The Economic Survey 2017-2018 warns about high stock valuations

Published: January 30, 2018 at 10:05 am

Last Updated on December 28, 2021

The  Economic Survey 2017-2018 was published yesterday with a clear warning that the stock market valuations are too high and unless earnings increase, a correction should be expected. The survey also argued that the bond market seems to have forgotten about the growth in the national small savings fund. Amidst the euphoria about increased GDP growth projections, this warning should be kept in mind. The economic survey can be downloaded from here.

Economic Survey 2017-2018 on bond markets

In box 8 of chapter 1, titled, “Do Government Market Borrowings Reflect the Underlying Fiscal Deficit?”, the survey explains why the sharp increase in the 10Y G-sec yield (resulting in a fall of long-term gilt and dynamic bond funds) is not backed by reason. The survey argues that the bond market seems to fear (1) the issue of new gilts to handle the fiscal deficit (which it believes to be higher than documented) and (2) higher inflation (which is reasonable). The sudden increase in yield curve is a result of this.

It adds:  “Another factor contributing to the rise in bond yields has been stepped-up Open Market Operations (OMO) by the RBI. This amounted to a net sale of about Rs. 90,000 crores during April-December 2017-18 (compared to a net redemption of Rs. 1.1 lakh crores during the same period in 2016-17).”

Economic Survey 2017-2018: Bond Yields

The yield curve is a plot of bond yields vs duration. The curves shown are above where the longer duration bonds have higher yields is known as “normal yield curves”. Read more: The Bond Yield Curve as an indicator of what’s going on with the economy

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    The survey points out that the bond market has forgotten that

    Net Market Borrowings = Fiscal Deficit- NSSF net flows

    Where NSSF is the National Small Savings Fund where PPF, SSY, SCSS, NSC, KVP, MIS, TD, PO-SB contributions go. This has seen a sudden spike in contributions.This is because after demonetization, the NSS schemes have relatively better returns and better tax treatment (PPF, SSY).

    Economic Survey 2017-2018: National Small Savings Fund

    Therefore, there is no need for the central government to issue more bonds to handle the fiscal deficit. It has enough funds in the NSSF.

    As explained in the evolution of Public Provident Fund (PPF) Interest Rates, the state governments borrow from the small savings fund at about 2% higher interest than the rate offered to us! Therefore to decrease their spending, they preferred to issue more bonds rather than borrow from the NSSF. You can see the central borrowing has come down, while the state borrowing has increased sharply.

    The bond market has incorrectly interpreted higher state borrowing as due to higher deficits. This is incorrect. The states are merely trying to borrow at a lower rate by issuing more bonds.

    Economic Survey 2017-2018 on stock markets

    The survey shows that although the US and Indian markets have increased by similar amounts since Dec 2015 and now have similar price-earnings ratios, the underlying reasons for the increase are quite different.

    economic survey 2017-2018 US and Indian stock markets

    Economic growth in the US has increased, justifying its stock market increase. Whereas in India, the economic growth has decreased.

    us and Indian economic growth

    In addition, the real interest rates are very different. The real rate is the savings interest rate after accounting for inflation

    1 + real-rate = (1+ interest-rate) x (1+ inflation-rate)

    Lower real interest rates imply business can borrow easily. In India, the rate is high, therefore more savings and less consumption, meaning, less corporate profits and therefore fewer stock earnings. So the stock market should be reflected that by not increasing so much. This means that

    1: it will wait for earnings to catch up and 2: if they don’t, if oil prices remain high, if FIIs pull out, if local interest rates increase, it will correct sharply. The economic survey states this quite clearly. That is a lot of ifs there, but to quite the chief economic advisor (see presentation below): “only the paranoid survive”. (After Andrew  Groves book by the same name)

    Why is the Indian stock market zooming up?

    1: Investors purchased in the hope that a strong government will result in corporate earnings. As noted by me time and time again, this has not happened:

    Nifty Valuation Analysis with PE, PB, Div Yield, ROE, EPS of 21 NSE Indices (Feb 2017)

    Nifty Valuation Charts Nov 2016: PE, PE, Div Yield, ROE, EPS Growth (Oct 2016)

    Nifty Valuation Charts: Dec 2015 (Dec 2015)

    2: Post demonetization, with falling interest rates and poor returns from gold, investors turned to equity and equity mutual funds for better returns. Since the risk-free rates decreased, the extra returns that equity must provide for the risk rake ( equity risk premium – ERP) also fell.

    economic survey 2017-2018 gold returns and mutual fund inflows

    Equity risk premiums of US and Indian markets. See footnote on page 30 for details of calculation. This is a simple definition

    Equity Risk Premium = Expected return on stocks – risk-free-rate

    The survey says:

    Does this imply that Indian P/E ratios have reached a higher “new normal”? Perhaps. It’s possible that the portfolio shift
    set in train by the campaign against illicit wealth will result in a sustained reduction in the ERP. But it is worth recalling
    that a similar assessment was made in the US after its ERP fell sharply in the late 1990s-early 2000s. A few years later, the
    technology bubble collapsed, then the Global Financial Crisis occurred. The ERP surged to new heights and still hasn’t
    reverted to its previous trough.
    Beyond ERPs, sustaining current stock valuations in India also requires future earnings performance to rise to meet stillhigh
    expectations. And this outlook, in turn, depends on whether a significant economic rebound is this time well and truly
    around the corner

    Thus the survey opines that high valuations are not justified and

    sustaining these valuations will require future growth in the economy and earnings in line with current expectations,
    and require the portfolio re-allocation to be semi-permanent. Otherwise, the possibility of a correction in them cannot be
    ruled out.

    Should I be worried?

    “Would it help?” (guess the movie!)

    What should I do?

    The Economic survey has only stated the obvious to those who had their feet on the ground. The market cannot keep increasing without any sign of corporate earnings. So it would either wait (sideways movement) or fall sharply if the FIIs pull out or if the Indian savers switch to fixed income when RBI increases rates. So

    1: Lower expectations from equity.  The high returns you have got will eventually decrease, as sure as night follows day.

    2: If your goal is several years away, do nothing.

    3: If your goal is around the corner, you should not be in equity anyway! Round the corner here means within next 5 years (yeah 5 years is short-term). Why? because returns depend on market increase and time (more on this soon – we often forget about time)

    4: Do not fall prey to BS from sales guys about high GDP growth, Indian shining etc. and ignore your asset allocation.

    5: If you want to reduce the risk of a sharp correction, read more about tactical asset allocation models and implement it (easier said than done!)

    Economic Survey 2017-2018 Presentation by the chief economic Advisor, Dr. Arvind Subramanian



    Chapter 1 Economic Survey of India 2017-2018

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