Indian markets logged its highest single-day gain in almost a decade during the month when the Finance Minister announced a major reform-oriented tax rate cut for corporates. There was also some good news in the form of government approving stake sale in some large public sector enterprises and a few other disinvestment candidates. However, the broader markets did give away some of the initial gains from the tax rate cut announcement, as some negative news flow revolving around weak NBFC/Banks again came to the fore. In terms of India’s domestic economic activity indicators, barring consumer credit growth and electricity consumption, most other indicators like auto sales, consumer durable production continues to weaken sharply. On account of the consistent progress in rains, the all-India cumulative rainfall now stands in a surplus of 9% of long period average and water levels in reservoirs have improved significantly, which should bode well for the Agri/Rural economy. Consumer Durables, Oil & Gas, Cap goods were the sectors in the green, whilst Real Estate, Bankex, Infotech and Healthcare fell sharply during the month. In terms of flows, both FIIs (~$0.9bn) and DIIs (~$1.7bn) were net buyers during the month. Capital market activity remained muted.

While current growth trends in India are well-below expectation, medium-term, our positive outlook on the economy is premised on improving macro factors - controlled inflation, stable commodity prices, currency and continuing moderation of interest rates. Recent slew of measures by the Govt., including the corporate tax cut should likely have a favourable impact on consumption and investment demand even though timing of the same remains uncertain. Moreover, recent improvement in monsoons and higher potential spends out of unexhausted rural investment budgets augur well for a potential rural demand recovery. Over the last few quarters, we have been constructive on the Indian equity market from an opportunity standpoint; particularly in the mid and small cap segment given meaningful valuation corrections in several good quality businesses. Recent growth challenges seen across few sectors of the market are, however, unlikely to abate in a hurry and may keep earnings growth muted for a few more quarters. Recent actions of the government, do demonstrate a willingness to pursue short term measures and long-term reforms to put India back on a secular growth path and hence market will likely await further news flow around the same.

While corporate tax cuts do enhance equity valuations and support asset prices, it remains to be seen how quickly and meaningfully they spur investment or employment. There are other factors that turn tax cuts into viable stimuli, such as a well-defined investment agenda, deep structural reforms, flexibility of labor markets, elimination of trade barriers etc. In this context, the PM’s announcement in Aug 2019 of his plan to invest INR 100 trillion in infrastructure over the next 5 years to achieve an economic size of US$5 trillion is critical and we keenly await the contours of the same.

From a portfolio management standpoint, we continue to restrict ourselves to a bottom-up approach to stock selection and portfolio construction until stronger evidence of more broad-based growth emerges. Given the extent of the slowdown across various sectors of the domestic economy, we would also like to keep our outlook on growth recovery muted for the next 2-3 quarters even though the recent tax cut should be earning supportive for this fiscal year. We prefer to evaluate investment propositions based on flat to weak growth assumptions for the ensuing future and resultant price to intrinsic value equation. We remain wary of balance-sheet related risks to businesses.

RBI continued its rate reduction path and dropped the repo rate by another 25bps in early Oct’19 to 5.15%. With this last 25bps cut, the cumulative repo rate reduction from Feb’19 is 135bps. The stance of the monetary policy has been maintained as accommodative keeping the room open for further rate reductions in order to improve the economic growth rate. The Q1FY20 real GDP growth was at 5% and hence recently RBI reduced the full year growth estimates to 6.1% from 6.9%.

The bond prices have not reacted positively in the last 2 months, although RBI has reduced the repo rate by 60bps during this period due to apprehensions on the intentions of the government to stick to the fiscal target as outlined in the budget. The recent corporate income tax rate reduction potentially creates a deficit of Rs. 1.45 lakh crore for government’s earnings, which may translate to additional market borrowings from the government. Although in the borrowing calendar, government has stuck to the original fiscal target, the market is finding it challenging to come to terms of the governments’ intent. Although government has multiple avenues to bridge the gap, if any, the debt market feels the government may access the bond market for additional borrowings if the need arises.

The headline CPI remains benign at 3.18% and RBI’s estimates for the full year inflation is 3.5%-3.7% unchanged from before, although there are some upward price pressures on vegetables. RBI opines that the upward price pressure from food will be offset by the downward movement in oil prices.

With the recent reduction in the repo rate, the spread between the 10 year benchmark and the repo rate is 150bps whilst the long period average is under 80bps, also supported by

• Benign inflation environment. The drop in core inflation data closer to 4% is being reasoned out as a drop in demand and which is now visible across several sectors.
• Softening international oil prices as growth slows in several other economies.
• Improved sentiment amongst foreign investors leading to positive foreign inflows into debt
• The drop in global yields, particularly in US and Europe improves the relative attractiveness of the EM bonds
• Possible inclusion of Indian bonds in international bond indices (recently presented by Bloomberg in NY in the presence of PM Modi)

The weakening inflation pressures globally have increased reasons to believe successive rounds of rate reductions and QE across the globe. The Fed’s mid cycle 25bps rate reduction and the rally in bonds in Europe which is pushing the yields to historic low levels seem to be pricing in some probability of recessionary conditions around the globe. This rally in bonds is expected to have a spill over positive effect on Indian bonds as well. Additionally Indian policy makers also seem to be front loading the easy monetary policy action to support a revival of growth. 

Based on RBI’s persuasion we observe few banks have started to link their lending rates to an external benchmark, which RBI feels will work towards transmission of rates into the borrowers. So far, the transmission of lower rates into the system has been lacking.

We also feel that the lack of abundant liquidity in the hands of the banks is also delaying transmission of lower rates into the economy. 

So far, the transmission of lower rates has been restricted to only few select top tier credits in an environment of risk aversion. The eventual drop in interest rates should help in balancing the overall leverage across sectors over a period of time and ideally may help in attracting equity capital as earnings from savings and debt investments move lower. However, it remains to be seen whether this theoretical cycle follows through in India in this environment.

Outlook
We reason that the slowing domestic growth is a function of both slowing global growth and slowing domestic consumption. Headline CPI (presently at 3.18%) for CY20 is expected to be comfortably well within 4% due to benign oil prices, drop in core inflation and soft food prices (although there is some observed rise in vegetable prices in the recent period). The drop in core inflation in India to ~ 4% levels in the recent months after staying at over 5.5% for the last few years highlight the slowing domestic consumption. 

Thus with slowing growth and high real interest rates, RBI is likely to continue the rate reduction and attempt to push lower rates into the economy. However, drop in repo rate do not always guarantee lower borrowing cost, and hence we feel RBI may infuse liquidity so as to help lower the deposit rates of the banks and enabling them to price their loans cheaper. 

In this environment, we urge investors to start selecting funds in alignment with their investment horizon and longer depending on their individual risk appetite. Some additional fund duration over an investors investment horizon should work favorably, as the risk return matrix is tilted towards lower rates. We expect the actions of RBI to create additional demand for gilts and bonds in this environment.
Any upward revision in borrowing calendar of Government for FY20 may pose a risk to this view. However, it may get neutralized through creation of higher demand for gilts and bonds by infusing liquidity into the system by RBI, OMO, long-term repo and/or from higher demand for Indian bonds from foreign investors amidst low rates globally and the recent transfer of higher reserves from RBI to government.