Nothing much to rally except liquidity

It has been another episode of liquidity-driven rally since the beginning of the year. The triggers are hard to find, as fundamentals remain fragile with the intensification of the funnel effect. From Q3 numbers, it is evident, while top line growth has remained resilient, margin pressure has intensified, falling for 10 quarters in a row since the peak of the second half of FY10. And adjusted PAT (profit after taxes) growth contracted across most indices. Clearly, Indian equities have participated in the liquidity-driven rally notwithstanding these evidences.

Market behaviour seems to imply the earnings downgrade cycle has ended and is at the cusp on a new upgrade cycle. It has also been expecting sharper cuts in interest rates ahead. The conviction around these assumptions is fragile as reflected in the negative reactions to the no-change decision by the Reserve Bank of India (RBI) last week and the muted response to the Budget.

Leading indicators, such as deceleration in growth in narrow money supply, exports, nominal gross domestic product (GDP) and profits indicate slowdown in top line growth. While average inflation is likely to moderate, cost components can remain elevated due to high global crude prices and rise in pass-through (higher prices of fuel, electricity and rail freight) and increase in indirect taxes.

As the Budget announcement shows, intensification of fiscal pressure has resulted in withdrawal of remaining stimulants by way of hikes in excise duty and service tax rate. So, it will be challenging for demand to be supportive of pricing power. While withdrawal of stimulants is necessary for fiscal consolidation, it will have a negative multiplier impact on aggregate demand, for now. The key fallout would include weakening of the consumption boom, due to the squeeze on disposable incomes.

While interest rates have peaked, liquidity deficit is structural and will provide little headroom for rate cuts. Structural imbalances of declining savings rate and widening current account deficit are reflected on the persistent liquidity deficit, which has failed to ebb despite recovery in portfolio inflows, massive open market operation (OMO) purchases and cash reserve ratio (CRR) cut by RBI. Unless the structural liquidity deficit is narrowed, RBI will find little headroom to cut rates. Also, spillover of the pass-through will continue to keep RBI worried on the inflation front. Hence, the best one can expect from RBI now is some more CRR cuts and OMO purchases.

Convergence of imbalances to an equilibrium needs fiscal consolidation and enhancement in financial savings from households before the economy moves into a virtuous confluence of rising savings, investments and growth. Budget 2012-13 gives the impression of being pro-investment with 30 per cent expansion in capital allocation. But expenditure still expanding at 13.1 per cent and realisation of the 5.1 per cent fiscal deficit based on optimistic assumptions on tax and non-tax revenue growth and big realisations through 2G auction and disinvestments, this gives little comfort on the feasibility of fiscal consolidation. Also, reduction in the subsidy bill is contingent upon government’s ability to raise fuel prices soon. Hence, the sanctity of even the limited fiscal consolidation and pro-investment leaning seen in the Budget will depend a lot on the follow-up action, which is not a given yet. Thus, looking beyond the transitory swings, we believe challenges arising from domestic imbalances will continue to keep markets volatile. From the global standpoint, a sustained and steep fall in global crude prices due to risk aversion or sharper global slowdown can ease the constraints arising from falling savings and investments. Possibility of a sustained growth cycle in the US, thereby, pulling Europe out of recession, could be a positive surprise.

The author is co-head, institutional research, economist and strategist, Emkay Global Financial Services