India Equity Research: J. P Morgan - Government Expenditure and Equity Connect

Indian Equities Government Expenditure and Equity Connect

· Sectors with expected earnings support outperformed last week

· Earnings season started with the trend of positive surprise for the global sector and disappointment for local

· Disappointing growth indicators continue; the last leg of faster policy clearance starts

· Outlook on agri-inflation seems to have improved

· FIIs turn marginal sellers of equities; Suuti stake sale expected to support INR

· The best three consecutive years of equity performance since 1991 coincided with the slowest growth in Government expenditure

Caution rules. Last week’s surprises were on expected lines from a macro perspective. Growth indicators disappointed. Earnings season started with a beat from the global sector companies and a miss from domestic sector companies. The net effect was Sensex ending flat supported by global sectors and Consumer Staples. Domestic cyclicals and high beta names underperformed for the second consecutive week. The week ahead is expected to be more eventful with an important inflation print and quite a few important earnings reporting by TCS, Reliance, ITC, Wipro, HDFC Bank.

PMI services dips, IP declines. Growth moderation seems to be broadening to services and consumption. December PMI services fell to 46.7 vs. 47.2. November IP declined 2.1% oya led by a sharp moderation in the Consumer durable segment. For the festive quarter (October to December), car sales declined 6% oya Two-wheeler sales were relatively higher and increased 10% oya. Government’s final attempt before the national election seems to be accelerating but the real impact will have to wait, in our view. Government approved POSCO’s long pending environmental clearance last week.

Agri-inflation outlook improves. Inflation indicators, especially linked to agriculture, suggest lower inflation prints ahead. Besides the sharp correction in vegetable prices, MCX Agri commodity spot index has corrected 9% over the last quarter. Sowing in Rabi crop has increased 5.5% oya and is expected to keep fundamental price rise under check. Consensus expectation of today’s CPI print is 10.1% oya. Also, Friday’s disappointing non-farm pay roll in the USA did result in a meaningful 11 bps softening in US ten year yield to 2.86%. In India, one year swap curve currently is 8.40% vs. the current Repo rate of 7.75%.

Suuti support for divestment program. Last week, the Union Cabinet cleared the hurdle for the Suuuti stake sale. Suuti has stakes in ITC, Axis Bank and L&T. Higher dividends from large PSUs are also expected to support Government’s funding gap.

Quarterly earnings starts. 3Q earnings started on a positive note with Infosys surprising positively. Infosys management reiterated that global growth is improving. Indusind Bank, on the other hand, disappointed on NPAs. One of the most important trends in the corporate earnings would be margin performance as outlook on revenue growth acceleration remains muted. Analysts’ expectations on the margin front seem to be stabilizing. We highlighted in our earnings preview note (3QFY14 Earnings Preview: Global Lift; dated 8 Jan 2014) that excluding Cement, most industries are expect to report an improvement in EBITDA margin compared to last year.

FIIs turn sellers, mutual funds witness subscription into equity schemes. FII were marginal sellers of Indian equities in the Cash market (US$ 61mn) last week. India was an exception as most other markets saw net inflows, led by Korea and Taiwan. The impact of a weak US payroll data on near-term flows remains to be seen. EMBI spreads did widen by a marginal 10 bps last week. At home, DIIs were marginal sellers. Mutual funds led the selling. Interestingly, for the second consecutive month, we saw net subscription into equity schemes. Retail selling pressures could be abating. Last calendar year, we saw five months of net subscription.

Government spending and equity market connect. The concerns on India’s twin deficit and adverse impact on equity performance has increased over the last three years. The Finance Minister surprised markets positively by with a lower-than-budgeted fiscal deficit last year (4.9% vs. 5.2%). For the current year, indications are that the budgeted target of 4.8% won’t be breached. There are valid concerns that a cut in the “non-plan expenditure” is likely. A sharp cut in expenditure when growth is already weak won’t be supportive of earnings outlook here. How does a reduced growth in Government expenditure influence equity performance? See below a few relevant points:

· Government expenditure increase has averaged 12.7% oya over the last two decades vs. an average nominal GDP growth of 14%. This has resulted in a lowering of expenditure as % of nominal GDP from 18.2% to 15.1% during the period.

· The relative size of revenue expenditure pie has increased while that of capital expenditure has reduced. The trend is arguably not so encouraging at the current stage of India’s economic development. This combined with lower private sector capex is a risk for India’s potential growth rate.

· Government expenditure and equity market performance do not show a statistically significant linkage. But the impact of government expenditure on inflation, rates and financial savings available for the private sector makes it “qualitatively” a significant driver for broader growth and also for equities.Interestingly, the best three years of equity performance over the last two decades – FY04 to FY07 – also witnessed the lowest three-year average growth in Government expenditure. Of course there were other drivers also supporting the strong performance of equities. That was a phase of buoyant corporate confidence and higher investment activity. The next government will have a challenging job of reviving growth through increased private sector investments.

Figure 1: Government expenditure and Sensex return