Worsening outlook

Fundamentals warrant stock price correction

A series of adverse global developments have led to a deterioration of prospects for Indian companies. The Ukraine War has led to spikes in fuel prices and that of metals, paper, fertilisers, and wheat since Russia and Ukraine are major producers of those commodities. It has also meant a new round of semiconductor shortages due to shortage of neon. The rising energy import bill, and widespread supply-chain issues will lead to new upward pressures on the already-high inflationary trends. Corporate results in the December quarter indicated inflation was eating into profit margins and there may be more sustained margin pressures, going forward. The energy import bill will also lead to a higher current account deficit and heavy sales by foreign portfolio investors (FPIs) may lead to pressure on the rupee. The FPIs sold Rs 1.4 trillion worth of rupee-equity in fiscal 2021-22 and Rs 1.1 trillion of those sales have occurred since January 2022.

The FPIs are aggressively cutting exposure to emerging markets and risky assets because the US Federal Reserve has indicated it will raise rates to combat inflation in the US. Every major central bank is likely to align with the Fed, and the Reserve Bank of India (RBI) may soon need to adjust. Meanwhile, the Indian stock market remains extremely high-valued at a current PE of 22x for the Nifty50. The indices have held on due to strong domestic buying with the hope that economic activity is still normalising and also the fact that real interest rates are negative. In many sectors, activity is back to near pre-Covid (2019-20) levels or has improved further. But apart from the commodity sectors (energy, metals and agro-businesses), a wide swathe of Indian corporates have released cautious advisories alluding to higher expenses and weak demand. Bank credit offtake has also not increased in a manner that inspires confidence in consumption pick-up, or private sector investment. Banks also increased provisioning in Q3, which may indicate an imminent new round of bad loans.

The weak private consumption is perhaps due to high inflation and high unemployment, and it translates into lower sales growth for corporations. This weakness cannot be easily counter-balanced by higher government spending given the high fiscal deficit. Base effects, which led to spikes in rates of profit growth through the last several quarters are wearing off. Historically, the Indian economy has struggled whenever energy costs are high. In addition, higher interest rates will impact corporations with high debt. Higher interest rates can also lead to lower profits and lower credit demand, hurting the financial sector. To some extent, the continued normalisation of economic activity may counterbalance this. But the consensus is that profitability growth will be more muted in 2022-23 than in 2021-22.

Manufacturing could be hobbled by supply-chain issues. The differential between wholesale price and retail inflation indicates weak pricing power for industrials, which are unable to pass on cost increases. The automobile sector, for example, is unable to work at full capacity due to semiconductor shortages. Higher interest rates usually lead to lower valuations assigned to risky assets like equity. Such a downgrade is likely as these adverse trends play out. In addition, this is the sort of environment where shocks like sovereign defaults in Russia or real estate defaults in China might trigger panic. Investors would be well-advised to exercise caution about equity exposures under such circumstances.