Sign of caution? Top 4 macro factors which D-Street seems to be ignoring

BSE

The S&P BSE Sensex might have rallied by just about 18 percent so far in 2017 but there are various factors which suggest that the rally is largely led by sentiments and very little by fundamentals.

The latest macro data suggests a slowdown in the economy but euphoria on D-Street seems unabating. “We believe market participants may be ignoring the structural challenges to India’s GDP growth by overly focusing on the cyclical factors of demonetization and GST,” Kotak Institutional Equities said in a note authored by Sanjeev Prasad.

“In our view, weak investment demand (30% of GDP) is a far bigger ‘structural’ challenge for the economy. We are not sure how this will change in the short term,” he said.

Here is a list of top four macro factors which markets seem to be ignoring:

Weak investment demand is a far bigger challenge:

In our view, the general narrative about the slowdown in the Indian economy misses the negative contribution of continued weak investment demand. “Market observers have largely focused on demonetisation and GST as the ‘culprits’ for weak 1QFY18 GDP growth of 5.7 percent,” said the Kotak note.

However, we would note that investment demand (30% of GDP roughly) has been subdued for a fairly long time.

Specifically, the gross fixed capital formation (GFCF) component of GDP grew 1.6 percent in 1QFY18 and the slowdown in investment demand started from 2QFY17 after strong growth in the previous three-quarters (3QFY16-1QFY17).

Subdued investment demand

The domestic brokerage firm does not see any signs of a meaningful recovery in investment over the next few quarters. This has become a ‘rolling-forward’ expectation for the past few years now.

“We first sounded the alarm on an ‘investment cliff’ in our October 2012 report (The coming ‘investment cliff’ and how to avoid it) given the imminent slowdown in investment in the ‘traditional’ sectors,” said the note.

The investment component (GFCF) of GDP has grown at 1.6%, 3.4%, 6.5% and 2.4% in FY2014, FY2015, FY2016 and FY2017. It is simple math that if 30% of the GD were to grow at low-single digits, then overall GDP will struggle to grow at high-single digits.

Govt consumption cannot do the heavy lifting

Strong growth in government consumption has supported GDP growth in FY2017. This reflects additional spending related to 7CPC-related increases in compensation (wages or pensions) of extant and retired government employees.

The implementation of 7CPC-related increases by the ‘balance’ states will drive government consumption over the next few quarters. “We expect government expenditure to stay at elevated levels with several state and general elections in India over the next two years,” said the note.

However, base effects will result in more moderate growth in government consumption over the next few quarters. FY2013-16 average government consumption growth was 3.5 percent.

Private consumption may suffer

We note that private consumption (roughly 55% of GDP) has held up reasonably well, partly supported by high government expenditure and also, consumer leveraging.

However, we are not sure if private consumption can sustain at high rates without investment and job creation. Lastly, the impact of GST may be bigger than simple de-stocking in 1QFY18 if it was to lead to significant disruption in the unorganized economy.

“We doubt participants in the informal or semi-formal economy would be keen on hiring and investing without a better understanding of the economics of their businesses in the post-GST world,” said the report.

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