The US Federal Reserve has finally lowered the boom with its tapering announcement. But global equity markets barely blinked before continuing to run upwards. There were some interesting signals from the bond and currency markets. Those could be a harbinger of what will unfold as the taper actually starts.
The tapering involves a $10 billion reduction in the rate of the Fed's monthly operations. This means Quantitative Expansion 3 (QE3) will continue to push out easy money at a run-rate of $75 billion month. That is the same rate at which the Japanese are pushing out money in their own QE programme. The European central bank is also committed to holding rates down.
Most market players were expecting a larger taper so there was an element of relief to the rally. Also, it's apparent that the Fed intends to cut back very slowly from the $75 billion level. So QE3 could be on the table for the next 12 months, with gradual reductions in size. (Click for graph)
The bond markets saw US Treasuries being bid up after the taper announcement. There is a chance that US dollar bond yields will rise again in January as the actual cutbacks occur. The yen dropped, hitting a five-year low against the dollar.
If the tapering results in reductions to Emerging Market and non-US allocations, as expected, we could see a further trend of dollar hardening. This has interesting implications for India traders since the rupee has moved up on the basis of strong foreign institutional investor (FII) inflows and a lower Current Account Deficit (CAD). A reversal and dollar bounce from the 61-62 zone could be an useful trading opportunity.
The US economy continues to grow at a decent rate and Europe is looking at a turnaround, albeit much more slowly than America. In India, GDP growth for October 2013 lifted above the five per cent level, for the first time in the 2013-14 fiscal.
The signs for global trade look propitious - the Baltic Freight Index, which indicates shipping rates for dry bulk cargo, has more than doubled in the last year. Crude rates are likely to remain low, which is a positive of course. The US will produce more crude and crude equivalents (that is, shale gas) than it has since 1988. Iran could soon be back full-tilt as an exporter.
The Reserve Bank of India (RBI) has gambled on growth by holding policy rates steady in its December policy, despite rising inflation in November and a negative Index of Industrial Production. The central bank did warn that it would raise policy rates again, "off-policy dates" if required unless vegetable prices drop, as the RBI hopes will happen in December-January. Until and unless such drastic action is required, participants in the Indian market will assume it isn't going to happen.
In 2013, the Indian market indices lost around five per cent in dollar terms and gained around six per cent in rupee terms though even the rupee gains weren't sufficient to beat inflation. The equity markets were supported only by FII buying - they bought a net Rs 86, 679 crore between January and December - that is roughly $14 billion. In contrast, Domestic Institutional Investors (DIIs) were net sellers of Rs 72,564 crore worth of equity. This was the second year in succession when FIIs bought while DIIs sold.
Next year's price trends could be determined by contrasting institutional attitudes - or aligned ones. There are a couple of situations where DII and FII attitudes could potentially align and that would result in an unstoppable trend. The direction of course, would depend on the attitude.
The FII buying is to a large extent, predicated on an assumption of political change rather than of organic improvement in corporate earnings. Since general elections are not expected until April-May, FIIs will probably remain net positive at least until then. DIIs are likely to remain cautious, or net negative, until the election results.
If the Bharatiya Janata Party-National Democratic Alliance (BJP-NDA) gains a stable majority straight out of the Electronic Voting Machine, the FIIs will probably increase commitments, at least until the taper really starts biting in late 2014. We will also probably see a turnaround in DII attitude if the NDA has a straight majority. In that case, equity values would go stratospheric because the quantum of net investment would rise considerably.
On the other hand, if there's a hung Parliament, or against all reckoning, the United Progressive Alliance manage to hold onto power, the market will probably tank. There will be massive concerted institutional selling from both DIIs and FIIs. This could be fun for the bears and at the least, the hung Parliament situation is not an unlikely situation.
The most likely situation is somewhere in-between. The BJP and NDA will have to do their share of wheeling and dealing before they can come to power with a more diversified coalition. In that situation, there will be a lack of consensus among investors. We will probably see FIIs continuing to be more bullish than locals if there's a messy coalition. Locals have a sharper understanding of how quickly policy intentions can be dissipated in such situations.
In valuation terms, the Indian markets continue to look rich. The top rung of Sensex-Nifty stocks are trading at PE multiples of around 19. This would be justifiable if risk-free interest rates were below five per cent, or if earnings growth was expected to hit 20 per cent in 2014-15. Neither condition holds. Nor are macro-economic conditions expected to improve dramatically in the next six-nine months although they could get better. Under these circumstances, betting on a bull run is just that - a bet with a risk:reward ratio. It's likely to be a winning bet at least until the elections are called.
Disclaimer: These are personal views of the writer. They do not necessarily reflect the opinion of www.business-standard.com or the Business Standard newspaper
