After going through a few harrowing days in the last week post the tragic earthquake in Japan, markets now seem to be convinced that all is fine. Immediately post the quake, markets seemed to wobble a bit, with the uncertainty around the impact on global supply chains as well as the concerns around the possible meltdown at the nuclear plant in Fukushima. Now, most market observers feel that the reactors are in control, the impact on global growth will be no more than 50 basis points and the supply chain disruptions are by and large manageable. So much so that markets in the developed world are back close to pre-quake levels, despite the possibility of new tail risks emerging in Libya, where we have the possibility of an extended conflict and no clear end game.
Global markets seem to be in a mood to keep rising, ignoring the continuing build up of concerns. We now have oil prices firmly ensconced at levels of $110, ongoing worries in the West Asia and North africa region, with Yemen and Bahrain in stress. The West seems to be getting entangled in a protracted conflict in Libya, from which there is no easy or clear exit. Portugal now looks likely to need a formal bailout, with fresh elections a strong possibility. Ireland remains a sovereign debt concern. The European Central Bank and Bank of England look likely to raise rates very soon, and the Federal reserve also will have to allow QE2 (quantitative easing) to wind down post June. Interest rates will soon start rising in Europe, and the Federal reserve will no longer buy treasuries. The impact of all this on markets and rates could be disruptive. The fiscal issues in both Europe and the US remain unanswered, with most long-term investors pessimistic due to the huge debt burdens and unsustainable fiscal arithmetic we see in these countries. Sometime soon, somebody will have to address these fiscal and debt issues and the actions needed to correct these problems will be painful and growth destructive. China and its attempt to soft land its economy, is another potential tail risk event.
Yet, despite all of the above baggage, markets refuse to give up, money continues to flow into developed market equities and momentum remains on the side of the bulls. Investors seem happy to play the accelerating growth profile of the US in 2011, and believe that earnings can continue to rise with expanding margins. The bulls point to current valuations being cheap, especially relative to interest rates, totally ignoring longer term valuation metrics like the cyclically adjusted private equity.
We will need a growth or inflation scare in the developed markets to shake the complacency markets are now in. The growth scare could come in the second half of the year, especially in the US, when some of the tax cuts and fiscal stimulus expire, and economists will have to pencil in slower growth in 2012. If growth were to slow next year, markets will wobble and fears of an extended period of sub par economic performance will reemerge. The winding down of the QE2 experiment, will also throw up some interesting challenges as to how do markets handle this transition? Will rates move up quickly? Who will be the buyer of treasuries to replace the Fed? Stopping further quantitative easing is one matter, but how will the Fed bring down its bloated balance sheet, and unwind its bond holdings? When will bond markets force action to tackle the fiscal mess, will international investors allow the dollar to go to zero? All these are questions, which will have to be addressed in the second half of 2011. While markets are complacent today, all these concerns are building.
Assuming for the moment that global markets hang in there for some time, before the inevitable day of reckoning, how will India fare? Surely, strong global markets and risk appetite will be good for India as well.
The problem to my mind is that the way markets are reacting, commodities and oil are leading financial markets on the way up. These asset classes seem to immediately catch a bid at the first sign of positive investor sentiment. India as we all know struggles in an environment of strong oil and commodity prices, with the fiscal, corporate earnings, inflation and current account all in stress. If one were to take current oil and commodity prices as a given, India would have to raise inflation estimates, earnings would have to be cut, interest rate will rise and valuations would not be in an attractive zone. India may go up, but will definitely lag other markets as it is difficult to see significant absolute upside. The equity market (EM) versus the debt market (DM) trade will also continue in such an environment. The reasons DM has been leading the way in 2011, viz. a narrowing economic growth gap with the EM economies, lower exposure to commodity and food inflation, less margin pressure on companies, etc will all be still operative.
India will actually do better (at least relatively) if global markets and risk appetite weaken. As one saw in the first couple of days post the quake, market weakness was led by oil and commodities and India did much better than its EM counterparts. Much of our underperformance was made up in a matter of a few days.
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Thus, if global markets continue to go up, India will underperform on the way up, and has limited upside on an absolute basis, as the surge in global commodity prices will cap our upside. If global markets weaken, led by falling commodity prices, India will do better, but only in a relative sense, falling by less. Until we get our inflation issues sorted out, or push ahead on governance and economic reform-related issues, the market is probably stuck in a broad trading zone. The only caveat to this is investor positioning. Most funds are underweight in India, trading volumes have collapsed and investor interest in the country limited. The pain trade would be if markets move up, and catch investors on the wrong foot. Markets consolidating around current levels still seems the most probable outcome.
The author is founder and CEO, Amansa Capital