Dip before the Rise – Wealth Edge, August 2017

A plethora of events like weak inflation and IIP numbers, increasing hopes of rate cuts by RBI, roll out of GST, good monsoon and liquidity aided India’s benchmark Nifty to finally conquer the 10000 summit. The first seven months of 2017 has been a period of prosperity for investors, with equity markets making all-time highs and volatility remaining persistently low.

A key feature of the global economy at the moment, is that it is growing almost everywhere. Not at its pre-financial crisis pace for sure but still growing. Economists, on average, have raised their growth forecasts since the start of the year, with Europe a key component of those upgrades. A welcome development after years of unfulfilled promises. The only concern that can be seen is that Central bankers across have taken a more hawkish tone, questioning the level of policy accommodation given the recovery in the world economy. That said, inflation surprising on the downside presents a challenge. Federal Reserve is expected to proceed cautiously with its balance sheet reduction and, given low inflation, we now see little likelihood of further rate rises this year.

From a domestic stand point business conditions deteriorated in the last few months as the roll out of a nationwide GST disrupted supply and distribution links, just months after Prime Minister Narendra Modi’s cash ban roiled markets. Private sector activity dipped too. Some bit of the fall was on expected lines. Responding to a falling inflation and weak growth, RBI obliged by a 25 bps cut in repo rate which was more or less expected. However, a rate cut is not a magic pill for growth and demand as we have seen in the current interest rate cycle. As it has been seen in the past, banks reduce the rate when there is excess liquidity rather than when RBI cuts repo rate. Even though the pace of reforms is in place we are yet to see private investments kicking in. Private investments are low as banks are not lending, as they continue to suffer from the ghosts of the past. We have seen a shift towards retail lending from corporate lending. While banks continue to clean up and companies deleverage, we would eventually see lower interest rates becoming attractive enough for the lean and able companies, and thus private investments improving. We would also see the benefits of other structural reforms in the form of improved economic activity in the medium to long term.    

The mood in the equity markets is pretty exuberant. Faith and hope have driven Indian markets to a level where the gap between perception and ground realities is stark. There is hope that the seeds of reforms sowed today will start bearing fruits sooner or later. Earnings are yet to revive to the level that is close to current markets expectations of ~20%. However, in the preceding quarter we saw spurts of revival in the numbers. We may see a blip of a quarter or two due to GST implementation before we see a meaningful revival in earnings. The positive impact of GST and the cleanup of the banking system is what is going to drive growth, but in the medium to long term. Having said that, market needs to tone down their lofty expectations of earnings growth. We believe investing more and more based on the assumption that liquidity alone would continue to support can prove to be futile and risky at this juncture.

 

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