Structural reforms to drive bull-run in Indian equities
US equities have been hitting record highs since the announcement of its Presidential election results – driven by excess liquidity and optimism over future growth. Instead of a consensus expectation of tapering, the ECB has prolonged the bond buying programme till December 2017 – but has reduced the monthly quantum from Euro 80 billion to Euro 60 billion, from April 2017.
Despite abundant liquidity, the NIFTY50 is trading weak. The outcome of the referendum in Italy has created an uncertainty over the Eurozone. Global uncertainty has kept investors nervous. And, our government’s demonetisation drive has further clouded India’s growth prospects.
The excess liquidity in the banking system from demonetisation has resulted in a sharp fall in bond yields. India’s 10-year government bond yields have fallen from 6.84 per cent on 4 November to 6.48 per cent on 15 December 2016. On the other hand, US’s 10-year government bond yields have hardened from 1.78 per cent on 4 November to 2.60 per cent on 15 December, in anticipation of a FED rate hike. The spread between Indian and US bond yields have narrowed from 506 bps to 388 bps since 4 November, resulting in a sharp sell-off of Indian debt by overseas investors. The sharp rise in US bond yields reflects an anticipation of more FED rate hikes in 2017.
The RBI maintained a status quo in its monetary policy, to maintain its yield advantage, despite the consensus view of a 25 bps rate cut. Bond yields hit lows of 6.20 per cent ahead of the RBI’s monetary policy meeting, when the spread had narrowed to 380 bps. The status quo has helped correct the downward spiral in Indian bond yields, halting the exodus and reviving demand. FIIs have sold $6.2 billion worth of Indian bonds since 15 November.
Indian equities too are selling off due to uncertainty over growth, after the announcement of demonetisation. And FIIs have sold Indian equities worth $2.6 billion since 9 November.
Demonetisation is a structural reform and it is too early to gauge its exact impact on the Indian economy, as this is the first time since liberalisation that India has taken such a drastic step to counter black money. The impact is likely to be just a temporary disruption and not a permanent derailment of growth.
In its current form the Indian economy should be looked upon as a car with good suspension, driving at over 100km/h and suddenly hitting a speed breaker. The impact is bound to be jerky, but after the initial bump, the suspension will ensure the car soon regains normal speed.
In the near term, businesses dependent on high value, discretionary spends are more likely to get severely impacted. Real estate prices too are likely to correct. The ongoing cash crunch is bound to affect spending in the near term. But, as the RBI releases more cash into the economy, sentiment would improve drastically.
These temporary concerns notwithstanding, the demonetisation has brought about many positives. The current liquidity crunch will help promote digitisation, with Indians starting to adopt digital payment methods. The government has announced incentives to promote cashless transactions. State governments and local bodies have been encouraged to go cashless. Further, inflation is expected to remain subdued, which will enable the RBI to keep interest rates low.
As of now, about Rs12.44 lakh crore worth of demonetised currency has been deposited in the banks. This goes against the government’s initial estimate of Rs3-4 lakh crore not coming back into the system. The RBI has categorically denied the possibility of giving any special dividend to the government. Investors are now keeping a close watch on the government’s next move, as the 30 December deadline approaches.
As a large portion of the demonetised currency is already in the banks, the government would hope for an increase in the tax revenue, broadening the tax base and increasing India’s Tax-to-GDP ratio. The larger tax base will enable the government to lower its tax rates in the future. It may even announce a bumper budget to mitigate the slowdown and kick-start the economy. GST, which gets implemented later in 2017, will further reduce the informal economy.
Historically, the NIFTY50 has remained highly correlated with S&P 500. As US markets continue to strengthen, it is a matter of time before Indian equities too will buck the trend. India is currently in the midst of major structural reforms – the effect of which will be felt only in the years to come. This correction provides a golden opportunity to build a strong equity portfolio. India’s high savings rate will find a way to enter into equities in search of high returns, as no other asset class will be able to match these returns. However, in the near term, the equities may remain vulnerable to global flows.
This article was originally published in Business India Magazine.
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Disclaimer: The views expressed in this article are personal and the author is not responsible in any manner for the use which might be made of the above information. None of the contents make any recommendation to buy, sell or hold any security and should not be construed as offering investment advice.