Chinese tightening, Fiscal Deficit and the markets

Chinese tightening could be the best thing for EMs

Over the last several months as most central bankers across Emerging Markets have started on the path of tightening in order to control inflationary expectations, China the biggest contributor to the growth in consumption of most of the industrial commodities as well as Oil has lagged behind significantly in its tightening process. My view always was that in the absence of supply side flexibility in an economy like India the only way inflation will come off will be if China becomes serious about controlling inflation and also does that in right earnest by following up on initial moves aggressively. It now seems that this seems to be happening and as such we could see that inflation in India will get controlled at a rate faster than projected over the next few months. Initially most people, including the RBI had expected the inflation to cool off to around 5% by March. However the significant increase in food product prices due to a variety of reason (mainly weather related) actually led to inflation picking up instead of cooling down. Now the scenario could be exactly opposite of the last six months where most forecasters project that inflation will be sticky and actually we might see it coming off much faster.

Crude, steel and other industrial metal prices are unlikely to rally further given the tightening cycle across EMs and the fact that the severe easing cycle across the developed world will now finally come to an end after QE2 gets over. Already we see murmurs of inflationary concerns from the ECB and I believe that the US Fed will eventually need to move away from the accommodative stance sooner than later. Already we have seen that the US 10 year bond yields have moved up from 2.5% at October end to 3.75% as of today. This is despite the significant treasury purchases by the Fed. Technically the US 10 year bond looks to be moving up to at least 4%. This will have significant negative impact on both the US Government finances as well as the Fed’s balance sheet. The increasing servicing cost of the US Government borrowings will put a severe stress on the budget deficit and the ability to carry on with the fiscal stimulus. I wonder who is going to take the loss of the securities on the Feds balance sheet as and when they are unwound at a significant loss. Will it flow through to the Federal governments accounts? The steepening yield curve in the US clearly indicates that the market believes that the recovery is on its way. If the unwinding of the fiscal and monetary stimulus does not start soon enough the US economy will be starting at stagflation in not too a distant future. Anyways these are thoughts for a different subject which can be debated at length.

Interesting statistics and analysis on the Fiscal Deficit

As per my trend analysis of Indian government finances over the last 10 years and the reported revenue and expenditure figures till the end of December it looks likely that the fiscal deficit for the current year might be more near 4% as against market expectations of 5%. It might be difficult to believe at this stage; however it will require an abnormal amount of spending by the government in the last two months of the year to take the fiscal deficit higher than this.

The first contributor to the lower fiscal deficit is the change in the denominator i.e. the nominal GDP figure. As against expectations of around Rs 69 lakh crores the actual number is more likely to be between Rs 76-78 lakh crores. Now I present below the statistics for the last 10 years in which except for the years of the economic crisis when taxes were cut and revenues went down the fiscal deficit for the last 3 months has been in the range of 30-50k crores. It was more near Rs 1 lakh crores over the last two years.

The Gap between revenues and expenditure for the last 10 years starting 2001-02 for the last three months of the fiscal year i.e. January to March are as follows

2001-02 Rs 42707 Cr

2002-03 Rs 58378 Cr

2003-04 Rs 33525 Cr

2004-05 Rs 37736 Cr

2005-06 Rs 38014 Cr

2006-07 Rs 47936 Cr

2007-08 Rs 52236 Cr

2008-09 Rs 111852 Cr

2009-10 Rs 102327 Cr

2010-11 Rs ?????

In the year 2008-09 the total revenues of the government fell by 6% and expenditure went up by 25% and in the year 2009-10 the revenues went up by around 10% and expenditure by around 15%. (These were the two years of fiscal stimulus post the meltdown of 2008).For the first 9 months of the current year the expenditure of the government has gone up by just around 10% and revenues even ex of the telecom license revenue are up by over 20%. For the government to achieve a 5% fiscal deficit they will need to spend Rs 210000 Crores over and above their revenues in the period January to March 2011 which seems to be extremely unlikely. The gap between spending and revenues is unlikely to exceed Rs 100,000 Crores in my view as revenue growth continues to be strong. Let’s say that the government budgets for SBI rights issue, add ional fuel and fertilizer subsidy etc also the total gap cannot exceed Rs 140000 Crores.

If this hypothesis is true then the actual fiscal deficit should be between 3.7-4.1% of GDP.

I hope that my analysis has been understood for its logic by everyone. If this holds true then it would be very bullish for bond yields as well as the markets.

Market view

We had expected the stock markets to stabilize at levels of around 5400-5500 and form the base for the next up move. However large scale negativity surrounding the policy issues of the government as well as the inflation scare has kept the Indian markets weak in the near term and India has become one of the worst performing markets over the last three months. The correction that started almost exactly three months back has resulted in the Indian markets in terms of the Sensex and Nifty correct by around 18% from the top and the Mid cap indices correct by over 30% in the same time frame. The key for us is to analyze logically where markets will stabilize and what’s the outlook over the next one year.

At this point of time it is very difficult to be excessively negative on the markets as economic growth continues to be strong and inflation although a concern is largely a transitory phenomenon for the longer time frame. The excess global liquidity that has flown into commodity hedge funds and caused the kind of rally in commodities that we have seen over the last several months is unlikely to sustain for a prolonged perio
d of time.

Although initially inflation pressures came into higher growth economies like India, China and Brazil it has eventually started flowing into the developed world also. China has now become serious about controlling inflation and the European Central Bank has also started talking about inflationary pressures building up. The investors that are preferring the developed world markets which are essentially on the dual steroids of monetary and fiscal stimulus are extremely myopic in my view and the trade of underweight emerging markets cannot sustain for a prolonged period of time. Emerging markets which have already started the cycle of monetary and fiscal adjustment are better placed for the longer term than the countries of Western Europe and the US which will need to face up the prospects of scaling down their stimulus sooner than later. This cycle is likely to begin sometime later in the year and as that starts we will see commodity prices stabilizing and growth plateau in these countries. However by that time the emerging economies would have adjusted their inflation and growth cycles and will be better placed to grow with lower inflation over the next 3-5 years. Till six months back India was the darling of global investors and had got the maximum inflows in the year 2010. The beginning of the year saw most consensus forecasts for year end Sensex and Nifty at 24000 and 7400. Now following the market movements most people have come down to levels of 16000 and sub 5000 for the Nifty in the short term.

Over the last 3 months the US and European markets are up by 8-10% and India is down by 18%. The problem normally is that most investors extrapolate today into the future, however the best returns are made in adversity and as such I believe the next few days and weeks are the best ones for investing into India.

The key for investors today is to evaluate how things will be a year from now and not how things look today and also whether the relevant concerns have already been factored into the markets as they have performed over the last few months. I believe that 12 months hence when we sit and analyze the markets headline inflation could be 4-5%, the government would be more stable as the scams and governance issues will be behind us, growth outlook would be looking much better and the situation will be sanguine for investments. Mid cap company stock valuations have come down to extremely attractive levels and a large number of established and high growth mid cap companies are today available at single digit multiples. Similarly large cap valuations have also compressed significantly.

I believe that the downside to the markets is extremely limited at this stage. There is unlikely to be any large scale sell of Indian equities by global investors given the fact that equity as an asset class is expected to be the preferred asset class over the next couple of years. Although it is difficult to quantify the exact downside to the markets at the time of panic sell offs the downside in the worst case seems to be 5100-5200 for the Nifty and 17000-17500 for the Sensex. The correction in the markets is just part of a mid cycle bull market correction which should culminate over the next couple of weeks.

As such I do not believe that this is the time for investors to panic as the growth outlook and market outlook looks positive from here on.