Divergence Between India’s Economy & Equity Markets

(The following article appeared in BloombergQuint on November 7, 2019:

https://www.bloombergquint.com/opinion/economy-in-trouble-but-markets-at-a-high-why-the-divergence )

Divergence Between India’s Economy & Markets

Here’s a topical debate for us students of economics and markets.

Large swathes of India’s economy appear to be in distress. Yet, India’s key equity indices NIFTY50 and SENSEX are close to their all-time highs.

How do we account for this divergence? What are the implications for policy makers?

The Economy, Corporate Earnings, and Benchmark Equity Indices

There is actually little divergence between economic data and corporate earnings. The divergence is instead between earnings growth and stock prices.

Economic data suggests that both investments and consumption have slowed considerably in recent times, with several sectors of the economy battling deep, structural issues. NIFTY50 corporate earnings growth mirrors this economic narrative.

Consider figure 1, that traces the NIFTY50 index and its earnings over time. Over the past 6 years, underlying NIFTY50 earnings have grown by only 3.8% Compounded Annual Growth Rate (CAGR), belying the repeated predictions of double-digit growth that our equity dream merchants ritually provide us every year.

To redeem our dream merchants somewhat, despite this disappointing earnings growth, NIFTY50 index grew by a relatively healthy 11.1% CAGR during the same period.

This extent of divergence is unusual. Over the last twenty years, NIFTY50 earnings have grown by a much healthier 10.0% CAGR, even as NIFTY50 index grew by a similar 11.6% CAGR.

Equities beyond NIFTY50 and SENSEX

While NIFTY50 and SENEX are close to their all-time high levels, various Midcap and Smallcap indices are still 15% to 40% below their early 2018 highs.

However, the current yawning gap between relatively strong stock price performance and weak underlying earnings growth extends across the board.

For instance, NIFTY Midcap 100 index grew by 14.3% CAGR the past 6 years, even as the underlying earnings grew by only 3.7% CAGR during the same period.

As a result, price-to-earnings (P/E) ratio of Indian equities has risen sharply in recent times. The P/E of NIFTY50 has risen from 18.8 in 2013 to 27.5 now.

The Flow Behind the Price Resilience

Figure 2 traces the extent of Foreign Portfolio Investments (FPI) and Domestic Mutual Fund flows entering India’s equity markets between FY10 to FY20 (year-to-date).

Even as FPI flows slowed after FY15, domestic flows into mutual funds picked up sharply from FY15 onwards and saw a noticeable peak post demonetization in FY18.

The upshot is that over the past six years, strong domestic flows into equity mutual funds have helped equity prices overcome the sharp slowdown in earnings growth and register impressive gains.

What Explains the Domestic Equity Flow?

There are many reasons to account for this strong growth in domestic equity flows.

Association of Mutual Funds of India’s (AMFI’s) “Mutual Fund Sahi Hai” campaign appears to have worked very well indeed.

This and the growing tribe of distributors have helped increase retail awareness about equity mutual funds.

It certainly helps that on a tax-adjusted basis, equity investments offer the promise of much better return to savers than other asset classes, particularly with falling interest rates.

To further accentuate the comparison with other asset classes, debt funds have fallen out of favor with investors post the recent spate of defaults and downgrades. In fact, since April 2018, debt funds have seen a withdrawal of INR 1.4 lakh crores by investors.

All this has helped popularize equity “Systematic Investments Plans (SIPs)” to grow retail equity investments. Equity SIPs have grown steadily to INR 8,200 crores a month, and their average ticket size of just INR 2,900 underscores the stickiness of the flow.

What the Dream Merchants Tell Us

The dream merchants tell us that notwithstanding their disappointment with earnings (which they consistently overestimate), the current high price-to-earnings are sustainable.

After all, this mirrors a global trend. On the back of lower interest rates and easy monetary policy, USA’s S&P 500 price-to-earnings ratio has risen from 17.0 in 2013 to 22.9 now.

In addition, India remains an oasis promising growth and return, in an otherwise barren world grappling with ageing populations, slowing growth and negative returns. That justifies our higher valuations.

Finally, they point out that we cannot argue with the market. If there is a wall of retail savings relentlessly flooding the market seeking equity risk, equity prices will have to rise.

What Could Go Wrong?

Plenty.

First, notwithstanding the persuasive arguments of the dream merchants, authorities have to worry about the possibility of an equity bubble building. After all, any arrangement where prices are expected to rise purely based on continuing inflows rather than robust intrinsic value does sound perilously close to a Ponzi scheme. Especially given the governance and trust deficit that we are grappling with currently. What if domestic equity flows were to suddenly reverse?

There is one way to credibly address this risk – and that is to address the underlying distress in the Indian economy and restore confidence around its intrinsic value.

It would be a severe mistake to delay or deny the many deep structural reforms our banks, NBFCs, power sector, real estate, manufacturing, telecom, exports and public sector enterprises need, by taking comfort from a resilient stock market.

Second, a slow economy alongside a robust stock market has to be the easiest way to increase income and wealth inequality - a nightmare for any society. Again, one effective way to address this has to be to focus on reviving the economy.

Third, while increased savings into equity capital markets – away from gold and real estate – is welcome in principle, authorities have to consider whether the market in its current form has the capacity to absorb this wall of savings. They also have to recognize that their own tax incentives and monetary policy could be feeding this relentless flow into equity markets and contributing to this divergence between earnings and equity prices.

One way to address this would be to strengthen capital market governance and infrastructure, deepen secondary market volumes, and to bring tax treatment of debt savings – including into bank deposits – more on par with that of equity savings.

Summary

The core reason for the divergence between a slowing economy and robust stock markets could be the relentless wall of retail savings that is making its way into our equity markets.

This divergence is not healthy – besides increasing income and wealth inequality, it could threaten our financial stability.

One way to address this divergence would be to deliver on the many structural reforms that our economy sorely needs, and to therefore revive the economy.

Alongside, we should consider incentivizing other financial savings as much as we incentive savings into equity.