IBC, Financial Sector and Current Developments
Even as we have stayed positive on Indian markets over the past few months, we have repeatedly highlighted stress in the financial sector as the key risk for markets as well as the real economy. And on that front, recent developments provide some glimmer of hope. First, the Supreme court ruling in the Essar Steel case upheld the primacy of secured financial creditors over unsecured financial and operational creditors on distribution of proceeds. This should go a long way in expediting the resolution of stressed assets under the Insolvency and Bankruptcy code (IBC). Further, the government notified rules under section 227 of the IBC providing for insolvency proceedings of financial institutions which so far were outside the purview of the process. The RBI acted swiftly subsequently and superseded a stressed NBFC’s board. This should pave way for orderly resolution of stressed entities in the NBFC space.
Development in Real Estate and Telecom Sector
The government announcement of a Rs 25,000 cr fund for stalled real estate projects is a good move. Stress in the telecom sector seems to have peaked with the government giving comfort to all incumbents and following it up by deferring spectrum payments for FY21 and FY22. At the same time, all three private players in the sector announced the intent to hike tariffs thus raising prospects of improved financial health going forward. Resolution of promoter leverage at one of the larger media groups is another unrelated development but in the same direction. Overall, while the recent moves are in the right direction, a lot more needs to be done to rebuild confidence. The recent equity market up-move is partly hinged on expectations of continuing policy support and in part driven by global factors.
The global macro environment has turned for the better. While economic data isn’t deteriorating further, policy response stays more than accommodating thus leading to a happy situation for financial markets. Majority of central banks have resorted to monetary accommodation following a period of weak growth. The US Fed has not just stopped quantitative tightening but has in fact been expanding its balance sheet for the past three months. Fiscal policy is coming to aid too with the European Union as well as most Emerging Economies running expansionary budgets. Fiscal policy will play an even bigger role going ahead and complement effort on the monetary policy front, in our view- this a point we had discussed in detail last month.
Consequently, financial markets appear to now price in a global reflation. The US yield curve which was inverted till August-end is steep again thus allaying concerns of an impending recession. The amount of negative yielding debt which had peaked at US$17 trillion in August-end has since receded to about US$12.3 trillion as at November end. While safe havens such as Gold and US Dollar have gone sideways, risk assets such as emerging market equities and commodities are inching higher. Amidst this global backdrop, India is witnessing strong FDI and FPI inflows. A global reflation should further help the real economy through trade and export linkages.
Therefore, even as near-term growth continues to be weak, and the most recent GDP print of 4.5% for 2QFY20 is dismal to say the least, environment appears to be turning conducive for the economy to pick up at the margin. In this context, the much discussed disconnect between the state of the economy today and the stock market performance while not misplaced, should not be too worrying given markets in general tend to be forward looking. In fact, when the broader markets had peaked in Jan-2018, the economic prints were still running strong. Yet liquidity was getting tighter, both locally and globally, what with the US Fed having begun quantitative tightening in late 2017. This eventually started manifesting in weak economic growth numbers at least a couple of quarters later.
The Worry Factor
The other worry for investors is on headline index valuations with the price to earnings ratio of the Nifty on trailing earnings at dizzying highs. However, one needs to factor in that current earnings may not be the correct representation of corporate performance from a longer-term standpoint given that corporate profitability is severely depressed currently. Corporate profits as a proportion of GDP has dipped closer to 2% from a peak of over 7% in FY08 based on a sample of 20,000 listed and unlisted companies. The nominal GDP growth itself is running in single digits now versus mid-teens in the FY06-FY08 period. As a result, Sensex earnings have grown at an abysmal 5.4% CAGR over FY08-FY19 versus 14.8% from FY92 to FY08. Any reversion in economic growth and profits to GDP ratio would lead to a significant uptick in earnings.
An analysis of corporate India’s earnings recession suggests that over the past decade employee costs and other expenses as proportion of sales have risen, while the benefit of fall in raw materials hasn’t fully reflected in margins. While this can be thought of as negative operating leverage, interest burden and tax burden have risen too. Going forward, lower tax burden (due to recent tax cuts) and lower interest rates should directly aid profitability. In addition, better rate transmission, on the back of ample liquidity and improved confidence amongst financial sector participants, should lead to an aggregate demand uptick which will boost toplines, as well as margins through positive operating leverage.
The Glimmer of Hope
Additionally, some sectors that had been contributing to large pools of losses appear to be on the mend now, corporate banks and telecom being the largest two. The worst appears to be over for corporate banks on recognition as well as provision for stressed assets. Resolution may improve on the back of recent developments on the IBC front- SC judgment upholding seniority of secured financial creditors and inclusion of NBFCs under IBC. Normalization in credit costs can swing large losses to significant profits possibly. Telecom is another large sector that has been in the red given regulatory and competitive pressures. However, recent developments such as a potential end to tariff woes and potential government support for the sector may bring about an inflection in its fortunes.
All signs therefore suggest we could be at the cusp of a new earnings cycle. However, the strength and longevity of the cycle will depend on our ability to push structural reform. Following up on corporate tax cuts, the Union Cabinet recently approved The Industrial Relations Code Bill, 2019 which allows for greater flexibility to government on the threshold requirement for retrenchment and enables companies to hire workers on fixed- term contracts of any duration. Reforms on land and labour along with continued thrust on lowering cost of capital are essential for reviving investments. While labour is cheap in India, we need to focus on reskilling and education to ensure better labour productivity, while fostering innovation. Importantly, we need judicial and administrative reforms that ensure that sanctity of the contract is upheld, and speedy dispute resolution if needed.
A new earnings cycle should lead to broad basing of profit growth which in turn should improve the breadth of market performance. This is especially relevant as safe havens such as quality stocks and large caps trade at hefty premiums to the rest of the market today. Early signs point to a change in market undercurrent- ‘value’ stocks have significantly outperformed ‘quality’ over the past two months. Similarly, Nifty Midcap 100 has outperformed the Nifty with the two indices delivering 7.5% and 5.1% respectively over the past two months; however, this breadth improvement is yet to percolate lower towards small caps with the Nifty Smallcap 100 trailing with 4% returns over this period.
We expect RBI to cut policy rates by at least 25 bps on 5th December. More importantly, they should specifically target the term premium and credit spreads. Something like an ‘’Operations Twist’’ (buying long dated, selling short dated bonds) to bring down term premiums and easier refinancing window to target credit spreads alongwith ample liquidity will lead to stronger transmission and kickstart credit growth. While monetary accommodation is a necessary condition, strong policy action and seamless execution by the government are critical for reviving economic growth. Policy makers’ intent gives us confidence; we hope that recent data points will pave the way for speedy, bold and creative action. This should lead to further broad-basing of equity market performance, and shrinking term and credit spreads.