The cost of liquidity

Rural distress and slowdown of the global economy have ended the era of evergreen sectors

By Mohan Sule

Those who thought the passing of the goods and services tax constitutional amendment bill in both houses of parliament will unleash a secular bull wave have been proved wrong just as those who predicted Britain’s exit from the EU will trigger a prolonged bear phase. Both events are complex and their effects will be felt in driblets over the coming years as new issues get highlighted and old concerns fade.  The euphoric forecasts about the positive impact of GST were reminiscent of those witnessed on the eve of the increase in foreign direct investment in insurance companies to 49%. Similar to GST, the issue had attracted opposite opinions and had got stuck in parliament for a fairly long time. What do the commonalities between these two developments reveal? No doubt, investors’ confidence gets a boost on any reform undertaken to make the economy efficient. Foreign portfolio investors, the movers and shakers of the market, however, act anticipating the outcome of the initiative rather than waiting for the cold numbers capturing the impact at the ground-level. Traders build positions in the run-up to the climax. Ordinary investors see the impatience of big-ticket funds as an opportunity to make capital gains quickly. If the reward is expected to be huge, so also is the risk. The failure of the market to perform to script after the referendum on Britain’s exit from the euro zone trapped many short sellers. The behaviour seems typical rather than exceptional. Increasingly, it is becoming difficult to predict the market’s course by applying historical context.

More than traditional parameters such as economic growth, inflation, debt-to-GDP ratio and current account and fiscal deficits, liquidity is determining the trajectory of the market. As long investors are able to borrow cheaply, arbitrage opportunities will overwhelm decisions taken after painstaking scrutiny. As a result, equities in the US and India are discounting forthcoming events much ahead rather than react at the conclusion. The situation might have been different if the central banks in the developed countries were not making available money aplenty. The negative interest rates by the European Central Bank and the Bank of Japan are emboldening investors to take risks in emerging markets rather than at home and, in the process, skewering the global economy. Global liquidity is posing the biggest challenge to economic stability. Investors in developing economies are increasingly becoming reckless, buoyed by the irrational exuberance of their portfolios. Any stock showing some momentum attracts speculators. The run-up is speedier than the company’s capacity to jumpstart growth. The virtuous cycle attracts more inflow. The rich valuations of equities encourage pricey IPOs that might not be able to sustain going forward. Listing gains fuel a primary market boom. Weeding out companies whose capital expenditure plans are based on genuine demand rather than some fancy projections about the underlying strength of the sector will be the second obstacle that investors have to overcome.

The third puzzle is the concentration of investment ideas instead of even distribution of funds across the spectrum. This is surprising as a growing economy should have the power to lift all the sectors. Fall in unemployment should bolster consumption across the board and not only of cement, coal and two-wheelers. If this is not happening, it is not surprising. Not all industries are catering to the domestic market. Many are pure export plays, depending on the well being of their importing customers. Some others have been deliberately shifting their focus overseas to take advantage of the weak rupee or get around stifling domestic regulations and are unable to fully capture the buoyancy in the local market. Moreover, if the fall in raw materials prices is a boon for intermediates producers and end product manufacturers, it is a blow to producers of these commodities. Airlines and automobiles are predicted to soar on cheap crude. Ironically, the fall in oil prices signify tapering economic activity, indicating a slump in demand for the very services that are supposed to benefit from cheaper fuel.  A cheap currency does not necessarily translate into robust earnings for exporters if their destination markets are not healthy. Even usage of consumer disposables, another set of beneficiaries of dip in input costs, is hit by sluggish off-take. The experience of rural distress of the last two years and global slowdown have demonstrated that, unlike in the past, there is not going to be an evergreen sector that will offer an umbrella  during stormy weather. As a result, the investment horizon is becoming shorter and the basket of investible stocks shrinking. The mid- and small-cap space, in particular, is turning into a Ponzi scheme run by speculators.