Market triggers

Dollar, political stability and reforms will determine the course of the market in the current fiscal

By Mohan Sule

Now that the market has discounted the March 2011 quarter results and normal monsoon forecast, what will be the next triggers in the coming fiscal? The most important indicator will be the pace of foreign fund inflows, which had slowed down early this year on the strengthening rupee, but returned end of the last quarter on the weakening of their borrowing currency, the yen. Since the collapse of Lehman Brothers, resulting in recession in the developed economies and slowdown in the emerging markets, it is now clear that movement of funds into and out of a country is not solely dependent on its economic health. Many external factors such as currency equation, availability of cheap credit and valuation of assets in comparison with investment opportunities elsewhere figure prominently. Here, the moves of Federal Reserve chairman Ben Benanke will have to be followed. So far he has resisted calls to release US interest rates from the near-zero level due to anxiety that any steps to rein in the rearing inflation could be at the cost of the incipient recovery. Yet, end April, he announced the phasing out of the second installment of quantitative easing, or liquidity injection, by June, which could put pressure on interest rates and boost the dollar, a requisite to attract investment into the US. These are indeed contradictory signals. The US needs a weak dollar to boost its exports. At the same time, it cannot ignore pressure from China, its largest creditor, which holds most of its foreign exchange reserves in dollars. For the currency market as well as for companies selling overseas and importing raw materials and components this translates into volatility.

A strengthening dollar, however, will be good news for exporters to the US, particularly China and India. Tech companies, facing rough weather of late due to the weak recovery in the US, could be the biggest beneficiaries as long as the American economy does not blink in the process. Besides currency, foreign funds prefer countries with stable government. The world is not looking particularly attractive in 2011. Earthquake off Japan has set back the third largest economy at least by a couple of years. Oil is heating on unrest in the Arab region. A year ahead of change at the top, China’s present leadership has unleashed an unprecedented wave of repression to crush any signs of Jasmine revolution. The Chinese intend to decelerate over the next few years to insulate the country from overheating. How will the restless population, used to their economy expanding at an average 10% over the last decade, take to a growth rate of 7%? If the Chinese government can manage this transition “harmoniously”, the recent correction in surging prices of oil and base metals will sustain unless India, expected to gallop at 9% this fiscal, steps in as a substitute. The government is stable but has been weakened politically due to the various scams. It is doubtful if it has the appetite to undertake second-generation reforms including allowing more foreign investment in insurance and opening the retail sector. Even the announced aim of collecting Rs 40000 crore through PSU divestment looks ambitious: it was able to mop up Rs 22000 crore last fiscal as against the target of Rs 40000 crore despite a buoyant market and absence of any political danger.

Slowdown in foreign fund inflow against the backdrop of recovering US and EU economies too could make it difficult to get attractive valuation. The picture could reverse, if the government takes the bold step to sacrifice some amount of premium to bolster the domestic market. It is not only PSU stake sell-off that will be required to keep the economy humming. How the besieged government tackles subsidy will be interesting to watch. Petrol prices have been raised seven times totaling Rs 10 per litre last fiscal and another hike is in the offing now that the assemble elections to the five states are over. Oil marketing companies could get some more relief but will continue to incur losses. Fertiliser stocks have been looking up of late not only in anticipation of good rainfall but also on hints of freeing urea pricing. The firmness of resolve will depend on which way the results to the five state elections go because cutting the subsidy bill is bound to contribute to inflation. Not only that, awarding of infrastructure contracts, which have been picking of, too, will suffer if the government turns lame-duck. High interest rates, surging commodity prices, and a freeze on reforms and the resultant impact on foreign portfolio investment pose a challenge that could unnerve even a competent government. The baggage of corruption will make the task even harder if painful but necessary measures to keep the economy on course are viewed with suspicion by a cynical population or worse paralyses decision-making.

Mohan Sule

New rules of the game

After coordinated action to avert global meltdown, limiting the euro zone crisis and capping the yen, focus should turn to commodities

Mohan Sule

Can we return back to those days of the last decade when interest rates were low, liquidity was aplenty, economies were galloping, the markets were booming and newer companies were emerging on the trading screens to bet on? Look at the landscape now, from east to west. Power outages in Japan have disrupted supply chains across the world. China and India are battling inflation. The uprising in the Middle East has raised fears of prolonged turbulence disturbing the flow of crude. The sovereign debt crisis in the euro zone has spread to Portugal even as the European Central Bank has started increasing interest rates. The dollar is plummeting as the US Federal Reserve is stubbornly resisting calls to do so despite signs of recovery in the face of flat jobs creation and soft housing prices. Stock markets have become volatile as foreign portfolio investment moves in and out in search of arbitrage opportunities. The current turmoil and future uncertainty, however, have not dimmed the luster of commodities, which are continuing their bull run triggered last year in the belief that the worst is over for financial markets after the bail-out of big investment banks. Within the commodities group, bullion and industrial metals, at any given time, move in opposite direction. The upward movement of precious metals is dictated by fears that the good times are coming to an end, while the buoyancy in base metals stems from anticipated economic growth. This time, though, the correlation has come apart.

Gold and silver have become a separate asset class, de-linked from other investment options and assuming a form that suits investors at that point of time: hedge during inflation and an avenue to channel profit from equities. Base metals and oil, however, continue their connection with economic cycles. Just as the futures and options prices of forward contracts influence the cash market, positions taken by various participants for different reasons affect spot prices of commodities, too. The major difference is that while the impact of the sentiments in the stock market is restricted to buying and selling by investors to make or book profit, without making much of a difference on the day-to-day operations of the companies, unless they are preparing to raise capital, trading on commodity exchanges affects the spot prices of consumables, benefiting or punishing producers and users. Derivatives enable investors to bet big as well as cap risks, artificially altering the demand-supply equation. This was amply evident in the rise of crude oil in anticipation of decline in output from Libya, and even Saudi Arabia, on concerns of internal turmoil. Similarly, the Japanese currency took off immediately after the earthquake on expectation of investors who had borrowed in yen to invest in emerging markets liquidating their assets to repatriate back home and insurance companies selling their overseas assets to pay damage claims. Eventually, G7, the group of rich countries, had to pump in yen to cap the rise.

Excluding the concerted action by the European Union to bail out their members defaulting on sovereign debt, this was the second time that a group of countries was acting in unison after the Lehman Brothers’ crisis and resultant economic meltdown, which saw coordinated quantitative easing by central banks and fiscal stimuli by governments around the world. The IMF’s recent pronouncement that it is willing to help emerging countries to manage their capital flows better after all else including interest rate hikes and capital control measures such as taxes have failed is one more step towards institutionalising the process of managing the global economy. As most of the emerging economies save for Brazil and Russia are net importers of commodities, attention should shift to controlling their galloping prices. From the experience of the Organisation of Petroleum Exporting Countries, producers of metals should know that after a point rising prices can be self-defeating, resulting in global slowdown and inflation in the domestic economy. Equity markets have circuit filters. Exposure to stocks in the derivatives segment too is limited to the outstanding shares of a company. There is no such fencing for taking positions in the commodities futures market. Banning trading, as India does quite often, would be a disservice to large consumers who would want to protect themselves from future price volatility. Perhaps compulsory delivery rather than squaring off for contracts bought, at say 5%, above the current spot prices could induct some sobriety. If not, the alternative will be political instability, particularly in the emerging markets.