This happened at a time the Indian economy is struggling through the second wave of the covid-19 pandemic, with the slowdown expected to last through much of this year. The economy is likely to be in slow-burn rather than experiencing the quick contraction seen last year.
Meanwhile, the daily rate of vaccination, something which could help the country achieve herd immunity and get the economy back on feet quickly, has fallen dramatically after peaking in early April.
Also, many families have had to spend heavily in covid-related expenses. Those who haven’t, are scared about what will happen as and when the third wave strikes.
In this scenario, it is well worth asking what is still driving the stock market, in an upward direction.
A stock market doesn’t wait for things to happen. It discounts for possibilities. In an environment where the economy is expected to slow down, stock prices should have been adjusting for that possibility. But that is true only if you work with the assumption that the stock market and the overall state of the economy are linked.
Calculations based on data from the Centre for Monitoring Indian Economy show that the corporate profit of publicly listed companies — measured by their profit after tax as a percentage of the gross domestic product (GDP) — has been falling over the years. GDP is the measure of the economic size of the country. The ratio peaked at 5.84% in 2007-08. It was down to 3.46% of the GDP in 2013-14, before plunging to a two-decade low of 1.07% in 2019-20.
In 2020-21, in the midst of a pandemic, the profit after tax to the GDP ratio of listed companies which have declared their results so far, has jumped to 2.42% of the GDP. In absolute terms, the profit made by listed corporates in 2020-21 has been at an all-time high. This is even before all the results have come in.
It is important to understand how this has happened. A close look at the data tells us that the bulk of the profit has come from driving down costs. When large corporates drive down costs, they do so by renegotiating terms with employees, suppliers, and contractors.
These suppliers and contractors then renegotiate terms with the people and firms they work with. This is how things boil down the hierarchy. People working in these firms earn lower incomes and must cut down their own expenses to survive. So, what’s good for corporates, isn’t necessarily good for the overall economy.
Nevertheless, what’s good for the listed companies should be good for the stock market as well. Does this mean that stock prices have been going up because of the increase in profit of listed corporates in 2020-21? To some extent, yes. As the RBI Annual Report for 2020-21 points out: “Even considering… earning[s] growth of the corporates, the stock prices cannot be explained by fundamentals alone.”
Also, it needs to be mentioned here that stock prices have been rising faster than company earnings for close to eight years now, and price to earnings ratios of stocks have been at all-time high levels for a while now.
Hence, the fact that listed companies did well in 2020-21 can’t 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 mainly driven by money supply and FPI (foreign portfolio investors) investments.”
What does this mean in simple English? The year-on-year money supply (as measured by M3) as of March 2021, had grown by 11.74%, after having steadily grown by over 12% through much of 2020 and in January-February of 2021.
This has happened because the RBI printed money and pumped it into the financial system, to drive down interest rates. With tax revenues collapsing, the government’s gross borrowing in 2020-21 was expected to jump to ₹12.8 trillion. As the government’s debt manager, it is the RBI’s job to ensure that the government can borrow at low interest rates.
The RBI did just that. It printed a lot of money in 2020-21 and continues to do so this year. This led to two things. It drove down interest rates on fixed deposits, the major form of saving for Indians, to very low levels. In fact, once adjusted for inflation and income tax, the rate of return from fixed deposits is in negative territory.
This led to more individuals looking for a higher return and investing their savings in the stock market. This pushed up stock prices to higher levels, disconnected from the overall state of the economy.
This can be seen from the fact that the number of demat accounts, which had stood at 39.3 million as of December 2019, jumped by more than 40% to 55.1 million by March 2021. Clearly, more people have been trading and investing in the stock market, in the process driving up stock prices.
This also shows that there is no free lunch. The government being able to borrow at a low rate of interest has come at the cost of savers receiving a lower rate of interest as well. You and I are paying for this privilege of the government. This also has an impact on consumption, though it cannot be easily measured.
Other than the RBI printing money, foreign portfolio investors bought stocks worth a record $37 billion in 2020-21. This happened because central banks of the rich world, like the RBI, have been printing money, to drive down interest rates and help their governments borrow at low rates. Also, the hope was that at lower interest rates, corporates will borrow and expand, and people will borrow and spend, and thus help increase economic activity.
But this also led to individuals and institutions searching for higher returns and in the process, investing money in stock markets across the world. This also explains to a large extent the huge rallies that cryptocurrencies have seen, the recent correction notwithstanding.
It is the expectation that the central banks will continue printing money, that seems to be driving the stock market.
The RBI Annual Report warns against this in its annual report, in a slightly roundabout manner: “This assessment shows that liquidity injected to support economic recovery [read money printing] can lead to unintended consequences in the form of inflationary asset prices [stock market rising] and providing a reason that liquidity support cannot be expected to be unrestrained and indefinite and may require calibrated unwinding once the pandemic waves are flattened and real economy is firmly on recovery path.”
In fact, in the recent past, whenever there have been suggestions that the money printing cannot continue indefinitely, the stock markets across globe have been spooked. The fact that the Nifty has touched 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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