As they say, it is always darkest before the dawn. Equity markets seem to be the finest proponents of this axiom. They have a habit of surprising investors. What we have seen so far in 2012 sums it up pretty well.
Rewind to December and it seemed that markets might fall into an abyss — falling rupee, rising inflation, tight liquidity, sovereign debt concerns in Europe, FII outflows, rising fiscal deficit and widening current account deficit made a perfect recipe for disaster. Fast forward to the present and we have seen the rupee recover by 10 percent from its lows, inflation down to 7.5 percent, RBI supporting the rupee and infusing liquidity by way of OMOs and a CRR cut, European Central Bank (ECB) on its way to infuse huge chunks of liquidity in the banking system, possibility of US Fed keeping rates low through 2014, FIIs resuming their inflows in Indian equities and current account deficit being expected to narrow due to an import duty hike on gold imports.
Equity markets are up more than 15 percent in 2012 in a rally which at first looked like a short covering rally, but later, due to its sheer ferocity, has made some people think it may be the start of a more sustainable upward move.
Before commenting on whether the rally will continue, let us see what caused this rally. Was it fundamentals? Or was it liquidity?
Prima facie it seems like a liquidity driven rally that started on December 21, the day after the European Central Bank (ECB) lent 489 billion Euros to banks by way of LTRO (Long Term Refinancing Operations) for three years, to buy sovereign debt of troubled EU nations.
Today, markets have built in expectations of another trillion euros worth of liquidity infusion in the next tranche of the LTRO due on February 29. In terms of fundamentals, there have been some signs of hope both on the global as well as domestic front. Growth seems to have surprisingly revived in India as seen from the surge in HSBC PMI indexes in Dec 2011 and Jan 2012, whereas inflation has shown early signs of moderation. Even the RBI monetary policy stance seems to have turned pro-growth.
Will this continue? Your guess is as good as mine. With repayments of nearly 1.1 trillion euros due in 2012, neither can the EU afford to let Greece default, nor can it let yields rise prohibitively high so as to make refinancing impossible. Further, European banks have about USD 665 billion of debt due in the first six months of the current year, with a further USD 370 billion maturing by the end of 2012. In all probability, LTRO or backdoor QE, as one may call it, should continue for some time until Germany starts playing the role of hardliner once again. Liquidity environment is likely to remain supportive in the near term.
However, markets are unlikely to get much support from fundamentals in the near term as key indicators show growth moderating in the current quarter. On the inflation front, while there has been a temporary reprieve due to seasonal downside in fruit and vegetable prices, price pressures in high protein food items, fuel and power and non-food manufactured items still remain high and are yet to show sustained moderation. The RBI is also non-committal on easing interest rates, even though they clearly intend to ease liquidity.
What we have on our side in today’s markets is valuation. The other positive is the ‘expectations’ or ‘sense of disbelief’ in the market. To understand what might lie ahead, one needs to sense what’s going on in the investment environment.
One must be afraid of investor overconfidence, a high level of risk tolerance and a belief that risk is low. In contrast, one can take risk when investors are discouraged, risk aversion is running high, and economic difficulty is all over the headlines. Stocks have produced no gain for almost 4-5 years and no one’s excited about them, even though they are considerably cheaper. The ‘sense of disbelief’ in investment circles manifests from the fact that shorts have been built at every level in the current rally and mark-to-market losses are still being financed. Most investors today hold modest expectations for the markets.
Low valuations and investor indifference might mean that markets surprise on the upside. This makes us believe that the current rally might have some steam left in it as sentiments are not yet fully upbeat. Our stance remains positive for equities in the short term, though occasional pullbacks cannot be ruled out. A ‘buy on dips’ strategy should work well for equity investors in the near term. Valuations still remain attractive in specific pockets making it a perfect time for selective stock pickers following the bottom-up approach for stock selection.
Key risks to the above outlook might arise from surprise deterioration in the situation in Europe, the probability of which seems to have abated in the near term due to massive liquidity infusions from ECB. Apart from the above, results of upcoming state elections, mainly Uttar Pradesh, as well as the annual budget due on March 16 will remain the key factors to look out for in the near term. The RBI had clearly mentioned in its last monetary policy meet that any rate cuts in the near future will be contingent to the government adopting fiscal deficit reduction measures in the upcoming budget. Fiscal deficit is thus likely to remain the dominant theme in the upcoming budget.