BackShadow of worry over the stock market
Corporate profits have been sluggish despite the economic recovery. What should investors make of this paradox?
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The financial year is drawing to a close. The new earnings season will begin very soon. The very real possibility of weak quarterly earnings reports in the weeks ahead has already cast a long shadow over the equity market. The undertone of most analyst reports is still bullish. But there are growing worries as well. It is no wonder that the equity market has been choppy in recent weeks.
Indian equities have done very well over the past year thanks to two reasons. First, the strong mandate given by the Indian electorate to Narendra Modi in May exorcized the threat of political instability as well as raised hopes of a new commitment to economic reforms. Second, the macro fundamentals of the Indian economy kept improving even as the dramatic collapse of global oil prices helped ease pressures on prices, the current account and public finances.
The benchmark Sensex has gained 24.63% since 1 April 2014, making India one of the best performing markets in the world. The rally lost momentum long ago. The Sensex has barely budged since the end of December. Investors are still puzzling over the fact that the improvement in the macro indicators has not been matched by actual industry performance. This paradox has meant that most of the increase in share prices can be explained by the expansion in earnings multiples rather than in actual earnings. Indian markets are no longer cheap if one looks at valuations, which is why most analysts agree that the next leg of the rally will need to be powered by strong earnings growth. Most brokerages are predicting that corporate profits in the fourth quarter will grow in the single digits. And this comes in the wake of a fall in net profits of the top 30 companies in the December quarter.
There are several challenges here. Rural consumer demand is expected to be weak given the new round of farmer distress. Investment demand is restricted by the fact that the private sector is now focused on using cash flow to retire debt rather than invest in new capacity. Pushing exports is proving to be tough because of the weak global economy as well as a slightly overvalued rupee in real terms. It is no surprise that industry leaders are hoping for the promised public investment push, especially in certain areas such as power, roads, railways and housing.
Foreign money continues to pour into India because it looks attractive relative to other large emerging markets such as China, Russia, Brazil and Turkey. Inflows of domestic money into mutual funds has also picked up in response to the rally that began in February 2014 (and is hopefully part of an overall rebalancing of portfolios from physical assets to financial assets).
The big question now is whether corporate profits will eventually catch up with the overall rate of economic growth. In other words: is it safe to assume that corporate profits are lagging indicators of economic performance, in the sense that they will get more momentum only a few quarters after economic growth picks up? In a blog published by The Economic Times, economist Arvind Virmani has suggested that in a dualistic economy such as India, with a small organized business sector that has deep global links and a large unorganized sector that is driven by domestic demand, corporate profits will lag economic growth.
Investors are currently playing a waiting game. They see the positive macro story but are not sure how long they will have to wait before the micro story improves. This chasm will take time to bridge. The real worry right now should be whether patience will run thin in the months ahead, especially if there is another round of global financial volatility in case the US decides to raise interest rates in the second half of this year. No wonder the Indian equity markets are on tenterhooks.
Will corporate earnings recover to sustain the rally in stocks? Tell us at views@livemint.com
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