Looking at India as a high-beta subset of global equity markets.
Single economies are complex enough. Globalisation multiplies the complexity. The world economy is so inter-connected, that Asian stocks may jump due to some favourable event in Europe or the United States.
Most businesses are affected by globalisation – often positively. While their own domestic markets may become more competitive, they also gain access to external markets and their own value chains can improve if they have new sources of manpower and materials. But even a business insulated from external factors will see its price influenced by external events.
There are some interesting long-term implications to globalisation. We know that stock prices rise in the very long-term. But there can be 5-10 year periods, when stocks yield negative or zero returns. The classic antidote for a long-term bear market is to diversify into overseas markets, which may be doing better. Given increasing correlation between global asset prices this doesn’t work that well anymore.
The global commodity markets and forex markets, which generate far more volumes than global equities, have been highly correlated for decades. Equity markets have also become more highly correlated. In time frames longer than a quarter, it’s difficult to find a market that is consistently counter-cyclical to the general global trend.
It may not be pleasant to think of the Indian stock market as a high-beta subset of the global equity market but that is what it is. If you are going to invest in Indian equity, you need to have an idea of where global markets are headed because your returns will be related to that trend.
Last year saw excellent stock market returns almost everywhere. The year before, it was big losses. In 2010, there's consensus about economic recovery. Global GDP is likely to jump by 3 per cent, maybe even 3.5 per cent, in calendar 2010, after dropping about 1 per cent in 2009. India and China are expected to log above 8 per cent in both cases with Indian and Chinese corporate earnings rising at over 25 per cent over the next 4 quarters.
Stock prices always lead the real economy and valuations can be affected by sudden bubbles and crashes. In 2009, stock prices rose because investors anticipated an economic recovery in 2010 – indeed the last quarter (Oct-Dec 2009) was positive in most places. Now that the economic recovery is nearing reality, will investors be focussed on 2011 performance?
Indian indices are at 23 price-to-earning (PE) in the last four quarters while the Chinese market is trading at 30PE. The current valuations are high. The slightest hiccup in economic recovery in any major economy could trigger a crash.
More than the US or Europe, where expectations are not that optimistic, the real danger is China. The People Republic of China (PRC) + Hong Kong is a much bigger economy than India with a major influence on global GDP. Indian equity is fully-valued but China appears very close to a bubble. It's not only equity – there has been a major run up in Chinese real estate values as well.
There has been much recent speculation about a Chinese bubble. What are the factors to watch out for and how could one hedge this situation? One key indicator would be commodity prices. Metal and energy prices in particular are driven by Chinese demand.
If there's a bubble deflation in China, global commodity prices will crash. An Indian investor may be able to hedge a Chinese bear market that triggers a global bear market by shorting commodity futures on Indian exchanges.
Another indicator is the Dollar-Yuan rate. This is fixed by the PRC at around Yuan 6.8 / dollar. It is deliberately under-valued to keep Chinese exports attractive. If China tightens domestic liquidity as it has started doing, it will almost certainly hike the rate. A weaker dollar versus Yuan could mean a weaker dollar against other free-floaters like Euro, Yen, and Sterling.
That should translate into a stronger rupee versus dollar. This is not certain since neither Yuan nor rupee, are free float. But it would make sense to be long rupee on the rupee-dollar future. A new set of cross-currency trading possibilities could also arise once the newly-permitted euro, yen and sterling contracts are available.
Given reasonable luck, a crash will not occur in China or anywhere else. If expectations are met there’s room for price appreciation. But if there’s a crash, short-and medium-term returns would involve selling action on the commodity and forex front.
