The Dead Elephant : When Inflation Lies Low



Raghuram Rajan recently referred to the poor Q4 corporate earnings and remarked that if inflation has to fall, the short-term effect of this would show up in corporate earnings. Implying that Indian corporate profitability is dependent on the redistribution of wealth from inflation.

Declaimer: This article written was originally in November 2015, and some of the data points may be outdated.

The Indian Economy

Inflation has been the elephant in the room in the Indian economy since Independence. First, it was outright Deficit Financing, driven by Govt profligacy. Those who were the closest to Govt spending were the biggest beneficiaries of this largesse. This and crony capitalism, allowed them to sit atop the ‘commanding heights of the Indian economy’. Monopolize the money doled out of Govt banks, make something with licenses given by the Govt, and sell it back to the Govt to get some of that freshly minted cash being printed by the Alipore Mint.

How many of us believe this current deflationary cloud over the world is a long-term phenomenon? Driven by first the oil price collapse (which was driven by a structural change in world oil markets, where an erstwhile cartel lost its teeth and a new swing producer took over pricing) and a broader commodities bust (because of the China slowdown), falling currency values (both Japan and Europe, two of the world’s biggest exporting economies) and a global food glut, you saw deflationary pressures everywhere you looked. Locally in India, two factors: the oil price drop and the food glut, helped put disinflationary pressures on India, but the Chinese slowdown and the European/ Japanese currency declines led to an export slowdown and deflationary pressures on Indian imports.

As far as markets go, the short-term effects were deleterious. The oil savings were mostly distributed among the larger populace, and food inflation declined to give a breather to our macro-data. Govt finances have also improved, but corporate profitability and pricing power are under pressure from the currency declines and the sharply appreciated (relatively) Rupee. All this has created a deflationary mindset in the investment community.

Even as interest rates drop mildly, this deflationary mindset is leading to a small correction in equity valuations. Earlier, the baseline growth in the nominal economy fluctuated around 15% (about half of which was inflation, and the other half was real economic growth). Today, that baseline growth is more likely to be 12%, with inflationary expectations down to 6%. The drop in credit growth from the high 20s to the low 10s is an indicator of the new normal.

Anecdotally, the drop in big corruption had led to the real estate engine sputtering to a standstill. The upward pressure used to be exerted on 10% of the market, and the rest of the unleveraged market would hold. With that upward pressure suddenly taken off, the rest of the market quickly hit a decline, despite dropping interest rates. It will take many years to run off the inventory overhang in mainstream markets like NCR and Jaipur, which have Vacancy Ratios running at up to 70%. This will make real estate much more affordable, but several players will go belly up.

For a long time, the consensus P-E ratio for India was 15 times earnings, which must slowly correct down to, say, 13 times. This will not happen in the short run, because reflation will happen not very far from here. Global deflation is already showing signs of abating, with Europe coming out of outright deflation and Japan showing some growth. If China shows some recovery, we will see an improved 2016. The sharp rise in global bond yields would suggest a return to inflation.

Longer-term, debt ratios are not improving much, except for honorable exceptions like the American corporate sector and in a lesser way, the American consumer. The Indian corporate sector is a worry unless the Govt allows foreign capital to help deleverage our stressed assets. While Govt debt is under control, Indian growth needs better Balance Sheets than can be seen in the Indian corporate sector. This overhang will lead to a tepid recovery before it fizzles out over a debt destruction event. Unless we see a structural decline in debt ratios, you cannot expect an improvement in equity valuations.

Let me explain concerning a certain sector,

Let me explain concerning a certain sector, sugar. In an industry where everyone is underwater (this year the ENTIRE industry has reported a loss), one company is relatively debt-free. So while Bajaj Hindusthan has reported record losses, Balrampur has reduced interest costs, while staying in cash profit. Bajaj now needs some Rs.36 per kg in sugar prices, just to break even. At that price, Balrampur will be reporting bumper profits. It will be easy to cherry-pick the best assets of Bajaj, which will have to sell off assets if it ever wants to deleverage. So the industry will not grow, but Balrampur will. And this growth will be with a deleveraged Balance Sheet, recycling cash profits. I wrote the same thing about Paper Products some 5 years back, and look at it now. This is a very predictable method of booking multi-bagger gains in steadily compounding stocks.

When it comes to countries, India seems to be returning to inflation because of food shortages after a deficient monsoon, although it does not look like there will be a material change in inflationary expectations. But good inflation, the kind that is reflationary, and is driven by an increase in wages, which leads to an increase in demand, is still some way away. On a much lower base, we are seeing that in Europe, which is good news for the rest of the world.

But the debt destruction that must at the end of a credit bubble, has still to end. This has led to deflation, which will reduce the P-E ratio. As pointed out earlier, the Indian median has been around 15, because it is made up of real economic growth (5-8%) and inflation (7-10%) over the new millennium. For the next decade, we must keep in mind the coming crack in global bond markets, which will be driven by inflationary scares, whenever the velocity of money starts to go up. This may be some distance away, but it will happen. The point is, that growth will fall lower under the weight of all that debt, so deflationary pressures must lead to revaluation of the median P-E ratio to 12. Not much lower, because Indian growth will always be relatively higher than global growth.

How will this happen and over what period? Like any sensible analyst, I will not take a guess on timing, but I will try and outline just how it will happen. The current reflation will look like the end of the GFC 2008, and we have nothing to worry about until the Great Recession is officially declared dead. Then, at the start of the next boom, all that money lying under people’s mattresses will slosh around and inflation will shoot up. The bond market will collapse, and we will some spectacular bankruptcies, including a Lehman moment, a country default perhaps (not a Greece, but an Italy or a France, Japan more likely). This will push up yields, and this time, administered rates and monetary easing will not help. That will be a time like no other, and I hope I am dead by then. If I am not, I would have enough money under my mattress, maybe gold, if I can see it coming.

The Indian market will hit a low with a P-E of 8, but this time, the median should be calculated around 12. That would mean a peak of 15-16 times, the level it is now. So if you want to be prepared to work around these scenarios, please set your new ‘averages’ lower, while you the coming reflation as an opportunity to exit. Don’t get too optimistic at the top, I promise you the current coming top will also not go to 28 times earnings, like in 2007. It will stop much shorter, around 18-20 times. Our children will have to live with much smaller numbers than we saw in our generation. They will live most of their lives in a world with excessive debt, while you and I have lived in a much more innocent world. Of course, India will remain one of the best places in the world, much more innocent than the developed world. But those who can learn from the misdeeds of others will do well to carry more conservative attitudes if they want to live into serious old age.



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