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India Strategy - Fiscal response should ebb threat to consumption

India is currently facing a downdraft in consumption growth, which appears to be pervasive along with weak sentiment. We cite four reasons for the sudden slackening of demand -  A) Lingering effects of demonetisation and GST shocks, which created synchronous volatility in cycles for durables; B) Shock impact of global trade disturbances seeping through direct and indirect channels, C) Commodity deflation, causing nominal growth to decline and disproportionate shortfall in tax collections, forcing spending constrictions, and D) the ongoing NBFC crisis. We believe a policy response is underway soon, in the form of fiscal expansion and additional rate easing, which will create a neutralising multiplier impact on the above headwinds. The rural sector would perhaps be the first to revive, in our view. We see bottoming out of key variables in the agriculture sector, reinforced by continued strong government allocation in the rural sector. Earlier monetary easing of 75bps to 5.75% could be followed by addition of 25-50bp, which will continue to bolster household leveraged spending. However, we maintain that it will be the income effect of higher fiscal spending that will be effective at this juncture than interest rate easing. Accordingly, we remain Overweight on the non-durable consumption space. Our picks HUL, Marico, Dabur and Crompton Consumer are also based on our thesis that market leaders will continue to deliver better earnings, as the cycle unfolds.  

Discretionary consumption hit harder than staples: Consumption slowdown appears pervasive, but is still truncated. Consumer surveys and corporate commentaries indicate slowdown in both rural and urban demand, with the intensity higher in rural demand. The automobiles sector has been the most severely impacted, in addition to big-ticket consumer items, which too are facing challenges. However, not all is as bad; there are still several pockets of resilience in the nondurables sector. We see downside risk, if the above headwinds persist.

Global trade shocks a significant contributor: Global trade shocks have impacted domestic consumption though multiple channels. We estimate trade shocks since H2FY19 explain more than 50% of contraction in discretionary consumption volumes (primarily auto volumes). These sectors also suffered deep shocks during demonetisation and GST, impacting 660bp of the cluster growth, now creating synchronous declines. Our sensitivity analysis also suggests that the impact of trade shocks on consumer durables peaks out with a 6-month lag, but could persist for long even as it fades.

What will drive the recovery? When global trade turns unsupportive, government steps in with higher spending, implying continued thrust on entitlements and social infrastructure. We anticipate this will be the case even in FY20E, notwithstanding tax shortfall of Rs1.2trn. We highlight the steep rise in allocation through DBT and under MNREGA, recovery in terms of trade for the agriculture sector and the recent pick up in rural wages. RBI’s monetary policy response will be supportive and PSU banks would take the lead in reduce lending rate. Recapitalisation of PSBs and support to NBFCs are intended to ring fence the damage caused to the latter, but will take time.

Why stay with the leaders? Market leaders have learnt to generate gains from the market even during input deflation over last 4-5 years. Consumer companies have invested part of these gains in gross margins to drive volume growth and strengthen market shares. Events like demonetisation and GST coupled with the recent liquidity stress strengthened organised players over unorganised ones. Increased market dominance implies low risk of disruptive pricing actions.

IDFC India portfolio view: Our IDFC India portfolio allocation is aligned keeping this backdrop in mind. We are Overweight consumer staples, as pockets of segments in the sector are showing resilience. Also, additional fiscal stimulus should help further strengthen the demand in this segment. We believe IT will benefit from depreciation pressure on rupee and will also provide defensive support in an otherwise volatile market, which explains our Overweight stance on IT. We are Underweight financials, as volatility in rates (spillover effects of widening fiscal deficit on an over-flattened Gsec yield curve) and a weaker INR are key risks to the sector (details here).