Through Mihir Vora
A lot has happened in the past 12 months. In September of last year, there were high hopes for 2020 – signs of good demand-driven growth, especially in the rural economy. The government has announced tax incentives (15% corporate tax) for new investments in India over the next three years and the privatization of key PSUs. The markets took them positively and started to recover, but over the next few months the expected further acceleration did not materialize and the economy slowed to below 6% growth.
As we begin the new year, with equity markets nearing all-time highs, the economic outlook looks uncertain. So is there a disconnect between the two? Why are stock market valuations high? To answer these questions, we need to understand the economic context and the path markets take to get there.
Overshadowed by the spread of COVID-19, in February 2020 it was clear that the problem was huge and was spreading rapidly around the world. Various countries have started closures of varying magnitude; economic activity has come to a halt. For the June quarter, GDP growth was strongly negative. It ranged from -10% in developed economies to -24% for India! It looked like the world was going to enter a state of economic depression, even worse than in 2008. Fortunately, it was not.
Learning from the lessons of the past, central banks and governments in developed economies unleashed a range of fiscal and monetary stimulus that were different and far greater than anything anyone had seen before. The US Federal Reserve, European Central Bank, Bank of Japan, and most other countries cut rates, bought assets (stocks, debt) to support financial markets, offered lines of credit, and flooded the world with liquidity monetary. The governments of these countries have put money directly into the hands of the people, subsidized the wages of companies and offered tax cuts. Budget deficits have been increased from 6 to 20% of GDP! These measures amounted to a fiscal and monetary “nuclear option”. Given the size and breadth of these measures, they were successful and many economies experienced a V-shaped recovery in the quarter ending September 2020.
Global central banks and governments have made it clear that they will use all means to maintain market stability and support growth. In the United States, the two main parties are in favor of a second fiscal stimulus package.
Therefore the first factor To keep in mind in order to understand the markets is that the influx of global liquidity and low interest rates will continue for a long time and asset markets will continue to be supported by such measures. Easy money fuels the appetite for risk and so we have seen record participation of retail investors in global markets and we will also continue to see global money flows to emerging markets like India.
In India, too, the RBI has become markedly conciliatory and it is clear that for the RBI and the government, the goal of reviving growth is more important than controlling inflation at this point. It’s the second factor To note. The liquidity of the system is plentiful, interest rates have been lowered and we are seeing the impact of these measures in the form of lower borrowing rates. The budget deficit can also be allowed to reach high levels for about a year. This means that Indian consumers and businesses will benefit from low interest rates for a while. This has multiple implications. Lower rates can boost demand, as consumers and borrowers can buy bigger or more with the same EMI. For businesses, this means improved bottom line as interest costs decline and also increased borrowing capacity for future growth.
The third important point is that the Indian government has started to implement far-reaching fiscal and policy measures to keep investor sentiment positive, viz. reduction of taxes for new investments, production-related incentives for more than 10 identified sectors (Make-In-India), support for small and medium-sized enterprises, privatization of the main supply units and continued support for the rural economy, indigenization of defense production, labor reforms and agricultural sector reforms. These measures are structurally positive in the long term for the economy.
Now let’s take a look at valuations. This is where things can get more complex as there are no standard templates to use. Considering depressed earnings this year, ratios like Price / Earnings (P / E) for FY21 seem quite expensive. Even after estimating good growth for fiscal years 21-22, the two-year price-to-earnings ratio is higher than the two-year earnings history. However, if we look at other ratios like price to book value (P / B), they are not expensive. Indian corporate profits have been depressed for 4 to 5 years. If growth comes back to more than 7%, there is a rise on a P / B basis as margins improve and return on equity increases.
Equity valuations are also linked to interest rates. Lower rates, raise valuations. The expected two-year earnings yield (EY, opposed to P / E) is 5% compared to the 10-year bond yield of 6%. This 1% difference is around the long-term average, meaning stocks aren’t expensive compared to fixed income assets.
The powerful combination of the three factors discussed above can keep sentiment favorable and allow markets to ignore sluggish company results and valuations for a few quarters. In addition, while valuations appear expensive on certain parameters, they are justifiable on certain others. Overall, they indicate that the market expects a smart recovery from negative growth during FY21.
So while it seems there is a disconnect between the economy and the markets, it is just the difference between the current reality and the expected future. If growth materializes as expected, we will continue to see the markets doing well and the economy catching up.
What risks do we see? A significant risk is that we are witnessing a second / third wave of COVID-19 in Europe / the United States. A move towards prolonged shutdowns could derail the nascent economic recovery. In India, too, we saw a second wave in some states that had previously been very successful in containing the first wave.
In addition, India has so far benefited from a very limited fiscal stimulus (less than 2% of GDP). Thus, the recent recovery in sales may be due to pent-up demand and it must be seen whether it continues beyond the holiday season. With employment levels still below pre-COVID levels and many businesses shutting down, especially in service sectors, demand may not rebound quickly without new tax measures. Another key area to watch is financial sector stress which remains a matter of concern – as recent reviews of asset quality have been progressively better than expected – a clearer picture will only emerge after corporate results. in January-February 2021.
If these persist and the expected growth does not materialize, positive market sentiment will fade. Then there may not be a disconnect between the markets and the economy – we certainly hope that this scenario does not materialize!
So stay optimistic about the future, without losing sight of the risks!
Stay safe, invest wisely!
(Mihir Vora is Director and Chief Investment Officer at Max Life Insurance. Opinions are those of the author.)