The week ahead will give us some inkling of FII (foreign institutional investor) allocation patterns during 2014. Apart from being the beginning of a new financial year for FIIs, it will also mark the first tangible effects of the US tapering. The US Federal Reserve will be cutting the pace of quantitative expansion by $10 billion a month. In which markets will FIIs make adjustments to their allocations?
The consensus is that the "tapered" $10 billion will be pulled out of erstwhile emerging market allocations. If true, this would affect inflows to India, Brazil, South Africa, etc. The other effect we would expect to see is a hardening of the dollar because American government bond yields should rise. In fact, the 10-year US bond has already seen rising yields, in anticipation.
Lower allocations and a stronger dollar should be trends that traders can exploit. The possibility of going long on the dollar in the dollar-rupee futures market always exists. Another possibility is to go long in information technology (IT), pharmaceuticals and other export-oriented businesses that could gain on a stronger dollar. A third possibility is to selectively short counters where FIIs are overweight, which could see some trend of disinvestment. Each strategy has pros and cons.
IT is a "go-to" sector for investors looking for a counter-cyclical defensive against rupee depreciation. It should do well, especially as the US economy is looking up and most of India's IT service majors are heavily dependent on the US market. The IT index gave excellent returns through 2013. The issue here is that there is extremely high institutional ownership, including FII ownership. So if there's a generic cutback on India allocations, IT holdings could get pruned, leading to a price correction.
Pharma is a more dicey counter-cyclical. It's a very high-valued industry, with private equity discounts at twice the market average. Quite a few of the Indian pharma majors are also exposed to regulatory action. For one thing, the US Food and Drug Administration has started checking out quality standards at various exporters. In addition, drug pricing controls in India could be widened in scope. Plus, there are always patent-related disputes and lawsuits in the picture where this industry is concerned. There could be good pickings in the pharma sector but it could also be a very volatile ride.
The third set - potential shorts where the FIIs cut holdings - are extremely difficult to assess. Given Indian conditions, only the futures of stocks listed in the derivatives segment can be shorted with any degree of ease. Since these are derivatives, leverage enters the picture again. Stock futures have less extreme leverages than currencies but it is still significant at about 7:1 or more.
Also, shorting involves the usual problems with timebound instruments. If you think a stock is going to gain in price, you can buy and hold with some sort of loss limit. It doesn't matter if it takes several months or even years to start generating positive returns so long as the stop loss isn't hit. But a short position has to work within the relevant derivatives settlement. Else, there are painful decisions involving carry-overs.
None of these might develop if the FIIs decide to continue buying Indian equities and make their cutbacks elsewhere. If that does start happening, the first inkling will probably be a change in dollar rates. Watch for that signal and then make decisions according to your risk appetite and comfort with trading specific contracts.
The consensus is that the "tapered" $10 billion will be pulled out of erstwhile emerging market allocations. If true, this would affect inflows to India, Brazil, South Africa, etc. The other effect we would expect to see is a hardening of the dollar because American government bond yields should rise. In fact, the 10-year US bond has already seen rising yields, in anticipation.
Lower allocations and a stronger dollar should be trends that traders can exploit. The possibility of going long on the dollar in the dollar-rupee futures market always exists. Another possibility is to go long in information technology (IT), pharmaceuticals and other export-oriented businesses that could gain on a stronger dollar. A third possibility is to selectively short counters where FIIs are overweight, which could see some trend of disinvestment. Each strategy has pros and cons.
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The currency position implies exploiting a snapback since the rupee is trading quite high at the moment, with the dollar below 62. But traders dabbling in the dollar-rupee futures market, or more generally in all currencies, must always bear leverage in mind. Leverage in very high and a very small movement can lead to massive gains or losses. In addition, the Reserve Bank of India (RBI) and other central banks have a habit of interfering whenever there are useful trends building up. So, you always have to watch for a sudden reversal of trend, triggered by central bank action. Other issues can arise due to sudden increases in margins, etc. Leaving overnight positions open to exploit currency trends can mean waking up to terrifyingly large losses.
IT is a "go-to" sector for investors looking for a counter-cyclical defensive against rupee depreciation. It should do well, especially as the US economy is looking up and most of India's IT service majors are heavily dependent on the US market. The IT index gave excellent returns through 2013. The issue here is that there is extremely high institutional ownership, including FII ownership. So if there's a generic cutback on India allocations, IT holdings could get pruned, leading to a price correction.
Pharma is a more dicey counter-cyclical. It's a very high-valued industry, with private equity discounts at twice the market average. Quite a few of the Indian pharma majors are also exposed to regulatory action. For one thing, the US Food and Drug Administration has started checking out quality standards at various exporters. In addition, drug pricing controls in India could be widened in scope. Plus, there are always patent-related disputes and lawsuits in the picture where this industry is concerned. There could be good pickings in the pharma sector but it could also be a very volatile ride.
The third set - potential shorts where the FIIs cut holdings - are extremely difficult to assess. Given Indian conditions, only the futures of stocks listed in the derivatives segment can be shorted with any degree of ease. Since these are derivatives, leverage enters the picture again. Stock futures have less extreme leverages than currencies but it is still significant at about 7:1 or more.
Also, shorting involves the usual problems with timebound instruments. If you think a stock is going to gain in price, you can buy and hold with some sort of loss limit. It doesn't matter if it takes several months or even years to start generating positive returns so long as the stop loss isn't hit. But a short position has to work within the relevant derivatives settlement. Else, there are painful decisions involving carry-overs.
None of these might develop if the FIIs decide to continue buying Indian equities and make their cutbacks elsewhere. If that does start happening, the first inkling will probably be a change in dollar rates. Watch for that signal and then make decisions according to your risk appetite and comfort with trading specific contracts.