Waiting For The Recovery

It's finally official, from Alan Greenspan himself---a recovery is on the cards in the US. And if the US economy improves, can the world economy be far behind? Fed watchers are optimistic because Greenspan didn't use two key phrases he's used before. One of them was about "significant risks" to the US economy. The second was that it was "still premature to conclude about an economic recovery."

Instead, the Fed chairman said that he saw ``signs recently that some of the forces that have been restraining the economy over the past year are starting to diminish and that activity is beginning to firm.''

 

Should we cheer? There never was any doubt whatsover about the fact that a recovery is inevitable. The debate has been about when it will come about and how strong it will be.

On these counts, there is scope for plenty of doubt. First, it's true that US demand has held up well. But some demand may have been pulled forward on account of all those Christmas discounts. And second, what's the point of higher demand if it's due to discounts?

Volume growth that doesn't translate into topline growth, not to speak of the bottomline, is a mug's game. Profits continue to be under severe strain, and companies will do their best to stretch IT budgets.

Moreover, there will also be a reallocation of IT budgets to cyber-security. The bullishness in the US markets has been based on the premise that consumer spending will lead to a rebound in the economy. But although the markets have rallied, that's partly because analysts have lowered their estimates by huge amounts.

With all that liquidity sloshing around, all it needs is for the company to beat their tiny estimates for the stock to rebound. Consider what happened at Amazon.com, when that company made its first quarterly profit because of a foreign exchange gain. Hardly a sustainable improvement, but then any excuse will do.

So corporate profitability and cash flows are still very weak. It's unlikely, in this scenario, for companies to start capital expenditure once again. And till that happens, the recovery is not going to be strong. This will especially be true in the IT sector, where so much overcapacity has been built up. The worry is that the current recovery is happening on a binge of consumer credit.

What happens if the recovery is not strong enough and the consumer binge collapses in a welter of bad debts? It's worth noting that even if a recovery comes along, the S&P 5000 is already trading at a price-earnings ratio of around 40. Where's the upside from those levels, and what happens when investors realise that the upside is limited? That could affect consumer sentiment pretty adversely.

Further, corporate debt levels at US companies too are very high. If the recovery is not fast or strong enough, there could be bad debts there as well. That's when the credit-financed expansion will finally come to an end, when the banks get hit by their non-performing assets.

What about the Indian economy? The quarterly results have underlined what we have known for some time--that the third quarter has been a disaster for the IT industry. The question is--is this the bottom? Indian IT firms' quarterly results have shown that billing rates are under pressure.

Vendor consolidation is yet another trend in the industry, and that may have severe implications for the second-rung tech companies. Moreover, guidance has been extremely cautious, indicating large scale uncertainty.

Given the fact that Indian tech stock prices are discovered at the US markets, the point that technology stocks are still selling at around 50 times forward 2002 earnings is a big worry. It's interesting to remember that despite all the talk of a bottom being made in the US markets in September, the price-earnings ratio in that month was 21.

What about the old economy? The Hindustan Lever results showed that the good monsoons haven't really helped. On a year-on-year basis, growth in the company's FMCG segment slowed down in the December quarter compared to the September quarter. That's true for the rate of growth of the company's "power brands" as well.

Nevertheless, the problem may lie in the FMCG sector and not with rural demand. After all, Hero Honda has talked of good growth in its motorcycles on the back of rural demand. And there have been reports of a pick-up in tractors. It could be that stiff competition in the FMCG sector is to blame, particularly from mass market regional players.

Industrial growth has reached its nadir in November, but there are some signs of growth in the infrastructure industries. The quarterly results of the auto industry have been a pleasant surprise.

Refineries and PSU stocks look good. And there is no dearth of good companies with temporarily battered down earnings and stocks. But in the final analysis, the fact is that for most of the Indian corporate sector, this is a time of consolidation and not of overall growth. That fact will continue to bear down on the Sensex.