India in 2018/19: Balancing priorities
- Cyclical forces and structural changes have hurt India’s growth; markets have been well supported
- The divergence between the soft real economy and buoyant financial markets may not persist in 2018
- Macro risks have risen; we expect slower growth of 6.6% in FY18, before improving to 7.2% in FY19
- We expect modest INR weakness because of oil; conditions are becoming less supportive of INgov bonds
- We recommend holding Indian stocks as a neutral weight in the context of an Asia ex-Japan allocation
This is an excerpt of a more detailed deep-dive into India which we issued today. For the PDF of the report, please scroll to the bottom of the page or click on the tab on the right.Cyclical forces (twin balance-sheet stress and weak trade) and structural changes (expedited formalisation) have hurt India’s growth in the past few years. Real GDP growth slowed from 7.9% YoY in April-June 2016 (i.e. Q1 FY17) to a three-year low of 5.7% in Q1 FY18. Incoming data has been pointing to some stabilisation in Q2 FY18 on restocking demand and better consumption before losing momentum again into Q3. With businesses still adjusting to the goods-and-services tax (GST) regime, slow progress in corporate deleveraging, and limited room for fiscal support, we have nudged down our FY18 GDP forecast to 6.6% YoY from 6.8% previously. This compares to 7.1% for FY17. The central bank’s preferred gauge is the GVA (gross-value added), under which growth is likely to stand at 6.4% vs 6.6% in FY17.
Markets, supported by surging foreign direct investment and fixed income capital inflows, as well as record domestic flows to equities, have been well supported.
The divergence between soft real economy and buoyant financial markets may not persist in 2018/19; the economy could bottom out on the heels of a strong global economy, or markets could turn impatient if growth remains muted.
On the economic front, FY19 will see the government play a balancing act between reviving growth whilst maintaining its macro-stability credentials. The recent rating upgrade from Moody’s was a big boost to sentiment and is likely to lower offshore borrowing costs for Indian companies. But, it comes at a time when risks to India’s macroeconomic environment have risen compared to the past three years. Inflation is expected to edge up on higher commodity prices and stronger demand momentum, whilst the current account and fiscal deficits run the risk of re-widening. These will test the economy’s resilience against any unexpected event shocks, at a time when global tailwinds (oil and liquidity) look set to reverse.
We expect the economy to recover to 7.2% YoY in FY19, from a likely 6.6% in FY18. Consumption is expected to drive this revival as households benefit from higher wages and allowances, along with benign inflation and wide real rates. GST tweaks will help lower the tax incidence on consumers. Lead indicators, including auto sales and personal credit growth (for urban spending), as well as non-durables output (rural demand) are expected to improve.
The government has been on a fiscal consolidation path since FY12/13; the deficit was lowered from over 5% of GDP to 3.5% of GDP in FY17. Plans to trim it to 3.2% this year will be challenging due to weak non-tax revenues, high oil prices, and the need for government spending support. If the government sticks to the target, it needs to scale back expenditure as a precaution to any shortfall in revenues. Conversely, tolerating a modestly higher deficit target will be growth-friendly. We believe that the market’s pain threshold for the FY18 deficit is 3.5% of GDP, the target met in FY17. Adopting this target could open the door to widening the deficit to 3.2-3.3% in FY19, from the 3% recommended under the fiscal-consolidation roadmap.
We expect CPI inflation to rise from 3.2% YoY this year to 4% in FY19. Apart from a pick-up in food prices, oil prices are expected to feed into input prices while firmer demand lifts inflationary expectations. These factors will be partly offset by the fading impact of housing rent allowance increase and GST-related changes.
Concurrently, the inflationary impact from high oil prices, bank recapitalisation measures, and fiscal slippage risks are also under watch. Global central banks are mulling moves to normalise monetary policy. The US Federal Reserve is expected to hike thrice times in 2018 and twice in 2019. Hence, the RBI is likely to refrain from further rate cuts and keep rates on hold over the next year. In fact, rate hikes may be necessary in late FY19 if growth surprises on the upside and pushes inflation above its 4% target.
The Indian rupee will no longer be resilient to US interest rate hikes in the coming two years compared to 2016-17. We expect the INR to depreciate towards 67 and 68 against the USD in 2018 and 2019, respectively.
Externally, the INR will lack the support from a weak USD seen this year. Unlike the past two years, we expect Fed hikes in 2018-19 to be accompanied by higher (and not lower) US long bond yields. Apart from US growth rising above its post-crisis average, we are projecting the Fed Funds Rate and the US 10-year Treasury yield to rise above 2% and 2.75%, respectively next year. Fed hikes from December will be accompanied by an unwinding of the Fed’s balance sheet at an incremental pace. In addition to pushing for tax cuts, US President Donald Trump has been filling the Fed Governing Council with his nominees to roll back some of the bank regulations enacted during the financial crisis.
Conditions are becoming less supportive of India government bonds. After steepening (2Y/10Y segment) by over 50bps since early 2017, we expect the INgov curve to largely level shift higher in the coming quarters.
The unwinding of excess banking system liquidity since March (after the initial surge from the demonetisation programme) has been a headwind to INgov bonds. This is reflected in the 10Y yield spread of INgov bonds over comparable US Treasurys. The unwinding of excess liquidity is about 80% done (comparing the peak of excess liquidity to neutral) and we expect this measure to turn neutral by the 1Q18.
Curve steepening has already taken place with the 2Y/10Y spread touching 63bps, levels not seen since 2012. The current spread is close to the top of its seven-year trading range as shorter-term yields stay anchored by accommodative monetary policy. Noting that the curve has steepened tremendously since the start of the year, we are reluctant to continue chasing this trade. Meanwhile, shorter-term yields are rising modestly, but have yet to fully reflect monetary tightening risks. INR swaps point to a hike by end-FY19 (DBS has two hikes pencilled in). We reckon risks to 2Y INR rates are tilted to the upside amid the grind higher in oil prices. 10Y yields also breached technical resistance at 7%, paving the way for a revisit of 7.5%.
We believe the positive sentiment driven by Prime Minister Narendra Modi’s reforms are sufficiently priced into the Indian market and investors will need to take a reality check to assess India’s fundamental conditions for 2018.
There’s no doubt domestic stock market liquidity continues to be strong. Domestic investors’ active participation in the market is demonstrated by the rise in mutual fund flows and the outperformance of mid- and small-cap stocks over large caps. Domestic flows could continue to be positive until there is a sufficiently big shock to derail the momentum. On account of a heavy election calendar through 2018/19, we believe domestic sentiment is likely to be positive.
We recommend holding Indian equities as a Neutral weight in the context of an Asia ex-Japan portfolio allocation. Main investment themes are the revival of the rural economy, consumption, and banking-sector recapitalisation; the accompanying risk is the return of demand-pull inflation.
To read the full report, click here to Download the PDF.
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