Budget 2018: Populist, but no evidence of profligacy

There is little doubt that finance minister Arun Jaitley presented the Union Budget with an eye on the 2019 general elections. Politically, the rural sector has assumed disproportionate importance after the Gujarat elections and the recently concluded Rajasthan bypolls. Therefore, the government’s need to woo the rural electorate with special emphasis on farm incomes is understandable.

The budget focussed on rural India—particularly the agrarian economy—and the less privileged, but the government did not succumb to demands for free cash incentives, farm loan waivers or universal basic income. While shades of populism are visible in the budget proposals, there is no evidence of profligacy. The headline fiscal deficit target of 3.3 percent of GDP for FY19 is broadly in line with the consensus, while the market borrowing targets are lower-than-consensus.

The imposition of a 10 percent tax on long-term capital gains (LTCG) on equity investments and on income distributed by equity-oriented mutual funds is being perceived as a negative development. While the immediate post-tax earnings on such investments might be lower, the long-term prospects of the Indian economy remain intact; as corporate earnings resume their growth path, so would stock prices.

The LTCG tax will not have much of an impact, as post-tax returns on long-term equities will always be higher. However, that impacts short-term sentiments. We believe the quarterly corporate numbers are going to be better and those will improve investor sentiments.
I believe we are in a multi-year, structural bull run and equities will continue to deliver higher post-tax returns than other asset classes. While I would have liked the exemption on LTCG gains to continue for another five years, the government needs to raise revenue to fund its expenditure, and this is perhaps a relatively painless manner of doing so.

On the direct taxation front, there have been no other increases, save for the 1 percent increase in cess.

Regarding GST, we should quickly move towards the goal of a truly one-India-one-market. Not only are inter-state tariff barriers being dismantled, the physical infrastructure for efficient movement of goods and people across the country is also being enlarged through initiatives like DFCC (Dedicated Freight Corridor Corporation) of India, Sagarmala and Bharatmala.

There is a growing realisation among Indians that they need to begin paying their taxes. Post demonetisation, the government has been highlighting the rise in the number of people who file income tax returns. The GST framework is intended to significantly increase indirect tax compliance. It is perhaps with this premise that Jaitley has projected an all-time high tax-to-GDP ratio of 12.1 percent in FY19.

It’s evident that the government is laying a strong foundation for a vibrant India. The banking system, which forms the bedrock for economic growth, is being strengthened through continued focus on asset quality, recoveries and recapitalisation of state-owned banks. Recognising the fallacies of poorly-targeted subsidies that resulted in leakages and inefficient allocation of capital, India has been cutting subsidies in general.

Fiscal expenditure aimed at pump-priming the economy is seen as an opportunity to create national assets for long-term benefits. This is evident in the nature of projects taken under schemes such as MGNREGA. Though the main emphasis remains on providing employment, the aim is also to create durable productive assets.

The overall roadmap that the Narendra Modi-led government has built for India since it assumed power in 2014 remains unchanged. Yet, it has digressed from the deficit-reduction path set by its predecessor.

Despite the LTCG tax, equities will continue to deliver higher post-tax returns than any other asset class

Although the government was expected to postpone its 3 percent deficit target for the third time by one year to FY20, it has in fact been pushed forward by two years to FY21. A large deficit usually means inflation, and in turn, higher interest rates, which could be worrisome. How the promise of minimum support prices of at least 1.5 times the cost of crops impacts inflation is yet to be seen; rising crude prices could play spoilsport too.

Yields on India’s 10-year government securities spiked by 18 basis points after the Budget. Sovereign bond yields have risen every month in the last six months, the longest such streak since 2000. A rising interest rate environment does not bode well for corporate earnings, which have only now begun to revive after several quarters of disappointment.

Indian equities have been rallying since 2014 and scaling new highs, despite unmet expectations of an earnings growth revival quarter after quarter. Valuations have been running ahead of fundamentals, with the Nifty quoting nearly 20 percent above its long-term average trailing price-to-earnings (P/E) ratio*.

While the bull run has so far been driven by a multiple re-rating, the next phase will be earnings-driven. Global and Indian markets have seen a sharp pullback in early February. The overheated markets always had and will have serious corrections and that is what has happened.  

The quarterly results announced thus far indicate the beginning of the much-awaited earnings reversal. Next quarter, the earnings growth should be much stronger. However, how the earnings growth trajectory evolves beyond the next quarter will be influenced to a large extent by the trends in crude prices, inflation and interest rates, all of which appear hazy at the moment.

While I maintain that India’s long-term fundamentals remain intact, the journey for Indian equities is unlikely to be a smooth one. There will be periods of euphoria, driven by renewed hopes of a brighter future, interspersed with periods of gloom based on recurrent doubts over sustained growth revival.

Among the causes for cheer going forward could be better-than-anticipated earnings performance next quarter, continued global preference for equities, better-than-expected month-on-month GST collections, revival of private capex, and subdued inflation and interest rates.
Any concerns over global crude prices, adverse revisions in the government’s fiscal estimates, or possible spikes in inflation or interest rates could lead to periods of gloom. For long-term investors, I see no reason to panic and exit the equity markets, but neither do I advocate going overboard at any point in time.

(The writer is chairman and managing director of Motilal Oswal Financial Services)

*These figures were taken prior to the market correction in February