There has been a good deal of talk about the resilience of the Indian market during the recent panic after the earthquake in Japan. Any outperformance during the period has been modest—while the Sensex remained flat between the close of trading last Saturday and Tuesday’s close, the Dow Jones Industrial Average fell by just 1.6%.
But there is a point to the resilience story if we look at the slightly longer term—the MSCI India index as on 15 March was up 2.6% this month, while MSCI USA was down 3.4%. Does this mean that the sell emerging markets, buy developed markets theme is coming to an end?
As the US economy showed signs of a recovery, money flowed back to the US while emerging markets, which had been the favourite destination of funds, suffered. The upshot: year to 15 March, while the MSCI US index is up 1.9%, MSCI Emerging Markets (EM) is down 5.1%.
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Rising inflation in emerging markets and monetary tightening in these countries led to fears of slowing growth. Countries like India, which had high valuations and had attracted a large amount of funds last year, were hit the worst and MSCI India was down 12.5% year to date as on 15 March.
The question is: has that story changed? Fund-tracking company EPFR Global said emerging market equity funds “posted collective inflows of $8 million for the week ending 9 March, ending a losing run that ran back to mid-January.” That’s good news.
In its February survey of global fund managers, Bank of America-Merrill Lynch had said that, taking a contrarian stance, investors should sell developed markets and buy emerging markets, although it hedged bets by saying a peak in emerging markets inflation or upside surprises to Chinese growth are necessary to provoke fresh inflows to emerging markets.
The March survey is now out and it shows fund managers had already cut back on their equity holdings and increased the amount of cash they held even before the earthquake in Japan. Cash balances with fund managers rose from a low 3.5% in February to 4.1% in March. A net 14% of managers are overweight cash, compared with a net 9% underweight in February.
Since the March survey was completed before the earthquake, cash balances must have gone up even further since then. In short, fund managers are sitting on cash, which could provide fuel for a bounce in the markets in the near future.
Could part of the bounce happen in emerging markets? The BofA-Merrill Lynch survey showed investors are now neutral on emerging markets. That’s compared with a 5% overweight on emerging markets in February and a 43% overweight in January. Positions have thus already been savagely pared. And, most importantly, net fund inflows by foreign institutional investors (FIIs) into Indian equities have been positive this month. The amounts are not large, but there has been some net buying.
The trouble is that even if emerging markets are looking better, that may not hold true for India. True, both the Prime Minister’s economic advisory council and the Economic Survey have painted a rosy picture of high growth in 2011-2012. But it’s a catch-22 situation—if growth is really going to be so strong, then the Reserve Bank of India, which has been shouting from the rooftops about the need to curb excess demand to combat inflation, will surely have to tighten more.
And if, on the other hand, growth is likely to be lower than in 2010-11, as almost all economists and strategists from the brokerages believe, then that, too, would mean lower earnings growth, although RBI may not need to tighten quite so much.
There are other issues, too. The rise in the cost of capital appears to be taking a toll on capital expansion plans and the industrial production data show that while consumption is strong, investment demand is iffy. The credit-deposit ratio for banks is 75%, which indicates just how tight liquidity is and the likelihood of further increases in deposit and ultimately lending rates.
And then, of course, there’s the all-important issue of oil prices. Although oil has come off its peak as a result of the disaster in Japan, the nuclear accident there may lead to more reliance on other energy resources, which would raise oil prices.
For all these reasons, India is a big underweight in most fund managers’ allocations. A recent Morgan Stanley report said it had cut India from equal weight to underweight, ranking the market 17 out of 20 emerging markets. The report makes an important point: “Crucially, on a trailing basis, India’s price-earnings (P/E) relative to MSCI EM remains at a 40% premium. Yet, relative return on equity continues to deteriorate and is currently almost at parity with MSCI EM. This compares with an average return on equity premium of 42% in the January 2003-June 2007 period.” In short, the valuations are still high, but the underlying justification for the valuation no longer holds.
The positive for Indian equities, however, is that most of these concerns are in the price, which should limit further underperformance. The far more significant positive news, from a longer-term perspective, is China’s decision to lower its GDP growth target to 7% for the next five years. If implemented, that would ease inflationary pressures on oil and commodities.
Manas Chakravarty looks at trends and issues in the financial markets. Comment at firstname.lastname@example.org