As the world finally settles into the new normal and economies begin to open up, everyone from policymakers to economists are trying to establish the shape of the economic recovery. There are two popular ideas that everyone is talking about these days.
The first one is a V-shaped recovery where the economy nose-dives due to temporary issues but makes a similar recovery once we work things out—a sheer testament to man's strength in the face of adversity. The second popular idea is one of a W-shaped recovery where the economy is brought back up from its lows thanks to the economic stimulus provided by governments but once this artificial pump subsides, the economy crashes again before it finally sees a much more healthy recovery.
Now, this is where it gets interesting, the biggest question that everyone is asking, "Why is the stock market going up even though the latest economic statistics show the economy is in shambles?" While the letter 'V' (as of now) is seen forming on the stock market's barometer for the economy i.e NIFTY50's price chart, financial analysts believe this rise is unsustainable and an eventual correction is imminent.
While no one can predict where the stock market will move tomorrow, the K-shaped recovery sheds some light on why the markets continue to rise.
What is a K-shaped recovery?
The letters ‘V’ and ‘W’ can be traced on a stock market chart and hence map the economic recovery. However, it is important to note that the economy and stock market are two completely different entities. In a country like India where the stock market participants form a minuscule of the total participants in the economy, this effect is especially pertinent. A ‘K’ shaped economic recovery begins with the eventual decline as already witnessed but the path to recovery for the economy is split in two.
One section of the economy recovers quite rapidly, and may even exceed past prosperity. This section comprises wealthy asset owners and big businesses. We have witnessed this, as Reliance has raised over Rs 2.2 lakh crore through stake sales to improve their business and plan for the future. The 400 richest Americans' collective net worth has risen by $630 billion. The largest alternative investment firm—Blackstone Group, in its Q2 update, has written they have $156 billion in 'dry powder' or simply put, free cash and cash equivalents waiting to be deployed. This money, like from other affluent businesses and individuals will be invested in distressed real estate, private equity and the stock market. A stock market crash of close to 60 percent proves to be an excellent buying opportunity for these entities, as they understand that over the long-term, strong fundamentally sound businesses will last well beyond the pandemic.
The second section of the economy, which feels the pain of a business activity slowdown comprises of regular wage earners and small businesses. This effect is amplified in sectors that have been adversely affected by the pandemic like airlines, tourism and hospitality. As unemployment peaks, reaching an all-time high of 23 percent in April 2020, it is difficult for the average citizen to plan for the long-term when putting food on the table now is becoming increasingly difficult.
As a matter of fact, the world witnessed a similar economic recovery post the global financial crisis in 2008.
The consequences of a K-shaped recovery
The affluent section of the market recovers at a rapid pace through solid capital allocation in assets priced at a bargain. Regular citizens of the economy who feel the heat of the downturn, dip into long-term savings to tide over the short-term. For example, the Government of India has allowed salaried employees to dip into their EPF accounts to overcome their short-term cash crunch. While this may seem like a noble step, we ignore the long-term benefits that this individual would have reaped through the power of compounding when they retire.
Selling assets and breaking EPF accounts are for the fortunate. Daily wage earners and individuals who work in the gig industry, face the harsh reality of taking on debt to pay off on-going loans. This adds an additional debt burden which further worsens their situation in the long-term.
Preventing the K
The K paints a pretty glum picture of wealth inequality and it is something we should collectively try to prevent from occurring every decade. This is something that will ultimately come down to the actions of Governments and individuals. Fiscal policy has two modes—expansionary and contractionary. We are seeing expansionary policies now as the government is trying to stimulate the economy. The pressure point comes once the economy does start to do well, it is difficult to reign in these expansionary actions like low-interest rates, tax cuts and grants.
At an individual level, it is as simple as it gets; tried practices of personal finance management are the way to go forward. As companies build reserves to tide over such economic downturns, individuals must focus on creating their own rainy-day fund.
The K-shaped recovery is something we are witnessing right now. For those who belong to the wrong side of it, the shape of the recovery will not matter if they are sunk now. All crises provide an opportunity for reinvention. As a thought experiment, why doesn't the government practice contractionary fiscal policies like higher taxes during the good times? Some would argue it is like choking the economy but I would say it is just high-altitude training. So when the times do get rough, not only does the government have a reserve surplus to help everyone effectively, but also individuals who never got used to a lavish lifestyle, need lesser free cash to maintain their living standards...
The writer is co-founder and CIO of investment firm True Beacon and online stock trading platform Zerodha
The thoughts and opinions shared here are of the author.
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