The world is struggling with low demand. With consumers in the western world still in the doldrums and the Chinese investment boom fast ebbing, the world seriously lacks a demand engine that can spur growth activity.
Not surprisingly, the global inflation rate — if one excludes the 2009 crisis period — is close to a ten-year low and is likely to dip lower given the precipitous fall in commodity prices. Few expect a quick revival because when the market starts winding down after a commodities super cycle, it tends to develop its own momentum. Even unviable suppliers continue operations for much longer than desirable owing to access to cheap funding, particularly if the price weakness follows years of big profits. Sometimes, local government support also helps, like the recent royalty cuts for some iron ore mines in China. Costs also decline faster, not just because the currencies of commodity-exporting countries start to fall due to deteriorating trade balances, but also because prices of inputs start to come down and companies start to focus more on costs after years of focusing only on revenues. This is playing out with textbook precision in commodities such as iron ore. And while there may be factors that are unrelated to underlying demand or supply that have accentuated the precipitous fall in crude oil prices, the trigger for it does seem to be demand weakness.
There are three important ways in which weak demand, weak commodity prices and fear of global deflation affects the Indian economy and markets.
The first is the effect of global monetary policy on asset prices. Deflation can be debilitating to economies that have a lot of debt: of this set, peripheral Europe is the most well-known. Fear of deflation is provoking central banks across the world to further ease monetary conditions. The weighted average policy rate in countries adding up to nearly three-fifths of world GDP is already near zero, and the rest are mulling cuts as well. Further, the quantitative easing (QE) in 2015 is expected to be nearly twice that in 2014, with the Bank of Japan and the European Central Bank offsetting the end of QE by the US Federal Reserve. Sovereign bond yields are at historical lows in a large part of the world. This means that there is a higher premium for growth assets. Companies with credible medium-term growth prospects could thus continue to trade at valuation multiples that would have seemed uncomfortably high otherwise.
The India story
India is now among the last remaining bastions of demand growth in the world. Even at the lowest projection in the market right now — that is, 11% nominal GDP growth split equally between real activity growth and inflation, India is expected to have the fastest nominal growth in the world. Many erroneously slot India as an emerging market, whereas it has little in common with the others. In fact, groupings such as emerging markets and BRICs appear well past their sell-by date. Per capita GDP (adjusted for purchasing power parity or PPP) in most other emerging markets is two to seven times that of India.
Mexico was at India’s current level of prosperity in 1976, Brazil and Turkey were at India’s current level of prosperity in 1983 and Russia achieved it more than fifty years back. India is an economy with sub-Saharan prosperity and a developed world political system. With a remarkable improvement in state-level governance and technological changes, India is making rapid strides in improving basic infrastructure, electrifying households, helping nearly half of those that use firewood for cooking to transition to efficient and cleaner fuel, providing drinking water, all-weather roads, bank accounts, and so on.
No wonder, then, that the Indian market houses numerous companies spread across sectors that could grow profits by 15-20% a year for several years: the valuation premium of the Indian equity market compared with the world equity market could thus expand or, at the very least, stay elevated. Currently, it is only in the low teens, whereas it used to be 40% just four years back.
Global factor
The second effect has a negative impact on companies’ earnings: the impact of weak global demand and lower commodity prices for the economy may be marginally positive but the market is not truly representative of the economy. More than half the revenues of Nifty companies is effectively not denominated in rupees. And of the rest, a large part comes from banks that lend to companies that have prospects linked to global growth.
In particular, commodity producers, refiners and exporters to countries that are commodity exporters, are likely to get hurt. Consensus expectations for earnings growth are at 18% for the financial year ending March 2016, on top of 13% growth in the current financial year. We believe these estimates are likely to be revised downwards. These downgrades may be driven not just by global demand weakness, but also by revising over-optimistic projections on the timing of the recovery of the investment cycle. Many expect the first signs to become visible in the next financial year but that seems unlikely for now.
Going with the flow
The third is a risk to capital flows coming to India. According to Credit Suisse estimates, half of the flows that have come in over the past few years could have come from sovereign wealth funds in oil exporting countries. The reduction in oil prices means lower current account and fiscal surpluses or perhaps even deficits for some of these economies. This could have a meaningful impact on flows into India.
As asset allocators shun emerging market funds and increase their weights in India funds over time, some flows may still happen but the earlier steady flows are likely to be stemmed, particularly because this reallocation is unlikely to be rapid and could be phased out over several years.
Lastly, there is also the risk of a disorderly correction in global markets if some banks, funds or companies go underwater due to a sharp decline in commodity prices. Crude oil might be at $60 but we don’t know when or how the effects of $60 crude oil will become visible. While that uncertainty remains, global markets — including India — are likely to stay weak.
Closer home
And what impact could India-specific factors have on the economy? Economic momentum seems to have bottomed out but a meaningful acceleration it still some time away. Given India’s enormity and complexity, any central government action affects growth with a lag of several years. In the markets, however, even future growth expectations have an effect, which is manifested through valuation multiples.
While the government acts on many economic fronts, its role has shrunk significantly since 1991 and there are only four specific issues on which progress could have a broader economic impact: coal, railways, banking and the GST. Of these, GST is likely to be the issue that grabs headlines in 2015, as the government manoeuvres around various obstacles. Success at every milestone may excite the market, even though economic gains from GST are probably several years away.
With the nature of economic growth remaining the same, it is likely that the sectors with better earnings growth may continue to be the ones linked to consumption and exports, in addition to wholesale funded financial institutions continuing to benefit from surplus liquidity.
