Its election season again. As India gears up to choose the next government, equity markets make new highs in the hope that elections will throw up a 'decisive' mandate. There appear to be three expectations that are driving market performance. First, the expectation that a new right wing government will come in with a decisive mandate and help resurrect India's economic growth. The next assumption is that inflation will fall and consequently interest rates. Finally, this will lead to a resumption of investment activity by the private sector. Let's look at the likelihood of these happening.
Political stability-does it help economic growth?
A commonly held misconception, often repeated by popular media, is that political stability leads to faster economic growth. The Indian experience is completely at variance with this. Readers will remember that pre 1992, we had single party governments for the most part, with extremely poor track record of growth. The first minority government to survive its term in India was Narasimha Rao's government-that heralded a dismantling of controls-and unleashed economic growth. Since then, we have had higher growth than in any decade earlier. This also coincided with a period where we have always had coalition governments.
A recent report by JP Morgan (JPM) highlights that not only does the economy grow faster when the largest party is a smaller part of parliament (JPM defines index of political stability as ratio of largest party/parliament size), more stable governments have a poorer record in inflation management. The data suggest that contrary to popular belief, relatively unstable coalitions work better at growth and inflation management. As they say-be careful what you wish for, your wishes may be granted.
Can investment cycle revive?
The investment cycle in India went through a major up tick since 2004-peaking in 2012. This also coincided with increased demand partially fuelled by easy money. The shock in 2008 led to a demand slowdown, but with liquidity injections by global central banks, the slowdown did not last. Domestic factors have led to a decrease in investment post 2012. Policy issues with regard to land acquisition, environmental clearances, and mining rights led to large number of projects being stalled or shelved (see charts).
Can some quick decision making-the kind we have seen in the past few weeks by the existing government help revive the cycle? Recall that most infrastructure projects are sensitive to delays as they are usually heavily leveraged. Delay in project implementation can often lead to permanent unviability. In addition, with demand slowing, some projects may remain unviable even after debt restructuring. In essence, with weak demand leaving large capacities unutilised, it appears unlikely that investment demand will revive soon.
Inflation may be more difficult to control
High inflation and poor growth implies an economy that is operating near its peak capacity. India has grown at a more rapid pace in the past without the same levels of inflation. What explains this stubborn inflation and a weak demand scenario? Clearly, India's output gap-the difference between what the economy is capable of producing and what it currently produces-is not very large. As alluded to above, policy issues have constrained new capacities and reduced productivity of capital and labour. Consequently, demand revival could easily lead to another bout of inflation.
Un-seasonal rainfall in recent weeks will put paid to expectations of a good summer crop and food inflation may reappear. If demand were to revive, corporate India will attempt to restore margins-which would be inflationary. Given the recent stance of RBI to target CPI, it is unlikely that interest rates will fall in a hurry.
Investment in cyclicals is perhaps premature
Of late, interest rate sensitives like capital goods and banks have rallied smartly. However, this strategy is fraught with risk. The assumption that capital expenditure will rise is premature. No matter the government, it is unlikely that private sector capex will witness a major up tick in the next 6-12 months. In addition, demand revival carries with it seeds for sustained inflation and increasing CAD. On the other hand, weak demand will result in de-rating of markets.
The market appears to be trading at relatively inexpensive valuations. However, it has to be kept in mind that corporate India is also generating the lowest return on capital in over a decade. Therefore applying mid cycle multiples at cycle low earnings already discounts the turn-around that we are yet to see. For investors entering now, the investment horizon has to increase to at least two years to expect reasonable returns. In any case, investing in cyclicals can at best be a tactic, not a strategy for now.
Anand Tandon is an independent analyst.