2020 had been one of the worst economic years in recent memory, especially for India. Numerous articles and pieces of research have been compiled regarding the devastating effects that COVID-19 has had on the economy. Everyone has read about the 24% contraction that occurred during the April-June quarter. It was the worst growth rate seen amongst the major economies of the world and the governments handling of the crisis has been acutely criticised since.
At the same time, the financial markets in India have done extremely well. Since the 23rd of March this year, the day before India entered a nationwide lockdown, the Sensex and NIFTY have been up by 75%+. The richest Indians, the likes of Gautam Adani, Mukesh Ambani, and so on, have seen their personal wealth nearly double last year.
The same question is being asked in the US as well, where millions of people are struggling to make ends meet because of COVID and yet the US stock market is booming. NASDAQ has nearly doubled since the 23rd of March.
The fundamental difference between the economy and the stock market is this: the state of the economy tells us about what is going on right now. The stock market, on the other hand, is the expectation of what future profits are likely to be. So if the markets are doing really well now, it means that investors around the world believe that the economy is going to do really well in the future. That’s basically what investing is about.
So if investors all agree that the future is bright, should we be less concerned about the present? It’s not quite so simple.
Investors have this opinion about the future because of what they see happening today. Whether it is the announcement of a stimulus package or that of a new vaccine, good news breeds positive expectations. If none of this was happening, then it is more than likely that the markets wouldn’t be doing as well as they are. Human nature is also such that we need to keep ourselves busy, or at least that is what human nature has become under the current economic system that we live in. This means that whatever happens, we will eventually all go back to work and start producing things for people to buy.
Of course, there needs to be strong institutions in place that ensures that the economy can function. If we look at places like Venezuela, Brazil, Zimbabwe, and so on, standard laws of nature don’t seem to apply. People want to work, but the government has not been able to set up systems that facilitate such things effectively. The fact that expectations about India’s economic future are so high reveals what the public’s perception of India’s institutions is.
Historical evidence supports the above claims. When the stock market is booming, the economy is bound to do well. Numerous pieces of research have investigated the relationship between the stock market and the economy and they all come to the same conclusion.
There are a number of different reasons for why that is but chief amongst is the fact that the financial markets and banking system work alongside each other in order to facilitate growth. The liquidity that the market offers encourages investment and also facilitates the quick movement of resources.
The international markets also offer the opportunity to diversify risk. This is another feature of the stock markets which encourages people to invest. Individuals will be more willing to buy in to projects that promise high returns but come with higher risk because they know that they can spread out their investments in other safer projects as well.
Going forward the situation will get better, but it is important to remember that the markets can be volatile. If there is a second wave of the virus and the government decides to enter into another lockdown then the markets will surely let us know what they think. Share prices fell by more than 40% between February and March when investors saw that the virus was coming and was bound to spread. If that happens, it will mean that the road to recovery will be longer and harder, but we will recover eventually.