Economy-Market Disconnect: Be Cautiously Optimistic
The disconnect between the performance of the economy and the market is obvious. Nifty and Sensex touched record highs after the election results and are hovering around those levels. But the economy, facing major headwinds, presents a different picture. GDP growth rate slumped to 5.8 per cent in Q4 FY19, which is a 20-quarter low, and growth for FY 19 declined to 6.8 per cent, which is a five-year low. Consumption, which has been standing the economy in good stead, also weakened particularly in NBFC-financed segments like autos. There are no signs of pick up in investment and global environment is fast turning unfavourable.
So, why this disconnect between the economy and the market?
There are broadly two reasons: One, globally stock markets have been bullish since early February due to the risk-on triggered by the stance-reversal of the Fed. Markets that had discounted three rate-hikes by the Fed early this year are now discounting easing by the Fed. Two, the strong mandate for the NDA and the consequent political stability has triggered a ‘hope trade’ anticipating bold reforms by the government to kick-start growth in the economy.
Perhaps the broader market is a true reflector of the economic headwinds. Even though the Nifty is up by around 9 per cent YTD (as on June 12), Nifty Mid-cap and Nifty Small-cap indices are flat, in fact slightly negative. The record highs of the indices are due to the excellent performance of 10 to 15 stocks. Nifty’s resilience is due to the strength of these few large-caps, which have good earnings visibility. Most retail investors whose portfolios are biased towards mid and small-caps have not benefited from the current rally.
The RBI did the right thing at the right time. The 25 bp cut in policy rates along with the change in stance to accommodative from neutral is eminently desirable. The 6-0 vote in favour of the rate cut and change in stance make the policy all the more dovish. The scaling down of the GDP growth rate to 7 per cent and inflation target to 3.4-3.7 per cent for FY20 will ensure that the policy will remain accommodative for some time.
Going forward, the market is likely to be influenced substantially by external factors. Domestic factors like policy initiatives from the government, particularly the budget, are crucial. During the last five years, even though the nominal GDP growth has been impressive, earnings growth has been tepid, resulting in high valuations. If the market is to move into a higher orbit and sustain there, earnings have to improve. The big question, therefore, is what the new government can and will do to stimulate growth and support earnings.
Globally bond yields have crashed and hot money is chasing returns. Market signals – crash in global bond yields, sharp decline in commodity prices and a spike in gold – indicate sharp decline in global growth. Declining bond yields are good for the stock market. Softening crude prices and relative immunity from global trade skirmishes are clear positives for India. That said, it is important to appreciate the fact that there is no valuation comfort in the market now. Valuation is at a 20-year high: Nifty is trading at a trailing PE of 29 and forward PE of around 20. Investors need to be cautious about valuations even while remaining optimistic.