Why Sensex 20,000 and 5.5% GDP growth are compatible

The headline itself is an anomaly. The Sensex, which is currently at levels of 18,500, is expected to move up by another 8.1 percent to the 20,000 levels in the next few months.

GDP growth, which is forecast at 6.7 percent by the government and 6.5 percent by the Reserve Bank of India (RBI), is expected to fall to 5.5 percent for fiscal 2012-13.

One will question the wisdom of rising equity prices amidst a weakening economy, but the fact is that the seemingly strange and contradictory behaviour of the markets and the economy has a logic of its own. This logic, which is explained here, has been working over the last eight months and will work going forward.

The Sensex has returned around 20 percent in calendar 2012 to date. In the eight-month period of January-August 2012, the economic indicators have steadily deteriorated. GDP growth for the fourth quarter 2011-12 and first quarter of 2012-13 came in at 5.3 percent and 5.5 percent respectively. This is against full year 2011-12 growth of 6.5 percent. The sharp slowdown in economic growth is set to continue well into 2012-13, given recent trends in indicators such as IIP growth (negative in the April-July 2012 period), export growth (negative in the April-August 2012 period), vehicle sales (below 5 percent growth in the April-August 2012 period) and bank credit (grown by just 1.2 percent in the April-August 2012 period).

The Indian rupee (INR) too has not shown the enthusiasm of the Sensex and the INR is down 2 percent against the USD in the calendar year to date and is just off by 5.5 percent from record lows seen during 2012. Ten-year government bond yields are down just 20 bps in the calendar year to date, indicating that lower interest rates are not a factor in the Sensex upmove.

The steady inflow of FII money into equities is one factor that explains the rise in the Sensex despite a weakening economy, falling INR and sticky interest rates. FIIs have bought USD 12 billion of Indian equities in the calendar year to date and this buying has taken up equities by 20 percent in 2012.

The trend of rising equity and weakening economy will continue, but this time higher equity prices will be followed by the INR strengthening and government bond yields falling. The INR will strengthen from levels of Rs 54.30 to the USD on the back of the government showing some signs of policy action on improving its fiscal position and on sending out positive signals to global investors.

Politically-sensitive diesel price hikes (diesel prices were hiked by Rs 5 last week after a one-year period) and decisions such as allowing FDI in retail sends out the right economic signals. Disinvestment, tax reforms such as GST (goods and services tax) implementation and curbs on expenditure will also help the government’s efforts at fiscal consolidation.

The positive sentiments on expectations of an improvement in the fiscal deficit of the government will help bond yields trend down. Ten-year benchmark bond yields at levels of 8.20 percent will come off to below 7.5 percent as the markets lose fear of extra government borrowing. The weakening economy will force the RBI to lower rates, leading to a further boost to bond market sentiments. The RBI is still in inflation watch mode, with inflation at levels of 7.55 percent as of August 2012, but no signs of inflation stabilising, it will lower benchmark repo rates from present levels of 8 percent.

The FIIs will continue to buy Indian equities on the back of the bond purchases by the ECB and the US Fed. The European Central Bank and the Federal Reserve have announced open-ended bond purchases and this liquidity infusion will flood the markets with cheap money. The Fed’s policy rate is close to zero percent while the ECB policy rate is 0.75 percent.

The rise in Sensex, INR and 10-year government bond will not help economic growth for 2012-13 as the economy is still in the clutches of a downturn. However, post 2012-13, the positive capital markets will act as a stimulus to the economy, which itself will come out of a low base.

The Sensex is positioning itself for higher growth in 2013-14 and its uptrend should not surprise anyone.

Arjun Parthasarathy is the Editor of www.investorsareidiots.com , a web site for investors.