The Indian Equity Market: A Symphony of Economic Melodies

January 25, 2024 Mutual Fund

The dynamic Indian equity market, a vibrant tapestry woven with diverse sectors and driven by a vibrant economy, is constantly humming with the tunes of various economic factors. Understanding these melodies is crucial for effectively navigating the ever-changing landscape of Indian stocks.

Against the backdrop of geopolitical tensions and subdued global economic growth, the Indian equity market showcased remarkable resilience throughout 2023. Despite external challenges, both the S&P BSE SENSEX and NIFTY 50, India’s prominent equity indexes, currently trading at 71,423.65 and 21,571.80 (as of January 23, 2024), respectively, recorded substantial gains, marking 2023 as their second-best year since 2017.

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The trajectory of the Indian stock market in 2023 drew intriguing parallels with global counterparts, reflecting shared experiences in navigating a complex and dynamic economic landscape. India is projected to have one of the fastest-growing economies in the world in 2024-25, with an approximate growth rate of 6.5%.

The Indian equity market and economy are interdependent, with each influencing the other through various channels. While not perfectly correlated, understanding their connection can provide valuable insights when making investment decisions or analysing economic trends.

Let us have a look at the key domestic economic factors that influence the Indian equity market performance:

1. Gross Domestic Product (GDP):

A strong link exists between India’s GDP growth and its equity market performance. While not always a perfect mirror image, GDP plays a significant role in shaping investor sentiment and stock prices.

The economic engine, GDP’s growth, directly impacts corporate earnings and investor sentiment. A strong GDP fosters optimism, leading to higher valuations and market rallies. Conversely, a sluggish GDP raises concerns about corporate profitability, dampening investor spirits and potentially triggering selloffs.

Graph 1: GDP growth rate of the top 10 leading economies in the world

Data as of January 23, 2024
(Source: IMF – World Economic Outlook October 2023) 

As you can see, India is expected to have the fastest-growing economy in the top 10 in 2024, followed by China and the United States. The United Kingdom and Japan are expected to have the slowest-growing economies.

It is important to note that these are just projections, and the actual GDP growth rates could be higher or lower than expected. There are many factors that can affect GDP growth, such as changes in interest rates, inflation, and government spending.

The stock market can be volatile in the short run, reacting to news and events not always reflective of the real economy. Over the long term, however, GDP growth tends to be a reliable indicator of market performance.

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A strong GDP fosters optimism in the nation’s future, encouraging investors to enter the market and take on additional risk. This increased demand for equities results in price appreciation. On the contrary, a sluggish GDP signals economic hardship, impacting companies’ revenues and profits. This leads to lower earnings per share (EPS), making equities less attractive and triggering downward price movements.

However, do note even with a strong GDP, an already overvalued market might experience a correction, regardless of economic fundamentals. International events and economic conditions in other countries can also impact the Indian market, independent of domestic GDP.

GDP remains a crucial factor influencing the Indian equity market. While not the sole determinant, a strong GDP fosters optimism and growth in the market, while a weak one can lead to uncertainty and downturns.

Understanding this relationship is essential for investors seeking to make informed decisions and navigate the complexities of the Indian market.

2. Inflation

Often considered a quiet culprit, inflation erodes purchasing power and corporate profits. Inflation and the Indian equity market have a complex and often nuanced relationship. Inflation can have both positive and negative impacts on stock prices, depending on various factors like the level and consistency of inflation, investor expectations, and central bank policies.

High inflation squeezes consumer spending and raises input costs for companies, impacting their bottom line. This can lead to risk aversion among investors and market corrections. Conversely, stable inflation creates a predictable environment, boosting business confidence and potentially attracting investments.

Graph 2: CPI Inflation rates in India over the last 10 years

Data as of January 23, 2024
(Source: http://www.WorldBank.org) 

Central banks typically raise interest rates to combat inflation. In 2023, the trajectory of India’s inflation rate was a tale of two halves. It started high, peaking at 7.44% in July due to global factors and supply chain disruptions, but then steadily declined throughout the year, thanks to government measures and easing global inflation.

By December, it reached 5.69%, comfortably within the central bank’s tolerance band despite remaining above the pre-pandemic levels.

The impact of inflation on the stock market also depends on the type of inflation. Cost-push inflation, driven by rising input costs, can be more detrimental than demand-pull inflation, driven by increased consumer spending.

Government policies like price controls, subsidies, and fiscal spending can also influence the impact of inflation on the equity market. While inflation can sometimes catalyse stock market growth, it can also pose significant risks. Investors should carefully consider the specific economic context and company fundamentals before making investment decisions in an inflationary environment.

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3. Interest Rates

The monetary maestro, the Reserve Bank of India (RBI), sets interest rates to manage inflation and economic growth. Indian interest rate changes and the equity market are intricately linked, with each impacting the other in a dynamic way.

In India, the Reserve Bank of India (RBI) declares the Repo Rate, the rate at which it lends money to commercial banks, as its primary tool for monetary policy. Changes in the Repo Rate directly impact interest rates across the economy, playing a crucial role in managing inflation and economic growth.

Lower interest rates make borrowing cheaper, stimulating investments and potentially pushing stock prices. Conversely, higher interest rates make borrowing expensive, dampening economic activity and potentially leading to market downturns.

Table: RBI Monetary Policy – Repo Rates over the past few years

Data as of January 23, 2024
(Source:  RBI Monetary Policy Statements, Data collated by PersonalFN Research) 

The Reserve Bank of India (RBI) maintained the Repo Rate, the benchmark interest rate, at 6.50% throughout 2023. This was after a series of hikes in the first half of the year, raising the rate from 4.00% in February to 6.50% in June.

The main reason for the RBI’s rate hikes was to control rising inflation. Rising global interest rates, particularly in the US, put downward pressure on the Indian rupee. The Indian equity markets were volatile in 2023, reacting to both rising inflation and interest rates. While the initial rate hikes led to some downward pressure, the stability in the second half helped to stabilise the markets.

While the initial rate hikes led to some downward pressure, the stability in the second half helped to stabilise the markets. Indian interest rate changes play a significant role in shaping the equity market. While rising rates can dampen sentiment and valuations, falling rates can create a more bullish environment.

4. Foreign Direct Investment (FDI)

Foreign direct investment (FDI) and the Indian equity market are like two tango partners, their intricately linked steps influencing each other’s rhythm and direction.

The global vote of confidence FDI inflows bring fresh capital into the market, boosting liquidity and investor sentiment. FDI often brings in advanced technology, management expertise, and best practices. This can enhance corporate governance and transparency in Indian companies, attracting more investors and improving market efficiency.

[Read: Are Developed Market Funds Offering Worthwhile Opportunities to Indian Investors?]

Higher FDI indicates faith in India’s growth story and can propel the market upwards. Conversely, declining FDI raises concerns about India’s attractiveness as an investment destination and can trigger market corrections.

Graph 3: Net FDI Inflows into India over the past decade

Data as of January 23, 2024
(Source: DPIIT – FDI Statistics) 

FDI inflows into India in 2023 were mixed, initially boosted by strong equity inflows (USD 10,946 million in April to June quarter of 2023) and eased FDI norms, but ultimately falling short of previous records due to a slowdown in the latter half.

Government efforts to improve ease of doing business and production-linked incentive schemes hold promise for a potential rebound in Foreign Direct Investment (FDI) in 2024. FDI inflows can be volatile, driven by global economic conditions and investor sentiment. Sudden declines in FDI can potentially reverse market advances and trigger price corrections.

FDI plays a significant role in influencing the Indian equity market. While it can be a driver of growth and investors’ confidence, its impact is nuanced and depends on various factors.

5. Geopolitical Landscape

It is considered as the invisible hand; global events and regional tensions can trigger risk aversion and market volatility. The geopolitical landscape can cast a long shadow on the Indian equity market, both directly and indirectly, influencing investor sentiment and impacting various sectors.

Events like wars, trade conflicts, and political instability can lead to sudden selloffs or rallies, depending on their perceived impact on the Indian economy and corporate performance. Rising geopolitical tensions may create uncertainty and risk aversion among investors and may deter foreign investors from investing in India, leading to capital flight and reduced liquidity in the market.

The geopolitical landscape is a noteworthy factor influencing the Indian equity market, and understanding its potential impact is crucial for investors. While short-term disruptions are possible, India’s long-term growth prospects and ability to adapt to changing geopolitical realities bode well for the market’s resilience and potential.

Beyond these key economic factors, several other elements also play their part in the Indian equity market symphony:

• Monsoon Rains:  Crucial for agriculture and overall economic activity, good monsoons indicate well for rural spending and corporate earnings, potentially boosting market sentiment. El Niño, a periodic warming of the eastern Pacific Ocean, can cast a fickle spell on India’s weather patterns.Studies suggest that roughly 60% of El Niño years coincide with droughts in India, as weakened monsoon winds bring scanty rainfall, particularly in northern and central regions.
• Commodity Prices:  Global fluctuations in prices of key commodities like oil and metals can impact input costs for Indian companies and influence investor risk appetite.Rising prices can increase input costs for companies, squeezing profits and potentially dragging down stock prices. Conversely, falling prices can benefit some sectors but raise concerns about a global economic slowdown, dampening overall market enthusiasm.
• Policy Reforms:  Government initiatives like infrastructure development, tax reforms, and ease of doing business can improve the investment climate and attract capital, potentially pushing up stock prices.Conversely, policies seen as unfavourable, such as regulatory changes or protectionist measures, can create uncertainty and dampen economic growth, potentially leading to market downturns.

In conclusion, remember, the Indian equity market is a complex orchestra, with each economic factor playing its own tune. By understanding these factors and their interplay, investors can make informed decisions and confidently navigate the market.

This article first appeared on PersonalFN here