The drop in global commodity prices has raised expectations of a fall in inflation, lower interest rates and a revival in demand.
The slowdown in global economic growth finally put the brakes on prices of crude oil and metal prices, which were spiralling out of control and hurting the financials of corporates, governments and individuals.
The declining prices could not have come at a better time as the domestic corporate sector was struggling to cope up with higher inflation, higher interest rates and slowdown in industrial growth.
All this, a direct result of the higher cost of crude oil and metals, which serve as inputs for a vast majority of sectors. In a high interest rate environment, the hike in prices of products has led to a drop in credit growth and consumption demand.
The high cost of inputs, especially crude oil which spiked to $145 levels in the first week of July from $100 levels in May, and the fears of a runaway inflation was reflected in the markets with the BSE Sensex dropping steeply to 12,000 levels in the second week of July.
However, with crude oil dropping below its May levels, commodity prices cooling and consumption expected to pick up in the festival season in October-November, experts believe that a recovery in the economy and the corporate revenues are on the cards.
The rider is that the prices going forward must sustain at the current levels or drop, which may lead to slackening of monetary tightening, reduction in interest rates and finally attract investments and spending by corporates as well as the consumer. We take a look at the commodities, which have contributed to the current mess, the falling rupee, inflation and the sectors that will benefit from this.
The oil equation
Of all the commodities we import to power the wheels of our economy, crude oil is the most important. With 70 per cent of our requirements being imported and used primarily to run our transportation and power requirements, the spike in price of this commodity has a cascading effect on prices of most goods.
With the country consuming nearly 985 million barrels of oil in a year, every $1 fall means a saving of $1 billion for the exchequer.
With crude oil having corrected from its peak by about $40 per barrel, the Indian economy saves $40 billion. This will not only go some way in bridging the yawning fiscal deficit gap brought on by higher fuel (10 per cent of GDP), fertiliser subsidies, pay commission arrears and farm loan waiver, but also make available resources that can be utilised for infrastructure spending.
“The higher commodity prices,” says Ajay Bodke, senior fund manager at IDFC Mutual Fund, “has led to a drop in demand for commodities in developed countries and this is good news for Indian companies as it will ease pressure on their margins.”
The biggest impact of this will be on oil marketing companies that are forced to shoulder the subsidies on the sale of petroleum products which are imported at international rates but sold at subsidised rates.
| FUND MANAGER SPEAK | |||
|
| Anoop Bhaskar CIO (Equities), UTI Mutual Fund | Ajay Bodke Senior Fund Manager, IDFC Mutual Fund | Mihir Vora Fund Management Head-Equities,HSBC AMC |
| Lower commodity prices | Positive, see how inflation plays out | India will save $40 bn a year on oil | Positive, will benefit manufacturing sector |
| Depreciating rupee | Relaxing ECB norms will help | Good for exports, global growth concerns remain | Surprising as commodity prices are down |
| Inflation figure by March 2009 | Higher single digits | Has peaked, should come down | Will come down over the next two months |
| Global slowdown impact | Export demand projections need to be tempered | Lower commodity prices, ease margin pressures | India relatively insulated |
| India vs emerging markets | India better placed than Brazil, Russia | Not expensive, but earnings concerns remain | India should perform better |
| GDP Growth FY09 | Conservative at about 7.5 | 7-7.5 | 7-7.5 |
| Returns over a year/Valuations | Depends how it will turn out over the next six months |
NA | |
The metal dip and inflation
Unlike the sharp fall in oil prices, metal prices on aggregate have been coming down gradually. The Commodity Research Bureau index, which tracks the spot prices of the major metals has seen a fall of 23 per cent from its peak in May.
Analysts say that the impact will be positive on metals such as steel, which are used as a raw material or input for manufacturers and an end user item for consumers. While sectors which are likely to be benefited most by this are engineering, auto, capital goods and construction, metal stocks might feel the heat.
Says Amitabh Chakraborty, president, Equity, Religare Securities, “For India, 40 per cent of the stocks are commodity stocks. So, to that extent, their EBIDTA margins will be under pressure.”
While the metal sector is going to be impacted negatively, the dip in iron ore prices due to a slowdown in the demand of metals will help bring down the cost of inputs for steel producers. Lower international prices are not limited to metals.
International prices of agri commodities, with the exception of sugar which is firming up, are moving down. A normal monsoon in the country and rising buffer stocks will mean that the prices of food are likely to come down over the next two quarters.
Experts believe that this will help bring down inflation, which has peaked due to the base effect, to high single digits by January 2009 and to 7 per cent by March 2009. A gradual reduction in inflation could also prompt RBI to cut interest rates.
| EXPERT OPINION | |||
| Madan Sabnavis Chief Economist, NCDEX | Ramdeo Agarwal Managing Director, Motilal Oswal | Amitabh Chakraborty President-Equities, Religare Securities | |
| Lower commodity prices | Positive for engineering, auto and construction | Negative for commodity companies | Auto companies major beneficiaries |
| Depreciating rupee | Weaken further | Bad for those dependent on imports | Crude oil consumption will keep rupee under pressure |
| Inflation figure by March 2009 | 9 per cent | 7 per cent | 7 per cent |
| Global slowdown impact | Lesser than other economies, Exports to GDP ratio at 12% | Integrated economy, too many variables to ascertain impact | Emerging markets including India will be under pressure due to US slowdown |
| India vs emerging markets | Attractive at high GDP growth rates | Do well considering economy is doing well | Lower crude prices, India and China will outperform others |
| GDP Growth FY09 |
8-8.5 | ||
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The falling rupee
While the fall of commodity prices has helped bring down cost of inputs, the rupee’s depreciation by about 8 per cent since August 2008 and over 15 per cent since the start of the year is erasing part of the gains for corporates and the economy.
Says Madan Sabnavis, chief economist, NCDEX, “The depreciating rupee is worsening the balance of payments picture and we are running into current account deficit largely because of higher oil and non-oil imports.”
While this (higher non-oil imports including capital goods) indicates that corporate expansion is quite strong, if you couple this with the FII pullout ($7 billion since the start of the year), it exacerbates our deficit.
Analysts say that more outflows than inflows means that rupee will weaken further over the next two quarters. Companies which work on imported inputs will be hit while those that have export earnings to match will be able to offset the loss.
The biggest losers, says Anoop Bhaskar, CIO (Equities), UTI Mutual Fund, will be sectors such as telecom which have dollar denominated external debt and are earning in rupees. The beneficiaries should be the IT and textile companies, which are already reeling under the pressure of weak global growth.
Global growth slowing
The IMF predicts that global economic growth will slow down from 5 per cent in 2007 to 4.1 percent in 2008 and 3.9 percent in 2009. Lower demand, coupled with risk aversion due to the credit crisis where losses are expected to touch $1 trillion from about $600 billion currently, could take the wind out of growth. What are the implications of this for India?
Says Mihir Vora, head of fund management-equities, HSBC Mutual Fund, “The Indian economy does not rely much on exports (just 10 per cent of GDP), so even if there is a slow down in the global economy, India will still remain relatively insulated. However, in terms of sentiment, it could have negative impact from the perspective of the global investors or in the short term may result in lack of FII interest in the domestic markets.”
Thus, the implications are that lower global growth will bring down the prices of commodities further and may lead to lower interest rates as the danger of imported inflation diminishes. Interest rate sensitive sectors such as banking, auto, construction, capital goods and real estate should benefit from a drop in rates.
The road ahead
The Indian markets, which have been highly volatile (gaining and losing 1,000 points in the last 10 days), will seek direction from the Kharif crop, earnings in the second quarter and events unfolding in the political stage. The market would also seek confirmation of benign inflation and commodity prices over the next few months.
Domestically, the next quarter should lead to an upsurge in consumption due to a bumper harvest, farm loan waiver and pay hikes to 5 million central government employees. The festival season would indicate the reversal of consumption growth and credit offtake.
However, corporate revenues and earnings are expected to be lower in the second quarter due to higher input and interest costs and lower demand, which has been the case till now.
With festival season coming up, companies are looking at liquidating their stocks (to get rid of a costly inventory which is piling up), which will also help keep production lines occupied going forward. For the current quarter (Q2), sectors which have higher power and fuel costs will be hardest hit.
While FIIs have pulled out money from the Indian markets, falling commodity prices make other emerging economies such as Russia and Brazil (which are commodity producers) less attractive than ours. While there could be some uncertainties in the near term, the long term picture continues to be intact with GDP growth rates expected to hover at around 7.5-8 per cent and domestic saving at 35 per cent of GDP.
For the next one year, experts are conservative in their returns expectation and say that investors should look returns of about 15 per cent. Returns could also be impacted by the trends in global markets.
Experts say that the focus should be on domestic consumption and defensives such as FMCG and pharmaceuticals, which are safe bets and would be beneficiaries of a growth in domestic demand.
Sectoral impact
Auto
The auto sector has been one of the worst-affected due to the rise in metal prices, higher interest rates and dip in demand. The drop in commodity prices will help companies improve their margins and prompt price cuts ahead of the festival season.
While commercial vehicle and high-end car sales would continue to be muted due to high interest rates, demand for lower-end cars, two wheeler sales and tractors are likely to be driven by high rural demand. Two wheeler makers Hero Honda, Bajaj Auto, Maruti Suzuki and M&M could give good returns over the next six months.
Banking
Lower inflation numbers for the last three weeks had breathed new lease of life to the banking sector. RBI’s monetary policy, the initiatives of the government and good monsoons will ease inflation in the medium term.
Experts say that interest rates have peaked and may cool off by the year end. While the falling 10-year bond yield, from 9.5 per cent to present levels of 8.3 per cent, is a positive precursor, a small hike (25 basis points) by the RBI is though not ruled out (and perhaps, is already discounted by the market).
In the meantime, the banks have leeway to tighten their strings and focus on pertinent issues like cost cutting, asset quality and protecting margins. Banks such as SBI, ICICI, Union Bank and Axis Bank are likely to benefit.
Engineering and Capital Goods
The softening input prices should ease out some pressure on the margins as many of the companies have recently hiked product prices. However, a depreciating rupee is making imports more costly. The issues pertaining to interest rates, inflation and the slowdown in the industrial and infrastructure space are still in play. The rising interest rates and the input prices have compelled companies to go slow on the new investments.
Also, funding for new and the existing projects through equity (attracting investors) and debt have become more difficult. Though the strong order book will see them through the next two years and should have a positive impact on revenue growth, this is already reflected in the valuations.
What is needed is the pick up in the investments and industrial capex, which may happen only after companies get an assurance in the form of a pick up in demand. Analysts prefer stocks like Cummins India, Voltas and Crompton Greaves, as they are the most attractive in terms of valuations.
Metals - Ferrous/Non-ferrous
While there is some relief as prices of inputs (such as iron ore and coal) have come down, it is not enough as coal prices are still high. And Indian companies have to depend heavily on imported coal.
Additionally, the depreciation in the rupee has made the imports more costly. Also, whatever gain the companies will have on account of the fall in the iron ore prices has been passed on to the customers by way of cut in steel prices on account of weak global steel prices.
A few of these large players such as Sail and Tata Steel, which have their own iron ore mines and being integrated plays, should earn relatively better margins as compared to non-integrated players.
The Indian non-ferrous companies will be negatively hit on account of 20-30 per cent correction in the global commodity prices. Aluminum, copper and zinc manufacturers might get affected and will show lower margins and profits.
Most of these companies have a higher base as the commodities prices were better then. However, the falling rupee could be a positive for the Indian non-ferrous companies. Despite this and the benefit of new capacities, the net impact could still be negative as the global prices have corrected significantly.
Analysts expect margin pressure on companies like Hindustan Zinc, Hindalco and Nalco.
Pharmaceuticals
The fall in the rupee will help pharmaceuticals companies (Ranbaxy, Glenmark, Lupin), which derive a large chunk of their revenues from international markets.
Part of the higher import cost due to a rise in raw material costs from China and the costly dollar will be neutralised by exports. Companies with higher FCCBs (Ranbaxy, Sun Pharma, Wockhardt) on their books will have to account for it and there will be a translational loss.
Software
The weaker rupee will be a relief for tech firms that have been grappling with a slowdown in the US economy, which is one of their biggest markets. A one per cent depreciation of rupee against the dollar pushes up operating margins by 35-40 bps for IT firms, which however, this time around might get diluted due to growth concerns.
The earnings should nevertheless get a boost of 3-5 per cent in FY09 on account of a weaker rupee. The upsides due to the weakening rupee may be capped, if the RBI intervenes by relaxing ECB norms. Firms that have lower forex hedges (Infosys and Satyam) are expected to benefit the most.
Textiles
While the sharp depreciation of rupee against the greenback is a positive for the textile industry, it continues to feel the heat from higher raw material costs, slowdown in US (demand impact) and increased competition from countries like Vietnam and Bangladesh.
"Rise in cotton prices (30-35 per cent in last one year) would eat up much of the gains made by the industry from the reverse currency movements," points out Nirav Shah of Pinc Research.
Companies like Gokaldas and Welspun India would benefit the most, as more than 60 per cent of their business is in the form of exports; some gains could get offset due to weak demand.
Shah adds that with the softening of crude oil prices, polyester manufacturers like Indo Rama Synthetics and RSWM Ltd should be able to improve their margins.
With inputs from Jitendra Kumar Gupta, Dhiren Shah and Sarath Chelluri
