If there's one thing that can be said with certainty about the current rally in the Indian stock market, it is that the bull run of the last couple of years has been fuelled by global liquidity flows. That fact needs to be kept in mind when one considers the prospects for further increases in the Indian market.
True, there's a strong case made for investment into the Indian market on the basis of the fundamentals alone -- you could point to the robust earnings growth of Indian corporates and contend that few countries in the world present such opportunities; you could point to the flood of research reports about India's vast potential; you could argue that Indian companies have changed dramatically in the last few years, and that scarcely a week goes by without a company announcing plans to either set up a base abroad or take over a foreign company.
And you would undoubtedly be right. But that would not explain the fact that on the day when the Sensex breached the 8000 mark, so did the South Korean Kospi. And a day earlier, the South African JSE index reached a new high.
A few days ago, the Mexican market index had performed a similar feat. Add to that the fact that the FTSE Midcap index too has hit a new high, and it's not unreasonable to arrive at the conclusion that what has taken the Sensex above 8000 is not the strength of the Indian economy, but global liquidity.
In any case, with more than $7.5 billion worth of FII inflows into the Indian markets this year, it's pretty clear what's driving this market.
Global boom
The argument that we have a global asset boom is buttressed by the state of several other markets. One, emerging market bonds have also been seeing an immense amount of investor interest, which has led to their spreads over US Treasuries come down to their all-time low last Thursday.
Two, the price of gold was at a 13-year high in Tokyo on Friday. And three, real estate markets in the US are widely believed to be in the midst of a bubble.
Yet another indication of the sea of liquidity is seen from the US bond market -- despite the US Federal Reserve raising the Fed Funds Rate from 1 per cent to 3.5 per cent in ten steps of 25 basis points each, the yield on the US ten-year government bond is lower today than what it was a year ago.
As a matter of fact, the record low spreads on emerging market bonds tell us that risk appetite is perhaps at an all-time high. It is this enhanced risk appetite that is responsible for funds moving out of the developed markets in the last couple of years and scouring the globe for returns.
It is this increase in risk appetite that has pushed up asset prices across the world, adding momentum to price changes. And finally, it is this appetite for risk that has led to the spectacular growth of the hedge fund industry.
The pitfalls of predicting liquidity
However, the events of the last year or so have shown that trying to second-guess the intentions of FIIs or trying to gauge the state of global liquidity is a game strewn with pitfalls.
For instance, when the US Fed raised interest rates, signalling the turn of the easing cycle, many analysts believed that the flow of funds to emerging markets would be affected.
In fact, the meltdown in May 2004, which occurred not only in India but across emerging markets, was triggered on worries about such a move. But it's been over a year since the Fed started raising rates, and the Fed Funds rate has moved up by 250 basis points, without having any impact on fund flows.
Yet another line of reasoning was that the reason emerging markets were being preferred was because the dollar was weakening, thanks to the massive current account deficits in the US, and hence it made sense to sty invested in non-dollar assets.
But even this neat little theory has been disproved this year, when the dollar started strengthening against the major currencies - that didn't affect fund flows to emerging markets.
The third theory was that the US economic boom was the result of the massive injection of liquidity via monetary easing on the one hand and fiscal deficits on the other. As these two ran out of steam, so too would the US consumer.
And since the American consumer was the Titan holding up the global economy, America would slow down, incomes would fall, funds would see redemptions and flow to emerging markets would come down.
But the US economy continues to stagger along at a decent pace and there have been few signs of distress from the US consumer.
Of course, the going has not always been smooth. There have been periodic scares along the way, as happened in May 2004,in January this year, and in April, when the momentum seemed to be flagging. And most recently, the slowing down of FII inflows in late August led the markets to totter for a while.
Going forward
The question is, when will the liquidity cycle reverse? When will the appetite for risk lessen? One line of argument is that higher interest rates in the developed markets have not led to a slowdown in fund flows to emerging markets because the real rate of inflation continues to be very low.
This is what economists mean when they complain that the US Fed is behind the curve. In other words, much more tightening is needed before rising rates will start biting, and leveraged trades will feel the pinch.
There's also an explanation why the US consumer has continued to splurge. It's contended that rising house prices in the US has led to a wealth effect, which is bigger than the wealth effect on account of the stock market, for the simple reason that more people own houses compared to stocks. It is this wealth effect, so goes the argument, that has fuelled appetite for all kinds of products, including financial products.
However, the bulls believe that the US Federal Reserve is unlikely to do anything that will result in a bursting of the housing bubble, simply because that could have disastrous consequences for the world economy. What they're trying to do, accordingly, is gently deflate the real estate balloon.
The ideal situation for emerging markets is a US economy that is not too hot (because money would then stay in the US), nor too cool (because that would mean lower US markets, which are closely correlated to global markets) -- in other words, a Goldilocks economy.
Of course, it's entirely possible that investors will shift between asset classes and markets periodically. And while it may be fraught with danger to try and predict the future course of liquidity, the US bond market, with the yield on the 10-year government bond at a mere 4.12 per cent, is clearly betting on a continuation of the current benign conditions.
