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2019 was a year of contrasts in many ways. While the economy slowed down sharply, equity markets did well as the Nifty and the Sensex delivered 12% and 14.4% respectively. Yet within equities broader markets didn’t do well with the Nifty Midcap 100 and the Nifty Smallcap 100 indices losing 4.3% and 9.5% respectively. Similar was the story in debt markets. Even with a 135bps cut in policy rates by the RBI, rate transmission was muted. Term premium stayed elevated until the RBI intervened with ‘Operation Twist’, something we have been advocating, whereby it bought long-dated securities and sold short-dated securities. Overall, while g-sec funds did well thanks to an 81bps decline in 10-year yields, credit spreads stay elevated beyond the top-rated ones.
We had discussed the disconnect between the state of the economy and equity markets at length last month. A key factor leading to this has been the global reflation trade with majority global central banks, including the US Fed, following expansionary monetary policies. Second, stocks are forward looking and are pricing in a likely economic recovery, aided by factors such as ample liquidity, local as well as global, agri inflation along with good monsoons, and lagged impact of lower interest rates. Third, and the most important in our view, the current economic crisis has set tone for meaningful reform, like corporate tax cut and labour reforms, and raises expectations for a lot more.
A theme to watch out for this year could be the return of commodity inflation. In addition to accommodative central banks, fiscal policy is increasingly being used to revive growth globally. As China stimulates its economy, along with good supply side discipline, there could be upside risks to commodities. The CRB commodity index while up nearly 10% in 2019, at 186 levels is still significantly below the 2008 peak of 470. Similarly, the FAO Food Price index is up about 10% for the year and yet at 177 stays below the peak near 240 in 2011. Metal inventories are tight while Gold has been inching up. Brent crude is up 22% for the year but at US$66 stays less than half of its US$145 peak in 2008. Geopolitics, with the recent US-Iran conflict, has come to the fore again and poses further risks to crude oil prices.
Contrary to popular belief, inflation revival could help India as corporate performance has shown strong link to global inflation historically- better nominal growth helps through operating leverage as well as reduced debt burden and quicker deleveraging. The latter should have a positive impact on propensity of corporates to invest. A rise in food inflation is positive for rural economy. Rising inflation expectations help spur consumer spending. However, rising inflation makes RBI’s job difficult, but given the slack in the economy and contained core inflation monetary tightening may not be an immediate risk.
2020 could therefore very well be the year of a cyclical recovery for the economy. And as that happens several of the apparent divergences will begin to fade. Corporate profit growth should pick up the pace with market upmove. We have discussed in the past that amongst factors behind the current dip in corporate profitability are negative operating leverage, high interest burden and high tax burden, most of which will likely reverse and provide a cyclical uptick to profits going forward. Breadth should improve with mid and small caps playing catch-up to large caps. Credit spreads should normalize as confidence on economic growth revives.
While a cyclical recovery will help reversion in profitability metrics such as corporate profits to GDP ratio, Return on Equity, Profit to Sales etc, all of which have been declining for over a decade and are at multi-year lows currently, it is unlikely to take corporate profitability back even remotely close to the highs seen during 2007-08. Several structural factors such as a large yet inadequately skilled population, technological disruptions, lack of innovation and environmental concerns to name a few threaten to stall our march upwards. The time is ripe to look beyond 2020, and focus energies on ingraining sustainability into our development model.
While demographics have often been touted as our strength, looked another way, we have a large population that suffers from poor literacy, weak human development, and rising inequality. At the same time technology disruptions are making low end jobs obsolete. This may create an unemployment problem that feeds into aggregate demand challenges as well as social unrest with economic consequences, if not addressed properly. Yet if rightly used technology has the potential to upgrade lives of masses as we have witnessed through the telecom revolution, financial inclusion, and direct benefit transfer, to name a few.
To give credit where due, we have made progress on empowering the masses. The integration of rural masses with the mainstream through road, electricity, financially, digitally and through improved social security should go a long way in rural India catching up with urban India. Government schemes focussed on sanitation, cooking gas, electricity, drinking water, affordable housing etc should improve living standards of the masses. The resultant rise in aspirations needs to be positively channelized. Focus on education and reskilling, and creating jobs are the need of the hour. The large disguised unemployment in agriculture needs to be addressed. The government’s focus on making India a manufacturing hub through measures such as tax reforms is step in the right direction.
Environmental risks are bound to gain prominence. India ranks amongst the top three nations on deaths from air-pollution. Major cities like Mumbai and Chennai are at risk from rising sea levels. As per a NITI Aayog study, 40 cities are likely to face drinking water shortages over the next decade. There are serious concerns about soil degradation. India is still a US$ 2000 per-capita country and is yet to catch up meaningfully in the income ladder. In the process, the resource intensity of consumption is bound to rise. Ignoring the sustainability aspect can be damaging.
Recent policy developments, such as Delhi’s experiment with odd-even cars, move towards BS-VI compliance and now Electric vehicles, plastic ban in Maharashtra, plant closures in Karnataka around Bellandur lake, a copper plant closure in Tamil Nadu, cancellation of coal block allocations, ban on liquor sales on highways were in response to environment and social concerns. Such policy initiatives create both risks and opportunities for corporates. These businesses may have had a free ride on these matters in the past, but today they ignore them at their own peril.
On governance, multiple instances of auditor resignations, excessive leverage, questionable ‘related party transactions’ and accounting issues have come to the fore thanks to the ongoing slowdown. Such issues may remain unattended for years but once brought to the surface, they erode the economic value of businesses in one go. This trend is only accelerating and leading to massive profit and market cap shifts in favour of the cleaner corporates. To be fair, India ranks high on World Bank’s ‘Protecting Minority Investors’ category yet there is room for improvement on compliance and enforcement, and market forces continue playing their part in this.
We have also been making strides in the ease of doing business rankings which is heartening overall even as areas such as enforcing contracts still need attention. Artificial barriers created by lower ease of doing business all these years should fall with a continuous improvement on this metric. This should lead to more competition and lower return on equity. On the other hand, with access to resources having become more transparent now, there is case for increase in costs as well. The way to higher profits therefore is only through improved efficiency and innovation.
Innovation hasn’t been India’s strength either with total R&D expenditure at just 0.6-0.7% of the GDP. The cumulative R&D expense of top 500 Indian companies is less than the individual spends of some global giants. In addition, the lack of coordination between business, academia and government agencies on research is concerning. The recent government move to allow corporates to use their mandatory corporate social responsibility (CSR) spends on research is a good beginning.
As markets look at 2020 with optimism about a cyclical economic recovery, long-term sustainable growth of the economy will come only when businesses focus on sustainability. Companies focussing on triple bottom line (People, Planet and Profits) deliver sustained returns over long periods. As investors, focusing on sustainable businesses should not only help portfolio returns, it also sends out a signal to corporates to integrate sustainability in their business practices, which in turn creates long term win-win for all.
CIO – SBI Funds Management Private Limited
(Mutual funds investments are subject to market risks, read all scheme related documents carefully.)