All roads lead to Rome

As the ancient saying goes, that is what has been happening in the financial markets since the beginning of the current month. After Greece, Portugal and Ireland got downgraded to Junk the speculators have now trained their guns on Italy and Spain, as a result of which we have seen extreme volatility in the financial markets over the last few days. Along with this we have also seen a drama being played out in the US in relation to the Debt ceiling where despite both sides of the political spectrum knowing that this is something that has to be done a political game is being played out.

In midst of all of this we have also seen the start of the results season and the first few results have been in line with expectations. Most companies are still seeing a robust topline growth with some pressure on margins. The outlook of the technology majors is robust, thus providing a downside protection to the stock prices. The initial results from the banking space have also been good with the main monitor able i.e. NPA’s still in control for a vast majority of banks. The health of banks is important to sustain economic growth given the tight liquidity and high policy rates.

The Industrial production data that was released was way below expectations and for the first time in so may months the Inflation data also surprised on the downside. Inflation remains elevated but the bias for the remaining part of the year remains for a downward movement of inflation. As a result of the extremely tight monetary policy as well as a policy paralysis we have seen credit growth slowly starting to taper off as demand of funds for new capacity creation is drying on. The economy at this point of time is positioned in a manner where on one side the consumption story continues to be strong due to a strong employment situation as well as rural prosperity. The increase in realization on farm products, especially for cash crops combined with the dole outs under Bharat Nirman have led to strong accretion in rural incomes. The services side of the economy also continues to grow strongly. The problem today lies on the investment side where a slowdown in clearly visible. The only bright spot seems to be in the roads sector where NHAI has finally got its act together and order placements are progressing at a fast pace. The process of building new highways should now gain momentum which should continue at least for the next three years.

At this point of time it seems as if most of the domestic factors that have contributed to a downward movement of the markets seem to have been factored into the markets. However the risk today lies more from the global factors with policy makers in the Euro zone grappling with the response to the new crisis that has unfolded over the last few weeks which has sent yields on bonds of various countries perceived to be risky soaring. Although a lot has been written about this already, from whatever data is available I do not think that the kind of pessimism that is being displayed for the two larger economies of Italy and Spain is justified. It is accepted that Italy has a Debt to GDP of 120%; however the fiscal deficit for this year is projected at 3.9% and moving to a balance over the next three years. This is not such a dire scenario for the kind of battering of Italian bonds that we are seeing. There is too much cheap money floating around that is being used by speculators to short bonds and equities while pushing up commodities.

The other global factor has been the US Debt ceiling and a possible downgrade of rating of that country. I believe that the debt ceiling will be raised with the usual drama as that happened during the deliberations for the financial sector bailout talks; however the impact of a downgrade of USA’s sovereign rating could impact financial markets negatively. However this is something that we need to watch out for over the next few months. I had actually started turning negative on gold prices till this announcement came out. However a US downgrade could be a game changer for gold. Physical demand has fallen drastically after the recent uptick in prices and for gold prices to sustain we need a continued bout of uncertainty.

Market Outlook

I have been bullish on the markets for some time as my view has been that factors contributing to a downward market movement are largely in the prices. Most investors are underweight on India and domestically investors are on the sidelines and cash positions are high. Speculative positions are also extremely low. We have seen foreign investors pump in around USD 2 billion into the markets over the last few weeks. This has picked up a lot of slack from the markets.

Monsoons after being volatile have picked up well over the last week and this will be positive for agricultural output, prices as well as rural incomes.

The markets clearly seem to have made a bottom around the 5200 levels and it will now take a catastrophic event to take prices below that level. The markets are looking for a trigger to move up and that could be in the form of a short term resolution of Euro zone issues, US moving forward on the debt ceiling or/and RBI taking into account global uncertainties and not hiking rates in the 26^th July policy meeting. We could see markets being ranged till that date before making an attempt to push higher.

I still maintain my view that we should see a level of 6000-6100 for the markets, however a push beyond that will require some clarity on government policy making as well as the inflation outlook.