Riding high

Global stock markets have made a stunning recovery in October, and Indian equities have moved up in tandem with other markets. The Sensex and the Nifty are now trading about 2.5 per cent below their respective January levels — while the former has regained the 40,000-mark, the latter is just a few percentage points below its all-time high. This is remarkable, given the turmoil triggered by the pandemic. This rally is partly due to a combination of high liquidity and low interest rates. Also, paradoxically, equity investment has been enhanced by a lack of real economic activity. Every central bank, including the Reserve Bank of India (RBI), slashed interest rates and introduced liquidity-enhancing measures as the pandemic took hold. Inflation has since risen but a weak economy makes it hard for the RBI to raise policy rates, or tighten monetary policy. Real interest rates are negative, inducing more fund flows into equity. This can also be seen in the mutual fund data — money has moved out of the debt segment and into equity funds. In addition, with businesses operating below capacity, there are no expansions and little need for working capital. This releases more cash, which is also flowing into stocks.

The market is also banking on signs of economic revival. High-frequency indicators and initial corporate results suggest the crisis has bottomed out. Auto sales show improvement in domestic demand, and exports have seen an uptick. Many businesses such as automobile dealerships have also built inventories, hoping for higher offtake in the festive season. But all this is on the back of a catastrophic first quarter (April-June 2020) and a weak second quarter of last financial year (July-September 2019). Hence, expectations must be adjusted for low bases, regardless of whether comparisons are made on a sequential or year-on-year basis. Equity valuations are also high. The Nifty is trading at a price-earnings ratio of over 34. This is difficult to explain. For argument’s sake, even if the next six months are excellent, most companies will endure reduction in net profit and revenue in 2020-21.

Apart from private consumption, government spending is also constrained. It’s still an open question how badly banks have been hit. The recapitalisation of public-sector banks will be held up. The fiscal deficit might expand further. However, on the positive side, energy prices may stay low for the foreseeable future, putting less pressure on the trade front. The geo-political equations also need to be kept in mind. Indo-Chinese confrontation may be frozen for the next several months. The EU and the UK are into another round of heated negotiations. Most importantly, November’s US elections could mean a sea change in the world’s largest economy, if the Democrats are able to take over the White House. Opinion polls suggest this is likely, and the markets have started discounting the potential impact. Apart from its disastrous handing of Covid-19, the Donald Trump administration waged tariff wars, tightened visa regimes, and cut taxes and social security expenditure. A new administration could provide a much broader fiscal stimulus, and more social security. In addition, the Democrats may opt for an easier visa regime and end the tariff wars, which would be good for most global businesses. Market moves are always linked to future earnings expectations and those are very unclear, even if the economy is past the worst. Therefore, for now, easy liquidity and an absence of alternatives are pushing equity valuations to unsustainable levels.


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