Demonetisation Won’t Be The Non-Event That Current Forecasts Indicate: Morgan Stanley

Hattangadi: I think the show is aptly called Thank God It’s Friday. But even more so it’s the last trading day of the year. It’s been a very eventful year. A lot of unpredictable events happened this year. Like you said, trying to predict events has been the biggest fallacy of 2016. Time and again, pollsters have gone wrong attempting to predict the big events – whether it is the U.S. Presidential elections, whether it is Brexit. Trying to predict the market outcome of that event was even more problematic. It’s very natural to look towards 2017 and say, what are the big events out there – whether it is U.P. and Punjab elections, GST, what happens in the Budget. We seek out events because we want to anchor ourselves to an event. And I think the learning from 2016 is that we should not anchor ourselves to the market outcome of events. We have to take 2017 as it comes and not try to lay too much emphasis on specific events. So that’s the learning from this year.

Hattangadi: These events create noise. And trying to re-adjust our portfolio for every event when there’s an event happening every day, every week, when either there is something the Fed is going to do, or new leaders get appointed in China, there could be the French elections...there are so many events locally. Nobody thought November 8 was a big event for India because that was not on our calendar. We keep looking forward to events that are on our calendar and sometimes the biggest moves in the market are the outcome of events which are not on your calendar.

Kelkar: A lot of people have formed their view about the demonetisation, whether it’s working or not, based on anecdotes. We haven’t really seen hard data yet. That’s because December is the first month after the demonetisation and we will see data for this month start coming in January. November wasn’t a clean month. What happened is before the demonetisation, Sensex earnings growth expectation for financial year 2016-17 was 13 percent, and for financial year 2017-18 people expected 18 percent growth. If I see today, 50 days later, 13 percent has gone down to 11 percent and 18 percent has come to 19 percent. People haven’t really changed their numbers. This is an unprecedented event. We don’t have a template to analyse this event with. That’s why we don’t really know what the impact will be. What we are learning is that growth is going to be weaker than what most of the consensus is estimating. There may be pockets of strength in some sectors which may be unaffected by all this. But it’s not going to be business as usual. Markets won’t forget such an event in a month or so. Growth may be below expectations not just for 1-2 quarters, maybe for longer. I don’t think anybody can quantify it. The way we are going to play it is to wait for high frequency data. Let auto numbers come out in January, quarterly results from companies. For instance, in asset quality, the real picture may emerge six months later. So its fool-hardy to sit here and take a view. So we have to play it by the ear.

Hattangadi: I think our overweight on financials primarily comes from those companies that are focused on consumer lending. Bulk of non-performing loans is from the project finance-related corporate side of the book. The demonetisation, like Swanand mentioned, will have a very asymmetric impact on different sectors. So how it’s going to further impact the NPL cycle is difficult to predict at this point of time. The question in front of everybody really is whether what we are seeing on the project finance side will spill over further onto the SME segment as a result of the demonetisation. And that really depends on how prolonged the slump is going to be, the growth impact on the economy and whether or not the economy picks up fast enough. So it’s very difficult to predict the NPL cycle and what’s going to happen beyond project finance.

Kelkar: Staples was primarily a valuations call. If you look at the consumer staples universe today, it was trading at an average price-to-earnings ratio of 35 times for financial year 2017-18. The first half of the year, if you look at the volume growth for consumer staples companies, it was barely 2 or 3 percent. A leading consumer company reported a negative growth number in the second quarter. So when you put this kind of growth with that kind of valuations, it is difficult to have it in your portfolio and expect absolute positive returns. They are great companies, great franchises but we also look at valuations. We look at making money from an 18-24 month standpoint. That is where consumer staples was an underweight. The other issue we felt, if you look at it from an 18-24 months point of view, the commodity tailwinds that the consumer staples sector witnessed and took advantage of, that is abating. That is no longer as strong a tailwind as it was about 24 months ago. On the consumer discretionary side, we primarily had stocks in media and the automobile sector. Even then, the valuations were stretched but we felt that the growth valuation metrics were a lot more favourable than it was for the consumer staples companies. Also, falling interest rates benefit the consumer discretionary space more than staples. But again, these are portfolios in flux and no portfolio manager will come here and tell you that I am absolutely sure that I am running with the right portfolio right now because we are in uncharted territory. We need to have the humility to understand that these are portfolios in flux and maybe staples might weather the storm better than the discretionary space. If that is borne out by high frequency data, we won’t hesitate to change our portfolio orientation.

Hattangadi: Industrials is a very broad sector. The engineering segment is just one part of it. What we like in industrials is the transport-related segments. So there are stocks in the commercial vehicles segment, for example, where there was improvement. We like the transportation side of the industrials segment. On the engineering side, the order books have grown but the execution has not really kept pace. Over there, we had to really wait and see how good the execution is. Clearly, most of the capex is being done by the government since the private sector is in wait-and-watch mode, they have surplus capacity in those segments. So it is up to the government and the segments which are the leaders there are going to be the road and railways segments. We have to see how good the execution is going to be. So the order books have bloated but the execution has not kept pace so we now need to see how they execute the road and railway projects, defence ordering etc.

Kelkar: To play the devil’s advocate, the Nifty peaked on budget day in 2015, and bottomed in 2016. So it might be co-incidental. But there are a lot of expectations from the Budget. The primary expectations are that some pain deviation will come through. I don’t know in what form or shape it comes. There is a clamour for reduction of corporate tax rates. There is clamour for some sort of rural support. Demonetisation hit that part of the economy hard. Balancing all this with the fiscal math is going to be challenging. We have a 3 percent Fiscal Responsibility And Budget Management (FRBM) target for financial year 2017-18. I don’t know if it will be met. I don’t think markets are going to take it very badly if the FRBM target is not met. But we need to see the tax to gross domestic product number grow. If you ask me over the next 1- 3 years, what is the one number I’d watch for to check if the demonetisation has been a successful exercise, it is going to be the tax-to-GDP number. Because that number has been stuck in a rut for the longest time. The two macro numbers in India which have been stuck in the same band for the longest time are 1) tax to GDP and 2) manufacturing to GDP. Both these numbers are something to watch out for over the next few years. So the Income Declaration Scheme and others, and how much they can mop up, will it be a sustainable bump up to tax-to-GDP or is it just a one-off before it peters out again, those are the things we need to watch in the budget. The budget math, what kind of pain alleviation happens in terms of corporate and rural sector, those are the few things which will be important.

Kelkar: Again, we are India portfolio managers but we plug into our team which does a lot of analysis on these things. The dollar is at a fairly strong level, in fact the strongest in many years. A strong dollar, commodities which have peaked or are peaking, are coming off, the prospect of rate increases in the U.S. with bond yields looking up, corporate tax rates going down significantly if we go by what Mr. Trump promises...I think in all this backdrop it is going to be rowing upstream for emerging markets. It is difficult for emerging markets in this environment. EMs will not have a banner year in 2017, these economies had a good year this year. But we have to be careful about EMs as an asset class next year.

Hattangadi: We are going to see a continuous feedback loop next year, as is the case every time. So you have the economy or markets, giving a feedback to government and regulators, which is the RBI. Through the year we have to keep watching how this feedback loop works, because the Budget will try to alleviate some of the pain through some fiscal stimulus measures but then this has been such a shock in the economy and different segments have been affected differently, it is almost impossible to have measures that do give exact cure for the pain in each of the segments, as is required. There will be some segments where the stimulus will work better, there’ll be some segments which will probably cry out for pain, six months after the Budget, and something may need to be done there. So I think there is going be this constant feedback loop and the market see gyrations as the economy and the government responds to the signals from the economy and the markets. So it’s extremely difficult to predict how this is going to play out. I think it is going to be a very eventful year with a constant feedback loop. I think after demonetisation we’ve seen the government has through various notifications, tried to respond and I think we’ll probably see something similar in 2017 as well depending on how the economy and market react. You may see steps being taken through the year. Like I said again it’s not just February 1 that you need to look out for, it’s going to be the constant loop through the year.