Are stock markets decoupled from the economy?

Feb 13, 2012

In this issue:
» Despite rate hikes, interest costs for India Inc dip
» 'Fiscal consolidation' to be the theme of Budget 2012?
»  Are Chinese companies on the brink of a loan default?
» Growing importance of domestic markets for Indian IT
» ...and more!

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The country reported its Industrial Production (IIP) numbers last week. Industrial production has grown by 1.8% in December 2011 as compared to the 8.1% levels seen in December 2010. At the same time, the Indian economic growth has slowed down too. Just a few days ago, it was forecasted at sub 7% levels, the lowest in the past three years. But despite these macro headwinds, Indian stock markets have performed quite well over the past few days. Does it mean that the markets are seeing something that the entire economy is not? Or does it mean that the stock markets have decoupled from the economy?

The truth is actually neither of these two reasons. It is just simply the return of cheap money. That's right. Foreign Institutional Investors (FIIs) have pumped in nearly Rs 185 bn into the Indian stock markets since January this year. And this is the money responsible for driving stock gains despite the gloomy news. So where is this cheap money coming from?

The obvious answers are US and Europe. With near zero interest rates in the country, US investment institutions still continue to pump their cash into the more lucrative emerging economies. And India is still one of the more attractive investment destinations. In Europe things were even more interesting. The European Central Bank (ECB) lent money to the banks in the Euro zone at just 1% interest rates. And each and every bank mopped up these funds from the ECB and invested in more attractive investment destinations. Obviously India got a large chunk of this money as well. This is not the end of it. ECB plans to lend another Euro 1 trillion to the banks. So the flow of cheap money does not appear to be drying up anytime soon.

The cue that an investor needs to take from this is that it is pointless to chase the path of cheap money. Investing in stocks that are running up just because of FII funds , is one of the biggest mistakes that an investor can make. Because when the FII pulls out its money, like it did in late 2011, the same stocks would come crashing down. Therefore, the need to cautiously scrutinize the stocks is even more. Investing in stocks with sound fundamentals and cheap valuations is the only thing that will protect investor returns over the long term.

Why do you think Indian stock markets are performing well despite the gloomy macroeconomic news? Share your comments with us or post your views on our Facebook page / Google+ page.

 Chart of the day
With over 800 m subscribers (includes GSM and CDMA), India represents a huge telecom market. With the cheapest tariffs, it has seen telecom penetration going up from about 4% in March 2001 to around 71% in March 2011. But the huge surge in the number of subscribers has not translated to huge returns for the network providers. In fact, telecom operators have seen their profitability dwindling down. Hyper competition that led to sharp rate cuts is one big reason for this. As shown in today's chart of the day, profitability (Earnings Before Interest, Tax, Depreciation & Amortization or EBITDA) per minute has been on the fall for the telecom operators.

Data source: Company financials

Persistent high inflation had compelled the Reserve Bank Of India (RBI) to raise interest rates 13 consecutive times in the past. Despite this, many Indian companies managed to report a dip in interest costs in the December 2011 quarter. This was on account of the focus to cut costs and repay high cost debt. An Economic Times survey of the quarterly results of 275 companies in the BSE 500 (excluding banks and non-banking finance companies) showed that India Inc's interest expenses grew 42% YoY this quarter. This was lower than the 55% growth reported in the July-September quarter. What is more, interest coverage ratio during the period also improved. This was on account of cost cutting measures which enhanced operating margins. Plus, there are expectations that the central bank will resort to cutting rates going forward. If that happens, it will certainly contribute to the fall in interest costs. Having said that, certain sectors such as real estate, aviation and infrastructure sectors continued to face the heat. Debt in these sectors continued to remain at high levels. So interest costs refused to ease off. On top of that, low earnings visibility meant that the ability to make interest payments and repay debt was also on the lower side. The real estate and aviation sectors specifically face a lot of structural issues. Thus, it could be a while before they are able to spruce up their balance sheets.

Last year's Union Budget set a fiscal deficit target that was touted by most as too optimistic to be true. Now we have come towards the end of the fiscal year. The distressing fact at the moment is that all estimates have gone awry. The Finance Minister is having sleepless nights. A lot of criticism has been pouring in for having understated expenditure.

Let us remind you some numbers. The government had budgeted a meager 3.6% increase in expenditure in 2011-12 and a fiscal deficit target of 4.6% of GDP (Gross Domestic Product). As it turns out, the government has already announced extra borrowing of over Rs 900 bn in the current fiscal. So it's evident that reality is truly far away from what the government estimated. But hopefully, the Union Budget 2012-13 will be more realistic than last year. As per a certain official, a fresh plan is being worked out taking into account all revenue possibilities and additional provisions for expenditure that may be required for new commitments such as food security. Even the fiscal deficit target for the new fiscal will be over 5%. It is encouraging that the government is finally trying to align with reality. But that alone will not suffice. We need concrete reforms so that the fiscal deficit doesn't become a structural problem for us going forward.

Mass default as a possibility does not just threaten sick Euro zone countries like Greece and Portugal. The FT reports that China is equally vulnerable. But the similarity does not go any further than this. China is certainly no Greece and Portugal. For one, the dragon nation's growth rate will continue to be the envy of the world. Secondly, the size of the debt under risk is still very small as compared to the nation's GDP. Thus, there is every chance that the storm in China may pass off without causing a lot of destruction. However, there is a limit to how long this leniency can continue. Fortunately, China recognises this and is even considering the idea of fine tuning its economic policies quite seriously we should say. We believe it is the measures that the Chinese Government takes from here on that will shape the next 4-5 years of the Chinese economy.

Uncertainty in the global economic environment has been hurting India's software and services exports for quite some time now. And the bad news is that the National Association of Software and Services Companies (NASSCOM) is painting a gloomy picture for the coming fiscal year, a much slower growth than the last two financial years. However, all is not bad for the software sector. Surprisingly, the domestic market for the IT sector has been growing at a faster clip than the exports for the past three years (FY09-FY12).

And the more important point is that there exists a huge growth potential in the domestic market for the sector. The Indian government has taken many positive steps such as the Unique Identification Authority of India (UIDAI) program, Aakash tablet computer and several e-governance projects. This would help propel growth momentum of the domestic IT market going forward. No doubt, exports would remain as the biggest growth driver for the Indian IT companies. However, time has come that these companies should start looking beyond exports. They would do well to give a serious look to the domestic market as well.

Opinions are divided when it comes to investing in stocks and gold this year. The likes of Buffett have undermined the importance of gold investment. He cites metal's relatively less 'productive' nature than stocks as reason to avoid substantial investment. The legendary investor endorses his favourite asset class, stocks, even for difficult times. At the same time Moneynews has quoted Jim Rogers' pessimism with respect to stocks. The commodity guru has time and again insisted on the importance of precious metals and agri commodities for investors. Again his reasoning for avoiding stocks is logical. That the US Fed will keep pumping money is well understood. Hence stocks may go up despite poor fundamentals. Both Buffett and Rogers are, however, in agreement on one fact. Investing in US bonds is a loss proposition. Thus with such divided opinions of legends, investors need to build their portfolio carefully. For Indians we believe that there is a reasonable scope for investment in both gold and stocks. Provided you select stocks and allocate assets in prudent manner.

In the meanwhile, the Indian stock markets are trading below the dotted line after opening the day on a high note. At the time of writing, the BSE Sensex was down by 24 points (0.7%). Stocks in the capital goods and realty space were witnessing maximum losses. Barring China and Malaysia, most of the other stock markets in Asia closed the day on a positive note.

 Today's Investing Mantra
"Everyone has the brainpower to follow the stock market. If you made it through fifth-grade math, you can do it." - Peter Lynch

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4 Responses to "Are stock markets decoupled from the economy?"

Bakul Haria

Feb 13, 2012

The INFLOW is just because THERE IS NO other ALTERNATIVE (TINA) for the FII s and also because of chaep credit available to them.
What we need to worry about is EAse of doing business, Policy, EFFICIENCY (specailly our Government and its agencies) and Finally Fiscal Defeceit.


Srirama Krishna

Feb 13, 2012

Very well analysed and balanced. keep it up !!



Feb 13, 2012

As and when the stock market starts to ignore the negative news that is an indication of a beginning of a bull market.


kranthi Mark

Feb 13, 2012

Still @7% India is the second fastest growing economy in the world and valuation are compelling for FIIs since it is one of the underperformer in Calender year 2011.FII flows from past one month are risk in money not risk off money like bonds don't relate interest rates & FII flows ?? These flows are risk in flows may vaporise any time !!

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