Five reasons why market is charging ahead despite faltering economy

The benchmark Sensex and the Nifty both logged new all-time highs, surpassing their previous record in June. The markets have managed to charge ahead even as economic growth falters. For the three-month period ended September, India’s gross domestic product (GDP) grew at 4.5 per cent, lowest since March 2013. Decelerating for a sixth straight quarter, the growth number was also below consensus estimates. The market was largely unperturbed by the GDP shocker, almost sitting pretty around its new highs. Economic conditions are key for market performance as strong GDP growth results in strong corporate earnings — a key driver for stock prices. Then what explains the optimism in the market. 

Here are the key factors that have helped markets buck the trend:

Hopes of growth picking up: While the GDP data is released with a two-month lag, markets always try to factor in future expectations. Most economists and analysts are projecting economic and corporate earnings growth to pick up meaningfully next year. So despite the weak GDP footprint, the market has managed to power on hopes of this turnaround. “We expect 2020 to be better than 2019 and FY21 to be better than FY20 on account of five reasons,” says Prachi Mishra, India chief economist, Goldman Sachs. “Global economy should improve moderately; domestic financial conditions have improved sustainably following the rate cuts; fiscal impulse is expected to be positive; easing of supply bottleneck following series of reforms; and early signs of economic stabilizations.” The US-based investment bank is forecasting GDP growth of 6.6 per cent in FY21 and corporate earnings to grow 16 per cent in calendar 2020, slightly below consensus estimates of 20 per cent.

Robust capital flows: Deteriorating economic conditions globally as well as domestically have led to easing of monetary policy by most central banks. The US Federal Reserve has lowered policy rates by 75 basis points and has moved from balance sheet reduction to mild expansion. Similarly, the European Central Bank (ECB) has resumed its quantitative easing drive. Furthermore, most central banks, including the Reserve Bank of India (RBI) have cut interest rates. This has boosted liquidity and risk sentiment amid softening of bond yields. Over $6 billion has flown into India since September, driving up stock prices. Most other emerging markets (EMs) have seen robust fund flows as well. More importantly, economists are predicting the easy stance to continue. “If global growth stabilises and recovers over the course of 2020, as we expect, the monetary easing seen over the course of 2019 is likely to come to an end, with most major central banks on hold over 2020,” says Ric Deverell, chief economist at Macquarie.

Surprise tax cut: On September 19, Finance Minister Nirmala Sitaraman surprised the Street with reduction in corporation tax to 22 per cent (excluding surcharges) from 30 per cent earlier. The move saw the benchmark indices soar nearly 8 per cent in just two trading sessions. Just ahead of the announcement, the Sensex and the Nifty had plunged to seven-month lows on concerns surrounding slowing growth and financial sector turmoil. Analysts said the tax cut would boost aggregate earnings for Nifty companies by 8 per cent. Arguably, if not for the tax cuts, the benchmark indicies could have been 5-10% lower than current levels. This led to all around buying in the market amid realigning of stock prices with fresh earnings projections.

After the tax cut, the market has been hopeful that the centre will take more such measures to shore up the economy, which too has kept sentiment buoyant. “Following the surprise move to cut corporate taxes in September, speculation is high that a reduction in personal income taxes is on the cards next. With the all-in corporate tax rate at 25 per cent, it is likely that personal income tax rates, which are at 30 per cent-plus levels, will also be lowered, surcharges notwithstanding,” Radhika Rao, economist, DBS wrote in a recent note.

Some gain, most in pain: Benchmark indices touching new highs has been hiding the pain in the broader markets. So far this year, the Nifty is hovering around record levels, the Nifty Midcap 100 and Nifty Smallcap 100 are down 41 per cent and 25 per cent from their peaks. Also, several stocks are much below their record levels. Even in the benchmark indices, nearly half the stocks are back at their 2018 levels. Select bluechips such as Reliance Industries, Bajaj Finance, Asian Paints and ICICI Bank have gained sharply this year. While stocks like Yes Bank, Zee Entertaiment, Indiabulls Housing all down sharply. Similarly, automobile stocks too have corrected sharply amid drop in sales. Market players say divergence in the market performance is on account of weak economic conditions. In an environment of healthy growth, midcaps and smallcaps tend to perform better than the large caps.

Valuations expansion: Most of the recent gains in stocks have been on account of valuation re-rating amid weak earnings growth. This has resulted in valuations of several stocks soaring to record high levels. Analysts say investors have already priced in earnings growth for next year, which could mean muted returns in 2020. Goldman Sachs for instance expects Nifty 50 to gain only 8 per cent next year. “The performance in 2019 has been pretty good against the backdrop of soft profit growth. So we've kind of borrowed from potential performance in 2020,” said Timothy Moe, chief Asia-Pacific regional equity strategist at Goldman Sachs. High valuations also mean little room for disappointment. If earnings or GDP growth fails to pick up as estimated, markets could be vulnerable for sharp corrections, say analysts.

Low correlation between markets, GDP: Many studies have shown little correlation between markets and GDP growth. “GDP has virtually no correlation with near-term stock returns,” says a recent note by ICICI Securities, adding that the ccorrelation is “5 per cent with an R-squared value of 2 per cent.” “New age loss making ventures, regulatory changes, and high competitive intensity (telecom) have negatively impacted corporate profitability although GDP components may still continue to grow (productivity, wages, credit growth and data usage),” it says.

Also, “overseas operations of companies such as Tata Motors, Bharti Africa operations have had an adverse impact on corporate profitability in the recent past but may have very little impact on domestic GDP,” it adds. Analysts say given the low correlation it is likely that the market performs badly next year even as growth picks up.