Indian equities came crashing down yesterday after Finance Minister P Chidambaram proposed changes to the norms governing the tax residency certificate (TRC) required by foreign institutional investors. Confusion regarding this tax issue spooked FIIs, who withdrew over Rs 1,000 crore from the market yesterday, pushing the market to a three-month low.
While the outlook for the market remains uncertain, Ridham Desai, managing director of Morgan Stanley, advises investors to look at this current dip in prices as an opportunity to buy stocks. "Six months back, prices were very attractively placed, valuations were low, but the macro seemed very uncertain. The macro is certainly better than what it was and now stock prices have come down all over again. So I think this is an opportunity to buy stocks," he said in an interview to CNBC-TV18.
Macro-economic indicators improved ever since Chidambaram cane to be the head of the Finance Ministry and implemented a slew of economic reforms. Desai believes that the most worrying factors right now, the current account deficit and inflation, are expected to improve but will reflect only with a lag. He also expects to see the Reserve Bank of India to start its monetary easing cycle.
Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video.
Q: What are your thoughts on that googly on the Mauritian Foreign Institutional Investors (FII)? Do you think it is such a big deal or is it something which is roiling your clients this morning?
A: It certainly was yesterday. If you look at the market post-Budget there was hardly any reaction. Then suddenly this fine print came to the market's attention and caused the market to selloff. There was some lingering uncertainty overnight.
So, I do not think that it has been settled despite some reassurances from the Finance Minister and the Finance Ministry. The market is awaiting greater clarification on this matter. It does not seem to have been settled. I came away thinking that it is not likely to be a big thing, but the market is still a bit edgy about it.
Q: In your conversation with clients and colleagues what is the sense you got? Is it going to lead to some near-term selling pressure or are people just sitting on their hands for the next 24-48 hours? They do not want to put in any money till they know where things stand clearly with that tax issue?
A: Investors are assessing the situation. They are trying to understand the fundamental impact of the Budget. I do not think investors look at it from a one to two day perspective. There might be an opportunity in the pipeline. Let us evaluate this and step back for a moment.
Six months back prices were very attractively placed. Valuations were low, but the macro seemed very uncertain. The macro is certainly better than what it was and now stock prices have come down all over again.
So, investors are likely to step back and evaluate the fundamentals and come away thinking that okay, maybe this is an opportunity to buy stocks. So, I do not see any immediate reaction, except for some short-term traders or short-term investors who may have taken money out yesterday in response to the kind of panic that has spread in the market. However, from hereon, I think there will be a little bit more considerate evaluation.
Q: Is the macro really better? We have got a 4.5 percent print and nothing to suggest that it will be much better in the current quarter. Current Account Deficit (CAD) is worse than what it was six months back. Aside of inflation what is there to cheer about on the macro front?
A: There were three things. First is the macro stability indicator, which is your fiscal deficit and CAD. Second is the growth indicator and third is inflation. I would say that all of these are actually better than they were or at least looking like they will get better. The fiscal deficit was annualising 6 percent in September. It is now likely to be 5 percent, maybe not 4.8 percent. However, it is unlikely to be much higher than that.
So, we have certainly achieved a 1 percentage point fiscal consolidation largely through expenditure cuts, though it has not reflected it for next year. The second is of course the CAD, which was worst in the December quarter, will start improving. The CAD will respond with a bit of lag. However, the 1 percent curtailment of spending by the government will result in lower CAD numbers.
Inflation seems to have peaked and the Wholesale Price Index (WPI) is already suggesting that. The seasonally adjusted rate of inflation, the three month moving average is already at 2.9 percent and that leads the headline number by three months. So, the headline number is heading a lot lower in the next three months. I think consumer inflation should follow suit.
Finally on growth, the third quarter GDP print was a bit lower than what people expected. However, there were a few nuances there and our expectation is that actually growth will improve from hereon. We think the fourth quarter number will be in excess of 5 percent.
As one goes into FY14, at least the GDP growth number looks like it is going to 6 percent, so that is also improving. On all counts the delta is positive and the markets care for the delta. So, I think that is something that we can say that the macro is looking better than what it was six months ago.
Q: What kind of bias do you approach the market with then if that is your base assumption for the market? What do you expect to see over the course of the next few months?
A: First thing that we need to bear in mind is that there is a very uncertain global environment. That will keep coming back to affect stock prices in India to a lesser degree than last year. Certainly, it will impact India, especially if there are any untoward incidents like we saw with the Italian elections.
I do sense that the correlations are a lot lower. India is more domestic driven now than it was six or eight months ago. If you look at the correlation of returns it is actually at a five year low. Even though the FII flows have been so strong India is not being influenced by day to day movements across the globe. The second is of course domestic policy action and I expect more policy action in the ensuing days.
A lot of announcements were made in the Budget which has to be followed up with further action. As those things happen I think the markets will respond. We have the RBI’s monetary policy and the RBI will be looking at both the fiscal deficit and the inflation numbers. So, the likelihood is that we will get more monetary easing and the growth prints will get better.
Equities will inch higher for the rest of the year. We have had a very steep correction which has made valuations quite attractive all over again.
Q: Are you surprised and disappointed at the way midcaps have collapsed in last one month?
A: Certainly. I would say that I am surprised by the fall in the index itself or the force with which it has fallen. There was not any apparent trigger for it to happen, that itself was a surprise. We have had a slightly different strategy since September. Our strategy has been to buy large cap cyclicals.
So, we are a lot less focused on midcaps than we have been for the last five or six months. Midcaps were my favourite space in 2012. However, after we sensed a change in the macro in September we shifted stands to large cap cyclicals, which is what we favour right now over midcaps.
Q: Did you hear anything or any indication of anything in the Budget that would really push earnings growth going over the next few quarters? Did you hear enough to see that earnings will start improving dramatically?
A: Not specifically from the Budget. The Budget did not mar growth prospects. If you look at it the Finance Minister has held expenditure-to-GDP at constant levels over what will be a slightly depressed FY13. So, he is taking all the pain in the last quarter of this calendar year, which I think is one of the factors that may have led to the market selloff yesterday.
The markets suddenly realized that the GDP print in the immediate quarter may continue to look quite bad. So, that may have been one of the reasons that may have affected the stock prices yesterday. Things will improve a little bit in FY14 because the base effect kicks in and there is not such a big expenditure cut. He is relying more or revenues to curtail his fiscal deficit. I am slightly disappointed that he did not aggressively use tax instruments to boost financial savings. Financial savings are sub-8 percent. They are at a 20-year low.
We have gone back to 1990, pre-economic reforms. It is a big fall in financial savings and we need to do something urgently to boost them. They will go up when returns and real rates rise. However, one has the option for using tax instruments to boost returns by saying things like let us exempt bank interest income for a year from tax and put incentives on investors to put money into bank deposits over gold.
The absence of that was a little disappointing. I was expecting more aggression there. Aside from that I do not think there was any direct thing in the Budget to hurt or help earnings. Earnings will be helped as real rates stabilize which is going to be led by fiscal consolidation and a decline in the CAD. I expect the CAD to decline faster than the fiscal deficit, which will be good for earnings and nominal GDP growth will be in the low teens.
Therefore, earnings growth which has been hovering around 7-8 percent from the broad market will probably accelerate to the late teens in the next 12 months. So, I actually remain quite optimistic on earnings relative to where the Street is right now. The earnings environment is unchanged after yesterday’s event, but it is certainly looking a lot better than what it was six months ago.
Q: How would the RBI look at the absence of expenditure cuts in FY14? That is not great quality in reaching 4.8 percent. FM is assuming higher tax revenues which he will probably fall short on and he has underprovided on many of the subsidies and got to 4.8 percent, but his expenditure targets are fairly large for FY14. Is that the kind of quality you need to see or the central bank wants to see in getting to a better fiscal deficit number?
A: There are two things here. The adjustment in the expenditure has happened this financial year. So, one has to keep a note of that. The RBI has not responded to that. He has taken a big hit on expenditure this year. So, he has made that one adjustment. He is not making a further adjustment next year.
However, crucially for next year is the change in mix of spending. He is taking subsidies down as a percentage of GDP. If I recall correctly by almost 60 bps and he is increasing plan expenditure by 30 bps albeit from a very low level, but that mix change is I think crucial. So, the point is absolutely valid that there is no further deceleration in expenditure as a percentage of GDP in FY14. We have taken the hit in FY13, but there is certainly a mix change that is being budgeted for FY14. That is crucial because that mix change will have implications on inflation, which is arguably having a higher subsidy, fuse more inflation rather than incurring plan expenditure.
So, that mix change is important. However, yes, these are changes at the margin. They are not dramatic. I think it would have not been fair to expect a dramatic shift or a very big risk taking Budget given that after all it is going to be an election year. So, we are going to be in more nuance and those changes are there in the Budget.
Q: A lot of the expenditure has gone towards the social welfare schemes. I did not hear that much about infra spend. What do you takeaway from that for the infrastructure sector especially given what we have seen in earnings season gone by?
A: If you look at the total numbers NREGA is one part of rural spending or social spending and add up all the other categories. Last year they finished at 52 bps of GDP. For next year it is budgeted at 65 bps. So, it is not a very big change. It is about a 10 bps change as a percentage of GDP.
It is not being lifted dramatically. The Year-on-Year growth numbers look overstated because one has actually hit the numbers this year. I am not focusing so much on that. I am looking at their share in GDP. Non-social spending is also going up by a similar amount. He has increased the spending in proportion on both sides.
So, it is not that he has focused on any one particular area. I do not think there is further impetus to rural spending which by the way has been at high points and should have stopped rising which is certainly the case with this Budget.
Q: Do you think by the middle of FY14 given that earnings are still on a weak kind of trajectory and therefore tax collections may as well, he will figure out that he is not getting to 4.8 percent quite so easily and again have to slam the breaks as he did in Q3 and Q4 FY13 to get to that number so that rating agencies do not breath down his neck?
A: Look at it slight differently. They have been more aggressive with asset sales. If the markets open up a window which surely they will at some point in time, we are not going to be in this depressed sentiment all year. The government is opportunistic enough as they were in January-February. Looking back on January-February one can certainly say that the government used inflows very well to fund their deficit. They can do it again.
So, it does not necessarily have to hit expenditure. It is unlikely to hit expenditure because by the time one realizes if at all revenues are going to trail the expectations, it will be quite late in the year at a point in time when elections will be upon you. It will just not be politically feasible for a big expenditure cut.
They will have to be prepared for this and they will have to raise revenues whenever the markets offer them a chance and there is room there. The total Budget on asset sales is Rs 54,000 crore, but I see room to do a lot more, if the markets are conducive. So, to that extent one can expect that the government will keep up the supply at higher levels of the index.
Q: How do you think global markets have been moving?
A: Our global guys call this a period of great monetary easing. We are entering into the third cycle of this great monetary easing. We have seen two cycles already. So, all this bad news actually translates into more monetary easing. It turns out more positive for the markets than it looks on the face of it.
So, in case one gets some volatility, untoward incident in Europe it is likely to lead to greater easing. I think the liquidity environment in the world will remain constructive for India. Therefore, the outlook for flows will remain good so far as we do not do anything nasty out here, which I do not think is likely to be the case. If we are going to keep our story intact the flows will continue to come in.