Corporate tax cuts: Context & Consensus opinion

Amidst all the gloom & doom in the last few months over Indian economy, and FM Nirmala Sitharaman’s frequent press conferences (to an extent that it might have given complex to even TV anchor Lata Venkatesh’s time on air) to calm nerves in the last few weeks, stock markets were sinking and Nifty had closed at 7-month low yesterday at 10700- down 11% from all-time highs hit in Jun-19. The pain in broader market was significantly worse than what was being represented by Nifty (which was helped by IT stocks & few big gainers), with Midcap & Smallcap index down 29% and 44%, respectively, from their peaks they had hit in Jan-18. This performance appeared particularly miserable when compared to global stock markets, which are holding remarkable gains (20%+ YTD), with US markets kissing all-time highs. And it has come despite BJP govt. (perceived to be more market-friendly) getting re-elected with an overwhelming majority in the recent elections (May-19).  

     

To note, Q1 FY20 real GDP growth was 5% (slowest since 2013), and nominal GDP growth was only 8% (17-year low), courtesy low inflation. Also, recent government messaging (FM & Economic advisor to PM), has been that 'socialized losses & privatized profits' is no longer an option to revive economy.   When it was just about time for even hardcore bulls to throw the towel (at least for short-term), in a surprise move, FM has announced corporate tax rate to be reduced from 30% to 22% to revive the economy. And as smartly it could be, this positive news was announced by FM during market trading hours at 10.30am (vs. most of her other announcements post-markets), triggering animal spirits of investors in stock markets, and resulting in 5%+ move today, making it the biggest single-day move (+570 points on Nifty) in the last 10 years, with overall market-cap of BSE-listed firms rising by $100 bn today. Importantly, the reduction in tax announced had no caveats, no hidden clause, no preconditions attached, with a clear intent to revive growth. 

Given sudden change in investors’ sentiment, with some renowned voices (Vallabh Bhansali) calling it ‘the biggest step since 1991’, or few other calling it as ‘bold move’, or as turning ‘vicious economic cycle to virtuous cycle’, or with fund managers (Samir Arora) saying this can drive 10-15% stock market gains swiftly, I thought it is time for me to evaluate the facts closely, appraise the optimism, and ‘try’ to be rationale amidst this euphoria. Tuning into TV debates, or checking into my analyst friends/colleagues, I could not hear even one voice believing that markets might go down again, with most calling new-highs in the next 3-6 months (ceteris paribus in global markets). 

For the beginners, details of tax reduction announcement, and some preliminary questions are well explained in the link here . In simple words, lower taxes →higher corporate net profits →higher EPS → P/E valuation looks low, so market rallies. Further, higher profits can kick start the economy, as more money is now available to plough back/ reinvest in biz. → higher capex spending → more jobs/wage growth → more income in hands of consumer → more consumption demand. And even the least optimistic person will assess it saying corporate (especially in more competitive industries) could pass the tax benefit through lower prices for consumers, who might now consume more than before (i.e. higher volumes offsetting lower prices). 

Amidst this rare consensus among all, I try to split-up the impact of this announcement, with more emphasis on what can go wrong in my next blog, as the positive side of the debate is well-known to all. Like always, my attempt is to not to follow the herd mentality blindly, and check the realistic possibilities. For those, who could comprehend this basics well, I suggest reading the next part. 

Corporate tax cuts: Another hope for the markets!

Now that we have laid the basics in part-1 of my blog before, let’s try to structure our thinking given how financial institutions could evaluate such events i.e. getting into the details, understanding the possibilities:

What do lower corporate taxes mean simplistically?

When govt. lowers taxes, it is nothing but transfer of resource (capital) from one hand (Govt.) to other (in this case, Corporates). Both, Govt. & corporates, when given additional capital tends to sped on economic activities that boost the GDP. Now the key question is who can do a better job in spending effectively: In India, the govt. mechanism hasn’t worked well (corruption, bureaucracy, political compulsions, etc.). Further, in the past, we have seen large productivity/efficiency gains in the sectors/ services which have been privatized. In other words, if money is to be spent on reviving economy (and not towards socialist agenda), then it probably makes sense to have hands-off approach by govt. 

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What does this measure indicates of govt. intent?

Say now that Govt. had decided to transfer resource, it had 2 options: a) to give it to individuals directly by lowering personal income taxes or GST cuts, triggering ‘Consumption cycle’, or b) giving it to corporates triggering ‘Investments cycle’. Going by past experiences, Option A would have immediately instigated short-term economic momentum, and Option B, might not benefit short-term, but should hopefully revive capex cycle in the medium-term. Amidst the current backdrop of “Growth Recession” and prevailing negative sentiments, anyone would have been tempted to choose Option A, and show quick fix. But Govt. selected option B, probably bcoz: a) their vision to bring large longer-term impact through ‘Make in India’ campaign, b) compared to major & competing economies, tax rates in India were higher on corporates side (thus making them less competitive on global manufacturing), but broadly in-line with the world on personal tax rates, c) no political pressure as elections were just behind us.

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Will corporates spend on capex or will it be lost in pricing, or paying dividends?

Say now that corporates have higher resource and that IRRs of new projects will appear attractive, the key debate is: a) will they use it to spend on capex, or b) will it be retained by them and given back to only shareholders (through dividends/ buybacks), c) or will it be lost in lowering prices to retain market share. Over the next few weeks/ months, markets will increasingly look for evidence to see where the trend is, and will increasingly make or break the sentiment.

While some could argue that corporates are unlikely to spend on capex when demand environment is so-weak, the other side could say that with corporates spending on capex, demand will eventually pick-up. This therefore is classic chicken & egg dilemma i.e. whether Demand drives Capex, or if Capex drives cosumer demand?

My sense is for most large-size capex projects such as Refining/Energy, Steel, mining, the demand situation is more global in nature, and therefore we are unlikely to see major capex revival (as expected by many), given weak global economic momentum (I will not be surprise to see a Global recession in the next 12 months, unless again cycle is extended by Fed, ECB, etc.) But then, we could see some capex on manufacturing side (as India is incrementally more competitive) or from sectors that are domestically-driven (power, cement). Specifically, sectors which have historically seen lower competition, and higher return ratios (such as consumer, pvt. banks, pharma, autos, in that order) are likely to retain the tax benefits for shareholders, and spend on capacities as appropriate, while few others hyper-competitive sectors (airlines, infra companies, telecom, power) will eventually lose these added benefits. In other words, I do not think this move will see shift in leadership of companies in the index i.e. near-term the beaten down stocks might rally, but over 12 month period, we will see the same winners (high-quality, high PE stocks). 

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Will this step make India more competitive to China & Asian countries?

Amidst the backdrop of US-China trade tariff tensions, which has escalated in the last 1.5 years, it appears Mr. Trump is being keen to bring manufacturing back to US, or at the very least shift it away from China, so as to curb China’s rising influence on global economy.  With many Asian countries as contenders, India with its large labor-force, improving labor laws, and ease of doing biz do stand a chance, especially after these tax cuts. But is it enough to challenge the peers and see a shift in production is unknown. My sense is this is just the beginning, and we will need follow-up measures (factors of production i.e land & labor reforms, speedier approvals & lower bureaucracy, faster judiciary system, etc.), and this alone will not make India more competitive. We are at least 2-decades behind global manufacturing cycle, and catching up isn’t that easy, in my view. 

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Will it drive over-capacities in India?

As tax rate for new biz is even lower at 15%, there is high-probability in my view where existing companies could change corporate structure to create new company/ subsidiary and setup a new plant & shift productions there to avail these benefit. I read that cement companies did something similar in Rajasthan when taxes were reduced for new plants. This might create a problem of excess capacities (especially if demand doesn’t pick-up).

What is the impact on fiscal deficit?

The only, & obvious negative aspect from lower govt. revenues is higher fiscal deficit (budget target of 3.3% for FY20), and as a reaction we saw India 10-yr bond yields shot up by 15 bp yesterday to close at 6.8%. However, economist/ strategist who until yesterday were saying govt. doesn't have fiscal space, are now suddenly projecting only 20-40 bps slippages (vs. 70 bp of lost revenues) as they assume: a) some lost revenues will be borne by State govt. (40% share)., b) better tax compliance, and c) lower than planned spending in PM Kisan scheme, in which small farmers are promised 6k per year, and is being budgeted at 800+ bn with 140m beneficiaries, but disbursements so-far has been slow as finding farmers with proper land-records is increasingly difficult.

I think the market is under-estimating the impact from double-whammy of lower GST collections (+6% YTD vs. budgeted 14%) & now lower corporate tax cuts. While govt. might manage to dress-up the issue (through RBI dividends, borrowing from FCI & other PSUs, rather than on govt. budget) and manage to show only marginal increase in the fiscal deficit, I think sooner or later it will bring credibility issue on govt. accounting practice. Or we could see slower spending on govt. driven capex programs (roads, railways, etc.)

What is the impact on Inflation and interest rates?

With rate-cut cycle already in-progress, the risk often of higher fiscal spending, is a) higher inflation, & b) crowding out effect, resulting in higher borrowing costs for all. My sense is inflation is lesser of a concern when fiscal spending is through corporates, rather than consumption booster. And with RBI governor (Shaktikanta Das) coming from finance ministry, he will continue to move rates lower, and increasingly force banks to pass this rates to end-borrowers (from MCLR to external benchmark borrowing). Thus, borrowing rates will still continue to fall, in my view.

Although, I have tried my best to give straight answers to key questions on investor's mind now (without beating round the bush as typical analysts do), for those who cannot comprehend this economics above, but are looking for an answer to simple, straight-forward question- whether to buy equities now, or stay on sidelines, or sell the rally? 

Quantifying the impact:

Brokers say Nifty EPS will benefit by 6-7% over the 12 month period, as only 20 Nifty companies paid more than 30% effective tax rate in FY19. With FY20E Nifty EPS at Rs c.600, this 6-7% EPS upgrade (assuming all tax gains are retained by corporates & not passed through, which is optimistic assumption) translates into an additional Rs35-40 of EPS, and with P/E 20x, should translate into 700-800 points higher level on Nifty index. With today’s 570 point move, it means bulk of the adjustment is already done. If markets inches further swiftly, than it means it will be pricing-in added benefit from economy revival,  or P/E re-rating on expectations of FII fund flows, upwards earnings revisions, pick-up in demand, etc.  

Another elementary way to look at it could be if govt. forgoes 1.4L crs of tax revenues, and assuming all of that comes to listed companies profits (as lower tax rate were already applicable to smaller companies) and with P/E of 12x (lower bcoz of higher share of profits will flow to low P/E sectors like Energy, Materials, etc. & not all mid/small companies will be able to retain this lower taxes into profitability) than it translates into market-cap gain of 17L crs (17 trillion). The market-cap of all BSE-listed companies stood at 138 trn yesterday, and addition of 17 trn on this figure represents 12% move from the yesterday’s close. (note: 7 trn, or $100b, was already added today).   

In simple words, based on my preliminary calculation and few assumptions, I would expect Nifty to hit 11600 soon, but we might then see investors getting more realistic based on my discussion above.  

The Conclusions

In crisis lies the opportunity, and Indian govt. typically have taken big steps only when the 'going is bad'. We have seen it yet again, but I would classify it as 'fiscal stimulus', rather than 'mother of all reforms' as quoted by many (still believe demonetization was the boldest step, but unfortunately it did not bring desired outcome). Whether it will revive the much-need capex cycle, my initial assessment is no, but then I am no economist, and am hearing big corporate leader/voices who have more wisdom than me, saying this will bring back the 'risk appetite' and 'animal spirits'. I hope they are right. 

For stock markets, this is another 'hope trade', which like other reforms of last 3-4 years (demonestisation, GST, RERA, faster resolution of NPAs under NCLT) will give analyst/strategist fodder to write long research reports and make everyone believe in India's GDP potential, Modi's leadership, and longer-term high returns for stock markets. Unfortunately, I am not one of those perennial bulls, who believe in the heavily-marketed 'India Equity Story', and therefore am not a fan of monthly SIPs, which makes investors buy at all levels. I rather believe that Equities are to be bought when they are cheap and when there is fear, rather when there is euphoria like today- though it is easier said than done. 

I would trade this event with long call (as upside will come quickly in 1-2 weeks) rather than with any long cash positions. Before we get to face the reality (whether good or bad) of this announcement, the hope alone can attract lot many investors & drive market-returns.