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Structural boost for 30% of the market

Navneet Munot, CIO, SBI MF

10th December 2016

In a nutshell

In his monthly market outlook note, Navneet delves in some detail into the impact of demonetization, which he says needs to be understood from three perspectives: liquidity, wealth and income effect. While the near and medium term impact of demonetization is perhaps mixed, the long term benefits from digitization of finance and financialization of savings augur well for the financial sector, which makes up some 30% of market indices.

Indian markets witnessed a fall partly due to emerging markets sell-off after Donald Trump's victory and announcement of demonetization of high value notes by the Indian Government.

Trump's election in US has strengthened market expectations of rate hikes in US, and the shift of growth mantle from monetary policy to fiscal policy. We had been increasingly getting skeptical of incremental efficacy of global monetary easing. The money-pumping exercise had been leading to asset prices reflation but without a commensurate impact on real economy. Stagnant real incomes and rising income and wealth inequality in developed market led to increased discontentment among the population at large. There are fears that the best of globalization cycle and liberal policies is behind us.

Over the last two months, dollar has strengthened and bond yields across the globe including in emerging markets have risen sharply. India has been an exception to see bond yields falling massively. This has narrowed down India's interest differential vis-a-vis similar US treasury papers by at least 100 bps in last three months. Thus, Indian rupee, which has been a story of high carry and low volatility, will see some loss of attractiveness on the former. That said, RBI has the war-chest of $360 billion to contain volatility. In fact, while rupee depicted marginal depreciation against dollar, it strengthened against its trading partners in last three years. Given the depreciation in other emerging market currencies, rising crude prices and strengthening dollar, rupee has the potential to weaken further.

To gauge the impact of demonetization on growth, one needs to distinguish between liquidity, wealth, and income effect. Loss of demand due to liquidity effect or as one would put it 'unavailability of adequate quantum of rupee notes' would be transient and can be recouped to a large extent. Withdrawal of Specified Banking Notes from the system has also led to erosion of wealth for higher income sections of the society and to that extent may permanently impact the sectors which profoundly depend on demand from high income group. That said, in aggregate, the wealth effect might cancel itself in aggregate since one section of society would gain at the expense of the other. At last, consumption lost because of underlying incomes taking a hit may not necessarily be recouped. That said, the demonetization coupled with GST and other measures to improve India's governance are structurally positive for Indian growth story.

While the stated objectives of withdrawing Specified banking Notes (SBNs) was to curb the 'fake currency' generation which fund host of illegal activities (like terrorism) and black money in India, the exercise has had untended consequences to the Indian political, social and economic machinery. Apart from disrupting the business activity, it led to constrained consumption and potential balance sheet issues for household and businesses. We are into an uncharted territory and the clarity of future policy decisions has been marred, which makes the businesses postpone their investment decisions. Some of the sectors such as high end discretionary goods and services and real estate could be hit due to wealth effect. While government finances may benefit from better tax compliance, there could be adverse effect on indirect tax collections due to growth slowdown apart from the cost of this exercise to RBI and the government.

The RBI has clearly opined that the cancellation of legal tender status of SBN (specified bank notes) does not automatically cancel RBI's liability. This may nullify the hope of any near-term one time dividend transfer acting as a one-time fiscal bounty for the Government. Though (for longer-term), we refrain from concluding on that with certainty, as yet.

The demonetization exercise has significantly catalyzed the vision of the policy makers to achieve financial inclusion, lower cash utilization for transactional purposes (a move towards 'cashless economy') and to move the households towards financial products for savings (financialisation of savings). These achievements enhance the operational and cost productivity of the economy which may not be captured in linear projections of demand and supply.

Better tax-compliance and increased government revenue on sustainable basis can boost the infrastructure investment by the government. Move towards a cashless economy will ensure lower cost and traceability of transactions and detecting the discrepancies between a person's actual income and his/her transactions. All said and done, longer-term gains depend on follow-up reforms. The present move of demonetization has laid its axe on the stock of black-wealth. The measure alone does not deal with the generation process of black money. This is a long drawn battle and the present government seems to be determined notwithstanding the near term pain.

In the equity markets, Sensex is down 3% since 8th November. Performance down the capitalization curve worsened with the BSE Midcap index and the BSE Smallcap index underperforming the large cap Sensex by 2.8% and 4.5%, respectively. FIIs sold US$ 2 billion which was well-matched with significantly higher buying by domestic institutions. Valuations have corrected and are currently hovering at its long-term average of 16 times forward earnings. The demonetization impact might sustain for more than a quarter or two but given that there are too many moving parts, its bit too early to call. While the disruption in economic activity particularly on discretionary consumption may drive sentiments, one must not lose sight of the fact that a good part of index earnings (Technology, healthcare, energy, staples, telecom, global commodities etc) may remain largely insulated. Barring the risk of a deeper slowdown leading to systemic balance sheet issues, 'Digitalisation of finance' and 'financialisation of savings' actually augur very well for financials (almost 30% of index).

While the demand weakness in India and improved agricultural supply lifts off some pressure from inflation, rupee depreciation and rising commodity prices leads to imported inflation in India. Also, as the governor pointed out, India's inflation ex-food and fuel has been persistently sticky. Expectations of likely rural support by the government (in the form of higher MSPs or other income support measures), implementation of 7th Pay commission by the states and decision on HRA aspects of the pay commission may add to the inflation pressure in the ensuing year.

We sympathize with the predicament of the central bank which is bound by its inflation and currency stability objectives but cannot turn blind-eye to growth disruptions. Impossible trinity at its true test!

In the bond market, given that market pricing prior to the policy seemed aggressive and could be justified only with a 50bps cut, we had reduced average duration across funds before the monetary policy. Exuberance driven by easier near term liquidity and hopes of policy easing have led to domestic yields getting disconnected from global trends. Yields have moved up by about 25-35 bps across the curve from the recent lows. Markets could remain volatile leading into the US Fed meeting. We remain constructive, but with a slightly longer term approach as the monetary cycle remains accommodative and fiscal health is likely to improve structurally.

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