The Indian equity market has been reaching historic highs of late and investors seem to be relishing the prospect of a strong and decisive government taking charge in May. Technical analysts have been predicting Nifty targets starting from 7,000+, going all the way to as high as 8,400 in this calendar year. The surging bull market since mid-February has certainly emboldened chartists, and fundamental analysts are marshalling newer and increasingly incredible theories to substantiate their ever-higher targets for the market. Earlier bull markets had their own share of such theories, like the one in the early 1990s where the low per capita consumption in India of cement, steel, aluminium, fertilisers, pesticides, processed food, personal care products, pharmaceuticals and almost every other product or service, compared with the developed markets and even some of the larger developing markets would necessitate a quick catch-up with these higher consumption economies. This was supposed to deliver untold riches to the lay equity investor in the short term.
The bull market faded away soon and investors quickly realised that these changes in consumption patterns are not quick, quantum jumps but very gradual trend changes over several decades where there are very few winners. At the turn of the millennium, the extant theory was about the absolute foolishness of looking for profit and profit growth when eyeballs and footfalls and their super-exponential potential growth were all that was needed to be espoused for one to be regarded as a savvy investor. It took just a few months for this theory of eyeballs and footfalls to be debunked and sanity in valuations to be restored.
Bull markets, for sure, need unconventional and new theories to be propounded to sustain the momentum. A particularly ebullient technical analyst told me recently that once the market has risen enough to form a strongly bullish chart, the broad economic or corporate fundamentals do not matter because the market will create events to sustain the momentum. The received wisdom is that while markets do build up expectations on forthcoming events, they eventually react to these events as they unfold but, in my utter innocence, I had never thought that the market had the potency to create economic, political and social events to sustain an ongoing bullish trend.
To cite another recent anecdote, with most opinion polls suggesting that the main opposition party will get 200 seats or thereabouts in the ongoing federal elections and will have to do business with several other incompatible small political parties to get past the 272 magic number, the bulls have floated a theory that there is a strong Modi wave and opinion poll results do not matter during such a wave phenomenon. To support the theory, the example of a relatively unknown Raj Narain humbling the mighty Indira Gandhi in the 1977 hustings because of a “wave” is highlighted. This theory will shortly be put to test and the market is indeed awaiting the election results with bated breath.
Success has one father too many
The finance minister has been claiming that his stellar stewardship of the economy is the root cause of the rally. Improvement in the current account deficit, keeping the fiscal deficit under control, possible moderation in inflation numbers and the several recent approvals for stalled projects are the examples cited in support of the prudent management of the economy. The naysayers, on the other hand, argue that the improvement in current account deficit is ephemeral, given the highly suppressed gold imports that would need to be liberalised to meet domestic demand, now being largely met through rampant smuggling.
Down and out
Capital expenditure has declined to a nine-year low
The modest export growth seen in the last two quarters is partly because of export competitiveness thanks to the near-12% depreciation of the rupee during the period. This competitive edge has now been largely lost because of the recent rupee appreciation, as also the significant depreciation in the currencies of competing export economies. While there has been some moderation in oil imports because of the economic slowdown, as also moderation in oil prices, the steep fall in import of capital goods points to continued disinterest by corporate India in capacity creation.
The fiscal deficit has indeed been “controlled”, quite largely by a substantial postponement of subsidy payments; crippling the financial strength of public sector undertakings (PSUs) through large, forced dividend payouts; directing PSUs to buy government divestments of PSU equity; as also a severe curtailment of Plan expenditure, which again does not augur well for prospective economic growth. While some of the stalled projects have indeed been cleared, these projects will take quite some time to collect the pieces from where they were left some years ago and achieve commissioning to show up in incremental economic growth.
The list of woes for the economy then clearly overweighs the positives enlisted by the finance minister. Still, if there is one reason one cannot completely fault the government for the economic slowdown, it is because of the global demand slump and the increasing integration of the Indian economy with the global markets. Moreover, the government has not resorted to an unbridled borrowing binge, as many other countries have done, to sustain growth and to fight the global financial meltdown.
Yet, the one thing that has been the bugbear of the Indian economy — it’s also something the electorate will bear in mind while voting — is inflation. India has seen high inflation in the past few years despite near-deflationary conditions in most parts of the global economy. To be sure, with soft international commodity prices, India’s inflation problems are not really of the imported variety but largely on account of domestic reasons. In response to the global financial crisis, like most governments, India did the right thing by providing fiscal stimulus to the economy.
However, the fiscal measures were largely oriented towards generating aggregate consumer demand to stimulate economic growth, rather than the classic Keynesian prescription of increased public investment. In fact, investment, whether public or private, got subdued because of the severe constraints in getting approvals for land acquisition and natural resources, as also forest and environmental clearances. This, along with increasingly higher agricultural support prices, large disbursements under the social welfare programmes, unaddressed supply-side constraints and burgeoning non-merit subsidies, has continued to sustain high inflation levels, even when manufacturers continue to have weak pricing power. In retrospect, one can also conclude that the fiscal stimulus measures continued for much longer than required because the opportunity to repair government finances when domestic demand picked up in 2010 was lost.
More worrying is this: most economists now opine that inflation in India has become largely structural on the back of the regular increases in support prices, larger coverage of non asset-creating social welfare programmes, uncontrolled and misdirected subsidies and the pressure on labour costs with even a cyclical economic upturn unlikely to bring inflation down to sub-5% levels.
The Modi effect
If these basic economic ills are going to haunt us, robust uptick in foreign portfolio inflows in March and the resultant all-time highs in the Nifty are likely to be for reasons beyond just the halting progress in fixing the problems in the economy. The reason for the high is not hard to guess: the one notable change over the last few weeks is the increasing likelihood, if opinion polls are to be believed, of a Modi government being in place by May. Election results are generally expected to be a verdict on the incumbent government’s performance on parameters such as economic development and growth.
Election results in the past have often surprised markets
However, election results in the vibrant Indian democracy with a plethora of political parties and the myriad complex equations involving religion, caste, class, gender, region etc., have been difficult to predict with the opinion polls in both 2004 and 2009 getting the results spectacularly wrong. In the first-past-the-post parliamentary election system in India, even a small swing in the percentage of votes polled by a party, among the many parties contesting the elections, can cause very large swings in the seats won and this feature has been a big worry for psephologists.
The inability to accurately forecast election outcomes has frequently caused wild swings in the equity market, both in the run up to elections and the immediate aftermath of the results. In 2004, for instance, the Sensex collapsed by some 11% the day after the results because the incumbent NDA government was unexpectedly voted out and the UPA alliance that formed the government had to take the support of the Communist parties that were widely seen as market unfriendly. Again, in the 2009 elections, the Sensex shot up by some 17% on results day, triggering an unprecedented market-wide circuit breaker, thanks to the better-than-expected mandate received by the Congress party, which was able to form a government without seeking the support of the Communists who had earlier withdrawn their support on the issue of the US-India nuclear deal.
Life of its own
Research shows that inflation follows its own cycle and may not have much to do with political outcomes
Those gyrations aside, do elections really affect the economy? And how? It is reasonable to expect that an incumbent government would increase public spending to show visible development at election time and concurrently try to suppress inflation to show itself in good light with the electorate. This thesis has been tested in the OECD countries by researchers who confirm that such proclivities are indeed common with incumbent governments there. Given that the public discourse in India during the last couple of years has been largely on corruption, governance and stalled projects, public spending has been less on new infrastructure projects but more on non asset-creating social welfare handouts. The fight against inflation has been largely unsuccessful till now and hence the public perception about the incumbent government on issues such as growth, development and price rise is somewhat unfavourable.
Beyond the win
Clearly, with the inability of the present government to alter economic fundamentals, markets are counting on the new government to change course. Interestingly, a recent study by a large brokerage house on the last five federal elections between 1996 and 2009 has come out with some insights on how the economy generally responds to a new government. Possibly because of investment sentiments improving with a new government in place, GDP growth has been seen to be rising by around 1% in the first three quarters after a new government takes charge. Similarly, inflation tends to ease just before elections and then rise by 1-1.5% thereafter.
Though evidence suggests that growth picks up after elections, it might come after a significant wait
Again, possibly because of a newfound confidence in the government, the rupee is seen to appreciate against the dollar by as much as about 3% within three quarters after an election. Barring any major international imbalances, foreign portfolio inflows tend to significantly increase immediately after an election. These findings are not surprising because a new government has to take most of the tough economic decisions in the first couple of years of its tenure to try and ensure that the fruits of these decisions show up in terms of robust growth and development at the time of the next election.
Even then, in the last six federal elections, except for the 1991 election that led to the epoch-making economic reforms, a strong pre-election rally has never been sustained in the month post election. Similarly a pre-election market correction has always led to a strong market performance in the month after the election. But yet again, the “this time it’s different” feeling seems to be pervading the market. Expectations are running high that this time the history of pre-election rallies leading to post-election corrections will not be repeated.
Whether those expectations will be met or belied, things just may get better a few months after the election outcome. History shows that the performance of the market during the period between two successive elections tends to be quite good except for the two years of the tottering Third Front government during 1996-98. After the initial turmoil, the market tends to stabilise and chart a path based on policy changes and their impact on economic fundamentals while continuing to be influenced by global trends.
The received wisdom this time around is that a new government under a decisive leadership will rekindle the animal spirits of entrepreneurship and the economy will bounce back to a higher and sustainable growth trajectory. While this belief can and certainly has boosted market sentiment, it is important to subject this thesis to a reality check. To do that, one needs to look at the short history of what brought about the current slump in the economy. The cyclical economic downturn started at the turn of the current decade but sustained policy inaction and weak implementation has let the downturn deteriorate into a near structural one. This has led to a sharp 2% drop in the potential growth of the economy over the last three years with a high output gap — the difference between the potential and actual growth.
Nothing lasts forever
The last downcycle in the markets persisted for about six years, between 2HFY97 and 1HFY03
The hard reality is — and this is where the challenge for Modi would lie — economic cycles have a life of their own and a quick turnaround is difficult to achieve based merely on good intentions. Despite the robust agricultural growth recorded this year, GDP is likely to grow at sub-5% for the second year in a row in FY14, something that is happening for the first time after the late 1980s. Core CPI inflation continues to be stuck at near 8% levels despite the economic slowdown and there is a risk of headline inflation rising again with the likelihood of a weak monsoon ahead. Getting a hold on inflation, therefore, is likely to take some time and interest rates are unlikely to soften in a great hurry. The government’s fiscal position is also not in a good enough state to stimulate a large scale investment boom. What, then, is required to be done to revive the investment cycle? Typically, investment cycles do not turn around suddenly and in fact, the last investment downcycle lasted a full six years, from 1997 to 2003, though the initial work on the large infrastructure investments in power generation, national highways and some of the metro projects had commenced midway in the downcycle.
The current investment downcycle is well into its third year and the private sector does not seem to have any significant investment intentions currently. The government will be once again required to give the initial push to revive the investment cycle, though at some fiscal cost. Also, getting the several stalled projects started by giving expeditious approvals is a prerequisite to get the private sector interested in going back to the drawing board to plan new investments. For sustainable price momentum to show up in equities, especially the capital goods stocks, the planned new projects would have to reach the order placement stage, which could be several quarters away. So, where does all this leave the equity markets?
The markets have been surging on the back of robust foreign portfolio inflows, in excess of $4 billion year-to-date. A stable rupee, falling forex hedging costs and wide interest rate differentials on the back of a low current account deficit have ushered in robust debt inflows too, in excess of $5 billion year-to-date, thus causing an appreciation of the rupee by around 15% from its historic lows eight months ago. While the sentiment-led rally post a likely Modi government taking charge in May could last for a few weeks till, say, the presentation of the Union Budget in late June, economic ground realities do not point towards quick fixes that can reverse the economic downturn.
Even “un-stalling” stalled projects may not be easy because a majority of the projects are stuck on account of the problems in implementing the new land acquisition laws, which is a state subject, as well as commercially unviable contractual obligations with state entities. While the new government may be able to expedite environmental clearances, that may not be enough to set things right. Though analysts are forecasting a mid-teen growth in corporate earnings for the current financial year, these numbers may need moderation if continued high inflation and interest rates and a delayed rebound in economic growth remain a reality for at least a few more quarters. That apart, we have global flows to worry about.
No matter what the economic realities may be, Indian equities have been very large beneficiaries of the quantitative easing (QE) programme in the developed markets as a response to the global meltdown of 2008. Since then, India has attracted some $95 billion worth of foreign portfolio inflows. Tapering of the QE programme since January 2014 has impacted most emerging markets with reduced portfolio inflows and, in some cases, outflows. But India has been one of the notable exceptions where portfolio inflows continue to be robust despite the US tapering. If the current pace of tapering continues in the US, by around October the QE programme would have run its course and, as the Fed has indicated, around six months thereafter, monetary tightening may commence.
Prospects of even a mildly hardening interest rate scenario in the US could put paid to emerging market flows and this may well be the time when the market would have realised that there are no quick fixes to engineer an Indian economic turnaround. Indian equities are extremely vulnerable to foreign portfolio flows in the absence of robust domestic institutional support and even modest outflows can de-stabilise equities significantly. To illustrate, the unprecedented 60% fall in the Nifty in a matter of nine months between January and October 2008 was caused by just about $12 billion of FII outflows, despite domestic institutions pitching in with some $3.4 billion of investments during the period.
Keeping foreign investors interested in India equities will need 1991-like sweeping economic reforms. Most of the easier economic reforms that can generate quick economic benefits have already been carried out in India over the past two decades. The more difficult ones such as labour reforms, public governance, judicial and electoral reforms, infrastructure modernisation etc., are still at the work-in-progress stage and will take quite some time to show up in terms of accelerated economic growth. Over the past five years, the political leadership in power has ended up conceding much of the governance space to the judiciary and near-autonomous public institutions. This has created a distinct bias against any form of risk taking in government decision-making involving the political leadership, as well as the bureaucracy.
The new government would have to quickly restore the much-needed equilibrium between the legislature, executive and judiciary while maintaining the highest standards of integrity and transparency. If the new government goes down this difficult path, it may well take the best part of its five-year tenure to address these issues but this reform indeed needs to be put in place to take the Indian economy to the next level of growth and development.
As for investors, the prudent way out is to realise that Indian equities are probably going ahead of economic and corporate fundamentals and dismounting the sentiment-driven ride at some stage in the not-too distant future may indeed be worthwhile. The strong-hearted quick gun investors may like to ride the rally till immediately after the election results but the faint-hearted long-term investors are well advised to stay out of the short-term fireworks.
However, for the long-term investor, history has shown that the cacophony of elections and their short-term impact on stock prices does not come in the way of investing in well-managed and uniquely-positioned companies in sectors that have good growth potential and with reasonable entry barriers. Such stocks have been known to generate good investment returns for the patient investor even if one has made some small mistakes at entry. It is also important for investors not to fall into the usual trap of waiting indefinitely to get at least the purchase price on a patently unwise past investment decision but to periodically review the portfolio to feed in new information to decide if it is worth holding on to the stocks in the portfolio. Asset allocation is at the root of investment performance and investors are well advised to consider a prudent mix of asset classes to generate super-normal returns and not be committed to just equities.