Market Watch: Budget Fears & a Possible Structural Change in Investing Economic Metrics

Today's press contains reports on the finance minister's keenness to introduce the new tax code now instead of during the fiscal year starting 1 April 2011 (fiscal 2012). I decided to have a look at how the market might price such an event.

As previously announced, the new tax code will (a) reduce tax rates to 25% for companies & individuals will range from 10% to 30% (I use an average rate of 25%); (b) eliminate securities transaction tax, surcharge and cess; and (c) tax long and short term gains in investor hands at ordinary income tax rates; long term gains will be reduced by an indexation allowance (typically in line with inflation rates). I do not expect this event to occur in its original form; if enacted I expect changes from the draft; in particular, I expect rates lower than ordinary income tax rates for long term gains and possibly short term capital gains too. Nonetheless, the below analysis is based not on what I expect, but on the draft new tax code.

In the short term, the impact is likely to be strong as the new tax code is hard on short term investors and speculators. These folks, who play an important role in the price discovery process, will need to significantly curtail their activity in order to recognize higher tax costs which totally change the risk reward equation. In addition, there will be a money flow impact as India loses attractiveness relative to other markets. For long term investors, in my view the market needs to be at 15,924 to recognize the tentative change in taxation. There has been a structural change in the economic metrics; under the present laws, investors and corporate tend to pay Rs 39.88 to the exchequer; with the new tax code this rises to Rs 44.06.

During fiscal 2011, there will be confusion. In the new tax code, the tax burden shifts from corporate houses to investors. Earnings (post corporate tax) under the existing tax rules of Rs 1,070 expected for fiscal 2011, will translate into earnings of Rs 1,215 under the new tax rules. Analysts will scream that the market is cheap as it is trading below the long term median PE levels. But consider that the total investor plus corporate taxes has risen - a structural change in the economic metrics will have occurred, the market will need to trade at a PE of 13X, under new tax laws in order for it to equal a 16X multiple under present laws.

Keep in mind that elimination of capital gains, together with taxing gains as ordinary income might be beneficial for foreign investors. Most tax treaties provide for taxation only if the foreign investor has a permanent establishment in India; a passive investing activity is not likely to create a PE in India. If this interpretation prevails, it is likely to create a powerful magnetic force drawing foreign institutional investor to India; with corporate earning more and no tax burden, India will gain attractiveness relative to competing capital markets. Such an event can create a powerful bullish movement in the markets. However, if the government successfully asserts a position which preserves the nature of gain as a capital gain and not ordinary income, India will lose relative attractiveness. In this situation foreign investors will face the same higher tax rates as domestic investors; other than that there should be no change from present. But keep in mind that anti avoidance provisions in the new tax code may well hurt some foreign investors deploying capital into India via treaty structures lacking in substance.

The other thing to watch out for is volatility as people conduct bed and breakfast transactions to realize gains in this fiscal and raise the cost basis of their portfolio holdings so as to minimize future taxes.

All said and done, in my view the dip on negative overseas cues and budget fears should be bought. It is a dangerous time to speculate, but a good time to invest. In consideration of the risks, I will consider moving my planned rebalance event lower; I prefer a rebalance if markets hit 16k, but am considering allowing portfolio under-weights to equity to develop until the market falls to 15.5k. At 15.5k levels, in my view all risks associated with a structural change in the economic metrics are priced; I do not see any medium term economic risks on the horizon, earnings are coming in rather well, the leading indicators continue to indicate a robust recovery, fair values are rising even as market values fall. Interest rates may well rise, but this does not in my view constitute a threat to long term growth; interest rates follow a cycle, they in anticipation and during recessions and rise in anticipation and during expansions; it's nothing new and not to be feared.

Maths of the tax code impact is below.

Impact on Corporates
	Old	New
Pre Tax	1,620.97	1,620.97
Tax	486.29	405.24
Surcharge	48.63	0.00
Cess	16.05	0.00
Post Tax	1,070.00	1,215.72
Dividend	294.25	334.32
DDT	50.01	50.15
Profit Retained	244.24	284.18
Tax Burden (DDT+Tax & Surcharge)	600.97	455.39
Effective Tax Rate	37%	28%
Key Valuation Metric
Pre Tax Profit Less All Taxes (Corporate + Investor)	974.54	906.82
Market Multiple (16X Post Tax = 17.56XPre Tax Profit Less All Taxes (Corporate + Investor) )	17.56	17.56
Market Value	17,113.09	15,924.03
Earnings Growth (Nominal)	12.5%	12.5%
Impact on Investors
Cost Basis	17,113.09	15,924.03
366 Day Gain	2,139.14	1,990.50
Sale Value	19,252.22	17,914.54
Cost + Indexation (6% Long Term Inflation Rate)		16,879.48
Taxable Gain	19,252.22	1,035.06
Tax Burden (STT/Tax)	45.46	258.77
Dividend (Median LT Yield 1.6%)	294.25	334.32
Tax	0.00	0.00
Total Investor Tax Burden on Income & Gains	45.46	258.77
Tax % of Gain + Income	2.1%	13.0%
Total Tax (Corporate + Investor)	646.43	714.16
Total Tax (Corporate + Investor) % of Pre Tax Earnings	39.88%	44.06%

Policy Direction: What to Expect?

Budget time is coming. We know that the government is planning some significant disposition of interest in public sector undertakings. This is excellent; in my view the government should focus on running the Country not the Company! Divestment means that a journey in the correct direction has been re-started after a long hiatus.

Divestment comes at a good time; the funds realized will help reduce the fiscal deficit. Here there is a risk; the government could fritter away the proceeds in giving freebies to select special interest groups. But you know what, there is no election pressure to do so; thus whatever is done is likely to be good for progress. We have a pretty formidable leadership team and I have a very high level of confidence that they will make the correct decisions.

There is a fear that divestment will suck liquidity out of the market and leave the markets subdued. This may well occur, but in my view, the government will push the money right back into the market through a debt reduction program. Ultimately, with the loss of an income stream from dividend, the government must act to reduce its debt service requirements through de-leveraging.

As it happens, it is likely that healthy valuations from the divestment program will allow plenty of flexibility in meeting debt management targets, interest cost reduction targets and still have money left over after.  The availability of surplus divestment proceeds is likely to be invested in much needed infrastructure development. India is growing in a disjointed manner and investment in infrastructure is important; without infrastructure we risk developing a high cost economically unviable economy. To be efficient, roads, ports, air, power are key; as of now labor is cheap but everything else is expensive and inefficient.  I know various high profile bodies place India's currency much stronger based on purchasing power parity - in my view they are somewhat delusional - where true comparables are available, India is expensive.  For example, a toyota will cost more here than in the US; or in the unlikely event that you can find housing with adequate water, power, sewage, road access etc., in India, you will probably find that it is way more expensive compared with US.  Labor is cheaper at the low end, but I suspect adjusted for productivity, the saving will not be all that great.  Food is cheaper, but its catching up by the day.

With rising inflation, the threat of rising interest rates reigns supreme. Removal of liquidity from public hands can be expected to have a moderating impact on inflation levels. The return of liquidity to markets through a slow, widely communicated and sustainable debt reduction program should keep rates at the long end of the yield curve under control. If the government is buying back its own bonds, the upward pressure on demand for bonds should lead to moderated yields.  This narrow spread expected between the short and long end of the yield curve might pressure performance in financial services due to high expectations, but a flat yield curve with sufficient growth to prevent inversion will be good for the broader economy.

The government will want a healthy and confident market to ensure it gets a fair value for its asset sales. News flows and policy direction are likely to create just such an environment. I do not expect the government to over-price the issues; the high end of the valuation band can be expected for high quality issues, but the price level is unlikely to be at a level where demand or investor interest in the issue will be low. As of now, I believe much speculative money has flown to divestment candidates in anticipation of rich profits post issue; I believe public markets are ahead of themselves and setting up for a disappointment.

With deficits expected to come under control as a result of dispositions, it is likely that the pressure to raise taxes will be low. In addition raising taxes at a time when demands for continued stimulus continue might be seen as bad policy; this is a risk that cannot be taken. I do not expect any shocks on taxation. There is a risk that the government will seek to tax capital gains in line with what was proposed for the new tax code; it is possible that this will be a FY12 event if at all.

My own personal view is that a higher securities transaction tax in lieu of capital gains is the best option. A long term investor can expect to generate gains of 16% (10% in real terms) on average in India. Assuming that half of the ordinary rate of income tax assessed on the indexed gain is seen as a reasonable level for a capital gains tax, at present we would look for a 15% rate. A securities transaction tax of 0.75% paid by both the purchaser and seller would give the government 1.5% of sales proceeds which is equivalent to 15% of an average real long term capital gain of 10%. Continuing securities transaction tax has other advantages; everyone pays it regardless of whether they are residents or non residents or even treaty residents. It is also much easier to collect. Of course this would not work for day traders; here the rate could be lower on non delivery based transactions; or the rate could stay the same. Keeping a 0.75% rate (for buyer and seller) on non delivery based transactions might hurt price discovery; however, in my view the quality of capital committed to investment will rise dramatically. For short term capital gains, perhaps taxation at the higher of (a) the ordinary rate of tax with a credit for securities transaction and (b) the securities transaction tax would work quite well. I do believe the securities transaction tax will be more palatable to investors compared with a capital gains tax; Brazil's Tobin tax did not hurt. Besides, a capital gains tax assessed on non residents would be contrary with norms in developed economies; if such a provision is introduced, I fear that India will lose its premium multiple vis-à-vis other emerging markets before you can say Jack.

A Long Journey to Someplace Nice

The developed economies of the world remain in the grip of a secular bear market. Emerging and commodity markets remain in a firm secular bull market. The convergence of markets occurs as usual; within the secular trend all markets continue with normal cyclical trends – they will suffer cyclical bear and smile through cyclical bull markets together. As it happens, the secular trends are now old; the bear trend in developed economies started with the new century with the SP500 peaking in January 2000; the secular bull in emerging markets and commodities started with troughs in late 2001. The secular trends are no longer young; in fact they are positively aging at about a decade old. Yet secular trends can last between 15 to 18 years so the trend has between 5 to 8 years to run.

Within the secular framework we are well past the cyclical bear; the recession which started in December 2001 likely ended in July 2009 and as is normal, markets bottomed ahead of the recession end. Powerful rebounds off the market bottom for period of 15 months are fairly normal. So until May this year we can expect the market to maintain and build on its gains albeit at a slower pace. But after that we have a period of uncertainty. During secular bull markets the 30 months after 15 months following market bottoms tends to carry characteristics of a cyclical bull; over 30 months the market will trend upwards with investor bias shifting away from early cyclical to late cyclical and then to defensives. The problem is that during secular bear markets, the 30 months after 15 months following market bottoms tend to carry characteristics of a cyclical bear. One could argue that for us in India this should not be a cause for concern because we are in a secular bull. But there is a cause for worry; with US and developed economies in a secular bear, the global trend is secular bear; emerging markets and commodities can moderate but not negate the global secular bear.

My take on 2010 is bullish, but bullish with volatility and sector rotation. I expect risk taking to rise during the first 4 to 5 months of the year; during this period, we could see the SP500 trade at 22X to 23X prior year operating earnings (SP at 1,225 to 1,290). We could see the $ weaken considerably. We could see considerable narrowing of spreads between treasuries and corporate bonds. In India we could see the Sensex move over 20,000. Should this occur, it will be time to return to market weight (55%) on equities upping the allocation to bonds (15%) to underweight from zero-weight and maintaining overweight on cash (30%) positions.

For now, I remain overweight on equities (70%), zero-weight on bonds (0%) and overweight on cash (30%); also remain over-weight on cyclical and underweight defensives. Within equities, I am reducing over-weights on small/midcaps to buy defensive characteristics associated with large caps; I will also pay more heed to value compared with growth and finally I will avoid over-leveraged players with a high degree of sensitivity to movements in interest rates. If the market does trade at extreme valuations (Sensex 20,000 and SP500 1,250), additional defense will be called for; in addition to cutting allocations to equity, it will make sense to market weighting cyclical and defensive stocks.

The fall in markets following excessive risk taking is likely to return valuations to 950 to 980 on the SP500 and 15,000 to 16,000 on Sensex over a period of six months. If this occurs, it will be time to return over-weights to cyclical stocks and increase equity valuations, if for no reason other than a healthy respect for the secular bull trend in emerging and commodity markets.

In the US, q2 and q3 2010 might prove to be difficult quarters; on the positive side we will have rising job creation but the market will respond six months ahead of the uncertainty associated with the Senate elections in November 2010. The second year of the presidential election can be volatile with a downward bias with a return to an upward bias following elections.

So to sum it up for 2010:

First 4 months – bias overweight equities. Overweight IT/Material/Energy stocks; equal weight Financials, Discretionary, Industrials, Telecom; and underweight defensives (Staples, Health, Utilities). Sell on bullish extreme to transition to next 6 month bias.

Next 6 months – bias equal weight equities; all sectors at equal weight. Buy normalized median market valuations to transition to next period bias.

After 10 months – bias overweight equity. Overweight late IT/Material/Energy; equal weight Financials, Discretionary, Industrials, Telecom; and underweight defensives (Staples, Health, Utilities).

Each cycle is unique; leading into the new-year the sector watch series looked at typical cycle rotation which occurs. This post looks at events which might be specific to this particular cycle over a 1 year horizon; it is mainly my view on how things might evolve. And it goes without saying that the economy needs to be monitored to see how things progress; interest rates, inflation, $ levels, continued growth in EM's in response to rising commodities and tightening liquidity, commercial & residential real estate markets (including mortgage rate resets which will start rising towards a peak in 2011/2012), consumer spending and the risk of a double dip recession are some significant events to keep a close watch on. A lot hinges on when US rolls back the fiscal and monetary stimulus; be sure of one thing – it will either be too early or too late – it will never be just right. If it's too early we could see a double dip, with bonds outperforming equities. If it's too late we will have equities outperforming until rising inflation kills the fledgling recovery.

The only certainty is that the price of the financial crisis has not been paid in full – we will either see subdued markets for a while, or a rapidly rising market followed by a rapidly falling market (i.e. shorter more volatile cycles). Personally, I prefer the volatility. By beginning of 2014 we might have gone nowhere in real terms but we might also be poised with a journey to someplace nice.