The Finance Minister has pledged to keep the deficit close to 5.3 per cent in the current fiscal year. This target is somewhat at risk given that revenue collection has been slower than expected, there have been almost no divestment proceeds and following a tepid bandwidth telecommunications auction.
However, the recent direction of fiscal policy action has revived hopes that domestic growth rates will improve. Fuel prices have been hiked, there has been an increased willingness to cut the fiscal deficit, initiate cuts in government spending, both social and administrative, restructure state electricity boards and liberalise some foreign investment limits. All these serve to ease investor concerns, stabilise markets and help economic growth. To return the economy to a higher trajectory of growth, will require further, harsher, and far more politically contentious reforms. As such, this includes land and mineral resource allocation, further moves to improve the investment climate, and additional reductions in India’s fiscal and current account deficits. By building a consensus in parliament, we expect the government to be able to push through a goods and services tax (GST), a new direct tax code, land purchase and financial sector reforms. These will change the game -- and help return GDP growth to the high single digits (over 8 per cent). GST, for example, will alone add 150-200 basis points to GDP growth. Clearer land purchase rules will provide a firmer ground for industrial capital expenditure and public infrastructure projects.
Indian equities are expected to rise if domestic political concerns continue to ebb and the situation in Greece clears up. How much they rise depends on the Indian government approving additional Public Service Units (PSUs) divestments and further parliamentary financial services sector reform. Indian equities are trading at a historically cheap 12.6x versus their average of 13.8x (1-year forward earnings basis -- 10-year average). Earnings are expected to grow 15 per cent during FY12-14. This level looks attractive for investors looking to invest money in the Indian market over the next few years. Although the current earnings season’s momentum has been slack, we expect that further fiscal policy action, improved investor sentiment and easier monetary policy will drive earnings from the first quarter onwards. Flows from Foreign Institutional Investors (FII), at $19 billion year-to-date, have been robust and likely to continue given the current general backdrop. We therefore maintain our overweight stance on equities.
In the medium term, we expect Indian equities to continue to outperform against regional peers as risk appetite increases among global investors. Our Nifty target is 6,200 for March 2013. The main risks to our forecast lie in any reversal of domestic policy momentum, any political uncertainty, and a significant slowing of the US recovery, particularly if they go over the so-called fiscal cliff. Our preferred sectors are consumer staples, healthcare and IT. We are not as optimistic about telecommunications, utilities and industrials. Institutions with large interest income components, such as banks, however, will benefit from any easing in monetary policy.
On the fixed income side, given the overall backdrop, bond yields are expected to come off given the aforementioned monetary easing and improvement in liquidity seen from Q4-FY13. We also expect a 50 basis point rate cut in this fiscal year (Q4-FY13) and a further 25 basis point cut in (Q1-FY14). While the short-end will be driven by liquidity and long-end yields by policy action and government borrowing in the second half. Liquid fund returns should start coming off, with lower rates at the very short-end. Accrual funds still have some upside and it is a good time to lock in these funds. Medium term funds look attractive as they offer high accruals and have ability to generate capital gains along with softening yields. With the expectations of monetary easing, recent fiscal reform measures and RBI’s continuing support for system liquidity, we suggest investors to consider long duration funds or bonds as a portion of allocation opportunistically.
The author is Chief Investment Officer, RBS Private Banking
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