The Economy-Market Disconnect

In the long-run fundamentals drive the market: GDP growth and corporate earnings dictate the market trend. But, in the short-run, the market behaviour can be strange and complex. Bond yields, capital flows, exchange rate and expectations regarding interest rates exert a disproportionately strong influence on market movements. This may even lead to an economy-market disconnect, which is the case presently.

The economy is facing many headwinds: GDP growth rate slumped to 5.8 percent in Q4 FY19, which is a 20-quarter low. Growth for FY 19 declined to 6.8 percent, which is a 5-year low. Important economic indicators like the Index of Industrial Production, exports, imports, sales of automobiles and PMI confirm the slowdown. The survey report of the NSSO indicates high levels of unemployment. The NBFC sector, which has been driving consumption in many consumer durables segments, is facing serious issues and many NBFCs are in serious trouble. Monsoon in June has been hugely deficient.

Yet the Sensex and Nifty are hovering near record highs.

Why this disconnect?

Even though the economy is facing strong headwinds, the market is aided by strong tailwinds from capital flows. The dovish monetary stance of the leading global central banks, particularly the Fed, has sent global bond yields crashing. The US 10-year yield has crashed from 3.26 percent in November 2018, a decade high, to around 2 percent now, a five-year low. 2019 began with expectations of three rate hikes by the Fed; now the consensus is two rate cuts. This sudden reversal of the Fed’s monetary stance has accelerated FPI flows into Emerging markets like India.  In 2018 FPIs sold equity worth Rs 34000 crores. In 2019, by end June, FPI buying has crossed Rs 87000 crores. Sustained capital flows have imparted resilience to the market.

The bipolar market

It is important to appreciate the fact that the market has become highly bipolar. Nifty and Sensex are disproportionately influenced by 10 to 12 stocks that are doing extremely well. The stress in the NBFC and PSU banking space has benefitted some large cap stocks. For instance, the ‘H2B2’ stocks (HDFC twins HDFC & HDFC Bank and Bajaj Twins Bajaj Financial Services and Bajaj Finance) have benefitted substantially from this crisis. The excellent pedigrees of these stocks and their high earnings visibility have pushed their valuations very high. Similarly some high quality stocks like Titan, Asian Paints and HUL are quoting at PEs above 50 while stocks like ONGC, Coal India, Hindalco and India Bulls are languishing with PEs below 10. The Nifty Mid-and Small-cap indices are far below their peaks.  In brief, while Sensex and Nifty indicate bullishness, the broader market is far from bullish.

The temporary truce in US-China trade skirmishes and the dovish central banks are positives for the market. Therefore, it makes sense to remain invested in quality names and continue with SIPs. However, at these high levels, there is no valuation comfort in the market and sharp corrections cannot be ruled out. Investors may consider increasing the cash component in their portfolio.