Rising Sensex in a sluggish Economy

Source: BSE India

The paradox:
 
Equity benchmark Sensex has been hitting fresh record highs on a monthly basis even as high-frequency macro-economic data continued to show acute pain in the economy. The Sensex hit a lifetime high of 41,000 recently while Nifty soared past 12,100. But, the economy is in a state of slowdown with the GDP growth rate at a 6-year low of 4.5 per cent. The collapse of the automobile sector or the rising number of non-performing assets (NPAs), sluggish consumer demand or failing manufacturing sector; all have a hand in this deceleration of growth rate. The RBI slashed policy rates a record 5 times in 2019 to support a struggling economy as the shadow banking crisis caused a liquidity crunch in the financial sector.
 
This appears to be counter-intuitive prima facie since the stock market is supposed to be an indicator of the state of the economy. Many believe that the stock market has a positive correlation with the GDP growth rate. But is this really so? Several studies have compared GDP growth rate and stock market indices over different time periods and geographical locations, and have observed that there is either no correlation between the two, or there is a very low degree of correlation, while some observations suggest a negative correlation between the two.
 
Ideally, markets and the economy should move together as price of shares of a company should be correlated with its future earnings. Expectations of future earnings are formed from past and present earnings. Thus, during a slowdown markets should correct to reflect the current level of earnings. But several other factors influence the pricing of shares. Fresh availability of surplus liquidity at cheap rates, along with speculation of future earnings being better than today, can lead to such divergence. The convenient argument during a bull run has been “this time it is different"—however, it never is.
 
Reasons for Current Boom:
 
Optimistic future outlook: Reforms such as the goods and services tax, insolvency and bankruptcy code and the recently announced corporate tax cuts suggest a positive mid-term outlook for India’s growth once banking and financial sector stress is resolved. The other equally important factor is low interest rates in developed economies that have led to fresh inflows into India. All this, coupled with expectations that the direct tax code will be enforced in the next budget, has improved market sentiment.
 
Recent government intervention: After the budget for the FY’20, it was expected that the government will slash down the Corporate tax levied on the companies. However, no such decision was taken and hence, the equity market experienced major crunch as foreign investors withdrew their money from the Indian market In response to the high corporate tax. However, with the crashing economy and stock prices, the Modi Government acted by taking restrictive measures to stable the falling financial market. Modi himself has been taking steps to revive growth from a six-year low. In September, the cabinet slashed the corporate tax rate to 22% from 30% for existing companies and to 15% from 25% for new manufacturing companies. He’s also eased foreign investment rules in retail, manufacturing and coal mining. Also, 10 state-run banks were merged to create four big lenders. An amount of $1.4 billion funds were announced to salvage stalled real estate projects.
 
Ease of Tensions between China & US: The global equity market got a boost up after reports about the end of the trade war between Trump administration and China. The two nations are close to finalizing a modest trade agreement that would suspend tariffs. Trump took to Twitter by tweeting “Getting VERY close to a BIG DEAL with China. They want it, and so do we!”
 
UK Elections: After the landslide win of Boris Johnson in the UK, the clouds finally cleared on Brexit. As per the speculated reports, Boris might take the UK out of the European Union by the end of next month. As a result, domestic companies that earn significant revenues from the UK market hogged the limelight in Friday’s trade. Shares of Tata Motors, which earns around 16.30 percent revenue from the UK, were up nearly 3 percent on BSE.
 
Lack of correlation:
 

• Sensex and other stock market indices represent only a few companies that have a large market capitalisation. Even if a few companies in Sensex do well in terms of earnings, it reflects well on the index. Thus, it is not truly representative of the economy. The reason behind this anomaly is that the investors are looking to invest in large companies amidst the slowdown. This has made a few stocks really expensive, and as a result, the Sensex has gone through the roof.
  

 

• During a period of high economic growth, investors are optimistic about returns. They believe that they would get better returns in the near future. Hence, they are willing to pay any price to participate in the expected profits. High demand leads to an increase in share prices. As a result, they end up buying overpriced shares and get relatively low returns in the future, even if the growth rate remains high. Thus, Sensex falls, while the growth rate is still high.
  

 

• Another primary reason is the growth of globalisation and multi-national corporations. These companies derive a large part of their profit from markets outside their economy. Hence, an increase in share prices of these companies may not be indicative of the local economy, neither will they necessarily benefit the local economy. For instance, Tata Motors accrues profits through JLR, its 100 percent subsidiary, whose operations are outside India.

 

• Further, there are certain sectors in the economy that are highly competitive and have a low-profit margin. Any attempt made by them to improve their technology will hugely benefit the consumers and the economy in the long run. But it will hardly add any value to the company’s share prices, because of the low-profit margin. Hence, Sensex will go down even in a period of high economic growth.
  

 

• But the most important reason behind the ‘paradox’ is that stock market indices like Sensex build upon investor sentiment and hope. This hope and optimism hinge upon a number of factors like significant economic decisions and decisive political leadership. The stock market can increase even before actual growth is delivered.
  

 
Conclusion:
 
Traders and investors are hopeful that the government will take stronger steps in the next few months. They expect a cut in personal income rate, GST rate cut, labour and land reforms among others. These decisions will take time to impact the economy, but investors are nevertheless optimistic about the prospects. Even as the economy has taken a huge hit, stock market sentiment runs high. Hence, the stock market has factored in future expectations into its prices. All said and done, there might not be a correlation between the stock market and the economy. It is futile to defend the current political leadership and the economic slowdown using the stock market indices.