High valuations are due to contraction of economy at a time when markets made robust gains
India’s real GDP shrank by a record 7.3% in FY21, marking the first annual decline since 1980-81
India’s market capitalization to gross domestic product (GDP) surged to a decadal-high of 103.47% as of 31 March, signalling expensive valuation of equities but most likely pricing in a recovery in the near future.
The high valuation highlights the sharp covid-induced contraction of the Indian economy in fiscal 2021 at a time when the stock markets made robust gains. This led to a surge in India’s equity valuations as measured by mcap to GDP.
At the end of FY21, the market cap of all listed companies stood at ₹204.31 trillion with the benchmark Nifty rising 71% during the year. In contrast, the nominal GDP growth data issued on Monday showed a decline of 3% to ₹197.45 trillion last fiscal. India’s real GDP contracted by a record 7.3% in FY21, marking the first annual decline since 1980-81.
India’s market cap to GDP in FY21 is much higher than the long-term average of 77% but still lower than the peak of 149% of GDP in 2007. In contrast, the ratio, also referred as the Warren Buffett indicator, was at 55.77% in FY20, when mcap was at ₹113.49 trillion and GDP at ₹203.51 trillion. Markets had slumped nearly 26% in FY20 with a massive sell-off in March due to a nationwide lockdown to curb the covid spread.
However, as the indicator is still lower than the peak seen during 2007 despite the rally in equities, analysts are cautious but not particularly worried about the heated valuations.
“The markets do seem a bit stretched but it might be too premature to call it a bubble. The unprecedented global central bank liquidity and clear communication by all central banks has given the markets a lot of comfort. However, things that worry us are more on the input and material cost side, which are seeing a sharp uptick along with increasing inflation, which can dampen end demand. This can result in current earnings estimates looking a bit stretched as was seen in Q4FY21, wherein results beat on revenue front for the most part but missed on margins," said Amit Shah, head of India equity research at BNP Paribas.
He added that while the mcap to GDP ratio is high, it is lower than other markets like the US which is at 1.99 times. “Compared to the emerging markets average of 0.93 times, India seems a bit overvalued. But India, despite the recent slowdown in the economy, is still expected to be the fastest-growing economy in the world, hence we are not too worried as of now," he said.
The Reserve Bank of India has warned in its 2020-21 annual report released last week that unabated surge in domestic equities and asset price inflation despite the economic contraction pose the risk of a bubble. “Even considering the above expectations of earnings growth of the corporates, the stock prices cannot be explained by fundamentals alone. Present valuations, as in the past, are supported by improved corporate earnings," RBI said.
“RBI acts as a regulator and supervisor of the financial system. Hence, it has to raise caution at times so that the level of speculation in the markets does not go out of control and adversely affect the banking system. The current up move in the market may reverse as and when the interest rates/inflation ratio globally and locally starts to rise sharply and/or the local fiscal situation or the political situation deteriorates. The timing of these events is difficult to guesstimate as of now," said Deepak Jasani, retail research head, HDFC Securities.
In valuation terms, measured as price to earnings (PE) ratio, Nifty is currently trading at 20.48 times (one-year forward), hardly changed from 20.76 times at the end of March 2021. However, at the end of March 2020, Nifty was available at 12.84 times, indicating the steep rise in valuation. Meanwhile, the MSCI Emerging Markets Index was at 11.21 times at the end of FY20, 14.62 times at the end of FY21 and is still available at 14.28 times currently, much cheaper than India.
Meanwhile, economists expect the harsh impact of the second wave to continue in the near term. “More pain is in store as a resurgent covid wave likely stopped the economic recovery in its tracks. We forecast GDP will grow by 9.2% in FY2021-22, lower than RBI’s 10.5% projection, which we expect to be revised lower at the MPC meeting this week," said Rahul Bajoria and Shreya Sodhani, economists, Barclays.
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