DECOUPLING STAGE II

At various stages of the markets when the global financial markets tend to be linked to each other on a day to day basis most investors lose focus on the fact that over the long run higher growth economies with better growth prospects and earnings growth will outperform on a sustainable basis. However the key is that the decoupling always happens over a period of time and in times of panic and euphoria most markets tend to be linked to each other.

At this point of time the investor focus largely is around the crisis in the US which is more related to its economic growth prospects rather than the actual risk of a default by the US. It is actually quite perverse that the risk aversion trade has run so much that the US 10 year bond yields have actually declined from around 2.55% to 2.1% after the downgrade by S&P. However the reality in actual terms seems to be that there is now a realization that the US Government has run out of fiscal tools and the US FED has run out of monetary tools to revive the economy in the short run and the lower bond yields are actually a reflection of the fact that now investors believe that growth will be subdued for a longer period of time and the risks of deflation are greater than the risks of inflation.

In the Euro zone the issues related to the troubled countries have been well talked about however the rumors around the downgrade of France from AAA have continued to go around despite multiple statements by S&P that the rating is AAA with stable outlook. Similarly the credibility that ECB has built over time has come in use after their pledge to buy Italian and Spanish bonds where the yields on the bonds of these countries have fallen by over 1% each despite not much of actual buying taking place. This also goes to show that there was a heavy contribution of short positions in the increase of these bond yields. Now Italian/Spanish bond yields have come back near the range in which they traded in the first half of the year. However the pressure of rating agencies and the markets have now forced the hands of the governments of these countries to have a credible fiscal plan. This essentially means a cut in expenditure and increase in taxes that should drag economic growth. As such although the crisis in the Euro zone could have stabilized for now but growth prospects have also diminished. Among the other large developed economies Japan continued to remain in a state of virtually no growth and the sharp run up in the value of the Yen due to the risk aversion trade will further pressure growth prospects in that country.

In this over all scenario the focus will again shift to BRICS plus other high growth emerging economies that constitute around 20% of the world economy at this stage. These markets underperformed the developed markets since November 2010 till July 2011 mainly due to inflation concerns. The play for this short period of time essentially that the Western economies are now reviving fast and with low inflation and the developing countries will need to reduce growth in order to control inflation. This strategy did work for a short period of time, however this was largely a result of QE2 from the US Fed which unleashed a wave of liquidity into the global market place and instead of going into improving credit and economic growth in the US was used by Hedge Funds and commodity speculators to push up commodity prices. This in turn resulted into inflationary pressures into high growth Emerging economies. Now given the fact that liquidity is ample and US bond yields are at all time lows, and also the fact that the failure of QE2 was one of the reasons for the US downgrade we are unlikely to see a QE3 anytime soon. However I do believe that given the extremely low interest rates prevailing now an economic revival should take place, albeit slowly.

That brings us to the question of decoupling. In the previous market phase of the beginning of the rally of the markets in early 2003 till the bottom in March 2009 is as follows - Whereas the world index moved down by 17% in this period the Indian markets were up 240% and the MSCI EM Index was up 166%. (For some reason I am not able to upload the graph, which could have been more illustrative. The outperformance really took off after the fall of May 2004. At the beginning of the BRICS rally in 2003 EMs constituted just around 2-3% of world market capitalization. As of now they are around 16-18%. Over the next two decades this will move towards atleast 50% if not more.

In the second phase that started in March 2009 the MSCI World is up just 46% as against 102% for MSCI EM and 109% for the Sensex. This has been despite a severe underperformance of Indian markets over the period November 2010 till July 2011. I believe a strong decoupling phase similar to what started in May/June 2004 and got accelerated in July/August 2006 is likely to start now as poor economic prospects in the West and lack of reckless money printing will keep commodity prices subdued. The reasons for the same will be as follows

— Given the state of the global economy, specifically the USA, Europe and Japan nearly 50% of the world economy is unlikely to participate in the next big up move

— A shattered financial system, low savings rate and high fiscal deficits will take years to repair

— Given the fact that a large part of these economies is driven by consumption, rising unemployment and pressure on wages will subdue economic growth

— In the short run these economies can be pump primed through fiscal measures

— However over the next 5-10 years economic growth in these countries is likely to be between 0-2%

— High fiscal deficits will lead to a reduction in spending and increase in taxes which will further drag economic growth

— However in this period, India and some other EMs will stand out and show strong economic growth

— As a huge deluge of dollar looks for better returns, most developing economies with potential for reasonable returns will get huge inflows

— This will be a period of growth with low inflation as 50% of the world will not grow and demand pressures will be low

— External borrowings will remain cheap

— Fiscal deficit will not be a concern for fast growing economies like India as growth will lead to higher tax revenues and there are disinvestment possibilities

— Consumption will revive strongly as the situation stabilizes. Credit availability will be strong as NPA levels have been well controlled

As such the current phase of panic in the markets could be one of the best buying phases of the markets for any investor with a medium term perspective. This is not the time to be scared out of the markets but to be scared in.

“The actual risk tends to be the lowest when the perceived risk is the highest”