Expectation is to restore confidence and revive animal spirits despite external headwinds
The India dynamics since mid 2014 and now is different. The advantages from clear political mandate to NDA, sharp decline in commodity prices and good external appetite chasing India opportunities (and valuation re-rating) are now behind. After 20 months of NDA rule, there has been gradual decline in sentiment from euphoria to optimism to hope, and now at breakdown point to despair and scepticism. The best of external supportive cues are now behind. There is little downside to commodity prices, and it could only turn worse from current prices. The flow of FII liquidity is now reversed looking for exit options with little appetite to hold and accumulate despite de-rating in equity valuation and high fixed income yield from the high's of 2015. In short, the India optimism (and resultant wealth creation) didn't last for long, and now have turned from the best to the worst among both developed and emerging markets. In these tough on-ground dynamics, Budget2016 is not expected to score 10-on-10, and at best it would be pleasant surprise to get above-par score from stakeholders.
Macroeconomic fundamentals stable, but concerns remain on funding growth and fiscal prudence
While downside risks remain across the board, Current Account Deficit at 1.5-2.5% and CPI inflation at 5-6% is much better than what it was couple of years ago. The comfort here are from Brent Crude price stability at $30-45, sub zero WPI and relatively low core inflation. The concerns now are from balancing growth rate at 7.5-8.0% while containing fiscal deficit at 3.5% for FY17, stated as targets in Budget2015. The risk now is the downside review of these stated deliverables in Budget2016. Given the change in on-ground dynamics both from domestic and external cues, the practical (and realistic) approach will be to set FY17 GDP growth target at 7.5-7.7% and fiscal deficit at 3.7-3.9%. It will be loss of credibility for the Government, but it is prudent to accept the hard reality and work on achievable targets rather than setting wishful & tough targets.
The issues on hand are many across revenue, costs and investments. The revenue side of the balance sheet is mostly covered by taxation on top-line economic activities, tax on income & profits and dividend from public enterprises. There will be pressure on all these fronts in FY17. The cost components are heavy on interest payments, subsidies and administrative expenses. The budgetory deficit is largely from unproductive consumption rather than productive investments. The "borrow for consumption" mode remains and grows year after year for more than 6 decades now. There will be no relief on the cost side as well in FY17. Where we go from here?
The vicious circle that the system is stuck can't be broken when external appetite is low and domestic private investors sentiment is low. The equity to fund growth has to come from the public through budgetory allocation. The capability to provide leverage to equity through debt is low when most lenders are into credit risk-off mode, and into balance sheet clean-up exercise by aggressive provision for NPAs. It is worse when Bank's investment portfolio is now hit badly from spike in bond yields since Q4/2015. The Government now need to allocate funds from the Budget for growth, pull private (and offshore) investors participation and provide necessary bandwidth to RBI to script growth supportive monetary policy. All these are seen to be very tough to achieve without compromise on fiscal prudence.
Attention on fiscal deficit and capital gain tax
Most stakeholders have now zoomed in their attention on fiscal deficit (at 3.5-3.7%), GDP growth (at 7.5-7.7%) with worry on tightening the capital gains exemption from 1 to 3 years. The intent this time will be on being thrifty on unproductive monetary benefits (and consumption) for use for productive economic activities that would lead to demand for goods & services, generate employment and lead to wealth creation & higher consumption.
MARKET PULSE see Budget2016 as non-event given the limited financial bandwidth to be big-bang or deliver pleasant surprises. The FY17 BE for GDP growth is seen at higher end of 7-7.75% range set in ESR. The fiscal deficit will be targeted at 3.7%, mid-way between FY16 target of 3.9% and FY17 FRBM target of 3.5%. Other measures will be centred around pulling private and foreign investments while retaining cost and revenue structures unchanged. Needless to say, most of the focus will be on scaling up of economic activities through infrastructure-build, realisation of make-in-India manufacturing vision and uplift of agricultural & allied activities, and fulfilment of social obligations to urban, semi-urban and rural poor across health, education, housing, social infrastructure and financial inclusion.
What is the impact on financial markets?
While FY17 GDP growth at 7.75% and fiscal deficit at 3.7% will be acceptable to most stakeholders, anything beyond either way will lead to price volatility. However, change in capital gains tax structure (tenor and/or rate) will lead to knee-jerk downside reaction before stability. Given the need for money, the Government may be prepared the downside risk as short term pain. The valuation in equity assets have gone up significantly from FY14 to FY15, between August 2013 to March 2015 followed by value correction in FY16. It may not be a surprise if the Government either increase the exemption period from 1 year to 2-3 years or marginal upward revision in tax rate or both. Although, it would be viewed as step backwards post introduction of STT but the need for resources may make it compelling to bite the bullet.
The post-budget outlook on equity market is balanced on the outcome of Capital gains tax. NIFTY outlook is neutral between recovery into 7100-7350 or collapse into 6500-6850. The third option is for stability at 6850-7100 if it goes as non-event. Bank NIFTY despite having lost 35% from 2015 high (as against 25% in NIFTY), does not look relatively better given the combined impact from woes on PSU banks balance sheet and value correction in private sector banks. The outlook in Bank NIFTY is either for recovery into 14000-15000 or collapse into 12500-13500 with neutral option for consolidation at 13000-14000. It's near zero possibility of delivery of pleasant surprises that could trigger the NIFTY over 7350 or Bank NIFTY over 15000.
The most painful for the economy is the elevated money market rates at shorter end and high bond yields at longer end. While high long term yields is good for retail (and passive) investors, it's pain for the borrowers including the Government. It is unfortunate when RBI has exhausted most of its ammunition through 1.25% rate cut in 2015. The domestic investor appetite is now low with huge excess SLR in books, and less said the better on the plight of foreign investors with Rupee down from 58 to 69 by 19% since mid 2014. The Central Government gross borrowing is expected at 6.5-7.0 lac Crores, not including the supply of State Government bonds and UDAY bonds. The demand-supply dynamics will be heavy on the Bonds notwithstanding support from RBI through OMO bond purchases, while any rate cut will go ineffective. India 10Y bond yield 7.72% 2025 is already up from 7.45% to 8.10% post 50 bps rate cut on 29th September 2015, by 9% in less than 5 months. The new 10Y benchmark is up at 7.80% from issue coupon of 7.59% in less than 2 months. MARKET PULSE outlook is for stability in 7.72% 2025 at 7.95-8.10% and at 7.75-7.90% in 7.59% 2026 by squeeze of spread from 30 bps to 15-20 bps. Going forward, there will be demand for 7.72% 2025 from RBI and regular supply of 7.59% 2026. It will be painful for the Government (and equity market) if 7.72% 2025 shift post-budget play into 8-8.25% and 7.59% 2026 to 7.80-8.0%, while not sure of defence fire power from the RBI to hold play below 8.10% and 7.90% respectively.
USD/INR stay ring-fenced by Budget2016 jitters. The support for Rupee at 68.70-69.20 is firm from RBI, exporters and carry-trade borrowers in traction with 12M forward rate resistance at 73-73.50. The shorter end play for end March 2016 has stood firm at 69.20 with spot hold at 68.55-68.80. What Next? The short term big-picture range focus is at 68.20-69.20. The breakout bias adjusting for time-decay is for shift of post-budget play to 68.50-70, and would need miracles for Rupee recovery below 68.20 into 66-67.50. As always, the trigger is with FPI flows; will they exit or remain on hold or wish to accumulate? For new entrants, Rupee at 68.70-69.20 against de-rated value in equity and bond market (since March 2015) is attractive. For those who are light-weight, it is not bad to hold and accumulate for better average. The worry is from those who are over-weight on India; trigger of stop-loss exit will be heavy on Rupee and it would be beyond RBI to defend 69.20. The other major risk on Rupee is from Chinese Yuan devaluation and USD strength against major currencies. All taken, it's not good time for importers (and carry-trade borrowers) to stay risk-on (with unhedged imports and FC liabilities) while it gives comfort to exporters to stay risk-neutral at 68.70-69.20 (12M at 73-73.50) for shift to risk-off around 70 (12M at 74.25-74.50). During this phase, it is good for exporters to unwind risk-neutral mode to risk-on at spot 67.95-68.20. Importers are not in an enviable position (at spot 68.50-70) post sudden shift from 63 to 69 by 10% in less than a year and not sure of spot at 73 adjusting for time-decay. The post-budget range outlook is retained at 68.35/68.60-69.20/70, and good to retain end-to-end focus with stop at 68.20 and 70.05.
Best wishes and good luck ahead!
Moses Harding
harding.moses@gmail.com
9674734145
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