Hush on the shop floor

The Indian equity market has been on a tear of late, significantly outperforming other asset classes in India as well as other equity markets globally. There are three reasons for this strong performance: the first, a return to risk-taking across the world as well as some other economies going out of favour; the second, a bottoming out of the Indian economy; and the third, the historic electoral verdict that is likely to support market valuations for several months. Even if market commentators seem to be focused only on the last of these, all three are equally important, particularly for forward-looking analysis.

The return of risk

Let’s start with the return of risk globally: yields on fixed income products have fallen sharply this year, much against the inexorable increase in interest rates that was expected as the US Federal Reserve ‘tapered’ its quantitative easing (QE). Instead of yields on the ten-year treasury bonds rising to 3.3-3.4% this year, they have fallen to 2.4-2.5% levels. On top of that, the spread of emerging market bond yields over the US treasuries is again close to levels seen in May last year, that is, before talk of the ‘taper’ started. Similarly, against the widely held expectation of the dollar appreciating strongly this year, it has in fact depreciated. With the European Central Bank (ECB) now expected to experiment with negative interest rates and the Bank of Japan (BoJ) expected to continue to weaken the Yen, there is renewed interest in emerging market equities, including those in India.

Even among emerging markets, India’s prospects look far better than other major economies such as China, Russia, Brazil, Turkey or South Africa. In fact, despite no change in political leadership and continued high deficits, many of these markets and their currencies have rebounded in the past month or so — demonstrating the return of risk appetite among global investors. With the most substantial improvement in the current account deficit (CAD) and the positive change in government, India’s market has not surprisingly outperformed its emerging market peers this year. Investors worried about the Russian economy going into recession because of western sanctions in retaliation to its actions in Ukraine and the growth slowdown in China have almost by default gone overweight with India in their emerging market portfolios.

A cyclical bottom 

Then let’s look at the Indian economic cycle. Several indicators suggest that it was bottoming out even before the new government took oath. It is by now well-documented and understood that the downturn that started three years ago was driven by a slowdown in government decision-making and weakness in large-scale investments due to challenges in land acquisition and environmental and forest clearances. However, there were several temporary developments that worsened the downturn. 

First, the mining ban in Karnataka and Goa and the clampdown on illegal mining in Odisha, Jharkhand and Chhattisgarh brought down India’s official iron ore output from 220 million tonne to about 140 million tonne (the decline including illegal production was likely steeper). In addition to the direct job losses in mining, it had a ruinous impact on allied industries. Almost all of this reduction in tonnage went out of the freight market share of trucks — sales of new trucks more than halved, driving further job losses on suppliers of components to commercial vehicle (CV) manufacturers and increased stress among CV financiers.

Second, the failure of the national grid in August 2012 owing to overloading meant that the loading of the grid was subsequently brought down. As a result, the southern states of Andhra Pradesh and Tamil Nadu, together nearly 15% of India’s GDP, had to suffer power outages, whereas power plants in Odisha and Chhattisgarh were forced to idle.

Third, the stop-go uncertainty about the formation of Telangana meant that investment activity in much of Andhra Pradesh came to a standstill, as residents and investors were no longer clear on whether Andhra Pradesh was to be divided or not and, if it was, if there would be two parts — Telangana and Seemandhra — or three — Telangana, Rayalaseema and Seemandhra.

Fourth, the government was forced into fiscal tightening to protect itself from a rating downgrade to junk. The fiscal boost that came through in FY09-10 was then reversed in FY13 and FY14, when the economy actually needed a boost, demonstrating the perils of a pro-cyclical fiscal policy.

The above four factors are no longer impacting growth negatively and this by itself means broader economic momentum should pick up now. The mining ban in Goa and Karnataka has been lifted and while the return to peak historical volumes may not happen for a while, the negative drag of production cuts is behind us. With the state government acting promptly, the recent iron ore mining ban in Odisha may not be as disruptive as the ones in Goa and Karnataka were. Then, the north-south connectivity on the national power grid has improved and in a few months, the southern states should be able to source power from surplus states such as Odisha and Chhattisgarh. The formation of Telangana and Seemandhra may disrupt activity for a short while, but removes a large overhang over the investment horizon in the states. And lastly, even if the fiscal tightening was achieved by postponing expenditure, it did worsen the slowdown — it should be less negative going forward.

Many of the early indicators of a turn in the economic cycle, such as small-ticket consumer discretionary items and sales of cars and two-wheelers, have now started to see a tentative but visible pickup. An analysis of past cycles suggests that this should be followed by growth acceleration in sales of commercial vehicles. No discussion of the state of the real economy can be complete without discussing the informal sector: it employs 90% of India’s workforce and accounts for half of India’s GDP. Our research shows that the spread of cell phones, rural roads and electrification, among other things, is driving unprecedented changes in economic productivity in the informal economy. So much so that the established techniques of measurement are likely inaccurate, and GDP growth is likely to be under-reported by 1.5-2 percentage points. Many have asked what difference this growth makes if the reported growth is still sub-5%. It does matter: the companies whose stocks investors trade in are affected by changes in the real economy, irrespective of whether reported GDP number captures them or not. Perhaps just as importantly, this change at the bottom of the pyramid is likely why the electoral verdict was so historic. A historic verdict should improve growth visibility. 

That brings us to the third reason why equity markets have done so well so far: the historic electoral verdict. Political scientists have called this the most important election since 1952, given the discourse during the campaign that was devoid of explicit caste and religious colour and instead focused on jobs and economic growth, the marginalisation of the Congress and many caste-based regional parties and the quasi-presidential style campaign and voting. While these trends may impact India’s politics dramatically over the coming decades; for equity investors, the time horizons are shorter. Even on these terms, however, the results of general elections are very encouraging.

Firstly, this is the first government since 1984 where one party has a majority by itself, that is, more than 272 seats. This implies that none of the 12-15 economically-relevant ministries need be compromised: in the coalition governments seen since 1989, regional parties controlled many of these ministries and reform slowed down. For instance, an important reason that the Railways hasn’t changed much in the last three decades despite the rest of the economy getting transformed is that it has been run mostly by regional allies (that it remains a government monopoly is a bigger reason). The new council of ministers already shows this change.

Secondly, with the NDA just ‘one party’ away from a two-thirds majority in the Lok Sabha, its weakness in the Rajya Sabha, where it has only 26% of the seats, is more than offset. In case of a conflict between the Lok Sabha and the Rajya Sabha, the NDA can take legislation to a joint session of Parliament, where it possesses a majority. For a change, and perhaps for the first time since the telecast of parliamentary proceedings, we may see a functioning legislature and a government that can effectively pass any normal legislation it wants to.

Thirdly, given the strong vote shares even in states where the NDA is not currently in power as they have assembly elections scheduled for the next few months, in a year’s time, half of India’s population could be living in states where the NDA controls the assembly as well. This is a rare occurrence, and enables fruitful centre-state collaboration: after all, the centre mostly has policy-making powers, whereas the states have the responsibility to execute these policies. Even for large infrastructure projects such as the Delhi-Mumbai Industrial Corridor (DMIC), the NDA being in power from Punjab, Haryana and Delhi in the north to Rajasthan, Madhya Pradesh and Gujarat in the west to Maharashtra in the south can speed up implementation.

Change takes time and is rarely painless

While it is important to get a strong leader and a good government, what matters most to the market is how earnings and the economic trajectory will change over the next one or two years. And this is where investors betting on a quick revival of the investment cycle are likely to be disappointed.

Firstly, research done by Credit Suisse shows that in the past, it took six to eight years for any central government action to translate into jobs and growth. This is not necessarily on account of the inertia in the government but owing to the sheer scale of change management. Any change management consultant will tell you that bigger the organisation, the longer it takes to turn around. With 3.5 million employees affecting the lives of 1.2 billion people and acting through several layers of government, meaningful change in India is never quick or painless.

Secondly, India has a federal construct and the central government is just one actor. Under the same set of government policies, interest rates and inflation, over the past 24 years, there has been a wide divergence of state-level output growth. Some states such as Delhi, Gujarat and Maharashtra have outperformed, while others such as UP and Punjab have underperformed. This is because the state governments control law and order, land acquisition, education, power distribution, health, etc. All areas of achievements of Narendra Modi in Gujarat, that is, improvement of urban infrastructure, power distribution, irrigation and land acquisition, among others, are under the purview of chief ministers. As a prime minister, for example, he cannot drive the much-needed power distribution reforms in Uttar Pradesh. Many non-NDA ruled states are likely to resist following through on policies pushed by the new government for political reasons. This usually slows down change.

And lastly, the rhythm of reforms moves differently from what is widely believed. While many commentators fret about the lack of reforms, when asked for specific suggestions, they mention less relevant changes such as FDI in multi-brand retail or insurance. These may be important, but a simple assessment suggests that the more meaningful reforms are those where either the government reduces its footprint (for example, allowing the private sector into an industry where it earlier had a monopoly, such as the railways) or reduces trade barriers (for example, the weighted average import duties in India fell from an average of 78% in 1992 to less than 7% in 2010 and are still falling as free trade agreements (FTAs) with some large economies start to show up in numbers) or improves the allocation of capital (for example, legislative amendments that further strengthen the hands of the banks in collecting faulty/bad loans or growing the bond market to disintermediate the banks).

Running through the budget speeches since 1991, one notices an interesting pattern: each speech from 1991 to 2003 had the phrase “no room for complacency” (or its equivalent), irrespective of whether there was a minority Congress government, a fragmented Third Front government or a minority BJP-led NDA government. Between 2004 and 2011, this phrase disappeared from the speeches but made a re-entry in 2012. So, after a long period of complacency, the government panicked again, and the intention to reform came back. It’s easy to ask what, if any, is the evidence of economic reform by the previous government. On each of these three fronts, the outgoing government has attempted some reforms. For example, the tricky process of involving the private sector in railways was kicked off with the publication of five models of public-private partnership (PPP) in December 2012. 

That the model concessionaire agreements have still not been made available 18 months later is possibly owing to the internal resistance within the railways to the process. Before 1991, the government had a monopoly on 18 industries and in the first wave of reforms, allowed private sector participation in 15 of them. It is hard to imagine life today without private sector banks, telecom companies, media companies or airlines. But the one unchanging part of life has been the Indian Railways, where tickets still need to be booked months in advance, the train stations are dirty, high-speed trains remain a distant dream and not only has the growth in freight capacity disappointed, freight rates remain high by global standards.

The outgoing government also worked to strengthen the hands of the banks through amending the Sarfaesi Act in 2012, helped expand the bond market and signed numerous FTAs to further integrate the economy with some of the Asian manufacturing powerhouses: ASEAN, Korea and Japan.But these changes will take several years to show up in growth or earnings. We often hear about the new government taking advantage of ‘low-hanging fruit’ by accelerating project clearances. An analysis of projects under implementation in India suggests that of the ₹83 trillion of total project value, projects stuck with the central government have capex of only ₹21 trillion, or about a fourth of all projects. That means the remaining₹62 trillion of projects are largely unaffected by central government actions. 

The question worth asking is: if the government were to clear all projects stuck at the centre, would the investment cycle revive? 90% of these projects by value are in the power, steel, mining and oil and gas sectors; and just power and steel add up to two-thirds. If power and steel projects were to be cleared, would anyone want to invest in fresh capacity today? The answer, in our view, is likely to be no. Utilisation in the thermal power generation sector is near two-decade lows, and there is a large amount of capacity constructed and tested but not commissioned yet (so not part of the utilisation calculation), which exacerbates the problem. With plant utilisation in the mid-50s, even with 8% demand growth for five years, India won’t need fresh power generation capacity. But 8% annual demand growth has been the peak since 1991: demand growth in India is now much lower, and occasionally in the negative territory.

This begets the incredulous question: how can a country with per capita power consumption like sub-Saharan Africa have demand decline for several months? The trouble seems to be the state electricity boards (SEBs), through which 90% of India’s power is distributed. On account of SEBs’ stressed balance sheets, the government asked banks not to lend working capital loans to loss-making SEBs. As a result, power demand fell sharply, as these boards could not fund further purchases without loans. Reforming the SEBs is not directly under the central government’s jurisdiction and is in any case likely to take several years. Raising power tariffs is also not the solution, as power prices in India, given higher proportion of imported fuel as well as distribution inefficiency, are already at levels where demand elasticity is starting to play out. Which basically implies that if you raise tariffs, demand drops.
   

The other possible solution, that is, increasing production of domestic coal, faces another structural constraint in Coal India, which is struggling to get access to land and rail freight capacity.

Thus, there is no quick fix to the overcapacity in power generation. Similarly, other sectors such as metals, cement and autos, without which the investment cycle may not come back, also have low utilisation and significant excess capacity.

Elevated multiples

That brings us to the question: what next for the markets? Credit Suisse believes that with the growth in global industrial production having troughed, bond yields globally should start to rise. However, with continued monetary easing from the ECB and the BoJ, risk appetite globally should stay benign and supportive of equities. At the same time, sentiment on the medium-term outlook for India should continue to improve as the new government makes use of its breathtakingly strong mandate and starts to simplify procedures and embark on the much-needed but tough reforms. 

Interestingly, while most investors and citizens in India are optimistic about what the new government may do, foreign investors remain cautious. Their caution is likely driven by their experiences in Mexico, Japan and, to some extent, China, where a change of government drove high expectations and strong market performance. However, as the pace of change disappointed, late entrants to these markets only saw losses. This sense of caution is possibly why the veritable flood of capital that many expected post the unexpectedly strong election verdict has not come through.

In a perverse way, this caution is what suggests potential upside for the broader market. It is unlikely that any government steps are going to revive earnings growth in the next two-three years, for reasons discussed above.
  

However, as new developments on critical reforms such as the Goods and Services Tax, acceleration of coal production and public sector bank recapitalisation drive hopes of a future revival, fund flows should pick up. Thus far, most investors have refused to increase their allocation to India and have instead chosen to rotate within their India portfolios, driving down IT services and pharmaceuticals stocks and pushing up plays on the investment cycle, such as banks and industrials.
  

Though rising optimism on future prospects can push up valuation multiples for the broader market, it would be unwise to pay now for earnings recovery that may take several years to come through.