$3-trillion market-cap: What are investors seeing differently in stocks that is not showing in the real economy?

Market Outlook
Bloomberg Intelligence's strategists said these stocks are

Bloomberg Intelligence’s strategists said these stocks are “very well aligned to a few catalytic events that the market is presciently sniffing out” such as infrastructure spending, fiscal support to boost consumption and global tailwinds for exporters. (Representational image)

For the sake of analysis, it is sometimes useful to divide the economy into two slices: the financial sector and the real sector. Quite often, the developments in a country’s stock markets serve as a harbinger of what could happen in the real economy.

The trends in a country’s equity markets are among the most noticeable markers in an economy. Indian markets have vaulted to a $ 3 trillion market capitalisation last week. This begs the question: Is the real economy on the verge of a takeoff too?

Let’s examine this.

Ceteris paribus, Latin for other things remaining the same, is the most basic assumption in any economic modelling and analysis. For instance, the relationship between demand and price of a good.

The law of demand states that as price rises, the good’s demand falls. Likewise, as price falls, the quantity demanded increases. The relationship is inverse, but only under ceteris paribus conditions, that is other things remain the same.

But, what if the demand for a certain good goes up but its supply is limited or constant? In that instance, the good’s price will start rising as people try to outbid each other to get hold of the product. Since supplies cannot be replenished to meet the growing demand, prices will rise.

Who is driving the market rally?

That precisely seems to be playing out in India’s stock markets currently. Prices of mid-cap and small-cap stocks have fuelled the surge in record market capitalisation.

Importantly, domestic institutional investors (DIIs), mutual fund and insurance companies are driving this rally, reflecting their optimism in these classes of shares when foreign institutional investors (FIIs) have been moving out of Indian equities. For example, in April and May, FIIs have net sold Rs 9,659 crore and Rs 3420 crore.

The demand for a stock price is, among other things, is also a function of the company’s growth prospects and what investors think about it. It would appear that Indian DIIs have firmly placed their bets on a class of small and mid-caps that has pulled the value of Indian markets to above USD 3 trillion.

This, prima facie, appears to be an interesting paradox. What is it that investors are seeing differently in Indian stocks that is not showing up in the real economy?

The paradox at play

Most of the country is in the midst of a lockdown of some nature. The 15-20 biggest cities that generate about two-thirds of India’s gross domestic product (GDP) in value terms continue to remain in a state of economic standstill.

The services sector, the strongest edifice of India’s real economy, remains in a state of inaction. There are fewer cars on roads. Restaurants, malls, shops have remained shuttered down for weeks on end.

Demand for non-essentials have remained tepid. The looming economic uncertainty has also prompted people to defer planned purchases. The lackluster activity in the property market is a marker for these.

Car sales, too, will likely take a hit as households hold on to new buys. Such goods, and assets such as houses, are mostly bought through loans. Demand for such goods are determined not just by people’s current income but also their expectations about future earnings that will ensure confidence in their ability to repay debts.

With consumer confidence, at this point, wobbly, if not plummeting, the real sector, then, is mirroring a different picture.

The key question is how long the investors’ confidence will last? The answer to that lies in the real sector, which has quickly slipped from a sharp V-shaped rebound to a W-shaped fall.

Indian stocks will continue to command value, perhaps even more than now, depending on the pace at which the real economy canters back to normal activity.  Until that happens, the risk of an asset bubble will always remain.