Which sectors will outperform?

The latest data from the Wholesale Price Index (WPI) indicates India has been experiencing deflation for 15 months. The WPI has been running negative since November 2014. In January 2015, it saw minus 0.9 per cent change, year-on-year (y-o-y) over January 2015. The January 2016 y-o-y change was a little lower than the -0.7 per cent y-o-y change the WPI experienced in December 2015.

The negative WPI indicates manufacturers have seen steadily falling input costs over the last five quarters. This is confirmed if you look at quarterly results as well. Corporates have seen raw material costs trend down since the commodity cycle turned down in October-December 2014. Power and fuel expenses have also dropped.

However, if you look at the Consumer Price Index (CPI), the picture looks different. The CPI has eased down over the same period. But, it remains very much in positive territory. The January 2016 retail inflation values were at 5.7 per cent y-o-y, which was marginally up from the December 2015 values of 5.6 per cent y-o-y. One reason for the CPI being up is that it has a very large weightage for food (close to 50 per cent) and the food basket has risen in price.

Another reason for the rise however, is that the drop in the WPI has not been passed on fully to individual consumers. Corporates have not cut prices to reflect lower raw material costs. The government has not cut retail prices of fuels to reflect dropping crude costs. It has raised the excise component of retail prices instead. Banks have not dropped commercial interest rates to reflect the policy rate cuts made by the Reserve Bank of India. In turn, most corporates would argue that their overall costs have not fallen by much, if at all. In fact, costs have risen for most service industries. In the service sector, physical raw material costs are less important. One key expense for service sector businesses is employee compensation and employee costs are up across the board for all corporates.

Indeed, employee costs have risen for several quarters and by some measures are higher than ever before, averaging over 12 per cent of revenues for a broad sample of companies. Higher employee costs would certainly have pulled down profits for every service sector outfit. Even manufacturing businesses, which have benefited from low raw material costs, would have been hit by higher employee expenditures.

Taken together, results declared so far show that revenues have been flat or negative for most companies, and flat or negative across most industries. This leaves investors with a quandary in terms of trying to pick outperforming sectors.

Coming at it from another angle, public-sector banks are in bad shape and so are basic metals and energy commodities. So is construction, infrastructure, capital goods and real estate. Those sectors and segments all look worth avoiding in the short term, at least.

If we eliminate sectors with poor performances, we are still left with very wide swathes of industry, with average, uninspiring performances. Even the old perennials of FMCG and pharmaceuticals have some question-marks attached. FMCG cannot generate serious volume growth until rural demand recovers and that depends on monsoon vagaries. Pharma is very highly-valued and exporters are vulnerable to actions by America's Food & Drug Administration.

Under these circumstances, one possibility is to second-guess the Budget. The Budget may well follow up the recent protection for the steel industry against imports with sops of some description for other industries. Any such sops will depend on lobbying power and pinpointing likely beneficiaries is more a matter of understanding political equations than of analysing balance sheets.
The author is a technical and equity analyst