Markets are going through a dangerous and choppy phase. If economic growth is strong and confidence comes back, pressure will continue to build on governments and central banks to roll back quantitative easing and other emergency fiscal and monetary measures. The political mood seems to have changed in most OECD (Organisation for Economic Cooperation and Development) capitals, and it would be very difficult for any government to justify new stimulus measures in today’s environment. Public pressure to reduce government budget deficits and minimise public debt burdens is growing across the developed world.
Thus economic policy-makers are caught in a dilemma: how and when to exit these emergency measures? If they exit too soon, we run the risk of relapsing into weak economic performance and deflation (the dreaded W). In fact, in recent days, the CEOs of both HSBC and GE International have warned of the risks of an economic double dip and premature exit from the monetary and fiscal stimuli currently in place. If policy-makers delay the normalisation of policies, then we run the risk of higher inflation expectations getting embedded or the surplus liquidity creating fresh distortions in asset markets. Central bankers are rightly concerned with sowing the seeds of the next asset market bubble/bust in today’s hyper-stimulative policy framework. A laissez-faire approach to asset bubbles is no longer accepted in central bank circles. Nobody wants to clean up another mess.
Even markets are caught in a Catch-22 situation. If economic growth does bounce back with a vengeance, as some of the bulls think, it will force the hands of policy-makers to quickly pull back the emergency measures, which will ultimately be a strong negative for equity returns. It is unlikely that equity markets can continue their manic rise in the face of tightening liquidity conditions. Markets will probably do better if growth is slow enough to not force tightening. Yet, given the market reaction to the recent weak economic data, equities do not seem to be able to digest sub-par economic numbers, implying that an element of growth is already priced in. Markets seem to need incoming data to continue surprising positively to sustain the uptrend.
Equities are only cheap if you believe in a strong earnings recovery. However, to get a strong earnings recovery, you need robust economic growth. As it is unlikely that corporate houses can do much more cost cutting, we now need top line growth. If we get a robust economic recovery (as earnings estimates imply), policy-makers will reverse the emergency fiscal and monetary measures, which will tend to be a drag on price-to-earnings (PE) multiples.
Thus, unless we get a perfect “Goldilocks scenario”, where growth is strong enough to deliver earnings, but slow enough to not force policy-makers’ hands, equities are going to have a choppy few months as the countervailing forces of economic acceleration and liquidity withdrawal fight each other. It is not clear who will triumph.
Even in the Indian context, we need to worry about RBI beginning a new tightening cycle and rising interest rates. This tightening cycle will be a negative as RBI is not raising rates because the economy is overheating. The central bank is doing so because of inflation concerns in the face of spiking agricultural prices. G-sec yields are rising, hence, ultimately, interest rates will rise system-wide because of a huge government borrowing programme. In fact, bankers talk of a lack of credit demand from good quality borrowers. If interest rates were rising because of strong economic growth and an overheating economy, very strong corporate earnings would have compensated for the impact of rising rates on valuation multiples. However, rising rates will only damage multiples now, with no earnings offset. A strengthening rupee will further tighten financial conditions and damage profitability.
We are also yet to see any credible plan from the government to put the fiscal in order. We all seem to be betting on growth to bail out government finances. Unless we find a path to bring the fiscal under control, at the first signs of strong credit demand from corporate India, rates will spike further and we will be hugely dependent on global capital flows to sustain growth.
Having said all of the above, and while I do feel equities may be in a bit of a funk till some of these issues get sorted out, there is no denying that the picture is good in the longer term.
The reality is that most funds we speak to have not received much inflows this year. This applies to both India funds as well as pan-Asian vehicles. A lot of the flows have been either global macro guys allocating to India through ETFs, or regional and GEM funds raising their India weightage. However, everyone is talking about increased client interest, client visits etc. There does exist the possibility that we may see a surge of inflows into these funds towards the end of the year as investors position for 2010.
One can see increased research and press reports on this theme of the economic centre of gravity of the world shifting east. Not a day passes by when one does not see a research piece on this topic. The year 2010 will see China becoming the second-largest country in the world, the G-20 gaining importance, the shifting of voting power in the IMF/World Bank etc—all these are points reinforcing this theme. The perceived imminent collapse of the dollar also plays into this theme. Economic decoupling is back on the agenda, and the stark differences in the relative health of financial systems and growth outlook are apparent.
Many smart commentators feel that this whole cycle will ultimately end with a bubble in the emerging market asset class. This bubble will be led by large emerging markets like China, India and Brazil. Even today, according to most surveys and anecdotal evidence, a vast majority of the real-money, long-term investors are not positioned adequately in these large markets. They need to raise their weighting and move out of dollar-based assets.
Thus, while we may have a bit of a hiccup, if we can hold on and live through some short-term volatility and price declines, gains are likely. A correction is quite a possibility, which may even be severe but nothing like 2008.
