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Unless there is a very large fiscal slippage, market won't be surprised: Ridham Desai, Morgan Stanley

We are in a long-term bull market which of course will have corrections, says MS India MD.

ET Now|
Updated: Jan 31, 2018, 02.22 PM IST
ET Now
The market is prepared for a change in the holding period from one to a two-year holding period and it is probably priced in.
In an interview with ET Now, Ridham Desai, Managing Director, Morgan Stanley India, says investors must continue to invest in a systematic fashion and try not to time the market, leave that to professionals. Every month, put a percentage of your income into stocks.

Edited excerpts:

What should we expect tomorrow from market standpoint -- a 100-point Nifty swing and we will back to basics or in the current global context could the Budget make a meaningful difference?
I have no idea what the market will do on a daily basis. But, I think, we are looking at a budget in which the finance minister has already informed us that the glide path for the fiscal deficit will shift slightly. So, the type of fiscal consolidation that we have seen over the past three years may take a bit of a pause. I would guess that that has already priced in because market participants have already been informed about this in advance. Unless, there is a very large fiscal slippage, it should not surprise the market.

I would keenly watch for any expenditure growth. The trailing 12-month expenditure growth is actually high single digits, around 9%. That could accelerate next year to maybe 15% and that is going to form a big support for the economy in 2018. The Finance Minister will back it up with asset sales. We have talked about enemy property sales. There will probably be a big divestment target. There is also going to be some acceleration in revenue growth because if the economy picks up, then revenues will also pick up. GST will stabilise and therefore GST revenues will also pick up. All in all, it will be a fairly stimulative budget with focus on infrastructure and likely focus on rural India, especially rural infrastructure like electricity, roads, irrigation.

Direct benefit transfer should get a big mention. Housing should probably get a big mention. This will be a stimulative budget for growth and therefore growth will continue to accelerate. We are seeing that in the earning season. It is a pretty robust earning season so far. The mid-teen growth rate that we are seeing in earnings will probably accelerate as 2018 progresses.

All that the markets are fearing right now is whether or not there is going to be a long-term capital gains tax in any form. If that were to be the case, do you think come tomorrow, we could be in for a rude shock? Or do you think that somewhere the market has already started bracing itself. That is what some of the midcap and small cap selloff seems to be indicating that somewhere the market is preparing itself for maybe a move like this?
The market is prepared for a change in the holding period. Right now, you hold shares for one year, they become eligible for long-term capital gains which is basically zero per cent. Maybe that gets into a two-year holding period and that is probably priced in. I do not think per se a long-term capital gains tax is priced in. I do not think the market believes that the government will re-introduce long-term capital gains tax say at the rate of 20% and the worst case scenario for the market is both of these happen which is the holding period is extended and the long-term capital gains tax is extended. Now you could debate on both sides and frankly I think this is a 50-50 call, very hard to actually say whether it will happen or not.

On one hand, the government has probably got a large amount of asset sales to undertake this year and therefore buoyant share prices will augur well for their expenditure targets. On the other hand, as you have seen in The Economic Survey, the chief economic advisor has cautioned us against a building bubble in share prices. So it is a 50-50 but a more likely scenario is that the period for holding shares to be eligible for long-term capital gains is going to get extended from say one to two years. But if LTCG tax comes, then you will see a volatile reaction at least in the short run.

What about corporate tax? The glide path was given, but no action has been taken. We know the global mood. If tax cuts have been announced by the American administration, other countries will have to do something to align to stay competitive. Do you think it is imperative that a corporate tax cut of 2% to 2.5% should come?
It is a possibility but I would not hold my breathe for that because it is a year in which the government’s focus will be on enhancing expenditure rather than stimulating the economy through tax cuts. Mind you, they have already done a fair bit on GST well ahead of expectations. We have had three rounds of GST rate cuts and six months ago, I do not think people would have expected such outcomes by January of 2018. So they are focussing on realigning and rejigging indirect taxes.

A big cut in direct taxes, we will probably have for the direct tax score which is right now being authored and maybe will be ready next year and it will be the next government’s task to take that step. So maybe a token cut of 1%. I would not expect a major change in direct taxes at any level. There is another debate, of course, which is on dividend distribution tax and I think there are some representations made to the government that there is double taxation on dividends now because people receiving more than a million rupees of dividends today, pay marginal rate of tax on dividends which is an addition to the 20 odd per cent that corporates cut in form of dividend tax. So, there is two levels of taxation and maybe there is some view to change that and remove dividend distribution tax.

Again, I do not see this as a game changer. When the finance minister introduced this extra tax on dividends last year, nobody forecast that companies would respond with buybacks. Trailing 12 months, we have had $8 billion of corporate buybacks and amongst the other things that have been driving demand-supply for equities, this has also played a role. It is not a small amount, $8 billion is almost equal to 50% of all mutual fund buying last year. So, it is a pretty large amount of buying that corporates are doing to save the controlling stakeholders from paying dividend tax.

If they remove dividend distribution tax and make dividends fully taxed at the hands of the recipients, then probably buybacks will go up slightly. Net-net, it will be neutral for the market but that is the other debate around direct taxes. But to answer your question, I expect minimal changes to direct taxes in this budget.

The street pretty much has been talking about infrastructure spending as well as boosting rural demand as the two focal themes for this government’s Budget. What do you expect specifically on both those accounts, particularly on the rural economy side because I was making the point a few days back about how wage inflation has actually on average has grown 5% over the last few years, which is not even beating inflation. So is there tremendous scope of actually boosting consumption there and spurring demand?
This government’s approach has been very different. Unlike past governments in India which have doled out cash to poor people and as you have seen in the last experiment of doling out cash, created inflation. This government has focussed on building assets and that is a very different approach and it is a very good long-term approach because after you are done with it, you actually leave behind wealth on the balance sheets of poor people. It actually creates a transfer or wealth rather than just a transfer of income.

I do not see deviation from that theme so think about rural asset creation as the key focus here and the big announcement that I am expecting is last mile access for electricity. They have already brought electricity to bulk of India’s 600,000 villages over the past three and a half years but that electricity has not necessarily reached the homes of every single villager and that is an onerous task, it is a very tough thing to do and that is what they are going to attempt to do.

They will probably focus on bringing that electricity into the homes and if they were to do that across say 80,000-90,000 villages over the next 12 months, that will be a great achievement. And that would be one big announcement I am expecting in the budget. The other thing would be on rural roads. Road connectivity in rural India will play a big role in transferring wealth and income to rural India and in creating jobs as well, especially for the unskilled labourers who are leaving farm lands and looking for jobs in urban India.

I would also expect a pretty big jump in rural road spending. There is already a scheme out there; the Pradhan Mantri Gram Sadak Yojana and we should see a big focus on that. I do not expect increased focus on irrigation. This has been one of the things that they have been spending money on, maybe micro irrigation occupies more attention. The other big thing that will get discussed is DBT for fertilisers. The pilot projects are done, they have been successful and this has great potential in transferring money into the hands of poor farmers which hitherto was probably eaten away by middlemen and did not efficiently transfer to poor people. DBT for fertilisers could be a big thing.

As for MNREGA, spending will probably rise in line with GDP and so no acceleration there because again transferring income can prove to be inflationary, especially in a year in which the government expenditure is going up and the headwinds for inflation are converting into tailwinds. You do not want to put more pressure on inflation by transferring incomes directly through MNREGA. The Budget focus should be more on building rural assets rather than social give-aways.

The other key talking point is inflation. I know you believe that the impact on inflation outlook will be muted and that this is not just a local issue but also a global issue, given the trends in core inflation and oil prices. Back home it will be a mix of the government’s policy to manage inflation and the RBI’s. How do you look at inflation being tackled if at all it is a risk for the rest of the year?
It is an emerging risk. We have had this view that inflation bottomed last year and that is nudging higher. We also have opined at the end of the last year that the rate cycle in India is over and there is a chance that in the second half of this year we may actually begin to see tightening.

The approach of the central bank is pretty clear, their framework is well laid out, they will pursue positive real rates to keep the lid on inflation and they have also guided us on the range that they are going to pursue which is around 100 to 150 bps of real rates. So, they will react to inflationary pressures by lifting interest rates and it is quite possible that they do that in the second half of this year.

From the government perspective, the key is to keep expenditure on non-productive items in control and to keep the overall fiscal deficit in check. I expect both these outcomes in this budget. I expect the government to pursue non-productive expenditure. They will focus more on building assets than transferring incomes and I think they are probably going to keep the fiscal deficit around these levels. We will not get the same rate of consolidation that we have seen in the last three years but it is unlikely that the finance minister lets the fiscal deficit estimates climb from here so I think that is the way they will do their contribution.

Oil is certainly the joker in the pack and if oil continues to rise, then the impact on India will be a little different from the past. In the past, sudden rise in oil prices, especially when it was supply shock led created a currency market problem which then transferred to as inflation and caused rates to rise and growth to slow down so that was the transmission channel for oil. This time I expect oil to transmit slightly differently because India is firmly in BOP surplus and therefore I do not expect oil price rise to immediately affect the currency.

Instead, the government may end up cutting taxes in order to protect the consumer from the oil price rise. Remember, they raised taxes when prices were falling so they have a pretty good cushion there to cut taxes to protect the consumer from oil price rises but the minute you start cutting taxes, it puts strain on the fisc and it will compromise the government’s ability to undertake other expenditure and that will then hit growth.

So the transmission effect of oil will be a little different from the past because India’s macro stability is in very good shape with positive real rates, with declining fisc and a positive BOP. I expect a transmission impact to happen in the form of slower growth if oil continues to rise.

The economy is on a mend, globally things are looking up. I expect the finance minister would have optimistic assumptions for revenue and growth for the coming fiscal year, what to your mind in the current global and local backdrop would be a optimistic and a realistic assumption?
I will draw reference to the Economic Survey which makes a good point on the multiplier of GST. Contrary to the popular perception, GST has led to higher compliance and therefore growth rate in tax collection is exceeding nominal GDP. Ordinarily, when GDP growth is slowing down, the multiplier tends to fall and we have seen over the past few years, it has fallen to say 0.8-0.9% and just to clarify what I mean, if nominal GDP growth is 11% and slowing, tax revenue growth tends to be say 10% or 9% but when GDP growth starts accelerating, as we think it will be in 2018, that multiplier also actually starts rising.

There is a non-linear relationship between GDP growth and tax collection. Ordinarily, if GDP growth is improving this year say from 11% to 12%, then tax collection growth could rise from say 10% to 13%. So, that multiplier has gone up. On top of it, you have a structural factor like GST which is coming in play. Depending on what the nominal growth forecast is and assuming it is 11%, I would not be surprised if the tax revenue collection assumption is at 13% or 14%.

The success story really has been the disinvestment and again good quality government paper whether it is a) innovative way of raising money via the ETF route or b) taking some general insurance and insurance companies public. Do you think disinvestment assumptions of a lakh crore plus or number around one lakh crore is coming for next year?
Yes, it is quite possible that they have a pretty aggressive number given the success they have had last this trailing 12 months which has exceeded my expectations because in my post budget interview to you, I had expressed scepticism about aggressive disinvestment target and I said that was the one flaw in the budget numbers and I have been proved wrong because they have managed to exceed their target pretty well and in advance.

If you look at the historical track record of Government in India, it is very rare for them to exceed their divestment target. You have to go all the way back to 2001-2002 when I think Mr Arun Shourie was the divestment minister and after that they have successively missed targets. So, the government this time has clearly beaten expectations. Given the tailwind of success of the last 12 months, it is a fair assumption to make that this year they will go for a big number and that will be needed for them to balance the budget because if you are targeting acceleration in expenditure growth and you do not want to be too optimistic about revenue collection and you are going to have a conservative number there, then the way you balance this is by pursuing asset sales. So, that is par for course.

It actually circles back to demand supply for equities. Last year, the net demand supply was extremely favourable for stocks because there was limited supply. Of course, supply did rise and it ended the year at about $28 billion and it jumped up considerably from the previous year but this year I am sensing that supply is going to go up even more and probably end up in the $40 billion mark, which then will start putting pressure on their demand supply equation and could be a drag on share prices. To some extent, midcaps are responding to the drag because they are expecting more supply and from the government as well as from the private sector. That is something that we need to keep an eye on.

As an investor, when you have already made 40% returns on the Nifty last year, and over 40% when it came to the broader markets and irrespective of this recent correction that we are beginning to see in the broader markets, what can you do? Do you wait for that big impending correction that everyone is talking about which could be perhaps led by something globally and maybe we are in the midst of that already given how US equities have panned out in the last two days or do you start digging out contra bets right now? Do you begin to already look at IT and pharma? Do you go back to the drawing board and begin cashing out of names where you have made obscene sort of returns in the year gone by?
Let us get some facts out of the way. The US correction has meant that the Dow Jones is down 2% from its all-time high levels and that is hardly a correction. The second fact we should understand here is that while we all talk about rising share prices in India and some quarters even alluding to a possible bubble, very little about this stock market rally is actually India centric. It is largely a global bull market, stock prices are going up everywhere. This year, India has underperformed emerging markets. Emerging markets are up double digits, I mean China is up lot more than double digits so the Nifty has actually done nothing this year compared to what markets around the world have been doing and not just this year but for the past several years.

Last year, the Nifty was up 35% and that was a middling performer. We track over a 140 indices globally and the best performing index globally was actually the small cap index of India which is up 65% and the second best performing Index was MSCI China. So, if there was any sort of exuberance it was actually in the small and midcap space and very appropriately that is correcting this year. I am not surprised by it, we have been worried about broad market valuations. Market cap to GDP was nudging towards 100%, it peaked at about 90 to 93% and now it has come down from there, It makes sense or the broader market to correct which does not necessarily apply to the Nifty but as far as the markets’ next move is concerned, this is a question that we keep asking ourselves, where is the next 500 point Nifty move? It primarily depends
on what the US does and it is not going to be an India centric call.

Unless some nasty surprise comes in the Budget which then causes the Nifty to correct on its own, it is more or less global for now. I expect India to outperform but that also is contingent on oil prices. To answer your question on what the investor should do, my view is continue to invest in a systematic fashion, do not try to time the market, let the professionals do that. Come in every month, put a percentage of your income into stocks. We are in a long-term bull market which of course will have corrections and some of them will be nasty corrections. We had one nasty correction at the end of 2016 when demonetisation was announced, we had one in February 2016. We did not really have any big correction last year. So, the market is overdue for a correction and it could happen anytime but so far as you are investing systematically, you can withstand that though I would opine that midcaps may go down a bit more before they settle down and get ready for the next move. We are in a three- to five-year bull market and at the beginning of a new profit cycle but of course that does not mean that share prices do not correct.

One final point, in this earning season thus far, the companies that have reported have beaten sales side estimates in three out of four cases but stock prices have gone up only in one out of three cases. This tells us that the market was already expecting this. So, while the growth cycle is turning, it is always a function of what is priced in and as far as midcaps and small caps are concerned, they had gotten a little bit out of hand and now they are appropriately correcting.

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