As 86 percent of the currency in circulation in a cash-driven economy was outlawed on November 8, 2016, activity in both the formal and informal sectors came to a standstill. Irrespective of what the official estimates say, the fact that an unprecedented economic seizure materialised in the October-December 2016 quarter (Q3FY17) is undeniable. As the economy recovers from the shock of demonetisation and as remonetisation takes place, a recovery from the lows seen in Q3FY17 is but obvious. However, what is critical to note is that the large informal economy will shrink rapidly as the government makes it difficult for businesses to operate in the informal sector without paying taxes.
Our travels to the interiors of Tier-II and Tier-III Indian cities suggest that the informal sector is shrinking rapidly and hence downsizing its workforce.
Moreover, throughout the country, the Small and Medium Enterprises (SMEs) are struggling to adjust to the new normal with less cash and more tax compliance. A large part of this SME community is telling us that they will simply not be viable under this new construct.
So what does this mean for the markets in general? Contrary to everyone's expectations, a historical mandate earned by the National Democratic Alliance (NDA) at the Centre in May 2014 and a pro-business prime minister have not been able to revive the corporate earnings materially. Over the last two financial years – FY14 to FY16 – the benchmark Sensex Index Earnings Per Share (EPS) growth stood at a measly 1.7 percent on an annualized basis. At 3-4 percent, the story for FY17 doesn't look to be turning out any different if Ambit and consensus estimates are anything to go by. A large part of the blame for such lacklustre earnings growth resides with the banking sector which forms a chunky 32 percent of the index weight. A continuously increasing stress on banks' balance sheet combined with a muted credit growth (sub-5 percent as of March 17, 2017, on a year-on-year basis), has meant that the aggregate earnings for the banking sector have declined by 35 percent over FY14-FY16.
This is largely on the back of Ambit's banking team which remains one of the biggest bears on the banking space. We have a 'sell' on all the 14 banks under our coverage. From a quarterly standpoint, we reckon that the EPS hit will be even more pronounced in Q4FY17 than it was in the December quarter given that the results in the quarter gone by were flattered by:
- Channel stuffing by manufacturers who found themselves besieged by dealers and distributors who wanted to get rid of their old currency notes; and
- Postponement of bad news by lenders who (sensibly) slowed the pace of lending radically in light of demonetisation but who did not have to recognise the incremental impairment caused by demonetisation in Q3FY17; thanks to the 90-days past due delinquency rule that most lenders follow for provisioning on impaired loans.
We believe that the impact of the black money crackdown and demonetisation is likely to show up in the Q4FY17 results season.
Cement volume growth for the whole quarter is likely to be down around 8 percent and the pricing is expected to remain weak for most of the regions on a quarter-on- quarter basis.
Indigestion in the distribution channel will lead to a slowdown in demand - which is already evident in the fast-moving consumer goods (FMCG) and two-wheeler spaces - and as the asset quality impairment related challenges catch up with the lenders. On the positive side, however, demonetisation seem to have had a temporary impact on sectors like passenger vehicles and other consumer discretionary as low-ticket item categories like apparel or multiplexes witnessed steady revenue recovery. Most of the consumer discretionary companies in our coverage universe should report double-digit growth. Similarly, under capital goods, execution across sub-sectors is likely to be strong, led by pick-up in the infrastructure-led demand and possibly low base.
However given a bleak overall economic backdrop, valuations for the Indian equity markets have run way ahead of the underlying fundamentals and any negative surprise with respect to the earnings' expectations is likely to lead to a significant correction in the Indian equity market.
Nitin Bhasin is the Head of Research and Sumit Shekhar is an Economist in Ambit Capital.
The views expressed here are those of the authors' and do not necessarily represent the views of BloombergQuint or its editorial team.
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