On 1 February, the HSBC India Manufacturing Purchasing Managers’ Index for January showed a strong reading of 56.8, a slight improvement over the December level. The index for new orders was even higher, indicating good growth ahead. Yet the Sensex fell 1.7% on that day to a five-month low. Investors seemed to be worried that high growth would only lead to higher inflation, which would mean trouble in the months ahead.
Also See | Not Much Of A Correlation (PDF)
How much of a difference does inflation make to the stock market? The accompanying chart plots the rate of wholesale price inflation against the Sensex. The results do not show much of a correlation, except in 2008, when the big fall in the markets coincided with a sharp rise in inflation. But that was the time when the financial crisis had hit the West, valuations in emerging markets had run up very rapidly in the last few months of 2007 and there were lots of other reasons besides inflation for foreign investors to avoid risk. On the other hand, the Bank of America-Merrill Lynch (BofA-ML) survey of fund managers for January 2011 shows its risk appetite indicator at a strong 46, against a long-term average of 40.
Also Read | Manas Chakravarty’s earlier columns
It’s intuitive, though, that inflation should be bad for markets. It leads to higher interest rates, which affects growth and it also leads to uncertainty. It also eats into savings, which again affects demand. In countries such as India, which imports most of its oil, the impact on the economy is even worse. But Citigroup’s chief Asia strategist Markus Rosgen says in a 24 January note: “We see no, literally no, relationship between inflation and valuation of Asian markets.”
Is another reason for the sell-off higher than expected growth in the US and the repatriation of funds there? That’s what the data says. According to funds tracker EPFR Global over $3 billion moved out of emerging market funds in the fourth week of January, with outflows from Asia ex-Japan funds at a 37-week high. In contrast, money continued to flow into developed market equity funds, not just into the US but also into Europe and Japan.
During the bull run of 2003-07, US gross domestic product (GDP) growth decelerated from 3.6% in 2004 to 3.1% in 2005, 2.7% in 2006 and 1.9% in 2007, while India’s GDP growth moved up from 7.5% in 2004-05 to 9.5% in 2005-06, 9.7% in 2006-07 before falling to 9.2% in 2007-08. So we had a combination of slowing growth in the US and accelerating growth in India, which might have led to India becoming a favoured destination for investors.
This time, according to the International Monetary Fund’s latest World Economic Outlook update, while GDP growth in the US is expected to go up from 2.8% in 2010 to 3% this year, growth in India is expected to fall from 9.7% in 2010 to 8.4% in 2011 (calendar year, GDP at market prices). In other words, while the growth differential between the US and India remains high, it’s going to come down a bit this year, so the relative attraction of the US market has improved. This year, global growth is going to be more evenly distributed and so will asset allocation. In November 2010, according to the BofA-ML survey, a record net 56% of global asset allocators were overweight emerging markets—by January, that was down to 43%.
What matters is the level of inflation and therefore, as a corollary, the level of interest rates. What we’re seeing at present is that bank deposit rates are as high as they were in 2008, which was the top of the last business cycle. Interestingly, the yield to maturity of 10-year government bonds was lower in February 2008 than today. AAA-rated corporate spreads have moved up by around 50 basis points since last October. And crude oil prices are also where they were in February 2008.
These are the reasons why India has been hit particularly badly in the recent sell-off. Another reason could be the disappointment with the government. The latest NCAER-Mastercard Worldwide survey of business expectations in India showed that its political confidence index is at 110.7 in January 2011, compared with 144.4 in October 2009. The premium in the Indian markets that came about when the second UPA government was formed without Left support has now vanished.
Interestingly, the Korean and Taiwanese markets have done very well recently, a reflection of the more export-oriented nature of their economies. A Citigroup report points out that upward earnings revisions are rising in North Asia, another reason for investors to shift there. What we’re seeing now is therefore a churn in allocations among markets, a churn that is likely to last for some time.
What could bring Indian equities back into favour? A decline in inflation and a pull back in crude oil prices will help. Valuations, at around 14.5 times FY12 earnings, are not expensive, provided earnings hold up. And finally, we can hope for a prudent and sensible Union Budget, but nobody is holding his breath waiting for that one.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org