The Budget isn't important for stock markets: Ridham Desai

Interview with the head of India Research and India Equity Strategies, Morgan Stanley

The Budget has become a highly overrated document, says Ridham Desai, head of India Research and India Equity Strategies, Morgan Stanley. In a conversation with Niraj Bhatt and Hamsini Karthik, he explains why fiscal consolidation would remain the key focus in the coming Budget. Edited excerpts:

How do you see the government’s policy on fiscal consolidation this Budget? 

We think fiscal consolidation will continue. It has helped rebalance the economy along with the Reserve Bank of India’s (RBI) positive real rate approach, and this has stemmed inflation. Growth is slowly recovering and coming out of the dull phase of the past five-seven years. Consolidated fiscal deficit is still high at six per cent, and there is room for it to fall. We still run a primary deficit, which means we are borrowing to pay interest, which is not sustainable. 

Will the government continue to focus on infrastructure spending? 

Infrastructure spending has been one of the anchors of the economic recovery that we are witnessing. The government has engineered this extremely well over the past two-three years, with infrastructure growing in high teens. It has successfully shifted the focus to the public sector from the private sector, which was over-leveraged and unable to execute projects. As a percentage of gross domestic product (GDP), infrastructure spend is just a little below its all-time high of 9.5 per cent, and that level is likely to be crossed in FY18. 

There is a lot of debate on tax. What is your view? 

Besides fiscal consolidation and infra spend, the third focus area of the Budget will be rationalisation of taxation. Corporate tax could reduce by one per cent, in line with what the Finance Minister had said, and some exemptions would be removed. 

The next issue is on the fine print of GAAR (General Anti-Avoidance Rules). This will not impact the economy, but only foreign portfolio investors (FPIs), and hence it could impact the market. The ideal scenario would be an exemption for FPIs from GAAR, and in lieu of that, a higher or differential securities transaction tax is charged. From the government’s perspective, it implies assured tax collection and it removes a lot of uncertainty for FPIs. We could see some changes in indirect taxes if the government wants to move towards GST (Goods and Services Tax) rates. 

How do you see the Budget impact on the stock market? 

From a stock market perspective, the Budget has become a highly overrated document. The current rally in the markets has more to do with global stock markets and a lesser-than-anticipated impact of demonetisation than with Budget expectations. Corporate earnings are better than estimates. The intra-day volatility on Budget day has halved in the last 20 years. So from a stock market perspective, the Budget doesn't really occupy much importance in determining market trend unless it is an extreme one. 

In the same way, our research shows that state elections are also not consequential to markets. They would be consequential only if there were a shift in the political landscape like the 2013 state elections which gave a clear indication of a shift in favour of Bharatiya Janata Party (BJP). Hypothetically, if the BJP lost all five states, there could be some short term decline, but it won’t change the market outlook for the next six months. What the market ultimately cares about is what happens to growth, and that’s why I am bullish on stocks. 

What is making you bullish? 

Valuations are attractive, both relative to emerging markets and to bonds. So, on a relative basis, India is attractive; we are seeing growth. Corporate earnings in the September quarter had been the best in five years. Had demonetisation not happened, the December quarter could have been the best earnings quarter since 2011. That gets deferred by three months. 

Again, the reasons are not purely India-centric. Exports growth is accelerating. Industrial production growth is at a five-year high and consumption is strong, the only area of weakness is private capex. But, we see that turning positive sometime in 2018. The main pillars of economic performance are all looking up and that’s why stock prices are looking up. 

Are there any risks to your view? 

A big upswing in commodity price could upset India’s terms of trade and bring the threat of inflation back. The other risk is that of a global sell-off. India, being the eighth largest market in the world is a large-cap stock in the global context. Any global sell-off will impact India. But back home there are very few things to mess with growth at this stage.

What is your view on interest rates?

The US Federal Reserve will likely increase rates as the unemployment rate is now pretty low relative to the past. If US rates are going up in the next 12-18 months, it is unlikely that Indian interest rates would move down from here. We are mostly done with rate cuts; there is probably room for just one more. Lending rates too aren’t going to fall much: The RBI policy rates have fallen by 175 basis points since January 2015, while State Bank of India’s effective lending rate is down 200 basis points, indicating that transmission has taken place. That is not necessarily bad as it actually signals that the economy is in a good shape. 

What are the sectors you like? 

There’s a macro top-down trade in India. The three sectors that stand out for me are consumer discretionary, financials and technology. Consumption demand is quite strong and consumer discretionary is benefiting from the leveraging of household balance sheets. In financials, we have to be a bit careful as there would be staggered performance. Banks will face margin pressure due to rate cuts and by the time their liabilities get repriced, their interest margins will continue to fall. Non-banking finance companies, on the other hand, will not face this problem as they have shorter liability duration. They would probably lead the rally and banks will follow. However, the situation for public sector banks, which require capital, will not change materially. They will continue to lose market share. For the entire sector, there’s a lot of liquidity after the note ban, which will lead to a recovery in loan growth. Growth also means that you will see a surge in mergers and acquisitions, where banks will step into funding the transactions. Retail growth is strong and eventually private capex will kick in. 
 

I find tech stocks cheap and the market has become too pessimistic on them. If the US growth is accelerating and wage inflation is rising, then Indian tech companies are in a sweet spot as American companies have to outsource notwithstanding the policies they would have. The US does not have enough engineers and has to outsource if it increases capex. There will be greater demand for enterprise software and hence greater demand for Indian IT companies.