Month: February 2015 | Page 5

“When the facts change, I change my mind. What do you do, sir?” – Attributed to John Maynard Keynes.

The Controller General of Accounts releases fiscal deficit numbers towards the end of every month. The latest set of numbers released late last week show that the fiscal deficit for the first nine months of the financial year between April to December 2014 was at 100.2% of its annual target.
The fiscal deficit target for the current financial year is Rs 5,31,177 crore. The government ran a fiscal deficit of Rs 5,32,381 crore or 100.2% of the targeted fiscal deficit during the first nine months of the financial year. Fiscal deficit is the difference between what a government earns and what it spends.
In my columns so far I have remained sceptical on the ability of the government to meet its fiscal deficit target, given that the growth in its tax collections has been way off the mark than what it had assumed when it had presented the budget. But this might change in the days to come.
The reason for this is very simple—the fiscal deficit target that needs to be achieved is always expressed as a certain proportion of the gross domestic product(GDP) of the country. The GDP is a measure of all the goods and services produced in a country. It essentially tells how big the economy of a country is.
The GDP can be measured in multiple ways. As Diane Coyle writes in GDP—A Brief But Affectionate History: “You can add up all the output of the economy, all the expenditure in the economy, or all the incomes.” Theoretically these numbers should match. But they never do given the discrepancies that creep in at the time of collection of data. In this column we will discuss things from the point of view of output of the various sectors in the economy.
The finance minister Arun Jaitley had set an absolute fiscal deficit target of Rs 5,31,177 crore when he presented the budget in July 2014. This was essentially 4.1% of the projected GDP of Rs 12,876,653 crore in 2014-2015.
If the projected GDP goes up, the fiscal deficit as a proportion of the GDP automatically starts to come down. Essentially this is what will happen.
Last week, the ministry of statistics and programme implementation released a new methodology to measure GDP. It changed the base year for measuring GDP from 2004-2005 to 2011-2012. The structure of the economy keeps changing. Hence, the GDP calculations also need to keep pace with this change. Over and above that the data that the government has access to keeps improving over the years, and this also needs to be incorporated in the way the GDP is calculated.
As Crisil Research points out in a research note released on February 2, 2015: “This base revision incorporates the changing structure of the economy, especially rural India. The revised series for GDP…in addition to change in some estimation methods, now also incorporate information from new datasets, in particular, Census 2011, annual account of companies as filed with Ministry of Corporate Affairs (MCA), NSS Unincorporated Enterprise Survey (2010-11), NSS Employment-Unemployment Survey (2011-12), Agriculture Census (2010-11) and Livestock Census (2012), NSS All India Debt and Investment Survey (2013) and NSS Consumer Expenditure Survey (2011-12).”
This new GDP data essentially suggests that the Indian economy grew by 4.9% during 2012-13, and 6.6% during 2013-14. The earlier calculations had suggested that the Indian economy grew by 4.5% in 2012-2013 and 4.7% in 2013-2014.
While, there is not much difference in GDP growth in 2012-2013, between the new method and the old method, the difference in GDP growth in 2013-2014 is significant. One possible explanation for this lies in the fact that as per the new method of measuring GDP, the manufacturing sector grew by 5.3% in 2013-2014, whereas it had contracted by 0.7% as per the earlier method. A similar sort of dynamic seems to have played out with mining and quarrying sector as well. As per the old method the sector contracted by 1.4% in 2013-2014, whereas as per the new method the sector actually grew by 5.4%.
Also, trade, hotels, transport and communication grew by 3% as per the old method of measuring GDP. In the new method trade, repair, hotels and restaurants grew by 13.3%. Further, transport, storage, communication & services related to broadcasting grew by 7.3%.
The comparison does give us a drift of why the GDP growth was higher in 2013-2014 as per the new method. Nevertheless there are doubts being raised about this jump in growth from 4.7% to 6.6% in 2013-2014. The Chief Economic Adviser to the ministry of finance Arvind Subramanian told Business Standard in an interview that: “India is perhaps unique in that GDP revisions result in lower numbers rather than the typically high upward revisions…The key 2011-12 estimate of GDP is actually two per cent lower than previously estimated.” Given that, the 2011-2012 GDP is down by 2%, the growth in the latter years has been faster.
Further, it needs to be remebered that 2013-2014 was a crisis year for the Indian economy where external capital flowed out of India and interest rates had to be jacked up. Imports also fell. As Subramanian put it: “Import of goods apparently declined 10 per cent; this, even after accounting for the squeeze on gold imports, is high. Typically, growth booms are accompanied by surges in import, not declines.” At the same time inflation was very high slowding down consumption. So, the other data goes against this upward revision in the GDP number for 2013-2014.
Further, what does this change mean for the current financial year’s fiscal deficit? The GDP numbers for 2014-2015 calculated as per the new method will be released on February 9, 2015. Subramanian feels that there won’t be much of a difference if the projected GDP growth as per the new method remains the same as is being currently expected. While we will have to wait for the actual numbers to come out, nevertheless if the GDP growth turns out to be faster than the 5.5% growth that had been calculated as per the old method, the denominator in the fiscal deficit to GDP ratio will actually go up and thus push down the ratio.
This will be good news for the government which is struggling to meet its fiscal deficit target. In fact, this change in methodology may also give the government a little more leaway to arrive at the fiscal deficit number for the next financial year, allowing it to spend more. The question though is whether the financial market will start believing in India’s new GDP numbers? That remains to be seen.
(The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on February 3, 2015)

An interesting piece of analysis, which is carried out almost every time the quarterly results come out, caught my eye on January 26, 2015, in the Business Standard newspaper.
The combined net profit (adjusted for exceptional items) of 290 companies which have declared their results for the period between October to December 2014, grew by just 2.2% in comparison to the same period last year.
Interestingly, this set of companies had declared a profit growth of 12.6% during the same period last year and 9.8% during the period July to September 2014, the newsreport points out.
When it comes to the growth in revenues of these companies the results are worse. The combined sales of the 290 companies which have declared results fell by 4.4% in comparison to the same period last year. This is the first drop in eight quarters.
In fact, if banking and financial companies and IT exporters are taken out of this sample, the combined revenues fell by 11% in comparsion to the same period last year. The net profit fell by 4.8%.
These are not great numbers at all. While, the sample size may not be big enough it is a cause for worry nonetheless. Further, the projection on revenues growth isn’t great either. Crisil Research in a recent report said that it expects revenue growth of India Inc to “slip to a 6-quarter low of 7% on a year-on-year (y-o-y) basis in the December 2014 quarter.” “Revenue growth was around 9% in the preceding quarter and 13% in the December 2013 quarter,” Crisil Research pointed out.
Nevertheless, the stock market has continued to rally. Financial theory tells us that stock prices are ultimately a reflection of discounted future earnings of a company. But that doesn’t seem to be the case here. If the stock market was expecting quarterly results to be bad then it should have been falling, as per theory. But that doesn’t seem to be happening.
Having said that we are looking at data for just one quarter. How strong is the link between earnings growth and Sensex returns over the long term? Ambit Research has the answers in a recent research note titled The Three ‘Stories’ That Drive the Sensex. As can be seen from the following table there is”no meaningful relationship between Sensex returns and earnings per share growth between financial years 1992-2014.”

No meaningful relationship between Sensex returns
and EPS growth between FY1992-2014

Source: Bloomberg, CEIC, Ambit Capital research

How do things look if we plot Sensex returns of a given year with earnings per share growth of the previous year? Again there is no meaningful relationship between Sensex returns and lagged earnings per share growth between financial years 1992-2013.

No meaningful relationship between Sensex returns
and lagged EPS growth between FY1992-2013

Source: Bloomberg, CEIC, Ambit Capital research

In fact, the relationship between Sensex returns and economic growth (measured in terms of GDP growth) is also not meaningful, the research note states. This is something that valuation guru Aswath Damodaran also told me a few years back when I had asked him: “How strong is the link between economic growth and stock markets? “It’s getting weaker and weaker every year,” he had replied.
So what drives the Sensex? “Over the last 30 years, there has been a pronounced tendency for the Sensex’s returns to revert to the mean, with the mean being around 17%,” the Amit Research note points out (See the following table).

Rolling five-year Sensex return CAGR

Source: Bloomberg, CEIC, Ambit Capital research

Another very good predictor of Sensex returns is the political-economic cycle. “The Sensex seems to move in sync with India’s political cycle (which in turn seems to have a profound influence on India’s economic cycle). In particular, the Indian economy seems to move in 8-10-year economic cycles, with the beginning of these cycles coinciding with decisive General Election results (eg. 1984, 1991, and 2004). Then in the first three years of these economic cycles, the Sensex seems to appreciate sharply as investors discount the decade-long economic cycle. So, whilst the Sensex’s 30-year CAGR is 16%, its CAGR during the first three years of each of the economic cycles (1984-87, 1991-94 and 2004-07) is ~33%,” the Ambit Research note points out.

The remarkable synchrony between political and economic cycles in India

Source: CEIC, Ambit Capital research

These rallies stem from the Indian middle class’s hope of finding a strong leader and that in turn leads to the Sensex rallying for the next three four years. Using this theory we can say that the current Sensex rally will last till 2017-2018.
Also, for the past few years we have been living in an era where the narrative of central bank omnipotence holds. As Ben Hunt who writes the Episilon Theory Newsletter puts it:“ central bank policy WILL determine market outcomes. There is no political or fundamental economic issue impacting markets that cannot be addressed by central banks. Not only are central banks the ultimate back-stop for market stability (although that is an entirely separate Narrative), but also they are the immediate arbiters of market outcomes. Whether the market goes up or down depends on whether central bank policy is positive or negative for markets.”
Over the last few years central banks of developed countries like the Federal Reserve of the United States, the Bank of England and lately the Bank of Japan have been running an easy money policy by printing money. The European Central Bank has become the latest central bank to join the money printing party.
While the Federal Reserve has stopped printing money in October 2014, the Bank of Japan and the European Central Bank are still at it. And this “easy money” has been driving financial markets all over the world. In this world, earnings and economic growth do not matter. What matter is how much money is coming into the stock market.

(The column originally appeared on www.equitymaster.com as a part of The Daily Reckoning on February 4, 2015)