The Great Indian Consumption Conundrum

It is a well-known fact that in the last five years, the Indian economy has slowed down considerably. GDP growth between FY13-FY18 has averaged 7% (under the new series) which pales in comparison to the 9% average growth (under the old series) registered during FY04-FY11. Also well-known is that the slowdown has been brought about by a marked decline in domestic capex activity as well as stagnant exports. After gaining market share by over 1.5% during the last decade, India’s total exports as a % of global trade has plateaued at 2% for the last many years (Chart 1). However, more noteworthy, is the unusually large decline in capex activity which the economy has experienced in recent years. Thus, while Gross Fixed Capital Formation (GFCF) grew at roughly 2x the rate of GDP growth between FY04-FY11, its growth has now fallen much below GDP growth in the last few years.

                                          Chart 1: India’s share in world trade has stagnated

With two major engines of the economy moving in slow-motion, needless to say, private consumption has been the sole driver of economic activity in the current decade. In fact, what is striking, is that the share of private consumption in GDP has declined in every single decade, since independence, except the current (Chart 2). There is no doubt that consumption has provided the much-needed lifeline to the economy at a time when other engines have failed to fire. Generally, in an economic recovery, first consumption picks-up which in turn leads to better capacity utilizations and consequently leads to pick-up in capex activity. Therefore, consumption led growth is not bad per se. However, in India’s case, while consumption has undoubtedly supported growth, it has also resulted in the emergence of certain structural imbalances. These structural imbalances if not addressed can have serious implications for the long-term growth potential of the economy and can turn the “Great Indian Consumption Story” from a boon to bane.  

Chart 2: Rising Private Consumption (% of GDP)

These imbalances have manifested itself in mainly two forms:

• Consuming more of what is not domestically produced: India’s consumption profile seems to be increasingly misaligned with its production profile. A testimony to this is the continuous  rise in India’s non-oil non-gold trade deficit in the last few years (Chart 3). It has always been convenient to blame oil and gold imports for India’s external vulnerabilities. However, beyond the oil curse, what is being ignored is the steady deterioration in the composition of India’s import basket.  In fact, electronic goods appear to have become the new gold with electronic imports more than doubling since the start of 2010. While a weak commodity cycle has masked India’s external vulnerabilities in the last few years, underlying trade balance has continued to worsen. As the support of benign commodity prices wane, the economy could become increasingly susceptible to an external shock.
• Declining household savings rate: In most emerging economies, out of the three stakeholders, savings by the household sector tends to the be the largest and the least volatile component of the overall savings rate. While corporate and government savings fluctuate with the business cycle, household savings are generally determined by more structural factors like demographics. In India, household savings rate has been on a rising trend ever since data is available (from 1950s onwards). It is only since 2010 that this trend appears to have broken with household savings rate declining continuously (Chart 4). A possible explanation is that in the absence of any significant income growth in the last 5 years, households have increasingly started to substitute savings with consumption. Moreover, higher consumption can be supported not only by withdrawal of savings but also higher debt. This too appears to be happening with household debt in India rising recently (albeit from very low levels). 

 Chart 3: India's worsening non-oil non-gold trade balance

Chart 4: Declining Household Savings (% of GDP)

What are the implications of the above?

For the last many years, discussions of India’s growth have centred on one simple question: how soon will the economy revert to 8-10 percent growth? The question is at times posed as if such a reversion is a fait accompli, a phenomenon just waiting to occur. Perhaps it is even just around the corner, given all the structural reforms the government has implemented in recent years.

However, history suggests that no economy has been able to achieve consistently high economic growth without accompanied by rising savings rate. The economic success of many East Asian economies is a case in point. Experience of these economies show that during the phase of good demographics, household savings rose sharply. This in turn led to higher investments and propelled these economies into a higher growth trajectory (Chart 5). On the other hand, in many LATAM economies (Brazil, Argentina, etc.) despite favourable demographics, household savings rate remained stagnant with households substituting savings with consumption. Not surprisingly, this led to creation of several macro imbalances (high interest rates, high inflation, high CAD) with the economies falling into what is known as a “low-income trap”.  

                  Chart 5: In China, savings & investments grew during phase of good demographics

                                             Chart 6: This did not happen in case of Brazil

India is at the cusp of realizing its own demographic dividend. It therefore becomes imperative to exploit this phase of good demographics optimally to prevent the economy from going the "LATAM way". However, household led current account imbalances which result from declining household savings rate are difficult to tame. Also, it is not ideal to solve it by stifling the consumption engine through contractionary policies. This is because such policies (be it fiscal or tighter monetary conditions) tend to have a greater adverse impact on capex activity rather than making any significant dent on consumption trend. Instead what is required is a supply side response, i.e aligning the country's production profile with its consumption profile. “Make in India” cannot remain a mere slogan. “Make in India by Indians for Indians" is the urgent need of the hour. For this, a collective effort by all stakeholders including the RBI and the Government is needed. A clear vision and execution strategy to achieve the right growth mix cannot be compromised for any other objective. 

Who Moved My Interest Rates?

Any investor who has spent reasonable time in financial markets would tend to agree that the narrative can change very quickly as far as asset prices are concerned. Roughly a year back, the world was grappling with the idea of negative interest rates. In fact, in early 2017, close to US$10 trillion worth of global bonds had negative yields. This was unprecedented and led to widespread concerns of deflationary pressures in the global economy. Fast forward to 2018 and the concern has now shifted from NIRP/ZIRP to the recent sharp rise in bond yields. There has been an across the board sell-off in DM bond yields with the US 10-year treasury yield increasing by roughly 80bps since last September.

This brings us to the question – what macro outlook are US treasuries currently pricing in?

In order to explain the behaviour of longer-term rates, it is useful to decompose the yield on a long-term bond into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium.  If we look at recent inflationary expectations (using US 10-year breakeven rate as a proxy), we observe that while they have risen, they continue to remain well-anchored around the Fed 2% inflation mandate (Chart 1). In other words, US ten year yields are currently discounting a relatively benign profile for CPI inflation. Thus, inflation expectations cannot be a good explanatory variable for the recent sharp move in US treasuries.

Chart 1: US Bond Yields have risen far more than inflationary expectations

One of the major reasons why bond yields have spiked recently is that markets have finally begun to price a more aggressive Fed. In fact, the market implied Fed policy rate hikes is now closest to the FOMC’s median dot plot than it has ever been since the start of the tightening cycle. The Fed futures rate is now pricing in 3 rate hikes this year as opposed to one hike being priced in at the beginning of the year. Consequently, this adjustment in expectations has led to the recent sell-off in bond markets. Although difficult to measure, there seems to have been a rise in term premium as well. All these years, large scale quantitative easing programs by major Central Banks created an artificial demand for bonds and helped to keep term premiums extremely low (in fact term premiums moved to negative territory). This trend finally seems to be changing. The interplay between a heavier prospective supply of bonds by the US Treasury and the absence of Fed purchases now seems to be finally weighing on long term bond yields.

Going forward, US bonds face two significant headwinds. Firstly, the ongoing trade war can lead to a significant rise in inflation risk premium than what is currently been priced in by the bond markets. In the last two decades, world trade has played a very important role in bringing down inflation globally through free movement of goods as well as labour. Any reversal of the same could create significant inflationary pressures. Secondly, there could be a serious mismatch between the demand and supply of US treasuries going forward which could raise term premiums further.

In the past few years, the US Treasury has needed to (on net) raise about three percent of U.S. GDP from the market to fund the budget deficit. A portion of the deficit has been funded with short-term debt, so funding deficits of that size have required roughly 2% of GDP per year in (net) issuance of Treasury bonds and notes. However, with the Trump tax plan, the fiscal deficit is rising toward 5.5% of GDP, which implies that the Treasury will need to sell about 4 percent of GDP of bonds (on net) a year—not the roughly 2 percent of GDP it now sells. On the other hand, the Fed will be cutting back its Treasury portfolio at an annualised pace of $90 billion a quarter, or a bit under 2% of GDP, once the roll-off is fully phased in. The market consequently will likely need to absorb over 5 percent of GDP of longer-dated Treasury issuance—a real step up from the current level.

It is very usual that equities perform well when bond yields rise – it is a clear sign of growth. However, two things need to be kept in mind about the current cycle. Firstly, ultra-low interest rates have propelled global equity valuations close to record high levels. Some mean reversion is likely as interest rates rise. Secondly, thanks to ultra-low interest rates, U.S. firms have spent roughly $4 trillion on share buybacks since 2009, making corporations the biggest single source of demand for U.S. shares. Buybacks have “accounted for +40% of the total earnings-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012”! This trend is also likely to be impacted as the cost of debt rises further.   

Coming to India, the Indian bond market has been in the midst of a massive turmoil of its own in the last few months. From a low of 6.4%, the Indian 10-year G-sec has seen a jump of more than 120bps in a span of just 4 months! It is important to note that Indian G-secs have seen a sharp sell-off at a time when yields in other EMs have been extremely contained (Table 1). Thus, it is clear that local rather than global factors have been responsible for the recent carnage in the domestic fixed income market. 

Table 1: Sharp Under-Performance of India 10-Yr G-Sec vs. EM Peers

So what has brought about this movement? As is the global case, inflation does not seem to be the culprit in our case too. While the inflation prints since Nov-18 has inched higher, it still remains comfortably within the RBI mandate. Moreover, both RBI and consensus forecasts for the next 1 year remains relatively benign. Also, what is rather interesting to note the current gap between the repo rate and the 10-year G-sec is unusually large (more than 150bps). In fact, it is the highest ever barring the period of the Great Financial Crisis (Chart 2). On the face of it, this implies that markets are pricing an extremely aggressive RBI hiking cycle (atleast 75bps of rate hikes this year). However, neither RBI's current inflation forecast nor its current stance warrant pricing of such aggressive hikes. In other words, bond markets seem to be perturbed not by RBI but by some other factor.

Chart 2: The Gap between the 10-Year G-Sec and Repo Rate is unusually large

This "other" factor appears to be demand and supply. On the supply side, fiscal slippage in FY18 as well as concerns over the FY19 deficit target (on the back of optimistic GST projections) seems to have made markets rather uncomfortable. On the demand side, as the demonetisation induced surplus liquidity situation has quickly evaporated and as credit growth has picked up (rising credit-deposit ratio), the demand for G-Secs by commercial banks has progressively come down (Chart 3). The demand angle has been further exacerbated by PSU banks not willing to buy G-secs due to complete erosion of their treasury income which were the biggest contributors to their calendar 2017 profits. In fact, volumes in the bond market seem to have collapsed quite a bit. Bond trading volumes averaged Rs.290bn a day in the first two months of this year vs. Rs.435bn in the same period last year. 

Chart 3: Rising CD ratio resulting in reduced demand for G-Secs

As we know, the Indian economy is in the early stages of a cyclical recovery after being impacted by two major disruptions – demonetisation and GST. Given that the recovery is quite nascent, rising cost of capital does not bode well for the sustainability of the economic acceleration. Moreover, cost of capital has risen even before RBI has embarked on its rate hike cycle which suggest that domestic liquidity conditions remain very tight. In such a scenario, it becomes important for the RBI to refrain from further adding to the financial tightness. It is quite likely that liquidity situation improves momentarily in 1QFY19. This could be accompanied by some cyclical pickup in inflation aggravated by base effect. However, RBI should overlook these developments and maintain status quo. Also, when liquidity starts to turn unfavourable in the latter months, the RBI should proactively supply durable liquidity (via OMOs). A delayed response could lead to further hardening of rates. Growth has suffered too much for too long. Protecting the ongoing nascent growth recovery is now the urgent need of the hour for policymakers! 

A Decade is a Rather Long Time!

8^th January 2008 was a watershed moment in the history of Indian financial markets. It was on this day that the Nifty made its major top after rallying by a monstrous 500% since the start of 2002. Similarly, the S&P 500 rallied 95% between Jan-02 to Dec-07 and then fell by a whopping 60% in the ensuing months. We are now in the 10^th anniversary of the worst ever financial crisis which the world experienced since the Great Depression of the 1930's. The scars of the crisis are still etched vividly in the minds of the investing community. In fact, it has significantly altered the way policymakers and investors think about the economy, recognising the important role that financial frictions play on the functioning of the business cycle.  

Fast forward 10 years and most global markets are now making new highs. In fact, the S&P 500 is up a massive 72% from its previous 2007 peak while the NIFTY has also registered similar gains during the same period.  This brings us to the question - what have been the similarities and dissimilarities of the current bull-run vs. the previous? Are two bull markets always the same?

The common thread between the last market peak and the current highs appears to be stretched valuations. Global market cap to GDP reached ~100% at the end of 2007 before declining sharply as the financial crisis hit. Global market cap once again stands at ~100% of GDP (Chart 1) and most markets are currently trading at the top decile of their respective long-term one-year forward P/E history. 

                                   Chart 1: World Market Cap (% of GDP) back to  2007 levels

However, this is where the similarity seems to end. A defining feature of the last bull-run was synchronisation. This synchronisation occurred at two levels:

• Global Business Cycle Synchronisation: The opening up of world trade and China’s accession to WTO at the end of 2001 created a virtuous cycle which helped improve productivity levels across all major economies. The result was that the business cycle of most economies got aligned with potential growth increasing together in the first half of the previous decade and getting bridged together in the latter half of the decade. The biggest reflection of this came in the form of convergence of monetary policies with all major central banks cutting and raising rates in tandem

• Business and Market Cycle Synchronisation: As the global economy grew at a robust pace thanks to trade openness and productivity gains, it translated into revenue and earnings growth worldwide. This in turn propelled global markets higher. Notwithstanding the excesses that got built into the financial markets towards the fag end of the bull-run, a large chunk of the market returns in the previous decade were backed by strong economic fundamentals.

While synchronisation was a major characteristic of the last bull market, divergence seems to be the name of the game of the current rally. Firstly, business cycles appear to have become misaligned – US looks like a late cycle economy, Euro area appears to be a mid-cycle economy while most Emerging markets are in the early to middle stage of an economic recovery.  This divergence is once again well reflected in the conduct of monetary policy – while Fed is well into the hiking cycle, the ECB and BoJ continue to ease.

Not only have business cycle diverged, but financial markets too appear to have become disconnected from the business cycle. Never ever in the history of financial markets have this kind of disparity been seen between the financial economy and the real economy. While 2017 has only been the first year of a broad-based global profit recovery – most equity markets have already hit new highs. Thanks to the liquidity super-nova courtesy the major central banks, equity markets appear to have borrowed too much from the future.

A few other discrepancies between the last and the current bull-run include performance of asset heavy vs. asset light models. The last cycle was all about capex while the current cycle has been all about consumption. It is therefore not surprising that the market cap of FAANG+BAT now exceed the entire market cap of Germany! Similarly, trade openness was a big theme of the last cycle while protectionism has gained significant ground in the current cycle. Above all, the political landscape has undergone a massive change all across the World. After all, ten years ago who could have imagined that an eccentric TV show host would go on to become the President of the United States of America or British political leaders would be negotiating for an exit out of the Euro zone.  

Surprisingly, nowhere have the divergences been as acute as they have been in India. For instance, most of the macro data points currently suggest that the Indian economy is in the early stages of a cyclical recovery – capex to GDP, profit to GDP, credit to GDP and inflation are at cyclical lows. Yet most of the indices are sitting at new highs with frothy valuations that are generally observed towards the fag end of the business cycle.

This sharp divergence between the real economy and the financial economy means that we are likely entering a phase where the tussle between bottoming fundamentals and sky-high valuations would certainly lead to higher volatility. Indeed, the absence of volatility in the markets specifically in the last few quarters is also unprecedented.

What is even starker is how dramatically the composition of the market has changed between the last bull-run and the current. This is highlighted in the table below:

                                           Table 1: Sectoral Composition of BSE 500 Index

The above table clearly shows the large adjustments which the market has undergone in the last ten years. The share of the so-called “old economy, capex driven, asset heavy” sectors have shrunk massively, while consumption driven stocks (consumer NBFCs, consumer discretionary, consumer staples, etc) have gained at their expense. This is not surprising. The 2002-2008 business cycle in India was led by capex while consumption share in GDP declined precipitously. On the other hand, the current cycle is the first in last many decades, where the share of consumption in GDP has actually increased.

Market changes are constant but very difficult to predict. At one hand, no one would have envisaged the kind of changes that has happened over the last decade. However, the fact of the matter is that these changes if caught at the right time, give tremendous opportunity for alpha creation. For instance, the Nifty is up 75% in the last 10 years, where as many sectors and companies which aligned themselves to the macro changes have risen by multiple times.

We acknowledge that predicting how the aggregates would shape up is a daunting task. But it’s also true that macro/sector/theme rotations are permanent features. No two bull markets are ever the same. The winners of the last bull-run may very well turn out to be losers of the next. The above particularly holds true for the Indian economy. India by virtue of being at a nascent stage of its development cycle keeps undergoing rapid transformation from time to time. For instance, formalisation, financial inclusion, supply-side reforms and digitisation are some of the changes that the economy is currently witnessing. These changes will ensure that our market composition keep changing rapidly. This in turns provides a tremendous opportunity for active asset managers to beat benchmarks. What's critical is to find "where is the sweet spot"? Getting the rotation right and early is the key!