May 2022: Inflation – a headwind for corporate profits and markets

As is customary for us, we decided to review the quarterly results for the non-financials in the BSE500 for the quarter ended 31-Mar-22 to get an idea of how corporate results are shaping up. Below are the headline numbers:

BSE500 (Non – financials) Sep-21 Dec-21 Mar-22
YoY Revenue Growth 33.0% 28.2% 24.0%
YoY EBIT Growth 28.2% 19.3% 15.5%
EBIT Margin 12.4% 12.1% 12.3%
Excluding Energy & Materials Sep-21 Dec-21 Mar-22
YoY Revenue Growth 25.0% 19.7% 17.0%
YoY EBIT Growth 17.0% 7.1% 5.8%
EBIT Margin 12.6% 13.0% 12.5%

While aggregate revenue growth continues to be healthy, operating profit growth is lower. High commodity prices have boosted the profits of the material and energy sectors. If we exclude the material and energy sector from the calculations, revenue growth drops from 24.0% to 17.0% and operating profit (EBIT) growth drops from 15.5% to 5.8%. Clearly, the high commodity prices have dented the operating margins of the non-commodity sectors. So, while corporate revenues have been healthy, high commodity price inflation is eating into the margins of corporates and it remains to be seen whether high inflation will begin to impact economic growth at the margin, going forward.

The markets continued their fall during the month of May and at one point the Nifty 50 was down 8% for the month – a relief rally since then, has meant that the Nifty is down a little less severe 3% for the month. Markets globally have tumbled – the Nasdaq100 is down 24.4% from its All Time High, the S&P500 is down 13.7%, Nifty is down 10.9% and the BSE500 is down 11.6%. The median stock in the S&P500 is down 22.8% and in the BSE500 is down 33.9% from its All Time High. The below table shows the drawdown from the All Time High for the BSE500, S&P500 and Nasdaq100 constituents. As can be seen from the table, 38% of the BSE500 and 35% of the Nasdaq100 are down more than 40% from their All Time Highs.

Down between % of stocks down from all time high
BSE 500 S&P 500 NASDAQ 100
80% – 100% 6% 1% 2%
60% – 80% 10% 6% 12%
40% – 60% 22% 14% 21%
20% – 40% 41% 37% 33%
10% – 20% 16% 23% 22%
Below 10% 6% 19% 11%
Total 100% 100% 100%

What seems to have spooked markets globally is persistent inflation – US inflation for April 2022 came in at 8.3% which although lower than the 8.5% recorded for March 2022, is way beyond the 2% target of the US Fed. The minutes of the latest meeting of the US Fed suggest that the Fed participants expect 50 basis points interest rate increases at the next couple of meetings in an effort to bring inflation under control. It appears that the Fed may keep hiking interest rates until it sees a significant fall in inflation. The Fed also laid out a plan whereby it would reduce its more than $8 trillion balance sheet – at a rate which will go up to $95 bn per month from August 2022. This is a significant change – whereas several months back the Fed was providing liquidity of almost a trillion dollars per year, it will start reducing liquidity at the rate of a trillion dollars per year.

Markets have been buoyed over the last 2 years because of ultra-low interest rates and a huge infusion of liquidity by all the major central bankers globally to combat covid. With the huge jump in inflation globally, that era seems to have come to an end as central bankers raise interest rates and reduce balance sheet size to combat the beast. The continuing war in Ukraine has boosted the price of crude oil and other commodities and India as a large net importer of oil and other commodities, will be impacted. In an environment like this, protecting capital over the long term is of paramount importance and we take comfort in the fact that we own high quality companies that have stood the test of time and most of them are trading at prices that are very reasonable in relation to their long-term prospects. We have reduced or exited stocks in our portfolio which had become expensive and thus reduced the risk in the portfolio. We also have a small amount of cash in our portfolios which we can deploy if we get good opportunities.