Why is the market ready to take this short-term pain in economy
Earnings growth will look better in FY20 largely due to corporate-focused private banks.
Optically, earnings growth will look better in FY20 largely due to corporate-focused private banks. Reduced provisions will significantly boost profitability of corporate-focused banks in FY20 over that in FY19.
While improved earnings growth of FY20 will support the market, there is a challenge emerging on the real economy, mainly driven by consumption slowdown.
Auto sales are down for last three months. Scooter sales turned negative after a decade in FY19. Consumer staple companies are talking about a slowdown in the days to come, if not about the slowdown seen in Q4 of FY19. Consumer durables are also witnessing subdued demand.
Investment hasn’t taken off for a while as capacity utilisation has remained low. There are unmistakable signs of growth slowing down across sectors. It is not negative growth, but certainly below-potential growth.
While this below-potential growth rate is evident for some time, the market seems to be not noticing it. That paradox is probably explained by the causes of potential slowdown and market expectations about solutions emerging to tackle the same.
India was suffering from high inflation for some time. In order to bring down inflation, RBI was mandated to manage the monetary policy. Over the years, RBI has brought down inflation from double-digit levels to lower single digits, by restricting liquidity and keeping real interest rates elevated. This successfully brought down inflation but the inflationary expectations probably hasn’t come down as much.
The side-effect of a tight monetary policy and higher real interest rates has been on growth. Q4 FY19 GDP growth came in below expectation at 5.8 per cent year on year.
The introduction of disruptive reforms like GST and demonetisation resulted in better tax compliance but further slowed down the growth. Most of the PSU banks were put under PCA norms a few years back, restricting their ability to provide credit throughout the length and breadth of India Inc.
NBFCs tried to fill the vacuum created by the inability of PSU banks to lend due to major asset-liability mismatch. In September, 2018, IL&FS default resulted in refinancing for NBFC coming under severe pressure. Today part of the slowdown is accounted by tight liquidity, elevated real interest rate and limited transmission.
The market believes taking this short-term pain is worthwhile as it will be easy to change the course once the new government gets down to business. The liquidity shortage can be tackled with forex swaps, OMOs and, if needed, a CRR cut. The post-election period in the past has witnessed a return of cash to the banking system. Elevated real interest rates can be cut down aggressively as long as inflation remains under control.
Barring a spike caused by higher oil prices or bad monsoon resulting in higher food prices, inflation is likely to remain below RBI’s target level.
The Bimal Jalan Committee is soon likely to finalise its report on excess reserve held by RBI. Those excess reserve can be utilised to recapitalise PSU banks and make them move away from PCA norms. This will restart the credit cycle, which can be supportive of growth. In some sense, the equity market is expecting better earnings growth as inflation is low, which will allow a series of rate cuts and create abundance of liquidity with better transmission.
It is anybody’s guess if the optimism of the market will be rewarded or not in the days to come. As an investor, there is no option but to follow a disciplined investment approach in times like this ahead of some events and an optimistic market. The time-tested tool of asset allocation along with a disciplined systematic investment approach will help navigate better in such times.