Why the stock market is disconnected from the Indian economy
This came at a time when the Indian economy is struggling during the second wave of the covid-19 pandemic, with the downturn expected to last for much of this year. The economy will likely be in a downturn rather than experiencing the rapid contraction seen last year.
Meanwhile, the daily immunization rate, something that could help the country gain herd immunity and quickly get the economy back on its feet, has plummeted after peaking in early April.
In addition, many families have had to spend heavily on covid-related expenses. Those who haven’t are afraid of what will happen as the third wave hits.
In this scenario, it is worth considering what is still pushing the stock market, in a bullish direction.
A stock market doesn’t wait for things to happen. He discounts for the possibilities. In an environment where the economy is expected to slow, stock prices should have adjusted for this possibility. But this is only true if you are working with the assumption that the stock market and the general state of the economy are related.
Calculations based on data from the Center for Monitoring Indian Economy show that the profits of publicly traded companies – measured by their after-tax profits as a percentage of gross domestic product (GDP) – have declined over the years. GDP is the measure of the economic size of the country. The ratio peaked at 5.84% in 2007-08. It had fallen to 3.46% of GDP in 2013-14, before plunging to a two-decade low of 1.07% in 2019-20.
In 2020-2021, in the midst of a pandemic, the after-tax profit-to-GDP ratio of listed companies that have reported their results so far, jumped to 2.42% of GDP. In absolute terms, the profit realized by listed companies in 2020-2021 reached an all time high. This is even before all the results are known.
It is important to understand how this happened. A close look at the data tells us that the bulk of the benefits come from cost reduction. When large companies cut costs, they do so by renegotiating terms with employees, suppliers and contractors.
These suppliers and contractors then renegotiate terms with the people and companies they work with. This is how it sums up the hierarchy. People who work in these companies earn lower incomes and have to cut their own expenses in order to survive. So what is good for business is not necessarily good for the economy in general.
However, what is good for listed companies should also be good for the stock market. Does this mean that stock prices have risen due to the increase in profits of listed companies in 2020-2021? To a certain extent, yes. As the RBI’s annual report for 2020-2021 points out: “Even considering …[s] business growth, stock prices cannot be explained by fundamentals alone. “
Also, it’s worth mentioning here that stock prices have been rising faster than corporate earnings for almost eight years now, and stock price-to-earnings ratios have been at unprecedented levels for some time.
Therefore, the fact that listed companies performed well in 2020-2021 cannot be the main explanation for the continued rise in stock prices and the huge disconnect with the state of the economy.
So, what explains this? As the RBI Annual Report points out: “The stock price index is primarily determined by the money supply and the investments of the REIT (foreign portfolio investors). “
What does this mean in plain English? The one-year money supply (measured by M3) in March 2021, had increased by 11.74%, after increasing steadily by more than 12% during much of 2020 and in January-February 2021.
This happened because the RBI printed money and injected it into the financial system, to bring down interest rates. With the collapse in tax revenues, gross government borrowing in 2020-2021 is expected to rise to ₹12.8 trillion. As the manager of the government’s debt, it is the RBI’s responsibility to ensure that the government can borrow at low interest rates.
This is exactly what the RBI did. He printed a lot of money in 2020-2021 and continues to do so this year. This led to two things. It lowered interest rates on fixed deposits, the main form of savings for Indians, to very low levels. In fact, once corrected for inflation and income tax, the rate of return on fixed deposits is in negative territory.
This has led more people to seek a higher return and invest their savings in the stock market. This has pushed stock prices to higher levels, disconnected from the general state of the economy.
This can be seen from the fact that the number of demat accounts, which stood at 39.3 million in December 2019, jumped more than 40% to reach 55.1 million in March 2021. It is clear that more people have negotiated and invested in the action. market, thus pushing up stock prices.
It also shows that there is no free lunch. The fact that the government can borrow at a low interest rate has come at the expense of savers who also receive a lower interest rate. You and I are paying for this government privilege. It also has an impact on consumption, although it is not easy to measure.
Besides the RBI printing money, foreign portfolio investors bought stocks worth a record $ 37 billion in 2020-21. This happened because the rich world’s central banks, like the RBI, printed money to lower interest rates and help their governments borrow at low rates. In addition, the hope was that at lower interest rates, businesses will borrow and grow, and people will borrow and spend, and thus help increase economic activity.
But it has also led individuals and institutions to seek higher returns, and in so doing, invest money in stock markets around the world. This also explains to a large extent the huge rallies that cryptocurrencies have seen, despite the recent correction.
It is the expectation of central banks to continue printing money that seems to be driving the stock market.
The RBI’s annual report warns against this in its annual report, in a somewhat roundabout way: “This assessment shows that the liquidity injected to support the economic recovery [read money printing] can lead to unintended consequences in the form of inflationary asset prices [stock market rising] and provide a reason why liquidity support cannot be expected to be unlimited and indefinite and may require a calibrated unwinding once the pandemic waves are flattened and the real economy is firmly on the path to recovery. recovery.”
In fact, in the recent past, whenever it has been suggested that money printing cannot continue indefinitely, stock markets around the world have been scared. The fact that the Nifty hit an all-time high means investors haven’t taken the RBI’s warning seriously.
Vivek Kaul is the author of Bad Money.
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