Some clues on global cues

If you flip to a business channel after 4 p.m. on a market day, chances are that a mysterious pair of words — Global Cues — will be flashing on the screen. “The fall in domestic stocks was on global cues arising from the belief that losses in the US mortgage market would impact the world’s biggest economy...” the anchor explains.

What constitutes these “global cues” and why do Indian stocks react to fears of a US recession or interest rate changes in Japan? Here are a few answers:
Why global cues?

The phrase ’global cues’ is a way of explaining the positive/negative effect of events in other markets on Indian stocks. Global cues have an impact on Indian stocks because of two factors. First, India’s financial markets and its economy have developed greater linkages with the rest of the world, as companies trade, expand their operations, acquire and borrow actively overseas.

Second, there has emerged a large class of global institutions and funds that dabble in and actively switch money between stocks, bonds and currencies from across the world. Such investors today play a key role in stock market movements.

As equity markets in Europe and the US mature, those seeking higher returns on their investments have made a beeline towards the emerging markets, India included. Foreign Institutional Investors have pumped in nearly $60 billion (over Rs 2.5 lakh crore) in Indian equities so far and are major stakeholders in Indian companies. As their radar is always on for the best investment opportunities worldwide, any change in interest rates or stock prices at any of the major global markets has a bearing on their investment decisions for India.

Tip: Don’t be content with knowing that ‘global cues’ caused a stock market slump. The trick lies in identifying cues that impact your stocks and sectors.

Events that matter

The following types of global events have, in the past, had a material impact on Indian stocks:

Interest rate changes in foreign countries — this determines whether borrowing money becomes cheaper or dearer. Keep a close watch on the US Fed/Bank of Japan/European Central Bank-related news.

Any appreciation/depreciation of major currencies against the rupee — US Dollar or Yen are most significant.

Spike in commodity prices and possible factors behind them — especially steel, crude oil and metals.

Trend in Asian markets (same day) and US markets (the previous day) — this determines the overall breadth as well as direction for the Indian markets.

Major announcements/statistical releases regarding the US market — mortgage market, economy, growth, inflation and their impact.
A Yen for trade

Large foreign investors borrow money in Yen in Japan and then invest in emerging markets, including ours. Suppose a US fund-manager borrows in Japan at the rate of $1=130 Yen and invests in Indian equities at $1 = Rs 41. The Indian stock markets have given a return of 16 per cent for the year.

Assuming the Yen depreciated against the dollar by about 7.7 per cent for the year and the dollar depreciated by 4.8 per cent against the rupee… this pegs the yearly returns for the fund-manager at 28.5 per cent (16 + 7.69 + 4.88) in Indian stocks!

This strategy, called “carry trade” is popular because an investor borrows a certain currency at a relatively low interest rate and uses the funds to purchase a different currency yielding a higher interest rate.

The Japanese interest rate has been hovering at less than 1 per cent for some time now (it was zero per cent for several years!). This effectively means that foreign investors can invest in Indian stocks using a relatively cheap yen and earn whopping returns.

The risk in this carry trade is the uncertainty about exchange rates. If the US dollar fell in value relative to the Japanese yen, then the US fund-manager would run the risk of losing money. When the Japanese currency gains strength against the US dollar, many of these traders may be forced to unwind positions, as they reportedly did in March this year.

Tip: Changes in interest rates have a direct bearing on currency movements. Major changes in the US dollar or the Japanese Yen can trigger volatility in Indian stocks.
Sub-prime woes and sub-par returns

The US sub-prime mortgage problem, cited as the reason for the recent stock price meltdown, tells you exactly why we should keep an eye on developments that have a global impact.

By definition itself, sub-prime mortgage loans are riskier loans made to borrowers who are unable to qualify under traditional, more stringent, criteria. This means these mortgage loans inherently carry a much higher rate of default (failure to pay up) than prime mortgage. So what prompts lenders to make funds available to these unreliable homebuyers?

The answer lies in a process called securitisation: where similar loans or mortgages (low-quality debt) are packed off as a negotiable security and sold off to firms.

Investment banks such as Bear Stearns and Merrill Lynch bought these loans from organisations such as Freddie Mac (nickname of Federal Home Loan Mortgage Corporation) to capitalise on higher interest rates without much effort.

Freddie Mac is a US Government-sponsored corporation that purchases residential mortgages and securitises them. Sub-prime mortgages totalled $600 billion in 2006, accounting for about one-fifth of the US home loan market.

All was going well until there was a cooling off in property prices and a steep rise in defaults by borrowers causing more than 20 sub-prime mortgage lenders to fail in the US. The failure of these companies caused the mortgage securities market to collapse.

With the fear that the mortgage crisis is growing bigger, an impending slowdown in the housing boom, and thus in the US economy itself, is a possibility. That is bad news for Asian economies and corporates, whose growth rates are hitched to a sustained boom in product and services exports to the US.

Tip: Markets often overreact to situations. When in doubt, delay investments.
Bad weather in Kuwait

Global changes in commodity (especially crude oil) prices hold considerable sway over stock prices because of their implications for corporate earnings. Factors such as lower oil inventories in the US or hurricanes in an oil-field can influence crude oil markets and escalate prices. This is important to stock markets not only from the point of view of refining companies, but also others.

A shortage of oil means higher fuel prices, which can cause a ripple effect on transport cost across sectors. Higher crude oil prices can also escalate input/raw material prices for oil-derived products and raise costs for companies that use them as inputs, trimming their earnings growth.

Tip: Understanding commodity price trends is important for stock market investing. Follow London Metal Exchange (LME) news if you are investing in the steel sector and New York/London WTI/Brent crude quotes for oil prices.