COMMENT-The Economic Survey carries some important messages for equity markets

Madhuchanda Dey                                                                                      Moneycontrol Research

The Indian Economic Survey’s hawkish tone about Indian stock market valuations may not be music to the ears of investors looking to put money in their next SIP (systematic investment plan). And while the encouraging commentary on the macro outlook should sooth nerves, there’s enough of a red flag from oil prices for investors to take sit up and take notice.

Indian equities – in an uncomfortable zone?

The survey highlights that while Indian and U.S. equities have rallied in tandem, in India it was despite deceleration in growth, a falling corporate earnings-to-GDP ratio and high real interest rates, contrary to the United States where the macro fundamentals were robust.

What appears to be driving India’s valuations was a fall in the equity risk premium reflected in a massive portfolio re-allocation by savers towards equity in the wake of policy-induced reductions in the return on other assets (demonetisation has taken the sheen off gold and real estate).

However sustaining these valuations will require future growth in the economy and earnings in line with current expectations. So keep a hawk eye on earnings.

Encouraging commentary on growth

There seems to be light at the end of the tunnel. The Survey observes that many of the issues that hamstrung growth in the past are getting resolved. The shadow of demonetisation and GST-led disruptions are behind us, the twin balance sheet problem of stressed corporates and weak banks is getting addressed through IBC (insolvency and bankruptcy code) resolution and recapitalisation. Finally, synchronous global growth should give a boost to exports.

The economy has begun its acceleration in the second half of the year. This should allow real GDP growth to reach 6.75% in FY18, higher than the CSO’s forecast of6.5 percent, implying that growth in the second half would rebound to 7.5 percent.

Growth should rebound to 7-7.5% in FY19 thereby re-instating India as the world’s fastest growing major economy.

Cues for the upcoming budget

Employment: Finding good jobs for the young and burgeoning workforce, especially for women.

Education: Creating an educated and healthy labour force.

Agriculture: Raising farm productivity while strengthening agricultural resilience. Finally, strengthening the sustainable engines of growth—private investment and exports.

The Survey points out that climate change—whose imprint on Indian agriculture is already visible—might reduce farm incomes by up to 20-25 percent in the medium term. The government’s laudable objective of addressing agricultural stress and doubling farmers’ incomes consequently requires decisive efforts to bring science and technology to farmers, replacing untargeted subsidies (power and fertiliser) by direct income support, and dramatically extending irrigation but via efficient drip and sprinkler technologies.

Markets should look for announcements in all the above-mentioned areas in the Budget as also some tinkering with import tariff that could foster domestic manufacturing.

Prepare for modest fiscal slippage

The Survey says that a pause in government’s fiscal consolidation relative to 2016-17 cannot be ruled out. The deficit for 2017-18 will include Rs 80,000 crore (0.5 percent of GDP) in capital provided to public sector banks. Hence setting overly ambitious targets for consolidation, especially in a pre-election year—based on optimistic forecasts that carry a high risk of not being realised -- will not garner credibility either. Pragmatically steering between these extremes would suggest a modest consolidation that credibly signals a return to the path of gradual but steady fiscal deficit reductions.

Closure of unviable banks on the agenda

The document points out that alongside the twin balance sheet action, complementary reforms to shrink unviable banks and allow greater private sector participation is required. The recently proposed Financial Resolution and Deposit Insurance (FRDI) bill would be important in this regard.

Oil price – the Achilles heel

In recent times, fiscal deficits, the current account, and inflation were all higher than expected, albeit not threateningly so, reflecting in part higher international oil prices—India’s historic macroeconomic vulnerability. The Survey points fingers at aggressive output cuts by Saudi Arabia (and Russia) in advance of the planned listing of the Saudi Arabian oil company, Aramco, which could force oil prices even higher.

So in sum what does it mean for interest rates?

If future earnings and economic growth are so bright, justifying high equity prices, interest rates cannot remain low forever.

The Survey draws our attention to high frequency indicators that suggest a robust recovery is taking hold as reflected in overall GVA (gross value added), manufacturing GVA, the IIP, gross capital formation and exports. Real non-food credit growth has rebounded and behaviour of manufacturing exports and imports in the second and third quarters of this fiscal year has started to reverse. The cash-to-GDP ratio has stabilized, suggesting a return to equilibrium after the demonetisation disruption. The expansionary fiscal policy is also providing a boost to aggregate demand.

Private investment seems poised to rebound, as many of the factors exerting a drag on growth over the past year finally ease off.

All this said, while the direction of the indicators is positive, their level remains below potential.

While growth is making a comeback, oil prices are forecast by the IMF to be about 12 percent higher in 2018-19. Assuming the increase is passed on into higher prices, rather than absorbed by the budget through excise tax reductions or by the oil marketing companies, it would exert inflationary pressure.

Not only inflation, it would impact the current account, the fiscal position and growth, and force macroeconomic policies to be tighter than otherwise.

Finally, if markets were to experience a “sudden stall” induced by sharp corrections to elevated stock prices that could trigger capital outflows, policy might then have to respond with higher interest rates, which could choke off the nascent recovery.