WPI inflation witnessed a yet another
contraction in the month of September and registered a deflation of 0.26% YoY,
down from -0.52% in August. The print came in slightly lower than the estimates
as the general consensus was around -0.5%. This was the 6th month
where we have seen a contraction. All the segments witnessed a deflation in
prices, except for the Primary Articles. However, on a monthly basis primary
articles contracted while Fuel & Power and Manufactured products saw rise
in prices.
Core inflation rose in September
India’s WPI based inflation witnessed a further
contraction in August. The persistent moderation in WPI since May-22 has been
mainly because of constant decline in mostly all the major sub-indices.
Although at a slower pace than previous month, this month’s fall in the
wholesale prices can be mainly attributed to all the sub-indices except for the
primary articles, as food prices (although slowing down) remains in the
positive. The deflation in Fuel prices have slowed down as international crude
prices have again started to pick up. We expect food prices to cool down in the
coming months, all while fuel prices may turn out to put pressure on the
headline WPI figures. The core prices remained in deflation for the 7th
consecutive month as it fell by 1.4% compared to 2.2% in the month of August.
September’s report clearly shows that the
inflationary pressure caused by high food prices have eased down considerably -
which clearly indicates a good sign for the market. However, production cut done
by Saudi Arabia and Russia could hurt the prices further on the upside.
Clearly, the tightness forced by the RBI has started to show, as both core CPI
and WPI are on a downtrend, which eliminates the volatile fluctuations of food
and energy prices. This report came after the CPI recorded a print of 5.02% for
the month of September, which took a detour from the 7.44% it had hit in the
month of July.
India’s trade deficit narrowed in Jul’23 on the
back of a sharper decline in imports than exports. But it reflects slowing
demand and global trade. As trade was the biggest driver for post-pandemic
recovery, the receding global bounties are having a wider impact on the
domestic economy, particularly the employment-intensive services sector. While
RBI has the buffer in the form of forex assets, the spillovers of external
sector vulnerabilities can manifest into volatile currency and rate markets.
Overall trade reflective of slowing
global and domestic demand: At the segregated
level, the oil trade has been contracting since Mar’23 by 20% (YoY) on average.
Non-oil & and non-gold/silver trade has also contracted by 5.9% (YoY) on
average since Dec’23. This is reflective of simultaneously slowing global trade
and domestic demand.
Contracting services trade has a larger
bearing: With the current declining trend of
the overall trade since its peak in early 2022, it is going to have a
multi-layer cascading impact on the formal sector. Overall services trade and
its components, which remain a significant source of formal and informal
employment, have started exhibiting signs of moderation or contraction.
Indian equities should be able to offset some
of the downward pressure emerging from the downward adjustment in valuation of
global financial assets due to the sharp rise in risk-free rates (UST yields).
Not only are inflows into domestic MFs likely to be resilient, EPS growth and
revisions are both supportive of time correction. With a cyclical upturn in
capital formation supporting the structural improvements in labour and
productivity growth, the domestic economy should also be able to offset some of
the headwinds from the ongoing global slowdown. A sharp US recession, though,
can drive a spike in risk premia and also intensify growth headwinds for the
economy.
Structural drivers likely to drive 7%
growth annually
We believe India can grow at ~7% annually, with
1% growth in labor input supplementing 2%-plus growth in total factor
productivity. We expect strong TFP growth to continue (2.4% CAGR in the five
years pre-Covid), on (1) the state continuing to cede space to the private
sector (the latter generally uses labour and capital better); (2) improving
macro (roads, highways, airports, ports) and micro (last-mile access to energy,
piped water, internet and financial services) infrastructure; (3) formalization
of retail and construction; (4) net services exports; and (5) state capacity improving.
Improving capital formation to provide
cyclical boost, offset headwinds
The pre-Covid growth slowdown was due to a fall
in growth of capital formation (bad-loan clean-up and a real-estate downcycle).
This is now changing: dwelling construction is picking up, and leverage on
corporate balance sheets and lenders has likely bottomed out. These should
offset the several cyclical headwinds faced by the economy.
The first is limited fiscal space and a falling
fiscal deficit ratio. Second, even with a pause on repo rate hikes, financial
conditions can continue to tighten as loans roll over. Third, as the global
economic slowdown is already hurting growth in goods and services, a likely US
recession next year can intensify pressure in some of the export-driven
sectors.
Real-estate cycle turning after a
decade-long downturn: No sub-continental sized
economy like India can grow rapidly without strength in dwelling construction.
Despite 2.4% annual growth in household formation (Exhibit 28:), a
houses-to-households ratio of 0.97 in 2019, 4% annual growth in the size of
houses (the floor space per person in India is ~100 sq ft, vs 550 in China and
700 in the US, Exhibit 29:), and rising quality of construction, the value of
dwelling construction in India barely grew over 2012-21.
Time correction for now: lower global
P/Es, and steady EPS growth
The US Treasury (UST) yields have risen 2 pp,
and are likely to remain elevated, in our view. With Nifty earnings yield
spread over UST yields at record lows, P/E can remain under pressure despite
the USD 30-35bn of unintended flows into domestic equity MFs.
P/E premium to world is already elevated at
30%. Markets may time-correct as Nifty earnings are in much better shape than
in the past decade: (1) for-the-year EPS seeing upgrades vs sharp 10-25% cuts
in the prior decade; and (2) double-digit growth FY24-26E vs 4% CAGR 2011-20.
In our 30-stock model portfolio, we are overweight financials, autos,
utilities, cement, and real-estate, and underweight IT, industrials, and metals.
During the past three months, the benchmark
10-year US treasury yield has surged toward 4.75%, about 100bp higher than the
mid-Jul’23 level. Notably, the rise in the yield is not limited only to the
longer end, but it is seen across the curve and more at the shorter end, as the
spread between the 3-month yield and the 10-year yield has actually narrowed
from -1.5pp in mid-Jul’23 (and 4-decade low of -1.89pp in early Jun’23) to
-0.9pp in Oct’23, last seen in early 2023. (All data used here is as of 16th
Oct’23).
If the cost of funds increases sharply and
continuously, it is usually believed to hurt borrowers. Nevertheless, since a
bulk (~90%) of household loans are fixed-term, higher rates have not pinched
customers in the US. Because of this, the burden of higher interest rates will
be borne by the lenders, due to the higher cost of roll-over and/or refinancing
the loans. On top of this, the financial institutions also see a drop in the
value of their securities portfolios due to higher interest rates.
Moreover, although higher rates may not affect
existing customers, they are likely to affect new demand badly, hurting home
prices. This, if happens, will have the potential to broaden and sharpen the
economic slowdown. However, mortgage/non-mortgage loans continue to grow
decently, which shows that consumers are not worried so far.
None of these troublesome implications, thus,
have played out so far. Our expectation of a serious US slowdown by mid-2023
did not materialize, and even the soft landing theory has been elusive. The US
economy remains strong, supported by the drawdown in savings by US consumers,
which is in contrast to most other rich nations.
However, this is unlikely to continue for a
long period, especially if bond yields stay so elevated. Only ~8% of the market
participants expect a rate hike on 1st Nov’23, down from 33% a month ago, and
29% expect it in Dec’23 (up from 2.3% a month ago). It means that the majority
of participants would be surprised if the US Federal Reserve delivers another
rate hike, like they projected in their Sep’23 policy meeting.
We believe that even if the Fed does not hike
rates in the next meeting, it cannot afford to loosen its stance. If so, bond yields
will remain elevated, and the longer they stay high, the higher the risk of an
economic slowdown is. Accordingly, we push our expectation of a US economic
slowdown into 1HCY24.
Unrealized losses of the financial
institutions have surged
If the cost of funds increases sharply and
continuously, it is usually believed to hurt borrowers. Nevertheless, since a
bulk (~90%) of household loans are fixed-term, higher rates have not pinched
customers. Because of this, the burden of higher interest rates will be borne
by lenders, due to the higher cost of roll-over and/or refinancing the loans.
On top of this, financial institutions also see a drop in the value of their
securities portfolios due to higher interest rates.
According to the Federal Deposit Insurance
Corporation (FDIC), the unrealized losses on investment securities of all the
FDIC-insured institutions in the US have amounted to close to or more than
USD500b during the past five quarters. Since the Fed started hiking interest
rates in Mar’22, unrealized gains have disappeared (from USD29.4b in 3QCY21)
and large losses (totaling USD558b in 2QCY23) have emerged. The unrealized
losses are divided in the ratio of 45:55 between available-for-sale (AFS) and
held-to-maturity (HTM) securities portfolios.
We are not suggesting that all these losses
will be realized. However, it is probable that some institutions may be forced
to unwind their positions unwillingly, making it economically very difficult
for them to survive. Overall, it may not bring down the entire financial sector,
but it definitely holds the potential to send chills. Of course, timely
intervention by an extremely active US Fed could change the course.
World steel association in its October 2023
outlook revised steel demand growth estimate to 1.8% in 2023 and reach
1,814.5mt downgrading from 2.3% YoY earlier. As steel using key sectors like
infrastructure and construction witnessing impact of high inflation and high
interest rate leading to slowdown in both investment as well as consumption.
However, recovery in auto production continued in 2023, helped by order backlog
and easing of bottlenecks resulting high growth for most regions. For CY24,
world steel demand is expected to show 1.9% YoY growth led by demand improvement
in World ex China.
China -
The real estate sector have shown state of weakness as key indicators like land
sales, housing sales and new construction starts continued to fall in 2023. However,
government infrastructure spending stood as major driver for steel demand. As a
result, steel demand is expected to rebound by 2% YoY at 939mt in CY23 after
fall of 3.5% in CY22. The various measures undertaken by the government should
lead to stabilisation in property sector. Hence, under this assumption, the
steel demand for CY24 is expected to sustain at CY23 level.
India -
India remains bright spot in the global steel industry benefiting from surge in
construction and infrastructure sector driven by government spending as well as
recovery in private investment. After growing by 9% in CY22, demand is expected
to show healthy growth of 8.6% in CY23 and 7.7% in CY24.
US -
Despite the resilience of the US economy to steep interest hikes, steel using sectors
are feeling demand slowing down. Particularly, residential construction is affected,
which is expected to contract in 2023 and 2024. Manufacturing has been also
slowing, but the automotive sector is expected to continue its post-pandemic recovery.
The lagged effect of tight monetary policy points to downside risk for 2024.
After a fall of 2.6% in 2022, steel demand is expected to decline by 1.1% in 2023
and then grow by 1.6% in 2024.
European Union and UK - In CY23, EU economy stood stronger than expected to able to manage
energy crisis arising from the Russia-Ukraine war. The high interest rates and
energy costs had heavy effect on manufacturing activities. Though, recovery in
automotive sector continued. The steel demand after a fall of 7.8% in 2022, is
expected to fall by 5.1% in 2023. Although in CY24, demand is expected to see
rebound as impact of current adversaries likely to cool off.
View & Outlook: Developing nations to
spearhead global steel demand
Overall, worsening economic outlook due to
influence of monetary tightening that hurt consumption and investment alike.
The construction sector has been negatively affected by the high interest rates
and high-cost environment, especially the residential sector. Falling housing
sales have led to financial troubles for major Chinese real estate developers,
generating concerns about the health of the economy. For CY2024, auto sector
growth likely to decelerate, China to remain uncertain depending on the policy
direction to tackle economic difficulties, regional conflicts such as
Russia-Ukraine, Israel-Palestine and elsewhere further add to downside risk.
Steel demand dynamics in emerging and developing economies continue to diverge,
with developing nations excluding China remaining resilient to global
headwinds. After falling by 0.6% in 2022, steel demand in emerging and
developing economies excluding China will show growth of 4.1% in 2023 and 4.8%
in 2024.
India’s steel production and demand remained
strong for a seasonally slow quarter. Domestic crude steel production increased
by 15% YoY during July-August 2023 while other major economies witnessed a
decline over the same period. Various economic indicators also signal strong
demand from the infrastructure, building and construction, and automotive
sectors, a trend likely to gain momentum in 2HFY24. Prices of major base metals
fell during 2QFY24, with zinc/aluminium recording a decline of 25.7%/8.6% YoY and
4.5%/5.2% QoQ. Lead and copper prices were relatively resilient at USD 2,170/t
(+9.8%/+2.5% YoY/QoQ) and USD 8,356/t (+7.9%/-1.5% YoY/QoQ), respectively.
Silver/gold prices slid lower by 2.5%/2.7% QoQ but remained higher by
22.6%/13.3% on a YoY basis, respectively.
Primary steel producers under our coverage (JSW
Steel, SAIL, and Tata Steel) are estimated to report a 3%/1% YoY/QoQ drop in
2QFY24 revenue due to lower steel prices and seasonal factors. However, despite
seasonality, the EBITDA margin is likely to remain stable driven by higher
volumes and lower raw material costs.
Strong domestic demand is likely to keep the
earnings buoyant for JSW Steel and Tata Steel, partially offsetting the impact
of lower sales volume estimated at their respective international operations.
We estimate strong sales and EBITDA recovery for SAIL driven by 13%/5% YoY/QoQ
growth in 2QFY24 reported production.
Mining companies MOIL, NMDC, and Coal India are likely to report a YoY EBITDA growth
of 28% driven by strong operational performance. APL Apollo Tubes (APAT) and
Surya Roshni (SYR) are estimated to report EBITDA growth of 29% and 19% YoY,
respectively, driven by high-margin value-added product portfolio and higher volumes
partially offsetting lower steel prices. For our non-ferrous coverage (Hindustan
Zinc, Vedanta, and NALCO), we estimate a YoY/QoQ drop of 21%/3% in EBITDA
reflecting the movement in base metal prices. Overall, we estimate 2QFY24 EBITDA
of our metals and mining universe to increase by 13% YoY but decline by 5% QoQ.
We currently have BUY on SAIL, TATA, JSTL, MOIL, NALCO, SYR, NMDC, COAL, and
VEDL, and HOLD on APAT, and HZL.
Strong domestic demand: India reported a 17% YoY growth in monthly crude steel production
in August 2023, and remains one of the few countries globally to consistently
record growth in steel production. India’s September 2023 manufacturing PMI
came in at 57.5, above the neutral level of 50 for the 27th consecutive
month, indicating strong order intake and sustaining demand.
The latest Index of Industrial Production (IIP)
data for manufacturing activity in basic metals also indicated a strong demand
scenario, as it increased to 215 in August 2023 vs 207.7 in July 2023 (2011 as
the base year). Strong demand, increasing volumes, and lower raw material costs
are likely to outweigh the impact of lower steel prices and help key ferrous
companies maintain EBITDA margins during the quarter. We believe, earnings have
already witnessed a significant pullback in 1QFY24 as key metal prices normalised
from the record levels breached during the same period last year and, going
forward, higher volume-enabled operating leverage will ensure margin sustenance
while higher demand keeps prices in check.
Rising exports disaffirm overcapacity
risk in China; will likely keep steel prices
rangebound
Steel demand from the property sector in China,
largest steel producing country, remained subdued during the quarter slashing
hopes of a faster economic recovery. However, expected steel production cuts
have not materialized as well due to an offsetting demand from the
infrastructure and manufacturing sectors. China’s PMI data showed expansion in
September 2023, after recording a contraction in manufacturing activity for two
consecutive months. Lack of domestic demand from the property sector has also
led to a rise in steel exports from China. During April-July 2023, China
produced 364.6mt of crude steel, a marginal increase of 0.36% from last year.
Over the same period, exports of finished steel to India increased by 27% and 58%
YoY in value and volume terms, respectively. We believe, China is likely to
take milder production cuts for the rest of the year due to concerns over
economic growth that would keep exports high and inventories at a comfortable
level thus providing downside support to steel prices.
