First of all, EM share prices have been rallying at the same time as the dollar has been appreciating. Such a divergence has not happened since 1997-98, and since then any period of dollar strength has always been seen as a headwind for EM equities. Currently, EM equities have seen a surge in local-currency terms, while EM (ex China) currencies have been steadily depreciating.
Global materials and mining stocks have been weak over the past few weeks. The same also holds true for global commodity prices more broadly. Despite this, EM equities have performed well. While there have been periods of similar divergences in the past, they have never sustained for long. Something has to give. The strong correlations in the past have been based on the fact that both global materials as well as EM equities are sensitive to global growth. Today, they are giving out a mixed and contradictory message on the prospects and trajectory of global growth.
Another similar divergence is that the relative performance of United States global cyclical stocks relative to defensives has peaked in the past few weeks (according to BCA Research). This relative performance between cyclicals and defensives also correlates well with EM equities over time and is based on the same notion - that both the measures track, and are sensitive to, changes in global growth.
There has also been a growing divergence between share prices and corporate profits globally. Since January 2012, global stock prices (ex United States) are up about 30 per cent, while the earnings per share (EPS) of these markets is down by about three per cent. For the EM universe specifically, EM equities are up by 15 per cent, while the EPS is down by nine per cent (again, according to BCA Research). Thus, the entire rally in the EMs over the past two years has been on the back of multiple expansion, not strong EPS growth. One is supposed to come to the EMs for strong earnings and economic growth, not as a play on multiple expansion.
All the divergences noted above have never lasted beyond a point. It seems that various parts of the market have different views on the outlook and sustainability of global growth and corporate profitability. While one can never be sure which way these divergences will correct, it is a potential warning signal for EM equities. The bears will argue that the recent market moves are more momentum-driven and emblematic of chasing performance, rather than based on solid fundamentals. If the market signals given by commodities and global cyclicals are correct, the fundamentals for EM equities may actually be deteriorating.
This has obvious implications for India. If the sentiment towards EM equities were to worsen, India is now a market that is quite well-owned among the EM funds. It is unlikely that we will be able to just sail through an EM pullback. Strong equity markets are critical to the India revival story; we need them for both balance-sheet repair (for corporate India)and to help the fiscal deficit (divestment in public-sector undertakings, or PSUs). The quantum of equity paper coming out of India over the coming few months will be massive, and in the tens of billions of dollars. To get this fully subscribed, we need sentiment to hold.
Another related issue facing India is its relative attractiveness within the EM universe. Till a few months ago, India was clearly looking like the best bet in a mediocre neighbourhood. China was perceived to be a basket case that would go through its own Minsky moment. Korea and Taiwan were cheap, but also leveraged bets on the United States' consumer and the electronics cycle. South Africa had serious macro-economic woes - and the less said about Brazil the better. Thailand seemed embroiled in never-ending political chaos. Even Indonesia, a former top performer, had people worried as elections loomed and the economy began to stall. Among this lot India looked OK; only Mexico seemed to attract more interest and excitement.
Today, however, things look very different. Most investors seem to feel that China has stabilised, and the dire predictions of economic collapse are dismissed by most. The markets there have basically been flat for 14 years now; so they look cheap on many parameters, and are attracting interest again. Xi Jinping is seen as a very strong leader, who has an economic reform agenda, and the resources and determination to see through his programme of economic restructuring. No one still thinks that Chinese growth will fall below six per cent, or that there will be a systemic crisis in their banking system.
Korea has had some taxation changes that reduce incentives for squatting on cash by the large chaebol companies. Korea has always been a value trap, screening cheap - but because of poor corporate governance and the tendency of their large companies to be in perpetual asset-building mode, it has never got the valuation multiple. If these new laws provide incentives for Korea Inc to become more shareholder-friendly and a better allocator of capital, then we could quite easily have a significant re-rating of their equity markets.
In Indonesia, Joko Widodo has won the elections, is more pro-business than his predecessor, and is the man the markets wanted as the new president. Thailand has a new leader, and in meetings with foreign investors he has impressed everyone. There is a clear focus to revive the economy and invest in infrastructure. This market is already back in favour.
Brazil has the potential to see some political change as well. It's still early - and most likely nothing will change in the country, but we do have elections coming.
The simple point is that India is no longer the only story in town. Yes, the victory of Narendra Modi has been received with great enthusiasm by global investors. Many people feel this could mark a turning point in India's economic fortunes. The markets and investors seem to be willing to give the new government the benefit of the doubt, and be patient. However, unless we start seeing a clearer economic vision from the new government, people may lose patience. There seems to be a surprising hesitation in the government to tackle any economic issue - no matter how important - if politically controversial. The government seems singularly focused on unclogging the pipe and tightening administration, while consigning policy to the back-burner.
Unclogging is badly needed, and will work for some time as we pick the low hanging fruit; but eventually, we will need to bring more economic talent into the government and focus on the harder, politically sensitive stuff. We need to keep investors interested in the India story and excited about our long-term growth and development - too much depends on it. We are no longer the only game in town. Other countries are also upping their game. Investors have a choice of which country they want to back for the long term.
The writer is at Amansa Capital