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When the central bank governor points out the disconnect between the steep rise in stock markets and the state of real economy, it is time to take notice and act accordingly.

The story so far…

India recently announced Q2 GDP contraction by ~23% for FY2020. And yet, the stock markets have barely blinked. Sectoral behaviours are starkly different – Financials are down ~25%, Tech is up ~20% and Healthcare oscillates in between depending on daily news and updates!! FMCG has been largely flat throughout, as demand for items other than those deemed essentials is still struggling.

Since bottoming out in late March-early April, markets have rebounded almost 40% all across. However, most of this can be attributed to the fact that global central banks have injected more than US$6 trillion into financial markets and reduced interest rates to maintain liquidity. And this liquidity is leading many to look past the underlying economic fundamentals and financial stability risks.

The broad market index NIFTY50 seems to have recovered miraculously after its March 2020 lows, but one must keep in mind that the recovery has largely been pushed by Reliance Industries, with a little help from Airtel, HUL, Nestle and a couple of pharma companies. This has generated a lot of skewness and not helped equity investors in their decision making. One can assume that a true recovery of the stock market in India can be judged once foreign capital starts to flow in again at pre covid levels across the broader market.

Business Insider points out that people are ignoring massive unemployment (India organised sector clocked 8.35% in August 2020 as per CMIE), social frictions, pandemic risks, global geo-political tensions, etc. and are indulging in speculative buying.

 Citigroup has said that day traders with excess money supply, have fuelled this stock market euphoria further and there is a 70% probability of a downturn in the next year…

 How it might all play out?

The RBI governor has tried to assuage current investor fears saying that the central bank will take all optimum measures to prevent a recession-inflation (stagflation) situation in the country. And this actually puts another round of stimulus on the cards! As an equity investor, not only should this even more excess liquidity in the economy be of concern, but also important is how it impacts interest rates, inflation, fiscal debt and India’s sovereign rating.

As India borrows more and more from external sources, we run a good change of our sovereign credit ratings deteriorating further. And this, in turn, will make foreign inflow of capital even more less, or at best, delayed. Not good for the stock market…

In addition, as governments borrow to finance the huge fiscal deficits, primarily due to Covid-19, interest rates will rise. This will negatively impact spending and saving, affecting company profits and making stock market returns even harder to come by. Hence, by pumping money, the central bank is actually trying to keep the interest rates down, but here too, this results in lower returns on fixed income instruments! A conundrum indeed!

Now that we know all this, what to do?

Learn and track should be the ‘mantra’ for all investors in the current scenario (this actually works well for any given time as well!). By all shots, it seems the economic recovery on a macro scale will not be very quick, nor without a few painful results. This reality will likely catch up with the markets as well, sooner or later. And as a prudent investor, one needs to be prepared should the worst-case scenario arise.

The foremost approach recommended is to plan out the investment strategy with discipline and research. Be aware of the asset allocation and the risks associated with each asset class. Specific to equities, a judicious distribution across resilient business with a high-quality balance sheet (low debt) and strong cash flow projections would be sensible.

It might also be a good idea to hedge one’s portfolio during uncertainties. It can be through allocation or derivatives, if one is comfortable using those.

If you are not familiar with the nuances, do not bet too much on distressed investments, simply because they have become dirt cheap right now – like travel, airlines, oil, etc. They could potentially turn around big, and some of them surely will, but be aware that most will surely go under. Identifying the ones that will survive is the key.

Right now, one has to be prepared that given the unique dynamics of our economy and demographics, India’s recovery might lag its global peers. There is also a recurrence of the virus infection waves in cities that had supposedly brought it under control a couple of months back. Hence park only truly excess cash in market investments, something that can stay invested for a longer time-frame (and not be required in case of any unforeseen emergency). Be on the lookout for supportive policy pushes, more than one of which will be needed to get our systems back on track.

Needless to say, along with all of the above, patience and common sense are advised. Do not be unnerved by the volatility of it all. One will tide through this well, with a systematic investment approach. Even if we go through a bear market please remember that with each subsequent bull market, the losses sustained in the bear market are completely recovered. Focus on staying power. Maybe small, but definitely intelligent investments.