In yet another reminder of how dependent the Indian market is on foreign capital, Friday’s market crash owes its origin to—of all things—rising defaults in mortgages in the US.
Contagion from these products has spread, via securitization, new and complex derivatives, hedge funds and lax rating agencies to the US corporate bond market.
The consequence has been another bout of risk aversion, and spreads on emerging market bonds have widened to their highest since June last year.
The worry is that—since US banks now have to carry a lot of the contaminated loans on their own books, instead of selling it to gullible investors—they will no longer be able to fund the leveraged buyouts and the private equity (PE) deals that have boosted the US markets. The cost of capital will go up and hot money flows are likely to be hit.
That view seems corroborated by the rising yen, as the carry trade unwinds. Risk aversion has also hit US mutual funds, with outflows last Tuesday hitting $5.5 billion (Rs22,165 crore), according to TrimTabs Investment Research, the second biggest outflow this year.
All this will squeeze liquidity. The trouble is that Indian equities are not cheap, which is why they fall harder during a sell off, evident from the fact that the Sensex fell far more than other Asian markets on Friday. It’s also worth noting that a lot of inflows coming into India are PE inflows, and PE could be hit hard by the US credit crunch.
But while the markets have been dragged down by problems within the US financial sector, the outlook for growth continues to be rosy, with the International Monetary Fund (IMF) revising its global output target upwards for most regions, apart from the US.
Even within the US, unemployment is low and corporate earnings robust. The US current account deficit—the fountainhead of global liquidity—continues to be enormous and there’s little reason why the Japanese investor should remain happy with the paltry returns on his yen investments, which means that the carry trade should continue to thrive.
Back home, the investment-led boom is very much in place, with the IMF predicting 9% growth this year and 8.4% next year. Global non-fuel commodity prices are now predicted to rise 14.5% this year, higher by 10.3 percentage points than IMF’s April predictions. And, best of all, six-month Libor (London Interbank Offered Rate) on US dollars is supposed to be 5.3% this year, around the same level as it is currently.
In sum, while one source of liquidity has dried up, others remain firmly in place. And with the fundamentals so sound, the environment this time is very different from the late 1990s, when the long term capital management default shook global markets.
ITC: Surprises galore
ITC Ltd shares had underperformed the National Stock Exchange’s Nifty by over 25% between January and 24 July, on fears that higher taxes would stamp out a large chunk of the company’s cigarette sales. The company’s results have proved that those fears were exaggerated.
The cigarettes business grew by 21.2% after including the amount charged under newly introduced taxes such as value added tax (VAT) and central sales tax. Excluding them, revenues from the business grew 8.9%, primarily driven by pricing increases to adjust for higher excise duties.
Analysts say that volumes fell marginally, which is actually a positive surprise since the markets had factored in a huge fall in volumes owing to the recent price increases in the region of 20% to adjust for higher excise, VAT and other taxes. What was even more surprising is that profit from the business increased by 15% despite the fall in margins.
Competitor VST Industries Ltd’s decent results last week had alerted the markets that things may not be as bad as expected.
VST has reported a 6.5% growth in gross sales and a 25% jump in net profit. As a result, ITC shares started rising even before it announced results. After three straight days of gains, the stock is near Rs175 levels it started the year with. Also, the level of underperformance relative to the Nifty has halved to 12% (See chart).
The company’s non-cigarette business (34% of gross sales) didn’t perform as well. Although their revenues grew 24.7%, profit grew just 6.3%. But this was largely owing to one-off factors—the paperboards, paper and packaging business, for instance, was affected because of a planned shutdown of a machine. But thanks to the robust growth in the company’s core business, net profit grew by 20%, justifying the company’s current valuation of 20 times FY08 earnings.
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