Sentiment is everything

Stock market pundits attribute the rise (and fall) of the markets to sentiment. Imprecise though it is, the almost universal belief that the stock markets are driven by sentiment has served experts and lay people well.

But then what determines sentiment? Take the current Indian context. The new Government headed by Narendra Modi has everything going for it. The stock markets have zoomed. New records were set recently.

Significantly, whatever macro-economic data that have been coming in show an economy on the mend. The NDA Government cannot obviously take all the credit for the perceived revival but not many seem to be giving credit to the previous UPA Government even partially.

That alone should explain what robust sentiment means — an uncritical attribution of positive developments to the NDA Government, especially to Prime Minister Narendra Modi.

Yet, one has to realise that sentiment can be ephemeral. Although it does not look like happening, investors, especially small and retail ones, should be very cautious.

Stock markets

To continue the narrative, the record-breaking performance of the Indian stock markets recently cannot be attributed to any one single factor. However, in a pecking order of possible causes, the formation of a new BJP-led NDA Government at the Centre in late May, will figure right at the top.

On September 2, the Sensex crossed the 27,000-mark for the first time, and climbed further on Wednesday. It might be a coincidence but new records were set up on a day the new Government completed 100 days and has, therefore, been taken to be the markets’ endorsement of the new rule. The Nifty had crossed the 8,000-level a day earlier on September 1. These are dizzy levels, and to probe whether the market valuations are justified or will endure, the stated causes for the phenomenal rise become important.

The new Government dominated by a single party has brought with it the promise of stability, improved governance, and economic reforms. Admittedly, it is too early to evaluate the government on these parameters. On reforms, for instance, the Government has taken steps to hike the foreign direct investment cap in the insurance sector and defence. The NDA Government deserves some more time to carry out its promises but the expectations from it have zoomed. Popular wisdom is that the stock markets reflect the mood of the economy. That need not always be true. The markets flourished even during long periods of the UPA rule, which was perceived to be inept in economic matters.

Stable rupee

However, there appears to be a stronger justification for the new Government’s claim to have reversed the overall economic sentiment, which during UPA rule was low. The financial markets are generally the first to capture the sentiment. Besides the stock indices, the rupee has remained stable, no mean feat in the light of global uncertainty and a rising dollar.

Underpinning the rupee’s stability and the markets’ rise is the continued inflow of capital from abroad. Foreign institutional investors (FII) bought Rs 78,400 crore of debt and a mind-boggling Rs 1.02-lakh crore of debt instruments in the first eight months. FII flows have helped bridge the deficit in the current account, but over-dependence on them has left the economy dangerously exposed to the vagaries of foreign capital.

Apart from destabilising the economy, a sharp reversal of FII flows, however improbable, can sink the stock markets.

In the end, a host of domestic and external factors besides the promise of the new Government are responsible for the improved sentiment in the stock markets. Gross domestic product (GDP) growth in the first quarter of 2014-15, at 5.7 per cent, exceeded all expectations. The current account deficit, considered unmanageable, has been narrowing. There is a buzz that the sovereign rating will be revised upwards, although that feeling is not shared by all the prominent rating agencies.

All these, as much as the changed political situation, have pushed up the stock indices to new record. But there are threats.

The Sensex cannot keep going on one way always. Also, while there is much that Mr Modi’s stature and early initiatives have done to boost sentiment, it is obvious that one man or a few individuals alone cannot be responsible for keeping the markets happy, and, more importantly, in spurring economic growth.

>narasimhan.crl@thehindu.co.in

(This article first appeared in The Hindu on Sept 8.)