Profits under pressure

Earnings growth will be a constraint for markets

The macroeconomic situation is improving, going by the latest gross domestic product (GDP) estimates and inflation prints. The inflation rate has declined, while GDP has grown faster than expected. However, the extraordinary profit margins of the Covid period are normalising and slower earnings growth could lead to valuation downgrades for equity. The 2022-23 (FY23) results of some 900 listed companies indicate net profit growth declined for most sectors, except financials. The aggregate net profits of a sample of 907 listed companies, which are constituents of the BSE500, BSE MidCap, and BSE Small Cap indices, grew by just 4.6 per cent year-on-year (YoY) in FY23, a sharp deceleration from 60.4 per cent in FY22 and 89.7 per cent in FY21. These companies reported combined net profits of Rs 9.94 trillion in FY23, up from the Rs 9.5 trillion a year earlier, and Rs 5.93 trillion in FY21. Earnings net of inflation declined in FY23, since inflation ran at a much higher level.

The earnings slowdown was worse after excluding banking, financial services and insurance (BFSI). The combined net profits of 823 non-BFSI companies were down 8.9 per cent YoY to Rs 6.43 trillion in FY23 compared to Rs 7.06 trillion in FY22. The base effect inflated net profit growth in FY22. However, revenues climbed an impressive 23.3 per cent compared to FY22. This is encouraging, though inflation boosts nominal revenues. One key determinant was the trend in interest rates. The Reserve Bank of India (RBI) started to increase policy rates with an out-of-turn raise in May 2022, and it halted the cycle of hikes only in April 2023. Banks and non-bank financial companies raised lending rates in sync with the RBI, while offering higher deposit rates only with a lag. This enabled higher net interest margins (NIMs), putting the financial sector in a sweet spot since credit demand also accelerated. NIMs are now likely to start tightening with banks facing stiff credit-deposit ratios and offering higher deposit rates.

In the meantime, non-financials had to handle a progressively higher cost of financing through FY23. Interest costs in Q4FY23 were 29 per cent higher than in Q4FY22. Corporations also faced raw material inflation as well as rising energy costs (up 43 per cent YoY by Q4FY23) and higher wage bills (up 20 per cent YoY), which explains why profit margins were hit. Inflation is now moderating with metals, coal, gas, and crude oil coming off their highs. As a result, cost pressures, which were hurting raw materials and energy-intensive businesses, have started easing. Interest rates are also expected to have peaked. These outcomes would be favourable.

Consumption demand is another key variable. In the past two fiscal years, demand was driven by government spending and that will continue to be high in FY24, given the thrust on infrastructure development. There are now some signs private consumption demand is recovering — sectors such as two-wheelers, housing, and fast-moving consumer goods have seen a pickup in sales. It is also worth noting that valuations for the BSE Sensex, at 23 times the earnings, are a little higher than the average 22.9 in FY23. The Nifty is similarly valued at 21.6, again a little higher than in FY23. The indices are trading close to their all-time highs, thus far sustained by hopes of strong growth. However, if earnings growth does not accelerate, there could be a valuation downgrade.