2 How important are capital market driven wealth effect tailwinds for formal sector engine of the economy?

Anybody who invested a significant sum when the stock markets crashed in March 2020 would have almost doubled it today. The ongoing stock market rally is bound to have generated a significant amount of positive wealth effect in the economy, especially among the classes and institutions which matter when it comes to big ticket investments.

A look at the PE multiple – the ratio of price of a share and earnings per share – of the benchmark BSE Sensex shows that the stock market is more overvalued than it was before the pandemic. The persistence of a loose monetary environment has also encouraged another route to making stock market windfalls, where both institutional and high net worth individual players have exploited low interest rates to borrow money and invest in IPOS just to make listing day gains.

The problem with such capital gains avenues is that they are not self-sustaining. As expectations of monetary tightening, both in India and abroad, increase, capital flight to advanced countries and profit booking endeavours might lead to a significant correction. Any such development is bound to create a significant negative wealth effect. While financial market exposure is not as high in India as it was in the US during the 2008 crisis, any significant correction will have a not insignificant effect on business sentiment. And corporate profits did not suffer significantly during the pandemic, ruling out the possibility of a large rebound as things improve. This reduces the likelihood of significant tailwinds to capital markets.