The not-so-almighty dollar
There is, as the chart shows, a close correlation between the rise of the Sensex and the fall of the dollar. A weak dollar results in non-dollar assets, including emerging market equities, becoming more attractive for US investors. Analysts claim that we now have a dollar-funded carry trade, which means investors borrow very cheaply in dollars and park the money in high-yielding non-dollar assets, getting an extra bang for their buck as the dollar depreciates. The problem, though, is that if the US growth is surprisingly strong, the dollar may appreciate.
Stephen Jen, earlier of Morgan Stanley and currently with BlueGold Capital Management Llp in London, is credited with the theory of the “dollar smile”. Just as a smile curves upwards at both ends, so does the dollar strengthen during times of rising risk (as in the flight to the dollar after the Lehman Brothers Holdings Inc. bankruptcy) as trades get unwound.
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The dollar then trudges along the bottom of the smile, as the US economy muddles through its mess, only to trend higher as the economy strengthens. Much depends, therefore, on how strong the US economy can become. Till then, the theme of a weak dollar and flows to non-dollar assets should continue, punctuated with bouts of profit-taking as the dollar gets oversold. A stronger rupee, predicted by almost every economist, will be negative for exporters, including the information technology sector.
Compared with the markets of the developed world, emerging markets have fared far better in 2009. Partly, this is because they had fallen harder, so the rebound has been faster; partly because banks in emerging markets have been largely unaffected by the crisis; partly also because economic growth has been much stronger. The combination of low growth in the developed world coupled with ultra-loose monetary policy results in excess liquidity flowing out of developed markets to the high-growth emerging markets.
So far, the recovery in India has been V-shaped, but a period of consolidation is likely in the near future. Also, if growth revives in the developed world, that might lead to more money flowing to Western markets and less to emerging markets, which have become pricey. There’s a lot of pent-up demand in the US, which could be unleashed if the job market improves.
Illustration: Shyamal Banerjee / Mint
The International Monetary Fund, however, forecasts a very lukewarm recovery in the Group of Seven economies and a rebound in the emerging world. As long as the two-speed global economy continues, the theme of two-speed markets should persist. But Indian markets must then beware of the formation of bubbles, all quivering and primed to burst.
A key risks to the current optimism on Indian markets is that firms may fail to deliver on growth. As the chart shows, much is expected from Indian companies in 2010-11, with growth in earnings per share for the Sensex firms above 20%. The pace of earnings upgrades has decreased. Headwinds companies may have to battle include the withdrawal of excise cuts; a lack of support from government consumption, as the impact of the Sixth Pay Commission arrears peters out; higher interest rates; and higher commodity prices, leading to lower margins. Demand, especially rural demand, may also dip if high food prices persist. Valuations are stretched and markets priced to perfection; disappointments will lead to sell-offs.
A matter of interest
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The markets have risen on a tide of liquidity in 2009, a tide gushing out of the central banks of the world. As economies improve and capacity utilization edges up, central bankers and governments will now have to formulate an exit strategy that will withdraw the stimulus, at the same time making sure that their economies, like frail invalids, do not slip back into recession. This tightening of monetary policy will send a few tremors through markets, as investors worry about its impact on global liquidity.
One reason for the flow of funds into risky assets has been a flight out of money market funds in the US. That may change if interest rates rise in the US. So far, excess capacity has ensured that loose monetary policy and high fiscal deficits haven’t led to inflation. But in India, inflation will move up and the Reserve Bank of India will have no choice but to tighten. That will cramp the style of rate-sensitive sectors such as automobiles and real estate.
It’s important to remember, though, that if the tightening is slow, as happened in 2004-07, then the boom can continue, with just minor shudders along the way. Despite expectations of high inflation, if nominal bond yields are low, real interest rates will go up. Money will thus flow into equities, commodities and gold. And after the PE (private equity) expansion-led growth in 2009, nearly everybody is predicting a stock-picker’s market in 2010.
The golden lining
Perhaps the biggest theme of 2010 will be how the uncertainty trade plays off. The flight to the US dollar in 2008 was the result of unwinding positions worldwide, as investors sold assets and reduced their leverage. That kept a tight lid on gold prices, since gold is priced in dollars.
But as the dollar weakened and as investors began to worry about the impact of huge fiscal deficits and ultra-loose monetary policy, gold prices have soared. The move to diversify central bank reserves away from the dollar has also boosted gold prices. To be sure, speculative interest in gold is also at a high, so spasms of profit-taking are inevitable. Whether the US government will be able to instil confidence in the dollar will be crucial for the outlook for gold. Of course, gold will also be the big hedge against the fears of a double dip in the world economy, as the stimulus gets withdrawn.
Graphics by Ahmed Raza Khan / Mint