After the significant cuts to India’s corporate tax, we remain cautiously constructive on Indian equities, but are refraining from adding more active risk to our existing position.
Dong Chen, Senior Asia Economist and Julien Holtz, Emerging Market Strategist
The Finance Ministry of India recently announced significant cuts to India’s corporate tax rates. This move lowered the existing Indian corporate income tax rate to 22% from 30%. The cuts represent the Indian authorities’ latest effort to deal with a slowdown in growth. Indeed, the GDP numbers for Q2 were disappointing, with headline growth dropping to 5.0% year-over-year (y-o-y) from 5.8% in Q1.
The Indian government estimates that the tax cuts may lead to an annual reduction in tax revenue of INR1.45 trillion (roughly 0.7% of GDP). The cuts will likely have a positive impact on the economy in the medium term through higher investment and possibly higher consumption. More importantly, the tax cuts are a significant move from a structural reform perspective. However, we believe the near-term impact on Indian GDP may be limited. Our Indian GDP forecast for FY2019-20 remains unchanged at 6.0% (down from a previous forecast of 6.8%).
Indian equity markets reacted swiftly to the new fiscal stimulus, jumping by more than 8% in two days. This appears commensurate with our estimated earnings uplift for the largest Indian companies (~9%). Given already optimistic earnings growth expectations, the fact that the market slightly discounted the upside appears pretty fair.
Despite the recent deterioration in the economy, investor expectations and positioning remain very constructive on Indian equities. Further disappointment could therefore occur in the short term should the effectiveness of recent measures be questioned, or should additional tension appear in the financial sector. The main risk for Indian equities in the short term resides in high valuations, which are being driven by optimistic earnings growth expectations for both 2019 and 2020, especially relative to other EM countries.
Nonetheless, the structural strengths of the Indian economy, coupled with a strong cocktail of monetary and fiscal measures, lead us to stick to our constructive stance on Indian equities at this stage. However, we are refraining from adding more active risk to our existing position, especially since some investors may be tempted to “sell on strength” to benefit from the recent rebound. Assessing the effectiveness of recent measures—or lack thereof—should be investors’ primary focus.