Rising stock markets amid GDP contraction pose risk of a bubble, says RBI

'The widening gap between stretched asset prices relative to prospects for recovery in real economic activity emerged as a global policy concern,' RBI said in a note

The central bank, in its annual report, has issued caution over the meteoric rise in stock prices at a time when the country’s gross domestic product (GDP) has contracted.

India’s benchmark indices have more than doubled from the post-pandemic lows made in March 2020. Several individual companies have seen multi-fold jump in their stock prices. This, even as the economy has headed south.

“This order of asset price inflation in the context of the estimated 8 per cent contraction in GDP in 2020-21 poses the risk of a bubble,” the Reserve Bank of India (RBI) has said.

Not just India, almost all global markets have seen a sharp rebound in their benchmark indices since March last year underpinned by aggressive stimulus measures.

“Prices of risky assets surged across countries to record high levels during the year on the back of unparalleled levels of monetary and fiscal stimulus, and the turn in market sentiments following positive news on the development of and access to vaccines and the end of uncertainty surrounding US election results. The widening gap between stretched asset prices relative to prospects for recovery in real economic activity, however, emerged as a global policy concern,” RBI said in a note titled "Is the bubble in stock markets rational?".

The central bank has quoted research work that highlights factors influencing the stock market. These include economic growth, inflation and money supply.

“The stock price index is mainly driven by money supply and foreign portfolio investor (FPI) investments. Economic prospects also contribute to movement in the stock market, but the impact is relatively less compared to money supply and FPI,” RBI observed citing an autoregressive distributed lag (ARDL) model, which considers factors such as Sensex movement, economic outlook and FPI flows.

In 2020-21, domestic equity received highest-ever FPI inflows at Rs 2.74 trillion ($37 billion). The previous record for highest-ever FPI flows for a financial year was in FY13, when overseas investors had pumped in Rs 1.4 trillion ($25.8 billion), as per data provided by NSDL.

This liquidity has helped drive up stock prices. However, there are fears that a reversal in flows in an event that the US Federal Reserve starts tapering its bond buying programme or raises interest rates would have a damaging impact on the stock markets.

The RBI said “calibrated unwinding” might be needed.

“Liquidity injected to support economic recovery can lead to unintended consequences in the form of inflationary asset prices 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.”

The risks are particularly high as the markets trade ahead of the fundamentals. The central bank highlights that stock markets are “overvalued” as the price-to-earnings (P/E) multiple is much above the long-term trend, while the dividend yield has fallen below historical levels. Improved corporate earnings have partly supported the market gains, RBI observes.

Over the years, the market has traded above its historical P/E multiple due to decrease in interest rates and equity risk premium (ERP)—the return an investor makes over the risk-free rate, which is typically the yield on the 10-year government security.