‘Markets are likely to find relief in a stable government’

With two key events — the interim Budget and the Reserve Bank of India’s monetary policy review — over, investors are now eyeing the outcome of the upcoming general election. SANJAY MOOKIM, India equity strategist, Bank of America Merrill Lynch, tells Puneet Wadhwa that the mid- and small-caps are likely to de-rate, especially as investors take a step back in the run-up to the election. Edited excerpts: What are your interpretations of the interim Budget proposals and the outcome of the Reserve Bank of India’s (RBI’s) MPC meet?

The interim Budget has introduced the farmer income support scheme and reduced taxes for lower income individuals without increasing the fiscal deficit. The implementation of the Pradhan Mantri Kisan Sampada Yojana is critical. Economic theory suggests that long-term investments in infrastructure-related areas are essential for sustained growth.

Even as the interim Budget deemphasises these into the election, there is hope that government agencies can continue capex-related spending through extra budgetary borrowing. It is possible that electoral and political incentives continue to direct policy towards redistribution. Yet it is important that the government retains focus on ‘growing the pie’ while ‘distributing the pie’. The rate cut announced by the RBI last week supports our long-term view of consumption

over investments for economic recovery.

How are the markets likely to react to a coalition government at the Centre?

The central government does control critical policy areas. Yet, it could be argued that the impact of any political surprises in Delhi on the economy is gradually reducing. Equity markets are likely to nonetheless respond to electoral outcomes. The markets are likely to find relief in a stable government, which can be expected to last its full five-year term and have fewer constraints from coalition partners. Equity investors are likely to view a fractured coalition in Delhi with some dismay. That could lead to some downside to Indian equity prices.

Are the markets prepared for a higher fiscal deficit?

As long as interest rates do not respond adversely, we believe equity markets are likely to view fiscal expansions positively in the short term. Some revenue forecasts for FY20 (2019-20) may be termed aggressive. GST (goods and services tax) collections are expected to grow close to 18 per cent year-on-year, and the government is relying on ~90,000 crore in disinvestment revenue. These, at the moment, do not drive any significant concern on fiscal deficit. It may be possible for the government to stay close to the 3.4 per cent (fiscal deficit to GDP) forecast through some expenditure management. Any significant increase in oil prices could hurt the fiscal math in FY20.

How are foreign investors now viewing India as an investment destination?

We believe a majority of investors, rightly or wrongly, are currently focused on the upcoming election and the potential volatility in stock prices around the event. The stock market also offers a limited set of large-cap ideas, as stocks that are delivering on growth have become very expensive on multiples. The difference in P/E multiples between the top 10 percentile of MSCI India stocks and the bottom 10 percentile is at an all-time high and continues to rise, while the gap between the growth of the top 10 percentile and the bottom 10 is falling, and is close to lows. This increasing dispersion has likely been driven by falling global cost of capital, as central banks injected liquidity. As that tide has turned, there is a risk that elevated Indian stock valuations could come under pressure.

Your views on non-banking financial companies (NBFCs) and banks?

Banks in India seem to have largely recognised the bad assets on their balance sheets. Gross NPA additions should slow down as loan growth improves. Many banks are still close to their historical P/B (price-to-book) averages and there has not been any significant re-rating. This creates a strong investing case — especially on a relative basis — for Indian banks. Some NBFCs have seen concerns about the quality of their assets, but we believe the size of the potential problem should be relatively small when compared to total system assets. Liquidity in the system is likely to remain sufficient, especially with the RBI stepping up its Open Market Operations (OMOs).

What are your prefered sectors?

We are overweight on financials and stocks that are linked to rural demand (such as the two-wheeler sector). We have recently reduced our underweight on information technology companies, as the demand environment has started to improve.

Do you recommend investing in midand small-caps?

As a basket, mid-cap companies still trade at a premium to large-caps even as they have not delivered better growth. These stocks are likely to derate, especially as local investors take a step back into the election. This is happening already. The headline index has been supported through 2018 and January 2019 by a handful of large-cap stocks. The broader market has been significantly weaker. Close to 30 per cent of the BSE500 was down 10 per cent or more in January 2019, even as the Nifty was flat.

MANY BANKS ARE STILL CLOSE TO THEIR HISTORICAL PRICE-BOOK AVERAGES AND THERE HAS NOT BEEN ANY SIGNIFICANT RE-RATING. THIS CREATES A STRONG INVESTING CASE, ESPECIALLY ON A RELATIVE BASIS, FOR INDIAN BANKS