Originally Published 2018-02-06 08:09:00 Published on Feb 06, 2018
Uncertainty in financial arrangements is crippling and its trauma lingers. The good news is that this sell off is temporary. Stock markets are now back to where they were just two weeks ago.
Post-Budget uncertainty, global cues drives market sell-off

Those who live by the stock market must pay for their indiscretions. The stock market slid by 2.7% on 2 February 2018 — the day after Budget Day and then by an additional 0.88% on Monday, 5 February 2018. Four drivers could have fuelled the sell-off.

First, inflation fears arising out of the Budget proposals. The fiscal deficit this year has overshot to 3.50% of the GDP, with no respite likely even next year. Mix this with the possibility of oil prices increasing further and the picture turns toxic.

Oil prices (Brent) started increasing from $46 a barrel in end July 2017. They reached $60, three months later, in end-October 2017. The high of $70 came in mid-January 2018 with a subsequent cooling off to $68 per barrel this week.

Consumer price inflation in India, was at 4.5% in 2016-17. Thereafter, it declined through the first half of 2017-18 but increased to 4.9% in November 2017. But food prices tapered off, so 2017-18 is likely to end, with a similar inflation level as 2016-17.

Note that crude oil price increase during the second half of 2017-18, of around 50%, has not directly fed into Indian inflation because government passes only a marginal proportion of crude price changes to final consumers.

2017-18 was a perfect storm. Growth reduced by at least 1% due to the shocks of demonetisation and introduction of the GST. These negatives have abated. Direct tax collection this year is 2.5% higher than budgeted. Next year they are budgeted at 14.4% higher than receipts this year. Receipts from GST next year are budgeted at 54% higher than this year. These positives illustrate that broad fiscal stability around 3.5% of GDP is possible, even if crude oil continues to trade at $70 in 2018-19.

Fiscal policy in 2017-18 has prioritised putting income in the hands of consumers — government pay and pension hikes; pro-poor income support (MGNREGA) and farmer income support at the expense of publicly financed investment in infrastructure. More income with consumers creates aggregate demand for better utilisation of the surplus manufacturing capacity. Reviving exports — driven by an uptick in world trade — will also absorb some surplus capacity and create value. Inflation fears are consequently overblown.

Second, the big bear of multiple increases in the US Fed funds rate, to cool an over-heating domestic US economy, has been looming over developing markets. Last week bond prices fell, pushing up yields in US and Europe, in anticipation of increases in the fed rate. However, yesterday, bond yields pulled back up. The signals are unclear. More likely it is domestic drivers which are punishing markets.

Third, we have a large community of around 40 million domestic investors in our stock markets. Around Rs 1 trillion flooded stock markets, post demonetisation, as the earlier mouth-watering returns in realty and cash and carry trade dried up in January 2017. Savvy intermediation by mutual funds and portfolio management companies facilitated the switch into financial assets by investors.

But most investors buy and sell based on trust, led by their share brokers. These market participants are likely to have advised investors to sell and book their capital gains in anticipation of the long-term capital gains tax (10% of capital increase) being imposed on all equity sell trades from 1 April 2018.

This advice is flawed since it ignores provisions, sensibly introduced by the Budget, of “grandfathering” capital gains till 1 February 2018. It makes little sense to sell in a turbulent market, unless you desperately need the money. But who can shake an investor’s faith in their trusted share broker — who incidentally, earns a fee on both the sale and the re-investment in — what else but shares!

The recent experience with demonetisation has not helped. Uncertainty in financial arrangements is crippling and its trauma lingers. Under such circumstances, rumors acquire an undeserved potency, over reason.

Fourth, treasury management requirement of mutual funds, particularly for their “dividend based” schemes, could also have prompted a sell off. The budget has proposed a 10% dividend distribution tax on equity mutual fund schemes, to level the tax imposition on capital gains (the basis for investor earnings in growth-oriented schemes) and dividend distribution (the basis for investor income in dividend-oriented schemes). Mutual funds will try and distribute the maximum dividends to their investors, in this fiscal itself, to save them the tax imposition next fiscal. This requires mutual fund to sell equity holdings to generate the cash required.

At the risk of gross simplification, 60% of the sell-off, of around 3.5% of market capitalisation till close of 5 February 2018 was due to investor uncertainty about future taxation and the treasury needs of mutual funds. Inflation fears possibly drove 25% of the sell off, whilst global cues were responsible for the residual 15%. The good news is that this sell off is temporary. Stock markets are now back to, where they were just two weeks ago on 16 January 2019. A mere storm in a tea cup, created by investor exuberance in anticipation of a “please all” budget.

So, hang onto your shares and count your blessings over time. If you hold an equity portfolio of Rs 20 lakhs, an 8% dividend payout of Rs 160,000 will attract a tax of just Rs 16,000 — easily absorbed by postponing purchase of a microwave oven. In the case of additional capital gains, over and above the higher of the purchase price or the market price of the share on 1 February 2018 — assuming a gain of 15% or Rs 300,000, is just Rs 30,000. Making do with the existing car tyers would do the trick. That, eating out and taking the metro or a taxi are rational and possibly pleasurable substitutes.

This commentary originally appeared in The Indian Express.

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Sanjeev Ahluwalia

Sanjeev Ahluwalia

Sanjeev S. Ahluwalia has core skills in institutional analysis, energy and economic regulation and public financial management backed by eight years of project management experience ...

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