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Upsurge of retail participation in equities is cyclical, not structural

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Mr.Dhananjay Sinha

Head of Research, Economist & Strategist

13 Oct 2017

The epochal ascendance of retail flows into equities since mid-2014 has caused 193% upswing in Mid-cap index with its PE soaring to 42x, c.83% higher than benchmark indices. Expanding valuations of Mid-cap and Small-cap stocks have had a magnet-like effect by pulling inflows from retail investors, further stretching the market valuations.

Post May’14, net inflows into equity MFs have witnessed a phenomenal upsurge to a monthly average of Rs54bn and have had a dream run since demonetization, averaging over Rs100bn per month since Nov’16. This is in stark contrast to an average redemption of Rs14bn in the previous 5 years, i.e. since early 2009, which was the first phase of the bull market following the global financial crisis (GFC) of 2008-2009. So clearly, the recent upsurge of retail participation in the equity bull-run has lagged the initial phase that was dominated by the FIIs.

Many have argued that the consistent bulging of flows into equity MFs in the face of recent FII selling reflects an inflexion point towards a phase that will structurally be dominated by domestic investors.

But, how sustainable is this perceived structural shift of retail participation in the equity markets?

The consensus view revolves around the substitution effect in favour of equity instruments when other avenues of savings have become less remunerative, with declining interest rates on deposits, real estate prices remaining stagnant and gold losing its sheen.

Our research reveals significantly different viewpoints. Most importantly, household participation in equity markets is highly cyclical and the recent upsurge probably has the weakest fundamental backing in all the 4 upcycles since 1990.

Over the longer term timeframe, our analysis reveals a high correlation (0.82) between the proportion of household savings flowing into equities & debentures and market valuations. Importantly, the peak level of retail participation in equity markets (1992-1996) saw the proportion of equities & debentures/household savings rising to an average of 10%, with PE ratio averaging 35x. Contrastingly, during the periods of declining valuations, household participation has declined considerably to an average of 1.5% of total savings.

Typically, upswing in household participation in equities and MFs is also accompanied by economic boom and sharp rise in corporate earnings, fueling the rise in household disposable income, compensation and broader savings.

In contrast, rising flows of household savings into equities in the current cycle since May’14 has coincided with weak economic growth, flat corporate earnings and deceleration in employee compensation growth at 6-7%. Household financial savings rate (financial assets less financial liabilities) remains low at 7.8% of GDP, considerably lower than 12.2% in FY10).

Separately, the long-term correlation between interest rate on bank deposits and proportion of household savings flowing into equity or equity linked instruments is positive (0.46) instead of negative, which is necessary for the substitution effect. This is because interest rates are pro-cyclical in nature, rising with improving economic and business cycle. Correlation with real interest rate is negative but insignificant (-0.28). Likewise, savings in gold is strongly linked to rural and agri sector GDP growth, which can happen along with rising inflows into equities (e.g. 2005-2010). With respect to real estate, the affinity of households to enhance exposure to property is structural in nature; even in the current scenario, when compensation growth is modest, mortgage loan growth of banks and financial institutions has been high at 15-20% (Mar’17).

Hence, the current upturn in MF flows (over the past 3 years) doesn’t appear to be structural. We estimate that the structural portion of household savings in equities & debentures is 50% lower than the estimated current level of 3.4% of total household savings.

The high correlation and two-way causality between valuation measures and equity MF flows in the current context makes it imperative to look at the embedded risk factors.

At this juncture, there exists a precarious balance between valuation, earnings growth and global risk-free rate is critical for the financial markets. The moot point is that all these variables are displaying disconcerting signs– risk-free rate is bottoming out from historical lows, multiples are at historical highs and earnings growth has remained stagnant.

Sustainability of market exuberance is pivoted on the ability of the central banks, especially the US Fed, to normalize the overly accommodative monetary policies without letting the risk-free rate to inch up at a faster pace than the earnings growth. But, things can become tricky if there is: faster drawdown in Fed’s balance sheet, or rate hikes by the Fed or more-than-anticipated tightening in global liquidity, thereby sustaining FII sell-off, triggering a meaningful correction in market valuations.

Statistically, FII flows have significant lagged correlation and causal impact on India Mid-cap valuation and MF flows. And, despite their lower contribution, FIIs still capture 2.5 times the secondary market turnover (NSE+BSE) compared to MFs who even at the recently elevated level contribute only 14-15%.

Secondly, the combination of domestic fiscal expansion and global trade protectionism can further constrict global saving surpluses in the emerging markets, including India, resulting in higher rates and inflation.

Third is the risk of domestic earnings continuing to fail expectations, as has been the case over the past years. And fourth, re-emergence of India’s “twin deficit” problem amid receding excess global liquidity.

The crux of our assessment is that for the equity MF flows to sustain the positive momentum: a) FII flows have to turn positive and b) rising valuations of Mid-cap indices need to sustain. Therefore, notwithstanding the increased dominance of equity MFs in recent times, if FIIs remain net sellers for a long time, it would put in jeopardy the present lofty market valuations, especially in the Mid-cap index, which in turn can lead to redemption of MF flows. Our analysis indicates that equity MF flow boom lasts for 3-4 years and its downturn is triggered by global factors; in the current cycle, we have already crossed 3 years.