Earnings growth and corporate profitability are at cyclical lows in India

What is your assessment of the state of the Indian economy and the stock market at this point? Is the current economic situation purely a consequence of economic cycles, which can be addressed through fiscal and monetary measures or do you see structural issues, which may require structural policies to fix?

We feel the Indian economy’s current slowdown is more cyclical in nature, and is the result of several factors coming together at the same time. Several reform measures such as GST, RERA, demonetisation have disrupted the way business was traditionally done and the resultant adjustment process has reduced activity levels in many sectors. Also, the slowdown in government spending in 2HFY19 and the first three months of current fiscal, weak agricultural commodity prices that have impacted spending power in rural India and the drying up of liquidity in the wake of defaults by some large NBFCs have all affected economic growth. None of these are structural factors. The key structural positives of Indian economy viz. strong demographics, low household debt levels, increasing urbanisation and a balanced economy not overly dependent on commodities or exports are intact. We expect economic activity to improve over the next 12-18 months as the disrupted business models are gradually adjusting to the new regulatory scenario, liquidity has improved significantly and government spending is coming back.

As regards stock markets, we see several positive emerging while sentiment remains gloomy. Market valuations are near longer term average, in fact many sectors and stocks are trading below their long term valuation multiples, interest rates are declining & repo rates have moved to 5.4%, liquidity is improving and oil prices are stable. So conditions for economic recovery are clearly there. We feel the recent weakness is a good opportunity to increase equity exposure in their portfolios.

What are your views on the tax related and other fiscal measures announced by the finance minister over the last month and half? Do you think more measures will be required to revive economic growth? Will there be an impact on our fiscal deficit and bond yields thereof?

The corporate tax cut announcement is definitely a significant measure to improve competitiveness of Indian businesses and boost the animal spirits of the markets and the entrepreneurs. The measures are not sector specific and are clearly aimed at encouraging investments. The tax cuts and other measures announced by the Finance Minister in August such as recapitalisation of PSU banks,measures to improve MSME sectors etc will help in improving growth in a more sustainable manner rather than just giving sops to some troubled sectors.

The corporate tax cuts is likely to increase fiscal deficit by a large margin (tax shortfall estimated at Rs.1.45 trillion) and Government bond yields have risen post the announcement. The rise in yields has been contained so far as Government can adopt some other measure (strategic divestment of PSUs, foreign currency bonds etc) to reduce the impact.

What is your outlook on earnings growth over the next 3 to 5 years from FY 2020 onwards? Reduction in corporate tax rates will obviously have an impact on EPS, but what in your view, will be other drivers of earnings growth in the moderate term?

Earnings growth and corporate profitability are at cyclical lows in India. EPS growth in the last five years has been below the nominal GDP growth. Similarly, corporate profits as a % of GDP are at 2.7% is at levels last seen in 2003 and well below the peak of 7% seen in 2007. Last few years, the GDP growth is driven more by consumption while exports and domestic investments were not contributing to this. We see capex cycle improving in the medium term, as corporate India’ debt situation has improved in the last three years. Also the recent tax cuts encourage both investments and exports as India’s tax rates are comparable to east Asian countries. This will enable Indian companies to become part of global supply chain and capitalise on the current China-US trade tensions. Thus, increase in investments and improving export competitiveness will lead to improvement in profitability and earnings growth.

What are the global risk factors for equity investors in India at this point in time?

Key risks for markets remain any sharp rise in oil prices and significant slowdown in global growth.

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