gains—the post-Trump sell-off across EMs on the back of the stronger dollar, which coincided with the concerns about the economic outlook following demonetisation. Nevertheless, a fair bit of the bad news has now been priced in and the equity market appears to have found some support at current levels. While we remain wary of near-term volatility, as the impact of demonetisation unfolds, we believe current valuations are appealing enough to gradually add long-term exposure. India’s high return-on-equity (RoE) and an expected 17% earnings growth for 2017 stands out in Asia, justifying its relatively higher valuations in Asia. The high RoE is likely to remain a key draw for international investors.

Rupee-denominated bonds had a good run in 2016. Three months of healthy monsoon which helped lower inflation, two rate cuts and an improved liquidity environment drove bond prices substantially higher in 2016. We believe scope for further gains exists, but are likely to accumulate at a more gradual pace in 2017. India’s inflation is restrained and subsiding, its central bank is still ‘accommodative’, system liquidity remains plentiful and demand for government bonds from key institutions such as PSBs (which are flushed with deposits following the demonetisation) remains robust—this is enough ammunition to support likely another year of gains for bonds. A relatively high interest rate and favourable external sector dynamics are likely to support the rupee in wake of a rising dollar. We believe the rupee is likely to be amongst the more resilient, albeit not immune, of the EM currencies in 2017 and could even strengthen should the global risk appetite turn favourable.

However, it’s important to be selective within bonds. We retain our preference for high quality bond sectors such as government, quasi-government and AAA-rated corporate bonds amidst likely post-demonetisation stress for some of the lower-rated sectors. Also, amidst falling deposit and interest rates, one needs to prepare for the ‘emerging’ reinvestment risk. Thus, it’s increasingly important to capture the current elevated yields by extending the maturity of bonds.

There’s little doubt that the Indian economy has been rattled by the recent global and local events, but it’s important that we look beyond the immediate news events—India’s resilient fundamentals, coupled with long-term benefits of demonetisation and economic reforms is likely to make India the only major economy with the potential to grow over 7% in the coming years. The current uncertainty should be seen as an opportunity for those positioning for the long-term.

Saurabh Jain is executive director, head investment strategy and sales and Aditya Sharma, director, investment strategy, Standard Chartered Bank.

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