Consumption needs to revive

The cut in corporation tax rate could potentially boost margins of companies

It has often been said that a crisis presents opportunity. This week certainly had all the ingredients of a crisis and the government has responded with measures that helped reverse downbeat sentiment. It remains to be seen whether these will also help revive the economy.

The drone attack on Saudi Arabia caused near-panic. It was followed by the default of yet another Indian financial firm. Some good news in the form of the US Federal Reserve’s rate cut was expected, and it was discounted before it happened.

The substantial cut in the corporate tax rate on Friday was unexpected. So was the removal of surcharge on capital gains. The former measure could boost corporate earnings, while the latter will help improve trading volumes.

Taken together, this should mean a reversal in the outflow from equities. The government reckons that the tax cuts will lead to a drop of about Rs 1.45 trillion in 2019-20 tax revenues. It means the fiscal deficit will soar, and the fisc was already at worrying proportions. In the short to medium term, the government’s space to engage in other counter-cyclical measures has got reduced. The bond market could come under pressure since this will inevitably mean more government borrowing.

Friday saw a relief rally as the market started to discount the unexpected good news. A more measured response is likely this week, once the details have been absorbed and fully understood. There could be a reaction if traders sell into the rally, booking profits. We may also see a continuation of the up-move.

In technical terms, the market jumped 6 per cent on Friday, which is a huge up-move. That move was also backed by positive indicators like strong volume action, and good advance-decline ratios. The combination of price up-move plus volume expansion should be net bullish. The zoom on Friday has pulled the indices up to around the level of the 200 Day Moving Average. There is a lot of resistance at these levels but if the Nifty can cross above the 11,300 level and stay above it, it would be a new bull-market by definition.  

One of the critical factors will be foreign portfolio investor (FPI) attitude. Between September 1-19, FPIs sold Rs 5,500 crore of equities. Anecdotal evidence suggests FPIs were net buyers on last Friday. If they stay so, it will indicate a sustainable reversal of sentiment.

Of course, the change in sentiment cannot be sustained without significant improvement in earnings. Q2 results will be poor but there could be a bounce in Q3. That will also incorporate the festive season, which kicks off in early October. Every consumer-facing business is desperately hoping for a pickup in consumption during Puja–Diwali. If there is higher consumption, the tax cuts could act like a steroid and boost earnings. Of course, analysts will have to de-seasonalise indicators during the festive period to make robust comparisons and see if changes in profits and revenues are meaningful. The last festive season (October 2018) was weak so there could also be a boost from base effects too.

If earnings doesn’t respond strongly to the cut, sentiment will collapse all over again. Don’t forget that there are other structural problems in the economy besides high tax rates. There’s the complicated GST, for example. A strengthening rupee with a high current account deficit is also an anomaly. A stronger rupee encourages imports and makes exports more expensive, when exactly the opposite is required. The tax cuts also don’t directly boost consumption – they boost earnings and net profit margins.  If revenues don’t rise much, and operating margins (PBDIT over revenues) don’t improve, market action will taper off and investor mood will sour again.

The amazing mood swing on Friday suggests sentiment has turned around. Cold logic tells us that a corporate tax rate reduction of 8 percentage points should boost net margins considerably. The removal of surcharge on capital gains should encourage trading. But the key to an economic revival will be the return of consumption. We’ll get a chance to assess what the tax cuts have done for consumption only in Q3. If the RBI backs this up with a rate cut in the next Monetary Policy Review in early October, that would lend muscle to consumption. That’s the next thing that the optimists are expecting now.