Disclaimer: The IIP may not be what you think it is.

I wish I had written the following article a month ago. I, for some time, have been a believer that we are going to see an inflection in the business cycle of India. But every time I would utter such a view point I would be met with an onslaught of sell-side and media reports talking of how corporate India is bleeding. The key metric that traders await to affirm this negative view is the monthly Index of Industrial Production (IIP). Until Friday June 12^th, the numbers for this year have been disappointing and non-indicative of any real activity growth in the economy. (I am a non- believer of the index but do not intend to change your stand on it).

For a number that is quoted very often in leading financial newspapers and used frequently by traders to move markets in either direction, very little reporting is done on the method of arriving the number. Below is the disclaimer that any report judging the economy’s strength on the IIP, should contain.

“The all India IIP is a composite indicator that measures the short-term changes in the volume of production of a basket of industrial products during a given period with respect to that in a chosen base period.” So in other words, the IIP is an abstract number which represents the magnitude of the production in the industrial sector for a given reference period. The IIP index published in India by the Central Statistics Office (CSO), however, only deals with registered manufacturing units. By definition this includes those manufacturing units that employ 10 or more workers and use power; and 20 or more workers but use no power. On an average, the entire manufacturing sectors accounts for 16% of India’s GDP. 10 percentage points of that comes from registered manufacturing units but 6 percentage points of that comes from the non-registered manufacturing units, which get ignored in the IIP calculation. Therefore, the indicator the market uses to gauge the manufacturing strength in India in fact ignores 37.5% of the manufacturing in the country.

Also, the United Nations Statistics Division expanded the scope of the index to include Mining & Quarrying, Manufacturing, Electricity, Gas steam and Air-conditioning supply, Water supply, Sewerage, Waste management and Remediation activities. Due to constraints of the data availability and other resources, the present general index of industrial production compiled in India has in its scope limited to Mining, Manufacturing and Electricity sectors only. Thus of the 10 percentage points, a few registered manufacturing units are still not covered in the Index given the limited scope of the survey.

It is difficult for the CSO to standardize the data even within this limited scope. With 16 different sources contributing to the index, standardization of data collection across the nation becomes an even more of an impossible task.

This difference in data collection could result in the index portraying a different picture of the ‘ground reality’ than the true facts. For example the sample size for data collection for the different components is decided by the respective source agency. The only guideline stated in the CSO handbook says, “Generally, efforts are made to cover all the major units”. The definition of major is however left up to the source agency and it has changed with time depending on whether the department is understaffed or overstaffed.

“The basic data used for compilation of the index is the production in terms of quantity. However, there are certain items especially capital goods such as Machinery, Machine Tools, Ship Building etc. on which the production data is furnished in value terms. In order to remove the effect of price rise from the index, the production figures of such items are deflated on the basis of Wholesale Price Indices (Base 2004-05), compiled by the Office of Economic Adviser, Ministry of Commerce and Industry, before compilation of index.”  This is yet another example of how the different sources of data can lead to discrepancies owing to differing methods of data collection.

Given the size of the undertaking, and the varying sectors covered by the index, it would be nearly impossible to conduct the operation without different sources. It is however the lack of standardization across departments and the consequent lack of data validation checks that require this to be highlighted as a glaring drawback in the quality of the data point released every month.

Before releasing the data, the CSO confirms the accuracy of the data points with the source agencies if there is a significant deviation from the data point in the previous month.  The underlined word in the previous sentence demonstrates the peril of using such an index.

The intention of this article is not to convince people to ignore the IIP numbers altogether but rather to provide a disclaimer for those ‘consuming’ this index. Put in a cliché manner, the intention is to provide one with the grain of salt to ‘consume’ this data with. 

Maybe there is still some lustre in gold

Given the performance of the equity markets in India, most financial newspapers are gung ho about how retail investors should invest in mutual funds or SIP's and not even consider real estate or the eternal global currency, gold, as a form of investment any more. But maybe there are a few gains to be made by investing in Aurum.

Overall thoughts on the commodity

Fundamentally speaking the gold markets seems to be in balance. The degree of imbalance in the short term would at most be demand falling by 1% causing a temporary imbalance but otherwise I do not believe that there is an imbalance in the physical market. With capacity additions now tapering off into H215, as per the new mine addition schedule, I think there could also be a slight tightening in the market. In terms of flows- currency uncertainty, the fall in Chinese markets witnessed last week and the risks of a Greece default and delays of a fed rate hike given US GDP shrinkage numbers being released last week- all lead me to believe that gold is positioned to correct upwards soon.

I don’t know if we will see the 40%+ recovery we have seen in oil prices since they have bottomed but I would not be surprised. I have realized that in the most traded commodity markets- oil and gold- the market imbalances don’t have to be great for there to be an immense pressure on prices induced by financial liquidation. Even with oil the imbalance was of just over a percentage point that precipitated into a 55%+ decline.

Risks to my view

There are two fundamental risks to my view. One would be rising retail domestic investor involvement in the stock markets in India. Jewelry demand in China fell by 10% in Q115. Though this was in comparison to a historic high in first quarter demand in China in 2014 and though the demand was still 27% above the 5 year demand average in Q1, a part of this decline can be attributed to rapid rise in the domestic equity markets. Gold is looked at as an alternative investment by many retail investors. If domestic participation by retail investors in the local stock market rises, some demand for gold would be lost. 8 million new accounts (DMAT) were opened in China in Q115; a 433% increase y-o-y. Given the rising involvement of retail investors in the domestic market in India, jewelry demand supported by need for alternative investment could take a hit.

Another risk to my view is the surge in recycling of gold in Turkey. Given the slowing economic growth, rising unemployment and growing political risk in Turkey, we witnessed the Turkish Lira plunging in Q1. This propelled the price of gold locally to 100 Lira/ kg with gold. This caused a lot of people to cash in their gold for currency and led to a rise in recycling supply for the metal.

How the flows work in Gold’s favor now?

Investors turn to gold, the eternal global currency, when paper currency markets register volatility or in cases of geo-political instability. The world seems to be ripe for both of those to occur now. Currency volatility has dominated 2015. The one popular trade- long dollar- is also lightening up now with people unwinding their long positions owing to uncertainty of a fed rate hike.

Movements in real rates are inversely related to movements in price of gold. With the shrinkage in US GDP noted last week it seems even more unlikely that the Fed will raise rates in their June meeting. This coupled with the rising risk of default in Greece as well as the uncertainty of the future of Chinese markets given the over 9% drop in the Chinese A Shares within two days last week- will force some retail investors into gold.

Moreover the relative strength of the underlying commodity to its miners’ stock price seems to be at a historic high. My guess would be that should there be a correction we would see miners correct a lot more than the commodity price itself.

How do the fundamentals hold up?

Globally, Q1 demand was only slightly weaker than last years’ with most of the fall caused by the increased domestic participation in the equity markets in China. Given the move last week, some of the fringe investors will be drawn back to gold. Moreover growth in demand in India, SE Asia and the US should offset the fall in demand in China.

The key fundamental factor supporting my view on gold is the supply curve. Not only are the mine capacity additions tapering off in H215 but we also see the cost curves adjusting to the lower gold prices having faced lower prices since mid-2013. A correction in gold prices will therefore create increased cash flows per ton for miners who have devoted a lot of the operational energy on lowering costs and adjusting to the new price levels over the past few quarters.