Five reasons why a correction appears difficult

The Sensex has rallied by close to 10% in the last eight trading days, but a correction does not look likely anytime soon.

There are five good reasons for this:
1. The re-flow of global liquidity into markets.
2. US Federal Reserve and Bank of Japan maintaining ultra loose monetary policies
3. ECB wary of tightening too much too soon despite inflationary threats
4. China showing signs of a soft rather than hard landing, and,
5. India shrugging off effects of inflation and scams.
FIIs who were net sellers of equities in January and February are net buyers in March. They had sold over $2 billion of equities in the first two months of 2011, but bought $1.5 billion of equities in March.

FII buying is likely to continue on the back of renewed risk appetite for emerging assets and this is seen by the fact that EPFR, the fund flow tracker, has reported that April has started off with a bang, seeing the biggest daily inflows into emerging markets since November 9, 2010.

The first few days of April have seen FIIs net buying $500 million of equities. Currency movements also suggest strong flows. The US dollar, index which is a measure of the dollar’s value against various currencies, is holding close to calendar-year lows, indicating a weakening of the greenback.

This is reflected by the strengthening of the Asian currencies as well as the euro against the dollar.

The Korean won has gained around 4% since mid-March, while the rupee has gained around a percent against the dollar. The euro has gained around 3% in the last fortnight. A weak dollar coupled with strong flows into emerging equities suggests that the markets are using the dollar as a funding currency for risk asset purchases.

The US Federal Reserve is still maintaining ultra-loose monetary policy despite signs of the economy improving.

Manufacturing growth in the US for March came in at seven-year highs, while unemployment came down to 8.8% from 8.9% seen in the previous month.

The US economy created 216,000 jobs in March against market expectations of 196,000 jobs being created.

The Fed wants economic growth to gain momentum before shifting from its accommodative stance. The loose policy will keep the dollar under pressure as other central banks in the emerging economies including China, India and Brazil are raising rates to bring down inflation expectations.

The Bank of Japan is committed to keep liquidity high in the system to counter the effects of the earthquake and tsunami.
Bank of Japan’s policy will be ultra accommodative and will support a loose fiscal policy to negate the economic effects of the recent natural disaster. This will keep the yen under pressure, making it the funding currency for carry trades.

Eurozone inflation for March printed at 2.6%, the highest since October 2008 and above the European Central Bank’s target of below 2%.

The ECB has raised rates for the first time since July 2008 in keeping with its stance as an inflation targeting central bank. However, given the debt issues in the Eurozone where countries such as Ireland, Greece, Portugal and Spain are facing debt refinancing problems due to their excessive sovereign debt, the ECB will be hard-pressed to tighten policy on a sustained basis.
Higher ECB rates strengthens the euro against the dollar, which is a sign of risk appetite as the market borrows in dollars to fund asset purchases in other currencies including the euro.    

China raised its interest rates on April 5, the second time this calendar year, as a move to bring down inflation expectations. China’s inflation is trending at close to 5% levels and the government is committed to place a lid on inflation.

The tightening policy is strengthening the renminbi, which has risen 4% versus the dollar in the last one year and is touching its highest levels in almost 18 years.

China’s tightening is not slowing down the economy drastically with March manufacturing showing a growth after four months of degrowth. The government is confident of bringing the economy to a soft landing rather than a hard one and this is positive for asset markets.

On the domestic front, a feel-good factor seems returning. The economy has suffered high inflation over the last one year with the wholesale price index averaging a growth of over 9%.

The RBI has been tightening monetary policy for the last one year to bring down inflation expectations. Sentiment has also suffered due to the 2G scam unearthing political and business nexus. However, the economy itself has come out well with GDP growth of 8.6% for 2010-11.

The government has also improved its finances with fiscal deficit at 5.1% of GDP for 2010-11, below budget estimates of 5.5% of GDP. The budget estimates for 2011-12 are also positive with GDP growth projected at 9% and fiscal deficit at 4.6% of GDP. The outlook from key sector of information technology is positive with the majors looking to add on 20% more employees this year.

The fact that the Sensex has regained a lot of lost ground this year with a healthy March rally is underlying the positive note in the economy. The cricket world cup win is also a sentiment booster.
Given these, an uptrend looks more probable than a downtrend.