More and more buyers are being found for the “emerging markets bubble” theory, thanks to the huge amounts of money pouring into them, sending their stock markets to record highs. The reasons for the move are entirely rational. As the Bank Credit Analyst, a well-known global independent research firm, puts it: “Global portfolio investment flows continue to move towards equities, commodities and currencies that are farthest from the US housing market, i.e. away from the epicentre of economic weakness.”
With the Damocles’ sword of a recession hanging over the US, why would an investor want to be exposed to that market? It’s a strong argument, made even stronger by the falling dollar. Since all other currencies are appreciating against the dollar, non-dollar assets and currencies deliver easy returns. While the Bombay Stock Exchange Sensex went up 25.3% this year to 2 October, the Dollex (the BSE index that tracks the performance of Sensex scrips in dollar terms) has gained 36.5% over the same period.
But if investors are fleeing US assets, how do we explain the Dow rising to new highs? Surely, if the US is facing a recession or, at least, an economic slowdown and if its banks continue to be exposed to the aftermath of the subprime meltdown, there’s little reason for investors to buy US equities. For an answer, it’s necessary to look a little more closely at the behaviour of the US market. Closer inspection shows that the stocks that are performing well in the US market are those which have an exposure to the global economy. While consumer discretionary and financials, the sectors that are a play on the domestic economy, are laggards, materials, industrials, energy and technology, all of which are dependent on global demand, are doing well. As a matter of fact, with a depreciating dollar, exports should do very well indeed, as will those companies with large overseas operations. US market experts are drawing attention to the fact that there are two markets in the US, with very divergent performances.
Given the increasing decoupling between the US and the global economy, it may be possible for a section of the US market to reach new highs while the economy slows down.
The mirror image of that trend is the turning away from tech stocks in the Indian market. These stocks are at least partially a play on the US economy and the strength of the dollar and investors in India are applying the same logic that’s causing US investors to flee US-centric stocks. Nor is this view limited to savvy investment banks and other institutional investors. A recent study by US fund tracker Lipper found that inflows into US domestic stock funds had fallen to levels not seen since 1994. On the other hand, Morgan Stanley recently raised a $1.5 billion (Rs5,925 crore) buyout fund for Asia, nearly treble the bank’s previous Asia fund raised two years ago. Inflows into emerging market funds, as EPFR Global points out, were at an 85-week high during the fourth week of September. As EPFR observed, “it was US, Japan and Europe equity funds that provided the cash which flowed back into emerging markets funds. Combined redemptions from these three fund groups totalled $13.04 billion for the week as dollar weakness and fears about the fallout from the turmoil in the US subprime loan market continued to weigh on sentiment.”
That’s not all. Some equity strategists that are long on Asian stocks are advising their clients to short US and European financial stocks as a hedge. The outperformance of one asset class would mean the underperformance of the other.
CLSA strategist Christopher Wood writes in a recent issue of his newsletter Greed & Fear that “it makes sense to remain structurally overweight Asia and global emerging markets— most particularly for genuine long-term investors such as pension funds. For a new round of Fed easing is akin to lighting a match to the Asian asset-reflation story”. All the signs also point to several rounds of Fed rate cuts, thanks to the deep-seated problems in the US housing sector. Wood points out that the strengthening of currencies such as the euro could persuade the European central bank too to start cutting rates, using continued weakness in the credit markets as an excuse. That would open the floodgates into Asia even further. At the same time, Wood is also concerned about the impact of a US slowdown on commodities. He doesn’t think that Chinese and Indian demand is enough to drive oil prices higher, for example. The current spike in commodity prices has more to do with a weaker dollar than with resurgent global demand. That’s the reason Wood would “rather continue to own interest-rate sensitives in Asia ex-Japan geared to domestic demand rather than commodity cyclicals”.
In the Indian market, it is sectors such as capital goods and banks geared to domestic investment demand that have been the leaders in this rally. Interest-rate sensitive stocks, which have lagged the market after rates started rising, have already moved up substantially from their lows. The bet that investors are making is that dollar inflows will be so strong that RBI will be forced to intervene in the forex markets to defend the rupee. That will unleash so much liquidity that, even if RBI does its best to mop up the liquidity, it may not be able to prevent interest rates from drifting down.
Globalization has led to dual markets everywhere—a set of stocks in every market tied to the domestic economy and another connected to the rest of the world. In the current rally, while those stocks that are connected to emerging markets will do well in the US market, stocks dependent on the domestic economy will outperform in the Indian 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.