All fall down

If anyone needed a lesson in how integrated global markets have become, the last four weeks should have provided one that will not be forgotten easily—including in India, where the Sensex has fallen 16 per cent since February 9. A small trigger in China has led to a global contagion of correction across global equity markets. As Stephen Roach, chief economist at Morgan Stanley, said in a Los Angeles Times column, “Like nearly everything else in the world these days, it now appears that global stock market corrections are made in China.”

A week ago, today, the Chinese stock market fell 8.84 per cent because there were concerns that the government was going to clamp down on loans that were funding stock market investments. While this caused some bearishness, there were other triggers as well. What is known as the Japanese yen carry trade—borrowing cheap yen to invest for better returns in other currency markets and pocketing the difference—has been in the news as investors are turning risk-averse, unwinding riskier assets and closing out such trades. The US has had its own problems—mortgage defaults are on the rise, consumer confidence is declining and concerns about a recession have pushed down US markets. This last development increased concerns in markets like Japan and Europe, and the domino effect continued. In India, the foreign institutional investors (FIIs) triggered selling, with local players participating amid the global meltdown and an uninspiring Budget. While there may be many proximate causes, the larger reality is that markets all over the world had become expensive and investors were not ready to take more risk.

This is the third consecutive stock market correction in India which has been part of a global phenomenon. In May 2006, the choppy correction began with rising crude oil and other commodity prices, which meant that there would be cost-push inflation. That correction ended when the US Federal Reserve announced that it would stop hiking interest rates. In the correction that began in October 2005, the trigger was again global investors withdrawing funds from over-heated markets—only for them to come right back a few weeks later.

Where does this leave India’s markets? As always, market pundits have started talking about the suddenly lower risk appetite for equities, and why investors should look at equity risk premium once again. The fact is that Indian stocks had become expensive. The Sensex was trading at a trailing price-earning multiple of 23.25 on January 15; that number has now declined to about 19.1. As P/Es go, even that is considered high if one’s worldview is pessimistic. If the US slips into a slowdown or recession, it will take a large part of the world with it. Even if India is an island of strong economic growth within, it has much closer links with the rest of the world economy than was the case even a decade ago. Also, institutional investors may want to stay with safety. A lot of professional investors have also been pointing out that most stocks have not recovered their losses 10 months ago, and that a handful of stocks is propping up the Sensex.

It is possible that some value buying will emerge from the sidelines—be it by long-term institutional investors or their domestic counterparts. But the real bet is on whether the Indian economy is slowing down, and if so then by how much. Also, what impact will that have on corporate earnings? The answers will not be available for another month.