GDP to Market Cap Ratio: Exploring the Link between Macroeconomics and Investments

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You may ask why I want to include macroeconomics in a personal finance module. After all, personal finance is focused on an individual or family’s finances while macroeconomics looks at the economic health of a country.

What is the connection here?

No matter your preference, the state of the nation has an influence on your financial stability, particularly if you’re setting aside funds for long-term objectives such as retirement.

Picture this: you have retirement as your target. To reach your goals, you are meticulous in selecting mutual funds, keeping up with a consistent savings rate and increasing it annually. You don’t let yourself be swayed by the temptation of withdrawing funds during that time.

No matter the nation someone inhabits, it’s possible that they could face economic difficulties due to defaulted debts and find themselves immersed in unfaltering political unrest and social conflict.

Given the situation, do you think your savings will do well?

Picture your country standing at the verge of a major economic transformation, with a favourable age structure and benevolent Government. Despite these attractive prospects, you elect to keep your money safe by investing it in gold.

Do you think you’d have taken the right investment decision here?

Therefore, I strongly believe that one should be familiar with the nation’s macroeconomic situation, making comparisons to prior states and attempting to envision what the future holds.

This chapter will provide an overview of the essential macroeconomic principles. If this is something that interests you, then it might be beneficial for you to look into a more in-depth undergraduate book about the subject. You won’t regret taking the time to read up more on it!

 

– Gross Domestic Product (GDP)

This is a fundamental metric for us to address, so we will begin here. For those who know ‘GDP’, you can move ahead. Those who are unfamiliar with it, let me give a brief explanation.

Following my sister’s matrimony in 2002, she relocated to Coimbatore, Tamil Nadu. In my early 20’s I would frequently journey there on weekend sojourns to be with her and spend a few days together. My sister had a captivating neighbour in Coimbatore that she would often tell me tales about, and on one of my visits I got the chance to meet them, too.

This neighbourly home had the trio of a husband and wife in their mid 50’s, as well as their teenage daughter. The husband was in charge of a kitchenware store which stocked essentials such as rice cookers, pots and pans. His wife ran a small homemade Papad and pickle business, while the daughter taught classical dancing to youngsters in the neighbourhood.

My excessive inquisitiveness led me to attempt to calculate the funds this family earned. I do not recall the precise calculations, but I can recall these figures; my hypothesis was that –

o   The husband sold goods worth 2 to 2.5L lakhs per month.

o   The wife sold goods worth 25K every month.

o   The daughter charged 500 per month per kid and had ten students, which was 5K per month.

Roughly, this miniature and praiseworthy family’s monthly income ranged from 2.3 to 2.8L or an aggregate of 34L annually. With no extra sources of revenue, the all-inclusive fiscal yield of this family pertained to that very total of 34L.

It is understandable to conclude that the family’s Gross Domestic Product (GDP) was 34L per annum. This number reflects the value of all economic activity for the family, ranging from kitchenware sold, papad and pickle manufactured and distributed, to dance classes offered as a service.

Step back and consider the nation as a whole. Factories, businesses, and various other service units throughout the country collectively generate economic output. The total economic value of all these entities that operate within the nation’s boundaries represents its gross domestic product (GDP). When these organisations are successful and prosperous, it will naturally lead to an increase in GDP.

We all want to see the growth of the GDP, which is indicative of a healthy economy.

Have a look at the Indian GDP ranking –

I found this information on Wikipedia; it listed the 2020 GDP rankings of various countries according to estimates from the IMF, World Bank and UN.

India’s estimated economic output is between 2.6 and 2.9 Trillion USD, putting it just below some of the world’s largest economies such as China, Japan, UK and Germany – ranking around 6th or 5th.

It’s wonderful that we rank in the top 5 GDPs in the world, however it’s essential to grasp how our GDP grows. We are determined to go beyond top 5 and get there swiftly.

We can measure the expansion of a country’s GDP by using its growth rate, presented in terms of percentage. For instance, when the percentage is 5%, it shows that the GDP has increased by 5%.

We won’t be discussing the process of estimating GDP growth rate today, but we will instead use the widely accepted figure.

Now, when it comes to measuring the GDP growth, there are two terms you should familiarise yourself with –

o   The nominal GDP growth rate

o   The real GDP growth rate

The GDP’s growth rate is measured by two methods; if you’re familiar with our modules, you’d know this is the CAGR. We’ve talked about it numerous times already.

To put this in context, take a look at this new paper headlines –

The reference point here is the ‘nominal growth’ rate.

The nominal growth rate is the absolute growth rate and, though it may be sufficient for some purposes, should not be taken as an accurate depiction of the situation.

Let me explain.

Consider it like investing Rs.100 in stock. Over a period of 5 years at 10% growth, the value of that Rs.100 can reach Rs.161/- eventually. However, it is not possible to equate this value to that of the same amount today because of inflation which affects the buying power of money annually.

Hence, to obtain a precise representation, we must take inflation into account when calculating the GDP growth rate. By doing so, we are able to arrive at the real GDP growth rate.

Real GDP growth = Nominal GDP growth – Inflation.

Assuming the inflation at around 4.5% (ranges between 4.5% to 5%), real GDP of India –

10% – 4.5%

= 5.5%

Do take a look at this snapshot; it estimates the real GDP growth at 5% –

The snapshot is from the Department of Economic Affairs; you can read the entire paper here – https://dea.gov.in/sites/default/files/March%202020.pdf.

This chart from the paper caught my attention, and I believed it would be beneficial for you to have here for quick reference.

Due to COVID, the majority of economies experienced a contraction in GDP last year. Nonetheless, they are projected to recover in 2021 and perhaps 2022. The stock markets appear to be factoring this in, but we can’t be sure if it will play out as expected.

Anyway, at this point, I want you to take a break and think about this –

o   You understood what GDP is

o   You understood the GDP growth rate, both nominal and real.

How is this relevant to personal finance?

 – GDP and Market cap

We discussed the concept of market cap in Varsity. For those who are unfamiliar, here’s a brief overview –

We can assume that the stock price of a certain company is Rs.75/- per share, with a total of 1000 shares outstanding.

The market cap of this company is –

Stock price x total outstanding shares

= 75 x 1000

= Rs.75,000/-

The overall number of outstanding shares of this firm remains the same, however, the stock value can vary from day to day. The market capitalization is directly proportional to the price share.

Now assume another company has 2000 shares outstanding, and the stock price is 105 per share. The market cap of this company is –

= 105 x 2000

=2,10,000/-

This company has 2000 outstanding shares and the stock price is 105 per share, making its market capitalization 200,000.

75000 + 210000

=2,85,000/-

Hopefully, with this instance, you got a grasp on the idea of ‘market cap of the market’. As of Jan 2021, Indian firms had an estimated total market cap of approximately $2.5 Trillion.

The relationship between a country’s GDP and its stock market is clear: As the former grows, so does the market capitalization. When that increases, equity investments tend to be profitable as well – something we have seen in the past.

When examining GDP data, consider the current state of the nation’s economy and anticipate how it may change in the coming five to ten years.

For instance, here is a thought about the Indian GDP situation –

o   India is a 2.6 Trillion USD GDP as of 2021

o   The real GDP growth rate is 5.5%

o   The countries above us in the GDP rank, i.e. Japan, Germany, and the UK, have large GDPs, but their real growth rates are lower.

If India takes no drastic action in either direction, its GDP rank is likely to rise even with a moderate rate of economic growth, especially when taking into consideration the slowing pace of growth in developed countries.

Contemplate a rising GDP coupled with the world’s most extensive democracy and a strong labour force; the result is surely an impressive sight.

In conclusion, these factors often lead to increased investment which should serve to improve corporate performance and the nation’s market capitalization.

Will this happen overnight? No.

Will this happen over the next 1-2 years? Maybe not.

Will this happen over the next 8-10 years? Well, it seems likely.

Hence, the need to stay invested for a longer-term.

– India Inc

When considering a corporate entity, revenue and expenses should be taken into account. Depending on both, the company may make a profit or face a loss.

When we look at India as a company, the elected government serves as its management. The primary sources of income are taxes, while capital and revenue expenses make up the majority of outlays. If this equation yields a positive result, it is a surplus for our nation; however, if not, it causes a deficit.

By looking at the above figures, we can determine that the Financial Year 2018-19 was represented in Rupee Crores. To gain a better comprehension of these numbers, let’s take a closer look.

India Inc’s Revenue is referred to as ‘Receipts’. These provide funds for the Government, through two major sources: Taxes and Non-tax revenue.

Taxes Revenue – Tax revenue is the money gathered by the Government from various sources. This income is usually divided into two categories – Direct and Indirect Taxes. Direct Taxes are those paid by individuals, such as Personal Income tax, and Corporate Income tax, paid by businesses.

Indirect taxes mainly include the tax in the form of ‘GST’.

As you can see, India Inc collected close to 14.8L Crore as taxes in 2018-19; this includes both direct and indirect taxes.

When considering the 14.8L Cr, this is the ‘net to the centre’. This indicates that the actual tax collection amount is greater. After inspection of this report, we can get a more precise value. From what I recall, roughly 2/3 are retained by the centre and 1/3 are distributed among states.

Non-tax revenue – Apart from taxes, the Government has another source of income: non-tax revenue. This mainly consists of dividends from PSUs (such as LIC, NTPC, ONGC, and NALCO) that the government holds a majority stake in. Furthermore, the government also makes money through its disinvestment program- i.e. selling off shares in these companies. All things considered, the earnings from non-tax sources in 2018-19 was estimated at around 2.4L Crore rupees.

Total revenue is the sum of these two revenue lines, which is roughly 18.2L Cr.

The Government has expenses which can be sorted into two groups: ‘Revenue Expenditure’ and ‘Capital Expenditure’.

Revenue Expenditure – Expenditure on Revenue comprises subsidies for a range of Government programs, salaries for public servants and interest payments. This major bill for the Government totaled 21.4L in the given snapshot.

Capital Expenditure – The capital expenditure of 3.1L Crore is the Government’s expenditure on infrastructure such as roads, bridges, hospitals, electrical grids and transportation.

It is evident that the Govt’s capital expenditure of 3.1L Cr is drastically overshadowed by its revenue expenditure of 21L Cr. With an increased focus on Capital expenditure comes better infrastructure, enhanced business growth, more employment opportunities and improved tax collection.

As an investor for the long haul, it is important to monitor trends of spending and get an idea of how the nation is developing.

The combined value of revenue and capital expenditure makes up the Government’s total expenditure, estimated to be around 24.57Cr.

The Government gathered revenue of 18.2L Cr, but their outgoings amounted to 24.57L Cr – almost 6.3L Cr more. This difference is termed the ‘Fiscal Deficit’.

From the same report, I’ve pulled the GDP data –

The country’s GDP as per 2018-19 data is 190.1L Crore. If you calculate the Fiscal Deficit as a percentage of GDP –

6.3L Cr / 190.1L Cr

= 3.3%

Any macroeconomic talk invariably centres around this ratio; the Government is making tremendous attempts to keep the Fiscal Deficit to GDP ratio under 4%.

To put this in perspective, do check this extract from Wikipedia –

The US’s fiscal deficit as a percentage of GDP is nearly 4.7%, which is quite staggering.

While at it, we can crunch one more data point, i.e. net tax collected as a percentage of GDP

= 17.3/190.1

= 9.1%

The ratio, taking into account the contributions from state governments, is estimated to be 11-12%. Tax revenue as a percentage of GDP is an important indicator; the greater this figure is, the more funds are available for tackling the budget deficit.

Higher tax collection can be facilitated through newer job creation, business expansion, improved ease of doing business, and compliance.  Such factors can encourage higher revenue into public coffers.

To remind you again, tracking these numbers is necessary to understand how the country works. When investing for the long term, your success depends largely on how well India performs.

Without a sense of these basic details, it is equivalent to investing in the dark.

That’s all we have time for today – so much to say on this expansive subject, and we’ve just scratched the surface.

We have reached the conclusion of our Personal Finance module, and I sincerely trust that you have taken as much pleasure from reading it as I did in putting this material together for you.

Best of luck, and may your investments be profitable!

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