Daily Voice: Change in income tax structure unlikely in budget, some incremental reforms to stimulate growth possible, says Julius Baer's Unmesh Kulkarni

Is it the right time to include safe havens like IT, FMCG, and pharma in a portfolio for healthy returns in the coming quarters?

Our preferred equity themes for 2025 are rural recovery, late-stage real estate plays and large caps. And with the Indian equity markets finally showing signs of a meaningful correction, sentiment can selectively shift in the near term in favour of defensives. We like mass consumption (rural and welfare spending) and large private banks.

The IT sector was one of the high performing sectors in 2024, returning 22% return. The expected pick up in US growth is positive for Indian IT, as IT spends (including discretionary) from US banks, retail etc. are likely to improve. Digital, Cloud, Generative AI, Cybersecurity and IOT present long-term opportunities for Indian IT. A weak INR is another positive for the sector.

However, there are some challenges too. The global spend on IT services is moderating, which will affect IT services export. Also, while the increasing adoption of AI could provide opportunities to the IT players, it can also pose some challenges to the ‘labour arbitrage’ advantage that India has enjoyed over the past several years. And the recent spurt in global yields could lead to some pushback of the anticipated revival of discretionary spending.

We are neutral on the IT sector (given that valuations have risen) and prefer a stock-specific approach.

In Pharma, we expect a better outlook for domestic-focused businesses and companies having a strong product pipeline and catering to specialty/niche products in the US markets, which offer better realisations. While the pricing erosion in the US generics market has been benign over the past few quarters, it remains a key monitorable.

In the FMCG space, there is a slowdown in urban discretionary spend, apart from intense competition in traditional FMCG companies and the quick service restaurants. We prefer companies with broad portfolios, innovations and launches, as well as companies with a greater rural presence, as rural consumption is seen recovering.

Overall, we prefer incremental allocation to large caps over mid/small caps, as large caps are relatively more reasonably valued.

Have you turned significantly bullish on the banking and financial services sector, especially after the recent correction?

While we are structurally positive (long-term) on the BFSI space, given the long-term economic growth prospects and lower valuations, in the near-term, however, we prefer to be selective. We prefer large banks that are quality lenders with better asset quality.

Banks with higher exposure to unsecured loans and microfinance are expected to see moderation in growth, given the stress in the sector and the accompanying clampdown by the RBI.

On the other hand, large private banks have lower exposure to the stressed sectors, are well capitalized and have better profitability. Bank stocks have underperformed meaningfully over the past couple of years and are relatively cheap and attractive. However, in the near-term, there is a possibility of temporary NIM compression for banks, with RBI expected to cut rates by 50 bps in CY25. We are neutral on the NBFC space and would stay with the quality lenders.

Do you think the equity market has already discounted most of the negativity associated with the expected US-favoured policies under the Donald Trump administration post-January 20?

Indian equity markets have cracked between December and early January, with Trump and his prospective policies dominating headlines. Nifty 50 has corrected 11-12% from the end-September peak, while the broader market has corrected 12-14%.

The Trump-related impact on Indian equities will largely be driven by how the global sentiment around this evolves, especially once Trump has been in office for a few days/weeks. The Dollar strengthening bias, if it persists longer, will act as a near-term headwind for EM equities, including India.

However, there are other domestic factors as well, that are in a way driving the (low) FPI sentiment. The robust earnings growth over the past couple of years has moderated to single digit in FY25, driven by aggressive fiscal consolidation, contraction in credit growth (partly due to regulatory interventions) and delayed government spending in H1FY25, due to the general elections.

Overall, we continue to remain constructive on the Indian equity markets, driven by the earnings cycle and strong domestic liquidity, coupled with likely comeback of FPI flows. Markets could be volatile in H1CY25 as debates persist around Donald Trump policies and comeback of India’s earnings growth momentum. The high valuations of 2024 are now correcting and present an opportunity to buy the markets/stocks in dips. However, return expectations need to be muted in CY25 as domestic earnings need to catch up with valuations, and the global sentiment needs to normalize in the Trump era.

Are you confident that the US Federal Reserve will pause its rate cut cycle in the first half of 2025?

Post the recent US Presidential elections, with the new President-elect Trump making a spate of announcements, US markets are perceiving the new regime to be pro-growth. With the promise of reflationary policies leading to higher growth and higher interest rates, the bond markets in the US have sold off in December, with the 10-year US Treasury yield climbing 50 bps since the US elections, while the Dollar index has gained more than 5%. The Fed cut rates by another 25 bps in the December policy; however, it indicated that it would slow down the rate cuts, with only 2 rate cuts likely in CY25.

The recent stronger-than-expected US labour market report, however, makes additional monetary policy easing in CY25 less likely. The expectation of higher economic growth, a solid labour market and sticky inflation is likely to restrict the Fed in its rate cutting cycle, for now. Our global research desk expects the Fed to pause through CY25.

Do you think the FY26 Budget will be a non-event for the market, despite expectations for measures aimed at boosting economic growth and consumption?

In the upcoming Union Budget for FY26, the Government is expected to continue on its path of fiscal consolidation. As in the previous Budgets, the Government might announce some incremental reforms to stimulate growth, and some measures to boost rural consumption, which has lagged earlier and is now beginning to show signs of recovery. However, some of the benefits of FY25 such as high dividend payout by the RBI and the healthy tax collections from capital market activities could be lower in FY26, which, coupled with the recent populist measures announced by the various States, could put some strain on the Government’s finances and its willingness to spend more. Some tinkering of the duty structure for imports/exports may be possible, given the tariff card being played out by Trump.

From the equity market perspective, the incremental reforms and prudent fiscal management would generally be perceived as neutral. Any major relief for specific sectors in anticipation of tariffs could be on-the-margin positive for those sectors. We do not expect any material changes in the income tax structure, as the revamp of the tax structure took place only 6 months back in the last Union Budget.

Do you believe the economy is experiencing only a temporary slowdown?

The Indian economy is currently going through a cyclical slowdown. The high inflation of the past couple of years (especially food inflation) and high interest rates have impacted consumption, and the delayed government spending has further added to the loss of momentum. The global reflation trade and a resurgent US Dollar have taken a toll on the INR as well as our forex reserves, which have fallen about 10%, while it also restrains the RBI from providing aggressive measures to support growth. Various macro indicators of the economy have shown signs of slowdown, and the GDP has contracted from 8.2% in the Q1FY23 to 5.4% in Q2FY25.

However, India is still one of fastest growing economies among several nations, given several structural factors weighing in our favour - political stability, ongoing reforms, focus on capex, healthy balance sheets of corporates and the banking sector, ample forex reserves and an overall resilience of demand and growth. With the government spending expected to pick up in H2FY25, coupled with favourable agri dynamics and steady improvement in rural demand, consumption should start picking up.

Commodity prices and oil prices are contained, and domestic interest rates should start coming off in CY25. Inflation has started coming off with food prices beginning to moderate, and the RBI is expected to cut policy rates by about 50 bps in CY25, which should spur demand. H2FY26 should see domestic growth prospects improving. The global trade/tariff situation and the accompanying higher global yields and strong USD are however clouds of uncertainty.

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