Surjit S Bhalla: Round up (unusual) numbers

JADU ECONOMICS

As markets stall due to psychology, a rethink on a revaluation of the Chinese renminbi is warranted.

Global equity markets have been flying high since the beginning of the year. Locally, experts, brokerages, and investment houses have all been forecasting equity levels well beyond 7,000 for the Sensex.

The index came within kissing distance of the magic number on two separate occasions last week; the surpassing of this number was to herald a new leg, with 7,000 as the base.

The UPA government was licking its self-inflicted wounds after Goa, Bihar, and Jharkhand, but it was taking somewhat unseemly, and a wee bit arrogant, pleasure in the Sensex going up.

Some of the policy makers felt that the market advance was a vindication of the goodness of the Budget, even perhaps that the financial markets welcomed the "innovative" and deplorable taxes like the transactions or the fringe benefit tax.

Something else also happened as global markets ratcheted up. They encountered a round number barrier.

While a complete analysis is under way, I cannot recall a single other instance when so many markets were so close to so many "primary" (in market jargon) psychological numbers.

The Dow within kissing distance of 11,000; the Sensex within spitting distance of 7 000; the Footsie at 5,000; Brazil at 30 000; Korea at 1,000; the Nikkei at 12,000.

And there are several more.

So many markets, so close to levels that deserve a salute. And markets have respected these "psychological" barriers. All of them have retreated at least a few percentage points from this level; several of the declines are around 5 per cent, with Brazil down 12 per cent and Turkey down 14 per cent.

The relevant question is: is the salute over, and will markets march back upwards?

A tough call, but first a small comment on why the round number theory works. (There is even an academic paper on this subject, published sometime in the mid-nineties!) It works because of psychology: markets are ruled by fundamentals""and sentiment!

What a round number does is concentrate attention, and forces market participants to re-evaluate. It often is a target in the first place (as 7,000 undoubtedly was) and as the goal is reached, there is satisfaction, profits, and an attempt to redo the fundamentals.

Often, the convenient, lazy, and sometimes accurate way is to raise the bar""witness how investment houses have raised the Sensex target to 7,500 and beyond.

The reason why the future is not necessarily a one-way street has to do not so much with technicals, as with fundamentals.

A major reason for the surge in global markets last year, and in the first few months of this year, was because of what happened to economic growth.

Around May, the first official IMF estimates of world growth will appear. What they are likely to show is that last year (2004) was the best year for world growth since 1984""upwards of 4 per cent.

Not since the early seventies has world growth been above 4 per cent per annum for two consecutive years. This large acceleration (remember, this is an acceleration of world output) has occurred from a high base of 3.2 per cent in 2003.

Most likely, markets, as is the wont of markets, have extrapolated world growth to be at least as high in 2005 as 2004. With this extrapolation of growth has come the forecast of earnings, and with that has come the bidding up of stock prices.

But there is reason to believe that the global party may be in for some (oil) slips. Prior to November, several analysts (including myself) felt that there was a 10 to 20 per cent political premium in the price of oil.

The elections (both US and Iraq) have come and gone, and oil has hit new highs. Sixty dollars for a barrel beckons, and we are perilously close to (another) round number.

So don't be surprised if the price of oil soon stalls, and even declines. Nevertheless, this sustained increase in the price of oil will slow down world growth.

Another growth dampener is the cyclical increase in real interest rates""already up by about 100""150 basis points.

Thus, it is likely that this year will be the "year of the breather". Globalisation and worldwide competitive pressures ensure that the growth cycle is much less of a cycle today than in past years.

The swings are moderated, and with that the cycle. But markets often march to the beat of a momentum drummer. They have anticipated too high a growth this year, and will possibly make a low when they anticipate too low a growth.

So what is the trade? First, a side conclusion. The Budget in India was an India-specific event, and the Sensex breathed accordingly. The reason for the market going up after the Budget had little to do with the "goodness" of the Budget (indeed, for the companies, and their bottom line, the Budget was a huge negative) and more to do with international euphoria.

Equivalently, the market going down has little to do with the Budget, though the downside will be exaggerated if the finance minister persists with the (loony) fringe benefits tax.

As world markets consolidate, the marginal investors are likely to throw in the towel. This will have a dampening effect in individual markets, and jointly, in world markets.

A longish period of consolidation should dampen irrational euphoria that is pervasive, not just in India but, as shown in the table, in most markets worldwide.

So consolidation, with some chance of a downward spike. What about an upward spike? Possible, but less likely.

A different outcome is also possible""that is what makes markets markets. There is no inherent reason why world growth cannot be above 4 per cent this year.

However, for this to happen, there will have to be growth drivers to counter the effects of an increased real price of oil and commodities and higher real rates. One such driver is a non-marginal revaluation (say, 10 to 20 per cent spreadout over a year) of the Chinese currency.

If China were to stop its "make thy neighbour a beggar" exchange rate policy, then growth around the world (including all importantly in the developed countries) would be more stable, and somewhat higher.

If not, then dampening world growth in 2005 should bring the focus back to China and its mercantilist exchange rate policy. As Europe goes further into the doldrums, and Japan parallels Europe, a justifiable demand for a realignment of Asian currencies (read China) will reoccur.

The arrogance of China should diminish as it realises that it too is dependent on the world. If it does not, then the markets will bid up the dollar, and with it, the Chinese exchange rate.

And then the second leg of expansionary world growth will start, and perhaps the 4 per cent target will be hit in 2006.

So the major trade is a revaluation of the renminbi. This is likely a necessary condition for an acceleration in world growth, and world equity markets.

Besides a collapse in the price of oil (unlikely), this revaluation (also unlikely) is the only possibility for equity markets to gather steam and not only make new highs, but also to end up there.

ssbhalla@gmail.com