It wasn’t so long ago that the talk was all about how insulated India was from a slowdown in the US.
The story was that while the rest of Asia is dependent on exports, our economy has the good fortune to be based on domestic demand, which would keep it relatively insulated from the storms raging elsewhere in the world. So ran the argument. Unfortunately, one by one, those fond illusions have all been demolished.
Look around the stock market today and we find that the stocks that are dependent on domestic demand have taken the biggest beating. Auto stocks were the first to fall, weighed down by rising interest rates. The logic at the time was that while higher interest rates would hurt consumption demand in the economy, investment demand would remain strong, because companies were all planning capacity expansion and the government was at long last taking the task of building infrastructure seriously. Capital expenditure was for the long term and would not be affected by a small rise in interest rates.
Yet, even companies dependent on investment demand have been hit hard, more so than auto stocks because they had been bid so high to begin with. The BSE Capital Goods index, a gauge of the health of investment demand in the economy, has lost much more than the Sensex this year. Power stocks, another play on investment growth, have also been massacred. The banking sector, which has always been a proxy for the domestic economy, is down in the dumps, with the BSE Bankex underperforming the Sensex. Instead, the stocks that have been the best performers this year have been IT stocks, which ironically have little to do with the domestic Indian economy and are instead dependent on the health of the beleaguered US economy.
Why has the sentiment changed so dramatically? First, although the Reserve Bank of India was trying to force the economy to cool down, the markets ignored it altogether and blithely went on breaking new records on the way up. Investors paid no attention to the signals the central bank was sending out that the cycle had topped. Signs of overheating were everywhere: in rising inflation, in the shortage of spare parts, in huge jumps in real estate prices, in ever-rising salaries. Yet, the markets were operating on the assumption that the “India story” had somehow overcome the business cycle and that the growth rates notched up at the peak of the cycle would be maintained for decades. That myth has now been busted.
Next, although it’s correct that India’s economy is driven by domestic demand, it is at the same time dependent to a large extent on foreign fund inflows to meet its trade deficit. True, foreign direct investment has been increasing in recent years and remittances, too, are a large source of funding. But, as the recent depreciation of the rupee has demonstrated, in the short run, portfolio flows and inflows from external commercial borrowings matter a lot.
And then, of course, there’s the price of oil and other commodities. When considering the weakness in the US economy, one assumption was the flood of liquidity released by the Federal Reserve would spill over into emerging markets. Instead, it weakened the dollar, which in turn sent the price of commodities soaring, playing havoc with the economies of the commodity-consuming emerging markets. Since many of these economies peg their currencies to the dollar, import prices have gone up considerably. That’s why it’s not just India that is facing a huge problem from rampant commodity-price inflation—all the countries in Asia face the same problem. The central banks of countries such as Indonesia, the Philippines, Vietnam and Pakistan have all hiked interest rates recently, in spite of slowing growth.
And finally, there’s the big question mark on valuations. The reason why IT stocks have done so well this year is because, apart from the rupee depreciation, these stocks were available cheaply, having missed out on last year’s big rallies. All they’re doing is playing catch-up. As for the FMCG and pharma sectors, these are classical defensive sectors, which work well during bear markets.
The problem is that despite the business cycle, stocks in India continue to be at a premium to the region. At the end of May, the S&P/Citigroup broad market index for India was valued at 18.3 times one-year forward earnings on the basis of IBES earnings estimates compared with 13.89 for all emerging markets. At the beginning of the year, the one-year forward P-E (price-earnings multiple) for the India index was 25.62 compared with 15.6 for all emerging markets. The premium has halved, but then the premium on Chinese stocks is down by two-thirds. The sell-off this week, however, should have further decreased the premium.
Simply put, the Indian economy and markets were big beneficiaries of a big rise in risk appetite during 2004-07. Currently, despite the Fed rate cuts, risk appetite is low, because the big banks that have been the source of leverage in the system are busy getting more capital to repair their balance sheets. They are unlikely to take on the same level of risks, as they used to, in a hurry, while more stringent regulatory oversight, which is inevitable, will also be a dampener.
Till risk appetite returns, the Indian market will have to cope with low inflows, rising inflation, rising interest rates, a slowing economy and looming elections. Moreover, with the fiscal situation rapidly getting out of hand, it is not certain that things will get better after the elections.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at firstname.lastname@example.org