The debate on whether there is any relevance to the market capitalisation to gross domestic product or GDP ratio rages on. Especially today, when this ratio has moved above the 2007 highs for a large number of Western markets such as the US, Germany and the UK(countries that were supposed to be impacted by the financial crisis the most) but have moved down substantially in other markets. Emerging markets which did not see any crisis but had their growth curtailed due to the slowdown in global growth as well as inflationary pressures in their economies.

Country-specific events such as geopolitical issues in Russia, slowing growth and a large debt in China, have also impacted this ratio. Market capitalisation to GDP ratio of most large EM’s declined from over 150 per cent at the end of 2007 to a range of 40-65 per cent currently. On the other hand the same ratio for the US, the UK and Germany in most cases is above 110 per cent of GDP.

Ratio cycle The reasons for this are not difficult to fathom. Every economy goes through phases of profit expansion and compression while the GDP and the turnover (sales) of companies continue to grow. The phases of profit expansion make the profit growth higher than the growth in sales. As profits grow more than the turnover of the companies, in general the Return on Networth or the Return on Capital also move up. This leads to an upward re-rating of the companies in that economy. During this phase the market capitalisation to GDP ratio of that stock market expands.

On the other hand, when growth slows down, inflation is high and interest rates are high; typically, the companies do not have operating leverage (which means a higher profitability due to better capacity utilisation), during this phase profits grow slower than sales turnover. Companies which are very investment heavy or asset heavy actually go into losses during this period as we have seen in India over the last three years. During this time as companies are not doing well the banking sector also experience higher non-performing assets which lead to a compression of the valuation of banks. Thus, there is a vicious cycle where the outlook for the future also looks bleak and brings down the market cap to GDP ratio.

Now, let’s see the reasons for the divergent trends globally. Most of the developed economies have very low interest rates at this point in time, and wage pressures are low due to low inflation. Under these circumstances companies in these countries are enjoying high profitability.

For example, profits as a percentage of GDP in the US are today at a new high. As profits have moved up, the valuations in these markets have also moved up despite there being anaemic growth in these economies. So, today we have a weird situation where the money printing by developed market central banks have led to a stabilisation of these economies but have led to higher inflation and economic instability in emerging markets.

Exporters gain Valuations in Indian markets also reflect this trend. Export-oriented companies that benefit from growth prospects in the US have seen their valuations expand while companies where domestic growth matters more have seen a compression in valuations thus taking the market cap to GDP in India down to around 65 per cent today.

So, what lies ahead? A peaking of the inflationary outlook combined with stability in the INR should lead to a stabilisation and improvement in the domestic economy. We are likely to see a counter cyclical monetary policy in India vis-a-vis the western countries. The US Fed has indicated interest rate hikes after a year. Bank of England and ECB might follow suit. Now this will have twin effects. First, the speculative trade in commodities will get contained further. Second, it might slow down capital flows into emerging markets. However, if inflation is contained and growth revives, India will get much more capital flows than expected.

The case for expansion in India’s market cap to GDP, going forward, is extremely strong under the circumstances. As such wealth creation in the Indian markets over the next three to five years could be huge due to a combination of a stronger growth in profitability as well as a re-rating of the economy, that is expansion of market cap to GDP in the same time period. The ratio moved up from 45 per cent in 2003 to 160 per cent by the end of 2007 in the case of India.

If this ratio moves back to a level of 100 per cent combined with a nominal GDP growth of 11-12 per cent over the next five years, there could be a 150 per cent+ return potential. This means Nifty above 16,000 and Sensex above 55,000.

A stable and progressive Government can provide an upside to this estimate and vice-versa.

The writer is a financial consultant

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