A risky market

The year 2004 saw a continuation of the main market trends of the previous year. The most significant of these is the continuation of lax monetary policy in the United States, with real interest rates continuing to be negative.

The upshot has been very high levels of liquidity in the US economy, which fuelled bull runs in a variety of asset classes, including emerging market equities, bonds, commodities, and gold.

The rally in the Indian stock market in 2003 and 2004 must be seen in this global context.

This excess liquidity is a symptom of great imbalances in the global economy. Put very simply, the world economy today is one where the US consumes and Asia produces. To enable that system to work, it's essential that the US consumer is able to borrow at low interest rates.

That has been arranged through the easy money policy in the US, on the one hand, and the Asian central banks' willingness to recycle their dollar hoards into US bonds on the other, which in turn increases liquidity in the US and drives down interest rates.

At the same time, the yawning current account deficit in the US results in downward pressure on the dollar, which in turn makes non-dollar assets more attractive.

Low interest rates in the US also result in yield-hungry investors looking at markets abroad. The result has been a flood of portfolio investment in emerging markets, driving up stock markets and keeping bond yields down.

That's been the narrative for global markets in 2003 and 2004, and the story for the Indian markets has been no different.

If that is the main theme, there have been a number of smaller, concurrent themes. Excess liquidity has also led to an investment boom (some would call it a bubble) in China, which has led to a rise in commodity prices, in particular oil prices.

And finally, negative real interest rates in the US have led to the "reflation trade" by hedge funds, with cheap money being used to drive up oil, gold, stock and bond prices.

Recent volatility in the oil and commodity prices points to the influence of these hedge funds. For 2005, therefore, it's important for the Indian markets that foreign portfolio inflows continue, which essentially means that the global trends of 2003 and 2004 should persist.

Unfortunately, there are several risks to this scenario. Asian central banks may decide not to invest their reserves in depreciating dollar assets""that would not only hurt growth in the US, it would also have disruptive consequences for the global economy, and the jump in US interest rates would lead to a drying up of liquidity.

No one can assess the precise risk of this happening. Investors in India would do well to keep a wary eye on the dollar and on bond yields in the US.

The year 2005 is also likely to be one when expectations from the broad Indian market will have to be tempered, because stock valuations are no longer cheap, compared to other emerging markets.

Further, the rally in many mid-cap stocks should make investors cautious. Investors will also need to be careful about the quality of new issues hitting the market.

In other words, while the market will continue to rise as long as liquidity flows continue, 2005 may be a year when picking the right stocks becomes important. Long-term value, rather than momentum, should be the investor's watchword in 2005.