Risk rising for consumer stocks?timing is everything

* While we have been OW (overweight) on FMCG stocks for growth protection and due to significant headwinds to the investment cycle, we are beginning to grow concerned about the possibility of a bigger-than-expected consumer slowdown. The first signs are visible?growth in discretionary consumption has already turned weak. Weakness in non-discretionary consumption is starting to show up in company results.

* Consumers have benefitted at the expense of future growth because of the government?s loose fiscal policy post-GFC (global financial crisis), which has also played a significant role in India?s CAD (current account deficit) problem. The result has been India?s imbalanced growth?high consumption and slower investments.

* The pressures on currency, inflation and sovereign ratings have finally forced the hand of the government. For the first time subsidy cuts are happening before, rather than immediately after, elections.

* We estimate that the overall effect of hikes in fuel prices, electricity tariffs and railway fares so far has been to the tune of $28-30 bn. We reckon that another $9 bn impact could come through if a full catchup on diesel prices were to happen. Additional electricity tariffs could likely cause another $13 bn burden on consumers.

* A slowing investment cycle implies a significant slowdown in job creation. This will likely hinder the ability of consumers to both spend and trade up. Further, recent depreciation of the rupee will likely raise prices for consumers, especially for items such as electronics etc., which have become increasingly large in consumer outlays.

* Even as investments remain weak, the added consumer slowdown implies that overall GDP growth may continue to disappoint, in our view.

* However, while the recent RBI action to stem rupee depreciation realigned expectations of a declining rate cycle, we believe that the slowdown in consumption and investment demand will in turn lead to a reduction in CAD (current account deficit) which should clear the way for a positive rate cycle emerging over the next few quarters. We are neutral on banks.

* Tactically, RBI?s moves to tighten liquidity have increased the overhang on rate cyclicals with the implication that consumer sectors may continue to perform till such time when the rate cycle starts to move down again.

The increasing travails of the Indian consumer

Loose fiscal policy led the consumption boom post-GFC: Post-GFC, the sales growth of consumer companies saw a big upturn. Even though overall GDP growth did not accelerate beyond pre-GFC levels, the growth in consumption was significantly higher.

The government was the main provider of this stimulus: Government stimulus has taken many forms, including social schemes, salary increases for government employees, increasing MSPs (minimum support prices), lower customs and excise duties and a freeze in fuel and electricity prices. A simple way to look at the overall impact is to look at the overall fiscal deficit or the combined borrowings of states and the Centre. Even as the economy recovered, this stimulus was not rolled back. We note that actual relief to the consumer was even higher than that, as oil PSUs, railways, as well as state electricity boards have borne significantly higher subsidies which are not consolidated under fiscal deficits.

Wealth effect has added to the consumption boom: Loose domestic and global monetary policy and a significant real estate boom have led to a significant increase in real estate prices in both urban and rural India. This, coupled with a sharp increase in gold prices, has also led to a significant wealth effect-led consumption boom in rural India.

Rural India has benefitted at the expense of urban India: The government?s constant intervention in agricultural prices through aggressive MSP hikes has led to the balance shifting in favour of rural India. Of late, especially, as the investment cycle has slowed down, urban India has suffered more as income increases have not been enough to offset higher inflation.

But this may be coming to an end?Fiscal stress and a crisis-like situation in various sectors (oil, power, etc) have led to the government finally starting to give in to a correction of its earlier populist policies. Given that India is in a pre-election year, there will be push and pulls to this process (Food Security Bill is an example of this). On an overall basis, we still believe that Indian consumers have seen, and will continue to see a significant increase in the burden on their finances.

Slowdown in the investment cycle: The continuing slowdown in the investment cycle will typically mean much slower job creation. The Manpower survey has shown a clear deceleration in hiring intentions over the past five quarters and we believe this situation will likely persist, if not worsen, from here.

Overall fiscal deficit reduction through expenditure cuts: Apart from cuts in subsidies, the general clampdown on expenditure growth due to fiscal stress is also leading to a consumption slowdown. The government is a large spender in the economy either directly or indirectly via transfer payments. The slowdown in government spending should show up as less income in the overall economy.

Notional wealth effects peaking out: With real estate companies in some financial distress and with the pace of fresh capex still slow, the flow of money into buying new land parcels will likely reduce, in our view. Even though gold prices are still reasonably high in rupee terms, their inexorable upward march has come to an end, for the time, we think.

Portfolio implications

Consumer sector is expensive: Consumer stocks are now trading at very expensive valuations. Is there a benchmark we can use to deal with these valuations? We prefer not to look at the past 10-year history because that period coincides with the best economic phase in India?s history and will not reflect conditions in which defensives tend to get expensive.

A better period is 1998-2003, wherein, with the exception of the tech boom in 1999-2000, market and economic conditions were quite similar (with some differences) to current conditions in the economy. Consumer sector valuations currently are at levels last seen around the Asian crisis, both in absolute and relative value terms.

Is cutting exposure to consumer risky? Clearly, with no major hopes for a quick revival of the investment cycle (we expect the slowdown to last for at least two more years), relative fundamentals of the consumer sector look extremely attractive indeed. However, we note that: (i) the consumer sector is now in danger of seeing a significant slowdown; (ii) relative valuations are not building in any danger of a slowdown and are almost building in business-as-usual even as rest of the economy is suffering, and; (iii) absolute valuations seem to be implying a very high ask for future growth and are, therefore, at risk of disappointment, we think.

Among defensives, we would shift out of consumer and into IT services and pharma: Given the overall negative sentiment on the economy, we think that a negative call on the consumer sector is a tough one. However, given current valuations and our belief that the sector will likely start to see a slowdown going forward makes us believe that the best performance of the consumer sector is behind us. We are going neutral FMCG.