Global rally

A deluge of liquidity has swamped our bourses, lifting the Sensex from 7,000 to 8,000 in record time.

Almost every impartial observer has called for caution, and there's no doubt that the market has moved up too far too fast. FII inflows have been more than $7.5 billion so far, and the pace has increased in the last three months.

The result has been a rise in valuations, to the point where the Indian market now looks expensive compared to its peers. The irony is that the re-rating of the Indian market has occurred against a background of higher oil prices, a slowing down in earnings growth, a rise in cost pressures, an upturn in interest rates, and a pause in the reforms process because of opposition from the Left.

Analysts have pointed out that there has been no material change in their earnings estimates in the last six months that would warrant such an influx of liquidity.

On the other hand, there is also no shortage of arguments advanced by more optimistic observers. They have pointed out, for example, that the reduction in interest rates to a much lower threshold calls for a re-rating of the market, that the India story has been recently discovered by foreign investors, that several investors, such as the Japanese and the pension funds, take a ten-year view on India, that the Indian market offers breadth, and that India today is where China was a decade ago, poised for take-off.

Moreover, the supply of fresh equity through new issues has been absent, which has played a role in boosting valuations. Yet another argument is that India is one of the fastest-growing economies, and its relatively high valuation is therefore justified.

However, perhaps looking at the Indian market in isolation would be the wrong approach. On the day when the Sensex crossed 8,000, the Korean market index too rose to an all-time high, while the South African market index touched a record high a day earlier. Stocks have been rallying from Japan to Mexico, buoyed by a flood of liquidity unleashed by cheap money.

To take another example, it's not only the Indian midcap index that has been growing by leaps and bounds""the FTSE midcap index too hit a record high recently. Risk appetite remains at very high levels, a trend best observed from the very low spreads on emerging market debt.

In short, it's not just the emerging equity markets that are booming""emerging market debt is equally buoyant, while commodity prices as well as gold are also doing well. So far, all the dire predictions of a drying up of liquidity due to higher Fed rates have proved to be false.

Other prophecies of doom and gloom, such as the risks to the world economy from imbalances due to the high US deficits, the long-awaited slowdown in the Chinese economy, the danger to the economy from the high oil prices, have all proved to be premature.

The key to the whole puzzle remains risk appetite. Should anything happen to diminish this appetite, the overflow of funds will dry up, and emerging markets will totter across the globe.

That trigger could be anything from high interest rates in the US to a collapse of the housing bubble. But the low yield on US long-term government bonds seems to indicate that the market is betting on rising asset prices.