Rising inflation and rising bond yields are making headlines nowadays. With celebrity market observers warning global investors against the biggest inflation scare in the last 3 decades, investors seem to be getting jittery about corporate profitability.
Instead of evaluating the present situation from the academic standpoint, we would rather limit our discussion to assessing the impact of rising inflation on India Inc. But before we do that, it’s imperative to evaluate whether the inflationary pressure is structural or transient, just to know how scary the scare might get.
There's no such thing as bad weather, only unsuitable clothing—Alfred Wainwright
Inflation is a macro-trend but it doesn’t affect all companies equally. Its impact on the profitability and market share of a company depends entirely on how well-prepared the company is to handle the situation. No wonder, seasoned fund managers talk about bottom up stock picking almost always and yet, investors take keen interest in identifying the next big theme.
Along with metals, agricultural commodities also witnessed a huge spike as the global economy began to recover from the pandemic shocks, in the second half of 2020. Food and Agriculture Organisation’s (FAO’s) monthly food price index has been steadily rising from July 2020 onwards. Therefore, it looks like inflation isn’t only on account of supply disruptions and restocking.
Recently, palm-oil prices made a nine-year high. According to the Council of Palm Oil Producing Countries (CPOPC), structural as well as one-off factors have contributed to a sharp rise in prices.
The spread of coronavirus and strict social distancing norms affected the availability of labour and, in turn, production in the world’s largest palm oil exporting countries—Indonesia and Malaysia. These two countries collectively account for 85% of global production.
India is the second largest consumer of palm oil after Indonesia and accounts for 11.6% of the world’s total consumption.
(Source: USDA: United States Department of Agriculture)
Growth in production and consumption reflects a Y-o-Y change.
Indonesian government has capped agricultural land availability while Malaysia has curtailed its palm plantation to 6.5 million hectares. Crop yield in these countries has been falling due to ageing trees. Under such circumstances, re-plantation is crucial to improve productivity and ensure sufficient supply of palm oil. As stated by CPOPC, 1% re-plantation can create a short supply of 1.1 million tonnes.
On this backdrop, the impact of biodiesel programmes in the world’s largest palm oil producing countries in future remains to be seen. CPOPC has termed these factors as structural changes in the global palm oil supply. Diversion of oilseeds to the fuel market in major producing countries has lowered the availability of produce for export even in other oil categories.
Prices of palm oil and soybean oil are positively co-related. So far, a tight supply of Soybean and sustained oil demand also worked as a catalyst for palm oil prices.
But don’t jump to a conclusion that oil prices will rise vertically.
Consumption demand for vegetable oils has remained steady.
Fuel demand in Europe hasn’t recovered fully yet and the implementation of the biodiesel blending programme is unlikely to pick up steam until the end of 2022 in Indonesia and Malaysia.
Trade data for February suggests that, Indian exports of iron ore, rice, other cereals and oil meals have jumped 167.8%, 30.8%, 546.5% and 245.4% year-on-year, respectively. Although exports include re-export as well, the trend reasserts firmness of demand globally.
Nonetheless, India’s vegetable oil imports fell 0.5% in February and the growth for April-February period has been 11.1%.
USDA has lowered India’s palm oil import outlook for 2020-21 on the back of inventory built-up in the last few months. According to USDA, the production of Soybean in Brazil and that of rapeseed in Australia and Europe in 2020-21 is likely to more than offset the lower production in rival oilseeds.
Australia’s Department of Agriculture expects global soybean production to rebound sharply and reach a record high level over the medium term as strong international prices are influencing planting decisions in the key producing countries.
Saxo Bank has reported interesting observations, meanwhile.
Hedge funds trimmed their net long positions by 4% in the key 24 commodities of the futures market on a weekly basis as on March 09, 2021. Besides those in the precious metals and copper, net long positions in the agriculture commodities witnessed a fall ranging from 2% to 20%. The net long positions as a percentage of 52-week extreme positions have dropped considerably for a number of commodities including copper, soybean, wheat and corn amongst others.
Rising bond yields seem to have capped the interest of investors in commodities.
Considering the factors above it appears that the falling inventory levels and tight demand-supply conditions have underpinned commodity prices so far. Speculative demand driven by unprecedented liquidity might have played its part as well. That said, barring developments in the palm oil sector, price increases in other agriculture commodities don’t look structural.
Inflationary pressure on automakers and on white goods companies has been more pronounced. Leading auto companies such as Maruti Suzuki, Hero Motocorp, Mahindra and Mahindra and Eicher Motors, amongst others, have already undertaken price hikes on selective models to pass on the rising raw material prices. High fuel prices and long waiting periods (for taking automobile delivery), owing to the shortage of semi conductors, are already affecting auto sales.
If the present trend of high inflation sustains, at some point it may depress demand. Once we come through the current phase of rising commodity prices, it will be crucial to see how quickly demand can bounce back.
FMCG companies have also increased prices selectively. As per media reports, large FMCG companies such as HUL and Godrej Consumer, P&G, Marico, ITC and Wipro Consumer Care to name a few have announced price hikes for select product categories such as soaps, teas, edible oils and beauty products.
(Source: ACE Equity)
The only blessing in disguise is that rising commodity prices may reduce stress in the banking system. Indian steelmakers are expected to pare down debt by Rs 35,000 crore, according to Crisil estimates.
Unlike stock prices, rising commodity prices affect the real economy more directly. Liquidity driven rallies can’t prop up commodity prices beyond a point unless backed by a favourable demand-supply scenario.
On this backdrop, it’s imperative to track Q4FY21 results of consumer facing companies to identify how strong the underlying demand has been amidst rising inflationary pressure.
Mounting commodity prices are likely to affect unorganized players more acutely. Will organized players further expand their market share?
So far, it’s been seen that FMCG companies are more concerned about retaining market share. They have opted for price hikes only where they have been confident of retaining market share despite price increases.
While tracking quarterly earnings for the next few quarter, you may want to pay close attention to inventory gains, if any. The prices of many industrial commodities including those of metals, have witnessed an accelerated rise from the beginning of 2021.
Rather than top line or bottom-line growth (which is likely to be impressive for the next 2-3 quarters due the low base effect), profit margins would be the right barometer to measure the performance of India Inc.
Some savvy investors and market observers think potential improvements in FY22 earnings are already in stock prices. But then wouldn’t it be selective thinking to assume that markets haven’t factored in the impact of rising input costs as well? After all, commodity markets are forward looking too, just like stock markets are.
Rising inflation, falling inflation, no inflation, hyper-inflation, reflation, deflation… the jargon is endless. Instead of getting swayed by terms, intelligent investors prefer to ignore noise and focus on asset allocation. While selecting stocks for their portfolio, they bet on companies that can dress up befitting the occasion.
There are economic facts and economic predictions, and economic predictions are a total waste—Peter Lynch
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We, Ventura Securities Ltd, (SEBI Registration Number INH000001634) its Analysts & Associates with regard to blog article hereby solemnly declare & disclose that:
We do not have any financial interest of any nature in the company. We do not individually or collectively hold 1% or more of the securities of the company. We do not have any other material conflict of interest in the company. We do not act as a market maker in securities of the company. We do not have any directorships or other material relationships with the company. We do not have any personal interests in the securities of the company. We do not have any past significant relationships with the company such as Investment Banking or other advisory assignments or intermediary relationships. We are not responsible for the risk associated with the investment/disinvestment decision made on the basis of this blog article.