Imported volatility in Indian markets

You'll see extra volatility and sudden sell-offs when optimism dims in New York or Frankfurt

When economists make projections, they leave wriggle room for acts of God, or unpredictable black swan events. The prognosis for the global economy in 2020 was generally positive. It factored in downside risks from a potential escalation in the Iran–US faceoff, the impeachment of the US president, and others. 

The novel coronavirus out of Wuhan is a black swan: An epidemic centred in China wasn’t part of any mainstream risk-modelling.  As of now, it’s being assumed that global growth will remain positive but there will be slowdown caused by the disruptions of dealing with the disease. 

The lockdown in China has caused disruptions to trade. It has also messed up global supply chains. China is the manufacturing powerhouse of the world. It supplies not only finished goods but also components for practically every sector you could think of. There have been major disruptions to the electronics industry, and to automobile manufacturing, for instance. 

The current estimates for growth are based on assumptions that the disease will be contained soon and the disruption will be short-term. Those calculations could change if the disease proves intractable. It has a high infection factor (“R0” or “R-nought” in epidemiologist jargon), and it can be fatal. We don’t know how many people have been infected, but there have been over 500 deaths so far. China has decent public health standards — far better than many other nations where the disease is likely to be “exported”. It’s possible that the disease will flare up elsewhere and if so, the potential for economic damage is being underestimated. 

The upside to this is that central banks will be opening the taps wide, or keeping them open, to combat any potential slowdown. The major central banks were already oriented towards easy money. Indeed, the People’s Bank of China (PBOC) was among the few majors not to have eased rates in the recent past. It’s very likely that the PBoC will indulge in monetary easing now. More money being freely available everywhere makes it likely that there will be higher FPI flows to Third World stock markets and bonds. 

The Reserve Bank of India (RBI) has decided to hold status quo on interest rates although retail inflation is now well above the upside limit of 6 per cent. Since the inflationary spiral is due to expensive food, it’s assumed that this is temporary. The RBI will also maintain an “accommodative” stance with respect to liquidity. It has to do this. 

The Budget makes it clear that there will be a lot of government borrowing to fund in 12-18 months. Government borrowing will crowd out private sector borrowing from the bond market.  Indeed, the Budget also indicates that regulations will be eased to ensure that overseas investors can be more active in the bond market. 

The promise of that new liquidity has led to a quick revival in the stock market after a crash in the Budget session. Corporate results for the third quarter (Q3) have been nothing to write home about. But that’s not really driving prices anymore. It’s the global situation. 

There have been phases like this before, when movements in Indian and other Third World assets have been tightly correlated to movements on the NYSE and Nasdaq.  One such phase occurred after the subprime crisis, for example. Traders went long or short on the Dow Jones and the Nasdaq in a given session, and then did precisely the same things in the next session in India.  

This pattern of strong correlation to overseas markets could last indefinitely. This is useful for a short-term trader. He or she can look at what happened to the Dow and Nasdaq the previous night and take appropriate positions in the Nifty. However, a long-term investor has to find ways to filter out that overseas influence to judge if the market is over or under valued.  

It also means that there will be “imported” volatility in Indian bonds and equities. If something spooks Wall Street, there will be a crash on Dalal Street and vice versa, if Wall Street is bullish, Indian equities will also rise. As a consequence, the rupee is also likely to see sudden jolts. 

Be prepared to ride out this phase. You’ll see extra liquidity, extra volatility and sudden sharp sell-offs when optimism dims in New York or Frankfurt.