BackWhy did the Sensex rise in the first place?
Accounting for the risks that have emerged, the surprise isn’t the Sensex’s fall but its preceeding rise
Premium(Hemant Mishra/Mint)
After the (fall in the markets on Friday, the benchmark Sensex is still above the lows it had touched in June this year. That goes for the lows it reached in April as well. Perhaps, instead of asking what caused the sell-off, the question we should be asking is: has there been an improvement in the economy or in corporate earnings that justified the bounce in the market from those lows?
The answer is a clear no. The purchasing managers’ indices show a sharp deterioration in June and July. Corporate earnings for the June quarter have been dismal and earnings estimates continue to be revised downwards. Barclays Research, in their note on Indian earnings dated 12 August, point out that consensus earnings estimates for the year to March 2014 have seen a downtick of 222 basis points since the beginning of the June quarter earnings season. One basis point is 0.01%. These data points indicate that far from a recovery, the economy may not have even have reached a bottom.
The plummeting rupee has forced the Reserve Bank of India (RBI) to tighten liquidity in a bid to stem its depreciation. Food inflation has continued to be stubbornly high. There has been a sharp change in sentiment from expectations of gradual loosening of monetary policy to an increasing realization that RBI’s tightening measures are unlikely to be as temporary as they are made out to be. Bond yields have zoomed up.
And, looming behind all this is one factor that has dramatically increased the risks in the markets—the prospect of the tapering of asset purchases by the US Federal Reserve, thereby slowly turning off the liquidity spigot that has kept asset prices high. This prospect of a reversal of Fed policy has led to capital flows out of emerging markets, resulting in downward pressure on their currencies. Encouraging signs of a turnaround in the US economy and also the first hints of stabilization in Europe have reinforced the preference among investors for developed rather than emerging market equities.
Fund tracker EPFR Global’s recent data showed net outflows from emerging market equity funds for the eighth time in the last 12 weeks, while emerging market bond funds extended an outflow streak extending back to late May. The August survey of global fund managers by Bank of America Merrill Lynch (BoFA-ML) show that equity exposure to emerging markets is at its lowest level since November 2001.
After taking into account all these factors, all the new risks that have emerged and the dashing of earlier hopes of a rate cut and an investment revival, the surprise is not that the Sensex has fallen, but why it went up in the first place.
The broader market, incidentally, has behaved very differently. The BSE midcap index, for instance, is almost 10% below its April low. The BSE smallcap index too is down more than 9% since the low in April. The broader market appears to have factored in most of the deterioration in the economic environment. Much depends, of course, on the sector. Among the sector indices, the BSE bankex, realty, power, metal and capital goods indices are all at levels well below their April lows.
As far the currency is concerned, there’s little to choose between the depreciation in the rupee and the Indonesian currency in the past month, while the Brazilian real has fallen more. So, whether the rupee will stabilize soon or not depends to a great extent on the US economy and on what the US Federal Reserve does.
This isn’t the first time the rupee is depreciating in recent months—between February and June 2012, it went from 49 to the dollar to 57. But that fall was reversed due to a combination of factors: a slew of domestic reforms that reversed sentiment in the market; the announcement by the European Central Bank that it would do whatever it takes to save the euro; and the start of third phase of quantitative easing by the US Federal Reserve. At present, however, not only are there no new reform measures, even the announcements made last year haven’t borne fruit. Rather than provide a fillip to sentiment, the government’s recent measures have been more of a dampener. And far from unleashing more liquidity on to the world markets, the US Fed is now intent on tapering the flow.
One of the objectives of government policy in India has been to try and pep up the markets with talk of reforms. Unfortunately, the talk hasn’t translated into action on the ground and spirits, animal or otherwise, haven’t revived. Nor is it likely that the government, with elections round the corner, will announce any bold initiatives.
The good thing is that much of this is already discounted in the markets. It is entirely possible, as the BoFA-ML survey says, that it’s time for a short-term bounce in emerging markets, simply because they have been oversold. What is not discounted is the damage that will be done if liquidity remains tight for a long time. The Sensex past price to earnings multiple is still above the levels it was at in May and June last year, before the rupee bounced back.
And the elephant in the room is the threat of a ratings downgrade. In May this year, ratings agency S&P warned there was a one-in-three chance of a ratings downgrade. The odds have considerably shortened since then.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com
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