Corporate profits

Your Money: Six Reasons The Prospects For Business Profits Are Better Now

The flight of earnings to oil is always a concern and should be watched for near term earnings performance. If the rupee wins in real effective terms, this could prove to be a hindrance for profits.

After a long period of earnings recession, corporate margins could enter positive territory. Here are six reasons why the earnings outlook is turning positive:

The rupee is no longer overvalued
The real effective exchange rate is closer to fair value, although still exceeded. The flight of earnings to oil is always a concern and should be watched for near term earnings performance. If the rupee wins in real effective terms, this could prove to be a hindrance for profits. We argue that the Reserve Bank of India (RBI) has been cautious in adjusting its monetary policy to meet its inflation target (hence expectations higher than actual inflation). With headline inflation below target, the RBI may be more inclined to cut real rates.

Beginning of a new investment cycle
The government has spent countercyclically on direct investment in recent quarters. Thus, public sector investment spending is reaching multi-year highs (including all public entities – central government, state, and public sector enterprises). At the same time, capacity utilization in the manufacturing sector is increasing. The same is true of asset rotation, a larger signal for greater use.

With real growth hovering around 7%, capacity utilization could exceed 90% in the next two years, levels at which production increases become more difficult. Thus, investments must now be made assuming an average construction period of two years. We believe that once the dust settles on the election, business investment will begin a new cycle from fairly depressed levels. Indeed, our AlphaWise work reaffirms this point of view.

Risk appetite returns
Corporate balance sheets have been restructured over the past three years and the debt-to-equity ratio is on the rise again.

Return of pricing power in 2020
With the depletion of the capital stock, even a small acceleration in demand would cause prices to rise in several domestic sectors. We’re already seeing it in banks, hotels, airlines, commercial real estate and cement – and it could spread to other sectors by 2020.

Stronger GDP growth prospects
For overall benefits, stronger macroeconomic growth is needed. As our economists forecast faster GDP growth, that’s good news for profits. The stronger growth outlook rests on a resumption of public investment, stronger consumption and stable export growth. It is also fueled by a possible recovery in business investment. These are factors that also contribute to company margins, so in a way, they feed into each other.

Base effect
India is emerging from its deepest and longest earnings recession, which pushed the profit share of GDP to an all-time low, last seen in 2002. As earnings are averaging relative to GDP and with a likely acceleration in GDP growth, we think profits could consist of around 20% per year over the next four to five years.

Edited excerpts from the Morgan Stanley India Equity Strategy report

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