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The current rally in equities poses economic risks

Indian equity markets are considered the most disengaged from the economic reality. Some argue that the optimism is largely because the long to medium-term prospects of the economy remain bright due to a stable government, policy reforms. Mint examines these arguments.

Indian equity markets are considered the most disengaged from the economic reality. Some argue that the optimism is largely because the long to medium-term prospects of the economy remain bright due to a stable government, policy reforms. Mint examines these arguments.

What is happening in the stock markets?

Equity markets the world over have recovered very swiftly from the lows that were experienced during the early days of the coronavirus pandemic. India’s recent rally has added $605 billion to the market value as the economy has gradually unlocked and the economic activity has resumed. The benchmark index, BSE Sensex, has risen by 45% as it trades at 24 times earnings, while Nifty is at 23.5 times the one-year ahead earnings. This rally comes despite several institutions cutting India’s growth forecast and cautioning against a likely economic contraction in the current financial year.

What are the factors behind this discord?

There is a sense of optimism, driven by the policy support of governments and central banks, which have announced successive measures to ensure financial markets continue to operate smoothly. These measures have helped avoid the real stress from spilling into the financial system as it can trigger a financial crisis. The low cost of capital across the world combined with foreign investors confident of medium-term growth prospects is driving investments in Indian markets. Domestic participation of retail investors has also gone up over the last few months as people look for a higher return on their savings.

Stark difference
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Stark difference

Is the rally in Indian equity markets sustainable?

A rally in the markets must be justified by strong economic fundamentals and that means that companies would have to register swift improvements in their earnings to justify the high share prices. However, there remains a possibility for the stock markets to go back to pre-covid levels by the end of this year, according to several analysts.

What happens if risk preferences change?

There are far too many unknowns for the real economy as the pace of normalization of economic activity is contingent on what happens to the progression of the pandemic. A second wave of coronavirus cases could induce further lockdowns, which would disrupt economic activity, push several firms into bankruptcies, and create stress in the financial system. In such a case, investors are likely to rush to safe assets, marking another instance of a sell-out from capital markets causing price correction across sectors.

Could this lead to an economic downturn?

A disconnect between capital markets and the real economy is a sign of vulnerability and this is not unique to India as globally, capital markets have performed well even as the economic situation has deteriorated. Any change in the attitude of investors causing a correction in risk asset prices such as equity can trigger a financial crisis. The expectations of support from the fiscal and monetary authorities as investors reassess their risk appetite would be key.

Karan Bhasin is a Delhi-based policy researcher.

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