The Sensex is down by around 3.3% in the past one month, while the Dow Jones Industrial Average is up 2.5% (as on 14 December). That more or less sums up the market action in the past month—funds have flowed back to the US, on better economic data there.

The Bank of America—Merrill Lynch (BofA-ML) survey for November had sent strong sell signals for equities. Cash with funds was very low, risk appetite levels were very high. A sell-off did happen, but only in emerging markets.

Graphics by Yogesh Kumar/Mint

Investors are buying into the US recovery story and that could lead to a bout of underperformance by emerging markets. This month, the MSCI World index, which tracks developed country markets, has done better than the MSCI Emerging Markets index.

Investors also believe that loose monetary policy in the US will lead to inflation, which seems to have led to a sell-off in US bonds. Higher inflationary expectations have also led to funds moving into commodities. The survey points out that commodities are the second most popular asset class after equities and the net overweight in commodities was pushed a bit further up to 22% from 21% last month. That has unpleasant implications for inflation in countries such as India. The US dollar is seen as less undervalued than last month, but with US equities perceived as attractive, that may not be sufficient to mitigate current dollar strength.

The conclusion: “The trading sell signal triggered by low cash holdings worked briefly last month before being swept up by positive US macro data. Handicapping the risks of US growth, EM inflation and EU peripheral funding against pro-cyclical positioning could see a need for portfolio rebalancing into next year. For contrarians the sells are: EM equities, energy and technology; buys: global financials, utilities, Europe."

What about the Indian market? Global emerging market investors’ underweight position on India increased sharply last month, while India is now the least preferred market for Asia Pacific investors. That should protect the downside for Indian equities.