RBI Annual Report: Is The Bubble In Stock Markets Rational?

A person creates soap bubbles in Washington Square Park in San Francisco. (Photographer: David Paul Morris/Bloomberg)

RBI Annual Report: Is The Bubble In Stock Markets Rational?

Unless you have been living under a rock, you know that India’s benchmark equity index, the Sensex, has doubled since the slump of March 2020, when the Covid crisis hit home.

The drop in the market proved short-lived even though the economic scars were long-lasting. The Indian economy is set to contract 8% in FY22 and while it will grow on that weak base in FY22, concerns around consumption and investments remain.

The stock market doesn’t seem to care. Does this suggest that there is a bubble in the market? Partly, said the Reserve Bank of India.

A study published in the RBI’s annual report created a model using stock prices, money supply, Organisation for Economic Co-operation and Development composite lead indicator and foreign portfolio investments in the secondary equity market for the period April 2005 to December 2020.

The results suggested that the stock price index is mainly driven by money supply and foreign portfolio investments. Economic prospects also contribute to movement in the stock market, but the impact is relatively less compared to money supply and FPI.

This assessment showed that liquidity injected to support economic recovery can lead to unintended consequences in the form of inflationary asset prices and providing a reason that liquidity support cannot be expected to be unrestrained and indefinite and may require calibrated unwinding once the pandemic waves are flattened and real economy is firmly on recovery path.
RBI Study - Is The Bubble In Stock Markets Rational?

The study said that not all aspect of the market’s movement are irrational. Present valuations are supported by improved corporate earnings and this part of Sensex increase can be seen as rational, it said.

However, when seen from the lens of the price-to-earnings ratio and dividend yields, the markets appear overvalued.

“The deviation of the actual P/E from its long-run trend shows that the ratio is overvalued. Measures of dividend yield also signal that markets are getting overpriced,” the RBI study said.

It added that a decomposition of changes in equity prices indicate that the rise in equity prices during 2016 to early 2020 was mainly supported by a decrease in interest rates and equity risk premium, with increase in forward earnings expectations contributing to a lesser extent. The risk premium rose immediately after Covid and then eased.

Thereafter, a spike in ERP on Covid-19 concerns initially contributed to equity prices declining sharply to compensate for increased risks. However, equity prices registered an impressive recovery, subsequently, aided by easing of ERP. Currently, dividend yields have fallen below their long-term trends. As such, two-way price movements are possible going forward.
RBI Study - Is The Bubble In Stock Markets Rational?

How Is The Economy Faring?

The macroeconomic costs of the second wave can be limited to the April-June 2021 quarter with possible spillovers into July, according to the annual report. The central bank, however, admits that this scenario is possible only if the second wave peaks by mid-May.

In all other outcomes, losses in terms of lives, employment and output are likely to be adverse and long lasting, cautioned the central bank.

The onset of the second wave has triggered a raft of revisions to growth projections, with the consensus gravitating towards the RBI’s projection of 10.5% for the year FY22, the report said. The pandemic itself, especially the impact and duration of the second wave, is the biggest risk to this outlook, it said. Yet, upsides also stem from the capex push by the government, rising capacity utilisation and the turnaround in capital goods imports, it added.

Key Pointers:

  • For April and early May 2021, available high-frequency indicators present a mixed picture. While mobility and sentiment indicators have moderated, several activity indicators have held their own and shown resilience in the face of the second wave, according to the report.
  • An important factor that brightens the prospects of the recovery is the fiscal policy stance. The thrust on infrastructure can create conditions for broadening the revival.
  • The conduct of monetary policy in FY22 would be guided by evolving macroeconomic conditions, with a bias to remain supportive of growth till it gains traction on a durable basis while ensuring inflation remains within the target.
  • Inflation pressures from pulses and edible oils are likely to persist in view of supply-demand imbalances, while cereals’ prices may continue to soften with the bumper foodgrain production in FY21. Crude oil prices are expected to remain volatile in the near term.
  • Cost-push pressures have also emanated from non-energy commodity prices and could firm up further as economic activity normalises and demand picks up.
  • As pandemics typically leave markets less competitive, the increase in number of active Covid-19 cases with the beginning of second wave from March 2021 along with the associated effects on supply chains amid containment measures could also affect inflation going forward.
  • The unwinding of some of the policy measures undertaken in the wake of pandemic warrants a calibrated and gradual approach. Going forward, financial market movements would be guided by progress in containing the Covid-19 pandemic.
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