While GDP and stock markets have had a positive relationship for a long time, the divergence is evident since 2018. Even as GDP growth has dipped, indices bounced sharply post the COVID-driven correction. For example, Sensex bounced 45% from the lows of March 2020 and is just 10% from its all-time peak. This huge divergence between GDP projections and stock market performance has been quite intriguing. However, this is true, not only for India, but for most markets across the world. Why is that so?
Everything will be OK with liquidity
Back in 2008 when the Lehman crisis hit global markets, central banks had only one option; infusing liquidity. Infuse they did; because major central banks infused $4 trillion into the markets. This may not have really helped production or productivity but it surely caused asset inflation. At least, the liquidity infusion ensured that demand compression did not last too long. In fact, by 2010, the global markets were back at the peak.
Year 2020 has seen a lot more aggression in terms of liquidity. The US Fed cut rates down to zero even as RBI slashed rates by 115 bps in 2 months. In 2008, central banks infused $4 trillion over 2 years, in 2020, liquidity infusion was $6.5 trillion in just 4 months. Markets are expecting this infusion to have a multiplier effect on stock markets due to asset inflation and heady valuations.
This time it is supply, not demand
In light of the COVID syndrome, the concern is less on the demand front and more on the supply front. Companies have been facing physical supply chain disruptions in sectors like automobiles, electronics, metals and pharmaceuticals. This fall in GDP is creating a sharper dichotomy between companies that cannot handle the disruption and companies that can. For example,companies with economies of scale like Reliance and Hindustan Unilever or an IT company like TCS or Infosys are not overly impacted by physical supply chains. Here the Kurtosis in the market becomes evident as these stocks are gaining value much faster. That is also visible in the way the FAANG stocks have built heft in the US markets.
Household balance sheets are actually improving
How can household balance sheets improve when people are losing jobs? That is the paradox. One lesson from past recessions is that a large number of households come out with stronger balance sheets than they went in. This is largely due to a better control on expenditure, lesser opportunities to spend, fewer borrowings opportunities etc. If you leave out the most vulnerable sections, most people are still employed and earning close to their pre-recession income but spending a lot less. Even in rural areas, there are stimulus benefits that are visible in data points like rural inflation, tractor demand etc.
In 2008, India dithered on rate cuts and liquidity infusion. This time around, rate cuts have been aggressive and liquidity infusion was over $300 billion. This will substantially improve the household balance sheets and the savings level of the economy. If you have doubts, look at the spurt in demat account openings in India.
Low yield could be the joker in the pack
When the economy is getting into negative growth, the bond yields fall sharply as it factors in further rate cuts and liquidity infusion. This is evident in bond yield across the world with US 10-year bond yieldsunder 1% for a long time. Even in India, as the chart below shows, bond yields are at multi year lows.
Let us look at stocks differently. If you don’t buy stocks, what do you do? Bonds offer incredibly low returns. The yield on US bonds has dipped from 3% in 2018 to 0.6% today. Indian bond yields have fallen from 8.4% in 2018 to 5.8% today. That is negative returns in real terms if inflation is factored in.So buying stocksof companies that are still profitable despite the Covid-19 recession is an better choice.
Why are bond yields low? Bond markets expect GDP growth to be tepid for another couple of years and expect RBI to pursue easy-money policies. So a weak GDP expectation is actually becoming a fuel for equity demand.
An economic recovery or a vaccine for COVID-19 will be boosting factors. Till then, the equity markets are likely to celebrate the economic weakness. Of course, this optimism will be restricted only to the less vulnerable companies in the market.