Economic Spotlight India Market Strategy Reforms And Rally · We have listed down 5 major factors that have contributed to the recent economic slowdown for the Modi led government

Edelweiss Professional Investor Research

Economic Spotlight

India Market Strategy Reforms And Rally

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Ashutosh Gehlot Market Strategist [email protected] +91 (22) 6187 9533

Ankita Pathak Economist [email protected] +91 (22) 4342 8638 Shobana Krishnan Chief Economist [email protected] +91 (22) 4272 2636

Date: 27th May, 2019

India Elects A Majority Government, A Positive For Reforms Agenda Verdict of the mammoth 17th General Elections are out. In line with the exit polls

predictions, Bharatiya Janata Party (BJP) once again emerged as the single largest party in

the Lower House of the Parliament, establishing a comfortable majority by itself winning

303 seats of the total 542 in the lower house. The win itself is historic for India as the one-

sided sweep for the consecutive term is only second to 1984 General Elections where

Congress won 414 of the 542 seats. A strong mandate at the centre translates to greater

policy certainty which is positive for the business environment.

A more empowered government at the centre is likely to take swift and decisive action.

The several challenges faced by getting re-elected in a slowing economy are likely to be

addressed over the course of next few quarters. Since many of these challenges are

cyclical, the ability of the government to address them is high. We argue that fiscal

profligacy which has been an area of concern over the last two years could soften

considerably as pre-election populism abates and nominal growth pushes tax revenues

higher. The larger boost to financial markets could come through a dovish monetary policy,

expansion in credit and improvement in liquidity across segments of the economy. We

continue to watch government and RBI’s regulatory actions for correcting liquidity stress

and unclogging of cyclical bottlenecks.

For structural challenges the sheer majority of the government, especially once it assumes

majority in both the houses of the parliament, will lay a sound basis of structural reforms

like no other period since the reforms of 1991. We believe that a number of reforms in

land, labour, MSME development and direct taxes are likely to get attention in this term

of the government.

Earnings Revival to Buoy Equities, Remain Positive

We expect NSE-500 earnings to increase by 30% while Mid-cap earnings would nearly

double in FY20.

The surge in earnings growth would be brought about by the profitability revival in

Public Sector Banks. We believe profits of PSBs in the NSE-500 universe would rise by

165% in FY20 to ~INR 39,000 Cr. while PSBs in NSE Midcap 100 universe would see FY20

profits at ~INR 11,000 Cr., a 139% jump.

Based on these fwd. earnings expectations, our Nifty target is 13,000-13,500 level while

Midcap 100 Index target is 25,000 level in the next one year.

The broader markets, especailly in the midcap index is trading at nearly 16 times its 1

year forward earnings. This is significantly lower than its average of the last 5 years

which is at 20 times. We expect brodaer markets to outperform frontline indices.


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NDA 3.0 - Majority In Both The Houses In May 2014, NDA held only 65 seats in Upper House causing hurdles in controlling the political narrative and passing major legislation. Since then, NDA has gained significant foothold in winning states election with about 17 states under their power. Currently NDA holds 101 seats in the Upper House, well short of majority of 122. Our calculations indicate that NDA could add about 25 seats in its kitty by 2020, assuming status quo in upcoming state elections. This is important as any major reforms requiring constitutional amendment would require 2/3rd majority in the Upper House. NDA 3.0 would be thus more empowered to carry structural reforms.

Source: Edelweiss Professional Investor Research

Getting Re-elected In A Slowing Economy- Major Challenges India’s economic recovery after facing double jolt from demonetization and introduction of GST was short lived. Q4 FY19 GDP is

projected to slump to 6.5%. World Economy is slowing down and the new government will face the challenge to keep India

immune from the slowdown.

Synchronous Slowdown in Global and Domestic Growth


NDA BJP, 303

NDA Allies, 50

UPA INC, 52

UPA Allies, 40

Others, 97

NDA sweeps the Lower HouseComposition of Lok Sabha

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We have listed down 5 major factors that have contributed to the recent economic slowdown for the Modi led government to

focus on.

a. Missing Investment- Investment have fallen to about 26% of GDP in FY18 from the peak levels of 35% in FY08. In the past

few years, investments have been propelled by government as private investments dried up. Under-utilization of installed

capacities, low realization and high leverage continue to be key problems burdening private investments. Capacity

utilization has been slowly inching up at 75% but it remains lower than the ballpark number of 80 which triggers new

investment. A few numbers like monthly cement production hitting a life high of 33mn tones in March’19 seems

encouraging.

Lingering Slowdown in Investment


b. Fault Lines in the NBFC space - Confidence crisis have loomed over Indian NBFCs since the collapse of high rated

infrastructure financer IL &FS group. Post the collapse, the borrowing cost of NBFCs soared causing much stress to their Net

Interest Margins. With the banking system already burdened with high stressed assets, NBFCs provided an additional line of

credit. NBFCs had been steadily gaining market share from the Public Sector Banks and accounted for about 30% of the total

advances in the economy. Thus, it is important to address liquidity crunch faced by the NBFCs without causing moral hazard.

The recent RBI circular inviting comments of Liquidity Coverage Ratio indicate the regulators interest in strengthening the

sector and may be a precursor to alleviating the stress from the NBFC space.


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c. Low wage growth- Real Rural wage growth has been abysmally low at an average of 2.3% in the past 5 years much lower

than the 10 year average of 5.2%. Low food prices and dull construction activity are cited to be major problems for low wage

growth. Private sector wage bill has also been rising at a very slow pace. Compensation to Employees has risen by only 8.2%

in FY19 as against the 10 year average of 10.35% (Source: CMIE). Low wage growth thereby leads to lower purchasing power

and lower demand. This could be one of the drivers of prolonged period of suppressed inflation in India.


d. Widening Fiscal Deficit- Fiscal Consolidation has been difficult is past years with combined central and state fiscal deficits

and IEBR borrowing being as high as 10% of GDP. State deficits have been burdened by UDAY schemes (estimated at around

INR 4.3 Trillion), GST shortfall. With a threat of competitive populism prevailing in the economy, there is a pressing need to

keep the deficit under control. The “quality of deficit” also has to be improved. FY19 fiscal deficit target was met by cutting

down on Capital Expenditure and high IEBR borrowing. It remains a challenge to move the center fiscal deficit back to the

long term FRBM target of 3%.

Ballooning Centre and State Deficits


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Corporate Salaries Have Stagnated… …with low wage growth in Rural Areas


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Work in Progress- The Incomplete Projects NDA 3.0 is well equipped to address some of these challenges through measures which are easier to implement or are ready to

be implemented. As the focus shifts from politics to economics, these low hanging fruits should be the focus areas of NDA 3.0.

a. Focus on Quality of Fiscal Deficit

In their maiden budget in FY15, NDA government had promised to achieve medium-term target of Fiscal Deficit at 3% of GDP in

line with FRBM guideline. Pre-election populism bout and rise in crude oil significantly increased the revenue expenditure.

Previous divestments during NDA 2.0 tenure only transferred hands from one PSU to another solely for the sake of meeting fiscal

targets. For example, ONGC bought HPCL, PFC bought out REC, stake sale of NHPC to NTPC etc. The new Government should set

a genuine divestment policy. The Rolling of an Income Support Scheme was considered a perfect opportunity to subsume

inefficient subsidies. The pre-election interim budget dodged that opportunity leading to a 42% Y-o-Y rise in rural/agri focused

schemes. We remain hopeful this budget could be more prudent on this front and populist measures would taper off. Disruptions

from GST, low economic activity and low corporate profitability leading to a slowdown in direct tax collections dented the receipts

of the Government. Going forward, we believe that these disruptions will ease out and the Government could once again signal

targeting the fiscal deficit of 3%. We believe that the new government should focus on “quality of fiscal deficit”.

Forces in Favour:

i) Improving GST receipts: Total GST collections have been about INR 1 trillion in FY19, improving from an average of INR 90

billion in FY18. To add, GSTR 3B filings have averaged around 74 lakhs in the last quarter- a significant increase from 70 lakh

filings in the first quarter of its implementation. We expect GST collections to improve on account of better compliance and a

reversion in nominal GDP growth.

ii) Additional Dividend from RBI : The Government will have the ability to extract additional dividends from RBI to the tune of

INR 1 lakh crore which would provide additional fiscal comfort.

iii) Rise in Nominal GDP: Finally, as the Nominal GDP increases, the Government will have additional capacity to spend while

keeping the headline Fiscal Deficit under control. This could prove to be one of the most important driver of corporate revenue

growth and thus profitability in FY20 and beyond.

b. Expansionary Monetary Policy

"We recognize that investment driven Growth requires cheaper cost of capital. By anchoring inflation at 4%, and clearing up our banking system, we have created the space for structural reduction in the cost of capital"- BJP Manifesto, 2019

The Manifesto has recognized the need of reduced cost of capital, hinting towards lower real interest rates prevailing in the

economy. Since our strategy, another rate cut was exercised in April 2019 bringing Repo Rate down to 6%. Headline Inflation has been below RBI’s target of 4% building a case of rate cut. We believe there is room for rate cut by another 50bps in FY20.

Liquidity deficit has shrunk from April’19 high of INR 1.16 trillion to an average of INR 0.45 trillion in the last week and will

ease further as pre-election cash demand wanes off. Comfortable liquidity will aid in efficient transmission of interest rate

cuts.


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c. Revival In Credit Supply:

Indian Financial Sector has been continuously plagued problems- rising stressed assets, resolution woes and the NBFC

liquidity crisis. NDA 3.0 could focus on alleviating the stress from the NBFC space. One of the ways could be by establishing

an additional credit line for the NBFCs. Additionally, capital could be infused to the tune of INR 1 trillion in the Public Sector

Banks.

Privatization or mergers of PSBs could be another agenda of the newly formed government

There should be emphasis on getting more PSU’s banks to pass resolution to be able to lend. 6 banks have come out of the

Prompt Corrective Action (PCA) framework and as more follow, total lending capacity will increase.

d. Reforming Distressed Sectors- Aviation, Telecom and Power

The previous Government tried to divest ailing Air India but the sale was unsuccessful. In the meantime, private Airline Jet

Airways was grounded and put the aviation sector under stress. Consequently, monthly domestic airline traffic fell for the

first time in six years. The new government will be expected to devise a plan to fix the stress in the sector.

In its last tenure, BJP tried to divest major telecom PSUs- BSNL and MTNL. Since the two have failed in gaining profits, selling

them off will enable private players to gain economies of scale.

The power sector continues to be reeling under stress as losses and debt continue to pile up at the DISCOMs while electricity

generation grew by a modest 3.6% in FY19. UDAY was formulated to improve the financial health and operational efficiency

of the country’s debt-ridden power distribution companies. It aimed to bring registered losses of DISCOMS to below 15% by

FY19 and bring down the gap between average cost of supply and average revenue realized to zero. So far only 15 states have

been able to bring AT&C losses below 15%. The major challenge comes from the inability of DISCOMs to structurally raise

prices. After UDAY had been implemented, aggregate DISCOM debt had fallen from ₹2.7 lakh crore in September 2015 to

₹1.9 lakh crore in FY16 and ₹1.5 lakh crore in FY17. This downward trajectory is now expected to reverse, moving up to ₹2.28

lakh crore in FY19. Thus, the new Government has learning’s from a suboptimal result in UDAY and needs to undertake a

major reform to resolve the distressed power sector and address structural issues.

e. Other Important Reforms

There have been certain reforms formulated by the previous NDA government, the pace of enactment of which will be swifter

under the current Government as NDA is likely to gain majority in both the houses. Here’s a recapitulation of the major

drafted/pending bills that will gain limelight as the new government comes into power.


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Bills Awaiting Consensus

The Right to Fair Compensation and Transparency

in Land Acquisition, Rehabilitation and

Resettlement (Amendment) Ordinance, 2015

Land Reforms: Acquiring land for industrial activity remains a major constraint in India. The Government has drafted the bill exclude five categories of projects, i.e, (i) defense, (ii) rural infrastructure, (iii) affordable housing, (iv) industrial corridors, and (v) infrastructure including PPPs where government owns the land from cumbersome formalities.

The Micro, Small and Medium Enterprises

Development (Amendment) Bill, 2018

Industrial Dispute Act

Industrial Reforms: The bill increases the turnover amount for industries to be

classified under MSMEs. This will aid more industries to take advantage of the

benefits offered to MSMEs.

The Draft Direct Taxes Code Bill

Direct Taxes: The bill will consolidate laws related to direct taxes. The initial bill

aimed at reducing Income Tax slab for the individuals but also took away the various

exemptions that are currently offered.

It also proposed reduction of corporate tax to 25% of business Income.

However, the NDA government has set up a committee to edit various proposals of

the bill. Implementation of such bill could potentially simplify the cumbersome tax

procedure in India and increase compliance

Draft Labour Code on Occupational Safety, Health

and Working Conditions, 2018

Draft Labour Code on Social Security, 2018

The Contract Labour (Regulation and Abolition)

Amendment Bill, 2017

Draft Labour Code on Social Security & Welfare,

2017

Labour Reforms: Multiple labour reforms are in pipeline have aimed at providing

better occupational safety, higher social security, competitive wages and higher

contractual labour.

Market Outlook: Debt Market:

Expected reigning in of the fiscal deficit and easier monetary policy, should attract sustained FII flows going ahead. They

would be aided by the increasingly dovish stance of major central banks like US Fed, ECB, BOJ and PBOC.

A strong mandate for the ruling government attracts significant interest from foreign investors. Total FII net inflows of USD

27 Bn. in debt markets and USD 18 Bn. were seen in FY15 against an average of USD 6 Bn. and USD 10 Bn. respectively in the

last ten years.

Also, according to our calculations India is currently the third most attractive emerging market in terms of real yields adjusted

for currency volatility, making it attractive for FII inflows into debt markets.

RBI is likely to infuse more than INR 2 trn of liquidity through OMOs and Dollar Swaps in FY20. Scheduled commercial banks

which have been nearly absent from the bonds markets are likely to return in FY20 thereby reducing the interbank deficit.

Increasing flows would lead to substantial easing in borrowing yields going ahead. We expect G-sec 10 yr. yield to fall to a

level of around 6.5%.

https://www.prsindia.org/billtrack/draft-labour-code-occupational-safety-health-and-working-conditions-2018

https://www.prsindia.org/billtrack/draft-labour-code-occupational-safety-health-and-working-conditions-2018


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Equity Markets:

We estimate NSE 500 (broader market) PAT to grow by 30% and Mid-cap 100 PAT by 96% in FY20.

This would be brought about by a broad based earnings revival in Public Sector banks, which would return to profitability

after four years of benign or negative profits. We expect 165% earnings growth in NSE-500 PSBs. Decline in the quantum of

provisioning and smooth resolutions under IBC would spur the earnings recovery.

Easing in credit spreads have historically led to immediate upgrades in estimated corporate earnings. Corporate bond

spreads should decline as credit risk would ease due to resolution of IL&FS along with continuity in the IBC regime. 5 year

corporate bond spreads have already eased by around 40-50 bps in the last 3 months.

Currently, more than 45% of the edelweiss broad market universe currently trades in the bottom 30 percentile of their

historical valuation levels. At such attractive levels, we expect a broad-based recovery in equity markets.

Since the total market cap of the Midcap Index still trades at 44% of India’s core GVA, falling from a high of 72% at the end

of 2017, we believe attractive opportunities are starting to arise in the midcap universe. A broad earnings recovery would

give further boost to the sector.

We expect Nifty could rise to a level of 13,000-13,500 while the Midcap Index can rise to a level of 25,000 basis current

blended Fwd. 12 Months EPS estimates.

Auto & Ancillaries, Mid-cap Financials and FMCG sectors are currently attractive on the basis of valuations.

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India Ranks Third In Terms Of Real Yields Adjusted For Currency Volatility

Most Attractive Yields Ranks


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Our Base Case Earning Projections Indicate Surge in Profitability

NSE 500 (INR Cr.) FY14 FY15 FY16 FY17 FY18 FY19 E FY20E

Total Adjusted PAT 4,04,422 3,99,125 3,81,869 4,76,196 4,46,122 4,99,535 6,48,727

Adj. PAT Ex. PSB 3,70,836 3,65,127 3,98,181 4,72,696 5,22,395 5,59,535 6,09,432

PSB Adj. PAT 33,585 33,998 -16,312 3,500 -76,273 -60,000 39,295

Y-O-Y Table FY14 FY15 FY16 FY17 FY18 FY19 E FY20 E

Total Adjusted PAT -1% -4% 25% -6% 12% 30%

Adj. PAT Ex. PSB -2% 9% 19% 11% 7% 9%

PSB Adj. PAT 1% -148% 121% -2279% 21% 165%

Midcap 100 (INR Cr.) FY14 FY15 FY16 FY17 FY18 FY19 E FY20E

Total Adjusted PAT 53,181 51,731 34,137 51,106 26,604 56,092 1,09,930

Adj. PAT Ex. PSB 40,698 40,600 48,613 53,446 61,936 84,482 98,992

PSB Adj. PAT 12,483 11,131 -14,476 -2,340 -35,332 -28,390 10,938

Y-O-Y Table FY14 FY15 FY16 FY17 FY18 FY19 E FY20 E

Total Adjusted PAT -3% -34% 50% -48% 111% 96%

Adj. PAT Ex. PSB 0% 20% 10% 16% 36% 17%

PSB Adj. PAT -11% -230% 84% -1410% 20% 139%

*PSB PAT is based on standalone numbers.

* FY19 PAT is calculated based on actual as well as annualised numbers.

NSE Midcap Index Is Now Trading At An Attractive Level


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45% of Stocks in Our Broad Market Universe Are Undervalued

Valuation Tracker Current

% Stocks Trading In Bottom 30 Percentile of Historical Valuations

Apr-19 Mar-18 Mar-17 Mar-16 Mar-14 Mar-12 Mar-09

Edelweiss Broad Market Universe 45%** 33% 28% 48% 24% 44% 68%

Price Performance- 2 Yr. CAGR 10% 18% 11% 21% 42%

Automobile & Ancillaries 63% 28% 28% 61% 17% 17% 44%

Financials 52% 33% 4% 71% 35% 78% 87%

IT 30% 17% 65% 35% 17% 48% 86%

Capital Goods & Infrastructure 46% 40% 29% 44% 8% 46% 79%

Pharmaceuticals 32% 32% 54% 39% 21% 43% 62%

Consumption Durables & Apparels 33% 33% 27% 27% 33% 47% 62%

FMCG 53% 30% 37% 30% 37% 37% 52%

** 45% stocks out of the 293 stocks that we track are trading in the bottom 30% percentile of their historical valuations

*Relevant valuation parameters have been used for each sector

*Edelweiss Broad Market Universe: 293 Stocks.

Source: Bloomberg, Edelweiss Professional Investor Research


Given the expected reforms and a general turnaround in the economic cycle, we remain bullish on the markets. Multiple forces

will be at play and we believe reflationary forces will form the backdrop of the next growth trajectory. Mid-Caps remain our

preferred space with a room for significant rally going forward.

Undervalued Overvalued

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Mid-cap Index Historically Outperforms After Election Results

Midcap/Nifty

-29.15%

-27.52%

-27.54%

Election Result Dates


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Edelweiss Professional Investor Research 12

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