Budget Increasingly Constrained On Big Bang Reforms, Says BofA ML’s Sanjay Mookim
The Indian government will need to make some tougher choices in the near term given macroeconomic conditions but the Union Budget may not be their preferred platform.
That’s the word from Sanjay Mookim, director at Bank of America Merrill Lynch on BloombergQuint’s weekly series, Thank God It’s Friday. “The Budget is becoming less of a platform for major changes,” he said, adding that the only likely announcements from Finance Minister Arun Jaitley will revolve around the fiscal deficit number and direct taxation.
Here are edited excerpts from the conversation.
What are your thoughts on where the Indian economy stands currently?
In the short term, we have hit what I call peak macro. On most metrics, whether it is current account deficit, the fiscal balance, bond yields or inflation, a lot of the tailwinds which India had over last 2-3 years seems to have turned and the equity markets seem to have taken notice of it. We are in a slightly more difficult spot than we have been, and policymakers and the government will need to make some tougher choices in the near term.
However, the positive news is that the government has instituted major reform whether it is Bankruptcy Code, GST, the Real Estate Act. All of these are extremely powerful changes. This causes turbulence and disruption in the short term but the long term benefits of these reforms are significantly powerful and we will continue to accrue benefits for years to come.
In the extreme short term we have hit peak macro. The government has its hands tied tighter than it had previously but in the medium term there can be tailwinds from the reforms that have been instituted. So, it is a bit of a mixed bag.
You estimate the Sensex to be around 32,000 by December 2018. There are expectations that earnings could catch up. Does that mean we may not see much upmove at least for the large caps?
There are two variables that drive equity prices, broadly. One is earnings themselves, and then the multiples. In theory, multiples are correlated to earnings growth. If there is higher earnings growth, then the multiple should be up. What has been happening in India and rest of the world is, multiples have gone up outside of earnings growth. They have gone up on the basis of liquidity injection, on the back of the global equity rally. That is cyclical.
While I agree that Indian earnings should improve in FY19 over FY18 – in fact, we ourselves estimate an acceleration – part of it is the economy doing better and part of it is just base effect because we have had a bad FY18. Nevertheless, the risk is that the multiple itself turns down. While sitting in India, we focus on India specific factors and on how the economy is doing, the multiple cycles is actually a globally correlated asset rally. My worry is that, what we are not focused on, but we are all aware of what is happening. That is a bigger risk to Indian equities this year than earnings themselves.
What influence does the 2019 general election have on government policy and what does it mean for equity market in India?
The classic example is to expect the government to be more populist getting into an election or try and avoid measures that might hurt them politically. From an expenditure perspective, it means that the government will have that much more incentive to continue with social spending like increased spending on rural housing and roads, things that have an impact immediately and not five-year road or airport building plans.
They may be good to announce but it doesn’t impact the vote-getting power in short term. You would expect government to swing from a very capex oriented expenditure to a very revenue or short-term focus. From a market perspective that may have mixed effects. Infrastructure sector may lack momentum from expenditure but rural consumption, consumption-driven stocks could see some tailwinds going forward. The trouble for government is to find the money to do this. If the budget is tight, there is chatter that they might consider expansion of deficit, one time perhaps. It may be politically necessary for them to do that in the general elections.
Is it fair to assume that nothing major can be expected from the budget in terms of big bang reforms?
The budget is becoming less of a platform for major changes. Especially because of GST, indirect taxation has also been taken out of the budget. Therefore, the chatter is about direct taxation, about long-term capital gains tax, about personal income tax changes because that’s the stuff left in the budget. Fiscal deficit number and direct taxation.
I do not expect any major surprise in terms of policy changes in the budget. Really nothing constrains the government from having to do everything in the Finance Bill. I wouldn’t expect major reform changes other than tax rate changes which may or may not happen.
How real is the possibility of long-term capital gains tax?
Market chatter on that picks up every year ahead of the budget. I don’t know if the government is serious about it. We won’t know until the budget actually comes out. But the market does think that it will happen. Let’s see.
As an investor, what would you look forward to in the Union Budget?
The big number would be the fiscal deficit because it has an impact on bond yields. If the government were to one time increase the deficit to 3.8-4 percent, a meaningful step up from 3.2 percent, then that means a significant issuance of bonds which means bond yields go up. In theory, that should have a negative impact on multiples in India, because the alternate cost of capital is going up. Sector-wise higher bond yields can exert pressure on certain NBFCs which rely on wholesale funds for their operations. So, there can be some sector-wise implications too.
Personal income tax cuts, if it happens, could stimulate demand and make some changes to the prospect of consumer companies, discretionary staples. Capital gains tax could be another issue. But I don’t see too much beyond that.
Any expectation from budget specifically for the banking sector?
The budget is not the platform to make any decision on bank consolidation. I do not think corporate governance metrics allow governments to make the decisions. The boards need to agree to do the merger. The Union government can’t make the announcement that these mergers will happen. Maybe an intent statement will be put in the budget. But firm execution or progress of consolidation cannot happen in the budget by definition.
At what point in time, do you think that crude can be a considerable threat to the Indian economy?
We are already in some sort of trouble because of the crude price. The oil ministry is handed out a budget for paying LPG, kerosene subsidies. For the first three years of this government, the oil ministry has stayed in that budget. They have managed to live within it. This year the ministry has run out of its budget in the first half and has to go back to the finance ministry to pay additional money to pay kerosene subsidy and LPG. So, this is the first time for the current government, that they are running behind on oil subsidy payments already. So, it is not a problem which will arise in future, but it’s already creating a fiscal problem.
My estimate is the government need Rs 10,000-15,000 crore over and above the budget to fund kerosene subsidy and LPG. In this environment, finding Rs 10,000-15,000 crore is going to be a bit of a challenge for the government and we have to see how they will handle it.
Let’s talk about the plays for election 2019.
I won’t talk about the political aspect of it, but from an economic perspective, it can be a stimulant for spending from a government angle. I don’t know if the government will exercise headroom on the fiscal deficit but if they do expand the deficit and incur additional expenditure, then certain sectors in India like the consumer, rural-focused auto companies, and finance companies, they may see a near-term bump-up in sales.
What are the real estate companies factoring in?
Investors are looking for a much quicker improvement in demand. The volumes pick up first, then utilisation tightens and then you see price momentum which is ultimately a bigger driver of real estate stock prices. It is excitement not just of RERA but the affordable housing scheme that the government has launched. In many ways, the affordable housing scheme is a relatively mass market and not restricted to very low-income categories. Therefore, the scope of it is very large. Even the listed developers have been talking about the prospects of affordable housing. Demand can be really strong if housing or the mortgage is subsidised. That reinforces the view that investors have, that the housing cycle in the low pricing category might be about to improve. There are some signs that there is a pick-up already.
Is it fair to assume that the market returns from housing finance company will be a lot more sanguine this year?
I think the market returns from the whole market will be more sanguine. I do not expect a slowdown in demand for mortgages. We do not think that there has been deterioration of credit standards at the lending companies. There have been good checks and balances in the kind of loans that are being offered even now. However, every credit space is cyclical. The cyclicality can be long or short. Even the mortgage cycle in India will see NPAs at some point. Higher bond yields are a problem for wholesale packs. From a topline perspective, we think the NBFCs should have a decent run for the next few quarters or months at least. Profitability wise there is some pressure. The problem for the market is that each of them is extremely expensive.
How are you choosing companies, if consumption-based companies benefit from a likely populist budget?
I think that consumer discretionary companies with a slight rural bet, which could be autos with rural exposure, are probably likely to have the bigger delta. From a top down aspect, that’s how we filter. Once you identify a broad theme, then we want to pick stocks bottom up – which companies are executing properly, which companies got proper tailwinds in place and so on. The rural discretionary names will look better slightly better placed than the rest.
Watch the full interview here.