Be cautiously optimistic

The disconnect between the performance of the economy and the market is obvious. Nifty and Sensex touched record highs and are hovering around those levels. But the economy, facing major headwinds, presents a different picture. GDP growth rate slumped to 5.8 percent in Q4 FY19, which is a 20-quarter low, and growth for FY 19 declined to 6.8 percent, which is a five year low. Consumption, which has been standing the economy in good stead, also weakened particularly in MBFC-financed segments like autos. There are no signs of pick up in investment and global environment is fast turning unfavorable.

So, why this disconnect between the economy and the market?

There are broadly two reasons: One, globally stock markets have been bullish since early February due to the risk-on triggered by the stance-reversal of the Fed. Markets that had discounted three rate-hikes by the Fed early this year are now discounting easing by the Fed. Two, the strong mandate for the NDA and the consequent political stability has triggered a ‘hope trade’ anticipating bold reforms by the government to kick-start growth in the economy.

Perhaps the broader market is a true reflector of the economic headwinds. Even though the Nifty is up by around 9 percent YTD (as on 12^th June), Nifty Mid-cap and Nifty Small-cap indices are flat, in fact slightly negative. Stocks of highly leveraged companies are sharply down. Nifty’s resilience is due to the strength of a few large-caps, which have good earnings visibility. Most retail investors whose portfolios are biased towards mid and small-caps have not benefited from the current rally.

The RBI did the right thing at the right time. The 25 bp cut in policy rates along with the change in stance to accommodative from neutral is eminently desirable. The 6-0 vote in favour of the rate cut and change in stance makes the policy all the more dovish. The scaling down of the GDP growth rate to 7 percent and inflation target to 3.4 to 3.7 percent for FY 20 will ensure that the policy will remain accommodative for some time.

Going forward, the market is likely to be influenced substantially by external factors. Domestic factors like policy initiatives from the government, particularly the budget, are crucial. Globally bond yields have crashed and hot money is chasing returns. Market signals – crash in global bond yields, sharp decline in commodity process, and spike in gold – indicate sharp decline in global growth. Declining bond yields are good for the stock market. Softening crude prices and relative immunity from global trade skirmishes are clear positives for India. That said it is important to appreciate the fact that there is no valuation comfort in the market now. Valuation is at a 20-year high:  Nifty is trading at a trailing PE of 29 and forward PE of around 20. Investors need to be cautious about valuations even while remaining optimistic.

Posted: June 2019