The Indian economy is at an interesting point. We had two large scale policy moves in recent time - the much controversial Demonetization in November last year, and the implementation of (a somewhat rundown version) of Goods and Services Tax regime this year. Early this month, we had the first GDP print following these two major steps. The headline prints came in lower than consensus - 5.7 percentage for Q2 vs. 6.5 (and 6.1 last quarter). This was followed by equally weak Industrial Production release. A stronger than expected headline CPI prints did not help, as this squeezes the room for any rate cuts from the RBI.
A closer look at the GDP data (see component break-down in the chart below) shows some serious weakness. The private consumption part (C) has weakened significantly following the demonetization (the vertical red dashed line). The investment component (I) has been weak for a while (although staged a comeback in the last quarter). Exports growth was not helped by a strong rupee. In last few quarters, government expenditure helped the headline a lot. But the sustainability of this is questionable. We will have the fiscal deficit data out later this month. But the street does not expect anything great.
The story of the IIP paints a similar picture (see chart below, overall IIP, manufacturing, base materials, consumer durable, consumer non-durable, capital goods, electricity, intermediate goods and mining respectively). While demonetization appears to have caused a negative shock, in general most of them peaked out before that, around early 2016 to be fair. The capital goods, which staged a minor comeback since bottoming out in 2014, again resumed the downward trend, along with most (except consumer durable, and to some extend mining).
This is all in a relatively benign global macro scenario. In spite of the Fed taper 2.0 announcement, we have little jitters in the markets. Rates, both global and local, are relatively low and volatility remains subdued. Oil prices remain range-bound. A rally in oil along with a weakening INR following Fed and expected ECB taper later this year can worsen the scope of fiscal stimulus. Most in the business sectors does not expect private investments to turn around before end of this year at the earliest. The investment exuberance back in 2004-06 left many corporates laden with unmanageable debt burden and bank balance sheets with NPA.
In this background of weakening macro story, the Indian equity markets is in a tear. The flagship NSE Nifty Index posted a YTD 21%+ gain, among the best globally and compared to it's own history. The trailing 12-month PE ratio is looking worryingly high. High valuation remains a big concern among investors in this, and most other traditional metrics (a bit better in terms of price to book).
However, comparing the PE ratio to its historical average is not very good way to capture everything that goes on to determine fair price. In the most basic approach, the price of equity is a function of market risk free rates (say the local sovereign bond) and equity risk premium. Following the approach in this paper from AQR, I modeled the BSE SENSEX P/E based on the risk factors - the bond yields as well as the equity and bond volatilities (as in the original paper) along with current account balance as a percentage of GDP (reflecting the fiscal risk of the economy) and spread of bond yields to US Treasury (captures the flow risks). The last two are more relevant for an emerging market economy like India. The time-series shows a marked shift in relationship between pre- and post-crisis era. I fitted the model only on (monthly) data from 2010 onward to capture the recent dynamics. As it turns out, the bond vol has little contribution to market risk premia for India. The bond yield and equity vol shows significant but low correlation, whereas the CA deficit and spread to treasury captures a significant portion of the variance. The chart below shows the fit on this model (adjusted R-squared ~0.72).
However, comparing the PE ratio to its historical average is not very good way to capture everything that goes on to determine fair price. In the most basic approach, the price of equity is a function of market risk free rates (say the local sovereign bond) and equity risk premium. Following the approach in this paper from AQR, I modeled the BSE SENSEX P/E based on the risk factors - the bond yields as well as the equity and bond volatilities (as in the original paper) along with current account balance as a percentage of GDP (reflecting the fiscal risk of the economy) and spread of bond yields to US Treasury (captures the flow risks). The last two are more relevant for an emerging market economy like India. The time-series shows a marked shift in relationship between pre- and post-crisis era. I fitted the model only on (monthly) data from 2010 onward to capture the recent dynamics. As it turns out, the bond vol has little contribution to market risk premia for India. The bond yield and equity vol shows significant but low correlation, whereas the CA deficit and spread to treasury captures a significant portion of the variance. The chart below shows the fit on this model (adjusted R-squared ~0.72).
According to this model, the PE ratio is only slightly on the over-valuation side - not a cause of great alarm. According to this model, the market was highly over-valued around late 2011, and early 2015. We saw corrections in both cases. Also the under-valued period, early this year, was followed by upward corrections as well. This model does not forecast a large correction anytime soon unless we rally up a lot quickly from here (obvious caveat: these are in-sample results).
But what is most interesting, and perhaps most significant is the recent flows that we have seen in Indian equity markets. Traditionally, the equity markets in India has been shunned by a large portion of retail investors. The experience of scams in 1990s and the melt-downs, once during dot-com busts and another in 2008, did not helped. The foreign portfolio investors dwarfed the domestic flows in cash equities for a long time (although it is a different story in F&O). But since 2014, something changed. The extra-ordinary flows in to the equities markets, led by domestic mutual funds (presumably on the back on retail savings channeled to equities) completely outpaced the foreign flows.
But what is most interesting, and perhaps most significant is the recent flows that we have seen in Indian equity markets. Traditionally, the equity markets in India has been shunned by a large portion of retail investors. The experience of scams in 1990s and the melt-downs, once during dot-com busts and another in 2008, did not helped. The foreign portfolio investors dwarfed the domestic flows in cash equities for a long time (although it is a different story in F&O). But since 2014, something changed. The extra-ordinary flows in to the equities markets, led by domestic mutual funds (presumably on the back on retail savings channeled to equities) completely outpaced the foreign flows.
Is this a mass optimism following the 2014 election outcome and equity rally? Or are we witnessing a major shift in the savings behaviour of retail investors in India. The retail money has missed the initial come-back equity rally following the 2008 crash, and a part of the early 2014 rally as well, where the foreign investors made out handsomely. But much of the late rally in Indian equities has gone to the retail pockets. Is this dumb money chasing recent gains? We do not know for sure, but as we argued above, we are some distance away from any valuation melt-down in Indian equities. And the flow signifies the loss tolerance of the retails - who are sitting on some comfortable profits - has quite a bit room before panic. And finally, the weakening property markets and demonetization may have incentivized a permanent change in retail behaviour.
We do not know for sure. But what is the implication if it is indeed a fundamental shift in savings behaviour? As argued above, the macro in India is down, but with policies properly executed, the turn-around can be sharp. If oil remains range-bound and the Fed and ECB do not stray afar from the implied forward curves, we will have little in terms of global shock to upset the local economy. On the other hand, the efforts to put banking sector NPA in shape, along with the full kick-back of the GST regime should significantly improve the badly needed private investments. Add to this mixture this retail savings paradigm shift, and we are looking at the very beginning of a multi-year rally in Indian equity markets.
