PERILS OF OVER-EMPHASIZING A FEW TURNING POINTS

GDS: Gross Domestic Savings (Fiscal Year)
GDCF: Gross Domestic Capital Formation(Fiscal Year)
Sensex year-end (Calendar Year)
Source: Bloomberg; RBI

It seems from this graph that the Indian equity market delivers sustained stellar returns when the gross domestic savings and capital formation rise significantly. This suggests that superior market moves coincide with periods of rising trend growth rate of the economy (for the logic please see my previous post). Careful statistical analysis, however, points to a positive but statistically tenuous relationship.


SENSEX RETURN = 20.90(0.0034) + 0.93*GDFC Y-o-Y%(0.2645)
P-values in the brackets.

R^2= 5%

The obvious conclusion is that economic growth is only one part of the puzzle. Valuation is important. Rapid growth which has already been discounted by the market will not help.

9% GROWTH IN THE FACE OF A GLOBAL RECESSION: DREAM ON; ANY EQUITY RALLY BUILT ON THIS THEME WILL FACE GROWTH DISSAPOINTMENT IN THE FUTURE

The India growth story is a strong one. India has the most important advantage: top quality human capital. Not many countries with comparable social parameters can boast of India’s success in some quarters of higher education.

My view of Indian Trend Growth Dynamics: With Infinite Supply of Labor on the Margin, Trend Growth Rate is Determined by Productive Capacity: Gross Domestic Capital Formation and Ultimately on Funding Sources = Gross Domestic Savings + Sustainable Level of Current Account Deficit

1. Exports pick up leading to an increase in capacity utlization. A surge in capital formation results, which increases the productive capacity of the economy.

2. Initially, the current account deficit widens as funding needs outpace domestic savings. Ultimately, savings pick up as the propensity to save is higher from profits than from wages. And also because at higher levels of income, there is more leg room to save.

3. The higher gross savings rate leads to a rise in trend growth in terms of sustainability of funding available to finance the higher level of capital expenditure.

4. The down-leg begins with a down-turn in exports which spills-over into capex through the capacity utlization route.

5. Consumption spending is stable and grows at the new trend rate, providing stability to the economic ascension.

6. The savings rate dips in the downturn.

Rising trend growth is the norm for the Indian economy. Yet, do not underestimate the importance of cyclical forces.

Figure 1. Since the Mid-80s, cycles in GDP growth have been closely related to perturbations in exports. I have calculated the cyclical component by treating a 5-year moving average of GDP growth as the trend.



Figure 2. Cycles in Gross domestic capital formation are intricately linked to external sector performance.



Figure 3. Private final consumption expenditure lends stability to the expansion.



Figure 4. Government final consumption expenditure runs counter to the cycle, implying a countercyclical fiscal policy.





BOTTOM LINE

India’s trend growth has risen in the last 5-years to around 7%-8% as the gross domestic savings rate has climbed to about 32% (assuming an ICOR of 4). In the next big capex cycle, the trend will rise to 9%-10%. But that is not likely to happen without a recovery in global demand. And we should not forget that the last 5-years were more an exception than the norm. Until then, 6%-7% is more likely to be the outcome. That's pretty good, but it is way below 9%.


Source: Handbook of Statistics, RBI
All data at constant prices.
GFCE: Government final consumption expenditure.
PFCE: Private final consumption expenditure.
GDCF: Gross domestic capital formation.

VALUATION MATTERS: RISK-ADJUSTED RETURN PERFORMANCE: U.S. HIGH YIELD TRUMPS S&P 500; USING LEVERAGE TO ENGINEER SUPERIOR RETURNS GIVEN RISK CONSTRAINT

The S&P 500 has rallied almost 40% from the March 9, 2009 lows. U.S. HY (HYG) and U.S. IG (LQD) are up 28% and 8%, respectively.

Yet, risk adjusted performance tells a different story. And that is what really matters because any asset class/security can be levered up/down to provide the desired risk-return characteristics. Clearly, the investment with the highest ratio of mean to standard deviation would dominate in this framework.

Based on this criteria(see Figure 1), U.S. High Yield performed the best in the rally since March 9, 2009, followed by equities and U.S. IG.

Assuming that we could borrow at 10%(see Figure 1), it was possible to engineer a portfolio that would have outperformed stocks while commanding the same risk defined in terms of standard deviation.

The key message of the story is that valuation matters. At the March 9 lows, stocks were modestly undervalued, but U.S. High-Yield looked battered and offered better potential risk-reward characteristics.

Figure 1