Equities seem on course for a rough ride

It remains an FII game, despite the emergence of stronger domestic players.

MUMBAI: Indian equities are becoming more vulnerable to global trends as is evident from the movements in equity indices globally.

Equities across the globe have performed well in the two-and-a-half year period from December 31, 2003, to December 31, 2005, with varying degrees of performance (See table).

India, among the countries under consideration has performed the best over the period with absolute returns of around 97%, while the US has been the worst performer with absolute returns of just 8%.

In the current calendar year 2006, equities after touching peaks in May 2006, fell sharply and touched lows for the year in June 2006.

The fall from peaks was the highest in India with a 29% fall while UK and US had the lowest falls from peaks at 8%.

The recover has also been sharp from lows, with India gaining 28% from lows while US and UK came in last at around 6% and 4% gain from lows, respectively.

A look at the flow of dollar into Indian equities would reveal that the equity performance has been fuelled to a large extent by liquidity flows from abroad.

The loose fiscal and monetary policies of the US government, as seen by the increasing current account deficit and record low interest rates maintained by the US Federal Reserve (benchmark Fed Fund rates was brought to a low of 1% to spur growth) has led to a large flow of dollars into emerging markets.

India is a prime beneficiary of the flow of dollars as seen by the build up of its foreign currency reserves.

No, we are still very much dependent on FII flows
The current calendar year 2006 has seen the pace of FII inflows slow down . FIIs till date have invested only Rs 16,000 crores in Indian equities (January-August 2006) against Rs 29,700 crores in the similar period last year.  In May 2006, FIIs pulled out Rs 7,400 crores from Indian equities, contributing to the fall in Sensex by around 28%. Though, this selling was absorbed by domestic mutual funds who bought Rs 7,500 crores of equities, the Sensex, still fell, proving that the drivers of Indian equities are still FIIs. The climb-back of the Sensex from lows were also driven by FIIs who were net buyers of Indian equities in June, July and August for Rs 5,600 crores, while domestic funds were net sellers of Rs 2,300 crores in those three months.

The 5800, 11,500 key indicators
The movement in key indicators over a two-and-a-half year period would place things in perspective for the outlook for the markets ahead. The following table gives the movement in the key indicators and their impact on the future direction of the market.

How would the indicators have to behave if the stock markets have to generate positive returns?

The stock market to continue on its uptrend, has to attract FII flows at a faster pace that what it is doing now. FIIs on the other hand, have to factor in higher borrowing costs, higher market valuations and a potential slowdown in world economy brought in by higher oil and commodity prices and higher interest rates due to central banks rate increases globally.  Central banks have to stop their rate hikes as increased borrowing costs have the potential to bring down consumer demand leading to fall in property prices and sales of automobiles. However, central banks to stop rate hikes require to see the threat to inflation brought about by higher economic growth die down. Central banks stopping rate hikes could mean slower growth and fall in market valuations.

Oil prices have to come down as high oil prices crimp demand, stoke inflation and increase government fiscal burden in emerging economies. However for oil prices to fall, global demand has to slow down, again a sign of weakness for stock markets.  The dollar requires to continue its downward trend for emerging markets to attract greenback flows. However, for the dollar to fall further US current account deficit has to increase, and if this happens the US Fed can only raise rates further. A fall in current account deficit suggests a slowdown in US consumer demand for world goods, again a sign of weakness for emerging market stocks.  Corporate sales and profitability require to grow at the same pace seen it has been growing over the last three years.

For this to happen, interest rates have to remain steady or come down, liquidity has to be ample in the system, credit growth has to be strong, oil prices must come down and world economy has to stay on a strong growth path.