Modest growth raises concerns about sustainability of market rallies

In early November, I wrote a piece suggesting that the Indian economy was functioning as expected: Muddling along. It rarely falls into a full-blown recession but it also struggles to achieve sustained acceleration. This observation was immediately illustrated when India’s GDP (gross domestic product) growth, after reaching 8.2 per cent in FY24, fell to 6.6 per cent in Q1 (the first quarter) of FY25 and then further to 5.4 per cent in Q2. Growth is unlikely to return to 8 per cent anytime soon, but it also seems unlikely to dip below 5 per cent. If the original “Hindu rate of growth” was 3.5 per cent (the average annual GDP growth between 1950 and 1980), the new Hindu rate of growth is 5.5 per cent. The official reasons for the economic slowdown in the last quarter are varied: One, the Reserve Bank of India’s restrictive monetary policy; two, lower government capital expenditure (capex) due to the ongoing general and state elections; and three, a slowdown in private-sector capex due to domestic political factors, global uncertainties, excess capacity, and fears of dumping in India. 

While these explanations are accurate, they are merely proximate causes at the moment. The underlying reasons can shift. Next time the GDP numbers are announced, the slowdown could be attributed to global economic weakness, rising oil prices, or another drop in domestic capex. The essential fact remains that the Indian economy is weak — hampered by poor policies, poor governance (including high levels of corruption), and a high-cost, low-output structure. The government’s Monthly Economic Review for November 2024 points out that “private capex levels are affected by global uncertainties, excess capacity, and fears of dumping”. These are structural issues that cannot be solved quickly. How, then, will private capex suddenly rebound in the coming quarters? The Indian economy has largely been on auto-pilot, delivering only modest growth. While our growth may be higher than many other countries’, it is not sufficient to propel India rapidly into middle-income status. The prospect of India entering the “rich country” club remains a distant dream. 

The critical question is whether the stock markets reflect this reality. A 6 per cent growth rate is good but not a sufficient reason for a runaway bull market, especially when Indian stocks, particularly in the small-cap sector, have had an extraordinary run in the past two years. The S&P BSE Smallcap Index rose 47.52 per cent in 2023 and 29 per cent in 2024. The Nifty MicroCap 250 Index did even better, jumping 66.44 per cent in 2023 and 34.35 per cent in 2024. Meanwhile, the Nifty 50, weighed down by the slow growth of giant stocks, rose by only 20 per cent in 2023 and 9.58 per cent in 2024; yet for the ninth consecutive calendar year, the index is poised to close in the green. And yet, it would be naive to assume that these exceptional returns will continue indefinitely. The question that investors should ask is: If economic growth remains modest (at around 6 per cent), can the smallcap and microcap sectors continue to deliver extraordinary revenue and profit growth? 

There is a case to be made for smaller Indian companies continuing to record strong growth. Since the last quarter of FY23, they have benefited immensely from massive government spending. After years of slow economic growth, the Modi government tried to boost it by spending around Rs 11 trillion annually on infrastructure projects such as railways, roads, urban transport, waterworks, energy transformation, and defence production. Government capex as a percentage of expenditure reached 28 per cent in FY24, up from just 14 per cent in FY14. However, while government capex increased by 33.7 per cent last year, it has contracted by 6.6 per cent in April-October of FY25. As the main engine of India’s economy has slowed, GDP growth has also weakened. 

There are expectations that government capex will rebound sharply in the last quarter of this year, which is typically stronger than in other quarters. However, the challenge with relying on government capex is that it is heavily dependent on government revenue, and those are weakening. With the economy now settling into the “new Hindu rate of growth”, growth in central-government gross tax revenues has fallen to 10.8 per cent in April-October FY25, compared to 18 per cent in FY23 and 14 per cent in FY24. Similarly, GST (goods and services tax) collection has slowed significantly. After 26.2 per cent growth in FY23, as the economy rebounded from the pandemic, GST collection grew just 11.9 per cent in FY25 and 9.3 per cent in April-November FY25. 

Other worrying signs are emerging as well. In April-November FY25, growth in power consumption slowed to 3.9 per cent, down from 9.7 per cent in FY24. Cement production increased only 1.8 per cent during the same period, while fuel consumption grew just 3.3 per cent. While it is too early to draw definitive conclusions, if these weak indicators persist, there is a risk that India could slip into a prolonged slowdown similar to the one experienced between 2014 and 2019. The best-case scenario is that these markers improve only slightly; after all there is no reason for them to improve sharply. Where are the engines of growth? Regardless of whether we face the worst-case or best-case scenario, what happens to high-growth expectations, already priced into the stock markets, especially in smaller companies, after two consecutive years of exceptional returns? That is the key question for investors.    The writer is editor of www.moneylife.in and a  trustee of the Moneylife Foundation; @Moneylifers