Economy in stress and markets on a high; time to be careful?

The equity benchmark Sensex scaled a new all-time high of 40,816.38 in the morning trade on November 20. Not just the Sensex, even the Nifty has been rallying at a time when concerns over the Indian economy are growing, with macroeconomic data pointing to a slowdown.

Why is the market behaving differently from the economy?

“Markets usually run ahead of macros and price future growth. There are three positive indicators for growth – reduction in the corporate tax rate, proposed divestment of large public sector units and a possible resolution of the US-China trade impasse. Therefore, we see growth coming back in 2020. Now, we expect broader markets to outperform,” said Sanjiv Bhasin, Director, IIFL Securities.

Experts and brokerages are of the view that the market is factoring in a recovery in the economy.

“The market and the quality part of the market are largely factoring in a reasonable recovery in the economy and earnings,” said a report from Kotak Institutional Equities.

A key reason for the market rally is the improved September quarter earnings.

The September quarter earnings were not a complete disappointment, as most of the companies reported in-line or better than expected results.

Tax cuts have positively impacted the earnings in the higher tax bracket. The key positive from the Q2 results season is that even on the operational front (sales and EBITDA), the misses did not exceed the beats and were largely neutral, say experts.

“The hope of a faster recovery in earnings because of a cut in the corporate tax is keeping the market higher,” said Rusmik Oza, Head of Fundamental Research at Kotak Securities.

For the last few months, the government has been active in addressing the concerns about the economy. This is also supporting the sentiment, Oza said.

Bank and financial stocks are among the major contributors to the gains. Oza attributed the rally in bank stocks to the Supreme Court’s ruling on the Essar Steel resolution.

“The Essar Steel case verdict is a big positive for banks. This verdict should be seen in a broader view, as now bidders will be much more comfortable in bidding and banks will have this belief that the probability of recovery will be high now,” said Oza.

Global financial firm JP Morgan had called the Supreme Court decision on the Essar Steel resolution a landmark judgment. Nomura said the order favoured banks and identified SBI and ICICI Bank as its key beneficiaries.

Near-term consolidation likely

Hungarian-American investor George Soros had said, “Stock market bubbles don’t grow out of thin air. They have a solid basis in reality, but reality as distorted by a misconception.”

The hopes of recovery in the economy and optimism around corporate earnings should not turn into misplaced optimism, experts say.

“We remain sceptical of a quick recovery in the Indian economy given several structural issues, the limited fiscal capacity to support consumption or investment demand and inefficacy of policy rate cuts given crowding out by the high government borrowings,” said Kotak Institutional Equities.

An extended slowdown could result in the market losing hope of an imminent revival in demand supported by government action, the brokerage said.

Coming back to the market, experts say the upside will be capped for the market and some consolidation is likely in the near-term.

Pankaj Pandey, Head of Research at ICICI Securities, pointed out that this is a stock-specific market. Midcaps and smallcaps are underperforming the benchmark.

“It is a stock-specific market so not expecting a broad-based rally. So far, it looks fair as it is following the directional cues,” he said.

The valuation of the market is also a point that experts highlight.

The Indian market’s high valuations are being supported by a combination of factors, including low global and domestic bond yields, expectations of a China-US trade deal, expectations of further reforms in India and Street’s expectations of a strong earnings recovery over FY2020-22.

“We see risks to all these points and thus, any negative changes to the market’s expectations, especially related to further reforms in India and strong earnings recovery, could disappoint the market,” Kotak Institutional Equities said.