Slow and Unsteady

Unless you have been hiding under a rock, there is no way you could have missed the incessant chatter around the economic slowdown. Is it structural or a blip before things get back on track? Are we moving towards a global recession? Is there light at the end of the tunnel? There are far too many questions and, be warned, you won’t like the answers.

Economic textbooks tell us that an economy is officially in recession when growth contracts over two quarters. A recent article in The Washington Post says there are nine economies including Germany, UK, Brazil and Korea on the brink of a recession, threatening to push the US, the world’s largest economy, over the edge. The US–China trade war isn’t helping things either. China’s economic growth fell to 6.2%, it’s lowest since 1992. Also battling a growth slowdown of its own is India with economic growth falling to 5.7% for the April-June quarter, marking the fourth quarter of declining growth. The previous quarter (Q4FY19) had posted the lowest number in five years at 5.8%, after a steady decline from 8% in Q1FY19. 

The previous growth slowdown lasted for five consecutive quarters after March 2011. And it looks like we are staring at another significant economic slowdown. “Average growth for the first eight months of 2019 is around 5.5% which is something that has not happened in one or two decades. That is a serious slowdown,” says Ajit Ranade, chief economist, Aditya Birla Group. Core sector growth is at four-year low, investments at 15-year low and gross tax revenue during the April-June quarter at 1.4% compared with 22.1% last year. No wonder then Moody’s has cut India’s GDP growth rate to 6.2% for 2019 against its earlier projection of 6.8%. Even if the economy grows by 5.8% in the second quarter, it still needs to grow by 6.6% in the second half to get to the projected 6.2% for 2019 and that is a tough ask given the current scenario. “A structural slowdown cannot be cured by pumping more money as fiscal stimulus or by slashing interest rates,” mentions Ranade. According to him, structural reforms should focus on improving the household savings rate by incentivising savings and ensure India is export-competitive.   

This time, right from falling innerwear sales to news reports that consumers are now crimping on hair oil and biscuits, there is gloom all around. Confidence is low. “We are in a classic business cycle downturn,” says Raamdeo Agrawal, co-founder, Motilal Oswal Financial Services (MOFS). He adds that a downturn typically lasts for about two years, going by the Sensex return over 25 years.

Weak consumer demand, lower government spending and a liquidity crunch has taken a toll on India Inc’s earnings growth. But the problem with earnings growth runs a little deeper than just the macro issues plaguing the economy. While the economy may have grown at an average of 12% in nominal terms since 2012, it does not reflect in corporate earnings growth.  In fact, the ratio of corporate profit to GDP has declined from 7.8% in 2008 to 3% in 2018 due to significant decline in profit margins (See: Show me the money). Earnings growth for corporate India has significantly trailed nominal GDP growth over the past decade. Nifty earnings have grown at an average of just around 7% over the past 10 years from FY09 to FY19. In contrast, the previous decade (1998-2008), Nifty earnings saw a much healthier growth of 13% which lead to corporate profit to GDP ratio expanding from 2.3% to 7.8% at its peak lead by export-oriented sectors and a strong investment cycle especially from 2003-08. Part of the earnings growth problem is the lack of innovation among listed companies, says First Global’s vice chairman Shankar Sharma. “Innovation in listed companies has been next to nothing for 25 years and business models across sectors such as telecom, FMCG and IT are dated. There is a limit to how much these companies can deliver,” he says. “When you don’t have innovation, you need tons of capital for growth. And the moment capital dries up, your growth is over.”

The sluggish corporate performance, however, didn’t seem to dampen analysts’ expectation. “Earnings growth has been tepid for the past seven years or more. Every year, the sell-side analysts are prone to taking these flights of fancy where they begin the year with an earnings forecast of over 20% and then that is followed by a series of downgrades. It is almost an annual ritual now that has dented their overall credibility,” says Saurabh Mukherjea, founder, Marcellus Investment Managers. And it has been raining downgrades this year after the lackluster first quarter performance. During the Apr-Jun quarter, Nifty companies clocked revenue growth of 6% as compared to sales growth of 13% during FY19 and net profit growth was 2% against growth of 9% during FY19, due to subdued domestic consumption and investment, and soft commodity prices.

With things looking ominously bad, there seems no way the rest of the three quarters can make up for this. For the Nifty 50, Kotak Institutional Equities has slashed its FY20 net profit estimates to 15% from 24% at the beginning of the results season in 2018. What’s more, they are not ruling out further downgrades to earnings of automobiles, capital goods, construction materials and consumer durables due to continued subdued demand, and for global commodity and IT companies due to global economic slowdown.  

Analysts at MOFS see a glimmer of hope in financial companies. They expect 13% profit growth for the Nifty in FY20, out of which as much as 90% would be from financials. If one were to exclude financials, the profit growth for Nifty companies would be flat in FY20. While most fund managers and analysts continue to be overweight financials, there are concerns emerging there as well. Even as the corporate nonperforming loan (NPL) cycle seems to be largely behind, there are slippages seeping in from retail, agri and MSMEs. If these slippages increase, it will push earnings recovery further away.

Premium…for what?

For many years, the Indian market has always traded at a significant premium to other emerging markets on the premise of higher corporate earnings growth but, in its absence, does it warrant the significant premium? “The market has gotten tired waiting for an earnings recovery, and is finally taking a knock. You cannot turnaround earnings quickly; such a prolonged earnings decline was last seen in 2002-2003. If earnings outlook is below average, why should valuation be above average?” asks Agrawal. The Nifty currently trades at 19x its FY20 estimated earnings, in line with its long-term average (See: Reversion to the mean). It may look reasonable at the current level; however, if earnings growth continues to decline, then it is steep for a no-growth or low-growth scenario. Agrawal says that the broader market is more expensive, trading at 22-23x and that valuation is difficult to sustain in this kind of an earnings outlook. “We don’t know what the new level will be because interest rates, too, are coming down. We don’t know what the ‘new normal’ valuation will be, it could be 17x or 20x.”

The correction in the market has not made things easier for investors. “It offers little in terms of investment inputs given the huge price-value distortion across the spectrum. The Indian market has ‘trifurcated’ (based on valuations and quality of companies) making it more challenging for investors,” says Sanjeev Prasad, co-head, Kotak Institutional Equities. He categorises the market into three buckets, the super expensive stocks that are trading way above their fair value – leading consumer staples, frontline IT and private financials trading at over 35x 12-month forward P/E and 3.5x 12-month forward P/B. The second category are the ones trading closer to fair value (private banks such as Axis and ICICI, pharma and IT) that would re-rate faster than the rest at the hint of an economic recovery. The third bucket trading way below its fair value include stocks of HFCs, NBFCs, PSU banks, oil and gas companies, utilities and metals where there are governance issues or global factors at play and they will continue to languish because the market just does not have that kind of risk appetite now.  

In a risk-averse environment, investors find consumer staples a safe haven because of strong cash flow and clean balance sheets. “Consumer sector valuations were difficult to justify even earlier but, in a world of relative performances, their earnings quality and visibility helped them re-rate. Going ahead, relative growth and not just absolute growth will remain relevant,” says Gautam Chhaochharia, head of India Research, UBS Securities. But the premise of such valuations is that it would outgrow the market and this premise could go out the window if growth continues to tank.

Take the case of market darling Page Industries where volume growth declined 2%, revenue growth was almost flat and net profit declined 10% in April-June quarter. While the stock has lost 29% on the back of its weak performance since the beginning of FY20, it still trades at 47x estimated FY20 earnings. Consensus estimates peg earnings growth to be 9% in FY20 as the company tackles channel issues and weakening demand. “We are not sure if multiples will hold up for richly valued consumption related stocks if India’s economic growth was to remain subdued for the next few quarters,” cautions Prasad. While in some cases, you may be relatively insulated from the volatile market gyration, you won’t be laughing all the way to the bank investing at such expensive valuations. And for Agrawal, that just isn’t a winning investment strategy. “You cannot buy a low growth company at high valuation and expect to make money,” he says with conviction.

While auto stocks have come off their highs and some of them are trading at five-year lows, valuations are still at risk given the impact of regulatory change. Weak consumer sentiment has led to auto sales declining for nine months straight, forcing auto manufacturers to lay off workers and halt production to keep costs in check. Even as the industry is looking to deal with the structural shift caused by EVs, much of its present day problems are self inflicted. Protected by high tariffs, players had little reason to innovate or be globally competitive. “India Inc is equally to blame because they haven’t built any business of scale or size and have been happy selling to the so called billion population and waiting for organic growth,” says First Global’s Sharma. 

The slowdown and credit tightening have affected sales across sectors. “Tight liquidity from NBFCs and banks has caused near term stress in demand and businesses, and that has got amplified by lack of trust and confidence given negative news flow,” says Sunil Singhania, founder, Abakkus Asset Manager. “Earlier NBFCs used to borrow from banks and MFs and forward lend it, now that is not happening, banks have gone to the other extreme, and as a result lending lines are choked up,” he adds. In a bid to boost demand and festive sales for the automobile sector which makes up for 49% of the manufacturing sector, the government has announced a slew of relief measures including increased depreciation and assurance that BS-IV vehicles will be allowed to run for their full registration period. The government is also pushing banks to reduce interest rates on auto loans, besides providing more credit to non-banking financial companies.

No green shoots

A lot of the India story has been sold on consumption and increasing purchasing power of the middle class and rural population. Over the past seven to eight years, driven by cheap financing, consumption has been on the upswing even as the pace of wage growth – both urban and rural – declined to single digit over the past five years (See: Buy now, pay later). Rural wage growth declined from 27.4% in FY14 to less than 5% in FY19. Similarly, corporate salaries also clocked single-digit growth rate in FY19.

As a result, rise in consumption has been far higher than rise in income levels. Household savings rate which was around 23% at the beginning of the decade has fallen to 17%. There has also been a significant increase in household debt and post the NBFC liquidity crisis, the consumer no longer has access to leverage to sustain consumption. Given their low savings, consumers aren’t happily tapping their e-wallets for discretionary spending. Apart from consumption, the other driver of economic growth over the past three to four years has been government spending to make up for the lack of private investment. However, the high fiscal deficit is now starting to restrain government spending and if fiscal consolidation has any sanctity, spending to boost the economy may be a dire option.

Nilesh Shah, CEO, Kotak Mutual Fund, thinks in times when growth turns challenging, all the effort should be around reviving it rather than steadfastly sticking to the fiscal process. “You have to give growth priority over fiscal discipline and inflation management. It doesn’t mean we have to be imprudent but higher growth will lead to better tax collections. You also have to ensure that banks have enough capital to back the right entrepreneurs,” he says. In a bid to revive investor sentiment, the government announced infusion of #700 billion in public sector banks, in addition to speeding up GST refunds. Shah says while the steps will boost sentiment, we can’t take for granted that better sentiment will result in better fundamentals and capital flows. “This is just one over that has gone in our favour but we have to remember that we are playing a test match. There are still several steps that need to be taken to ensure better transmission of credit, lowering the high real interest burden and improving the ease of doing business,” points out Shah.

Kotak’s Prasad believes neither monetary nor fiscal stimulus is going to be effective to stem the decline in economic growth. “Deep structural reforms may be the only option to reverse the current economic slowdown and increase India’s investment and GDP growth rates. The RBI may cut policy rates by another 15-40 basis points but that may not be sufficient to revive economic growth,” he says. With uncertainty increasing in the global environment, private investment is hard to come by but UBS’ Chhaochharia foresees an opportunity. He says the current slowdown could be a perfect time for Indian companies to capture the manufacturing shift from China. “It is a golden opportunity for India and we think the markets may be underestimating the potential for the same to play out. Beyond factor market reforms, sector specific incentives and ease of doing business will help,” he says. 

But those changes are tough and time consuming. For now, the only instant lever that the government has is monetary policy. The RBI has changed its stance from neutral to accommodative and has cut interest rates with the promise of more. But the transmission of these rate cuts has been sub-optimal. Bulk of India’s borrowing and lending is through the banking system and bank rates haven’t fallen. There’s good reason why. Banks are competing with small savings schemes which offer higher rates to consumers. The government dips into the small savings scheme quite significantly to fund its borrowings. To ensure there are more than adequate inflows into the schemes, investors are offered attractive rates which acts as the floor for bank deposit rates.

Taxing times

While the FY20 Budget was expected to bring in some feel good, it did quite the reverse adding to market woes. Foreign portfolio investors turned sellers after the finance minister introduced higher tax rates. FPIs have sold shares worth over $3 billion, while they were net buyers worth $11.3 billion till June. “You have to market yourself in the global arena. Don’t assume that investors will come because we are India. We have to make the investing climate so conducive that people can’t ignore,” reminds Shah. In a bid to halt FPI exodus, the finance minister finally did rollback the surcharge apart from easing the regulatory and compliance framework for FPIs. 

First Global’s Sharma, though, says the surcharge was just part of a deeper problem. “The stimulus announcement will definitely bring about a short-term bounce given the carnage the market has seen. But the FPIs were not selling merely because of the surcharge. There is strife in the economy, the kind we haven’t seen in years impacting growth and corporate earnings. The stock market sees these things in advance and you have to trust its foresight,” he explains. 

Amidst the gloom, there is some silver lining in the form of improved monsoon and lower oil prices, which will reduce the import bill. In May 2014 when the BJP came to power, crude oil was at $107/barrel and declined to $46/barrel allowing the government to raise fuel tax to fund social sector schemes. While oil did move to $80 in October 2018, it has been on a steady decline since. Singhania expects some demand revival during the festive season. “It is a crisis of confidence rather than liquidity because growth is not very visible. Apart from the challenging domestic environment, there is renewed stress from global factors and even if we are fairly insulated, we can’t escape the impact of global equity market flows. But with government spending coming back in the second half, things will start to improve,” says Singhania.

But consumption could take more time to sustainably recover as private investment has to increase for job creation and higher wages. Job creation is facing a massive challenge with the Periodic Labour Force Survey pegging the all India unemployment rate at 6.1% in FY18 which is a 45-year high. According to the survey the number of unemployed during FY18 was more than double what it was in FY12 at 28.5 million. And during the five-year period (FY13-18) only 500,000 net jobs were created even as 18 million joined the workforce, precipitating the unemployment crisis.

Although creating jobs is a vital component of the macro that needs fixing, most investors are focused on the here and now. Even as the market is trading close to its 10-year average multiple, the valuation looks expensive given that more earnings downgrades could be in store. At such times, consumer staples, tier I financial and IT stocks may seem safe, but the price for safety does look very high. In a polarised market where margin of safety comes at a very high price and value comes with a lot of uncertainty, investing can be frustrating. In times of uncertainty, cash is always king. “I would rather wait for a green shoot and buy a stock 20% higher than catch a falling knife. I would sit tight on cash. Capital preservation is key,” advises Sharma.