The key question for the Indian stock market is: When will foreign funds return to our shores? At the moment, the mainstream view among fund managers in India seems to be that the economy will recover in the second half of the year and the markets should start discounting that.
That may be erring on the side of optimism. Ajay Rajadhyaksha, who is head of fixed income strategy at Barclays Bank in the US and therefore has a ringside view of the current crisis, doesn’t see risk appetite returning before next year. Recent signs of conditions easing in the US do not herald a recovery.
Rajadhyaksha points out that there are three negative feedback loops operating in the US at present. The first one is the impact of the financial crisis on the real economy, the deterioration in which, via bad loans, affects the financial system negatively and so on in a downward spiral. This is a cycle that has to be broken by repairing the banks on the one hand and providing a boost to the economy through government and central bank action on the other.
The second negative feedback loop lies in the mortgage market. For example, commercial mortgages are not being made by banks even to creditworthy customers because yields in the secondary CMBS (commercial mortgage-backed security) markets are as high as 15%. Secondary market yields are high because investors are not certain that the existing mortgage loans will be rolled over. The US government is trying to break this logjam through TALF, or the Term Asset-backed Securities Loan facility, under which term finance is made available for buying asset-backed securities on a non-recourse basis, which means that any losses on the deals will be made good. Finally, there’s the third negative feedback loop that is the result of inability of people to pay their mortgages, with resulting foreclosures and falling house prices, which in turn lead to more foreclosures and so on. The plan announced by US President Barack Obama on Wednesday is an attempt to fix this problem.
The good news is that all these negative feedback loops are being addressed. Rajadhyaksha estimates that housing prices in the US will stabilize in the third quarter of the current year and the US will lead the world out of the recession. But much depends on the speed and adequacy of the US government’s response.
Trouble is, the world after the recession will still be a very different place, with lower US consumption and higher savings. That means the export-oriented economies of Asia will find the going difficult unless they are able to stimulate their domestic consumption. Moreover, the global financial system is unlikely to go back to the levels of leverage seen before the crisis. That would mean lower fund flows to countries like India and depress risk appetite for several years.
Where does that leave equities? Rajadhyaksha believes fixed income rather than equities will do well for the next few quarters. That ties in with Citigroup’s observation that the trough-to-trough cycle for equities in Asia is eight years; since the last trough occurred in 2001, the next one is due this year.
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