Headlines mislead sometimes (some would say at all times). The tyranny of the headline lies in its indispensability despite it being imperfect by design — if a five-word headline for a 1,000-word article could contain the same information, you wouldn’t need the latter at all. Stock market indicators suffer from the same malaise: By blending together the performance of scores of stock prices into one number that everyone can track, they provide convenience, but at the cost of perfection. Most of the time, the convenience outweighs the imperfection. These are times when the reverse is true.
Stock prices, in theory, reflect the future prospects of a company, which in turn are linked to the economy. Therefore, intuitively, stockmarket indices like the Nifty and the Sensex are seen as indicators of the robustness of the Indian economy. Inferences flow both ways: The Nifty making a new high is taken as a sign that the economy is doing well and similarly, if the economy is doing well, investors pile into the equity markets expecting stock prices to also do well. By this logic, the current weakness in the Nifty, which is down nearly 7 per cent over the past 12 months, has dampened sentiment about the economy. This comes at a time when several hard broad-based indicators like oil and auto demand are pointing towards an economic recovery.
What is driving this divergence between the real economy and stockmarket indices? In our view, the weakness in stockmarkets, in particular of the larger listed stocks, is linked to weakness in the global economy. This manifests itself in two ways: First, through strong business links to global trends among larger companies and second, through fund outflows.
More than half of the revenues of the top 100 listed companies (53 per cent to be precise) are fundamentally unrelated to the domestic economy. These consist of metals, energy and petrochemical companies, whose prices are driven by global demand and supply, telecom and auto companies with large global operations, exporters of information technology services, pharmaceuticals, autos and auto components, and even capital goods and construction services. Even the remaining revenues that are, on surface, driven by the domestic economy are not immune to global trends. A large proportion of these come from banks that are hurt by their exposure to loans given to metal companies, which in turn are seeing pressure due to global weakness.
Then there are the fund outflows. Net selling by foreign institutional investors (FIIs) in the past nine months has been the highest on record, excluding the period around the global financial crisis. In our view, this is primarily driven by fiscal problems in oil-exporting economies caused by the precipitous fall in oil prices. When oil prices were high, these economies (particularly those in West Asia and Scandinavia) were generating large fiscal and current account surpluses, which were deployed into equity and bond markets globally.
Given the then rosy long-term prospects of emerging markets (EMs, of which India is also a part), EM funds saw strong inflows, and as these were then deployed into various markets, India saw strong FII buying as well. Now, as the oil-exporting economies struggle to balance their budgets, they are being forced to pull back funds, driving redemption-based selling. Further, as metal prices have fallen sharply as well, the current account deficits of other EM economies like Russia, Brazil, South Africa and Chile have widened, and they are going through a downward adjustment to growth. Thus, even without the redemption pressure, these funds may have seen some outflows. As a large part of FII funds in the Indian markets came via EM funds, India is seeing outflows too, despite economic stability and good growth.
Taking another approach, it becomes clear that the markets and the economy aren’t really disconnected — it’s just that the indices are not representative. The market capitalisation of the top 100 stocks (BSE100) has fallen by 5 per cent in the last 12 months, whereas for the next 400 stocks (let’s call them the Next400), the aggregate market capitalisation has increased by 9 per cent. This is a rarely seen divergence, and is explained by both of the reasons mentioned above. The larger stocks are more pressured by FII selling as they have higher FII ownership, and they also have much higher fundamental linkages to global trends. The Next400 stocks are dominated by sectors like consumer discretionary and non-banking finance companies that are less exposed to global trends, and better reflect the improvement in the Indian economy. They are also less owned by FIIs.
This likely also explains the pervasive feeling of gloom in the business press, which focuses primarily on news coming out of the larger companies, and the widespread (and misplaced, in our view) disbelief on the level of GDP growth reported by the Central Statistics Office.
So long as global commodity prices stay weak, both FII outflows and global growth weakness may persist, and the popular stockmarket indices may continue to flash red when the economy is in fact healing. Indeed, there is a chance that globally, things may become more volatile. Weak oil prices are already causing problems in the junk bond market, for example. The rate hike by the US Federal Reserve last week may not cause much volatility in the near term, as almost everyone in the markets was expecting it. However, this move is likely to further the de-pegging of the Chinese yuan from the US dollar, removing one of the few remaining certainties in the global economy — and one must always remember that markets hate uncertainty.
This divergence will likely reduce over time on both fronts as markets keep evolving. Indices regularly shed weaker companies and add stronger ones: Over the next few years, as the Indian economy continues to outperform global trends, it is likely that they may become more representative of the economy. Similarly, it is likely that India becomes an “asset class” by itself, that is, given its idiosyncratic economy, global savings may choose India-focused funds rather than investing in India through EM or Asia funds.
But in the interim, the lesson from all of this is that one shouldn’t draw inferences about the strength of the Indian economy from the more popular stockmarket indices.