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The shape of the current market recovery in India

The shape of the current market recovery in India
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First Published: Wed, Mar 31 2010. 12 15 AM IST

Updated: Wed, Mar 31 2010. 12 15 AM IST
Where are the markets a week after the hike in policy rates by the Reserve Bank of India (RBI)? The Bombay Stock Exchange’s (BSE) Sensex is above the level it was at before the policy announcement. Among the rate-sensitive sectors, the BSE Bankex is higher, the BSE Auto Index is around the same level as it was before the announcement and the BSE Realty Index has fallen a bit. In short, the impact has been positive. The movement in the 10-year government bond yield, too, has been positive.
But then this is only the first of a series of tightening measures, and interest rates are certain to head upwards. During the last business cycle, RBI started raising interest rates in October 2004, but by October next year, all it had done was raise the reverse repo rate from 4.75% to 5.25%, while the repo rate increased from 6% to 6.25%. These small steps had no effect on the equity markets and the Sensex saw a rise of 55% between October 2004 and October 2005. This time although policy rates are lower, other interest rates are starting from a more elevated level and inflation, too, is higher. Much depends, therefore, on how rapid is the pace of tightening by RBI. HSBC Holdings Plc economist Robert Prior-Wandesforde says that he expects policy rates to be tightened by another 175 basis points by mid-2011. (One basis point is one-hundredth of a percentage point.) If that happens, the pace of tightening will be much more rapid than during the last cycle. That will also start having an effect on growth, which is why Prior-Wandesforde believes that the gross domestic product growth rate for 2011-12 will be lower than that for 2010-11.
Given this scenario, how will the markets behave? A recent research note by Citigroup Inc. says that Asian markets move through the cycle in four phases. In the first phase of the recovery, the markets move up sharply higher from very low valuations. The second phase, however, is a steady grind higher, based on the recovery in corporate earnings. Price-earnings multiples are already high so the market has to depend on earnings growth to move higher. The third phase, says the report, is the “this time, it’s different” phase, when justifications for high valuations are trotted out and the market moves up sharply again. And the fourth phase is when the euphoria wanes and the market tumbles again. Let’s see whether the Indian market conformed to this model during the last cycle. Here are the returns for the Sensex during the boom phases of the last cycle: 2003—up 73%; 2004—up 12%; 2005—up 42%, 2006—up 46% and 2007—up 47%. It’s true that we saw phase I during 2003, followed by a period of very tepid returns during 2004, but after that we had three years of excellent returns. While the last cycle in the Indian markets may not have played out exactly according to the Citigroup script, the interesting part is the pause after the initial recovery, during which period the market slowly builds up the strength for the next leap forward. As the Citi report says, “Investors’ returns in Asia ex are both front-end and then back-end loaded. The middle part is pedestrian, harder work and less financially rewarding. Like it or not, this is effectively where we are in terms of Asian markets. The recovery was last year; we are now waiting for earnings to come through, monetary policy is in the process of tightening, and liquidity, previously the sole preserve of equity, must now be shared with the real economy. All this makes for more pedestrian returns.” We’re already seeing that this year, with the Sensex having gone up only marginally in the last six months.
Foreign institutional investor inflows, however, have resumed. The majority view seems to be that growth will remain tepid in the developed markets and central banks there are in no position to start raising interest rates rapidly. Worries such as those over Greece will also ensure that central banks remain accommodative. That combination will mean a lot of excess liquidity, which should continue to be available to drive up asset prices. The external liquidity environment, therefore, is likely to remain benign for some time. Domestic growth, too, should be strong in the immediate future, especially as capital expenditure gets under way.
Of course, no two cycles are the same. The last boom, in particular, is now widely seen as exceptional, because it was a bubble. But then this time, too, there are plenty of voices pointing out that we’re seeing a government finance bubble and others saying that China’s boom, too, is unsustainable. The jury is still out on whether the West will go through a Japan-style deflation or will get back to normal soon.
All that can be said at the moment is that growth is likely to be strong in the short term, despite rising interest rates. That should support earnings and the markets. As far as liquidity is concerned, Barclays Capital Inc. points to one interesting development. In its recent Emerging Markets Outlook, Barclays says, “We believe there has been a shift in investor type among offshore investors in EM (emerging markets). Before the crisis, hedge funds accounted for a higher proportion of the investor base. Position unwinding by these leveraged investors often ended up exacerbating temporary market sell-offs into bigger risk flares and increasing asset price volatility. However, we think the current investor base has a higher proportion of real money accounts, a trend that is bringing some stability to EM markets.”
Manas Chakravarty takes a weekly look at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com
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First Published: Wed, Mar 31 2010. 12 15 AM IST