Downplayed risks

Stock prices, they say, are slaves to earnings. But in India, for the last four years, they have been acting pretty much like free spirits. The BSE Sensex has vaulted by over 70 per cent in this period despite just a 14 per cent absolute expansion in its constituent companies’ earnings. Despite faltering growth, Indian stock markets have gleefully expanded their valuation premium over global markets. While market participants have advanced a variety of justifications for soaring stock prices, the latest Economic Survey has come up with an interesting explanation.

The Survey points out the identical gains in India’s Sensex and the US S&P 500 in the last two years. This has led to the price-earnings ratios of the two markets converging at 26 times, it notes, despite clear divergence in their underlying economies. While the Indian stock market surge has coincided with a decelerating economy, falling corporate profits-to-GDP ratio (3.5 per cent) and high real interest rates, US markets have been backed by an improving economy, stable corporate profits-to-GDP ratio (9 per cent) and negative real rates. What the Survey is hinting at, but doesn’t really stick its neck out on, is that US market gains thus have far better fundamental moorings than India. It may have been more circumspect had it used an apples-to-apples comparison of India’s S&P 500 index (PE of 29 times) with its US counterpart. Then, while warning of a “sudden stall” in global asset prices, the Survey stops short of extending this dire warning to Indian markets. Instead, it surprisingly posits that the higher PE for Indian stocks may represent a “new normal” where domestic investors have shrunk their demanded equity risk premiums. Based on the fivefold expansion in mutual fund inflows in FY17, it argues that the Modi government’s anti-black money campaign has possibly nudged investors to make a structural shift away from cash, gold and property, forcing them to settle for lower equity returns.

But the reality, in fact, may be far more unpalatable. The world over, retail investors chase high returns. Indian investors have been upping their equity bets right alongside double-digit market gains. The tax-free status for equity returns, on top of plummeting debt returns, may have driven this investing behaviour far more than on any rational re-assessment of risk premiums. A policy-level rethink on the exceptional tax breaks on equities may therefore be necessary to quell the euphoria. It would be unwise to assume that the new-found domestic fancy for stocks will ring-fence India’s market from any global tightening of rates; foreign portfolio investors, with 25 per cent of stock, still hold considerable sway over the markets. Therefore, apart from waiting anxiously for the resurgence in corporate earnings that the Survey mentions, Indian policymakers and investors also have to keep a very close watch on adverse global cues that can trigger that asset price meltdown.

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