Make a switch to Financial Assets

By Nimesh Shah
Managing Director & CEO
April 2nd, 2014
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After a dismal macroeconomic scenario prevailing since the last couple of years, we are now witnessing a gradual improvement in the economic environment. This improvement is noticeable in declining trade deficit primarily due to decline in imports, fall in the current account deficit to 0.9% of GDP (Gross Domestic Product) in QE Dec 2013 from a high of 6.5% of GDP in QE Dec 2012, deceleration of Wholesale Price Inflation (WPI) and Consumer Price Inflation (CPI).

Inflation, which has been stubbornly resisting decline, has now started yielding to reversal in vegetable prices and an improving CAD (Current Account Deficit). Headline WPI which had touched slightly below 12% in Feb 2009 now stands at 4.3% in Feb 2014. A cautious RBI (Reserve Bank of India), which has until now preferred inflation control over growth, is also closely monitoring the gradual decline in inflation rates, brightening the possibility of reduction of interest rates in the near future.

Steady improvement in these indicators coupled with a probabilistic scenario of a stable government at the center post-elections in May 2014 will now shift the focus to economic growth.

Two key aspects that bode well for India’s economic growth are its urban sector growth and infrastructure development. India’s urban sector, which constituted about 45% of India’s GDP in the 90’s, today constitutes about 63%. This has been an important impetus in India’s economic growth over the last decade. With increasing urbanization from the present modest rate of about 31% of India’s population, this will only accelerate in future. While so far, there has been focus mainly on rural growth, this will shift to urban growth especially in relation to urban consumption, services, employment and infrastructure.

To facilitate economic growth, improving infrastructure will be one of the top priorities of the government. Higher spend in this area will increase employment, consumption and savings. In addition, this will provide further impetus to policy reforms.

Policy reforms that are underway, such as liberalization of FDI (Foreign Direct Investment) limits in telecom and defense, allowing FDI in multi-brand retail, civil aviation, broadcasting, reduction in fuel subsidies due to increase in diesel prices, divestments in PSUs and passage of the land acquisition bill and the pension bill will also give a fillip to business sentiment.

A combination of improving macro-economic indicators, focus on growth and an imminent reduction in interest rates clearly indicate a case for investing in equity and debt.

Let’s first consider the case for equity investing.

The Indian stock markets (as represented by the S&P BSE SENSEX index) touched a high of 21,200 in Jan 2008 and after over six years, has now crossed that level (in Feb 2014). Meanwhile, during this same period, earnings of the 30 leading companies that comprise the SENSEX have grown from Rs 833 crore to Rs 1,295 crore i.e. a rise of 55.5%. Market capitalization of the Indian stock market (aggregate value of all listed companies) as a percentage of Gross Domestic Product (GDP) which stood at 103% in 2008 now stands at a mere 60% of GDP.

Furthermore, within the equity markets, while the SENSEX comprising large cap companies now stands fully recovered surpassing its previous highs in 2008, the mid cap and smaller companies, represented by the BSE MIDCAP index, has yet a long way to go providing very attractive investing opportunities vis-à-vis the large cap stocks. Compared to the SENSEX which had touched 21,200 in Jan 2008 and now has surpassed that, the BSE MIDCAP which was had touched 10,113 in early Jan 2008 stands at only 6769, yet 33% below its previous high! Clearly, the mid and small cap space provides a strong case for equity investing for significant capital appreciation.

During the last few years, Indian investors have steadily increased their investments in physical assets such as real estate and gold. With indicators now clearly favoring equity especially in the mid and small cap space, investors must return to equities in order to participate in future gains.

With respect to debt investing, as stated earlier, the need for economic growth will compel RBI to reduce interest rates.

In the span of the last 11 years (2002 onwards), interest rates have fluctuated between 10.4% to a low of 4.75%. Whenever interest rates have moved up, economic growth has suffered and at 9% plus, the RBI intervened to bring it down. Interest rates were gradually reduced between 2002 and 2004 (from over 10% to under 5%) and again in 2008, from approximately 9% to under 5%. With inflation (both WPI and CPI inflation) expected to remain significantly lower in FY 15(WPI: 4.5-5%; CPI: 7-7.5%) than the levels in FY 14, a lower CAD at about 1.5% of GDP, which in turn, would result in a stable currency, and moderate credit growth, all bode well for lower interest rates in times to come.

Now that the government has successfully managed to bring key indicators under control, they now need to provide a positive push for economic growth. For the year ended March 2013, the Indian economy grew at a dismal rate of 4.5%, the lowest growth rate over the last decade; the country will need to grow at a rate of about 5-5.5% over the next few years to regain lost ground. For growth to take place, companies need to borrow to set up new projects, which, in turn, will increase employment, and result in a higher growth in trade. However, currently companies are unwilling to borrow at the current high rates of interest; doing so will make their projects unviable. Clearly, the need of the hour is to reduce interest rates to trigger economic growth.

Not only do historical indicators show that reduction in interest rates is imminent, other indicators make this expectation even more convincing.

With the hope that crude prices remain in control and there are no geo-political events that may adversely impact growth, policy reforms, decline in interest rates, repair of government, corporate and bank balance sheets, kick-starting of the investment cycle within the overall framework of a decisive and stable government at the center portends the start of a secular bull run providing attractive opportunities for an equity investor with a 3-to-5 year investment horizon and also to debt investors resulting from declining interest rates.