September 2009: Government deficit and borrowing

Equity markets continued to be strong during the month on the back of continued strong inflow of funds towards equity markets. Interest in midcap stocks has been even stronger. Equity market strength is partly assisted by Foreign investor inflow of close to $ 4 billion during the month, near its all time monthly high inflows. Even domestic market inflows into equities have been strong.

The general perception, causing strength in equity markets, is the belief that the recession that one saw in 2008 is over and the future should be bright. Our interaction with several companies indicate that the business confidence at the ground level is far from the optimism one witnessed in 2007 and business conditions continue to be difficult. Even in the US, though there seems to be early indications that the economy has started to stabilize, it is difficult to believe that the global recession is over when unemployment in the US continues to be 10%.

One of the main reasons for the strong equity markets is the surplus liquidity and accommodative monetary policy being adopted by governments across the world, including India. When the banking sector in India went through a crisis towards the end of 2008, the RBI implemented several policy measures creating an easy money supply environment. CRR was reduced, the Repo rates and reverse Repo rates were reduced, accounting norms for banks and corporate borrowings were liberalized. Interest rates were kept low, in order to stimulate demand. This accommodative policy can last for some time, but cannot last for ever. If it does continue a loose monetary policy for too long, inflation would start to rise. Already, inflation as defined by the CPI (Consumer Price Index) is past 11%, leading to negative ‘real’ rates of interest. Note that your bank deposit is yielding 7% before taxes, whereas your costs are going up at 11%.

Several people ask why equity markets are volatile at all. If a stock is worth Rs 100, should it not trade at Rs 100, whereas in reality, it trades at Rs 80 sometimes and Rs 120 sometimes. The BSE Sensex has been seeing an annual volatility of over 60% and even developed markets like US,  Japan, UK and Germany have seen annual volatilities of about 30-40%. This is based on the past 18 year data – please see the attached spread sheet for more data. One of the main causes for this volatility is changes in interest rates, liquidity and monetary policy.

We believe the current ‘easy’ monetary policy being adopted by the RBI is way above historical average. RBI will continue with the accommodative policy till the global economy is definitely out of recession. This is part of a conclusion arrived at the G20 summit (the top 20 economies in the world meeting). With some consensus building up on the ‘end’ of the recession, the RBI does not have much of a choice, but to reduce money supply soon. Or else, inflation can go out of control. In the meantime, we are increasingly finding stocks reaching the top end of their estimated valuation range. There is more opportunity to sell stocks, than to buy.