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It’s A Bond Not Equity Budget, Says Morgan Stanley’s Ridham Desai

India’s proposal to issue sovereign bonds in the foreign market is a confident step, says Desai.
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Nirmala Sitharaman, India’s finance minister, center right, Anurag Thakur, India’s finance and corporate affairs minister, second left, and other members of the finance ministry pose for a photograph outside the North Block of the Central Secretariat building in New Delhi, India. (Photographer: T. Narayan/Bloomberg)
Nirmala Sitharaman, India’s finance minister, center right, Anurag Thakur, India’s finance and corporate affairs minister, second left, and other members of the finance ministry pose for a photograph outside the North Block of the Central Secretariat building in New Delhi, India. (Photographer: T. Narayan/Bloomberg)
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India’s Union Budget 2019 favours the bond market over equities, according to Morgan Stanley’s Ridham Desai.

“The government bonds are in a bull run,” Desai, the head of India equity research and India equity strategist at the investment banking firm, told BloombergQuint in a conversation. The budget’s proposal to issue sovereign bonds in the foreign currency is a “confident step”, he said, adding it’s a “risk India was unwilling to take from past 75 years” due to uncertainty around its macro-stability.

“As a country, we feel far more confident about our macro-stability environment because inflation is lower,” Desai said.

It’s a bond budget, rather than the equity budget. It’s very good for bonds.
Ridham Desai, India Equity Strategist, Morgan Stanley

Still, he said the government bonds are not overvalued relative to equities. But at some point of time they would be and then investors can make big call on equities, Desai said.

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Budget 2019: Why Former RBI Governor Rangarajan Thinks Sovereign Foreign Currency Borrowing Is A Bad Idea

Bullish On India’s Growth

Desai said Finance Minister Nirmala Sitharaman’s maiden budget is growth-oriented. He’s bullish on India’s growth story and said the country is set for a better growth environment.

Desai, however, is cautious on the global equities for the next 12 months. Morgan Stanley on Sunday downgraded its investment recommendation for global equities to ‘Underweight’ amid the ongoing trade war tensions. India, he said, is well-placed in the dynamics and has the potential to outperform the global markets on the relative basis.

Stock Picks

  • Desai said the automobile sector is witnessing a cyclical slowdown due to issues among non-bank lenders. Cyclical issues with autos, according to him, will get fixed as growth comes back.
  • Desai said he wouldn’t buy “something as defensive as” the information technology stocks as they are expected to have lower growth on significantly higher valuations.

Watch the full interview here:

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Budget 2019: What It Means For Stocks And Sectors

Here are the edited excerpts of the interview:

Do you think with this budget, the government and the Reserve Bank of India tried to bring down the cost of capital?

I am very happy with the budget. There were three things which we were hoping for. We were hoping that government will capitalise on a very attractive global environment and they have gone for it in an aggressive way. We were hoping that they will address the problem of public sector banks, with respect to the capital. They added a liquidity window for the non-banking financial companies also. That wasn’t in my base case. I was hoping that they will not actually hold to the fiscal deficit. If anything, they have budgeted it lower and the numbers look credible for a change and therefore fiscal deficit looks achievable.

I think we are set for a better growth environment. I will call this a growth-oriented budget and bringing the cost of capital down is supportive of growth. That is an outcome of controlled inflation for five to six years. As a country, we feel far more confident about macro-stability environment, because inflation is lower. And therefore, sovereign bond—that was a risk which we were unwilling to take for 75 years because we are always unsure about our macro-stability. Now, we are more assure that we can take that risk. I think this is a very confident step forward. So, I am very pleased with the budget.

The government has penciled a very large sum of transfer from the RBI. The Bimal Jalan committee is in favour of a number of close to Rs 8,000 crore. You can argue that the government owns the RBI and they can take the final call. But if that committee doesn’t propose such a high number, it’s a big number which might go away from the expectations of the government?

We should look at an incremental number. There is an annual dividend flow which the RBI gives to government. So, you can increase the annual dividend flow. I am not too perturbed about it.

The budget is not very different from the interim budget. In the revised estimates, tax revenues came behind a tad and so they had to boost revenues. They used three to four sources. They have taxed the super-rich, which is an assured stream of tax flows, which is Rs 12,000 crore in kitty. They have raised taxes on diesel and petrol, which is an assured one because four companies collect it and so it is in bag. They have raised dividend from public-sector undertakings and the RBI in which the government decides how much cash flows they want to pay out. That cash flow which lied with PSUs can either be spend on capital by themselves or be transmitted to the government. In the current environment, it is a better thing to transform to the government which will ensure that fiscal deficit is not high and that allows the RBI to be accommodative, which allows rate to be lower and fuel capital funding for the country as a whole. It is better spent in the hands of the government.

They have lifted the divestment target which I am cynical about as we didn’t have any real divestment in the past few years. It is the same thing as dividend. Whether you call it dividend or divestment, it is a same thing. It is a transfer of cash and is an accounting thing. It affects the central government’s account.

On the revenue side, the increase that they have engineered is a fairly short stream of flows. Therefore, the deficit is okay. We are not talking about boosting expenditure. Several commentators have thought that the government should raise fiscal deficit. But that could have been a mistake, because we have hard earned macro-stability and we should not tamper with it and leave the work on the economy to be done by the RBI. The economy was going through a monetary problem and not a fiscal problem. Monetary policy had been too tight for too long and now the RBI has worked on it for the past four months and they have loosened it. We will see the impact of it. If the government had taken a risk on the fiscal side, the RBI would have been a little hesitant to continue with its accommodative stance. Instead you raise money abroad, which is very strong message that the government is sending about how it wants to fund deficits going forward. It is also sending a message on how it feels about the macro-stability and I concur with that view.

She (Nirmala Sitharaman) was also granular in her budget about the capital market issue, suggesting to bring down the holding of the companies and getting the public holding from 25 percent to 35 percent. Also, the long-term capital gains going to government’s kitty?

That is a proposal that they have asked the Securities and Exchange Board of India to look at. It is not a decision taken, but it is complex and not straightforward. I don’t think the decision will come quickly on this. There are multiple aspects of raising minimum shareholding. It may put off the companies, which may raise capital in future because they have to dilute a lot in upfront and companies don’t want to do it. You may shoo away the companies who are planning to raise capital. That is not good for the capital markets. It may cause multinational companies to take a re-look. 75 percent is the threshold on which the resolution gets passed. You go down to 65 percent and you are dependent on minority shareholders, which may not be a comfortable position for the listed MNCs. They may choose to de-list. Again, you are shrinking the capital markets. It may also lead to depending on what time frame is given to the companies for the extra supply of equity. We have estimated BSE 200 companies, and if all companies need to get 65 percent then it is $30-35 billion of extra stocks in the market. That is the other implication.

It improves liquidity because free float has been a problem. If you increase free float, and there are other measures to increase the free float, because the very important announcement in the budget with respect to the free float was subsuming of the foreign direct investment and the foreign portfolio investment limits. This is an interesting thing. Hitherto, since 1993, the FPI limit was automatically at 24 percent and it was up to the companies and their board to make a proposal to the shareholders to increase it. A lot of companies chose not to increase it, because they where afraid of the foreign entities coming and raiding their company. As a consequence, India’s free flow is lot lower than the emerging markets average and we are underrepresented in the EM index relative to our gross domestic product size. Our GDP share is 15-16 percent, but our EM index is only 9 percent, largely because our free float is a lot lower. Now it raises the FPI limit to the FDI, limit which is 100 percent in most cases. So,  the FPI limit now is at a 100 percent and the companies now need to take action to lower it. Imagine companies going to the shareholder and saying that we want to reduce the FPI limit, because we don’t want our share price to go up. It is very hard to do. It was a very important move.

If you combine this, and then increase in public holding, it increases the free float and that increases passive flows and active money into India. But it is very complex and not a straight forward thing. SEBI and the market participants will engage experts to understand the ramifications. This is not a done deal, but a proposal. 

A couple of experts mentioned that raising of free float is enabler for India to get included in certain other emerging market indices?

No. India is already there. It is fourth or fifth rank in the emerging market index. In the MSCI Index, it has got a large pool of assets which are benchmarked to it. We have been not receiving a fair share of passive flows, because our weight is lower than the GDP rate. So, it could make a big difference to the amount of flows that come into India, which is consistent to the overall theme of the budget. There is a low hanging fruit, with respect to attracting capital flows and investments into India because people are looking to diversify away from China. This is hitting the nail right where it ought to be.

What happens, if this proposal is accepted in some shape or form? The quantum of papers which hits Indian markets, do we have the depth to absorb so many papers?

In 2010, the government had made it 25 percent and it did have much disruptions. Public sector companies have not yet met the 25 percent threshold, which is why the finance minister in her speech said she will urge all the public sector companies to get to 25 percent. It is long overdue. They had to get it a awhile back. Private sector companies have already got to it and it was not as disruptive.

Supply is disruptive when markets are weak. If it is a strong market, the supply is always welcome. So, this is not about supply. The issue goes beyond supply. Supply is the fourth factor in this list. I am worried about the companies, which are envisaging listing in the future and controlling stakeholders feel that 35 percent is too much to dilute first up. A lot of companies don’t need that much capital upfront. Unless the promoters are selling down their own stake, if the company is raising capital then they want to raise it in tranches, rather than sell a third of outstanding equity to raise so much capital upfront. It depresses the return on capital. I am more worried about that.

How would you breach that 35 percent?

We don’t know, and it is too early to discuss it. We will discuss after the SEBI has put its proposal and then we will examine the details. I am sure the market participants will highlight all these issues when it comes to SEBI, and we will see how it goes.

Other is opening of the FDI in media, aviation and insurance. A lot was desired for the auto space, but the push went towards electric vehicles. Petrol has become expensive by Rs 2 per litre. How does it play out?

There is a cyclical thing and a structural thing. The cyclical slowdown has been largely engineered by what happened to the NBFCs and auto companies not anticipating slowdown and therefore inventory piling up and now the unwinding taking place. I am still piling up on auto stocks. It takes patience to make money, but when the money comes in then it will come hard and strong. That is a cyclical issue, which will be fixed with an overall growth. The budget has done lot on that front. NBFC gets funding via the banks in the RBI window, which is a very big change that happened post market. I don’t think the market completely understood it. Therefore, today is a slightly different day relative to the other markets as markets globally are weak. That is a cyclical bit.

The structural bit is that EV is a reality. Whether it comes in five years or 10 years is a matter of debate. So, we are going electric. I have seen this with the government and Prime Minister Modi. He is extremely convinced about India reducing emissions. So, it is not just EVs, but it is also the power sector and everywhere where pollution is an issue. And India does have a serious crises in air pollution. Crises in air pollution is bigger than the water. Even if the water crisis is making the headlines, the air pollution crises is bigger. We don’t feel it here in Mumbai, because we are endowed with a seacoast and all of our pollution drifts into the sea by the middle of the day. Even then, Mumbai is the 33rd worst air quality city in the world. We are better than Delhi, which is second or third on the list. But we are worse off than Pune, which is next door and is landlocked. Pune is 80th on list. And there are tonnes of top pollutant cities in the world and we are not even industrialised as a nation. So, air pollution is a crisis. Therefore, whatever is done is fair. But the time frame is debatable. EVs are coming. A lot of auto companies have to and a lot of them are doing it. We have heard from the auto companies and they are already getting ready.

There is a big supply chain disruption, which is a matter of debate for a lot of investors because a lot of auto ancillary companies are not viable in electric environment. They have to either fade away or have to re-engineer the business models and there could be some disruptions. Electric is one of those disruptions coming into India.

What is happening globally? What is your belief that markets will do over the next 12 months?

The absolute call depends on what the global equities do. We just went underweight on global equities overnight. The rationale is that historically, global equities, particularly the U.S. equities, which is a chunky bit of globe, have not done well when the Federal Reserve is dovish, and the growth is slowed. They do well when the growth is accelerating, and Fed is dovish. That is Goldilocks for equities. This is not a good environment when the Fed is going to be dovish. The reason for Fed to be dovish is because the growth is slowing. We are cautious for global growth. In the next 12 months, we will think that trade war is having its impact and it will take time for it to unwind even if China and the U.S. resolve it. The U.S. capex is certainly slowed down. I will therefore be vary about IT stocks in India, because there is a serious slowdown in the business cap. That is why we think that global stocks will underperform the asset classes. So, we have got underweight on global stocks. If the absolute global markets are not heading much higher, India will have its own problem of going high on absolute basis. But on relative basis, and India remains one of our top picks in the EM space, India is very well placed.

This is a conundrum for India. It has become a low bidder market. It does well when the world is not doing well, but that doesn’t give you absolute returns. It doesn’t do well on relative basis, when the world is doing well, but that give you absolute returns. I don’t know which one you want to choose. If you are a foreign investor, you’re fine with the first. If you are a domestic investor, then the second one is what you want. Returns in India will be harder to come by. The markets will require far more stronger signs about when growth is coming back, before it puts a bid on stocks. We are in a range and not breaking out in a hurry.

There will be stock picking opportunities, but the Nifty is not tearing away and that is largely to do with the global backdrop. 

And the fact that just five or six stocks are propelling the index higher?

That is not unique to the cycle. It has happened in the past, too. Lots of people make a big deal about it. The stock changes but the concentration of performance is not unique to the cycle. That concentration will start reducing when the growth comes by. So, it is purely a function of growth. The companies that have withstood the slowdown in growth are the ones that have delivered stock market performance and as the growth broadens out, the others will join in. If I want to make a two- to three-year call, then I will definitely buy broader market. It looks attractive and I have been saying this for three to four months now and I will keep saying this because it is hard to time the bottom. When these things turn, then they will turn very strongly. So, you have to take two- to three-year view. You have to wait patiently, and I think the broad market looks interesting.

If we are talking about growth petering off and what is happening globally, is it going to be that bad for Indian IT players?

It is a relative thing. If growth in India is picking up, when growth in the U.S. is slowing down then the domestic cyclicals will do better as compared to globally. So, it is a relative thing.

In terms of the earnings growth, is that expected to be higher?

10-12 percent growth will not look very exciting if the rest of the companies are doing 20 percent and I think 20 percent is on the cards. We didn’t have such a bad earnings environment last year for Nifty. We had high double-digit growth. I think we are in that environment where growth will start inching towards 20 percent.

I am bullish on growth in India. In that context, I don’t want to buy something which is defensive like IT with much lower growth and much higher valuations.

The overarching belief is that the global equities have underperformed and despite India showing growth in the near term, it is difficult to time when upside comes in? When it comes in, will it come with a bang for at least the broader market, which are relatively undervalued?

That’s the peril of making these six to 12 months forecasts. I prefer to buy equities as an asset class with long duration because equities are a long-duration asset class. This is not a period where I sense that we are in a bubble. We are certainly not in a bubble. That’s the time when you sell, and we are not there.

FII inflows, IT is slowing down. Is your base case that the rupee might appreciate from where it is right now?

That is a dollar call. It is largely U.S. and we are bearish on the U.S. dollar globally. With Fed cutting rates, the dollar will weaken, and emerging market currencies, in particular, will do okay. So, it is a good environment for Indian currency.

The balance of payments is looking fine. So far, we don’t get terms of trade shock via oil which looks unlikely if global growth is slowing, oil is also going to be reasonable, which is why taxing petrol and diesel is not going to a burden because oil prices may be falling. So, it will get absorbed in the oil price fall. The government did precisely that over first three years of its previous tenure, which is taxed oil and oil fell and it raised those revenues, which is why it was able to put infrastructure in place and consolidate the fiscal because direct tax revenues and indirect tax revenues from goods and services have been persistently weak.

I think super-rich can make contribution to the country. Rs 12,000 crore is not going to kill them. A lot of them voted for a majority government, so they trust the government will do okay with those revenues and they will not waste them unlike in the past where lot of tax revenues got wasted. And the government has the infrastructure in place not to waste that revenues—Aadhaar, direct benefit transfer. I think this is surcharge. And I know that surcharges that were imposed over last few years have not come off, but I hope and predict this will come away. It will be a temporary thing. The biggest beneficiaries of a growth turnaround are these super-rich people. 70,000-80,000 people in the population of 1.3 billion population, I think we should be happy that we can make contribution. Lot of people were upset about it but it is fine because the government had very limited options to tax at this stage of growth cycle and they needed to balance the deficit.

Bond markets have also been money churner for many people. What is the trade off? We are in slowing interest rate cycle. How will you play the differential between equities and debt?

I think government bonds are in a bull run and they remain so. But at some point, they will become overvalued relative to equities. At that time, you can make very big call on equities. They have still not become overvalued. They are getting there but we have not gotten there.

And finance minister wanting some retail participation in government bonds?

It is actually a bond budget rather than an equity budget in that sense. First of all, aggregate supply is constant because you have not raised the fiscal deficit. Then you are taking some of that and raising overseas. So, you are reducing the net supply. You are not raising fiscal deficit. I think this is very good for bonds.

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