A Monsoon Blessing

The expected bumper harvest and firmer grain prices this year could stimulate demand
for consumer goods, which would not be much affected by emerging capacity constraints

Vivek Bharati

The Sensex breached the 11,000 mark on Thursday, indicating that the lean summer season that set in
around the middle of May is finally giving way to optimism brought in by the monsoon. Slowly, but surely,
confidence is returning to the markets. Would the rally sustain or fizzle out?

The outcome would depend on the strength of India’s economic expansion, and signals from global
economic and market trends.

One factor that has helped pull foreign funds back to the Indian market is that the global economic situation
has not taken a turn for the worse as anticipated in mid-May. The US Fed has signaled interest rates are
close to their northern-most point and the outlook regarding inflation and growth is turning out better than
was expected a few months ago.

Looking ahead, a lot would depend on oil prices. If they stabilise around $70-75 a barrel, inflation rates in
OECD economies could stabilise, too, thus easing the pressure on central banks to raise interest rates
further. While global commodity prices could continue to be pulled up by China’s robust expansion, these
are not so critical to inflation rates as the price of energy. However, if the conflict in Lebanon eases, the fall
in oil prices would reduce global inflationary expectations.

The outlook for interest rate stability could then brighten, as also the prospect for increased fund flows to
emerging markets including India. Globally, revenues generated by high oil prices for OPEC, and the
gradually ageing population in OECD that depends on financial returns on savings and good performance
of the global economy together create a surfeit of liquidity that must come to emerging markets, chasing
higher returns. If the conflict in the Middle East worsens, this liquidity could seek lower risk assets such as
bonds or gold. But if peace returns, a part of the liquidity would search for higher returns from equity, both
in OECD and emerging markets.

And India is one market that could continue to provide a decent return. The first quarter results for this
fiscal reaffirm that corporate performance is robust and exciting; for Sensex stocks, corporate earnings rose
by nearly 25%. Firms that form the mid-cap and small cap indices on the BSE did even better; first quarter
earnings grew by over 30% and 60%, respectively.

The probability that such growth in earnings would sustain through this year remains strong, though some
risk factors on the horizon can’t be wished away. A worse scenario would be the collapse of global markets
brought about by a sharp spike in global oil prices following an escalation of the Middle East conflict. This
could provoke a global reversal in equity markets and India would not be able to escape the adverse impact
—FIIs would retreat till the climate improved. High oil prices would have to be passed through to the
consumers, which would hurt even the domestic investor sentiment and have an adverse impact on capex
and investment.

However, equity markets are facing

A better scenario would result if one assumes stability in oil
higher global risk factors. Investors
prices around the current $70-75 per barrel levels, and the
need to be cautious and invest in
cresultant stability in the global economic outlook. In this
firms that are not constrained by
case, equity markets would be driven by the expectation that
capacity
India’s GDP would grow at around 8%. This would sustain
corporate earnings growth at current levels.
There’s one factor that could cap both GDP and corporate earnings growth— emerging capacity constraints
in some sectors. While GDP growth is being driven by investment and capital expenditure, new capacities
in some cases may fructify only next year. Till then, an increase in the rate of investment would contribute
more to increases in the current account deficit through increases in import of tradeables.

One factor could help the economy grow faster than 8%, despite this. This is the monsoon. Though it
arrived late, the monsoon has moved well so far and has raised the prospect of a bumper harvest. This is
half the story, though. With grain prices firmer than last year, higher farm output would translate into better
revenue and incomes for, at least, the grain-growing farmers, which would stimulate demand.

Much of this demand would be for consumer goods such as textiles, footwear, low-value durables, fast
moving consumer goods, and for rural housing and farm-related infrastructure. Most of this would not be
constrained by capacity. Farm growth of around 4% would exercise a quick multiplier and could raise the
GDP growth rate to 8.5 or even 9%. This could drive corporate earnings to improve further.

In sum, a good monsoon could improve GDP growth and returns on equity. However, investors need to be
more cautious than earlier, as the global risk factors facing both the global and Indian economy remain high
and markets could beat a sudden retreat should things go awry.

Investing in companies that are not constrained by capacity and have the potential to generate higher than
average earnings growth would continue to bring rewards to investors. One assumption that runs through
all these scenarios is that India would continue to experience political stability, as it has over the past two
years and a half