A curious trend in the recent chaotic weeks in the financial markets is the way equity prices and the rupee have often moved in opposite directions. They usually move in tandem. The currency perks up when foreign institutional investors buy shares, and moves in the other direction when they sell. These past few weeks have seen remarkable stability in the equity market despite the sharp fall in the rupee.
The negative correlation between the two is at least partly because the fall in the rupee since May has been due to selling pressure by foreign investors in the bond market rather than in the equity market. US interest rates began hardening after the Federal Reserve indicated that it would begin to withdraw its extraordinary monetary stimulus. The interest rate differential with Indian bonds narrowed. In other words, US bonds suddenly became relatively more attractive. It is to widen the interest rate differential that the Reserve Bank of India has decided to tighten liquidity conditions since 15 July, much to the consternation of local bond traders and bankers.
The big question now is whether the bond selling (which is now abating) will be followed by selling in the equity market. Much depends on what happens to global portfolio allocations as a whole, especially how much money is being kept aside to buy shares in emerging markets such as India. Growth has slowed down in most major emerging markets. China could even be headed towards a hard landing. Countries such as India, China, Brazil and South Africa are now growing at around five percentage points below their 2007 peaks. Economist Nouriel Roubini argued in these pages last week that the next decade will be far tougher for emerging markets than the previous decade was.
Despite the obvious current problems, there are structural reasons to believe that the emerging markets will continue to grow faster than the developed nations in the coming years, continuing a process of income convergence. It is on this front that the behaviour of global investors is puzzling. One simple way to gauge their assessments to growth prospects in different countries is to look at how the price to earnings (PE) multiples have moved since the high noon of the last bull run.
The thumb rule here is that companies or countries that are expected to grow rapidly get higher PE valuations.
Now look at the data. In July 2007, a few weeks before the global credit crisis began in Europe, emerging markets had far higher PE ratios than their counterparts in Europe and the US. The ratios of the major indices in India and China were around 21 and 32, respectively, while the PE ratios of the major indices in the UK and US were 13 and 16, respectively. In other words, there was a wide valuation gap that indicated how investors were sold of the great emerging-markets growth story. Now take a look at current valuations. The Indian market is at 17 times earnings, the Chinese market at 11 times, the UK at 17 times and the US at 15 times earnings.
In other words, there is now no major difference in valuations. What is even more intriguing is that the Indian and Chinese markets are still below their 2007 highs despite the fact that the size of their economies have doubled in these past six years and the US and UK markets are close to their record highs even though their economic output has stagnated.
There are several explanations for such behaviour, from the possibility that the valuation bubble in 2007 was worse in the emerging markets than in the developed markets, to the fact that rock-bottom interest rates in the West have increased the attractiveness of all risk assets in the developed world, including shares. Some also argue that the globalization of earnings makes the US market more a proxy for the world economy rather than the American economy alone.
But the erosion of the old valuation divide between the developed markets and the emerging markets is also partly a reflection of a new scepticism about the growth potential of the latter group of countries. Whether this change in perception is temporary or more lasting remains to be seen, but it can be read as a warning to those who believe that strong flows into the stock market will be a predictable source of funds to finance the current account deficit.
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