Pedestrians walk past stores in the Zaveri Bazaar at night in Mumbai (Photographer: Dhiraj Singh/Bloomberg)

Significant Downside Risk To Earnings After Demonetisation: Jefferies

What’s your assessment on what demonetisation has done, and what does it do to demand?

I don’t look at demonetisation as an isolated event. It is a part of an anti-corruption process. It is as much a political process as it is an economic process. It won’t stop at demonetisation, it’s probably the most drastic step, but it is not going to stop until the next elections at least. This is going to be the primary plank on which the Modi government will fight the 2019 election which means you’ll see more and more coming. There are questions about how successful the previous measures including demonetisation has been in curbing corruption but you can’t look at it in isolation. The less successful these measures are, the more measures you will see because there is no choice for the government now. They’ve set the ball rolling, they will have to continue.

What this means for the economy is a pause in the short run. There is a significant amount of participation of people with hidden wealth and hidden income in the economy and that blends very well with white money. So if your black economy slows down, if there is wealth destruction in the black economy, it will have an impact on demand in certain sectors of the white economy as well. For example, all the car manufacturers are organised.

All dealers are organised and pay taxes. But there is purchase by people who have black money who go and buy cars. The hard part is we don’t know the proportion of people who participate in that. There is no way of knowing either. I know there are people who say that the proportion of cars bought on finance is 80 percent and therefore it is not a big amount. That is not the way to look at it. People with black wealth also have white wealth and therefore’they all use finance to buy cars. It doesn’t mean that the black wealth did not influence their decision to buy a car, didn’t influence the timing of purchase or the kind of car they purchased. All that it means is that the risk is on the downside to demand especially for consumer discretionary, high end luxury items and I would say to high end luxury homes as well. Now that is one side of the equation. Clearly the government has to have contra measures to it. On one hand there would be inconveniences to people during this process of demonetisation, there would also be job losses. The contra measure has to be through some kind of wealth income redistribution.

Downside Risk For Earnings

We have now seen people rework their GDP forecast and earnings forecast. What kind of numbers are you working with if you believe this will have a much longer impact.

First, I dont know how people calculate GDP numbers so I won’t have a guess at that. I would only say that if you were expecting ‘X’ earlier, it would be ‘X’ minus debt. What the ‘X’ is, what the delta is, is anyone’s guess. The risk is on the downside. As far as earnings go, the consensus estimates for about financial year 2016-17 is 12-13 percent growth and financial year 2017-18 is about 18-19 percent growth. We have grown at low single digits for the last 4-5 years. Now clearly there is section of the market which is not linked to this. It is all export linked, global commodity prices linked so they should be unaffected by this. Having said that there is a very large proportion of the earnings which are affected. So to expect financial year 2017-18 earnings growth to be strongest since financial year 2011-12, it is also a bit over optimistic especially considering there is also a GST angle to this. So there is lot of uncertainty considering the GST as well. So what we expect as a house is earnings growth as 8 percent in financial year 2016-17 and 13 percent in financial year 2017-18. But I would certainly say that as to these numbers are also on the wrong side. Remember that in the first half of financial year 2016-17 the earnings growth was of 2-3 percent. So 8 percent is also a very high number for financial year 2016-17. So we are looking at downside for financial year 2016-17 on our cautious estimates as well. So we are looking at significant downside risk to earnings as for now.

How long? Even if you look at the time that will be taken to replace these bank notes, some people say six months will take to replace these banknotes. Is that the time frame you are working on?

No. I worry less about this transactional impact of cash not being available.

That is the exchange.

That is the exchange. Hard calculation is that assuming that they had zero inventory as of now, we don’t know how much inventory they have. If they did not have inventory on any of the days, it would take them anywhere between 4.5-5.5 months to replace the entire amount. And make sure cash is available as per the amount. Not all of it is going to come back as cash. Because there was some cash sitting idle where velocity was nothing. There will be behavioral changes in terms of how people will retract. There will be more mobile wallets, check payments etc. So not all the cash needs to go back. But even if say, 80 percent of the cash needs to go back, we are still looking at February or March. And clearly during that period there will be transactional impact. There will be industries that transact primarily on cash getting impacted. The transactional impact will be more on segments that use cash, not necessarily on segments that have participation of hidden wealth. It is in financial year 2017-18 that the true impact of wealth effect and corruption coming down will be visible.

That is intangible isn’t it? Risk appetite, consumer sentiment, wealth effect, how do you quantify?

You can’t quantify it. I don’t think we should bother doing it. We can only look at the direction of risk. The direction of risk is clearly down.

Short-Term Market Volatility

What does all of this mean for the markets? We have seen the worst November in the last 5 years for a variety of reasons. What is going to define the trajectory of markets from here on?

See I think the short term will be very volatile. The next few months data points will be very volatile because there will be shifting of demand from November and December from may be January and February. So you would have one or two months of weak numbers which could be followed by very strong numbers in January or February. We should not extrapolate what is going on right now, neither should we extrapolate what is going on in January or February. The true impact of the permanent damage that this does to the economy because of wealth effect etc... will be visible only from financial year 2017-18. And that is when people will really start taking note of which sectors are impacted or where earnings are impacted. As of now unfortunately you can only theorise. The data points that we see right now are not too useful in confirming or denying theories.

Fund Flows

Let me talk about one data point that we can confirm, it’s capital flow. You see Rs 2.5 billion exit the markets, you are seeing foreign institutions exit emerging market as an asset class. $5 billion of bonds and equity put together. On the other hand, you are also seeing significant retail money coming in. Do you see that balance of one rescuing the other or do you see more the money going out if the Fed rate hike comes?

I wouldn’t say global money is easy to predict but clearly cost of capital globally is going up and if Fed does hike the rate, the risk is that there will be more outflows from the emerging market. In every GEM portfolio India is overweight. And unfortunately these stocks that people have overweight are very similar. And if you take the top 20 India funds or India allocations within GEM funds, I think 7 or 8 out of the ten stock holdings will be the same. So India is overweight. The stocks that people hold are also very very similar. So if there is outflow, it will have a meaningful impact on those particular stocks. And if people have to take money out of GEMs, India is a natural place to take it from because they are still sitting on gains. As far as domestic flows are concerned, it is a little tricky. Because what has happened is now real estate doesn’t seem to be a very attractive option. Especially over the immediate short term because of all this confusion. Gold hasn’t given much return. Fixed income yields are very little now and therefore equities is emerging as the only place that people expect some kind of meaningful returns. Also the experience of the last 3 sharp selloffs has been that if you put in money after the first 10 days of market fall you make money. August 2013, Feb 2016, June 2016 all these 3 episodes, if you put money after 10 percent fall in markets, you get tons of money. And people are anchored to that because this was the experience for the last 3 times, the same thing is likely to happen again. So domestic flows will be strong at least for the first few days.

Further Weakness In Rupee?

We have seen rupee downgrade significantly. What are the factors that are playing on the rupee in significant time? Do you have view on whether demonetisation is going to disrupt the trajectory of how the RBI is looking at it?

There are 3 factors influencing the rupee right now. First is the shrinking gap between U.S. rates and Indian rates. There has at least been a 250 basis points shrinkage in the last 1.5 years from the top of the gap between the two rates to now, there has been a 250 basis points shrinkage. Having said that inflation adjusted has not been much. Inflation in India has gone down, inflation in the U.S. has gone up. So inflation adjusted we are still above the mean in terms of the gap between the real rates in India and the real rates of the U.S. Of late the outflows have been more in emerging markets and India has been the worst affected. We have actually come out fantastically well from the unwinding of all the measures that we took in 2013 that money should have gone out in September-October-November. And I don’t think it has impacted the rupee all that much. And lastly, I was of the view that because of demonetisation, we could see some of the black money converted into dollars. It is probably happening we don’t know. Anecdotally You totally hear a lot of stories. The extent of such conversion and whether it has a large enough impact in the currency is what we have to..we won’t know that. But it going to be an influencing factor. As far as the Reserve Bank is concerned, I think as long as the depreciation is orderly, I don’t think they will or they should do anything about it. As it is our trail has been very weak. I don’t think they will take a view on where the rupee should be as long as there is much more intervention.

You spoke about the contra measures. How significant will this budget become and do you think this government is going to set aside fiscal prudence off the table for now and perhaps bring in some stimulus measures?

It’s a very interesting year because on the one hand you will have higher direct tax collections because of all the anti-corruption move, higher personal income tax collection. On the other hand, you could have some slowdown in indirect tax collection, both service tax and excise as well as some slowdown in corporate tax if our view of earnings turns out to be correct. Secondly you have this big animal called GST where the central government has made a commitment of 14 percent growth on revenue for the state governments which is fixed on financial year 2015-16 numbers. So in a sense state government revenues are largely low. Any volatility has to be taken by the central government. So it very hard to do the fiscal math now. It is very hard to put a finger on how the fiscal math is likely to be. It is extraordinarily important politically, that there is some kind of reflation.

First the demonetisation has made this entire anti-corruption move into a mass move. So in the process a lot of people have been inconvenienced. Second, I do expect job losses as a result. So we do have people being inconvenienced having job losses, not much of income growths and he needs the political support to continue this process. And therefore it is very likely that the government will have some kind of reflation. The direct will be different. What we have seen the government do in the last three budgets is be fiscally very conservative, bring down subsidies, bring down leakages and focus fully on government capex going down. I think this time the language will change. The language will be that we transfer money from corrupt to the poor. What form or shape it takes I do not know. But they have to do it. One, the best way to reflate economy in the short term is consumption. Capex unfortunately takes time, especially in India because we don’t have the institutional capacity to build roads and rail in a hurry. Look at Dedicated Freight Corridor, we have all the money, we have all the managerial capacity but we still get delayed. So therefore consumption is available. Secondly it is a political impetus. So I do expect some kind of measures that will be exclusively focused on people on the bottom of the pyramid. What form or shape it will take I think it is hard to say right now.