By Navneet Munot
A month is a long time in financial markets – while a lot has changed over the past 30 days, there is a lot that hasn’t. Troubles for a part of the financial sector remain and continue to be one of the key monitorables, both from real economy as well as financial markets standpoints.
Yet, the mood amongst equity investors is more optimistic now. Among the local factors contributing favourably are recent government initiatives, most notably the corporate tax cut, as also RBI’s intent of continuing with accommodative monetary stance as long as necessary to revive growth (within its inflation constraints of course). Global news bits have been supportive too, with some easing off in US-China trade tensions and an increasingly synchronised global monetary easing.
On the last point, a vast majority of central banks have been easing monetary policies in the wake of slowing growth. The Bank of Japan and European Central Bank are already experimenting with negative interest rates. Amid this, the US Federal Reserve has been among the more reluctant of central banks of late on aggressive easing.
While it too has cut rates recently, it has only referred to these cuts as mid-cycle adjustment so far. Yet, the Fed finds itself expanding its balance sheet again. Having abandoned quantitative tightening in August this year, the Fed announced last month that it will buy $60 billion per month in treasury bills to ensure ample reserves in the banking system, thus affecting an increase in the size of its balance sheet. The era of expansionary monetary policy therefore is back with a bang.
Yet, monetary policy and related experiments being undertaken by developed world central banks may not be enough, nor completely desirable, as means to sustainable growth. Despite recurring rounds of quantitative easing (QE) and continued ultra-low rates for over a decade, growth rates in most big economies have been significantly below trend. This has also manifested in the ever-declining velocity of money, which suggests every subsequent round of monetary stimulus has had lower impact than the previous one.
A revival in investment has been elusive, as easy money is only feeding a savings glut. Inflation continues to be below targets as deflationary forces loom large. The most worrisome aspect about inflation is that wage growth remain anaemic in most economies.
At the same time, the world is witnessing certain ill-consequences that have often been blamed on ultra-loose monetary policy. Negative rates may pose a severe challenge to stability of the financial system if risk-seeking increases substantially to protect margins. With the real rates close to zero or negative, financial repression is the most obvious outcome, wherein savers do not even earn enough to compensate for inflation.
A related and bigger consequence is the rising inequality and wealth gap as arguably QE and low rates disproportionately benefit asset owners and financial markets. The risk that this disparity in wealth, which so far has arguably manifested itself in political outcomes ranging from Brexit to Trump’s election, can eventually lead to social conflict is real.
This is not to say that monetary easing wasn’t needed to bring the world out of the global financial crisis. Sans this, the world would have been in much worse shape today. However, limits on monetary policy have perhaps been reached. Global policy makers will have to increasingly complement it with fiscal policy in our view. The US did experiment with it with major tax cuts but that ended up in higher dividends and buybacks rather than capital expenditure.
India linking tax incentives to new capacity creation is the path that fiscal reforms should follow globally. Fiscal policy in developed world will have to be geared towards big government spending-productive investments, revamping physical infrastructure, social causes like education and such things that lead to more widespread growth.
On one hand, this will help create large-scale low-end jobs thus leading to more sustainable economic growth, on the other this can be an opportunity to make the world future ready in the light of constant technological progress and rising environmental risks.
Physical infrastructure today is inadequate in most parts of the world in the light of improvements in digital technology and needs a revamp for better alignment to these changes- smarter cities, industrial automation, bridges and so on. The job creation that happens consequently helps offset job losses due to the same technological improvements. Similarly, risks on the environmental front are no more theoretical and already manifesting themselves in the form of health hazards, rising temperatures, extreme weather events, etc.
An infrastructure that is geared towards a cleaner and greener tomorrow is the need of the hour- investments in alternative energy, newer and smarter grids and supporting infrastructure is a necessity and that it also helps economic recovery is an added advantage that governments should be all too happy to embrace.
The icing on the cake is that factors needed for this infrastructure build-up have never been so favourable. Money is ultra-cheap with real rates negative through the developed world. Pension funds have been struggling for returns given low rates and expensive developed world equity valuations.
Infrastructure financing, therefore, may just be the opportunity waiting to catch their fancy. Similarly, natural resources and commodities are cheap thanks to the continuing deflationary pressures. With wage growth anaemic and labour costs benign, a combination of low-end labour and high-end technology will act to keep costs down too. The time is, therefore, ripe for governments around the world to seize the opportunity and take global economy out of the current prolonged slowdown in a broadbased and sustainable fashion.
The only caveat is that this should be done in a controlled manner without creating excesses or endangering financial markets.
Coming to India, the implication in the very near term is that central banks turning accommodative is positive as easy global liquidity significantly reduces the risk of capital account shocks. From a mid to long-term standpoint, India faces a massive shortage of risk capital and can significantly benefit by attracting foreign capital.
The recent corporate tax cuts, especially the 17% rate for new manufacturing, is a significant leap in this direction and if followed up with appropriate policy and regulatory realignment can make India the destination of choice. This is a point we had discussed in detail last month.
Finally, if fiscal measures globally help revive investment growth, as discussed above, this will further provide an added impetus to Indian investment growth. A new investment cycle may just be the trigger that brings about the much-awaited mean reversion on corporate profitability. On several cyclical measures of corporate performance such as return on equity, profit margins, and corporate profits as proportion of GDP, we are at multi-year troughs, very similar to the levels seen at the beginning of this century.
The same is true for economic growth, both real which had dipped below 5% and nominal which was in single digits, at the turn of this century, very similar to the situation today. The stage, therefore, appears set for a new cycle to begin.
One direct consequence will be a change in the complexion of the stocks that perform. The past few years have been characterized by a significant polarization as shrinking profit pool has led to investors flocking into the safety of the select few companies that continue to grow.
Last Diwali to this, while the Nifty is up over 9%, the Nifty Midcap 100 and the Nifty Smallcap 100 indices are down over 7% and 10% respectively. Breadth should improve as investment cycle revives and profit growth becomes more broad-based.
On debt, near term growth-inflation dynamic along with an elevated term premium should keep a ceiling on bond yields. Within corporate debt, polarization in favour of top quality continues as many others struggle to borrow.
An economic revival can change this eventually, but in the near term we go back to the point we made at the beginning that financial sector stress remains the big elephant in the room. A resolution on that front, including measures to revive real estate, stays a key monitorable for risk assets as well as the overall economy.
(Navneet Munot is Chief Investment Officer of SBI Mutual Funds)