The obfuscation around the steep market run-up and weakening growth has re-emerged with gross domestic product (GDP) growth downgrades to 5.0-5.5 per cent and declining profits not being enough of hindering factors. While the manufacturing sector has been a drag, the impact of the weak monsoon is setting in even as the services sector, thus far considered the bulwark of India’s growth story, has also started to slacken.
Clearly, the macro outlook is impacting corporate performance. For a broader set of companies, profits have contracted over the past three quarters with deceleration in sales to 12-13 per cent and continued margin pressure. Large-cap companies have to satisfy with 15-16 per cent. These compare with 22-25 per cent till three quarters back. The scenario is unlikely to improve for another three quarters.
The current conditions reflect the deeper negative fiscal multiplier of the large fiscal expansion and supportive role of PSUs and banks, that caused stimulant-led recoveries in the past. While the bounce engendered the consensus mirage of 8.5-9.0 per cent, misallocation of resources accentuated the decline in potential growth, which in our view is at sub-six per cent. Symptoms of these now manifest in persistent high inflation, widening fiscal and current account deficit (CAD). The ‘crowding out’ effect arising from high inflation, interest rates, taxes and declining savings have impacted investments.
Considering monetary easing as a cure for all would be a simplistic assumption as these problems are structural. Monetary easing against the backdrop of low real interest rates and little commitment towards fiscal containment will aggravate inflation impulses, discourage savings, sustenance of high CAD and further weakening of currency.
On the external front, decline in domestic growth along with signs of recession in many parts of the advanced economies highlight strong global linkages. According to our estimates, India’s GDP growth elasticity with respect to Europe and US are high at 1.4 and 1.2, respectively. What we are seeing today is the impact of trade linkages and the adverse terms of trade of high crude oil prices. But the impact of a more adverse financial condition is suppressed by near zero rates adopted by several advanced counties. While this has ensured that domestic equities, real estate and global commodity markets have remained buoyed and in denial of implications from sharply decelerated growth and profitability, this dichotomy cannot last long.
Thus, developments on fiscal management and outlook for the banking sector will be key triggers.
The vulnerability of fiscal management lies in the decline in tax elasticity and rising expenditure. Currently, the weaker fiscal health is camouflaged by lower tax refunds and non-payment of dues to oil companies. Adjusted for these two, the effective fiscal deficit for Q1FY13 could be astoundingly high at 50 per cent of FY13 Budget compared to the reported 37 per cent.
The banking sector, especially PSU banks, will have to grapple with economic slowdown, steep rise in gross NPAs and restructured assets. For several PSU banks, the GNPA ratio has risen to five per cent in Q1FY13 and inclusive of restructured assets at eight to nine per cent. Decline in credit growth and deteriorating credit quality are likely to elevate the NPA trajectory, going forward, and is an understated risk.
Hence, from the equity investment standpoint, companies having capability of showing resilience in sales, strong pricing power, low leveraging and quality management will attract high premium. Select utilities and pharma companies could be less vulnerable. Even as the economy moves towards normalisation the banking sector, especially PSU banks, will deserve a careful allocation strategy.
The author is co-head institutional research, Emkay Global
