June has been an anxious month for investors, with a series of global scares. The first one was the rise in US bond yields, which upset markets briefly in the early part of the month. That particular worry proved to be short-lived, but its demise was hastened by the next bout of risk aversion: fears of a meltdown in the US sub-prime mortgage market. That led to investors fleeing to the comparative safety of US bonds, sending yields down.
This is not the first time that investors have been biting their nails over US sub-prime mortgages—the market pullback in February/March, although attributed to a fall in Shanghai, was actually triggered by sub-prime woes. Recall that it was in early February that HSBC announced that its bad debts on account of these loans had totalled $10.5 billion (about Rs43,050 crore).
This time, though, there’s a twist in the tale, the extra excitement being provided by those dark lords that stalk the financial universe—the hedge funds. Two of US money manager Bear Stearns’ hedge funds are in trouble. That in itself is no big deal, because the mortality rate among hedge funds is very high. Also, when hedge fund Amaranth Advisors with $9 billion in assets went under last September, it caused hardly a ripple.
What’s different now is that Merrill Lynch, one of the creditors to the troubled hedge funds, is threatening to auction off some of their assets in the open market. That will mean these assets, which were so far being valued at their “model” prices, which is basically whatever fancy price their sellers were able to get away with, will now be marked to market. And since sub-prime mortgages, like other mortgages, have been cut up, re-packaged and sold to investors as “collateralised debt obligations” (CDOs), they are now dispersed across the investing community.
In fact, since sub-prime mortgages carry a higher rate of interest than normal mortgages, they have been especially attractive to investors hungry for yield. All of them will see the value of their holdings collapse if the CDOs are marked to market. That could lead to margin calls and a wave of selling as investors dump assets across markets to repair their balance sheets. And, the biggest worry of all, it could lead to a sudden withdrawal of liquidity, the fuel that has sustained the current boom. In fact, the increase in risk aversion in other markets is already evident from Arcleor Mittal’s postponement of a bond issue.
Thankfully, though, unlike in February/March, when the yen rallied to 115 to the dollar, this time the carry trade is alive and well. Although the yen did wobble a bit after comments from the Japanese finance minister, it’s still trading close to a four and a half year high against the dollar. And since Japan has been the fountain of liquidity to the world markets, investors would do well not to worry till the yen starts to appreciate. That’s the message that the 7% rise in the MSCI World index in June (as on 28 June) is giving us.
Back home, however, the market hasn’t been going anywhere. The MSCI index for India is down 0.9% this month compared to a 5.7% rise for the Emerging Markets Asia index, although the huge capital issues are one reason for that. On the other hand, it has beaten the Asia index over the last three months. The implication seems to be that India is a high-beta market that does better than the average in good times and worse during the bad.
But, if the Indian market suffers disproportionately from short-term global scares, it has also been, during the current boom, one of the best performers. A look at the MSCI indices over the years shows, however, that the Indian market has consistently outperformed the MSCI EM Asia indices, which, as a recent Mint analysis showed, is largely the result of PE expansion during the latest boom. This re-rating of the Indian market is not surprising, given the IT boom, the growing strength of Indian manufacturing, lower interest rates, the consumption boom, the increase in investment and the advances in operating efficiencies in India Inc. Investors have made good money by taking advantage of short-term weakness to buy into the long-term story.
Credit Lyonnais Securities Asia chief economist Jim Walker is one of those who believes firmly in that structural story. In a report titled Boomophobia, Walker says that most of Asia is yet to recover from the psychological scars of the Asian crisis of ten years ago. This psychology is best described, writes Walker, as “a fear of participating in the good times”. That’s what’s preventing most Asians from taking on more debt, as a result of which their debt to GDP percentage is still well below pre-crisis levels.
India, on the other hand, has no such hang-ups, maybe because we weren’t directly affected by the Asian crisis. India, says Walker, “is the standout investment opportunity in Asia”. He believes that “the underlying demographic structure of the Indian economy is similar to the US in the early 1970s, it is fully supportive of expanding PE multiples and optimism towards stocks in general. Long-term factors such as demographics and the property market along with cyclical positives such as falling unemployment, rising wages, a positive credit cycle and strong stock market participation all support a bullish view of the Indian market.”
Well, perhaps stock market participation is not that widespread, but then that only adds to the long-term potential of this market.
Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at firstname.lastname@example.org.