This year has been a choppy one for equities. The Sensex started 2010 at 17,473, fell a bit in February, regained its previous level in March, lost its footing for a while in May and then started to move up from June. The upward momentum started slowing in October and after a brief high in November, it started losing some ground.
What is interesting, though, is that the US dollar index started moving up from the middle of January 2010 and continued its upward movement till it reached a peak in early June. Worry about the debt burdens and unsustainable fiscal deficits in Greece and other countries of the European periphery was the reason for the strengthening dollar. After June, however, the response of the European authorities appears to have satisfied the markets and the dollar index started to fall. Notice that this coincided with the turnaround in the Sensex. Apart from a brief pause in August, the dollar index then fell all the way till early November. The weakness this time seems to have been driven by expectations of a second round of quantitative easing (QE2) by the US Federal Reserve, which was widely expected to lower interest rates further in the US, which in turn was expected to lead to money flowing out of the US into non-dollar assets, thereby leading to a weaker dollar. Ironically, the dollar index reversed direction once again in early November, after the announcement of QE2. It was a classic case of “buy on the rumour, sell on the news”.
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Perhaps it had little to do with quantitative easing. This was the time when the US economy, long seen to be practically comatose, started exhibiting distinct signs of recovery. Leading indicators started to improve, jobless claims started to show a downward trend, factory production rose and retail sales showed signs of a turnaround. It was this rather unexpected new-found strength of the US economy that led to a stronger dollar and the trend was aided and abetted by continuing problems in the euro area. The net result: the dollar index started moving up and the Sensex started moving down. The correlation between the US dollar index and the Sensex is remarkable.
Now consider what happened to US interest rates, taking the yield on the benchmark 10-year treasury note. This reached a high of almost 4% in early April and then started to fall, reaching a low of 2.38% in early October. The steep fall from around 3.4% in early June to 2.4% in early October coincided with the falling dollar index, which is probably an indication that the very low yields led to a flight away to non-US assets and the dollar fell as a result. The 10-year yield was at 2.5% as on 5 November, immediately after the QE2 announcement and it has never looked back since, steadily gaining till it reached 3.5% on 15 December. This coincided with a strengthening dollar and a falling Sensex.
During all this time, the Indian economy was doing better and better. Real gross domestic product (GDP) growth at factor cost was 8.6% in the first quarter of calendar 2010 and 8.9% in the succeeding two quarters. Sensex profit after tax growth shot up in the first quarter of the calendar year and was moderately high in the next two quarters. But notice also that in spite of the GDP for the September quarter coming in much higher than expected, it had little impact on the market. That suggests the driving force for the Indian market and indeed for emerging markets, is what happens to interest rates in the US. Recall that an International Monetary Fund study had pointed out that the single biggest factor accounting for returns in emerging market equities is liquidity in the mature economies.
So what are the trends at the end of 2010? As on 27 December, the MSCI US index was up 6.48% month to date and 10.41% three months to date. In contrast the return from emerging markets, in dollar terms, was 4.56% month to date and 4.6% three months to date. The scent of a US recovery had led to funds flowing into US equities, while emerging markets languished during the last quarter of 2010, a trend clearly brought out by the Bank of America-Merrill Lynch survey of fund managers for December 2010. Indeed, in the three months to 27 December, MSCI India was down 1.62% and MSCI China down 0.59%. On a year to date basis, however, MSCI emerging markets and MSCI India outperformed the mature markets, though not by much. The Chinese market, however, beset by worries about monetary tightening and a crash in the real estate sector, did much worse.
The other important trend at the end of the year, from India’s point of view, is the rise in commodity prices. Note that the Reuters Jefferies CRB index went down during the first half of the year and reached its January peak only in October. Since then, though, it has made a new high for the year in December. Crude oil prices, in particular, are headed up.
At the end of 2010, the Indian equity market faces the prospect of higher commodity prices, demand-pull inflation pressures and higher interest rates, while liquidity is being diverted to the US markets. And while earnings growth promises to be strong, the favourable base effect is wearing off, while valuations continue to be high. In short, conditions are worse now than at the beginning of 2010.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org