Is the rally a replay of 2010?

So far this year, investors have already returned over 40% of the cash they pulled out of emerging market equity funds in 2011, according to fund tracker EPFR Global. That rush of money has lifted the MSCI Emerging Markets index by over 16% this year, while MSCI India is up 30%, measured in dollar returns.

The received wisdom is the rally has been triggered by a renewed bout of monetary stimulus by central banks across the world. The European Central Bank’s Long Term Refinancing Operations ensured three-year loans at 1% to banks, not only bringing down government bond yields in Italy and Spain but also giving time to banks to fill up the holes in their balance sheets. The Bank of England has announced another round of quantitative easing (QE). The Bank of Japan has announced a further 10 trillion Japanese yen of asset purchases and the US Federal Reserve chief Ben Bernanke has hinted at a third round of QE, while announcing that interest rates will remain exceptionally low till 2014.

But haven’t we seen a similar kind of rally before? Recall the fears about Greece during the first half of 2010 and worries about a double dip in the US at that time? The US economy started to show signs of recovery during the second half of the year and the improvement in sentiment was aided and abetted by the run-up to the second round of quantitative easing in the US. The upshot was a big rise in fund flows to emerging markets during the third quarter of 2010. The Sensex, which had trod water for most of the year, started to move up in July, reaching a peak of over 21,000 in November.

We all know how that rally ended. The Indian market became rapidly overheated, with the Sensex’s trailing price-to-earnings multiple going above 23 in September 2010. Hopes of a US recovery led to money moving back to the US, while higher inflation in emerging markets and tighter monetary policy slowed growth in emerging economies, souring sentiment on them. The result was a shift in funds flow from emerging to developed markets. Look at the data: In the first quarter of 2011, EPFR Global data showed net outflows of $24.5 billion from emerging market equity funds, while developed market funds attracted a net $56.9 billion. Even Western Europe attracted net inflows. Contrast that to the third quarter of 2010, when emerging market equity funds saw a net inflow of $30.2 billion.

Is it going to end in tears this time too? The crisis in Europe has not gone away and already there’s talk about an end to the long-term refinancing operations. The data out of the US has improved, but nobody expects a V-shaped recovery, instead keeping their fingers crossed it doesn’t go pear-shaped. But there’s one key difference with 2010 for the emerging markets. Unlike in 2010, central banks are not in the initial stages of tightening monetary policy but have instead started to loosen their purse strings.

That’s a huge difference. Reserve Bank of India (RBI) deputy governor Subir Gokarn can take the credit of being one of the few who predicted this rally, when in a speech in early November 2011, he said that if a sustainable solution to the European sovereign debt problem emerged soon that would lead to global portfolio rebalancing among investors, which would mean more capital flows to India, which would result in less pressure on the rupee and, therefore, lower inflation, which would allow the interest rate cycle to turn, thus improving growth.

Of course, it’s not as simple as that. A sustainable recovery will take hold if inflation comes down below 6% to RBI’s comfort levels, if the government is able to contain the deficit and if it switches expenditure from consumption to investment, thus leading to a revival of investment demand. That’s a lot of ifs. And there’s another difference with 2010—crude oil prices are much higher now. Only a net 10% of global asset allocators are overweight commodities, according to the latest Bank of America-Merrill Lynch survey of fund managers, so prices could easily go higher. Also, this rally started when cash levels with global fund managers as well as overweight positions on emerging markets were low. That is no longer the position now.

But if the government does indeed grasp the opportunity for structural reforms, then the fund inflows can be used for the benefit of the economy, which in turn can lead to more fund inflows and a virtuous circle.

Manas Chakravarty looks at trends and issues in the financial markets. Comment at capitalaccount@livemint.com

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