End of the boom?

In the last two years, India's gross domestic product (GDP) has expanded at 9 per cent, and that seems to be the likely rate for this year as well. With inflation at an average of 5 per cent annually, nominal GDP growth has been around 14 per cent. The trend rate of aggregate corporate earnings will obviously be related to this GDP trend rate, but will be higher because the corporate sector is expanding faster than the overall economy (which is dragged down by slow agricultural growth).

Using the Nifty as a proxy for the corporate sector, since it represents over 50 per cent of market capitalisation, it is seen that since April 2000, the average growth in earnings per share (or EPS) for the Nifty companies has been about 19 per cent. In the past three years, the Nifty's EPS has grown even quicker""at about 33 per cent per annum. This sterling performance has driven stock market prices to record levels. In terms of returns to investors, the Nifty has yielded an annual growth rate of 35.5 per cent since March 2000. That is impressive by any global yardstick. But when the market has suffered some minor shocks, the question that investors will be asking is: What does the future hold?

The answer is related fundamentally to likely corporate performance in the short-to-medium term, which is the time horizon for most investors. In short, is it reasonable to suppose that corporate profits can continue to grow at more than twice the nominal rate of GDP growth""especially when the profits to sales ratio has improved substantially in recent years and is higher than in most other markets? The new financial year, in conjunction with the first half of 2008-09, is likely to provide the acid test. To all appearances, the economy is nearing or just past the peak of the business cycle. Interest rates have risen continuously since December 2005, and indeed have more than kept pace with rising inflation""and this will affect the demand for credit and goods.

On the supply side, key indicators suggest that some sectors of the economy are now hitting capacity constraints. For example, the cement industry's Q3 despatches were 102 per cent of rated capacity. The credit-deposit ratio of all banks was at 72 per cent by mid-February, and in April-December 2006 auto industry unit sales were above 94 per cent of rated capacity. Growth is likely to slow in 2007-08 due to simply lack of capacity. This might give pricing power to manufacturers, who would therefore be able to raise product prices and shore up bottom line, but there are limits to the consumer's spending power when rising interest rates have already jacked up the monthly repayment instalments on retail loans, and therefore left less money in people's wallets. India Inc. has massive expansion plans, but much of the new capacity will come on stream only in the latter part of 2008-09, and in the interim the increase in capital spending will jack up interest costs and impact earnings.

It would seem sensible to conclude that the surge in earnings per share will not therefore be sustained. It is hard to see much momentum buying taking place in this context, except perhaps by foreign investors who are sold on the India story and who will therefore want to buy at every decline in scrip prices""provided there is no wholesale exodus of money from emerging markets as global investors seek safety in home markets. Some of these factors could act as a cushion against any sharp stock market correction, but bear pressure will not be absent. The danger to be wary of is the double whammy""lower EPS growth coupled with a dip in price-earnings discounts.