Investors are Idiots – Fortnight of 1st September 2011 Issue 6
Play for trend reversal
August washed out one year gains for most markets. The August debacle has left equity markets from India to Germany in the red on a year on year basis. Gold performed while the Indian Rupee (INR) lost value against the US Dollar (USD). Bond yields fell with US ten year treasury yields falling by over 60bps and Indian ten year government bond yields falling by 13bps month on month. On a year on year basis, US equities have been the best performers with Korean equities following. Indian equities have been the worst performers over one year.
The sharp fall in equities has been accompanied by a fall in bond yields and a spectacular rally in gold prices. Gold returned 12% in August and has returned 50% year on year. The growing worries on sovereign debt reached a tipping point in August leading to risk aversion trades which saw equities fall and gold and bond prices gain. However it does look as if equity markets have seen their lows and safe haven assets have seen their highs. It is a good time for a trend reversal play, especially in hugely underperforming markets such as India and China.
The reason for underperformance of emerging markets in the last one year was due to the fact that economies from India to China were focused on fighting inflation. Central banks in these countries raised policy rates and tightened liquidity in order to contain inflation expectations, which were running at multiyear highs. On the other hand central banks in US and Europe maintained a highly accommodative monetary policy, keeping policy rates at all time lows and buying government bonds to pump in primary liquidity into the system. The governments in the developed world were maintaining a loose fiscal policy while Indian and China started tightening their belts in the face of worries of debt and inflation.
August 2011 has left the economies that ran debts and central banks that ran loose monetary policies high and dry. US debt was downgraded by S&P by one notch from AAA to AA+ with a negative outlook on the back of a lack of clear fiscal consolidation road map. Countries from Greece to France including Italy saw bond yields sharply rising up on the back of high levels of indebtedness. The annual Jackson Hole conference of central bankers in August saw the central banks chiefs throw their hands up in taking economies out of trouble. There is a clear lack of policy initiatives in the developed world to speed up economic recovery.
The positions now are clear. Emerging markets including India, which have raised policy rates and brought down fiscal deficits are in a much better position to come out of a slump. The only issue facing these markets is inflation and if a persistent global economic weakness keeps down commodity prices, inflation will no longer become a threat. A stable to downward trending inflation will give central banks in emerging economies leeway to keep policy stable or even loosen monetary policy. The fact that policy tools available for the RBI or the Bank of China is more than what is available to the policy makers in the US or Eurozone will lead to outperformance of markets of India and China.