The watershed FY22 budget has, in our view, changed the trajectory of the Indian economy and the markets. We now see a sustained recovery out of the post-pandemic slump and a multi-year growth cycle of 6%+, led by capital expenditure. This should support a strong market for the next few quarters, with a greater participation from cyclicals. We continue to be fully invested and focused on quality companies, with increased sector diversification to capture the changing trends.

Watershed budget:

The Union budget of FY22 could have a long-lasting impact on the direction of the Indian economy. In many ways, this budget heralds a new direction for India’s economic policy.

1. The government has taken a deliberate strategy of fiscal expansion. The structure of the Indian fisc is that revenues are very elastic to growth, but expenses are sticky. This warrants a countercyclical response: the fiscal deficit should be expanded in a slowdown. This change in mindset and approach would imply a faster recovery out of the multi-year growth slowdown that started in FY17.
2. The budget has set new standards for transparency on two counts. First, the “below-the-line” accounting of incremental expenditure towards food subsidies has been brought into the main budget. This has pushed up the headline fiscal deficit, but the improved disclosures demonstrate positive intent. Secondly, the tax revenue assumptions are conservative, which is rare for an Indian budget. This helps manage market expectations (always better to exceed promises) and improves credibility.
3. The pattern of expenditure is shifting towards capital expenditure from consumption. The share of capital expenditure in the budget rises from 13% to 16% between FY19-FY22. There has been some criticism levelled about the absence of an income support plan for the poor – however, the increased capex is a more durable stimulus and will ultimately flow through to the bottom of the pyramid.
4. The approach to privatisation is the other major inflection point on policy. The immediate positive impact is that it helps fund the expansionary budget without raising taxes. The more long-term benefit is that the privatised PSUs become more efficient and, over the longer term, stop relying on the exchequer for continued funding. 

The Economy:

The budget is likely to accelerate the recovery of the economy out of the pandemic-induced slump. The growth is expected to have a few peculiar features over the next 12-18months. First, the key delta is likely to be capex and construction, rather than private consumption. Second, higher income segments should continue to grow much faster in this period, as has been the case during the recovery period of the last 2-3 quarters. The good news is that this is a temporary phase – in 2-3 years, we expect the recovery to become more broad-based and inclusive. We are, in general, more optimistic after this expansionary budget and see a sustained 6%+ growth for a lengthy period

Cyclicals over defensives:

The government’s changed approach and the strength of the recovery could have implications for the market. We believe that cyclical sectors could sustain their relative outperformance over the medium term, after a long spell of defensives-driven markets leading up to mid-2020. The expected rally in global commodity prices is an additional facet to keep in mind. The other side of this coin that earnings growth could finally come back as a key driver for the market, vs the sustained rerating of quality stocks that was the hallmark of the previous decade.

Key risks:

The strong macro tailwind should sustain the markets for the next few years. A few risks need to be flagged, though we do not see any of them destabilising the positive momentum. The easy liquidity of CY20 is likely to slowly tighten, though the trajectory will be too gradual to disrupt the growth story. Long term yields, however, should harden further because of the increased borrowing. Rising commodity prices pose multiple challenges – inflation, margin stresses for user industries and, in an extreme scenario, a rising current account deficit. This should, however, be offset by continued influx of global liquidity.

Our approach:

We continue to build out our portfolio on our core principles: minimise cash holdings, focus on large companies with potential to gain market share, minimise risk by avoiding companies with weak balance sheets and poor capital allocation and emphasising sector diversification. We are, however, likely to tweak our stance to focus a little more on cyclicals – but to companies with strong balance sheets, cash flows and return ratios.