Steep climbs can be either exhilarating or scary, and the stock market’s vertiginous rise in recent weeks has given us ample scope for both emotions.
A lot now depends on what happens during the rest of this month, as companies start announcing their quarterly results. At current valuation levels, it seems that investors are expecting corporate profits to grow at 25% over the next few years. This is close to the average growth of profits in the past nine quarters.
Profit growth has outpaced growth in nominal GDP over this period—an unusual trend that will be difficult to sustain. Global trends show that corporate profits usually move in step with the underlying economy in the long term.
Yet, going purely by the experience of the past five years, share prices seem fairly valued. But the past is never a perfect guide to the future. The new quarterly profit numbers will be announced amid reports of an industrial slowdown. Various economists have already forecast a mild deceleration in India. The economy is likely to expand by around 8.5% this year, compared with its 9.4% growth in 2006-07.
Higher interest rates and a strong rupee are two obvious brakes. Higher wage costs, too, are a worry for companies. Already, there are signs of profit pressure in sectors such as automobiles and textiles. Demand for consumer durables is weak. And there is some evidence that real estate prices are cooling off, at least in the most overheated urban markets.
It’s not all worry out there. Some sectors will undoubtedly carry good news. For example, the unexpectedly strong showing on the farm front is likely to translate into strong demand for consumer non-durables in the villages. And there are no signs as yet of a slowdown in investment spending and demand for capital goods, despite higher interest rates.
So, the earnings announcements will be worth watching closely. Will Indian companies continue to grow their profits faster than the underlying economy? Perhaps not. Many brokerages are expecting a sharp slowdown in profit growth in the second quarter, perhaps as low as 16%.
This is not a complete surprise. While headline profit growth of the 30 companies that make up the benchmark BSE Sensex was 27% in the first quarter of the current financial year, core profits from operations were less impressive. Other income fattened the corporate cow, especially thanks to a dodgy accounting rule that allowed companies to show profits on the fall in the value of their dollar borrowing thanks to a strong rupee.
But it is also likely that companies will keep squeezing more from their workforce and capital assets through productivity gains. So, margins could be protected—or they could even get better. Higher margins would show that Indian businesses are still working hard to sweat their assets.
The expected slowdown in profits need not be a cause for long-term worry. As of now, there are no signs that the mistakes companies made in the mid-1990s will be repeated—especially over-investment and poor financial management. Corporate balance sheets are laden with more debt than the recent past, but they are far from being over- leveraged.
The long-term macro growth story, too, is likely to continue, as the economists of the Organization for Economic Cooperation and Development pointed out this week. India is likely to sustain economic growth of between 8% and 10% over the next decade. But there will be jumps and dips along the way.
These are cues investors will have to look out for. The huge leap in the market is likely to spark off a buying panic, as investors can no longer watch from the sidelines while equity prices go up, up and away. Cooler heads are needed right now.
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