Demonetisation, the economy and the market

Amay Hattangadi, Managing Director, and Swanand Kelkar, Executive Director, at Morgan Stanley Investment Management on why it's not possible to assign a causative weightage to separate the global reflation narrative from the demonetisation one.
By Guest |  22-03-17 | 
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The narrative on demonetisation has continued to evolve with the passage of time and the availability of quantifiable data. However, the tendency of most people to base their narrative on preconceived notions, political leanings and existing prejudices and biases is hard to overcome. Analysts continue to evaluate the political implications of this unprecedented move, using every election, no matter how small or large, as a quasi-referendum on demonetisation.

An alternative perspective

In this context, it is interesting to consider an alternative view posed by political scientist Garbriel Lenz in his landmark book Follow the Leader?. The author says that voters don’t choose between politicians based on policy stances, rather, voters appear to adopt the policies that their favourite politicians prefer.

Fareed Zakaria, who also quotes Lenz in his recent essay, says that gut decision and emotional appeal often trumps rational analysis in the choice of the favoured political leader. Moreover, voters seem to follow rather blindly, adopting a particular politician’s specific policies even if they know little or nothing of that politician’s overall ideology. So it appears that voters first decide on a politician they like, and then adopt his or her policies.

Lenz concludes that these findings imply that politicians have considerable freedom in enacting policies without fear of electoral repercussions. These findings invert the traditional view of democracy as a means for voters to express their policy stances at elections.

However, this essay is not about the politics of demonetisation, but rather what it means for the economy, and more specifically for markets.

Attempts to form a holistic view on the medium- and long-term effects of demonetisation on the economy have been challenging. The aggregation of first-hand experiences and hearsay has often formed the basis of extrapolation for the entire country. Clearly, no single or simplistic narrative can explain the impact on a large and diverse nation.

Much like the parable of the six blind men trying to describe an elephant based on the parts that they touch and feel, analysts have been trying to make sense of the impact of demonetisation. Some touch on the economic aspects, while others assess the political implications. Even within trade and commerce, the impact on the unorganised sector may be diametrically opposite from the organised sector. Rural India faces challenges that could be very different from the big cities. Stock traders tracking the ticker tape as a barometer of economic well-being can draw comfort from the fact that the stock market indexes are trading at levels higher than 8 November 2016. Some argue that the Dalal Street is merely reacting to a gush of liquidity from mutual funds, or that Indian markets have merely been lifted by a global reflation trade that began after the U.S. presidential election.

The much-awaited quarterly GDP data for December 2016 only succeeded in adding to the incredulity. Real GDP growth at 7% year-on-year was significantly higher than consensus estimates at 6.1%, and even more surprising was the full-year forecast at 7.1%.5 In our view, diligently tracking a dashboard of high-frequency indicators has served as a better tool for investors to gauge the pulse of the economy and choose sectors to invest in or stay away from.

As investors, our primary objective is to comprehend what all this may mean for the stock markets, recognising that the effects on the broader economy could be quite divergent.

  • A recent Merrill Lynch report points out that the quarterly earnings growth of the BSE500 stocks (which is a good proxy for the broader universe of listed stocks) for December 2016 was 22% over the same time last year.
  • A closer look reveals that higher commodity prices and lower nonperforming loan provisions for the Financials sector (compared to base year) were the main contributors for these buoyant earnings. If we exclude Financials, the earnings growth is much lower at 12%.
  • A ‘heat map’ in the same report outlines sector-wise trends of quarterly revenue growth which allows for more granular analysis. Companies that are largely dependent on the domestic economy saw an adverse impact on their revenues in the December quarter. The consumer-facing sectors, particularly those dependent on wholesale channels that use cash, were victims of the growth shock. In the consumer discretionary sector, for example, passenger vehicles did better than two-wheelers simply because the latter has a lower proportion of financing and typically involves cash payments.
  • Oil, metals and mining sectors bucked the trend as revenues were buoyed by higher prices than at the same time last year.

As Aswath Damodaran says in his recent book, Narrative and Numbers, it would be a fallacy to look purely at numbers without understanding the narrative behind the numbers. Hence the commentary from Indian companies in their post-results analyst calls is probably more important than the reported numbers.

An overwhelming majority seem to be indicating that from the March 2017 quarter onwards, they are witnessing ‘almost’ business as usual, as the disruptions from demonetisation fade away.

When asked to quantify, some business managers have indicated that ‘almost’ business as usual reflects a return to normalcy of the order of 80-90% of regular business activity.

India Inc. seems to suggest that the economy was already showing early signs of a cyclical pickup as we entered into the festival season last November. That tailwind was punctuated by the demonetisation announcement. The recovery is now underway, but growth is still lower than what it would have been if demonetisation had not happened at all.

The expectation is that, based on the pace of normalisation witnessed in the current quarter, the coming April to June 2017 quarter should reflect a return to trend growth that was observed until last November. If these observations were indeed to play out, it would be an unexpectedly swift recovery. We must confess, in that case, that compared to what we had anticipated in November 2016, both the magnitude and duration of the growth shock may turn out to be far more muted and transitory.

To conclude…

With markets trading higher than 8th November, there is a risk of complacency as people mistake the global reflation trade that is underway, to spin a positive narrative of speedy normalisation after demonetisation.

In a world where global markets are highly correlated, where almost half of Nifty Index earnings are dependent on global cues, and where foreign flows into India have turned positive year-to-date, it becomes almost impossible to assign a causative weightage to separate the global reflation narrative from the demonetisation narrative.

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