Your money: Six reasons why outlook for corporate profits is better now

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Published: April 9, 2019 1:23:27 AM

The leakage of earnings to oil is still a concern and should be monitored for near-term earnings performance. If the rupee gains in real effective terms, it could prove to be a headwind for earnings.

corporate profits, RBI, public sector investment, elections, corporate capex, GDP growth,Six reasons why outlook for corporate profits is better now

After a long period of earnings recession, corporate margins may be entering a positive territory. Here are six reasons why the outlook for profits is turning positive:

The rupee is no longer overvalued
The real effective exchange rate is closer to fair value, albeit still over. The leakage of earnings to oil is still a concern and should be monitored for near-term earnings performance. If the rupee gains in real effective terms, it could prove to be a headwind for earnings. We argue that the Reserve Bank of India (RBI) has erred on the side of caution as it adjusted monetary policy to achieve its inflation target (thus resulting in forecasts that were higher than actual inflation). With headline inflation below target, the RBI may be more inclined to reduce real rates.

Start of a new investment cycle
The government has counter cyclically spent on investments directly over the past few quarters. Thus, public sector investment spending is at multi-year highs (including all public entities – the Central, state government and public sector enterprises). At the same time, capacity utilisation in the manufacturing sector is rising. So is asset turnover, a broader signal for greater utilisation.

With real growth hovering around 7%, capacity utilisation could top 90% in the coming two years, levels from where output increases become more difficult. Thus, capex has to happen now assuming an average two-year build period. We think that once the dust settles on elections, corporate capex will start a fresh cycle from fairly depressed levels. Indeed, our AlphaWise work reaffirms this view.

Risk appetite is coming back
Corporate balance sheets have been restructured over the past three years and debt to equity is now rising again.

Return of pricing power in 2020
With the depletion of capital stock, even a small acceleration in demand would result in higher pricing in several domestic sectors. We are already seeing this in banking, hotels, airlines, commercial real estate, and cement —and this could spread to other sectors by 2020.

Stronger GDP growth outlook
For overall earnings, stronger macro growth is needed. To the extent that our economists predict acceleration in GDP growth, this is good news for earnings. The stronger growth outlook is premised on a recovery in government capex, stronger consumption, and stable export growth. It is also being fed by an eventual recovery in corporate capex. These are factors that help corporate margins as well, so in a way they feed into each other.

Base effect
India is coming out of its deepest and longest earnings recession, which has taken profit share in GDP to its all-time lows, last seen in 2002. As profits mean-revert relative to GDP and with a likely acceleration in GDP growth, we think earnings could compound around 20% p.a. over the next four to five years.

Edited extracts from Morgan Stanley India Equity Strategy report

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