The Hindu Business Line : What’s driving bullish trends in asset prices

Macroeconomic factors, broader than earnings or dividend growth, are now driving stock valuations. These factors seem to be pushing the benchmark valuation ratios to progressively higher levels, so that historical averages increasingly seem less important.

Macroeconomic factors playing a bigger role

T. B. Kapali

Over the past five years, there has been a sharp rise in the valuations of a wide range of financial and physical assets. As the accompanying chart shows, stocks have multiplied seven times between 2003 and 2007. Gold has doubled, though it obviously does not compare with the stupendous rise in stocks (Chart 1). Real estate — both commercial and residential — valuations have not been shown here as organised price collection and dissemination with respect to thi s asset class is yet to take ground in the Indian markets. But despite the limited data, it is safe to say that prices, on an all-India basis, in this asset segment too have more than doubled in the past five years.

The breadth of the movement, encompassing almost all asset classes (Indian bonds and the currency have not been included here though the Indian currency, particularly, has registered smart gains in the past five years), seems to suggest common drivers. If so and if those common factors were still in operation, what does this presage for asset valuations from here on?

Beyond traditional valuation measures

Here, we identify some possible explanations for the widespread nature of gains in Indian asset markets from a macroeconomic perspective. This explanation is attempted with respect to the equity markets though it could well apply to real estate/precious metals also. This does not rule out periodical market reversals of the type we have had very recently and also in the past 3-4 years. These are event driven in nature and do not weaken the larger macroeconomic drivers.

Such a macroeconomic approach could possibly throw light on why the conventional valuation ratios — the P/E and the dividend yield — are now well above (below for dividend yield) even their averages of the past year or two, leave alone medium- and longer-term averages. Segmental analysis of asset price movements without going into the macroeconomics which is structurally impacting the valuation ratios may have some limitations in explaining this broad-based move in Indian asset markets.

For instance, a study of the price-earnings ratio or the dividend yield (vis-À-vis their medium-term historical averages) may suggest that Indian equities are currently dangerously overvalued. Such a study could further say that a reversion to more “normal” valuation levels (the “mean reversion”) can well be expected any time.

The Nifty’s PE, for instance, has been between 12 and 18 for close to 60 per cent of the time in the past nine years — 1999 to 2007. And it was in the 18 to 25 range for another 35 per cent of the time. But Indian equities have risen so much, particularly in the past half year, that valuation ratios currently are above even the average of the past year or two, leave alone longer term averages. ( Chart 2 shows the historical movement in the P/E and dividend yield on the Nifty index).

Analysts have pointed out to the high earnings growth which is required to justify such rich relative valuations. Equally, disappointment on the earnings front is seen capable of producing deep price corrections. One of the critical variables in the conventional equity valuation framework is the level of the equity risk premium. It is possible that the macroeconomic factors have lowered, at least temporarily, the compensation for bearing equity risk.

Macroeconomic Factors

Chiefly, the macroeconomic factors which are possibly driving asset prices could be:

The high level of broad money growth in India. Broad money growth in the overall financial system has been well above the level of nominal GDP growth (or equivalently, the nominal expenditure growth in the economy). While nominal GDP has grown 12 per cent per annum on average in the past five years, average broad money growth has been much higher at 16 per cent. (Chart 3)

(Known as M3, broad money comprises coins/notes in circulation and most importantly, the deposits with the banking system.)

This level of growth in broad money supply if met by increased demand for money/near money balances may neither cause inflation in the prices of goods/services NOR spill over into demand for and consequently higher prices on other assets.

The demand for money basically comes from a transactions motive and also for being held in a portfolio of assets. Changes in the relative attractiveness of money when compared with other assets (the opportunity cost) could alter the share of money in overall asset portfolios of all economic agents. To the extent that the private sector holds more monetary assets than it prefers, there would be a shift of the excess money balances into other assets such as equity.

In a financially liberalising economy and also in an environment of macroeconomic adjustment (such as the case in India), money demand from a transactions motive will be high in the initial period of liberalisation. This is because the number and value of transactions go up as the economy opens up.

The key to maintaining growth in transactions money demand is to deepen financial inclusion, broaden credit creation and financial intermediation. In the absence of the same, the excess money balances will inevitably spill over into demand for other assets — be it equity, gold or real estate. Analogously and more broadly, if there is a paucity of good quality assets in which the excess money flows can be invested, it is likely there will be excesses in the valuation of existing assets. This broad pattern seems to fit quite well in the Indian case so far in this decade.

Broad money has grown sharply in the last 7-8 years. This has chiefly been on account of a larger macroeconomic policy preference for building up foreign exchange (FX) reserves. Indian FX reserves have grown from $40 billion in March 2001 to $270 billion in December 2007. To be sure, there have been valiant attempts to mitigate the effect on broad money growth of this massive increase in FX reserves. But the banking system has still been able to produce a level of broad money which is consistently running ahead of the economy’s capacity to absorb it without fuelling price pressures — both in the goods/services markets and in asset markets.

There has possibly been a portfolio shift of excess money balances on account of the lower level of interest rates on bank deposits till the middle of this decade vis-À-vis returns on other assets — partly corroborated by the near quadrupling of mutual funds’ AUM in the past 4-5 years. A broad range of Reserve Bank of India data shows that growth in transactions money demand may be weakening after expanding robustly earlier in this decade. This is also corroborated by the RBI’s own data on the level of financial exclusion and the narrowness in credit creation in the financial system.

Concurrently, the broader financial architecture has not been able to supply the required level of good quality assets which can absorb the increasing money supply. A bond market, for instance, is conspicuous by its absence in an economy of India’s size and potential.

Sustainability of current valuations

It is possible that Indian equity markets have moved into a high valuations environment for some time to come. The push for that seems to come from the present configuration of macroeconomic policy and the (high) likelihood of the current policies being persisted with. (Proof of that comes from the fact that Indian FX reserves increased by as much as $9.6 billion in the period ended January 18 in this calendar year. The stock markets have corrected severely in the subsequent two weeks. Just visualise where all the money created by that massive increase in FX reserves is going to get deployed in the coming weeks/months.)

Factors endogenous to the equity capital markets — their organisation, product suite, trading and settlement practices, the steady improvements in these as also the structural improvements in corporate financial performance — may only reinforce the above trends.

But, as is often pointed out in economics, everything depends on everything else and other things remaining the same. These other things — such as global macroeconomic, financial market conditions and how they impact the expected compensation for bearing emerging market risk — are currently favouring Indian markets. And they may well continue to do so in the ensuing period. However, it is difficult to say how far into the future is that ensuing period.

Note: This article was written before the recent severe fall in the stock markets. The author, nevertheless, believes that the arguments/line of reasoning advanced in the article hold good).

The author is Vice-President (Economic Research), Shriram Group Companies, Chennai. These are his personal views.

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