GDP & Stock market Relations.

Does GDP(Gross Domestic Product) impact stock markets?

As it is very debatable topic & everyone have their own views on it but this is one of study based on past data.

Recently India’s GDP data for second quarter of FY2020 came at 40 years low @     -23.9%. Which clearly shows that India’s economy is degrading. As overall world’s economy is degrading we shall not expect any good for ours. So a question arises that does the GDP data have relations with the Stock markets (Nifty)? Does the stock markets gets affected from GDP?

To get the questions answered let’s took a look at some statistics:

The India’s  ratio and Nifty EPS growth doesn’t seems to meet.

The relationship between Nifty EPS growth and GDP growth seems to have completely broken down in the last five years. 

Note: The growing gap between the two lines in the chart above; and

§       The fact that the lines often go in opposite directions.

Hence, the Nifty no longer appears to be a play on the Indian economy.

To understand why the Nifty no longer captures the dynamism of the Indian economy a good place to start is the index as it stood ten years ago. On the face of it, the ten year share price return from investing in the Nifty is a very respectable 15% but that is a deceptively flattering figure. A better way to understand the quality (or lack thereof) of the Nifty is to look at the return from investing in the underlying fifty stocks which were in the Nifty ten years ago – such a portfolio (equal weighted) would give you a return of a mere 7.7% per annum (CAGR over ten years) i.e. significantly lower than India’s nominal GDP growth which over the preceding decade has been around 12% per annum.

Why is this happening?

These trends belie easy explanations. It is possible that the Indian economy has altered so radically over the past decade that the Nifty no longer captures the development of the economy. (A market cap weighted index like the Nifty will mirror the past rather than reflecting what the best companies of tomorrow might be. A fundamentally weighted, say ROCE weighted index, will – arguably – do a better job of capturing tomorrow’s stars.)

Significant drivers of the Indian economy are no longer in the listed market. For example, taxi aggregators (Ola, Uber), online retailers (Flipkart, Amazon), electronics goods manufacturers, car manufacturers other than Maruti, hotels other than Taj, Oberoi and Lemontree, etc – basically most of the things that affluent India buys beyond FMCG and apparel – is no longer in the listed market. These companies are able to access capital at low cost without entering the stockmarket and therefore their contribution to GDP is not reflected in the stockmarket. In contrast, the US stockmarket us doing the opposite – US companies are increasingly generating their profit growth from Emerging Markets. As a result, the S&P500’s earnings are growing much faster than the American economy.

There are is another potential explanation for the disconnect identified above: namely, the composition of the Nifty kills the link between GDP & EPS growth:

§       Financial Services accounts for 39% of the Nifty’s weight, up from 20% in 1995. As per FY19 Gross Value Added (GVA) data provided by the Government of India, ‘Financial Services, Real Estate & Professional Services’ is 21% of the Indian economy i.e. Financial Services seems to be significantly over represented in the Nifty50.

§       Auto + Media + Telecom form 8% of the Nifty’s weight, down from 12% in 1995. As per FY19 GVA data, ‘Trade, hotels, transport, communication and services related to broadcasting’ is 19% of the Indian economy i.e. Auto seems to be significantly under represented in the Nifty50.

§        Construction accounts for 4% of the Nifty’s weight. As per FY19 GVA data, ‘Construction’ is 7.5% of the Indian economy i.e. Construction seems to be under represented in the Nifty50.

Investment implications

Does the composition of the Nifty matter? This is India’s premier benchmark index. This is the medium via which most investors tap into India’s economic growth. As the Indian economy undergoes structural changes, the Nifty’s composition needs to be relooked at. Otherwise, we will run into four big problems beyond the obvious issue that the Nifty will no longer be a play on the Indian economy:

§       The cost of capital for listed companies will get distorted. Over represented sectors (e.g. Financial Services will get capital at too low a cost (and that in turn results in bubbles in the Financial Services sector eg. the NBFC bubble which is blowing up in front of us at huge cost to the Indian economy). In contrast, under represented sectors (e.g. Auto) will have to pay over the odds for capital (when was the last time you saw an Indian auto company going public?).

§        For the advancement of financial savings in India, the Indian stockmarket has to efficiently expedite low cost passive investing. The rise of low cost passive indexing will be stymied if the benchmark index does not capture India’s economic growth.

The inability of the Indian stockmarket to provide lower cost funding than the Private Equity (PE) firms is depriving the Indian stockmarket of high quality companies which can dominate their sectors and help the stockmarket participate in India’s economic growth. The more important foreign companies and PE funded companies become in India, the bigger the questions mark around the relevance of the Indian stockmarket as a medium via which ordinary investors can benefit from India’s economic growth.

This was a study which I kept in front of you based on some past data and research of some reputed journals. Hope you would have understand it.