THE HUGE DISCONNECT
Gloomy economic narrative does not justify stock market highs
The disjunction between the economic narrative and stock markets is getting wider by the day. After falling significantly in the initial days of the Covid-19 pandemic, the markets have rebounded sharply even in the face of a strong consensus that the economy will contract. India has been experiencing this paradox with several other markets. In January, when the pandemic was just a blip on the horizon, the Nifty had hit an all-time high of 12,340 points. By late March, as India entered lockdown, the index had dropped about 40 per cent to 7,511. But in the next three months, it has recovered to about 10,300.
All economic forecasters have uniformly switched from predicting low growth this financial year to a reduction in gross domestic product (GDP), but the markets have not paid any attention to such forecasts. Corporate results were poor for several quarters even prior to the lockdown, the last quarter saw mass unemployment and there are now over 550,000 confirmed Covid-19 cases, with no signs of a flattening curve. In addition, the standoff with China may impact trade adversely. Also, the Nifty continues to trade at a current price-earnings ratio of 26.5, despite universally poor advisories from companies and no end to the pandemic in sight. However paradoxical and irrational as this may seem, some underlying factors have kept share prices buoyant.
One factor is global liquidity, which has pushed up global markets. The US Federal Reserve, for instance, has started buying bonds of companies. The Indian central bank has also ensured monetary conditions remain easy. Easy money creates a precondition for taking risks, which is one reason why foreign portfolio investors have bought stocks over ~35,000 crore in May and June combined (after selling ~62,000 crore in March). The Reserve Bank of India’s action has kept bond yields low. There is little demand for financing from companies since economic activity is down. Yields below 4 per cent are essentially offering zero real return. Given low or negative real returns from debt, investors have opted for one of two extremes in terms of risk. The conservative are hoarding gold, which is the traditional haven in uncertain times. The bulk of the investors, however, have continued to invest in equity, as evidenced by mutual fund inflows, which have continued to be strong through the lockdown. There is some logic to this continued faith in equity. While it is true that equity valuations cannot be justified in the short term and corporate performance will be highly unstable for at least the next year or two, in the long term, equities could still prove a better performer than other assets.
The issue is that there is no clear timeline to earnings improvement and, given the extreme disruption of the global economy, a sustainable recovery may take far longer than in a normal business cycle. It is also likely that many businesses will not survive to see the next uptick. Even unlimited liquidity infusion by central banks may not be able to save all businesses. This implies a “zombie market”, where businesses with poor prospects trade at unrealistic valuations. It encourages a further misallocation of investible resources. Any asset allocation plan would suggest maintaining some exposure to equities. But investors must be careful not to go overboard, given that high valuations lend themselves to sharp corrections.