This is a classic downward spiral and where it will stop is anybody’s guess right now. The government does not have the money to spend to create demand in the economy and if it attempts to do so, it will be at the cost of fiscal health. The repercussions of a weak fiscal is long term slowdown in growth.
Consumption demand weakness has manifested itself in the last few quarters while investment demand has been almost non existent over the past several years. There is a sense that the consumption demand weakness is temporary largely due to weak rural economy and a credit market freeze over the last one year. Hope is that demand will revive in the next couple of quarters but there is no sense of certainty in this.
The fact is that demand slowdown is having a spiralling effect that is further causing weakness in demand. Unless there is huge demand from the government or an external economy, the demand slowdown can continue. In the early 2000’s, China single handedly took up the world economy, as it grew in high double digits but now it is growing at 6%. Developed world demand is not enough to take up growth slack.
Weakness in consumption demand has resulted in slowdown in virtually all sectors, affecting jobs and creating uncertainty of employment. Export growth weakness has hurt jobs in the export sector. India’s exports have shown weak or negative growth over the last few months. Weakness in global demand for IT services has led to culling of jobs in the IT sector. Telecom and financial services, the fastest growing sectors in the 2000-2010 decade are struggling for growth at present. Jobs are at stake in these sectors.
The government is overstaffed and is looking to privatise, which will lead to more jobs being lost.
Given the weakness in demand and in employment, demand slowdown is manifested as consumers stop consuming on worries over their jobs. Small and medium scale enterprises are the worst affected by the slowdown and credit freeze, as their businesses degrow sharply, and they stop consuming as well. Entrepreneurs too feel the pinch of demand weakness and they too stop consuming non essentials.
Bubbles in Equity
Indian equity markets are on a roll despite weak macro- economic data and Q2Fy20 earnings. The corporate tax rate cut boosted market sentiments and improved earnings for most of the corporates in Q2Fy20. However, the guidance for Q3Fy20 is weak as most of the corporates have acknowledged festive season has been subdued in terms of top line. Due to the slowdown there has been significant manufacturing production & employment cuts in most of the sectors. As per CARE employment report, pace of employment growth rate in India slowed down to 2.8% in Fy19 from 3.9% in Fy18. Given such weak investment environment, significant amount of money has been reallocated to strong fundamental stocks despite their poor earnings, which has led to expensive valuations.
Indian Economy is Weakening ?
Industrial output in India dropped 4.3% (Y-o-Y) in September of 2019, following an upwardly revised 1.4% decline in August and worse than market expectations of a 2% fall. As IIP shows status of Industrial activity, lower IIP growth shows weak consumer spending, which resulted in lower corporate sales. The Indices of Industrial Production for the Mining, Manufacturing and Electricity sectors for the month of September 2019 contracted by 8.5%, 3.9% and 2.6% on yearly basis respectively. Other factors which have shown significant slowdown in economy are :
- IHS Markit India Manufacturing PMI unexpectedly fell to 50.6 levels in October 2019, the lowest since October 2017, from 51.4 levels in the prior month. Both output and new orders expanded at the slowest rate in two years.
- Infrastructure output declined 5.2% from a year earlier to September 2019, the first month of contraction since April 2015. Cement production declined by 2.1% in September 2019.
- Crude oil production declined by 5.45%, Natural gas production declined by 4.9% and Coal production declined by 20.5% in September 2019. Such steep decline in major energy commodity products shows weakness across energy products as well as other derivative products of Oil, Gas & Coal.
In addition to the current economy slowdown, stress in financial sector had a multiplier effect on economy growth in the form of liquidity & credit default issues. NPAs have significantly increased for banks in last couple of financial years. Credit market conditions are extremely poor with markets virtually frozen for most except a few issuers. Credit spreads have ballooned to alarming heights and this is affecting borrowers as well as lenders, a virtuous self-fulfilling cycle that caused the 2008 global credit crisis. Accounting to all above mentioned factors which has led to slowdown in most of the sectors had an impact on corporate earnings during H1Fy20.
Indian economy advanced 5% (Y-o-Y) during Q1Fy20, slowing from a 5.8% expansion in the prior period and missing market consensus of 5.7%. It was the weakest growth rate since the first quarter of 2013, amid a slowdown in manufacturing and construction sectors. Early estimates for Q2Fy20 GDP growth stood at lower than 5% growth. In order to achieve government’s ambitious target of USD 5 trillion economy in next 5 years, GDP real growth rate need to be at an average of 10%-11%. In order to revive the slowing economy, the government had announced several measures such as big bang corporate tax rate cut, special fund to infrastructure sector and Rs. 700 billion additional lending and liquidity of around Rs 5 trillion by providing upfront capital to PSBs. However, these measures could affect projected Fy20 fiscal deficit target of 3.3% of GDP and government might need to borrow more money from the markets in order to keep the economy afloat. On positive side, interest rates are at lows and system liquidity is at Rs. 2.5 trillion.
On the global front, ongoing US – China trade war has an impact on global economies, net export countries have been affected due to slowdown witnessed in China. Manufacturing and service PMIs for most of the developed economies have witnessed contraction in the last couple of months. On top of the trade war issue, US House passed a resolution on a vote of 232-196 laying out the framework for the next phase of President Trump’s impeachment inquiry, which will make the investigation more public,which could weaken investor sentiments. On the positive side, strong quarterly earnings reported by US companies has led Wall-Street indices to all time highs.
Menace of Valuation Bubble?
In the last one-year, Indian equity markets have witnessed extreme volatility, on the back of liquidity issues, tepid quarterly earnings, weakening macro-economic data and corporate governance issues. All these factors together made investors extra cautious and eventually money has been reallocated to such companies where there’s significant stability in fundamentals and no corporate governance issues. Consumption sector stocks have witnessed flood of money, which has led to expensive valuations. As per Economic Times report, as of June 2014, FPIs have invested 48% of their investments in top 100 companies and 77% in top 200 companies. This has now surged to 88% in top 100 companies and 96% in the top 200 companies. Demonetisation has also caused many investors to shift their investments in physical assets to financial assets. Also, shift from the unorganized to organized players due to the GST implementation has benefited large Consumption sector companies. The Nifty Consumption index, a barometer of companies that represent the domestic consumption sector, including consumer non-durables, healthcare, auto, telecom services, pharmaceuticals, hotels, media & entertainment, surged nearly 228% in the last 10 years and has outperformed the front-line benchmark index Nifty50.
Majority of the consumption-based companies have reported tepid growth in revenues and volumes for the second quarter of FY 2019-20. Hint of recovery in the revenues and volumes for these companies does not seem to be anytime near. Rural India has been the cash cow and root cause for surge in volume growth post demonetisation & GST implementation for consumption sector but rural India growth has halved from previously reported growth levels. Consumer businesses were desperately hoping for revival in consumption during festive season but they have reported mixed set of numbers for Q2Fy20.
Below table shows how top companies’ revenues has grown in last 10 years, most of the companies have reported revenue growth lower than nominal GDP growth. The main issue currently remains is how would these companies sustain such expensive valuations given such weak growth outlook? On a contrasting note, global companies that have reported better revenue and volume growth are currently trading 1/3rd valuation levels of what Indian companies are currently trading at. At the end of the day, ultimately current valuations must justify future earning potential of the company. Historically, forward P/e for Asian Paints and HUL had traded at much lower levels with a better outlook than how it is as of today. Surprisingly, 10 year revenue growth rate of HUL is much lower than India’s 10 year average nominal GDP growth rate.
If valuations continue to be expensive for consumption-based companies with the P/E being in the range of 47x to 75x without any future significant growth, this could lead to dramatic correction in share price of respective stocks.
“History doesn’t repeat itself, but it often rhymes”.
– Mark Taiwan