Play the liquidity-driven rally with care

Let there be no doubt that the ongoing rally in India is driven in a massive way by a surge of inflows from Foreign Institutional Investors (FIIs). Participation by mutual funds and insurance companies has paled in comparison. As a result, this market has been beneficial for speculators, traders and high-risk taking retail investors.This pattern is no different from what we have witnessed in the past in India.

FII flows have recovered by about $ 10 billion from the lows of 2009. They had been net sellers of Indian equities to the extent of about $ 2.5 billion by mid- March,taking equities to a low for the year.Inflows from FIIs since then has been on an upward trend and is approaching $ 9.5 billion and counting leaving a net inflow of close to $ 7 billion as of end July.

India was not an exception but an integral part of a bounce across emerging markets and the developed world. India and China have been at the forefront as the relative bright spots in an otherwise dim global economic picture.

Backdrop to the ongoing bounce: The announcement in early March that Citibank was making money in the first two months of the year (never mind the hundreds of billions in support from different arms of the U.S government) led to a spurt in risk taking world-wide.This was merely an excuse to embark on a corrective rally.

This process continues to be helped by interpretation of almost every statistic from the developed world in a positive way when the reality of the numbers has been different. In this endeavour, barring the sizeable number of persons who had warned of the crisis well in advance in varying degrees, everybody else is part of this see the light story.This is being cheer-led from the front by the governments, central banks and mainstream media. The list of cheerleaders is not a surprise as they have staked trillions of dollars of money belonging to citizens to bail out those who were responsible for the crisis.

Effectively those who did not tell you anything about the impending crisis are now the ones that are talking up the recovery story.There is little by way of insight from this group even now.What has happened is that macro-numbers are not falling by the dramatic percentages that showed up between October 2008 and March 2009. If the pace of that period had continued, we would be diving close to zero in absolute terms for several economic indicators. It was inevitable that the pace of decline will moderate and that is what is being counted as a recovery now. The exception is China where a binge in bank lending at the directive of the government has kick-started growth.

A wider cross section – the recovery-story group as well as those who saw the crisis coming – recognised the likelihood of a technical bounce, as equities had corrected sharply. This was a nice combination: as several of the persons who saw the crisis coming indicated the possibility of a technical bounce, it became a selling point for the recovery-story group.

Bear-market rallies are integral to the process and what we have had post March across the world is indeed one in that category thought a few aspects of it have changed in India in the wake of the Lok Sabha election verdict. Liquidity has been at the core, especially with interest rates close to zero across the developed world.

Risk goes off the surface: The governments and centrals banks of the developed world have now taken over almost every major activity in the economy, especially those that affect Wall Street and financial institutions. By taking the stance that no big institution will be allowed to fail even if the fundamentals pointed to such an outcome, risks has been taken out of even the credit markets that are usually sharp in pricing them.

Remember the credit markets provided cues in advance on the crisis but because there is now the backstop support of the government, most parts of this market are trading on a one-way street. Risk on private debt – especially in the financial sector - has declined, even as that of the safeguarding entity (governments) has risen. The only risk that credit markets are now pricing with anything resembling the normal efficiency (not referring to the efficient market theory) is government debt.Yields have risen sharply due to the likelihood of massive increases in borrowing by the governments in the developed world.

Even this rise in yield was for about two months spun as representing imminent recovery in growth and therefore the prospect of central banks raising interest rates.This spin has now been given the burial ironically by the Chairman of the U S Federal Reserve, Ben Bernanke (also the master of ceremonies for zero interest rates and trillions of dollars flooding the global economy as part of his efforts to avoid another Great Depression).

Steroid combo for equities: This is the backdrop to heady cocktail that is driving equity markets.

Government intervention + central bank + moderation in pace of declines + low interest rates + risk taken off the table due to perceived and actual government support + liquidity – this even beats the low interest environment in early parts of this decade that was a principal cause for expansion of excesses in borrowing and different asset classes. This combination could continue for a bit more. Support cast in the form of positive GDP growth rates for a quarter or two in parts of the developed world may help it further along as could news-flow from China.

The key question is what will happen when the government and central banks move away from the pivotal activist role that they now play. The other question is also will they ever move away given the magnitude of the crisis.We will examine this aspect on a different occasion.

Even if they are present, a long period of slow and low growth in the developed world appears the most likely best-case outcome.To have an idea of why, we would refer you to `Life in shrunk global economy’published in TheWise Investor May 2009 and `The grind starts now’ inTheWise Investor July 2009.

The comfort in India: India – along with China, Brazil and Indonesia – may be the spots that hold the prospect of a more sustainable economic growth path. From an investment perspective, the clearest Lok Sabha election verdict in two decades has negated to a large extent the risk of a dramatic collapse to the lows of October 2008, even if there are (and will be) corrective phases to the rally and a pullback in the degree of FII interest.

Even as you invest in this comfort zone, beware that the environment is laden with risks. Take note that much will depend on when and how the globaleconomy shapes up, when the massive support of the government/centrals banks starts to be taken off the table, though this could take time. Let us also remember that governments and central banks have played almost every card and short of risking an even more disastrous further rise in government borrowing, there is not much else in the kitty.

Compared to what most of the developed world faces in terms of risks of expansion in government debt, the fiscal problem in India – even as it is a cause for much concern – appears more manageable as the growth story over the next five-to-ten years is bound to be more robust.

This is a key factor attracting FII interest.That is not a reason to leave caution behind or take excessive risk, as eventually valuation will get aligned with sustainable fundamentals. Liquidity can take equities out of whack with fundamentals for a period but not forever. The direction and magnitude of this source of liquidity could also change if the for-now-wished-away negatives come to the fore in different forms.

(Published in The Wise Investor (March 2008), a monthly publication of Sundaram BNP Paribas Asset Management.  The views expressed are personal and do not necessarily that of the organisation.)