The last one year has been an unprecedented bafflement for equity investors. The pandemic caused a big economic shock which was also characterised by the quickest and largest rebound in equities.
In little over one year, India’s benchmark equity indices doubled, and are 32% higher than the pre-pandemic peaks in January 2020. The mid- and small-cap indices surged even more dramatically, rising by 140% and 170% from their respective lows. The characterisation of global markets is broadly the same. In the rebound from the lows, India has been among the top performing markets. But have business and the economy rebounded in any proportion similar to the market? What explains the resurgence and will it sustain?
But have business and the economy rebounded in any proportion similar to the market? What explains the resurgence and will it sustain?
Based on the somewhat optimistic official projections of 9.5% real GDP growth in FY22E, followed by 7.5% in FY23E, the compounded growth over the FY19 level would be just 1.8% and 2.9%, respectively. So clearly market capitalisation for equity markets has compounded exponentially relative to GDP. If the post GFC 2008 era was a liquidity driven surge, accompanied by feeble growth, the last one year has been superlative.
U.S. money supply to GDP has risen dramatically from sub-70% to over 90% in the aftermath of the massive expansion in the U.S. Federal Reserve balance sheet by $4.1 trillion to $8.1 trillion during January 2020-June 2021. Expectedly, India saw its forex reserves rising by over $130 billion to $609 billion, with foreign portfolio flow adding $36 billion. With domestic credit demand remaining low and large Indian companies deleveraging, the liquidity in the banking system has bulged significantly to 3% of total bank deposits. Thus, this combination of poor growth and liquidity deluge has resulted in valuation bubbles all across.
The statistically higher GDP growth in FY22 was largely driven by a favourable base effect of a deep contraction in FY21, but it is also true that there has been sequential improvement. Three factors behind this recovery were a) the strong fiscal response reflecting in combined fiscal deficit of centre and states rising to 13% of GDP, along with the massive liquidity support by the RBI, b) fading of the initial Covid-19 wave till the March quarter, before the second wave dealt another blow, and c) the revival in global trade volume, which was up 18% in the March ’21 quarter, compared to the pandemic lows in the June ’20 quarter.
Earnings projection for Indian companies has seen a major buoyancy; the average growth projections for NIFTY companies for FY22 and FY23 is at 33% and 23%, respectively, or an average of 28% over FY21. That amounts to a compounded growth of 22% till FY23 over FY19, which is significantly optimistic compared to the average of 2.9% real GDP growth.
Reasons for being sceptical about the optimistic earnings projection are several. First, the ratio of corporate profits to GDP has been declining consistently since FY08, from 7% to 1.5% (based on CMIE data). Thus, with real GDP growth expected to average at 2.9% (FY23 over FY19), it would require a major rise in operating leverage to translate into 22% average profit growth.
Second, since FY08, consensus earnings have seen consistent downgrades for one- and two-year forward projections; FY21 has been an exception when the over-pessimism led to very high volatility in projected numbers.
Third, we are seeing re-emergence of margin pressures due to a pervasive rise in commodity prices, including global crude and fuel prices in India. However, pricing power among Indian and global manufacturing sectors remains fairly feeble. Our study of lead indicators of OECD countries, where even in major advanced economies that implemented extraordinary fiscal stimulus in the aftermath of the pandemic, the underlying business cycle and consumer sentiment are not so strong so as to withstand the pervasive commodity price bubble that we have seen over the past 12 odd months. Prices have surged by 80%-200% across metals, soft commodities, and food indices. Our study also shows that pricing power among the U.S. manufacturing sector remains at the weakest level in a 50- year period, while the produce price index has shot up by 18% YoY on the back of rising commodity prices.
The situation in Indian manufacturing, also seeing similar cost pressures, may be weaker because of a much less vigorous demand revival. India’s fiscal spending support has been fairly conservative in global comparison. And it has been partially withdrawn due to tax implications of rising fuel prices.
Thus, in our case, liquidity has been the most important factor fuelling the exuberant rally. The critical question is whether it will sustain.
The answer lies in the future. Perpetual liquidity infusion would critically depend on future inflation risks. So long as the inflation trajectory remains contained, central banks can continue to expand base money supply and, as it overwhelms the real economy, financial asset bubble continues to enlarge. The wealth from asset inflation also becomes an important factor driving the pro-growth policy stance.
However, that can change dramatically if inflation gets out of hand. And that is the worry now.
The world over, the liquidity driven boom has had a distortionary compounding impact on frictional shortages in commodities. The synchronous hyperinflation in the commodity basket hints at significant speculative bias. Temporary fiscal stimulus has created construction boom in China and the wealth effect is translating into a housing price boom in the U.S.
Now there is increasing evidence that the rising cost pressures are impairing economic activities across several industries and countries. News trends indicate that the global concerns on inflation have risen to levels seen in early 2011 when crude oil prices surged to $110/barrel and commodity prices ranging from food, metals, and industrial materials surged by 80%-100% from the 2009 lows.
Views on whether cost inflation will subside on its own or will require a decisive policy response are divided. Several countries like China, Russia, Turkey, and India have initiated selective measures to tame inflation. But the most crucial will be the position adopted by the U.S. Federal Reserve, which is the fountainhead of global liquidity.
Our study suggests that the current situation is akin to episodes of elevated commodity inflation seen during 2008, 2010, 2013, 2019, all of which were followed by significant correction, in commodity prices, liquidity, and market multiples.
The estimated fair value for the Fed rate in our models is at 0.25%; it has reached levels above the actual zero rates, much sooner than in the post GFC 2008 era when it took 36 months to barely reach above the actual Fed rate at 0%. Thus, faster progress towards the Fed’s inflation, growth, and unemployment objective implies that the central bank could also be tapering its quantitative easing sooner than expected.
Thus, in the context of core inflation above 3%, and housing prices rising by over 20% since March ’20, there is little reason to continue with its $40 billion monthly purchase. Lower incremental liquidity could temper valuation multiples for equities.
Amid the current combination of bubble-like scenarios in commodity prices and equity valuations—especially in the mid- and small-caps space—it will be pragmatic to hold a conservative view. We are advising a contra stance to the deep cyclical sectors and stocks that we had been advocating since the March ’20 meltdown. It’s time for careful portfolio calibration.
Views are personal. The author is managing director and chief strategist, JM Financial Institutional Securities Limited.