Despite the turmoil in Europe, equity markets seem to be doing rather well. After all the sound and fury of the last three months, the MSCI World index is lower by an underwhelming 0.52%. True, MSCI Greece is down 29.5% in the three months to 7 November, but MSCI Italy has lost a mere 3.8%. MSCI US has gained 3.36% over the same period. MSCI Emerging Markets has done worse than Italy, losing 4.15%.
The Indian market, though, has done comparatively well, with its MSCI index losing a miniscule 0.31% in the last three months. And that’s if you take dollar returns—in rupee terms, MSCI India has gained 6.3% in the last three months.
By Shyamal Banerjee/Mint
What’s the reason? The Financial Times Alphaville blog threw up its hands on Tuesday, pointed to the contradiction between rising Italian bond yields and rising stock prices and asked readers to weigh in with their opinions. The Wall Street Journal’s MarketBeat blog asked more or less the same thing, wondering “what accounts for this risk-on rally in the face of a four-alarm fire in Italy.”
The fund flows have turned. EPFR Global, which tracks international fund flows, says that for the week ended 2 November, the combined emerging market equity funds enjoyed their best week since early April, taking in $3.5 billion. Flows into Asia ex-Japan funds rose to a 17-week high. Risk is on, once again.
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The question, though, is why are investors adding risk in the face of so much uncertainty? Part of the answer lies in the Bank of America (BoA)-Merrill Lynch survey of fund managers last month. The survey showed cash levels with global fund managers were high and many fund managers were underweight equities, which means that there was plenty of fuel for a rally. But cash balances were high even in earlier months and liquidity was plentiful, without fund managers having the courage to take on more risk. Instead, they preferred to park their liquidity in US government bonds, sending yields plummeting. What has changed recently?
Could it be the new European Central Bank governor’s dramatic entry by cutting its policy rate? Could it be that the market believes that European leaders realize they have to get their act together? Well, German Chancellor Angela Merkel has said it will take 10 years for Europe to recover from the crisis—hardly reason for optimism.
Could it be that the world economy is not really in as bad a shape as we thought? The latest update on the global economy is available from the JP Morgan Global Manufacturing and Services PMI, which tracks both the services and manufacturing sectors in countries across the world. This metric stood at 51.4 in October, signalling not only a modest increase in economic activity, but also a post-recession low. (A reading below 50 signifies a contraction from the preceding month).
In the US, October saw a slackening of the pace of expansion in both manufacturing and services. In Europe, France joined the Italian and Spanish economies in contracting. German growth has slowed. Among emerging economies, while growth in China was stronger in October according to the HSBC China PMI, the government surveys showed the opposite. And in India the HSBC India Composite index, which includes both the manufacturing and services sectors, came in at 50.3 in October, very slightly above September’s 50.2, which shows that growth is almost stagnating. Clearly, there’s little to celebrate in the fundamentals.
What then is the reason for increased risk appetite? The BoA-Merrill Lynch survey showed 92% of the fund managers polled believed a Greek default was inevitable, with seven out of 10 respondents predicting a default by April 2012. In other words, the worst about Greece has already been priced in. And while there’s not much to celebrate on the growth front, the saving grace is that the US hasn’t slipped into a double-dip recession, nor has China seen a hard landing. Also, there’s quite a divergence between US stocks and the US economy, since many US companies earn a large slice of revenues from faster-growing emerging markets.
In emerging markets, the reason for optimism is the drop in inflationary pressures and the consequent topping out of the interest rate cycle. Several central banks in emerging markets have either cut rates or have signalled a stop in rate hikes. This changes the outlook for emerging markets. And since the BoA-Merrill Lynch survey points out that in October only a net 9% of asset allocators were overweight emerging market equities, there’s plenty of juice to fuel a rally.
Also, valuations are quite reasonable.
Nevertheless, even if we do not consider worst-case scenarios such as an implosion in Italy, the longer-term outlook is not rosy. The US economy has months to go before it gets back on its feet and Europe will take even longer. Emerging markets like China and India are still in a downturn and growth is slowing. In India, the central bank may have signalled that rate cuts are over for now, but a higher fiscal deficit, the result of the slowdown, poses new risks.
But then, the bottom of a cycle is always a good time to invest.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at email@example.com