Investment can only come from savings and recycled profits. Hence,
Recycled Profits + Household Savings + Govt Savings + Foreign Savings= Investment, or
(Profits- Dividends)+ Household Savings + Govt Savings+ CAD= Investment
Declaimer: This article written was originally in June 2013, and some of the data points may be outdated.
The Death Spiral
I have broken up Recycled Profits into their components and used the common term for foreign savings, i.e. the Current Account Deficit, which has to be always funded by overseas (savings) flows, either as debt or equity/ remittances.
Now consider the death spiral. The main engine of Indian savings is the household sector, whose savings rate is down because of Inflation. And given high inflation, our proclivity to invest in gold keeps increasing, because it has been a historical hedge against Inflation. From the equation above, you will see in a little while that this is a self-fulfilling prophecy, i.e. lower Household Savings results in lower Investment (with much of it diverted to gold), leaving a bigger CAD, which puts pressure on the Re, thereby increasing gold prices. This creates a tailspin.
Let us assume that Govt Savings will never happen or improve. Now what will get the Investment equation back on track? If we assume that GDP per unit of Investment will stay at 0.25, we will need 36% of GDP in Investment to achieve 9% growth. Right now, the equation is approx.
Investment- Household Savings- Govt Savings- CAD= Recycled Profits
36% – 32%- (-6%)- 4%= 6%
If Investment has to rise, while Household Savings drops or stagnates, Govt Savings stays in the same place, while the CAD has its implications, it follows that Recycled Profits have to rise. Assuming that Dividends will stay constant, it only means that Corporate Profitability will rise.
The disenchanted cycle investor
At first, it looks like I have made a very obvious point. If capital issues are sluggish, corporates will only invest through debt, and when their Balance Sheets get strained, they will stop doing that. That will create a capacity crunch, which will trigger inflation for the retail consumer, which corporates will capture as additional profits. In a lot of dull and dowdy sectors, this is what you see.
So that is the cycle Investors get disenchanted with equities, diverting themselves to other assets like gold and real estate. This creates capacity crunches in Industrial Investment, so watching the flow of household savings can tell you something about corporate profitability, all other things remaining the same. The caveat at the end is key; both Govt Savings and the CAD are real jokers in the pack.
If you look at the same equation for the US,
Investment- Household Savings- Govt Savings- CAD= Recycled Profits
15% – 6%- (-6%)- 3%= 12%
Corporate profitability is at a historic high, with the market discounting linear growth rates to infinity. A cyclical dip in overall corporate profitability could provide substantial disappointment for the markets. India, on the other hand, is not so bad, if we conclude that Investment must eventually and inevitably rise. Assuming that household savings are not going anywhere, it can only happen when corporate profitability rises.
In a previous column, I argued that better times are ahead, for corporates and then markets. Well, this is the macroeconomic argument for Indian corporate profitability. It would mean that US markets will be sluggish, as the OECD-wide recession catches up with them. And Indian under-performance will reduce, as the market mean-reverts.
That would mean flows will come in, which would allow funding for the CAD, as a side-effect.
A key variable in this is the productivity of past investments, which affects both corporate profitability and household savings, depending on where it gets captured. A higher GDP growth rate is possible if the quality of investments is higher. Higher investment into exporting (or import replacement areas like energy) sectors will affect the CAD, provided enough overseas demand can be found. It does look better now than before.
Profits: A Measure of Demand Supply Balance
Exactly which parts of the economy will see this uptick in corporate profitability? For starters, those with the least amount of capacity increment, coupled with the highest delta relative to GDP growth. This is not a fixed equation, and varies substantially, depending on the stage of development and income that the economy is at. India, for example, is a poor country going to middle income for about 300 mn of us; and a country in abject poverty going to subsistence, for another 900 mn of us.
So products like basic foods, basic transportation, and basic infrastructure will find new and growing markets from among the 300 mn of us; while for the rest of the country, just coming out of poverty, it will mean subsistence, new electricity connections, T & D infrastructure, toilets, water connections, etc.
This is where the demand is. Profits, however, are another matter altogether. That is a measure of the demand-supply balance, past shortages in investment, pricing power, and new capacity in the pipeline.
What Happens to Various Sub-Sectors in the Markets?
Lastly, what happens to various sub-sectors in the markets? Which of these stories has not been discounted by the markets? I believe that the only outperformers are going to be those who show surprise upticks in earnings, much against consensus. That is difficult to predict in a largely sluggish economy, where nothing is going right.
But I will take a few guesses:
- The commodity downturn will not be as sharp and as deep as expected. Most value-adders over basic commodities/ minerals will come back quite strongly, because of capacity crunches thanks to a slowing investment cycle. For example, there has not been much capacity addition in sugar despite a moderate increase in demand. This should improve industry fundamentals, and some companies could outperform.
- Debt reduction in a high-interest-cost environment is a real value-adder. Companies that are still generating Free Cash Flow, even in a sluggish, low-growth environment, are still going to outperform. Don’t focus on growth prospects; that is thin on the ground anyway. In the “new normal” survival is growth, provided you don’t have to pay for it. In steel, for example, stock prices are priced in insolvency; if a company is still generating free cash flow, pay a big multiple for this FCF. Hold for a long time, and don’t expect the market to go anywhere in the meanwhile. Some companies in the telecom sector have high debt and are painfully paying it off.
- Companies that are going to see a steeper fall in their inputs than they see in their product prices. This will create big value-adders, and these companies will lead the next boom, whenever it happens.
- Another set of growers will come to the big mega-trend for the next 5 years: “King Dollar”. I am telling you, this is going to be the next big surprise, and never mind those fixated on the Budget Deficit. The primary trend is that the world will only exit the Great Recession on the back of a new technological boom, and it is probably going to come from the real cost of energy going to zero. The country that is at the cutting edge of this is the US/ Germany, and they will see a sharp, first-mover advantage that will shift purchasing power to their economies.
The Domino Effect
The domino effect of this is that anyone who is selling anything to these economies is going to get richer. Coincidentally, these 2 countries have the lowest unemployment levels, which are also (coincidentally) falling. In Germany, the trend will be exacerbated by some of the worst demographics in the world.
So any service company (IT?) that sells to these countries is going see some wealth creation.
In short, the themes for the “new normal” are debt reduction, value chain consolidation, or currency/ purchasing power considerations. To return to the macro-issue, corporate profitability in the US should drop from historic highs as their Investment Cycle ticks up, while our Investment Cycle will take shallow U before the debt reduction phase is over. In a slowing environment, we should be happy to see a downtick in inflation, which reduces the cost of capital. For the rest, dull and dowdy is the new fashion, if you can call it that…