By Mihir Vora
A lot has happened in the past 12 months. In September last year, there was great hope for 2020 – indications of good, demand-led growth, especially in the rural economy. The Government announced tax incentives (15% corporate tax) for new investments in India made in the next 3 years and privatization of key PSUs. Markets took these positively and started rallying but in 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, while stock markets are near their all-time high the economic outlook feels uncertain. So is there a disconnect between the two? Why are market valuations high? To answer these questions, we need to understand the economic backdrop and the path that markets have taken to reach here.
Dwarfed by the spread of COVID-19, by February 2020 it was clear that the problem was huge and spreading fast all over the globe. Various countries started lockdowns of different magnitudes; economic activity paused. For the June quarter GDP growth was sharply negative. It ranged from -10% in developed economies to -24% for India! It looked like the world would go into a state of economic depression, even worse than that in 2008. Thankfully, it was not to be.
Having learnt from past lessons, central banks and governments of the developed economies unleashed a series of fiscal and monetary stimulus measures unlike and much greater in scale compared to anything that the world had ever seen. The US Federal Reserve, European Central Bank, Bank of Japan and most other countries cut rates, bought assets (equities, debt) to support the financial markets, offered lines of credit and flooded the world with monetary liquidity. Governments in these countries put money directly in the hands of the people, subsidized payrolls of companies and offered tax cuts. Fiscal deficits were increased by 6 to 20% of GDP! These measures were the equivalent of a fiscal and monetary ‘nuclear option’. Given the size and scale of these measures, they succeeded, and many economies saw a V-shaped recovery in the quarter ending September 2020.
Global central banks and Governments have made it amply clear that they will use all means to keep markets stable and support growth. In the US both the leading parties are supportive of a second fiscal stimulus package.
So the first factor to keep in mind to understand the markets is that the flood of global liquidity and low-interest rates will continue for a long time and asset markets continue to be supported by such measures. Easy money fuels risk-appetite and thus we have seen record-high retail investor participation in the markets globally and we will also continue to see global money flows to emerging markets like India.
In India too, the RBI has turned distinctly dovish and it is clear that for the RBI and Government, the objective of kick-starting growth is more important than inflation control at this juncture. This is the second factor to note. Liquidity in the system is ample, interest rates have been cut and we are seeing the impact of these measures in the form of lower lending rates. The fiscal deficit may also be allowed to run at high levels for a year or so. It means that Indian consumers and corporates will benefit from low-interest rates for quite some time. This has multiple implications. Lower rates can lead to demand stimulation as consumers and borrowers can buy bigger or more with the same EMI. For corporates, it means improved bottom-line as interest costs reduce and also increased capacity to borrow for future growth.
The third important point is that the Indian Government has begun to implement far-reaching fiscal and policy steps to keep investor sentiment positive viz. reduced tax for new investments, production-linked incentives for more than 10 identified sectors (Make-In-India), support for medium and small enterprises, privatization of key PSUs and continued support to the rural economy, indigenization of defence production, labour reforms and farm sector reforms. These steps are long-term structural positives for the economy.
Now let’s look at valuations. This is where things can get more complex as there are no standard templates to use. Given the depressed earnings this year, ratios like Price/Earnings (P/E) for FY21 look quite expensive. Even after estimating good growth for FY 21-22, the two-year forward P/E ratio is on the higher side compared to history for two-year forward earnings. 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 4-5 years. If growth returns to 7%+ levels, there is a upside on P/B basis as margins improve and Return on Equity expands.
Equity valuations also have a link with interest rates. Lower the rates, higher the valuations. The Earnings Yield (EY, opposite of P/E) expected two years forward is 5% compared to the 10-year bond yield of 6%. This difference of 1% is around the long-term average i.e. equities are not expensive when compared to fixed income assets.
The potent combination of the three factors discussed earlier can keep sentiment buoyant and allow markets to ignore sluggish corporate results and valuations for a few quarters. Moreover, while valuations do look expensive on certain parameters, they are justifiable on certain others. Overall, they indicate that the market expects a smart recovery after negative growth in FY21.
So, while it appears that there is a disconnect between the economy and markets, it is just the difference between the current reality and expected future. If growth materializes as expected, we will continue to see the markets do well and the economy catching up.
What risks do we see? A significant risk is that we are seeing a second/third COVID-19 wave in Europe/US. A move towards extended lockdowns may derail the nascent economic recovery. In India too, we have seen a second wave in certain States which had earlier done very well to contain the first wave.
Moreover, India has had a very limited fiscal stimulus so far (less than 2% of GDP). Thus the sales pickup seen recently may be due to pent-up demand and it needs to be seen if it continues beyond the festive season. With employment levels still below pre-COVID levels and many businesses shut permanently, especially in the services sectors, demand may not bounce back fast without further fiscal measures. Another key area to watch is financial sector stress which remains an area of concern – while recent commentary on asset quality has been incrementally better than feared – a clearer picture will only emerge after corporate results in January-February 2021.
If these persist and expected growth does not come through, positive market sentiment will fade. Then there may not be a disconnect between markets and economy – we certainly hope that this scenario does not materialize!
So stay optimistic about the future, while not losing sight of the risks!
Stay safe, invest wisely!
(Mihir Vora is Director and Chief Investment Officer at Max Life Insurance. Views are the author’s own.)