Funny Capital Markets: they are down because…the US Economy is up
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Capital markets and their investors are funny creatures. Or, at least, they would appear funny to outsiders, say an alien or a normal business person. On 2 February 2018, markets fell off the cliff. The Sensex closed about 800 points lower. Was the market overvalued and it fell as it is expected to in every bubble? Or was it because of the introduction of the long-term capital gains tax in the Budget for 2018? Or, maybe it was because of a populist Budget? On 6 February, the Sensex opened around 3% or 1,000 points lower. Some respite came during the day as it gained and closed around 500 points down.
For the average India-centric retail investor, the only visible trigger was the Budget. It was speculated that the fall was due to the introduction of long-term capital gains tax on 1 February 2018—the only measure announced in the Budget that would directly impact stock markets. But there were other announcements, such as the new Minimum Support Price formula, which could possibly stoke inflation. Or was it the higher fiscal deficit or higher crude oil prices, which would impact the current account deficit? Or all these put together?
Popular stocks—those that are talked about in media more frequently, and which are probably in most retail investors’ portfolios—are in the overvalued territory.
Why is this happening, and why now?
Let us don our deerstalker hats and get on with some Sherlock-style investigations and deductions.
For sure, the whole thing started not in India but in the US. Also, it started not in February, not in January, but in December; in anticipation of the US tax reform Bill. Further, US home construction data and other economic data showed that the economy was already growing strongly; which was better than expected. This, combined with the tax reforms, led to a US bond sell-off with a global contagion. The US 30-year bond prices have been falling steadily all of January 2018, while the S&P 500 rose.
The reasons for the fall in bond prices (or rise in bond yields, for both 10- and 30-year US government bonds), were better economic prospects for the economy and the tax cuts. The better economic prospects would create more growth and lead the Fed to consider increasing rates faster. And the tax cuts could add fuel to the fire by putting more money in the hands of companies and consumers, thus stoking inflation; more reason for the Fed to increase rates faster.
Meanwhile, the stock markets were cheering the economic growth and the stimulus from the tax rate cut; leading to stock markets going up throughout January.
In anticipation of the 2 February 2018 employment report, bond yields started rising again from 1 February itself. Data showed that non-farm payroll employment increased by 200,000 and the unemployment rate was 4.1%—considered a nearly full employment scenario. Further, the report showed that wages had grown by 2.9%. This wage inflation and the tight labour market situation were clear indicators that inflation was likely to increase. Bond market yields started rising further (in other words, there was more selling in bond markets and yields rose) since the Fed would now have clear data points showing higher risks of inflation as well as better economic growth. Adding uncertainty to this was the fact that Jerome Powell would take over from Janet Yellen on 5 February 2018 as chair of the US Fed. Would he be more hawkish? The US bond markets and the economic data clearly indicated a high chance of the Fed hiking rates, starting March. Stock markets realized that the higher Fed rates and higher bond yields meant that the opportunity cost of holding stocks had increased, especially for the leveraged trader. Hence, a sell-off began in the stock markets on 2 February with a 666-point drop in Dow. That triggered a global stock market sell-off, including in the Sensex and the Nifty.
To summarize the Sherlockian saga, the good economic data from the US triggered a sell-off in bonds, which triggered a sell-off in US stocks due to higher opportunity costs (or higher discount rates, going forward). This triggered a sell-off in Indian stocks as well.
The forecast for earnings growth over the next 3 years for the US and European markets is in double digits. India, too, is expected to have an earnings growth of nearly 20% for FY19 and possibly even higher for the next 3 years. The forward price-to-earnings multiples are below 20; definitely not overvalued territory.
To close off with an ironical point: bond yields dropped again (signalling buying of bonds and rising prices) as the stock market sellers started rotating into the ‘safe haven’ of bonds.
All of this should settle down in a few days with the leveraged traders who were working with short-term borrowings exiting for the time being. With the lower market levels, the long-term cash-buying investors will start factoring in the higher future earnings even with a higher discount rate, and start buying. The markets are likely to remain steady post the transition period, riding on strong fundamentals and reasonable valuations in light of the higher forecast earnings.
Vikas Gupta is chief executive officer and chief investment strategist at OmniScience Capital.