Smart money drives financial markets

Excellent talk by Tom Williams - Author of "Master The Markets".

Why global markets are scaling new heights

Stock indices everywhere are hitting new highs. The Dow Jones Industrials, the Nasdaq, the Kospi, the Straits Times index, the Sensex and the Nifty, the Hang Seng, Australia’s ASX200 and even Egyptian stocks have all been breaking records.
How does one explain this fantastic surge in stock markets across the world barely a week after everybody came to know about the dangers lurking in the sub-prime mess in the US? Why is it that the Sensex and the Nifty are setting new records when almost everybody expects earnings growth to slow down and when the Infosys results have revealed the damage that can be caused by the strong rupee?

The usual answer to these questions is that it’s the result of liquidity. Liquidity has been the explanation offered for this bull run ever since it began in 2003, although there are differing accounts of why such a flood of money appeared in the first place.

Some blame it on profligate central banks, others on an excess of savings over investments. Liquidity is an all-encompassing term that means different things to different people, but in terms of numbers it boils down to one statistic: The ratio of global financial assets to annual world output has vaulted from 109% in 1980 to 316% in 2005, according to data compiled by the McKinsey Global Institute. Between 2002 and 2005, world financial assets increased from 272% to 316% of global gross domestic product (GDP).

Doesn’t the fact that interest rates have been rising across the world in the last couple of years mean that liquidity is coming down? Yet a rise in the Fed funds rate from a low of 1% to 5.25% seems to have had little impact on asset prices.

The same goes for the rising interest rates in Britain and the Euro area. Serhan Cevik, Morgan Stanley’s vice-president for North Africa and West Asia, points out that the market capitalization-weighted average of short-term interest rates in the world has increased from 1.5% at the end of 2003 to 4.3%.

There are several explanations. One of them is that interest rates are still low by historical standards. Till recently, despite the rise in policy rates, the yield on the US 10-year treasury note was well below 5%. Another version is that, because globalization has led to the induction of low-wage countries like India and China into the world economy, competition has increased and inflation is no longer a threat.

Accordingly, central banks find that they can stimulate their economies without stoking the inflationary fires. Part of the excess supply of money does go into the real economy, pushing up growth, but a lot of it flows into financial assets, boosting their prices. Yet another explanation is that interest rates in Japan are still very low, which is why the yen has become the funding currency for the carry trade. It’s only when the Bank of Japan starts to tighten, so goes the argument, or when the yen starts appreciating, that liquidity will be hit.

There are other reasons for liquidity to be abundant. The central banks of some developing countries, especially China, have been huge creators of liquidity, as they accumulate foreign exchange reserves, releasing local currency in return. (That’s exactly what’s currently happening with the Reserve Bank of India’s (RBI) attempts to prevent the rupee from appreciating.) The forex reserves, in turn, are parked in foreign currency bonds, usually in US treasuries, driving down interest rates there and adding to liquidity. Recent data show that China added $266 billion to its reserves in the first half of the year, while Russia, Brazil and India (Bric) added another $200 billion or so. That’s a $466 billion addition to liquidity by the Bric countries alone, without taking into account the surpluses of the West Asian oil exporters. As Cevik points out,

“The accumulation of foreign assets by oil exporters and Asian countries increased from 3.7% of global GDP in 1999 to 9.5% last year.”
Besides these central banks and the oil exporters, there are other players who add to liquidity by financial leverage, through the creation and widespread adoption of new financial instruments that cut up and bundle risk in new and complex ways. It’s estimated that the total amount of exchange-traded and over-the-counter derivatives have increased exponentially from 26% of global GDP to an astonishing 789%. The rapid growth of these instruments has enabled credit to be enhanced despite monetary tightening. Cevik says that derivatives and securitized debt instruments account for almost 90% of global liquidity, while traditional monetary aggregates represent a mere 10%. That is why commentators are so worried about the sub-prime contagion in the US—if its impact spills over to other asset classes, the contraction in credit could be explosive.

But for that to happen, interest rates need to go up further. The Bank for International Settlements has said that a rebound in the cost of oil as well as rising wages, increasing capacity utilization and falling unemployment may be stoking inflation. But it is by no means certain that inflation is rising.

Back home, however, the situation could be different. The topping out of interest rates has led to a sharp rally in equities. The Bombay Stock Exchange Auto index, for instance, is up around 9.5% in the past one month. But given the pressures on the rupee and the fact that market interest rates are lower than policy rates, the RBI may have no alternative to hiking the cash reserve ratio. The weight of money, however, tends to smother all doubts.

Stock Markets and Economy

A recent research note by Rob Subbaraman, chief economist for Asia at Lehman Brothers, explores the relationship between the equity markets and real economy in Asia. Subbaraman says equity prices can affect the real economy in four ways: by making households feel richer, as the value of their equity holdings rises, and this ‘wealth effect’ then spills over into higher consumption; by increasing business confidence; by increasing borrowing capacity by raising the value of assets pledged as collateral; and by raising the market cap of a firm relative to the replacement cost of its current assets (a factor known as Tobin’s q) which will induce entrepreneurs to add capacity.

Subbaraman finds that the state of the equity markets is important for the economy in only four Asian economies—Korea, Taiwan, Hong Kong and Singapore. For India, the correlation is not significant. That’s hardly surprising, since equities make up only a 4.3% share of Indian household financial assets, compared with 29% in Singapore, 22% in Taiwan and 19% in Korea. What’s interesting is that Subbaraman argues that if the frenzy in Shanghai continues, the share of equities in Chinese household financial assets will jump from 4.5% in 2005 to 8.7% by the end of this year. China’s market will then “no longer be a sideshow for its economy”. When that happens, global markets won’t be able to shrug off the dramatic swings in the Chinese stock markets quite so blithely.

There is plenty of research that points to the importance of deep financial markets for economic growth. Unfortunately, the empirical evidence is hardly supportive. China, for instance, has managed to sustain a blistering pace of growth with very underdeveloped stock markets. Earlier, South Korean and Japanese growth too did not depend on the health of their stock markets. But while the secondary market may not have an appreciable impact on the economy, surely the primary market does, through IPOs and follow-on offers?

Indian companies raised $7.23 billion (Rs29,643 crore) from the domestic capital markets last year, or around 7.5% of the increase in non-food bank credit during the year. And China’s raising of $56.6 billion from global markets last year certainly had an impact on its economy, as it’s a significant proportion of its bank credit growth. More interesting, however, is the impact of economic growth on stock prices. One of the main reasons for the attraction of the Indian market lies in the high growth rates for the economy, which leads to higher corporate earnings. That’s the reason investors from all over the world are pouring their money into Indian equities.

Could they be mistaken?

Economists researching the subject have argued that high economic growth is by no means a guarantee of high stock returns. A study by Jay Ritter of the University of Florida on ‘Economic Growth and Equity Returns’ found: “It is widely believed that economic growth is good for stockholders. However, the cross-country correlation of real stock returns and per capita GDP growth over 1900-2002 is negative. Economic growth occurs from high personal savings rates and increased labour force participation, and from technological change. If increases in capital and labour inputs go into new corporations, these do not boost the present value of dividends on existing corporations.” “Countries with high growth potential do not offer good equity investment opportunities unless valuations are low.” Historically, says Ritter, much of economic growth has come from infusion of capital into new firms, a conclusion that ties in with the large number of IPOs by Indian and especially by Chinese companies.
As US finance guru William Bernstein has pointed out, “The bad news is that if a nation’s economy grows at x% per year, per-share earnings and dividends do not also increase at x% per year—they increase at (x% - y%) per year, where y% is the amount of share dilution.” Also, in a competitive economy, the benefits of technology are usually appropriated by consumers. A couple of years ago, a study by ABN Amro
Bank and the London Business School found a negative relationship between per capita GDP growth and stock returns between 1,900 and 2004 for 17 countries.
Professors Elroy Dimson, Paul Marsh and Mike Staunton of London Business School, commented: “Investors who allocate assets to countries with high expected GDP growth do not, on average, achieve superior returns. Historically, buying into equity markets with a high GDP growth rate has given a return that is below the return of markets with a low GDP growth rate”.

So why do investors continue to flock to emerging markets?

Here’s the answer: Over the period 1951-1980, the period which marked the phenomenal rise of Japan, the Nikkei rose from 102 to 7116, a rise of 6,876%. Over the same period, the FTSE all-shares index rose from 41 to 292 and the Dow from 235 to 964, increases of 612% and 310%, respectively. But perhaps taking 1951 as the base is not right and the rise reflects Japan’s recovery from the destruction caused by the World War. Well, even if we take the two decades between 1961 and 1980, the Nikkei went up by 424% over the period, while the FTSE and the Dow went up by 186% and 56.5%, respectively. At least so far as the Japanese experience is concerned, rapid economic growth did result in superior stock market performance.