It may soon be time for risk-on, but India may not benefit

The rally in the equity markets that started around the end of last year has lost momentum. FII inflows have dwindled. Is it because of the lacklustre central budget, which did nothing to boost reforms? Are portfolio investors worried about the draconian provisions of GAAR? These factors might have had some effect, but the fact of the matter is that a retrenchment from risk has taken place worldwide.

That’s seen from the MSCI World index, which, as on 20 April, was down 2.3% during the month and the MSCI Emerging Markets index, which fell 1.9%. MSCI India did worse, but not hugely so, falling by 2.8% during the month. Fund tracker EPFR Global says, “The week ending April 18 saw EPFR Global-tracked Emerging Markets Equity Funds lose $716.4 million to outflows, the first back-to-back weeks of outflows since December as doubts about Chinese and European growth, the chances of further monetary stimulus in the US and policy trends in key markets all took their toll.” There’s another simple way to track risk appetite—just look at US money market fund assets. The Bloomberg chart shows that these assets, after rising from August 2011 to end-December, started to fall at the beginning of 2012. Since the beginning of April, however, they have been more or less flat, which implies there isn’t stomach for more risk.

There is, though, one very seductive argument about markets. If the US recovers and Europe manages to turn the corner, then investors will be more confident and risk appetite will return. If, on the other hand, the recovery in the US or Europe falters, then the authorities will open the monetary spigots and unleash a torrent of liquidity. Money will continue to flow to risk assets.

That may have an element of truth, but there are two strands to that argument. First, the continuing uncertainty has led to the risk on-risk off trade, with investors booking profits at every opportunity while retreating into safe havens at every hint of a reversal. This will continue till the deleveraging has run its course, the underlying concerns about the financial system are addressed and growth is back on track.

The other, short-term question is: Where will the liquidity flow to? In the last three months, the US markets have been the prime beneficiary. EPFR Global says that in the week to 18 April, flows into US equity funds were essentially neutral, compared to the selling in emerging markets funds.

Why are fund flows to emerging markets so tepid? A note by Citigroup offers an explanation. One reason for funds to flow into Asian markets was the promise that central banks would start to loosen their purse strings and that would bring back growth. The Citigroup note, however, says that Asian monetary policy is now largely in a period of stasis. It says, “With a favourable base effect on inflation disappearing, headline inflation is still expected to be rather close to the central bank comfort thresholds- the next rate move for many by next year is still more likely to be up than down.” In other words, the quantum of interest rate cuts is not expected to be large, especially since loose monetary policy by the central banks of the developed countries has raised commodity, especially oil prices. Depreciating currencies are another factor keeping import prices high, especially for countries like India that have large current account deficits. No wonder then that the rupee is once again under pressure.

In the short-term, though, it may soon be time for risk-on. The BofA-ML global fund manager survey for April says that cash levels with investors have risen to 4.7%, triggering a contrarian buy signal. In December 2011, just before the rally, they had risen to 4.9%. However, fund managers are now overweight emerging markets by a net 28%, compared to a net 20% in January, so the contrarian signal for emerging markets is not as strong as it was then.

How much of that money could come to the Indian equity markets? In January 2012, fund managers were underweight on India by a huge 61%. In April, they were underweight by a much more modest 20% or so. That doesn’t bode too well for fund flows to India.

Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at capitalaccount@livemint.com

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