Don’t Expect Immediate Action To Address Slowdown, Says Neelkanth Mishra
The re-elected government may not undertake market-driving actions on the economic slowdown, says Credit Suisse.
Having won the the second term, the Narendra Modi government will focus on broader economic issues and may not take market-driving action to counter the slowdown seen in the past few months, according to Credit Suisse’s Neelkanth Mishra
“There can be a sense of doubt for a policymaker whether to intervene or will this (slowdown) somehow correct by itself,” Mishra, India equity strategist and co-head of Asia Pacific strategy at Credit Suisse, told BloombergQuint. “It is a bit presumptuous on every market participant that political capital earned after months of campaigning should be spent on things which they want.”
The government, he said, is likely to focus on larger issues such as repealing around 44 complex labour laws and streamlining them into four new codes. The National Democratic Alliance-led regime could also prioritise to work on direct tax reforms, consolidation of public sector banks and may have another shot at affordable housing schemes, Mishra said.
Governments also are political parties so they will have political and social agenda as well. If they have to use the political capital, it is not necessary that it will be used on things that matter to us for the next three to six months.Neelkanth Mishra, India equity strategist and co-head of Asia Pacific strategy, Credit Suisse
Corporate Earnings To Grow Despite Slowdown
Mishra said there was no co-relation between the economy and the stock market performance as corporate profits did not grow at the same pace as the GDP in the past five years. “However, the converse could happen in the next couple of years—the economy slows but earnings growth for bigger indices could pick up,” he said, adding that growth would be driven by banks.
The banking sector is expected to continue its steady performance in the form of strong earnings, Credit Suisse said in a report released on Thursday after the election results. This, according to the brokerage, will be because of a steady loan growth and healthy net interest margins as the competition form non-bank lenders has faded away.
The total net profit of the eight banks in Nifty 50 is expected to be Rs 1 lakh crore in FY20, the report said, adding that they are driving nearly two-thirds of the earnings growth of the Nifty.
Watch the full interview here:
Here’s the edited transcript of the interview:
Do you believe it is back to fundamentals from day one itself? Are the fundamentals looking like that some urgent action is needed or can it be moved around at a slightly lenient pace?
I think it has to be back to fundamentals. In the last several months, if you told investors that the economy is slowing and there are stress points, and it doesn’t look like it will get addressed very quickly, the response would be to wait for the elections. Everyone was anticipating that if the verdict resulted in either a negative or a positive surprise, that could cause significant market volatility, and that would supersede anything the fundamentals would have driven on stock side. Whether justified or not, that is the way people are behaving. Now that elections are over, the question will be what next? Growth slowdown is now consensus and the questions are how quickly we can get out of it and what can the government do. I don’t think that the slowdown is steep enough to convince the government to take action. It is important for us to realise that any decision which government makes on political side uses some political capital—just like we use our savings, businessmen will use the capital. If there is capital earned through historic verdict like what the BJP and the NDA has won, then that capital can be used for certain purposes and there has to be a certain return on investment on top of it.
The slowdown is not as steep as the rhetoric says—there is clear auto sales weakness, airline traffic is weak, oil demand started weakening but there are pockets of strength. Cement and steel demand have not weakened that much. The largest staple companies are still reporting high single-digit volume growth. So, it is not a screeching slowdown. Therefore, there can be a sense of doubt that if I am policy maker, then do I need to intervene or will this somehow correct by itself.
The same thing is happening on the monetary side. Even if the government wants to address the slowdown, it doesn’t have the fiscal space and there is less intent at least in this government to use fiscal tools on the consumption side to accelerate growth. Monetary action is needed in terms of improving the supply of money that is M3 growth. For that we need very sharp rate cuts. Premiums need to be brought down and signalling from the MPC is required. There is not much that the government can do. It is a bit presumptuous on part of every participant in the market that somehow the political capital which is so hard-earned after months and months of campaigning and lot of strategising should be spent on things which we want them to spend on. The government will have its own priorities. Political parties have social agendas as well. If they have to use the political capital, it is not necessary that it will be used on things that matter to us for next three to six months.
So, we have to temper our expectations on faster government action on the economy. They will take some reforms which are on judicial side, direct taxes, administrative reforms. They may take a shot at triggering low-end housing or catalysing the construction of low housing. PSU bank consolidation could see much greater push than it has seen in last five years. There are things on the economic front which they will work on. But nothing will address the steadying slowdown which we have seen in the last couple of months.
What the expectations are regarding the priorities of the new government? Whether it appeals to market sentiment? Whether they tackle issues on ground like farm distress? Or will expectations not have to run too high from the market perspective?
The market expectations are suitably vague. Everyone expects that things will revive, and that government will do something. It is a historic and solid mandate and now they will do something. But I don’t think there is clarity on what is expected which is not new. We have been highlighting these topics in last seven to eight years that everyone wants reform and they don’t know what reforms are likely and what is it that they will like to see.
On some critical issues like labour which is long being discussed as a big problem in India. For labour law reform, there has been background work The 40-45 labour laws which have been passed over seven decades contradict each other and there is complexity. The government has tried to streamline it. The intent is to repeal those older laws and replace them with four codes on: wages, labour, social security, and worker safety and health care. The code on wages has already been introduced in Lok Sabha in 2017 and went to standing committee. Every new law must go through a standing committee. It was too close to the election when the committee report came out and the government couldn’t do anything about it. The code on labour is currently with the previous cabinet.
This is something which can be undertaken. They have done it for a few states. Using provisions in the constitution where states on concurrent subjects could do their own laws. Rajasthan, Madhya Pradesh andAndhra Pradesh have already modified the codes on labour. This could be done at the central level. These are the things which the government can do but not necessarily that it will affect earnings in next 12-24 months.
Do you see high price-to-earnings multiple getting offset by a potentially higher growth rate in the EPS?
That’s right. Whenever I want to teach someone looking at Indian market for first time, I start by saying that the market and the economy are very different. So the economy may have not grown at 7-7.5 percent in last five years but it didn’t seem to be reflected in corporate earnings. The converse could happen in next couple of years. As the economy slows—not sharply but it’s slowing—earnings growth for bigger indices would pick up or at least be in teens. 31 percent for FY20-consensus is perhaps a bit high, but you could see two-handle earnings growth in Nifty in FY20. It is an expensive market but then so are almost all of the equity markets in the world. The premium has not expanded. Within the market, it is prudent to be in stocks and sectors where there is growth.
Banks which have been our preferred pick for a while now have done very well. They are on Z-score, which is how many standard deviations away from price-to-book multiples you are. They are very expensive. Even if there is no further multiple expansion, given that earnings growth should be steady in next couple of years. Very few people realise that the eight Nifty banks could have profit of close to trillion rupees in FY20. Banks have a cyclical nature. The more profitable they are, the more capital for growth they need. So, medium-term prospects are right.
Those are the sectors which we are focused on. For the Nifty and indices, themselves, the high PE multiple is the global phenomena. With bond yields globally falling again, tremendous global uncertainty, those multiples will not get challenged. If India sees the kind of earnings growth that it will, then the broader indices should be fine.
For the sentiment around these earnings and the market to be good, is a healthy dose of reforms necessary or the markets will do well even if larger strategic reforms don’t get done? A lot of people said strategic privatisation is the key ingredient in all of this. Assuming that doesn’t happen at very quick pace but if earnings come back, do you think the market will be sanguine?
I think so. The world is very nasty place for equity investors and people who want to look for growth. Even though we may slow to 6.5 percent, that is sturdy growth on a $3-trillion economy.
There is no meaningful reform which you can do without disruption. Every economic reform is taking from one hand to other. From the system design perspective, it is in everyone’s benefit in the medium term but in the near term someone loses. For example, even if you do direct tax reform then there is lot of benefit which can be taken away from some industries. The headline tax will come down and in aggregate it is in everyone’s benefit. As these things happen, there will be unintended consequences. There could be companies which will see a sharp down revision in earnings. So, it will be disruptive. That period of disruption which we saw in GST. I don’t think anyone debates GST was in long term for the good of the country but it has been disruptive. It creates uncertainty which markets don’t like. So, we have to be very careful of what we wish for.
Everyone has a solid reason to expect or demand certain reforms. But we have this tendency of converting our hopes into forecast which we have to resist when we look at markets. It is not the prescriptions that matter but the predictions matter.
There are a lot of things which I will wish that government focuses on. Energy is the big risk for the economy. We have to address agriculture very aggressively. The NBFC problem needs to be precipitated. But given the way things are progressing, perhaps it will be allowed to find its own course. The things which I want to happen but I cannot make them my predictions. My predictions should be what seems to make sense from the government’s perspective.
One has to admit that the outcome in terms of monthly inflow of GST hasn’t been as strong as one has envisaged. A higher number has been called one-off. What is your thought?
Last year was a disappointment. The economy started slowing. A lot of nominal growth that we expected from high tax drivers like cars, steel, cement, petrochemical, plastics slowed. These are very large drivers of indirect tax collections. Oil prices went up but only for a bit. Steel prices did not change much. Car sales slowed. The economic slowdown led to a negative surprise. But the last two months have been positive. March collections have been positive. There was bit of pull in to meet the central targets or even the state’s targets. And people were asked to contribute more than perhaps they needed to pay. But what was surprising that despite a pull in from revenue, April still had a 10-odd percent growth. This was on the basis of things like paints which are large contributors of GST and have seen a rate cut. Adjusted for that, it was still at 11-12 percent which is not bad. Has it led to acceleration which one had expected? Not yet. Everyone is paying voluntarily what they needed to pay. A lot of changes are happening already. When we look at aggregate numbers of FY19, we have to remember, and it is sadly not something which the government gives details on but people in the government have said that almost one-and-a-half years of refunds were processed last year.
Adjusted for that, the growth have been much better. I am not yet pessimistic on the prospects. I think that as better enforcement happens and people ask questions, the collections and tax buoyancy should be better. Time will tell that if it is strong as it has been budgeted in FY20. There should be better growth and the last two months have been encouraging. One of the reasons that the government would be thinking that the economy is not slowing as much is that GST collections have been okay.
GST has not delivered as much as it could have. But with better enforcement, with some tweaks to rules and software, I think it is possible that growth is higher than the nominal GDP growth.
If we are not certain of the tax buoyancy and the balance sheet is looking stretched, areas which the government has to tackle and requires large dole-outs of cash are PSU bank recapitalisation or liquidity injection within NBFC space or infrastructure spending. All are large numbers. How does this happen?
I am not questioning the governments’ arithmetic on tax collection side. I am saying that there should be better buoyancy and buoyancy is percentage points ahead of nominal GDP growth that you see tax collection coming at. On the direct tax side, there is a healthy trend. While there was bit of slip last year, I think compliance enforcement will drive growth. I don’t think the government has the fiscal room or even the intent to use the fiscal room to boost consumption and drive accelerated growth in the economy. Their approach is rather to keep it that way. That you show some fiscal discipline and that will result in lower interest rates.
One of the problems in the economy right now and this is the problem with obsessing over the government is that we have seen worst side of two things. First, we have seen all the negative side-effects of a weak inflation which has stretched farmers, stalled transmission of incomes to power. But all the positive side-effects which would have been significantly lower interest rates have not come about. If you go back 40-50 years and see commentary in economic literature, people have assessed why India’s manufacturing in exports is so weak. One of the factors was Indian companies borrow at 12 percent. China is borrowing at 6 percent. How can we compete? We borrow at 12 percent because we have high inflation and high fiscal deficit and the government use to appropriate lot of financial savings.
Now, we have low inflation. While we can talk about public sector borrowings and all that, there is some concern on absolute levels but on relative level compared to India’s history, it is at historic low levels. Financial savings have done better than what has been reported by the RBI. The crowding out is a lot lower. Because we are seeing worst side of both the issues, the government is on a cycle which is adjusted by pay commission. If you think about pay commission cycles once every 10 years, the salary and pension go up by 2.5 percent of the GDP.
We cannot think about fiscal consolidation or fiscal deficit without realising where you are in the pay commission cycle. We have gone through pay commission cycle without the fiscal deficit going up and yet the term premiums, which is gap between the repo rate and bond yield, is still very high. Consumption stimulus, which used to come once in 10 years, has been much feebler this time which is a prudent measure. This has had a growth impact. That should have resulted in low premium, which we have not allowed to happen because of pure signaling on monetary side. We have a weak inflation. Because of food inflation, there is stress in agricultural side. But the positive side of it is in terms of lower rates has not happened.
This discordant policy is the root cause of the current slowdown and this needs to be addressed by significantly low interest rates. We are just relying on the government to do the needful. We are pushed back in old regime where the government ends up spending too much and the government cannot spend anywhere efficiently as private sector can and therefore cause inflation again. We go back to the old regime. Some of the alternatives which have been discussed in elections are worrying. Because we have distorted the monetary policy so much, we were forcing the political system to go back to regime of high inflation and high fiscal deficit. I don’t think it is desirable. We need now lower rates.
The NBFC sector is holding back and there is not enough fuel flowing into engines of SMEs, MSMEs. Rural income has been declining. Inflation stays in RBI’s comfort zone which suggests that rural income is stagnating. They don’t have much of disposable income which buttresses the consumption engine. There is no spending and therefore you don’t see that much growth coming in. Do you think there will be a good solution which the market will also like?
I don’t see a solution. I struggled to imagine as what the solution would be. Partly driven by political compulsions where the government did embark on PM Kisan which is to transfer income directly into hands of the smaller farmers. Beyond that some farm credit could happen. That’s the next step after a spate of loan waivers and the gricultural growth will perhaps pick up. There could be more money in hands of farmers which can act as fiscal boost. Beyond that, I don’t think the government can do much that can boost consumption.
The pay commission boost which happened in fifth and sixth commissions was 2-2.5 percent of the GDP. If you give that kind of hike to a government employee who then realises that this number will never come down, the change in consumption behaviour is quite dramatic—they immediately buy bigger cars and bigger houses. This massive and potent consumption stimulus takes a long time to fade out because the ripples last longer. In the Seventh Pay Commission, the increase was one percent of GDP. It was less than half of what we have seen in the previous two pay commissions. This consumption stimulus faded much faster.
The second thing is there is income problem. If money supply growth which is 10.5 percent, much below of what we think GDP should be growing at and has been lagging GDP growth for last two years, there is a problem in the financial system. Then income generation stalls. If income generation stalls, then consumption will slow down. We need to see money supply pick up very nicely. And necessary for that is the precipitation of the NBFC issue, which is unlikely. And given that the first priority for the government is to consolidate PSU banks, it [increase in money supply] may be not happening in hurry.
Third is sharp drop in rates for the borrowers. I think interest rates should be two percent lower. Repo rate can be 100 basis points lower. The term premium can fall by 70-80 basis points. The credit spread is elevated as well. All of this together, I can imagine mortgage rates falling from 9 percent to 7 percent and what it does to real estate market. These things need to happen, and they can happen. But I don’t think they are very likely to happen. Those are the things we need to be discussing. If it takes eight months for the MPC to cut rates by the quantum which it needs to, then the growth next year is going to remain slow