Why GDP growth, corporate earnings showing divergent trends

The deflator used by the official estimates is based on WPI, which has run negative for roughly five quarters. Hence, the deflator is actually an 'inflator' at the moment

How strong is the correlation between trends in gross domestic product (GDP) and corporate earnings? The answer to this question depends on multiple factors. First, we need to have a sense of the breadth of coverage of the stock market.

Listed businesses are found across most sectors. In India, manufacturing and services are pretty well covered and plenty of businesses are connected to agriculture and to mining, too. Some areas are uncovered. For example, e-commerce players are unlisted and so is defence. Also, major players in several areas (100 per cent subsidiaries of foreign multinational corporations or MNCs and a few family firms) hold high market share without being listed. But by and large, if a given sector is doing well (or badly), some listed stocks will reflect the performance.

A second factor is the way gross domestic product (GDP) is calculated. The value-added method takes data from the millions of firms that submit results to the ministry of corporate affairs database. That comprises both listed and unlisted businesses.

However, as many economists have pointed out, there is an apparent dichotomy. In the past two financial years (FY15 and the first three quarters of FY16), GDP is said to be growing strongly, while corporate results have been quite disappointing. In fact, the latest GDP estimates say growth accelerated in 2015-16, whereas corporate data indicate a slowdown. Economists who track trends in specific macroeconomic data (cargo traffic numbers, railway traffic, sales of automobiles and two-wheelers, power generation, exports, imports) assert that the data do not support a trend of acceleration.

The GDP calculation method places emphasis on efficiency rather than volumes. It is possible in theory for volumes to remain stagnant or even fall, while GDP increases due to better profitability. However, even this explanation doesn't satisfy. Corporate profitability has not increased and margins have not improved.

One possible reason for non-correlation is the difference between the nominal data and data adjusted for inflation. All corporate data is nominal whereas GDP data use a deflator to adjust for inflation. If inflation is positive, the deflator reduces nominal growth to reflect the impact of inflation.

The deflator used by the official estimates is based on the Wholesale Price Index (WPI), which has run negative for roughly five quarters. Hence, the deflator is actually an 'inflator' at the moment. It is increasing nominal growth to reflect the impact of deflation. Since corporate results are not subjected to a deflator, growth registered by corporate accounts lags GDP estimates.  

This method of using a deflator based on the WPI begs an important question. A large chunk of the Indian economy — over 50 per cent in fact — is services-oriented, and a very large chunk of GDP is generated by consumption rather than investment. Logically, services and consumption related activity should be deflated using some index based on the Consumer Price Index (CPI), rather than the WPI. The CPI has been positive through this period and if a deflator was based on it, it would return lower GDP growth. That might correlate better to trends in corporate earnings.

Another key factor could be interest rates. Rates affect corporate profits and stock market valuations. In value-added calculation, interest rates are reflected in the returns of the financial sector since interest paid is intermediate costs/transfer payment for other sectors. Interest paid has risen as a component of cost for many sectors, as credit cycles have lengthened. There have been defaults aplenty and bad debts have grown. The rising interest component pulled down overall corporate profits. But if there's window dressing in bank and non-banking financial company (NBFC) results, sticky loans could show up as profits in the financial sector and hence, add to GDP. This may also account for some of the discrepancies.

The author is a technical and equity analyst