A normal south-west monsoon is good news not just for farmers but also for sectors that gain when the rural economy is in good health. Tractors, agrochemical industry and packaged consumer goods, or FMCG sector, count among those.

That’s why even now, when agriculture is a relatively small contributor to the economy, news of a normal monsoon is greeted with some excitement by stock market investors. The India Meteorological Department (IMD) has forecast a normal monsoon in 2018, with rainfall likely to be 97% of the long-term average.

Just like any prediction, the monsoon forecast should also be taken with a pinch of salt, especially when investors plan to use it as a factor in their investment decisions.

One, this is the first monsoon forecast and will be updated in June, which will use additional data available by then and is more detailed. There has been significant variation in the initial forecast and actual rainfall in the past five years, barring 2017. Secondly, what counts really is the spread of rainfall—whether it is adequate in all districts dependent on rainfall for farming—and the timing of rainfall—whether it follows its usual pattern so that crops receive just the right rain at the right time. Too little or even too much rain can ruin crops.

The overall picture may seem buoyant but its effect on agricultural output and therefore income can vary. An SBICAP Securities Ltd report points out that critical factors will be distribution of rainfall among divisions—last year 13 out of 36 sub-divisions saw deficient rainfall despite the overall status being normal. Also, water reservoir levels this year are relatively low in the south and north, so adequate rainfall in these areas needs to be monitored, says the report.

Apart from being too early to call, agricultural incomes will also depend on the prices farmers get. If the crop is good but prices don’t match expectations, then the profit left for farmers after meeting their costs will not be sufficient to show up in consumption spending. They have loans to service too. The past few years have seen a soft trend in agricultural prices and while that may have ensured food inflation remains low, it has not left the farmers feeling richer.

The government’s announcements on giving a higher minimum support price (MSP) is a positive sign for farmers, but factors such as how it will be calculated, whether it is a substantial increase over what they got earlier, and whether market realizations remain below MSPs are some factors to keep a watch on. India will also see state elections followed by a general election in 2019. One can expect the government to try and ensure that farmers get remunerative prices for their produce. A good crop and remunerative prices will add considerably to farm income, and spending as a result.

Lastly, farm income is only one determinant of rural income. Non-farm work, including employment in local industries and construction work in infrastructure and residential construction projects, are crucial supplements of income. Growth in both farm and non-farm wages has been slowing down over the years (see chart). In the case of non-farm wages, this is despite all what we hear about infrastructure projects such as roads picking up speed. The country-wide slowdown in real estate projects too could be contributing to lower demand for labour and depressing wage growth.

With all that said, here’s a look at the outlook for some of the sectors dependent on the monsoon, if rainfall is normal.

What could send tractors off track

The tractor industry has benefited from two consecutive good monsoon. After contracting by 9% in fiscal year 2016 (FY16), tractor sales in the country zoomed by 15.5% in FY17 and by an even higher 20.1% in FY18, in spite of a relatively high base. That may explain why normal monsoon forecasts are cheering investors.

Shares of leading tractor makers are moving up—Mahindra and Mahindra Ltd (M&M) has risen by 6% since January on the back of good tractor sales, compensating for its auto segment, which is still attempting a comeback. Star performer Escorts Ltd has rallied 24%, while VST Tillers and Tractors Ltd has risen by 11% during the period.

While optimism among investors is not without reason, there are underlying risks too.

Tractor sales are directly linked to agricultural output and income. Importantly, if the government’s effort to increase MSPs leads to higher farm income, it will sustain farmers’ interest in cultivation. That will support demand for tractors. Being an election year only adds to optimism that government policy is likely to favour the rural community.

That apart, tractors are also being deployed in some states for non-farm activities. According to Anupama Arora, vice president and sector head (corporate sector ratings) at Icra Ltd, “Demand is growing from small farmers too, who deploy tractors for haulage to support rural infrastructure activities besides farming activities. Hence, the government’s focus on enhancing rural infrastructure will continue to support demand for tractors, which is showing no signs of slowdown."

Further, skyrocketing sales have translated into healthy operating margins of 11-13% for the tractor business of firms in the listed universe.

But there are risks to heady growth estimates too, if some of these assumptions don’t come true. Higher demand and rising commodity prices may see manufacturers increase tractor prices, which may eventually weigh on demand. This would also hinge on the cost of finance, which is unlikely to remain at the currently favourable levels.

From an investor’s standpoint, the valuations of tractor firms have already run-up. While Escorts and VST Tillers trade at a rich 23 times the estimated one-year forward earnings per share, M&M trades at a lower 18 times because its auto business is still not on a smooth road and is weighing down on earnings.

In other words, if all the factors don’t play out in favour of the farm sector, it could dampen the monsoon party for tractors.

Rains of limited importance to agrochemical firms

A normal monsoon forecast may not mean much for agrochemical companies, although they are directly dependent on the agriculture sector. After two sub-par years, the country received near-normal monsoon rains in 2016 and 2017. But agrochemical producers had a rather mixed experience with revenues growing in single digits.

Despite a favourable base, stand-alone revenues of Rallis India Ltd, a large agrochemicals company, increased by an unexciting 8.6% in FY17. Revenues of Dhanuka Agritech Ltd are up 5.4%.

Season 2016 started with a normal monsoon forecast. But as Rallis India points out in its FY17 annual report, the country has seen uneven growth. “Delayed onset of monsoon, excess rainfall in certain geographies and dry spells in some areas, especially in the southern states due to absence of the north-east monsoon, impacted cropping," said the company. The year saw lower crop pest pressure crimping growth of insecticides sales. Combine this with low prices of key crops, product offtake remained poor leading to inventory pile-up by end of the year.

2017 was no different. It also started with a normal monsoon forecast. But it provided no major boost to earnings. Revenues of Rallis India in the first nine months of FY18 increased 8.7%. Dhanuka Agritech registered a growth of 7.3%. Importantly, profitability came under pressure. Uneven and unseasonal rains impacted sales as farmers missed spraying, says an analyst. According to another analyst, pest infestation in FY18 was also low, reducing the requirement for agrochemical spraying. As sales remained subdued and the industry faced pricing pressure, companies were unable to fully pass on the rise in raw material costs. This weighed on profitability.

It should be noted that despite 2017 recording a near-normal cumulative monsoon, only 65% of the area received normal rains, according to the fiscal second-quarter results statement of Rallis India. The north-east monsoon, which was forecast to be normal, also ended at an 11% departure from the long-period average.

Overall a mere normal monsoon will not ensure good fortunes for agrochemical companies. Analysts cited above say that the timely onset, spatial distribution of rains and pest infestation are equally crucial for a good sales season. While these factors are missing in the previous two years, one analyst says companies are entering the FY19 season with better conditions. The groundwater level is not as bad as two years back and the inventory situation is better than in 2017. The remaining factors have to fall in place.

Glory days of rural demand not likely to return soon

We have seen two normal monsoon years in succession but packaged consumer goods companies have not seen their rural sales growth accelerate as expected. Market leader Hindustan Unilever Ltd has been consistently flagging that rural volume growth has improved but the gap over growth in urban markets has narrowed considerably.

The rural market is an important one for consumer goods companies. While the per capita consumption may be less than that in urban areas, the size of the population means that even a small increase in consumption leads to a sizeable increase in demand. This is particularly true for companies selling products of mass consumption. That’s why consumer goods companies followed the growing roads network in rural India to establish a rural distribution network.

If rural demand has disappointed consumer goods companies, there are a few reasons behind it. Some, such as depressed crop prices and slow growth in wages, have been mentioned earlier. Some one-off events such as demonetization in FY17 and the roll-out of the goods and services tax in FY18 disrupted supply chains of consumer goods companies. The recovery from that has been slow, and companies have had to expand their direct distribution network to restore their reach.

With all these events behind them, it is reasonable to expect rural demand to recover in FY19. The question is if it will regain impetus. If the monsoon is normal, and crop prices increase enough, then farmers will have more money in their pockets to spend. This should lead to higher demand, for sure. How much of that comes to consumer goods remains to be seen, but some increase in spending can be expected.

But a big increase in rural spending is unlikely unless you see non-farm income also pick up pace. There are no signs of a sustained revival in industrial growth, or infrastructure, or the real estate sector—traditional sources of demand for rural labour. This part of the rural economy will still feel the pinch of slower economic growth.

In sum, while a normal monsoon will see rural demand pick up, it will still be restrained and will not go back to the heydays of growth when India’s economy was firing on all cylinders. Meanwhile, valuations are higher with the S&P BSE FMCG Index trading at a price- earnings multiple of 41.5 times. That valuation depends more on what happens in urban markets and only a gradual revival in rural demand.