Halfway into its term, the Bharatiya Janata Party (BJP) finally seems to be generating some economic momentum. The goods and services tax (GST) has made progress, though it's still an open question if the April 2017 deadline will be met. The Income Declaration Scheme (IDS) has pulled roughly Rs 65,000 crore into the white economy, mostly through pressure generated by aggressive data analysis. The Rs 30,000-crore or so that will accrue from this scheme will compensate to some extent for the low telecome spectrum realisations.
On another front, the minister for roads, Nitin Gadkari, is making heroic efforts to unclog stalled projects by bringing stakeholders to the negotiating table. Coal production and supply has improved and the power sector is doing better, though the Ujwal DISCOM Assurance Yojana (UDAY) scheme might have deferred the recognition of massive, unrecoverable debts.
There have also been substantial improvements in global competitiveness rankings. Though the methodology of that survey leaves it open to being gamed, this does seem to reflect anecdotal evidence of an uptick in sentiment.
At the same time, other segments of the economy seem to have fallen down deep holes. Banking remains a big mess. Capital goods demand stays down. Consumption is picking up after being flat for two years. Unemployment is supposedly at five-year highs, though this data is also suspect. Manufacturing has barely grown, if we go by the Index of Industrial Production (IIP).
Export-oriented sectors are in deep distress and exports have shrunk for two years. Even the perennial cash cow, pharmaceutical, is struggling, due to stringent US Food and Drug Adminitration inspections. Information technology (IT)/IT-enabled services has seen consistent downgrades. The trade deficit has narrowed only because capital goods imports have eased, and that is not a good sign. Another danger signal is underreporting of gold imports. Smuggling is up; official imports are down.
All this indicates an economy just chugging along, with some positives and some negatives. The gross domestic product growth estimates of various institutions for 2016-17 are between 7.3 per cent and 7.9 per cent, net of inflation. That is the same range as 2015-16 and doesn't indicate major acceleration. Under the circumstances, the extremely high valuations of the stock market are nerve-racking for long-term investors. Major indices are trading at price-earnings ratios of 23-plus. It is a historical fact that long-term investors have rarely made money buying index stocks at a P/E ratio of 23 or above. Taking data between 2005 and 2016, the one-year "rolling" return is negative for investments made at above a P/E of 22.5 in two out of every three years. The average one-year 'rolling' return is minus 12 per cent for investments at such valuations. The average three year rolling return from investments at such valuations is also minimal, working out to about two per cent compounded.
However, the recent rate cut and continuation of easy global liquidity implies funds will keep flowing into the stock market. If this happens, prices could head up for an indefinite period. The argument for investing specifically in the financial sector gains strength, given rate cuts. As banks and non-banking financial companies pass on rate cuts, credit volumes should grow. The other side of the story is that bond yields are likely to drop as bond prices rise, offering capital gains. This could mean an opportunity for debt funds.
In addition to the rate cuts, the Reserve Bank of India (RBI) decided, while Rajan was still the governor, to enhance liquidity in the banking system. RBI has carried out open market operations (OMO), buying bonds from banks to push cash into the system. RBI will do this on an even more massive scale as it reverses foreign currency non-resident swaps worth $26 billion. Essentially, the central bank must supply dollars to banks to reverse the swaps, and it will then buy (rupee-denominated) bonds from banks to release those rupees.
There's a clear inverse relationship between liquidity and rates. The higher the liquidity, the lower the rates tend to go. As rates fall, money flows into risky assets like the stock market. Cynics (like me) generally get bearish when somebody solemnly explains why high valuations are justified and says "This time it's different".
Well, high liquidity is the obvious difference. While the liquidity increases, so will valuations. That's pretty much the case for going bullish at the moment. Fears that the US Federal Reserve will soon raise rates and thus cut global liquidity could be enough to tip stocks into another bear market.
