The evening of 8th November 2016, became a historic one for India when the Prime Minister announced that Rs.500 and Rs.1,000 notes would no longer be legal tender effective from that midnight. The implications of this announcement dawned on the citizens right away – Black Money would not be tolerated. The next morning, the stock market reacted swiftly to these developments.
Black Money has been a stumbling block to the Indian economy for a long time. Unfortunately, this ‘shadow’ monetary system has only increased over the years. When the current government came into power, tackling this issue was one of the important items on its agenda. The reasons were several – bringing this unaccounted money back into the main system, arresting counterfeit, and most importantly, curbing use of this money for terror activities.
Size of demonetization
The Indian economy has one of the highest interest rates in the world arising from the high level currency in circulation. It is estimated that the amount held in Rs.500 and Rs.1,000 notes in the economy is about Rs 15 lakh crore. Even if a portion of this money enters the banking system, it can help reduce interest rates significantly in the next few months. This will bring liquidity into the system and help reduce interest rates while helping restart several stalled projects and reviving the capital expenditure cycle from the following year. Not only will conversion of black money stimulate economic activity, it will also provide an impetus to financial markets by shifting investments from physical assets to financial assets.
Impact of Demonetization on Investments
Equity: Time to buy with a two year view. There is a general belief that the economy will suffer due to lack of consumption demand. While this is partially true for the near term, the reality is that it can be positive for the economic growth in the medium to long term. Unlike the Brexit times, where the reaction and the recovery time was instant in both the debt and equity market; we are of the view that the reaction time of demonetization may be prolonged.
After the ongoing correction, the outlook for equities has improved significantly. Even though in the near term it would be difficult to point when the equity markets will find their bottom, we are recommending retail investors to spread the investment between now and March next year, atleast in the case of equity investments. We may see volatility in the near term, but over the next two years, corporate earnings are expected to grow, which, in turn, may re-rate the markets. We recommend investors to consider investing in large caps, multicaps and infrastructure funds.
Debt: Returns likely to be front ended
As stated before, the demonetisation step will lead to more money coming back into the banking system thereby improving the system liquidity. The immediate result of this can be visible in Government securities yields in the medium term. As a result of higher liquidity, the Reserve Bank of India is mostly likely to cut interest rates, earlier than expected. This would stimulate the monetary cycle, which can lead to the fiscal cycle playing out.
This cycle will make fixed income investing appear attractive from a valuation perspective. We recommend investors holding on to their debt investments over the next six months in order to ride the entire cycle of falling interest rates. For those investors who have been sitting on the fence, we advise immediate investment in fixed income as returns are expected to be front ended. One must not hesitate and delay this investment since the opportunity may shift quickly. We recommend investors to stay invested in long duration funds. For new allocations one could consider investing in dynamic duration funds and short term accrual funds immediately.
To conclude, the opportunity continues to remain in financial markets. It's just that its door has opened wider, be it for debt and equity.
This article was published on November 26, 2016 in Business India