Understanding Economic Cycles To Beat The Markets !
Equity investors have been extremely confident about the long-term growth prospects that India has to offer. The confidence for the long term investors comes from political stability in India, its demographic dividend and corporate performance. Moreover, business models working fine for a majority of the businesses, big corporates flaunting healthy balance sheets, consumption story driving the growth, abundant liquidity in the system, controlled fiscal deficit and many more aspects unique to the Indian economy magnified the healthy perpetual growth in Indian economy.
Suddenly, the unchallenged aspect of the Indian equity market story – the strong and durable economic growth (GDP) – appears to be fuzzy. The very strength of the Indian equity market has become its weakness. And that is impacting the psyche of market participants, i.e brokers, wealth managers and especially the investors.
When the GDP growth touched 5 per cent in the latest quarter, it got confirmed that we are indeed in the midst of an economic slowdown. We do not need government officials to admit that we are in a slowdown and that macros have been decelerated. If we consider the nominal GDP growth, it has come down to 7.6 per cent from 12-odd percentage points. The GDP growth has hit almost a 16 years low.
What has triggered the slowdown?
The economic slowdown and its protracted nature has surprised several market observers. Many would attribute thecurrent slowdown to the lack of demand for goods and services in the economy. The private consumption has slowed, and the investment is being impacted throughout the economy.
We attribute the current slowdown to following four factors: -
Disruptions and poor implementation : The slowdown could have been exacerbated due to the impact of demonetisa-tion and hasty implementation of GST. The underlying impact of demonetisation and GST has been more severe than previously anticipated.
Tight monetary and fiscal policies adopted since FY14: Several experts believe the real interest rates in India are among the highest in the world and that the rates were kept stiff for too long. With interest rates being higher for too long the business suffered in terms of profitability and growth further triggering the slowdown.
Global Headwinds : The growth in exports have taken a sharp dive. This may be attributed to the US-China trade war and its unwarranted repercussions on world trade. The lack of growth and opportunities in India’s trading partner economies are posing challenges for exporters in India. The US-China trade war has pushed the global economy into a worrisome spot due to which the global GDP growth is expected to experience a sizeable contraction.
Financial /Liquidity crisis: The crisis in the banking system and among the non-banking finance companies, especially after the IL&FS saga, has threatened the very stability of the financial system in India. The impact of financial crisis is such that the consumer spending has become weak, which hitherto was Indian economy’s biggest strength. Consumer spending has become weak also due to loss of jobs, curtailing of loans by banks and subdued farmers' incomes.
Steps taken so far by the government to arrest the slowdown
The government has made several policy announcements to calm the nerves of the investors. Certain measures were also taken to attract foreign capital into the domestic markets. These policies and measures are as follows:
1. Increased the FDI limit in insurance intermediaries to 100 per cent
2. Eased local sourcing norms for FDI in the single-brand retail sector
3. Increased statutory investment limits for foreign portfolio investments
4. Provided non-resident Indians a seamless access to Indian equities
5. Concessions given to boost production of electric vehicles ☛ Thrust given to affordable housing
6. Merging weak state-run banks with stronger ones to spur lending
7. Government has got a windfall from RBI in excess of $24 billion. This money is expected to be used for spending, which in turn is expected to revive demand. The government has not yet specified how it proposes to utilise this money.
8. Removed I-T surcharge on FPIs
9. The policy interest rates have declined by 110 bps in 2019
10. The state-owned banks are being recapitalised
Clearly the step taken so far do not seem to have enthused investors in general. The breadth and the depth of policy easing has been limited so far, when compared to the action taken during previous instances of slowdown.
"More than half of the deceleration in economic activity during the current slowdown phase has been due to decline in consumption and a third of the consumption slowdown is concentrated in autos"
- Goldman Sachs report
Economic and Business cycles Vs Market Cycles
Time and again we have seen that the economic activity is never linear--it is always cyclical. The business cycles are nothing but periodic expansions and contractions of business (economic) activities. For example, if we take the case of auto industry in India, there are phases when the activity expands in the industry for 4 to 5 years, followed by a phase of 2 to 3 years of contraction. It is normal to feel optimistic during the expansionary phase as the output grows, efficiency improves, jobs are created and profits are delivered owing to the increasing demand. At the same time, it is normal to feel pessimistic when profits decline during the contractionary business cycles.
The current contractionary business cycle we are in is causing pessimism and the decline in profitability is visible across the sectors as the contraction this time around has been protracted.
The stock markets are simply discounting this extended slowdown in the Indian economy. Usually the markets start moving up even before the actual expansion in the economy happens. Markets rise sharply during the boom phase and start declining during the slowdown. The current slowdown, one of the longest (18 months) since 2002-03 has already pushed a majority of stocks down by more than 50 per cent.
The slowdown is discounted in stock prices as of now. It is only a matter of time that the stock market anticipates a recovery from the slowdown and the stock prices start moving up even before the actual economic recovery takes place. Thus, for long term investors, identifying the turning point becomes crucial and can prove to be extremely profitable. For equity investors, the most important question thus remains: when is the recovery expected so that the stock prices start reflecting the improving situation on the ground.
Going by the data on slackening economic growth and discounting the fact that the government has finally acknowledged that the slowdown persists, one can expect sluggish growth for another couple of quarters, at the most. Till March 2020, we may see subdued economic activity. In other words, the hard landing can go on for few more months till March 2020.
The recovery can be much faster depending on how the government spends (expansionary fiscal policy) the windfall it has received from the RBI and also how well the consumption improves hereon. The upcoming festive season will definitely lend support to propel consumption.
If we take a look at the GDP data and the Sensex performance since 1991 we can see that the markets have almost always risen post correction. If we consider the correction phases (Refer table below) we find that the markets tend to generate impressive returns post deep correction. Investors should simply be willing to remain invested for close to three years post deeper correction to experience impressive returns.
Cyclical Slowdown Vs Structural Slowdown
Rama Tanay Ratnam
Head of Products, Centrum International Services Pte.
"Global economic growth has been sluggish, both trade and manufacturing activity have remained beleaguered. Germany is sliding into a recession, India’s and China’s GDP growth has not been encouraging. An inverted yield curve suggests that investors are increasingly getting worried and it is just a matter of time before I see a global economic downturn. The trade war rhetoric of Trump, and Xi allowing the currency to weaken has really made the investors fear the obvious, because if the trade war continues, it will force corporates to reduce spending and investments including labour, harming the engine of growth. Trade war coupled with Brexit, elections in Italy and tensions in HK increase the risk of global recession. However, I expect a slowdown but not a major recession in the next 12 months, as I see there is a limit to the escalations in the trade war as there is an election pressure also on President Trump and we are moving to a looser macro policy regime"
Expressed views are personal
Lead Economist, Acuité Ratings & Research
"We Think The Demand Side Also Needs Urgent Attention"
When do you think the economy will bottom out?
The Indian economy is clearly witnessing a weak consumption driven slowdown. It is not only reflected in the Q1FY20 GDP growth print of 5.0%, but also in the substantially lower growth in private final consumption expenditure (PFCE). PFCE grew at a sharply lower rate of 3.14% in the first quarter of the current year as compared to 7.20% in the previous quarter and 7.31% on a yoy basis. This is also corroborated by multiple high frequency data indicators such as auto sales figures. high unemployment caused by a weak manufacturing GVA growth of 0.6% in Q1, along with low headline CPI inflation of 3.15% (July 2019) are further signs of severe demand side constraints. Consequently, we believe that India is in the midst of a classic Short Run Phillips Curve. However, we are concerned that if demand does not return, fiscal expansion accompanied by monetary easing will result in inflationary tendencies in the medium to long term. Therefore, if policy makers are not vigilant, a disconnect between unemployment and inflation threatens to push India into a sticky cycle of stagflation-high unemployment and high inflation. Acuité therefore believes that the downside risks to the economy will continue to remain given the extent of such demand weakness and the increasing global headwinds such as the China-US trade wars. In such a volatile scenario, it is difficult to hazard a guess on the growth figures over the next 2-3 quarters or whether the growth rate has bottomed out. However, we expect that the steps being taken by the government to revive the economy, along with a largely favourable monsoon across the country, should support some revival in growth from the third or fourth quarter of the current year.
Do you believe the measures announced by government so far will help stabilise the economy? What more steps you believe are a must in order to arrest the downfall in growth of GDP?
Acuité believes that the government is cognizant of the slowdown in the economy and has started to take a string of measures to arrest the slowdown. Upfront recapitalisation of public sector banks is a significant step and along with measures such as linkage of interest rates to repo rates, should help revive lending and effect better transmission of lower interest rates. However, most of the initiatives witnessed till now relate to the supply aspect. Given the deep impact of the slowdown on consumption, we think that the demand side also needs urgent attention. Essentially, it would imply higher income or savings with households that can translate into higher demand for goods and services. This can be affected through lower GST in specific sectors such as automotive and real estate where there has been a sharp downturn in demand or even temporary tax incentives for individuals linked to consumption. Further, tax incentives can be provided also to the corporate sector for fresh capital investments or new hiring in the current year. The government should contemplate various steps to generate employment across diverse sectors of the economy as employment will drive incomes and consumption. These steps may risk a deviation from the path of fiscal deficit but in our opinion, it may turn out to be a better option than risking a sticky stagflation scenario over the medium to long term. These steps should be taken earlier than later to arrest any further intensification of the slowdown.
India has managed to grow at 6 per cent in 2019 so far and clearly it is one of the fastest growing economies in the world, probably behind only China in terms of growth rate. It is ironical that in spite of being one of the fastest growing economies, investors are a worried lot. But investors are worried not for no reason. Investors are concerned as India, from being the fastest growing economies, has just become the fastest contracting economy and there is no sign of recovery yet. The famous V-shaped recovery looks like a distant dream and there are chances that the recovery could be a painful U-shaped recovery in the economy this time around. The stock markets are simply reflecting the situation on the ground.
The target set by the Modi government for a $5 trillion economy will require India to grow at 9 per cent or 10 per cent per annum. Going by the past four quarters' performance, it does look like India will reach $5 trillion mark only by 2026, a good 2 to 3 years later than the target of reaching the mark by 2023-24.
All is not lost for the equity investor though, as history suggests that the markets are not only forward-looking, but also rebound faster, better and disproportionately. The consumer demand is expected to be muted in the coming 3 to 4 months in spite of being a festive season. We may have a couple of more quarters of hard landing in terms of GDP growth rate, which makes us believe that the market bottom is nearby, and we are like to see a market bottom in the coming 3 to 4 months.
Clearly, the task in hand for the government is a difficult one as it has to achieve the fiscal consolidation and propel growth by a counter-cyclical fiscal policy. Without relying on the government decisions, investors can focus on the economic cycles and attempt to estimate when the cycle is expected to get into expansionary mode. Adoption of expansionary fiscal policy by the government could just be the beginning of changing fortunes both for the economy and for the markets!