Icarus hits an air pocket
So far, seen against the backdrop of the spectacular show last year, what’s happened in the markets is hardly a fall, not even a stumble—it’s at best a wobble. Indian and global markets are joined at the hip and the current bout of nerves is global. Local mishaps, such as the imposition of the long-term capital gains tax and higher bond yields, will lead to a lower premium over its peers for the Indian equity market, but apart from that it will move in tandem with global markets.
The argument for staying invested in the market usually goes like this: growth is coming back, both for the global economy and for India, earnings are doing well, so this is just a blip, a healthy correction, the pause that refreshes.
Yes, growth is getting better. The latest global composite Purchasing Managers’ Index, a gauge of economic activity in the world, was at a 40-month high in January. Both the International Monetary Fund (IMF) and the World Bank have forecast stronger growth this year for the world economy and for India.
The question though, is the price of that growth. During the 2003-08 bull run in the Indian stock market, the one-year forward price earnings multiple of the MSCI India index moved up to 17 only at the end of 2007, when the euphoria was at its peak. In May last year, it was already above 17, moving up to 18 by December.
This story is all about valuations. Ever since the financial crisis, central banks in the advanced economies have driven down interest rates to rock bottom and indeed into negative territory, while pumping out billions of dollars through quantitative easing. Higher asset prices were an explicit objective of central banks, which through the wealth effect was supposed to trickle down to economic growth. The policy worked as expected, driving up asset prices and expanding price earnings multiples across the world. The ratio of global stock market capitalization to GDP, as measured by the St Louis Federal Reserve, had by 2015 already crossed its 2007 peak.
There’s also a need for caution about growth. The IMF forecasts 3.9% growth for the world economy this year. But remember that global growth was 4.3% in 2003, 5.4% in 2004, 4.9% in 2005 and 5.5% in 2006. With interest rates so low and a tsunami of liquidity, is this all the growth we can get? Growth in global trade, crucial for emerging markets, was much stronger during 2003-07. And yet equity valuations were lower at the time. We are paying through our noses for second-rate growth.
That’s because global interest rates are much lower now. For example, the US 10-year government bond yield was higher than 4% for much of 2004 and 2005. Right now, analysts are saying 3% is cause for worry. With the cost of borrowing so cheap, the temptation to take a punt is strong.
One reason for low interest rates is low inflation. Even so, real interest rates in the US and other advanced economies are also very low. The yield on the 10-year inflation-indexed security in the US, a gauge of real yields, was around 2% in 2004 and 2005—currently it’s 0.7%. And because interest rates are so low, equity valuations are extended. Even the ultra-conservative Bank for International Settlements, discussing high equity valuations in its December 2017 Quarterly Review, said that while valuations were high, they ‘looked far less frothy when compared with bond yields.’
The spoiler, of course, could be higher inflation and the January survey of global fund managers by Bank of America-Merrill Lynch pointed to ‘inflation and bond crash’ as the top tail risk for markets this year. Concerns over higher bond yields have sparked the latest equity sell-off. Inflation in the developed markets is projected to go up a bit this year, but it’s unlikely to be a game changer.
There is another factor we have to consider. With so much money in equity funds and exchange traded funds and with the rise of program trading, much depends on how fund flows into equities are affected. If the market continues to drop, redemptions may accelerate. How fund flows pan out will then determine the level at which the market stabilises. That is true both globally and for India, where domestic flows have been very strong in the past year.
Much also depends on the central banks in the developed economies and the pace at which they tighten. It is the belief that they will do nothing to spoil the liquidity-fuelled party that ignited the exuberance in the stock markets. So far, developed country central bankers have rushed to soothe the market if it so much as stubbed its toe. But the choice they face is stark: let some air out of the bubble now, or allow it to expand and face a spectacular bust later.
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