Via Mint
The most interesting event of the past week was something that didn’t happen. On 30 May, the Chinese authorities announced a hike in stamp duty on share trading, sending Chinese stocks spiralling downwards.
As the Shanghai index plummeted 6.5% and the Shenzhen Composite fell by 7.19%, investors around the world held their collective breath, wondering whether this would trigger a collapse on Wall Street. That’s exactly what had happened in February and it took over a month for markets to recover from the damage.
Thankfully, this time it’s different. After the initial knee-jerk selling in the futures market, the party on Wall Street continued. The upshot: Markets rebounded smartly across the globe a day later.
The big difference between 27 February and 30 May is that the US markets didn’t follow Shanghai’s lead. International investors seem to have realized that the Chinese stock market doesn’t really matter and the speculative frenzy there has been driven entirely by local punters.
Nor does the stock market have much of an impact on China’s economic growth, which is driven by state-directed bank lending and foreign investment. It’s very unlikely that a market crash in China will derail the economy. That’s why the crash in the stock market led to only a 1% decline in Shanghai copper prices.
Global investors seem to have learnt these lessons. In February, the crash on Wall Street was primarily about worries whether inflation was making a comeback in the US and disappointment that rate cuts would not happen. This time, there are no expectations of a rate cut.
But perhaps the key message from the blasé attitude to the Chinese shock is that it’s an indication of the strength of the current global rally.
The Shanghai crash could easily have been an excuse for speculators to take some money off the table. The fact that it didn’t happen is a pointer that risk appetite is alive and well. As EPFR Global, a research firm that tracks fund flows to emerging markets, said recently, “Risk aversion took a holiday during the fourth week of May as investors poured money into most emerging markets fund groups. Latin America and Global Emerging Markets (GEM) Equity Funds had their best week in over a year…the spread between US Treasuries and JPMorgan’s benchmark EMBI+ index narrowed to a new record low of 153 basis points.”
Of course, the action in China is far from over. If Chinese stocks shrug off the latest salvo from the government, there’s little doubt that there will be redoubled efforts to cool the market.
So far, the authorities have tried interest rate increases and increases in the proportion of deposits that banks have to keep with the central bank, but none of these measures have worked. The reason is pretty simple: While the central bank is trying to cool the market, it is at the same time flooding it with liquidity, thanks to its policy of pegging the yuan to the dollar. As Chairman Mao would probably have said, this is the principal contradiction in China today. How they resolve these conflicting objectives will be interesting.
Back home, the Reserve Bank of India has its own contradictions, having to worry about juggling the exchange rate, the interest rate and money supply. But the good news is that the latest GDP numbers show growth is now being driven by capital expenditure and not so much by consumption. That implies a resilience to higher interest rates. Corporate balance sheets are healthy, with large cash balances and not much debt, which makes them able to go in for capital expansion without being hurt badly by higher interest rates. They can also access relatively cheap debt abroad or tap the capital markets. In any case, capex is less sensitive to interest rate increases than retail credit.
The slowdown, therefore, will be primarily in the consumer discretionary and export sectors. The markets have already priced that in, de-rating sectors such as autos and IT services, while upgrading capital goods and infrastructure companies. With good global and domestic cues, the BSE 500 closed the month with a gain of 6.3%, not a bad return for investors who are traditionally supposed to “sell in May and go away”.
Yet the surge in May has also been accompanied by a bout of downward earnings revisions. Consensus earnings growth estimates for FY08 for the stocks comprising the MSCI India index have been revised downward from 16.9% to 15.7%. That makes current valuations look really pricey, especially with a lot of new issues hitting the market. The fact that stocks have continued to rally in spite of the revisions is another indication that liquidity, especially global liquidity, is driving this rally.
So what could change the outlook for liquidity? Instead of looking at China, investors may do well to concentrate on the US.
The yield on the 10-year Treasury note moved up to 4.9% on Thursday, its highest level this year. The worry is that whenever the US long-term rate goes up, as it did in May 2004, April 2005, October 2005 and May 2006, emerging markets have tottered.
During the crash in May last year, the yield on the US 10-year note went up to a high of 5.18%. In May 2004, it went up to 4.8%, sparking a huge sell-off in emerging markets. Given this track record, investors would do well to be wary of rising US bond yields.