Will Macro And The Micro Finally Tango?

Ever since the global financial crisis of (2008-09) we have rarely seen both macro and micro (earnings) performing together to drive the Indian equity market. FY19 could be the rare year when that can potentially happen. While the macro part has looked up over the past few years, the micro (earnings) has consistently disappointed (Exhibit 11). Recent numbers, however, indicate a reversal of trend in both. Macro health, to an extent, will be dictated by the upcoming budget. With uncertainty regarding indirect taxation largely taken out (following the implementation of GST since 1 July 2017), the focus will be more on the quantum and quality of spending. While budget math of FY18 was adversely affected by both - a slower economy and inadequate GST collection (because of teething issues) - we believe that both factors could potentially act as tailwinds in FY19 because of the base effect. Acceleration in revenue growth will put more money in the hands of the government in a pre-election year. How it uses the largesse is going to dictate the macro. Earnings seem to be finally turning up, thanks to some lagging sectors (corporate banks, pharmaceutical and commodity companies) likely delivering a better performance. The macro picture threatens to worsen on the back of a global commodity upcycle and possibility of Central government frittering away its hard-won gains for a positive political outcome in 2019 (budget represents the last opportunity for populist handouts). 

A look at the mix of earnings of Nifty constituents indicates that India’s budget has only a limited direct impact, but has a larger indirect impact through cost of capital and the INR/USD rate. A large part of Nifty earnings (50%-60%) is directly driven by factors that Indian government has little control over (commodity prices, global growth, etc). The big delta in earnings in FY19 is likely to come from stocks which are globally linked (like Tata Motors, Vedanta, Coal India) and from corporate banks which are likely to provide lower for bad assets (SBI, Axis Bank). We believe the budget will have little impact on either of these buckets of earnings in a material way. Macro stress is currently visible in the form of inflation which has risen by 375bp from the bottom and the 10-year yield which has spiked from a low of 6.2% in February 2017 to the recent number of 7.45%.  We believe the sharp spike  in rates is partly because of apprehension among market participants that the government will deviate materially from the FRBM roadmap. We expect the government to stray from the FRBM path, but not much (see our economist Teresa John’s piece on the budget). Our view is that unlike in the past years of this administration, when revenue spending was kept in check, it is very likely that both capital and revenue spending will likely see equal emphasis and possibly revenue spending will have an upper hand. Considering the closer-than-expected Gujarat election results and supposed unhappiness within the farming community, there is likely to be a large focus on support to it through mechanisms to support product prices and greater subvention on farm loans (combined with a larger quantum). The higher spending in the rural/farm sector may be combined with some tax concessions in the lower income brackets (for middle class India) leading to a boost in domestic demand. We believe macro stability (keeping interest rate low) helps a large number of sectors including automobile, cement, affordable housing, infrastructure, non-banking financial services companies, etc. The focus on the rural economy and increasing farm incomes (and greater post-tax income among the middle income households) is likely to have a positive rub-off effect on farm equipment companies, automobile companies, select consumer staples and consumer discretionary companies.