The macro to micro transition
This is going to be a difficult year with more volatility and lower returns. Investors should brace for this
Over the last four years India has been a great macro story. In a tough environment for most emerging market (EM) economies, with falling oil and commodity prices, we have stood out. Consider the macro variables at the time the Modi government came into power, every indicator has since moved in the right direction. Inflation has dropped to sub five per cent on a sustained basis. Interest rates have dropped across all types of instruments be it government bonds or corporate debt. Liquidity has improved and the corporate bond market has come to life. The current account is not even discussed, as falling oil prices and the drop in gold imports has taken the deficit into very comfortable territory. We have reached the happy stage that the current account is being financed entirely through Foreign Direct Investment
(FDI). The Reserve Bank of India (RBI) has been fighting to prevent rupee appreciation over most of the past few years and foreign exchange (FX) reserves have been steadily rising. The fiscal has also been largely in control, with a slow but clear downwards trend. We may not have achieved the three per cent fiscal deficit target, but the government has been seen as fiscally responsible. It has by and large resisted calls from many economists to spend more. Obviously falling oil prices have helped tremendously, but we have also improved our institutional credibility, through adoption of a formal inflation targeting framework and moving decision-making to a monetary policy committee.
Over this same period, the micro in India has been difficult. The economy the Modi government inherited was weaker and in more trouble than commonly realised. It took longer to stabilise than most had thought. The elongated non-performing asset (NPA) cycle shows the weakness in the economy and corporate India. Even today, the private sector capex cycle remains in cold storage and we are still going through the process of balance sheet repair.
Then through a combination of the demonetisation and introduction of Goods and Services Tax (GST), we have seen significant shocks to the system. Both of these measures have hurt small and micro enterprises very hard. The economy has struggled for most of the past few years. These struggles have led to continued poor corporate profitability. Listed corporate sector profit share to GDP has fallen to under four per cent, compared to a long-term average of six per cent and peak of eight per cent. Earnings have been a source of continued disappointment over the past few years. Every quarter in the last four years has seen earnings cut, and negative revisions to the outlook. The earnings cagr has been sub five per cent in the first four years of the National Democratic Alliance (NDA).
This has been the setup for investors over the past four years. A good macro story, but disappointing corporate earnings. This is why we have seen continued P/E multiple expansion over the past few years. Falling rates and inflation, improved institutional credibility and a manageable fiscal have attracted capital, but the earnings have not come, thus multiples have inflated.
This story is now reversing. I feel the earnings cycle has reversed. There are clear signs of a pick up on the ground. The economy is recovering from the GST and demonetisation disruptions. Companies are raising production, and for the first time we see companies telling us of shortages in capacity. The GST has by and large been positive for listed company margins, and they are gaining share across the economy. Pricing is improving and discounts falling.
The December quarter just passed, was the first in years, where numbers were not cut. I am convinced that the coming March quarter will see a positive earnings surprise. India is now entering a cycle of upwards earnings revisions. Doing simple maths, if we see profit share normalise to six per cent from the current sub four, combined with nominal GDP growth of 11 to 12 per cent, India can deliver multiple years of 15 to 20 per cent earnings growth. This growth has been illusory to date, but I think the time has now come. Such strong growth will obviously attract investors and will stand out.
However, we now have a clear weakening of the macro story. On every parameter, things have deteriorated. Just as falling oil prices were a huge tailwind, their recent surge has become a significant headwind to the macro. Be it interest rates and liquidity, inflation, the fiscal or current account, every parameter is moving in the wrong direction. Not enough to cause a taper tantrum like crisis which hit us in 2013. But enough of a deterioration to take the sheen off the story and worry investors on the margin.
We thus have a passing of the baton so to speak, from the macro to micro. Earnings will once again become the driving force and not macro variables and P/E multiples. Investors will focus on specific stocks and their earnings. Strong earnings will be confronted with multiple compression. Markets will tread water as we go through this struggle of opposing forces.
India is going back to being a stock pickers market. The environment of a rising tide lifting all boats is not applicable to this year. This is what India used to be, investors would fret about the macro and politics, but find top quality companies on the ground and make their allocations based on this. We will once again see large differences in fund and individual stock performance.
This transition towards the micro will however, not be seamless. We are likely to see air pockets and turbulence. This is going to be a difficult year with more volatility and lower returns. Investors should brace for this. Do not expect another year like 2017, where markets literally went up every month like clockwork, with no real drawdown. Many of the retail investors flooding into the markets are new, hopefully they realise that 2017 is an aberration. Markets do not go up seamlessly, and deliver one per cent per month. It is critical that when confronted with the inevitable volatility and bouts of fear and market to market (MTM) losses, these new investors stay the course and keep their conviction. We cannot afford to have another lost generation of retail investors, those who come in to markets, get burned and then stay away from equities for the rest of their life.