Stock market returns are typically dependent on three factors, namely, corporate earnings, liquidity and sentiments. Sentiments are ephemeral, highly unpredictable and subject to quick reversals. While day traders and momentum players may depend largely on market sentiments, for longer term investors they are not a key factor in determining returns.
Liquidity has a relatively longer impact. Change in liquidity conditions is usually a consequence of some fundamental factors that determine the flow of funds.
The current pricing level of bonds in global markets suggests that interest rates are likely to remain subdued over a long period. Liquidity and cost of funds are unlikely to constrain markets over an extended period.
It would, therefore, be fair to aver that over the longer term, returns on stocks are likely to be determined largely by corporate earnings. It is here that we need to temper our expectations of future returns that may be seen coming from equity investments in India.
Let us start by looking at the past three decades. Since 1991, the national income of India has grown at 6.7% per annum. Inflation during this period has been 6.55%, providing a nominal growth in gross domestic product (GDP) of 13.69%.
Growth in corporate earnings can, in general, be expected to correspond to the nominal growth in the national income; hence, it is not surprising that the equity market has given a compounded annual return of a little under 14%, inclusive of dividends over this period. As per our hypothesis, nominal growth in national income, growth in corporate earnings and stock returns have all moved in sync over this period of three decades.
Assuming that the relationship is maintained in future too, estimation of nominal growth in national income becomes critical. This comprises growth in real national income and inflation.
Nothing, however, has generated greater controversy in recent times than the growth rate in real national income. Issues concerning measurement, the base year to use, comparison with the past rates and whether the slowdown is a cyclical or a structural one, the debate has been quite intense.
A large number of people believe that the current blip is likely to be reversed soon and a return to the heydays of 8% to 10% growth is quite imminent. An equally significant number hold the view that we are done with run-away growth rates of the recent past and must now reckon with long term rates of 5% or even less.
Depending on which camp one belongs to, the future growth rate in national income can accordingly be estimated.
The second component is the expected consumer inflation. Here we have relative unanimity, with low rates being universally accepted as the defining characteristic of the economy. From the days of double digit inflation, down to around 4% currently, it has been a significant journey over the last few years.
The Reserve Bank of India (RBI) has been able to rein in inflation, and it is expected that it will continue to display similar resolve whenever inflation threatens to rear its ugly head again. RBI has now been given the mandate to aim for an inflation of 4%, with a spread of 2% on either side and we could take that as the benchmark for future inflation.
In fact, the global economy is today fighting the threat of deflation, bonds are priced for low, even negative interest rates and I believe inflation in our country may go down even further.
In India, costs play a much more significant role in elevating prices than they do in developed countries. We are highly dependent on oil and commodities, besides food items, the prices of which are volatile and often lead to high inflation. Besides, the manufacturing process in India faces tremendous bottlenecks and transactions are not smooth and free. As we overcome such bottlenecks, better systems and processes should have a permanent salutary impact on prices and what is termed as ‘the cost push inflation’ is likely to be a less significant factor.
Low inflation combined with an uncertain growth in the gross domestic product (GDP) will have a dampening effect on nominal growth in national income and consequently on corporate profits. The high double digit returns that we have been used to are probably now only a historical curiosity and anyone who invests expecting such high returns will be a disappointed investor. Temper your expectations as you go forward.
Of course, there are several caveats to the above conclusion. It is possible that the relationship between corporate earnings and stock returns may not be as strong as we believe. The last decade has witnessed relatively low growth in corporate earnings in India but the stock returns have been much higher. In reality, investors have expected the corporate earnings growth to bounce back, taking the actual low earnings in their stride. Of course, this cannot continue forever; corporate earnings must come up to expectations or stocks will take a dip.
Corporate profits as a proportion of national income are currently at historical lows in India. A return to normal levels may boost corporate earnings beyond those of the national income and may thereby lead to much higher stock returns. The recent cut in corporate tax has made this a distinct possibility.
Currently, interest rates the world over are extremely low, even negative. Low interest rates boost risk appetite, leading to large funds flowing into stocks. An unusually large amount coming to stocks may be self-fulfilling in itself, ensuring elevated levels of stock prices. We have already seen this happen over the last decade when loose monetary policies of central banks in the western world quantitative easing (QE) have raised asset prices higher than any impact these may have had on consumer demand. Low interest rates and easy liquidity may increase stock prices beyond what is warranted by fundamentals.
It is useful to remember that while nominal stock returns may be lower than in the past, real returns, the inflation-adjusted returns, may not reduce significantly. Ideally, it is the real returns that matter in terms of purchasing power and the impact on wealth. Try telling that, however, to a typical Indian investor who has been used to much higher nominal returns! Expectations of investors are sticky in nominal rather than in real terms.
In any case, we are discussing long term returns. In relatively shorter periods, there is every chance that stock returns may not track the growth in nominal income.
Also, while markets may grow at less than double digits, individual stocks may chart their own path. Happy hunting therefore, for stock pickers; passive investing may not appear to be as attractive an option as it does now.
(Sunil Mahajan, a financial consultant and teacher, has over three decades experience in the corporate sector, consultancy and academics.).