India Inc.'s performance in the June quarter shows that sales and profits have grown at a decent clip with CNX 500 companies witnessing a 29 per cent expansion in sales and a 9.5 per cent growth in profits. But the question for stock market investors is whether this growth will continue. Right now, signals emanating from the economy hint that the current pace of growth is unlikely to linger. If stubborn inflation, rising interest rates and a slowing factory output are not reasons enough, growth blues in the European and US economies are not doing any good to the ‘India' growth story.
Lead indicators cool off
What lies ahead for Corporate India? A good advance indicator of the pulse of the economy is the OECD Composite Leading Indicators (CLI). The OECD Index, based on a country's industrial production, is designed to signal turning points in economic activity, about 6-9 months before it actually happens.
For example, back in February 2009, when pessimism was still high in the air, the CLI pointed to a possible trough in economic activity in India, indicating the beginning of an upswing. Linked to this CLI, the OECD business cycle clock traces an economy through the four stages of expansion, downturn, slowdown and recovery.
With ‘100' remaining the long-term trend line, an ‘expansion' implies that the CLI is above 100 and is displaying an increasing trend. If the CLI is still above 100 but is showing a decreasing trend, the country is said to be witnessing a ‘downturn'. Similarly, a CLI below 100, showing subsequent falls month after month, indicates a ‘slowdown' whereas a CLI below 100 but progressively rising, denotes a recovery. So, how is India positioned currently? According to this clock, the CLI for India moved out of the 'expansion' phase as early as July 2010 (100.9) and began its descent towards a ‘slowdown' in October 2010 (100.2) itself. This has happened even as the IIP showed a robust 11.3 per cent growth during the same month.
Since then, the CLI has displayed a steadily decreasing trend, touching a new low of 95.7 points as per the latest available July 2011 report. Since the OECD index has about 6-9 months lead time, it seems the worst is yet to come for the Indian economy.
A second lead indicator of economic activity is the survey of purchasing managers of about 850 manufacturing and service sector companies across the country. Called the HSBC-Markit PMI (Purchasing Managers' Index), this study captures the trends in new business orders, employment, input/output prices, backlog of work and stock of raw materials/finished goods every month.
For August 2011, the PMI for the manufacturing sector slipped to a one-year low of 52.6, down from the peak of 58 recorded in April 2011 (the 50-point-mark differentiates expansion from contraction). The services PMI too recorded a one-year low of 53.6 points in August 2011.
Sub-components of the survey reveal that more bad news is in store, in line with the CLI. Consider this. For the over 1,500 listed companies, net sales grew at a healthy pace of about 26 per cent in the June 2011 quarter.
Pause in corporate growth
But, going forward, top-line growth is likely to be constrained. That is suggested by the fact that purchasing managers, for five successive months since April 2011, have indicated weaker growth in new orders. New order growth in August has been the weakest in the last 29 months, pointing to a possible softening of domestic demand.
Numbers on the export order front are also not encouraging. Although the Government's export-import figures for June and July show high double-digit growth rates, the PMI's sub-index for new export orders had already slipped below 50 points (indicating a contraction) in July. The index contracted further in August, hinting at weakening prospects for export-oriented sectors such as textiles, gems and jewellery, etc. Auto exports too might take a hit.
The August 2011 manufacturing PMI gives out two other hints which support the proposition that volume growth might take a breather. One, after showing signs of slower expansion, backlog of work actually contracted for the first time since March 2010, pointing to lower capacity utilisation. This is in direct contrast to the situation of roughly a year ago, when backlog in work for both manufacturing and service industries showed a steady uptrend, leading to capacity constraints in a number of industries.
Two, the stock of finished goods has also decreased, attributable to a slower production growth and fall in inventory requirements. This apart, business expectations of the respondents over the next 12 months are less optimistic.
Hiring too has been reduced in recent months. The employment index for the service sector, for example, has contracted to below 50 in July and further down August, signalling successive monthly declines in staffing levels.
Finally, growth in intermediate goods, as captured by the IIP, has turned negative, at -1.1 per cent in July after several months of sluggish growth. Used as raw materials, a slackening demand for these intermediate goods from companies gives an advance indication of cooling off demand for the finished products.
Some respite
What might provide some relief to companies is that commodity prices, which hurt profit until the first quarter, have eased off quite a bit. But, with the demand moderating for rate-sensitive sectors and the PMI survey pointing to weakness in overall demand, the road to margin expansions may not be smooth.
Besides, survey respondents have already thrown hints at not being able to pass on the full impact of cost inflation to customers, pointing to a loss in pricing power.
At the net profit level, what could squeeze margins additionally is the lag effect of successive interest hikes. That said, big corporates have indeed reduced their leverage in FY-11, both by raising fresh equity and by repaying debt.
At 0.49 for the top 500 companies, the debt to equity ratio for India Inc. is the lowest in five years. That could do its bit to ease the interest cost burden. That the interest rate cycle in India is close to its peak also adds credence to this line of thought.