Booming markets in slowing economies. What are the markets signaling?

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An important learning from market history is that mid and small caps outperform in the long run. The best strategy to profit from the long run outperformance of the broad market is to patiently continue systematic investment plans.

Globally, stock markets have been rallying during the last three months. In the mother market US, the S&P 500 is at 52-week highs; Euro Stoxx 50 is at 52-week highs; Germany has tipped into recession, but the DAX is at record highs, French CAC is at 52-week high; Japanese Nikkei is roaring at 30-year high; in South Korea and Taiwan indices are at 52-week highs; in India, Sensex reached an all-time high on 21st June 2023.

In contrast to this bullish trend, the global economy is slowing down. IMF projects global growth at 2.8 percent in 2023, slowly recovering to 3 percent in 2024.

So, why are the markets rallying? What are the markets signaling?

Stock markets are complex. The short-term movements of the markets are influenced by a host of factors, which may not make sense to a lay investor. But, in the long run, the markets reflect the underlying economic and earnings fundamentals. Since the markets discount the future, market rallies indicate improving economic prospects, and market downtrends indicate emerging pessimism about growth and earnings.

It is important to understand that markets often overreact, both on the upside and downside. When the reality dawns, the excesses will be corrected. Last year, globally, markets corrected with big downturns in the developed world. In the mother market US, Nasdaq corrected by more than 30 percent. Markets were reacting to the aggressive monetary tightening by the US central bank Fed. The market fear was that the US economy will tip into a recession in 2023, perhaps in early 2023, impacting global growth. Most economists and market experts felt that a US recession was inevitable; many feared a hard landing for the US economy.

The fear was done

This fear, which was largely discounted by the market, did not materialize. Now, even though the US economy is slowing down, the near consensus is that US will succeed in avoiding a hard landing of the economy. Many experts feel that US might succeed in avoiding a recession. As the Fed Chief Jerome Powell said in his May commentary, “the case of avoiding a recession is more likely than having a recession.” This scenario is a major departure from what the markets feared and partly discounted. Markets are now bouncing back discounting the new emerging reality.

Indian economy is in a sweet spot  

Despite the global slowdown, the Indian economy is now in a sweet spot. India has, perhaps, the best growth-inflation balance among the large economies of the world. FY23 GDP growth came much better than expected at 7.2 percent. High-frequency data indicate the growth momentum sustaining. GST collections, advance direct tax collections, bank credit growth, auto sales, construction trends…all indicate a buoyant economy. More importantly, inflation is trending down: CPI inflation came at 4.7 percent in April and 4.25 percent in May, well within the RBI’s tolerance limit. WPI inflation is in the negative territory at -3.48 percent in May. The fact that inflation is trending down in India, when the developed country’s core inflation is stuck at around 5 percent is a huge positive.

This favorable growth-inflation dynamics is a big advantage for India. If inflation remains within RBI’s comfort zone, a rate cut is possible in early 2024, giving a further boost to India’s growth prospects.

Valuations are short-term rich but long-term fair

At record levels, market valuations are rich. Are the markets overvalued? From the short-term perspective, valuations are rich since Nifty is currently trading around 20 times estimated FY24 earnings. But, from the long-term perspective, it can be argued that the valuations are fair since India’s growth and earnings potential is much higher than that of any other large economy. Therefore, even while remaining cautious of the current high valuations, investors should remain optimistic about the future and stay invested. Trying to time the market to get-out and get-in is almost impossible and would turn out to be a futile exercise.

Monsoon is an area of concern

The poor monsoon in June is an area of concern. June monsoon deficiency is normal; but this year, so far, the deficiency is huge at above 50 percent. In the past, such deficiencies had been compensated by abundant rainfall in the subsequent weeks. So, let’s hope for the best. But, if rainfall is much below the long-term average, it will impact agricultural production, GDP growth and corporate earnings thereby impacting the market. Inflation may re-emerge putting the RBI in a tight spot. So, watch out for the progress of the monsoon.

Remain invested in high quality growth stocks and continue with SIPs

Investors should remain invested in high quality growth stocks and continue with their Systematic Investment Plans. An important learning from market history is that mid and small caps outperform in the long run. During the last 10 years, from 15th June 2013 to 15th June 2023, the average annual returns from SIPs in large, mid, and small caps were 12.19 percent, 16.5 percent, and 19.22 percent, respectively. The best strategy to profit from the long run outperformance of the broad market is to patiently continue Systematic Investment Plans.

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