Markets are front runners for the economy. Rising equity markets suggest faster economic growth going forward. Economic growth expectations lead to rising inflation expectations and bond yields tend to rise. However in India fiscal 2014-15 saw rising equity markets, falling bond yields, rising economic growth and falling inflation expectations. Sensex and Nifty have risen by over 28% over the last one year touching record highs. Ten year government bond yield is down 130bps since April 2014. India’s GDP has grown by 7.4% in fiscal 2014-15 from 6.9% growth levels seen in fiscal 2013-14. Inflation as measured by the CPI has come off from levels of 8.59% to 5.37% on a one year basis as of February 2015.
The signals sent by the market are mixed. Sensex and Nifty are trading at valuations of 24x trailing twelve months earnings, with valuations rising from levels of 18x over the last one year. However the government bond yield curve has flattened out completely with five, ten and thirty year maturity government bond yields all trading in a 10bps range of 7.70% to 7.80%. Flat government bond yield curve suggests that the economy is unlikely to grow unless interest rates come off sharply in the economy.
GDP growth for fiscal 2015-16 is expected in a range of 8.1% to 8.5% while inflation as measured by the CPI is expected at levels of 5% to 5.5%. Equity markets are suggesting higher growth but bond markets are suggesting weak growth while inflation too is suggesting growth pangs for the economy.
One theory that can explain the market and economic anomaly is that the flatness of the government bond yield curve is suggesting that RBI will cut rates that would lead to lower bond yields and lower interest rates in the economy, which in turn would lead to investments, consumption and economic growth. Inflation expectations are down largely due to weak global oil and commodity prices and not due to expectations of falling economic growth. Read our commodity knowledge series on oil and commodity price movements.
If the theory suggested here holds true, then Sensex and Nifty will register more gains and Ten Year Government bond yields will continue to fall. It is a Goldilocks like scenario.
Economic data continues to show weakness in the first ten to eleven months of this fiscal year.
IIP (Index of Industrial Production) growth for the April 2014- January 2015 period was just 2.5% against a growth of 0.1% seen last year. Manufacturing growth was 1.7% against negative growth of 0.3%. Capital goods growth was 5.7% against -0.8% while consumer durables growth was negative 14.2% against negative 12.5%.
Bank credit growth has slowed down considerably since last year. Bank credit grew by 10.37% year on year as of February 2015 against a growth of 14.65% seen in February 2015. Slowing bank credit substantiates weak IIP data.
Trade data shows that exports grew by 2.32% in the April 2014– January 2015 period while imports grew by just 2.16% with non oil imports growing by 7.5% largely due to 140% jump in gold imports. Anemic growth in exports and imports suggest weak external and domestic demand.