Only time will tell who is right, bullish markets or bearish commentators

The Indian equity markets seem to be on a roll. Powered by a stronger-than-expected economic recovery, massive corporate cost-cutting, record low interest rates and surging foreign flows, markets are now up double digits for the year, after being down almost 40 per cent at one point.

This is not a uniquely Indian phenomenon as risk assets globally have been on fire, ever since the positive trial data on the vaccines was published. November was the best month on record for European equities, and one of the handful of times that US equities delivered double-digit returns in a single month. We seem to be in the early stages of a rotation away from growth/tech and towards non-US markets, and value sectors such as the banks, cyclicals and commodities. The dollar is hitting multi-year lows. Emerging Markets (EMs) equities is an obvious beneficiary. While we have seen elevated flows into EM, given the extent of excess global liquidity, this is potentially just the tip of the iceberg as far as equity flows are concerned. India will get its share of the passive flows into EM. The reality is that today in the MSCI EM index, only five countries — China, Korea, Taiwan, India and Brazil — account for more than 75 per cent of the index.

We are also witnessing very concerning and negative articles on India from highly respected and knowledgeable observers of the Indian economy. These commentators are not being negative for the sake of it; they are genuinely worried about the Indian economy and its outlook. Their basic concern is around the long-term structural growth rate for India. Has it come down to sub-5 per cent? They feel we have a structural fiscal problem, bust financial system and no private sector capex. They worry about the government raising import duties. All point to the difficult times we have had over the past few years. As a report in this newspaper pointed out, over the last decade, India has delivered a GDP/capita (in dollars) at a compound annual growth rate of only 3.2 per cent, compared to China’s 9.2 per cent. Chinese GDP/capita was 3.3 times that of India a decade ago, today the gap is 5.5x.

Despite the flows, many global investors share these concerns and remain underweight the country. We get numerous allocators asking us to comment on these negative articles, and to present an alternative view.

It is obvious that India will see a rebound in FY22, owing to the base effect and normalisation. The question is what happens after that. Let’s address some of the negatives: The financial system today is in a far better shape than it has been for most of the past decade. As of today, all major banks have raised equity and are extremely well capitalised; the large corporate non-performing assets (NPAs) problem is recognised and provisions have been made, the NBFC crisis has mostly played out. The expected surge in retail/small and medium enterprise NPAs (after the Covid shock) has not happened if you believe the banks. This could be due to the moratoriums, credit guarantee scheme etc., but all banks are positively surprised with their current credit quality. There could be a second wave of insolvency in the coming months when the forbearance ends, but banks do not seem to expect that. Public sector banks remain weak, but on the margin they are improving.

Liquidity conditions have never been easier, and mortgage rates are near all-time lows. Both the sectors sensitive to falling rates, housing and autos are reacting to the fall with a noticeable pickup in demand. Given how subdued demand has been over the last few years, pent up demand will supercharge and extend the tenure of any recovery.

 On the corporate capex, we are seeing some signs of life for the first time in years. ICICI bank in its recent analyst meet talked of a revival in corporate capex. Other large banks are making similar noises. We have begun to see the first signs of large companies announcing new capacity, take UltraTech, which has announced a 20-million tonne brownfield expansion. Across cement, steel, chemicals, renewables, and pharmaceuticals, capacity expansion plans are being accelerated. FDI flows are at a record high. Large and well-run companies seem to be more bullish on new capacity creation today than they were pre-Covid. It is still early, but there are clear stirrings of life.

On the efforts to boost manufacturing, the production-linked incentive scheme, at least for mobile phones, seems well thought out and has attracted global attention. One will have to see the design for other sectors, but this can be transformational. I have also never seen any government in India focus and speak at such length on ease of doing business. Multiple steps have been taken and more are likely. Feedback from industry is that while not all steps to ease doing business are impactful, there has been a noticeable improvement.

Illustration: Binay Sinha
The other big change is at the company level. The extent of cost-cutting we have seen in corporate India, through the pandemic, has been breathtaking. Most companies are convinced that they have structurally cut costs and improved productivity. They are targeting hitting pre-Covid absolute profitability at 90 per cent of the revenues. As revenues revive in FY22 with a normalising economy, profits should explode.

The other aspect is capital allocation. Take the Tata group, for instance. Under chairman N Chandrasekaran, the group is far more focused on return on capital and profitability. Something similar is happening at the Mahindra group and many other large business houses. A greater focus on return on invested capital, cash flow and capital allocation is visible. The markets are aiding this behaviour change by amply rewarding this new focus. If this focus on capital allocation sustains, it will lead to higher return on equity and multiple expansion for the broader markets. The trend is still in its infancy, but the anecdotal evidence is clear in observed behaviour and discussions with companies.

The markets are sending a clear message. Growth will come back strongly in FY22, and sustain at higher levels than the bears assume. The broadening of the market rally sends the signal that growth will be broad-based. Coupled with this, profitability and returns on capital will improve dramatically. Given that the markets are climbing a wall of worry, many people do not believe the more bullish thesis. One must at least acknowledge the bullish view that markets are signalling, it could be a possible outcome.

It is common in India to dismiss the markets as casinos and having no signalling ability. Globally, equity markets are regarded as being part of the leading economic indicators. Policy-makers take their movements seriously. Today, there is a clear divergence. Only time will tell who is right, the bullish markets or the bearish commentators. It will be an interesting 12 months.

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