Making sense of India’s stock market surge

Indian equities rallied by more than 25% since the start of the year, making the BSE Sensex the best-performing equity market in Asia this year. In fact, all of these gains have been made since April, when India experienced the worst of the second wave of coronavirus infections. Since then, the Indian economy has shown strong signs of recovery and foreign capital has flowed into the equity market.

Is this surge in the equities market reflective of what is happening in India’s real economy? And what are the factors driving this surge? We speak with Ritesh Kumar Singh, chief economist at Indonomics Consulting and former assistance director of the Finance Commission of India, about the stock rally and related risks.

Unravel: What explains the record rally in the Indian stock markets?

Ritesh Kumar Singh: I think the five following factors have supported the current rally in Indian stock markets. The first is cheap and ample liquidity provided by the world’s central banks starting from the US, EU and Japan to India. Second, the low return (negative if adjusted for inflation) on bank deposits (the stick), and the steady increase in return on stock markets (carrot) has forced retail investors to put their savings in riskier equity and equity mutual funds. The third is what I call the China factor – Xi Jinping’s stringent climate change measures and China-US tensions, along with India’s high tariff walls, have meant better opportunities for India’s corporates, particularly those producing raw materials and intermediates such as steel and textiles, both in domestic as well as export markets. Fourth, the forced formalisation attempts starting from demonetisation and the implementation of the GST as well as the Kafkaesque lockdown measures have led to bigger listed companies gaining market shares at the cost of smaller firms, especially in the country’s informal sector. And lastly, reduced corporate taxes, which mostly exclude smaller business entities including sole proprietorship and partnership firms, LLPs and the whole of the country’s informal economy, putting them at a disadvantage vis-a-vis the large companies. All of these factors are behind the current rally in the Indian stock markets.        

Unravel: In your view, does the rally in any way reflect developments in the real economy?

Mr Singh: Conventional wisdom is that any sustainable stock market rally should reflect the actual and/or potential performance of the broader real economy. However, one must note that a stock market rally signifies mostly (if not fully) the performance (actual or potential) of listed companies. It doesn’t say anything about the health of unlisted companies or the country’s informal economy.

Unravel: Do you expect supply shortages and higher inflation to impact India’s stock markets? 

Mr Singh: As of now, many of the supportive global factors are gradually turning unfavourable. For instance, the US Fed is to start tapering, and with COVID restrictions now mostly over, merchandise exports may not do so well in the next two quarters and beyond as they have done in the last two quarters or so.

Moreover, ongoing commodity market inflation will raise input costs for a whole range of downstream industries, and lower their profitability even if higher costs benefit commodity processors such as Hindalco, JSW Steel or Tata Steel. Financially distressed households, due to income loss and poor return on bank deposits (plus increased input prices forcing consumer goods companies to raise prices), will cap the demand for discretionary goods and services. That may halt if not ruin India’s stock market party.

Unravel: Is the Indian stock market headed for a sharp correction, and by when?

Mr Singh: Many think that given the growing disconnect between financial markets and India’s real economy, rising inflation and high rates of unemployment, and continued distress in the country’s informal economy which employs 80% of the country’s non-farm workforce, and the US Fed’s tapering plans, it’s only a matter of time the stock market witnesses a sharp correction. This line of thought is not without merit.

However, as of now, I don’t foresee any sharp correction. There is no doubt the threat of Fed tapering is real. However, there’s still too much liquidity in the system, also forced by negative real return on bank deposits forcing retail investors to put their savings in equity and equity mutual funds. Moreover, in reality, the US Fed will only inject less liquidity going forward, and it will not close the liquidity tap completely for now.

Optimists argue the Indian economy is headed for a faster economic recovery even if that means continued good times, primarily for large corporations. Nevertheless, even if some correction happens in the next couple of months, it will not be uniform for all sectors. For instance, a continued focus on digitisation and related disruptions will keep the prospects of IT companies elevated. There’s no big picture change in healthcare—besides pharmaceutical companies have been laggards in the ongoing stock market rally—so they can expect relatively lower correction if any, vis-à-vis say metals. Despite increased input prices, FMCG companies with strong pricing power and relatively inelastic demand can expect lower risk of any sharp correction in their stock prices. I remain wary of metal stocks despite elevated commodity price inflation. The prospects of the banking sector, meanwhile, are again dependent upon the extent of increase or decrease in bad loans and the speed of wider economic recovery amid a muted credit demand from industry.    

Unravel: What are some of the risks stemming from the exuberance in the stock markets?

Mr Singh: In my view, the biggest risk remains the very enthusiastic participation of retail investors in the equity market. It is no secret that retail investors are invariably last to get in when stock prices have already gone up, and they are also the first ones to leave the ship when it starts sinking. In other words, they make less profits in a rally but lose the most money when a correction in stock prices happens. However, with near stagnant real estate prices, gold remaining range-bound and the negative real return on bank deposits, households and retail investors don’t have too many other choices other than investment in equity and equity mutual funds. That should be a cause of concern for policymakers.