Barely a day after the US Federal Reserve signalled that it might not cut rates in the future, the US markets told it loud and clear that that was wishful thinking.

Those who had assumed that the worst was over for subprime mortgages suddenly found fresh blood flowing from wounds they had thought were healing. This time, the problem seems to have started with the rating agencies, which had belatedly woken up to the fact that there’s a housing recession in the US. They have now gone on a downgrading spree for mortgage-backed securities, with products that were rated AAA being rerated as speculative grade in a matter of days.

And since the only reason investors had bought these products in the first place was because of the high safety rating, it was no surprise that they dumped them at the first opportunity, sending their prices plummeting.

Naturally, this will lead to a further round of write-downs in banks holding these securities and, as a consequence, bank shares have been hit very hard. Investment banks now seem to be outdoing each other in bringing out bearish reports on their peers.

Stocks fell in knee-jerk fashion across emerging markets, but the Sensex recovered smartly from its lows on Friday, despite the weakness in the rest of Asia. The Hang Seng index, for instance, fell by more than 3% or 1,024 points, but then banks like HSBC are listed on the Hong Kong market.

There should be no such inhibitions for the Indian market. As a matter of fact, subprime and other issues in the US market are actually good for fund flows to India, because they raise the probability of another Fed rate cut. As independent research outfit BCA Research points out, “there are major economic uncertainties and risks in the outlook, and the level of rates still seems too high. The Fed’s own calculations, ....based on inflation and potential output, indicate that the funds rate should be between 3% and 4%. The Fed has shifted to a neutral bias, but the easing cycle is only part way through."

Other things remaining the same, liquidity has increased as a result of the Fed rate cut and, as was the case earlier, most of that extra liquidity will find its way to emerging markets and particularly to the Bric countries.

Moreover, problems in the credit markets in the mature economies will mean that money will no longer go to those exotic derivative products and will instead be diverted to alternative channels. And finally, rate cuts mean a still lower dollar and investors will have an even bigger incentive to put their money into non-dollar assets. In other words, the Indian market is likely to benefit not just from the increase in liquidity but also from the substitution effect.

That said, corporate results show that there has been a distinct deceleration in earnings growth during the September quarter. Practically all the growth is coming from investment demand, with companies in the capital goods sector doing exceptionally well. But then, analysts have been warning for a long time about a slowdown in earnings, and earnings growth was lower even during the June quarter.

Simply put, slowing earnings growth is not a surprise for the market.

On the other hand, it’s possible that the next quarter may have some positive surprises. The seasonally adjusted ABN Amro Purchasing Managers Index for manufacturing in the month of October has the highest reading in the 31-month history of the survey. Output as well as new orders have surged, while output prices too have moved up. All this should be good news, provided it is backed by the government’s industrial production data due later this month.

The lower lending rates during the festive season should also help revive output, especially in the interest rate sensitive sectors. To be sure, valuations continue to be elevated, but then everybody knows that this rally has been fuelled by liquidity, that valuations are approaching bubble territory and the rationale for staying invested is that valuations always tend to overshoot during a bubble.

Currently, the Sensex is trading at a historical price-earnings multiple of 25, well below the 29 it reached during the peak of the dot-com bubble. Arguments are now made that while valuations may be expensive and growth may be slowing down, it is relative growth and valuations that matter and that we’re growing much faster than the advanced economies and our market is cheaper than China’s. But these are all post-facto justifications.

As a matter of fact, analysts have been having a tough time revising their price targets fast enough to keep up with the markets. The simple fact is that nobody can be sure when the bubble will burst, but as long as liquidity conditions remain benign, the odds are that it will continue to expand and that’s what the market players are betting on. High oil prices, which mean more surpluses with Opec nations, will add to the liquidity. This is a momentum market, pure and simple.

The big risk, as far as the Indian market is concerned, is regulatory risk. The finance minister and the RBI governor have made no secret of their dislike of “copious" dollar inflows and the impact it’s having on the rupee.

Sooner or later, if the flows continue, they’ll come up with measures to curb them. That’s the Damocles’ sword hanging over the Indian market. Investors would do well to keep a wary eye on the rupee.

Mint’s resident market expert Manas Chakravarty looks at trends and issues related to investing in general and Indian bourses in particular. Your comments are welcome at