Govt policies do not ensure returns in the short term: Govindarajan Chellappa, Jefferies India

In a chat with Nikunj Dalmia of ET Now, Govindarajan Chellappa, HoR, Jefferies India (by Nikunj Dalmia) explains how linkage between commodities and the Indian markets is under-appreciated

Nikunj Dalmia: Talking about three Cs - China, currency and commodities - frankly there is nothing new about the global data point yet markets are so nervous that something has really gone wrong.

Govindarajan Chellappa: To start with, there is an increasing correlation amongst various asset classes. As a result, chaos in one place transmits to other markets immediately. But I think that there are several fundamental linkages as well. While linkage with China is fairly well discussed, I personally think the linkage between commodities and the Indian markets is under-appreciated. We have seen and overanalysed the positives of lower commodity prices. So what it does to our fiscal through lower oil prices is that it apparently adds billions of dollars in consumers hands. Statistically speaking, from three years to now, we probably have gained about $70 billion as a country through lower oil prices. Of this, about $45 billion has been retained by the government, may be $5 to $6 billion by the oil companies and the rest have gone to consumers. It may not be a very large amount but consumers have still gained. This is the positive story that we have discussed analysed. But there are also negative effects of lower commodity prices which are starting to play out now.

The most important of the negative languages is between global agricultural commodity prices and rural incomes. When we look at rural incomes and especially the agri part of the rural incomes, we talk about rainfall and how bad it has been over the last couple of years. We also talk a lot about MSPs which honestly is fairly irrelevant. But very little analysis has been done on the impact of global commodity prices on local prices. About 6 per cent to 7 per cent of value of production of agriculture is what is actually influenced by MSPs. Its meant to be about 28 per cent but in reality it is only 6 per cent-7 per cent. There are 17 commodities that get MSPs, of which only two are actually implemented which is rice and wheat. Only one-third of actual output is bought by the government, the rest is free market price which usually trades in line with the landed cost. So affectively 6 per cent of total value of production of agriculture is determined by MSPs. However, almost 50 per cent of the entire value is exposed to global prices. It is not linked on a daily basis but look at agriculture in every major state. For example, in Madhya Pradesh, soya is the most important crop there it is almost entirely linked to global prices. Gujarat cotton, Maharashtra cotton and sugar, Kerala rubber, Uttar Pradesh sugar...every state has one or two large cash crops which takes the price cues from the global prices and part of the reason why we have agricultural and rural distress today is because those prices have been very weak for the last three years in rupee terms. Labour and fuel costs have gone up over a three year period. If profitability of pharma is squeezed because of lower agricultural prices globally, that is the first linkage. The same linkage also impacts consumer demand on rural areas. The third impact is on politics. We may see signs of this linkage in the upcoming budget, but you will see more and more electoral results being determined by what is happening in the rural economy. There nothing that the government can do but that is the way it works.

The second linkage is through capital expenditure of metal companies. Almost a fourth of capex of corporate India is by metal companies now. I am not including infrastructure including oil and gas because that is a little more complicated. Now the kind of profitability that metal companies have today, I find it hard to see how they can invest in capex even in maintenance capex forget expansion.

The third linkage is obviously through the banking system, we know as of September 2015 12 per cent of stressed assets was from metals.

Nikunj Dalmia: Largely steel.

Govindarajan Chellappa: Largely steel. The situation has probably gotten worse since then. The underlying reality is that exposure to metals is hugely stressed which is adding to the stress of the already bad balancesheets of public sector banks.

The fourth linkage, if it happens for the first time in several years, is through remittances. Now remittances have been a very very steady source of foreign currency income for us. It has been remarkably steady between 3 and 3.5 per cent for the last 15 years. It funds almost 75 per cent of current account deficit. Half of the remittances come from Middle East. With the kind of fiscal stress that some of the oil producing countries and Middle East are going through and talks of workforce shrinkage, it might translate into lower remittances for India with a lag especially if there are job losses.

Nikunj Dalmia: So the flow of money from NRIs working in the Middle East and sending money to home, is basically the remittances and that will come under pressure and it will change the CASA ratio for all the banks in the financial system.

Govindarajan Chellappa: Yes that is a direct impact but it also has a big impact on consumption. Kerala runs largely on remittances from the Middle East. Whole of coastal Karnataka, increasingly Uttar Pradesh and Bihar are also going also be affected and so it will have impact on current account deficit. It has an impact on our currency as well. So that is an important linkage. So far, India gets remittances amounting to $70 billion and Middle East accounts for $35-36 billion. That is the fourth linkage. The fifth linkage is the ability of the government to go ahead with the divestment programme. Most of its assets are anyway commodity linked that is why we keep seeing them postponing divestment target all the time.

So if you put all these things together, you realise that it is fine for crude to fall but it is not fine for other commodity price to fall. If I could choose I would say okay let only crude fall and everything else should appreciate but that is not the way it works. All commodity prices are falling and now there is an increasing recognition through the results of companies that there are other linkages that are starting to hurt us. So to cut a long story short, for Indian markets to do well from here, we actually need commodity prices to go up. It is not just a capital market linkage. Of course, there is a linkage between flows that go into commodities and emerging markets which usually are well correlated but even on a fundamental basis I would rather have slightly high commodity prices which will impact the fiscal deficit slightly negatively but does not have all the deleterious effect that it is having on rest of the economy.

Nikunj Dalmia: Now that is one side of the equation. The other side of the equation is that government is saving around $45-50 billion. That saving will be channelised back into the system to make more roads, give money to defence sector and railways would be spending more. Ao the multiplier effect of government spending could also surprise us.

Govindarajan Chellappa: There are two parts to my answer. The first one is that multiplier effect usually happens in a long term. What impacts the GDP growth today is the amount you spend on the rail road in the long term because of efficiency gains as better infrastructure will push up long-term growth rate. So for the moment let us stick to what happens to short-term GDP growth rate. Investment on roads and rails in the short term does not have multiplier effect in the short term. Second and more importantly, this perception that the government can drive growth, needs to have a serious reality check. The government is not a positive delta on GDP growth when its fiscal deficit is shrinking, government is a positive delta on economic growth only when the deficit expands.

Nikunj Dalmia: Because they are spending more…

Govindarajan Chellappa: The net spending does not look at only expenditure side or the income side but look at the fiscal deficit as well. If fiscal deficit expands, it basically means that the government is a positive delta on the overall GDP growth and when deficit is shrinking, they are a negative delta that has been the case in the current year. This year hopefully they will stick to the fiscal deficit target and therefore government is actually a negative delta on growth rate and this has been eloquently argued by Dr Subramanian in the mid-term economic review. This somehow has escaped the attention of most investors who still think that government is a positive delta. All that the government is doing is rechannelising some of the expenditure from one area to other, cutting subsidies but investing part of it in capital expenditure. Now going into next year, the ability of the government to rechannelise is actually going to come down because there is a big wage increase that is likely to happen. Now there are talks that it might get postponed or restructured. But if the committee’s recommendations were to be taken on board, next year you will probably be channelising government funds into wages of government employees which is a very very narrow stimulus given that there are 5 million central government employees and 4 million pensioners. So 9 million families will benefit but the rest of the economy will have to somehow pay for it if the fiscal deficit does not expand.

Nikunj Dalmia: We have discussed all the factors which could go wrong. Let us discuss some pointers which could go right. What could get right valuations? The fact that there is a chaos in the world and India would naturally benefit because we are still a service dominated economy, we still have sectors like IT and pharma? How do you defend that?

Govindarajan Chellappa: Well valuations are a fantastic tool for long-term investors but it is not a great tool for somebody who wants to make money in the short term. To look at several sectors and several stocks that have corrected enough for you to say it is a fantastic time to buy. I would say go ahead by many of these sectors with a full recognition that given the chaos in the world you might lose 20, 25, 30, 40 per cent in the short term.

Nikunj Dalmia: 20, 30, 40 per cent you are extending that number.

Govindarajan Chellappa: If you are talking about valuations, while there is chaos in the world, there is no sanctity in any number.

Nikunj Dalmia: What will it take for for financial Armageddon to happen?

Govindarajan Chellappa: I am not predicting one. I am saying in the event there is a chaos, valuation is a support in the long term but not in the short term. Second, there are certainly a lot of the things about the India story which is fabulous but it has been fabulous for several years. But obviously it goes through cycles but you mentioned two of the industries we actually like and this is partly because of our view on currency as well. Also because these industries exported to developed markets and do not face much competition from other countries which have much sharper currency devaluation. That is why I would be very worried about export of manufactured goods but I am not too worried about export of IT services and pharma which is mostly to the developed world. So IT and pharma stand out but in the medium term there are several other factors about India that stand out. I could start talking about a lot of jargons that the government talks about, be it Make In India, dedicated freight corridor or direct cash transfer. All these are fabulous themes to play on a 3, 5, 10 year horizon but these do not ensure returns in the short term.

Nikunj Dalmia: It can be proved on paper that macros, are great for us. Rates will come down, fisc is getting better, CAD is coming under control, gold import is down, but that has not translated into stock market return. In 2013, our macros were horrible, stock market return was great, the reverse is happening now

Govindarajan Chellappa: Let us see historical correlation in the last 20 years. For 17 out of 20 years, we have seen if commodity prices went up, Indian markets also went up. But there is a split between this linkage with that of the macro indicators. We have an index of fiscal deficit, current account deficit and inflation together because these are the three macro variables everybody follows. For 10 years, it is positively correlated and for 10 years, negatively correlated. From 2013 till now, we have done reasonably well in an environment where commodity prices have fallen which is against the normally established trend. But that happened because we started from an extreme. So when your deficits and inflation are at an extreme, then it starts to matter but if you are somewhere in the middle, it does not matter but if you are somewhere in the middle it actually does not matter. A 30-40 bps slippage in fiscal deficit next year, assuming it is for the right reasons, will not necessarily mean markets will do poorly.
Nikunj Dalmia: Looking at the global set-up, what is bothering us right now is the extreme selloff in commodity that can lead to a huge disruption in the commodity producing companies or countries. The financial sector may have escaped because they have ring-fenced the entire banks now. They are not allowed to buy propositions.

Govindarajan Chellappa: It is not a hypothetical question any longer. If you look at currencies of Brazil or Russia, look at what Saudi Arabia is trying to do with its currency peg, look at fiscal deficit of several of these countries, look at inflation figures in Brazil, you will see that it has already started to play out. We saw Nigerian currency move very sharply last couple of weeks so it is not a hypothetical question any longer. It started to impact the countries and companies that directly depend on commodities but the hypothetical question we need to ask now is how does it affect the rest of the world, how does the commodity move or the issues that Saudi Arabia is facing affect the consumer companies of India, it is hard to see the linkage but as you dig deeper the linkages are through remittances, they are through agricultural prices there are several linkages and those are the questions that we need to ask now that the question on what it does to those countries and companies I think it is answered by now, I do not think it is a question mark any longer.

Nikunj Dalmia Are we in an environment where liquidity is only going to get tighter? Will a situation come where sovereign flows will dry up and we could be staring at massive outflows?
Govindarajan Chellappa: The question on relative flows is easier to answer. Given our politics, reforms and our reasonable macro stability, it is fair to say that India will do better than the rest of the emerging markets on a relative basis. The absolute flows at this moment could even be called a disaster but capital flows change before I can wink. Six months back, if you had asked me what will happen to capital flows, our answer would be we probably would look like fools.

Nikunj Dalmia: What happened in the last six months that was so extraordinary?

Govindarajan Chellappa: The natural learning for us is it is better if we do not predict anything. I think we need to stick to how India has performed relative to other markets in terms of currency and capital flows.

Nikunj Dalmia: If I look at the history of bear markets or typical correction the markets will always overshoot, right now we are in line with what our earnings estimates are, in fact earnings estimates are still higher they have to be scaled down, so we can really overshoot on the downside if I look at the history of corrections?

Govindarajan Chellappa: Neither are the expectations too low, nor are the valuations too cheap which is reason I mentioned those big numbers of corrections could be 10-20-30 per cent. Again, I am not predicting those kind of corrections but if there were to be a fear, all pervasive fear, we neither have earnings support nor do we have valuations support. Valuation is slightly above average, on earnings estimate that are far above average, both bottom up and top down the index earnings for FY17 is forecast to grow anywhere between 17-20 per cent next year, which incidentally was the forecast for FY16 12 months ago, which incidentally was also the forecast for FY15 24 months ago, so we have always started with 15-20 per cent earnings growth and have kept correcting those estimates for that particular year but not changing the growth rate for the subsequent year. So yes, earnings estimates do have to come down. What is interesting is earnings estimates are coming down for all sectors. Every year if you look at the five years, there would be one or two sectors that escape it but almost all sectors irrespective of your perception about those sectors have had earnings corrections. For example, in last five years, consumer staples, have seen correction in earnings estimate, right. So no sector has escaped it, every year one or two sectors escape it, probably IT will be the one that is okay in terms of earnings estimate at this point in time, IT and pharma maybe.

Nikunj Dalmia: Why pharma? I am not referring to the regulatory problems that could be company specific but in general, generic prices are declining and they have declined quite a bit?

Govindarajan Chellappa: Sure, we have to look at what is not already known to people. What are the incremental risks that are coming because of the way the world is changing. Several of these issues, be it on generic drug prices or be it on FDA issues, are already well known and well factored into the prices. Where there is a reluctance to accept that are in sectors where traditionally you have not seen the linkage. Which is why I mentioned consumer staples. You do not see the linkage between soap sales in India and global commodity prices.

Nikunj Dalmia: Factors like China and crash in commodity are well known. My question is that the fears are known to the world yet the market reaction has been very volatile this year. Why?

Govindarajan Chellappa: The fears about falling commodity prices has an impact on our steel companies was well known and those stocks corrected immediately. The next step was the linkage with the banking sector as they started talking about their NPAs. So sector after sector, you start seeing the linkage but there are still several linkages that are not seen. That is the point I am trying to make. Take for example, motorcycle exports to Africa. This is to countries that have historically had their budgets balanced by oil production and now with contraction in oil production there might be strong long term underlying demand because of penetration but in the short term they may stop issuing LCs and this will ipact the auto companies. So these kind of linkages will start to play out over a period. What I am trying to say is that the direct linkage of what has happened is well appreciated, the indirect linkages are underappreciated at this point.

Nikunj Dalmia: The second derivative, the third derivative? So hypothetically a year from now when we could interacting on the same forum which would be January 2017, what kind of market do you think we could be staring at?

Govindarajan Chellappa: Sitting here right now, right here, I would say that Indian markets will do well if commodity prices bounce from here and if commodity prices stay stable at the current levels or fall further, I think we have a lot of trouble.

Nikunj Dalmia: Even if they do not go down?

Govindarajan Chellappa: Yes, if they just stay here, all commodity prices, just stay here I think we will some trouble that will show up in some market, either it will show up in currencies or it will show up in bank NPLs or it will show up in the fiscal, it will show up somewhere but if commodity prices stay here, I think we are in for troubled times.

Nikunj Dalmia: So you have a bearish view on rupee?

Govindarajan Chellappa: Well, I think rupee will depreciate against USD and there is still a lot of catch up that needs to happen with the other emerging market currencies.

Nikunj Dalmia: What is the out of jail card? What will get us out from this mess because we are in a mess. We never invited it but we are in?

Govindarajan Chellappa: Everything that the government is doing in terms of administrative reforms helps us in the long term it makes India a better place to manufacture in over the next 10 years. Skill India makes India a better place to set up factories over the next 10 years. But it does not change anything for the short term so I think we have to stop overanalysing what the government is doing. The government is also exposed to the same external factors that the stock markets are and they will have to react to it but I do not think they can control the factors too much.

Nikunj Dalmia: It is like saying that I have pressed a reset button on my laptop, when the reboot will start...

Govindarajan Chellappa: You have not pressed, somebody else has pressed it.

Nikunj Dalmia: Somebody else has pressed it but it is like somebody has pressed a reset button so when the aftermath will get diluted, when the world will get normalised, this year we have reported abnormal markets, abnormal volatility what will stabilise first?

Govindarajan Chellappa: What is driving all the markets is a strong correlation between all commodities, between commodities and emerging markets and amongst emerging markets and currencies of all emerging markets, everything is extremely well correlated so basically the view seems to be just sell everything, sell every risk asset and get out, the differentiation will start at some point in time. It is not going to start in a hurry. People will sell first what they can sell rather than what they should be selling but that will change over a period. That is not going to happen in the short term. So it will three, six months of stability before you start seeing some of these things change.

Nikunj Dalmia: So the next three to six months, fasten your seatbelts and prepare your portfolios for extreme volatility?

Govindarajan Chellappa: Absolutely.