February 2018

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Feb
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2018-19 budget faced unique pressures and constraints. India has participated in the global equity market rally but not fully in the global growth momentum - laying the narratives for counter-cyclical growth supportive measures in the budget. A pre-election year budget laid the possibility of higher expenditures and palliatives to certain stressed sectors of the economy. But, the rating upgrade by Moody’s had put the credibility pressure on the stated fiscal consolidation path. Further, with the advent of GST, government may not be able to change vast majority of indirect taxes, leave aside the prevailing uncertainty on the final revenue buoyancy. And finally, oil at US$ 70 per barrel and rising bond yields have begun to induce macroeconomic pressures and constrain the fiscal space.

Amidst all the push and pulls, the government had eventually sided with glidepath on fiscal consolidation. Fiscal slippage in 2017-18 was limited to 30bps and revised deficit estimate is pegged at 3.5% of GDP. The shortfall in indirect tax collection, profits transfer from RBI and telecom related receipts were only partly offset by higher direct taxes and disinvestment receipts, and explain the fiscal slippage.

FY19 pencils the deficit at 3.3% of GDP. Overall fiscal arithmetic looks credible and has frayed away from any populist spending. The consolidation is achieved largely through expenditure restraint.

Interestingly, tax-to-GDP is at the highest level while government expenditure to GDP is at a historic low. Total expenditure (ex of GST cess transfer to states) is budgeted to grow at just 9.1%. However, oil subsidy is unchanged for next year and could be at risk of slippage if crude oil stays high. While the capex spending share through budgetary resources is gradually declining, it is made good by increased capex through PSEs’ resources. A large part of the expenditure side (salaries, pensions, defense, interest payment) is sticky. Hence, it is imperative that tax-to-GDP ratio increase substantially to enable higher spending on social and physical infrastructure. To that end, GST, digitalization, data mining, crackdown on black money followed by likely reforms on the direct tax side should lead to higher tax revenues going forward.

Barring the uncertainty on GST (in the light of pending refunds and devolution to states), the assumed tax buoyancy on budgeted taxes appears realistic. Dividend from RBI and PSUs same as last year and telecom revenue at Rs. 487 billion – all appear to be credible. FY18 has seen the highest disinvestment proceeds in the history. Also, it is the first time in last 15 years that the disinvestment targets have been over-achieved. In FY19, the divestment proceeds have been pegged at Rs. 800 billion, which looks achievable. We hope to see beginning of strategic sales, as charted by NITI Aayog, materializing next year.

The budget continued its focus on rural economy and the farm sector- with measures focusing particularly on enhancing productivity. Government intends to ensure that the difference between MSP and market price is compensated to the farmers. The intent to liberalize the export of agriculture and commence an operation green (targeting higher production of key vegetables) bode well for the farm income. Phase III of the Pradhan Mantri Gram Sadak Yojna (PMGSY) will focus on improving the hinterland connectivity. The monetary allocation and targets for the rural housing schemes, though, stands broadly unchanged.

One of the big moves in budget was the expansion of social security ambit. This is pertinent to realize our true demographic potential and achieve an inclusive growth. While the monetary outlay on the new grand health insurance scheme in this budget is low, it can be ramped up as the proper eco-system is put in place. MGNREGA, Financial Inclusion, Atal pension scheme, Ujjwala Yojna and now the health insurance – India is constructing a variable of Universal Basic Income for at least its bottom of the pyramid. That said, effective execution will be the key.

The corporate tax rates for small businesses were cut to 25%. Tax relief to senior citizens, salaried employees and small enterprises can likely help in increasing the disposable income. Support to MSME sector can have positive impact on job creation. US has embarked on a sharp tax rate reduction which may be followed by most other economies. India may eventually have to follow suit and lower tax rate for big corporates as well. The thought of having a unique ID for businesses (on the lines of Aadhar which is for individuals) can go a long way in improving the ‘ease of doing business’.

Despite the headline commitment to fiscal consolidation and lower than expected gross market borrowings, bond market sold off. 10 year G-sec yield rose by 18 bps to 7.60%, suggesting the likely concern on MSP-hikes pushing inflation expectations higher and possible change in RBI’s stance. Rising global bond yields and crude oil prices are also weighing on the sentiments.

While the budget opens the door for large MSP revision, the eventual inflationary and fiscal impact will depend on the methodology for measuring the cost of production. A cursory study of the current price setting mechanism suggests that most agri-products are already witnessing an MSP of nearly 1.5x of their production cost.

The imposition of LTCG tax on equities and increased income tax exemption for senior citizens may attract more funds in the fixed income space. However, one also needs to take cognizance of the increased borrowings through public sector enterprises. Further the expected credit recovery can reduce the banks’ appetite for government bonds. Banks’ holding of G-Sec is already well above the SLR level and foreign investor limit on government securities is nearly used up. However, with increased penetration of insurance and pension sector, one needs to keenly watch their demand for bonds. We believe, investor should build exposure gradually as bond yields are entering in an attractive zone.

Coming to the equity market, the budget finally quelled the long-standing market speculation on long term capital gains tax (LTCG). Budget measures leading to higher disposable income along with farm and rural thrust, consumption growth momentum should continue. The continued focus on the infrastructure (9% increases in monetary allocation) is positive for the related sectors.

Rising bond yields may have an impact on domestic equity flows while global liquidity tightening could challenge the FII investment. To that extent, earnings trajectory will be closely watched in 2018. So far, the latest Q3 FY18 results are comforting. The revival in earnings is critical for such rich valuations to sustain. Last few years have favored growth over value stocks. However, recently we have seen interest emerging in contrarian themes such as corporate lenders, IT, telecom and construction. After the stellar performance in 2018, particularly in the mid and small caps segment, it is very important to keep an eye on valuations. With little scope of valuation re-rating, bulk of the returns are likely to be guided by earnings growth. We continue to focus on bottom up stock picking which we believe is the best way to generate alpha.

The event is behind us, so back to global cues and earning trajectory!

Navneet Munot
CIO – SBI Funds Management Private Limited

February 1, 2017

(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)

 

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