Animal Spirits: Are we looking at the end of the corporate profit cycle that began in 2020?

The one thing every CEO, indeed any person employed in the business world, dreams of is a profit up-cycle. This is the corporate equivalent of the proverbial—God’s in his heaven/All’s well with the world. Profits go up, companies feel bolder, invest in new projects, employ more people, hand out bigger increments and, yes, stock prices go higher. What’s not to like? Some excesses happen, but that is inevitable. No better example of such a phase than the 2003-2008 boom, probably the biggest up-cycle we will see in this era. It may have ended badly, but the memories are still sweet.

The decade that followed, with minor rebounds in between, was India’s ‘lost decade’ from a perspective of corporate profits. The particularly pronounced phase of this downturn was between 2013 and 2020 when earnings of Nifty companies grew in single digits annually, which for a high-growth economy like India ends up feeling like an earnings recession. Yet, such was the anchoring to the boom of 2003-2008 that brokers and analysts kept expecting profits to rebound every year, leading to the dispiriting phenomenon of earnings downgrades every quarter for nearly eight long years. The market proposed, only for companies to dispose. Year after year.

But finally, after a never-ending wait, and the excruciating cleansing by banks and companies of their past excesses, things started looking up in 2020, a bit before Covid-19 struck. A lean and hungry India Inc. looked like it was ready to shake off the blues and ring in another up-cycle. Gone were the drooping shoulders of market analysts, replaced by an expectant gleam in their eyes, as they drooled again about prospects of a multi-year boom. Earnings upgrades started rolling in. Stock prices responded gleefully and out sprang a splendid post-Covid-19 rally, leading brokers to proclaim, breathlessly, that it was the mother of all bull markets. Indeed, it was all going swimmingly well, at least on the surface, till some of the world’s papered over excesses such as unsustainably low interest rates and sky-high fiscal stimuli, had to play spoilsport. So, here we are again, less than a couple of years into our own profit ‘up-cycle’, wondering if the momentum can continue. The uncertainty was brought home last month when, after the earnings season gone by, brokerages downgraded corporate earnings expectations, after seven straight quarters of upgrades. It wasn’t by much, but enough to ring some alarm bells, as who can forget the down cycle of the last decade?

Such is the hold of recency bias on the human mind, that it is usual to underestimate the strength of a nascent trend at inflexion points, if this is indeed one. Thus, it is no surprise that analysts are still pencilling in 23 per cent earnings growth for FY23 and a somewhat more sober 15 per cent for the following year. This will probably need to come down as the global gloom deepens.

The biggest driver of this downgrade will be the same sector that contributed most to aggregate profits last year—commodities. Metal prices have plummeted from their recent peaks, and given the looming recessionary fears in the western world and the tightening in China, they may fall more. A full third of the Nifty’s profits comes from these commodity companies and this will hurt. Will some of it be offset through margin expansion for consumers of commodities such as autos? Possible, but not fully. The drag will be much greater.

Oil could have been the potential saviour amongst commodities, but the recent windfall tax on oil producers has put paid to those expectations. If anything, companies such as ONGC and Reliance will now add to the profit decline, the former more significantly.

Information technology is generally a stable source of profit growth, every year. Where at the start of the year, the massive thrust on digitalisation heralded solid prospects for this sector, now the impending slowdown in the US raises serious questions about the sustainability of demand. Equally, relentless attrition is squeezing operating margins and clouding the profit outlook for large IT companies. The sector may still churn out respectable numbers, but the delta may be down, not up.

These two chunky contributors aside, the other major profit contributor is what can be broadly classified as the domestic consumer segment, FMCG or discretionary. Here, too, rising inflation is squeezing out disposable income even as rising soft commodity prices dents margins. This isn’t a year when one can bank on them to bail aggregate profits out.

This puts all the heavy lifting at the doorstep of banks, which account for a third of the Nifty’s profits. This is a sector in good shape, having shed the baggage of the bad years. Yet, if one looks past the profit jump led by asset quality improvements of the year gone by, incremental profits may have to rely more on core operating business growth, and thus harder to come by. The low hanging fruit is gone, not to mention a creeping unease about the future quality of their loan book, retail included, if the current downturn intensifies. It still remains the best bet from a profit saviour angle, but not without downside risks. The stubborn reluctance of their stock prices to respond to the cheerleading of analysts may be a testimony to these bumps on the road.

And then there are smaller sectors like cement, where the swashbuckling entry of Adani threatens to change the competitive dynamics over the next few years, with sobering effects on the profit potential of listed incumbents.

Last, but not the least, there is Digital. Here, one cannot talk of lower profits, seeing how few of them actually make any, but the prospect of drying up of the private equity tap is forcing many of the lofty unicorns to tighten their belts, with unsavoury consequences. Not a day goes by without news of layoffs and shutdowns.

The overall picture is further complicated by the spectre of rising interest rates which, while admittedly not as big a drag as it may have been even five years ago, isn’t exactly helpful to the cause of profits.

We are not at the point of doom and gloom, and in all likelihood we will not get there, given the extent of clean-up that has happened over the last decade. The point is that complacency and over-optimism are dangerous things, which a lot of otherwise intelligent people are very prone to. This may turn out to be only a short-lived interruption to the corporate profit cycle that began in 2020, but could as easily be the start of a longer down cycle if the world were to lurch into a bigger mess next year. A profit up-cycle is not a birthright. Yes, conditions at home are conducive for one, but things could still go either way. For starters, the chances of a paltry single-digit profit growth in FY24 are very, very real. Who could have seen that coming even in January this year?