Point Blank. Markets and the Trump-Modi effect

Investors in the Indian stock market have been exulting as the Sensex has been notching new life-time highs since last Friday. But the Indian benchmark is not alone in this. The S&P 500 and the Nasdaq Composite too managed to close at record levels last week and the Dow Jones Industrial Average followed suit with a record high this week.

The similarity between the benchmarks of the two countries does not end there. Stocks in both markets have been defying gravity even as the fundamentals have been flashing red. It is quite obvious that political will has a large part to play in keeping the indices buoyant in the US as well as in India. With the US Presidential elections slated next calendar and a series of State elections over the next few years in India, it is clear that leaders of both countries are using the stock market as a means to keep sentiment upbeat.

But is this practice healthy for the long-term health of equity markets?

The Trump effect

The twitterati would vouch for the fact that the POTUS has his eyes firmly glued on the stock market performance and uses it blatantly to prove the effectiveness of his governance. “The stock market hit 25,000 yesterday. Jobs are at an all-time record and that is before we fix some of the worst trade deals and conditions ever seen by any government. It is all happening!”, ran his tweet in July 2018. And his latest tweet (on November 5): “Stock market hits record high. Spend your money well.”

Donald Trump has also triumphantly tweeted about the number of times the Dow Jones Industrial Average has hit record highs since he took over, to prove that his has been the most successful presidential term ever.

But such obsession with market indices is perhaps preventing natural corrections that is necessary to allow stock prices to revert to mean. The Dow Jones Industrial Average has not witnessed a bear market — decline of over 20 per cent from the peak — since 2008. Towards the end of 2018 however, the Dow Jones Industrial Average declined 19 per cent from its peak between October and December 2018 due to concerns about slowing growth and global trade war. But the Federal Reserve was literally bullied into halting its interest rate hikes and slowing its monetary tightening in that period, which helped US stocks pick up steam again.

This unwillingness to let stocks correct is however resulting in pricey valuations in the US market. According to factset.com , earnings of S&P 500 in the third quarter of 2019 declined 3.7 per cent, based on companies that have declared results so far. If the trend remains similar for all companies, this will be the first time the index has reported three straight quarters of year-over-year earnings declines since 2016. The forward 12-month P/E ratio for the S&P 500 is well above both the five- and 10-year averages.

The Indian scene

Similar interest in stock market indices has been displayed by many politicians in India. Back in the 1990s, it was common for the ruling government to ask the prominent mutual fund of those times to buy stocks and push prices higher, whenever there was a crash. While Finance Ministers like Pranab Mukherjee were quite disdainful about the role of stock markets in contributing to economic growth, others like P Chidambaram were very alert to factors impacting markets and quick to take actions to support stocks.

The Modi government in its first term did not really show too much interest in the Sensex or the Nifty. In fact many of the policies — such as re-introduction of long-term capital gains tax on equity and equity mutual funds and increase in surcharge and cess on corporate tax — had hurt investors and listed companies. That government perhaps had little to worry about market crash then since large-cap indices had remained elevated between 2014 and 2019, thanks to liquidity from mutual funds and pension investors.

However, in its second term the Modi government appears to be following the footsteps of the US President. While the sharp deceleration in consumption and GDP growth was purported to be behind the government’s recent stimulus measures responses, the 10-per cent decline in the Sensexin July and August also seems to have made the Centre act.

The rolling back of the increase in surcharge on capital gains and the massive corporate tax cut were largely aimed at lifting the stock market sentiment. What is more, the RBI is also lock in step with the Centre to boost investor morale.

But such political intervention is distorting price discovery. Even as the Sensex hits a new life-time, the revenue and operating profits of listed stocks have declinied in the September quarter compared to a year ago, based on companies that have declared results so far. Compounded average growth in net profit of companies forming part of BSE 500 between FY14 and FY18 was -0.41 per cent. It is, therefore, not surprising that Sensex’s price-earning multiple is at 20 per cent premium to its five-year average.

Investor sentiment matters?

Having seen that political will influences stock prices, the next question is: Why do governments worry about stock price movement?

One reason could be the wealth effect, due to which individuals tend to spend more when their equity portfolios sport robust returns due to stock market rally. Some governments could be trying to boost consumption through this route. Two, since stock prices reflect future expectations regarding the economy and business environment, leaders such as Trump have been interpreting market moves as a vote of confidence for their governments.

Three, research shows that investor sentiment does affect election outcomes. A paper published by Alan Crane, Andrew Koch and Leming Lin that analysed the US presidential elections at county level found that “counties with high stock market participation are more likely to vote for the incumbent party when the stock market has performed well since the previous election relative to low participation counties.”

While there may be many reasons why stock markets are important for political parties, influencing stock price movement through policy changes is not welcome. It is clear from the manner in which the US and Indian benchmarks are trading beyond their fundamental worth, that such continued influence affects price discovery.

It is a little difficult to see how the rally in US and Indian stocks will eventually end, but the Indian government will do well to continue with the policies that the Modi government adopted in its first term under Finance Minister Arun Jailtley: make policy changes only with long-term growth in mind and not worry unduly about short-term noise.

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