The Long Shadow of Global Linkages: Prediction made in 2008 holds true

Sentiment and liquidity in the equity market continue to be impaired by developments in the U.S, and increasingly, parts of Europe. India is not alone in the turmoil; it is, however, among markets that have lost the most in 2008 year-to-date. The phase of consolidation marked by high degree of volatility is likely to continue for the next few months till there is clarity that the worst in terms of news flow from U.S economy and global financial players is behind us.

In the domestic context, the market has not taken kindly to the Rs 60,000 crore loan waiver announced for farmers in the budget by the Finance Minister, P Chidambaram. The fear is probably more about a fresh bout competitive populism rather than just the budget proposal as such. The lack of clarity on how the banks will be compensated wholly or partially, the more likely outcome has also not helped sentiment towards banking stocks. Our broad view on the budget and also implications of specific measures is available at www.sundarambnpparibas.in.

Bird’s Eye View: We have a cautious view on our near-term outlook. Risk aversion is pervasive across markets and this situation is not likely to change over the next few months. A corrective phase in terms of market levels and time is likely to be healthy; the more so as it has already helped eject excesses in valuation levels in specific stocks, the significant speculative build-up in futures and options and the showcased as well as the less-known primary market offerings at bloated prices.

The incremental risks from a medium-term perspective are earnings downgrades in India, elevated levels of crude prices, a possible increase in the current account deficit and a slowdown in China.

Our view on the long-term outlook for the Indian economy and market is, however, as positive as it has been for several years.

Global linkages at work: The U.S may be gradually ceding its level of importance in the global economic context. This is, however, a process that is likely to happen only over several years and that explains why continuing negative developments in its economy have now cast a long shadow across the globe.

The vulnerability of the India to a U.S recession is relatively limited as compared to other emerging markets as far as economy is concerned The markets are a different kettle of fish. As highlighted in our India Outlook 2008 document, the global linkages of the markets and its implications are significant and this is unlikely to change anytime soon.

India had delivered blockbuster returns in the second half of 2007. Secular rupee appreciation and the completion of five years of a bullish phase with average annual returns of about 45% for the Sensex portfolio have also meant attractive in-the-money positions for investors who had entered anytime before July 2007. In this context, as risk aversion has taken hold and impacted sentiment and liquidity,

India was always likely to be in the frontline of fire when foreign investors decided to take profits. That phase is underway now.

Recession fears, the trigger: That the U.S economy was headed for a difficult period has been highlighted in our Market Outlook for a year now and to that extent, the emerging news flow is not a surprise. It was always going to be tough to exactly pinpoint when it could impinge on the markets; the effects have been postponed till early 2008 only by the gush of liquidity and a state of bliss that dominated trends across the world between August and December last year.

The U.S now appears to have stepped into a recession, though the birth date is likely be anointed, as always, a few months after the event start. Even in the October-December quarter, if one strips out the effect of export, aided by a rapidly sliding dollar, the domestic economy in the U.S suffered a contraction. This trend is likely to be accentuated in the first half of 2008. The near-desperate pace of ratecuts by the U.S Federal Reserve may take time to take effect on the ground and may only help in moderating the extent and not the recession. Worryingly, this phase of rate cuts is now accompanied by inflation levels elevated above comfort levels of central banks in developed markets. Notably the European Central Bank has so far steered clear of rate cuts, preferring to place emphasis on looming inflation rather than the threat of imminent slower growth.

Multiple legs for credit crisis: The crisis that came to the fore via subprime has enveloped several parts of the credit market. Just in the past month, at least three more parts of the credit market have joined the woes party now inflicting significant damage across a wider swathe of institutions. In this context, the write-off for poor quality credit assets at global financial majors, that is now approaching $-200 billion mark, may have substantial headroom to rise and we could expect news flow, including on institutional collapse (we have already had one major such event in the U.K) through 2008.

The ongoing massive write-offs will have an impact on credit flow to the economy due to erosion in capital and this consequence may not be neutralized by the Fed rate cuts. The magnitude of the still unfolding crisis is clear from proposals, which would normally be labeled as desperate and reeking of moral hazard, from persons in high office.

The crisis will have to run its course so that pain is taken out and this will continue to impact emerging markets across the board and economies in varying degree. This is why this round of market correction in India may not reverse as quickly as similar events in May 2004 and May 2006 though its economy may be among the least affected among emerging markets.

(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.)