Manas Chakravarty: And now, grey Tuesday?

What has changed in the year after Bloody Monday? Is there enough steam left in the forces that have kept the market up in the last 12 months?

The crash
Perhaps the first thing we need to grasp is that last year's May meltdown was a global phenomenon, the result of worries about the turn in the US Federal Reserve's monetary cycle, and the beginning of higher interest rates in the US.

If we set aside the events of May 17 as being a typical case of markets overshooting, caused by global fears on the one hand, and the vast amount of hot air unleashed by the domestic Left on the other, and consider the market movement in the month to May 26, 2004, a clear pattern emerges.

Between April 28, 2004 and May 26, 2004, the Sensex fell by 11 per cent, but the Indonesian market index fell by 12.2 per cent, while the Korean Kospi went down even more, by 13 per cent.

Emerging markets across the world tottered, and the MSCI Emerging Markets Free (MSCI EMF) index lost 8.7 per cent over the month. The panic had been fuelled by fears that a rise in US interest rates would lead to a re-enactment of 1994, when Fed rate hikes led to a cessation of fund flows to emerging markets, and markets dropped as a result.

What has changed?
Thankfully, nothing of the sort happened. Back to the present, and the MSCI EMF index was at 543.3 on May 11, a figure that is 27.5 per cent higher than on May 26, 2004. Over the same period, the Sensex rose 26.8 per cent, far lower than the gains made by some of the other markets, the prime example being Indonesia, which rose 47 per cent.

The boom in emerging market equities hasn't been matched by stocks in the developed countries. The MSCI World Index hasn't done too badly, rising 9.7 per cent between May 26 last year and May 11 this year. But the Dow Industrials haven't really gone anywhere. On the other hand, emerging market bonds too have done very well in the past year, and JP Morgan Chase's Emerging Market Bond Index Plus has risen by over 18 per cent in the last year.

The Economist commodity price index for metals is up 21.4 per cent in the past one year. The euro is at 0.77 to the dollar compared to 0.84 a year ago; the yen is at 104 to the dollar versus 113 one year back; and the rupee is Rs 43.5 to the dollar against Rs 45.4. The biggest change, of course, is in US short-term rates, with the US Fed Funds rate at 3 per cent compared to 1 per cent in May last year.

Liquidity
So why hasn't the rise in US interest rates led to a retrenchment from emerging markets? The answer probably lies in the behaviour of US long-term bond yields. Surprisingly, in spite of the rise in US short-term rates, the yield on the 10-year government bond in the US is around 4.2 per cent at present, compared to 4.79 per cent a year ago.

Nor is the drop in long yields confined to the US. In Britain, the 10-year bond yield is at 4.5 per cent, compared to 5.1 per cent a year ago, despite short-term rates having moved up. In Euroland, it's 3.3 per cent against 4.2 per cent a year ago.

Even more astonishing is the fact that inflation has been much higher, which should normally have raised long-term rates. Consumer price inflation was 3.1 per cent in March this year, compared to 1.7 per cent in March last year, and it is the same story in the UK, although inflation has remained at more or less the same level in the Euro area and in Japan.

Economists point out that when the yield curve becomes flat, that is, when the rise in long-term rates is not commensurate with the rise in short-term yields, that's a sure sign of a slowing economy.

The answer to this "conundrum" "" Alan Greenspan's description of long-term yields' stubborn refusal to rise ""probably lies in the growth of the money supply. Broad money growth in the US has remained the same in the last one year "" it was 4.9 per cent in March 2004, and was 4.9 per cent in March this year.

In the UK, broad money grew by 10.3 per cent year-on-year (y-o-y) last March, compared to 7.7 per cent in March 2004. In the Euro area, broad money rose at an annual rate of 6.5 per cent in March 2005, compared to 6.3 per cent in March 2004.

The other indicator of global liquidity is the rise in foreign exchange assets of Asian central banks. Chinese forex reserves, for instance, have grown from $ 439 billion in March 2004 to $ 659 billion in March this year "" a rise of $ 220 billion.

Japanese reserves have grown by around $ 30 billion in the past year, India's $ 22 billion, and Korea's $ 42 billion. Most of this money has been recycled into the US markets, raising the price of US securities and lowering yields.

The other part of the story has been slower global growth. GDP growth in all the major centres has slowed down. To illustrate, US GDP growth in the first quarter last year was 4.9 per cent, compared to 3.6 per cent in the first quarter in 2005. Growth in Japan, too, has slowed.

The implication is that while global money supply growth continues to be high, global growth has slowed, so more money can continue to be employed in speculation. The upshot "" continuing buoyancy in asset prices.

Going forward
But all this is history. Foreign institutional investors have been selling, the dollar has been rising and hedge funds have suffered losses. The big question is whether last year's trends will continue.

Since the biggest factor that has affected asset prices in the past few years has been global liquidity, it's reasonable to assume that going forward, too, asset prices will depend on trends in global liquidity.

The most recent trends seem to indicate that lower oil prices will cushion growth while also reining in inflationary pressures, which may lead to continuing flows to emerging markets.

As a matter of fact, a clear bottom seems to have formed in global stock markets around the end of April, and the markets have bounced back since then. That's true for the Sensex, the Dow, and many Asian and Latin American indices.

However, the liquidity cues are not so good. In the US, broad money growth is down to a y-o-y growth of 4.9 per cent in March, compared to 5.9 per cent in January. M3 growth has also slowed in Japan and the Euro area, although it has risen in the UK. At the same time, the accretion to forex reserves of the big Asian countries is slowing down "" although Chinese reserves rose by around $ 50 billion in the last quarter.

And finally, the latest US Treasury data show that Asian central banks, including the Chinese one, sold US securities in March. In other words, while a complete meltdown, as predicted by some notable bears, may be unlikely, there's hardly any doubt that global risks have risen, the "sweet spot" of low inflation and high growth is behind us, and liquidity flows show a declining trend.