Indian stock markets and real economy seemingly disconnected

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  Indian stock markets and real economy seemingly disconnected

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Read more on - Polity | Economy | Schemes | S&T | Environment

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• The story: Real versus Financial: In the real world, Indians are locked down in their homes, with little mobility, and struggling to get vaccinated against Covid-19 disease. In the financial world the stock indices refuse to slow down. The Nifty 50, one of India’s two premier stock market indices, ended at a record 15,436 points on 28th May, 2021, ignoring all health concerns.
• Covid and economy: This stock market rise is at a time the Indian economy is struggling through the second wave of the covid-19 pandemic, with the slowdown expected to last through much of this year. The economy is likely to be in slow-burn rather than experiencing the quick contraction seen in 2020.

1. The daily rate of vaccination, something which could help the country achieve herd immunity and get the economy back on feet quickly, has fallen dramatically after peaking in early April 2021. On 28th May, 30 lakh doses were administered, while the need is at least three times that if the target of "all adults vaccinated by 31st December 2021" is to be met.
2. Many families have spent heavily in covid-related expenses. Those who haven’t, are scared about what will happen as and when the third wave strikes.

• So what's up: As is known, a stock market doesn’t wait for things to happen, but discounts for possibilities. In an environment where the economy is expected to slow down, stock prices should have been adjusting for that possibility. That logic works if the stock market and the overall state of the economy are actually linked. 

1. While corporates profits (of listed firms) were down for many years in recent past, CMIE and other data shows a sharp rise in recent quarters (due to cost cutting). 
2. Profit after tax as a percentage of the gross domestic product (GDP), a useful ratio, peaked at 5.84% in 2007-08, and then was down to 3.46% of the GDP in 2013-14, before plunging to a two-decade low of 1.07% in 2019-20. Then, it rose in 2020-21, in the midst of a pandemic, to 2.42% of the GDP. In absolute terms, the profit made by listed corporates in 2020-21 has been at an all-time high. 
3. The bulk of the profit came from driving down costs. Large companies do that by cutting employee costs first, and then the cost structure of suppliers, and contractors.
4. These suppliers and contractors then do the same down the line, with their own staff. People start earning lower incomes and must cut down their own expenses to survive. 

• Listed firms and stock markets: The RBI Annual Report for 2020-21 pointed out that the central bank was puzzled at the rise of the indices, even after factoring into account the rising earnings growth of the corporates. Stock prices have been rising faster than company earnings for close to eight years now, and price to earnings ratios (P/E) of stocks have been at all-time high levels for a while now. So clearly cost-cutting (and higher profits) cannot be the main explanation for the continued rise in stock prices.
• The real driver: RBI points out that money supply and FPI (foreign portfolio investors) investments are driving Indian markets. The year-on-year money supply (as measured by M3) as of March 2021, had grown by 11.74%, after having steadily grown by over 12% through much of 2020 and in January-February of 2021. This happened because the RBI printed money and pumped it into the financial system, to drive down interest rates. With tax revenues collapsing, the government’s gross borrowing in 2020-21 was expected to jump to Rs.12.8 trillion. As the government’s debt manager, it is the RBI’s job to ensure that the government can borrow at low interest rates, and it did that by printeing a lot of money in 2020-21. 
• Two outcomes: First, that money printing drove down interest rates on fixed deposits to very low levels. Once adjusted for inflation and income tax, the rate of return from fixed deposits is in negative territory. So more people started looking for a higher return and investing their savings in the stock market. This pushed up stock prices to higher levels, disconnected from the overall state of the economy. The number of demat accounts, at 39.3 million as of December 2019, jumped by 40% to 55.1 million by March 2021. Second, it shows there is no free lunch, as the government being able to borrow at a low rate of interest has come at the cost of savers receiving a lower rate of interest as well. 
• Summary: The foreign portfolio investors bought stocks worth a record $37 billion in 2020-21, pushed by liquidity pumped by various central banks. At lower interest rates, the hope was that corporates would borrow and expand, and people will borrow and spend, and help increase economic activity. But this also led to individuals and institutions searching for higher returns and in the process, investing money in stock markets across the world. 

Read more on - Polity | Economy | Schemes | S&T | Environment

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