Services growth under par

Unless June growth is very high, current quarter won't be great

The PMI (Purchasing Manager Index) indices are among the most-followed, and least understood, of ‘fast-twitch’ economic indicators. The PMI is a monthly opinion poll designed to gauge business activity. A sample of managers are asked the same questions: Do they think indicators like output, new orders, export orders, new business, employment, inventory positions,  expectations are stronger, weaker, or the same as in the month before?  Just three answers are possible. 

The PMI formula then multiplies the number of positive answers by one, and adds that number to the number of ‘same’ answers multiplied by 0.5, while negative answers are eliminated (multiplied by zero). The sum is divided by the total number of respondents and normalised into a percentage. The data is seasonally-adjusted. 
 

Three indices are created, one each for manufacturing, and services and the third composite of services and manufacturing. Each index runs from 0-100, with 50 as the neutral point. Using this formula, expansion registers as a value above 50 and vice-versa, below 50 is a contraction. 

Acceleration in expansion, or steeper rates of contraction, can be judged by comparing this month's value with the prior month. A higher number indicates accelerating expansion while a lower number indicates steeper contraction (or deceleration if both are over 50). 

Historically, assuming the sample of polled managers is well-chosen, the consensus opinion of the PMIs shows good correlation with hard data. PMI also shows good correlation with corporate earnings growth. So, PMI indices are watched by central banks and institutional bond market investors.  

The PMI is a useful tool for managers themselves. For example, take the automobile value-chain. A car-maker decides production levels on the basis of new orders it expects. Those new orders drive component purchase orders. Up and down the chain, suppliers can also track the PMI to estimate future demand. PMI trends can then influence prices. Services businesses make staffing decisions, based on PMI expectations. 

The latest readings for May 2018, are 51.2 (manufacturing) and 49.6 (services), with the composite at 50.4. A look at the data since Jan 2017 indicates that manufacturing has, by and large, seen expansion. There's only one month of serious contraction in mid-2017 and that's easily explicable by the introduction of the Goods and Services Tax (GST).  Although the expansion has been slow, it has happened now for ten months in a row. 

Services, on the other hand, has seen a lot of volatility. Through calendar 2016, service PMI grew steadily until December when it contracted as demonetisation impacted. January 2017 saw further contraction. July-August 2017 saw contraction, which can be written off as GST-related.

But there was contraction again in November 2017 and in February 2018, and now, there's contraction in May 2018. One reason for volatility through 2017 and 2018 could be that GST hit services harder than manufacturing. In effect, the GST reporting structure turned one national market into many smaller ones and of course, GST raised the tax rate and hiked working capital costs. 

Every quarter since January-March 2017 has seen at least one month of services contraction. This has meant up-and-down earnings growth. If this pattern continues, there should be a rebound in June. Service sectors include financials, telecom, news and entertainment, and arguably retail, construction, etc. IT and ITES is heavily export-oriented but obviously qualifies. Earnings patterns across these sectors confirm that growth has been spotty. 

Polled services managers say that there was stagnation in new orders in May 2018, and employment growth was modest. Both manufacturing and service sector reported rising input costs and the services segment claimed it was hard to pass on costs. 

Consider the PMI’s good correlation with corporate earnings, and the fact that services contributes well over 55 per cent of Gross Domestic Product (GDP); GDP growth rates dipped to 6.6 per cent in 2017-18, from 7.1 per cent in 2016-17. That is explicable given that services growth has been under-par through the past six quarters.  Unless June sees extraordinary growth, it's hard to envisage the current quarter delivering much higher earnings growth for these sectors. Apart from base effect, a lot will depend onthe monsoon.