Why stock markets are going up?

Reasons behind the recent stock market rally

Introduction

We have seen Indian equity market indices (BSE SENSEX) rallying from the lows of ~ 26,000 level in March’20 to recent highs of ~38,000 levels . Stock markets across emerging as well as developed economies have provided stellar rallies in recent times. Let us understand the macroeconomic factors leading to this stock market rally.

Reasons behind stock market rally

• Before we take a look at the reasons for recent stock market rally, let us first understand what is meant by yield of a bond?

Bond Yield

• The most common metric for relative valuation of a stock is PE ratio. Let us say a stock is trading at a P/E of 20 x. Then its earnings yield is given as 5% (Earnings/ Price).
• Similarly, the interest which an investor earns on investing in bonds is called as bond yield. For example, an investor invests INR 1000 in bonds for 5 years and earns INR 100 as interest annually. Then the bond yield is calculated as (100/1000) 10%.

Bond yield vs Equity Earnings yield

• Let us take a look at the yields of government bonds issued by advanced economies.

• As we can see, 10% of the bonds issued by advanced economies are giving negative yield returns.
• This means that if one is going to invest in these bonds, instead of earning a return on capital, he/she would end up losing the invested capital.
• Let us understand this with the help of an example. An investor decides to park a sum of INR 1 lakh in these bonds for 1 year. Then he/she will have a sum that is less than INR 1 lakh by the end of 1 year. This is because the bond yield is negative, which results in loss of initial capital.
• A major chunk of advanced economies government bonds (~60-70%) have yields in the range of 0-1%. This category majorly constitutes US government bonds.
• ~20-25% of bonds have yields in the range of 1-2% and remaining 2-3% of bonds have yield in the range of 2-3%.
• If we compare these bond yields to that of average equity markets earnings yield ~20%, we can see that equity market offers attractive return.
• Due to this, major chunk of investment is flowing towards equity markets in developed as well as emerging economies stock market.
• This is the major reason for recent rally in stock markets.

Liquidity infusion by central banks across the world

• Central banks across the world have infused funds around ~$8-10 trillion in the markets to help economies revive from the current economic distress caused due to the pandemic.
• This extra liquidity will pump up the equity investments, ultimately causing the stock markets to soar higher.

When will this stock market rally end?

• One of the main effects of injecting liquidity in markets is that the inflation level starts rising. let us understand how.
• As the central banks across the world take an accomodative stance and keep injecting funds in the economy, it provides an impetus to the consumers to spend more.
• Once spending increases, increase in demand for products and services will surpass the increase in supply.
• This will lead to increased prices, thus increasing the inflation.
• Once the inflation increases beyond the target level set by central banks, they will take steps to curb this inflationary pressure by increasing the interest rates to absorb the extra liquidity.
• These increased interest rates then will attract more investment capital into the fixed income instruments. This will result in withdrawal of huge chunks of money from equity markets and investing it in fixed income securities.
• However, these cycles are not short term and happen over a longer term of period.
• How long the recession caused by on-going pandemic will continue is still uncertain and hence it is difficult to predict when will the central banks stop injecting liquidity into markets.

Conclusion

Due to lack of opportunities in debt market owing to lower yield , excess liquidity injected by central banks to revive the economy will find its way into the equity market causing the stock markets across the emerging as well as developed economies to rally.