The many signs of recovery across industries suggest that the earnings outlook for India Inc may improve over the next couple of quarters. However, it would be wrong to take this as a bullish prognosis for the stock market.
Aarati Krishnan
Investors looking for signs of recovery in India’s industrial landscape have been surprised by green shoots turning into flourishing foliage, in recent months. By now, some key sectors such as cement, passenger cars, two wheelers and durables have recovered sufficiently, to surpass the record levels of output clocked in March last year. Others, such as commercial or utility vehicles, after suffering particularly deep cuts last year, are climbing back from their lows. There have even been a few core sectors – power and steel- which have continued on a broad upward trajectory amid all this upheaval.
Trends in the index of industrial production (IIP) — the widely tracked gauge of industrial activity, drive home the point that industry has gotten away with relatively minor damage from the global recession. The period of contraction, going by the IIP readings, lasted barely six months from April 2008 to October 2008, before the process of recovery started.
Average IIP readings (to even out seasonal blips) show that industrial activity for the first four months of 2009 has expanded by 3 per cent compared to the same period in 2008 and by 7.6 per cent over the year 2007. No mean feat, given the backdrop of the global recession and the recent credit crunch. A breakdown of the IIP into its key sub-segments shows that activity in most sectors now hovers above last year’s levels (see Table). Consider these numbers. Cement despatches have grown by a robust 10.3 per cent over last year in the first four months of 2009. Monthly passenger car sales have expanded by nearly 30 per cent, while two-wheeler sales have risen 46 per cent from their lows last year; both are back on the growth path.
These sectors have, however, been some of the out-performers within industry. Individual sectors in fact differed widely, in the extent of hit they took, and when they began to recover. The IIP itself declined by 14 per cent from peak to trough, but sub-groups such as capital goods (33 per cent fall), consumer durables (lower by 24 per cent) and mining (23 per cent), suffered drastic shrinkage.
The differing trends in IIP constituents suggest that the process of recovery was linked to three factors. One, sectors that relied purely on domestic consumers fared much better than those that relied on industrial or export demand. The severity of the slowdown in commercial vehicles, capital goods and textiles, even as passenger cars, FMCGs and consumer durables got away almost unscathed, buttresses this point. The substantial boost to the income levels triggered by the Pay Commission proposals may have been a key demand driver for consumer goods.
Two, sectors that relied, to a significant extent, on rural and semi-urban demand were more resilient than their city-focussed peers. This trend is evident not only from sales of two-wheelers and FMCGs, but also from cement despatches, which rose on sustained rural housing off-take. And third, the three rounds of fiscal stimulus which gave a pre-election push to project completion, may have boosted demand for sectors such as cement, steel, power and engineering.
Having recognised that there is a recovery, can investors expect it to last? A prediction for the medium term is quite difficult to make.
However, lead indicators on industrial output do point to this recovery being sustained over the next few months. For one, the ABN Amro-Markit PMI (Purchasing Manager’s Index), moved back into positive territory in April and improved further in May. The index shows that purchase managers turned quite optimistic about output and employment driven by new domestic orders even though export orders remain weak.
Two, the index of core infrastructure industries, which tracks sectors feeding into industrial output, has delivered better-than-expected growth over the past two months.
Three, even if absolute numbers reflect sedate progress, investors can look forward to healthier year-on-year growth rates from the IIP and the sub-indices in the coming months, thanks to a favourable base effect. As April-August 2008 marked the trough of the cycle for many key sectors, delivering growth on that base may not pose much of a challenge.
Key triggers for sustained growth may come from accelerated public spending on infrastructure, the percolation of the deep interest rate cuts to borrowers and an improvement in the outlook for services, driven by an improving global economy. If the Budget manages to keep up the tempo of government spending, such industry-dependent sectors as engineering, capital goods and construction may see their fortunes revive.
Consumer-oriented sectors may be well-placed to sustain a recovery, on the back of higher incomes (boosted by the Pay Commission) and lower retail lending rates, which may allow room for spending on big ticket purchases. Sustainability of rural demand may hinge on continued public spending in rural employment and infrastructure and better access to agricultural credit. The looming risks to the ongoing recovery stem from the possibility of the developed economies (mainly US) slipping back into recession- throwing the services sector into disarray or a poor pace of implementation in public projects.
If the growth in IIP does sustain, will it result in a material improvement in the earnings picture for India Inc? Experience suggests that this is likely.
Trends in the IIP (despite its shortcomings) have had a strong bearing on the earnings performance of India Inc in recent years. A comparison of IIP growth with the sales growth of the CNX-500 companies for the six years from 2002-2008 (Refer article: “Does the IIP offer clues to corporate growth?” in edition dated April 6 2008), in fact showed a correlation as high as 0.79 between the two variables.
The analysis concluded that while the IIP’s direction does quite closely coincide with that of India Inc’s sales, the companies delivered growth that is far superior to the actual growth in output.
Assuming that this historical relationship continues to hold good, investors can look forward to better top-line growth from Indian companies in the current quarter, after two consecutive quarters of tepid growth. With input costs already well below last year’s peak and interest rate cuts likely to reflect in lower borrowing costs, an improving sales trajectory could well be all that is needed to pep up profit growth from here on.
While the earnings outlook for India Inc may have turned more positive on the back of the above factors, it would be wrong to take this as a bullish prognosis for the stock market. After its 80 per cent gain from the March lows, the stock market already appears to have anticipated and factored in a sharp improvement in the earnings picture for most companies.
In fact, valuations in sectors such as realty or commodities have moved well ahead of current fundamentals and appear to take a substantial recovery for granted. At this point, the room for disappointment, if the recovery makes slow progress, appears much higher than the potential for rewards, if IIP or earnings numbers surprise.
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