Why markets are rising in times of slowdown

8 min read . Updated: 28 Nov 2019, 08:18 AM ISTClifford Alvares, Nasrin Sultana

• Markets are at dizzy highs despite gloomy economic data. And things may get worse before they get any better
• Market watchers note that one of the best times to invest is when GDP growth is low. However, at current levels, India is still the most expensive among peers. This makes investing a risky bet

MUMBAI : Investors in India’s equity markets are really forward looking. Despite all the depressing news about the economy in the media, and a plethora of gloom-and-doom forwards on WhatsApp, the markets are at all-time highs. BSE’s Sensex touched the 41,000 mark for the first time ever on Tuesday and National Stock Exchange’s Nifty index surpassed the 12,100 mark, at a time when prime economic indicators and some high-frequency data are at loggerheads with the market’s euphoria.

It’s almost as if a section of the markets doesn’t give two hoots about the dismal economic data. It makes everything look hunky-dory, when it actually isn’t. “The Indian stock market is already factoring in reasonable recovery in the economy and earnings," analysts at Kotak Institutional Equities explained in a note to clients. Analysts at Jefferies India Pvt. Ltd echoed this view: “India’s equity markets appear sanguine that the worst has passed."

Simply put, the markets are up purely on the hope of a better future. And this dissonance between the markets and economic numbers naturally causes confusion in the minds of observers.

It’s another matter that there is nothing on the ground to support the optimism. Jefferies India, for instance, points out that its economic activity index slipped to a 15-year low in September. The broker’s Activity Index is based on 36 indicators including credit growth, automobile sales and electricity demand.

The latest reason for hope is the number of measures the government has taken to bolster the economy. Among other things, the Centre announced a massive cut in corporate tax rate. But analysts worry that the impact of these measures will take a long time to benefit the economy.

Report Card

“We remain fairly sceptical about any imminent recovery in the Indian economy," say Kotak’s analysts, citing multiple reasons. The current slowdown is because of structural factors such as low household income and poor job creation. Besides, the government’s finances are stretched and there is hardly any room for it to boost the economy by increasing spends. And while the Reserve Bank of India (RBI) is trying its best to bring interest rates down, the high borrowing needs of the government have kept real interest rates from falling meaningfully.

The upshot: things may well get worse before they get any better.

The hope rally

All the key indicators reveal that the economy is not in a good shape at all. However, the Indian equity market has largely been buoyant on account of better-than-expected corporate earnings in the September quarter and on expectations of further tax reforms by the government," says S. Naren, executive director at ICICI Prudential Asset Management Co. Ltd. He adds that global investor sentiment is up, with monetary easing by the US Federal Reserve, better-than-expected American GDP data and de-escalation of geopolitical risks.

In the September quarter, earnings for a number of companies got a boost from the cut in effective tax rate. “This is a short-term boost to earnings. It will only make rich companies richer, and is unlikely to cause the investment boost the government was hoping for," says the chief executive of a brokerage firm on condition of anonymity.

In the past five years, analysts have estimated double-digit earnings growth year after year for companies in the Nifty index, but average earnings growth has been only around 5% in this period. As such, the story of hope in the Indian markets isn’t new; it’s just that the degree of hope has become greater lately.

After a series of poor performances indicated by the high-frequency data, the GDP growth rate in the second quarter (Q2) is not expected to be any better than it was in Q1. In fact, Bloomberg puts GDP growth at about 4.6% in Q2, even lower than in Q1.

So, apart from hope, what else is driving the dissonance between the markets and the economy?

The liquidity gush

To be sure, a surge in global liquidity is good fuel for the markets. With interest rates abysmally low in some countries and even negative in others, naturally, some of the money sloshing around would find its way into riskier assets.

Not surprisingly, these funds start to chase assets where yields are positive. In fact, India’s 10-year domestic benchmark yield is hovering around 6.5%, which is near its five-year lows. This seems to be a cue for traders willing to take some risk and diversify into emerging markets.

In November so far, inflows from foreign institutional investors (FIIs) are at an eight-month high. FIIs bought Indian equity worth $2.54 billion in the month while they were net buyers of $12.49 billion in the year so far. In October, they pumped in $2.06 billion after a sell-off spree from July to mid-September.

On the other side of the geographic divide, domestic institutions have also been injecting more liquidity into the markets. Indian retail investors continue to have a high degree of optimism regarding stock purchases. Retail systematic investment plan (SIP) flows have been consistently steady, at about ₹8,000 crore a month, showing that retail investors still want to have a shot at equity gains. SIPs allow people to invest a fixed amount in a mutual fund scheme, periodically.

Just a few months ago, post the July 2019 Union budget, the market was heading lower after the government imposed a surcharge on foreign portfolio investors. However, in September the finance minister reversed the stance and even opened up its fiscal purse. Later, the government’s tax cut announcement was just the catalyst the market needed, and since then there has been no looking back. “Markets have been helped by continued inflows, foreign and domestic," says Gautam Chhaochharia, ED and head of India Research at UBS Securities India Pvt. Ltd.

A ‘hedged’ bet

It should not be forgotten that most of the optimism is restricted to a few big stocks. Only eight of the 30 Sensex constituents have gained more than 20% in the year to date, while the benchmark Sensex and Nifty are up 11-13%. The contribution of Sensex stocks to India’s market cap has grown from 44.77% in January to 47.23% at current levels.

The BSE MidCap and BSE SmallCap indices have lost 4% and 8%, respectively, in 2019 so far. Investors are buying select stocks with the hope that these will be immune to a large correction when the market sentiment turns.

But what this has done is that it made some Indian stocks very expensive. Besides, it has driven the valuations of the Nifty sky-high. In fact, stock markets have become as expensive as the 2008 era when valuations were driven north on high global economic growth before the Lehman crisis hit.

The Sensex now trades at a 12-month forward price-to-earnings ratio of 19.44 times, compared with 20.22 times on 10 January 2008, the peak before the global financial crisis, according to Bloomberg data. “The market is being driven by a select few quality stocks. After the rally in large caps, valuations have been fully priced in," says ICICI Pru’s Naren.

At current levels the Indian market is still the most expensive among peers. A corporate earnings recovery, critical at this juncture, may be derailed due to liquidity concerns and the slowdown in consumer demand.

An earnings challenge

This also brings us to the crucial point of where earnings will go from here. So far, earnings have been tepid. The slowdown in the economy means that earnings in sectors such as automobiles, consumer discretionary and some parts of consumer staples will be within the standard range. Orders in a large way have not yet trickled into the capital goods and infrastructure sectors, which means that this portion of the market is not expected to turn up just yet. That leaves only a few domestic consumption stocks to lead the earnings growth, not excluding banking and fast-moving consumer goods firms.

While the recent cut in corporate tax rates limited the pace of earnings downgrades, businesses continued to reel under pressure in the September quarter. A Mint analysis of 1,462 firms showed net sales in the three months ended September was the lowest in at least 27 quarters. Net sales decelerated 2.23% year-on-year, much lower than the 5.15% growth in the preceding three months, according to data provider Capitaline.

Clearly, while the government and RBI have stepped in to revive growth, analysts believe that their efforts will take time to percolate.

A call for reforms

But what the markets are probably expecting even more is the second leg of reforms that could drive economic growth. Some of this hope also springs from the fact that the government can use proceeds from privatization to pump prime the economy. However, a big impact is not expected here.

“In 2003-04, the government’s privatization and divestment measures drove the markets. While this reform measure is also being done this time, it will not move the needle much in comparison to 2003-04. So, the government must make some more fiscal room and push for vigorous reforms," says an economist at a leading brokerage firm on condition of anonymity.

It’s only then that a broad-based earnings revival could be expected, which could, in turn, raise the earnings of the rest of the market and not just the larger firms. This could also help the valuation dichotomy to narrow.

Market watchers have noted that one of the best times to invest is when GDP growth is low, like now. For example, in 2002, India’s GDP was very low, which was followed by a massive rally in equities until 2007. Of course, the difference between 2002 and 2019 is that while the markets were also at their lows in 2002, they are at their highs in 2019. “There is a significant disconnect between valuations of growth and value stocks, making value as a theme very attractive for investments," says ICICI Pru’sNaren.

Of course, all this hinges on the risk appetite of investors as well. As long as equity yields are low globally, riskier assets will have a field day. There’s also optimism that global growth will revive. That would mean that stock valuations could remain lofty for some time. Be warned.

Ashwin Ramarathinam contributed