Borrowing a quote from Tom McClellan, There are really only 2 fundamentals that matter for the overall stock market: 1) How much money is there? and 2) How badly does that money want to be invested?
All-time highs in the US stock indices and fresh 52 week highs in Indian and few other EM equity markets too have occurred over the past week. Market participants are willing to pay up to get a few ounces of growth. Brexit has made markets sanguine that Fed will not have the courage to talk about a hike soon and other major central banks around the globe, will keep pouring the sugar tonic of easy money.
It is now Bank of England’s turn to leave the camp of tightening bias to the camp of easing bias. It is a matter of time before BoE steps on the gas and unleashes near zero rate money into the economy, local as well as global. Global debt cycle, weak growth and high inequality causing socio-political strife has historical precedents. However, what is unprecedented is that we are seeing the same unfold at a time of fiat of money or paper currency. The fiat currency system allowed central banks to expand the base money literally without any meaningful limit. The bond vigilantes have been warning about the risk of hyperinflation but they have been barking up the wrong tree. In a world where secular debt cycle peaks, demand remains constrained for a very long time. In absence of the demand impulse, inflation can remain suppressed and hidden. Inflation has primarily been hiding in the financial assets and real estate as the global debt rebalancing process has caused the commodity bubble to go bust. So inflation is now the asset inflation, which instead of corrosive is actually virtuous for the asset owners. However, major chunk of risky assets are owned by the rich and hence the benefit of the asset reflation have flowed to them more than others. Therefore it is natural that inequality has risen and that is now polarizing the society. What central banks began as an exercise to rekindle growth has now caused distorted version of growth.
In that ocean of global liquidity Indian financial markets are perfectly placed to reap the benefit. Post election in 2014, GoI has been quite successful in altering the dominant narrative surrounding India. India is now seen as a nation which is willing to do what is necessary to unlock its vast potential. The list of reforms is long but it was important to make a start and shape the large message and that NDA has been quite successful in doing. The size of our financial markets are small compared to investable and speculative flows that are now swamping the global financial markets. Small and beautiful makes it a compelling destination where foreign money flow can cause massive upsurge in local financial asset markets, equity and bond. Indian equities not far away from the all time highs of 9100 odd it touched last year. It is not just the equity markets, local debt market is also on fire. Indian corporate and government debt prices are surging. Indian 10 year has touched the highest point since 2013, at 7.26%, and not very far from the 2013 lows of 7.17/18%. Strong momentum in these markets is also attracting local retail players to finally abandon their fear of capital losses and join the party. Price momentum is strong attractor, as it can over a period of time alter the narrative on its own. The fear of improving but still weak fundamentals are no hindrance to the great asset rush. In this bull market sell-side and buy-side has found their favourite pastime, the game of extrapolation. Human mind does the rest.
Indian Rupee is also finding it difficult to not participate in this great Indian asset chase. One can always blame the strong hand of RBI behind Rupee’s below potential performance against the US Dollar. Central bank is standing like a wall, kind of a Grinch in the land of Merry Christmas. However, we believe that is what a central bank should be doing, leaning against the ongoing theme of merry making or despair of markets. Bank of international settlements covered this aspect very well in their recent Annual Report.
Perry Mehrling summarized it well when he said, “How exactly are actually existing central banks supposed to deliver financial stability? The idea seems to be that they should “lean against the wind” of the financial cycle, by tightening more during booms. The pre-crisis orthodoxy of inflation targeting suggested the existence of an inflation-neutral “natural rate” of interest, and the Taylor Rule for optimally shifting policy rates in response to external shocks. The lesson of the crisis, according to the BIS, is that we need to replace that orthodoxy with a “finance-neutral natural rate” instead, in order to lean against the wind of the financial cycle.” Another of saying that would be, central banks needs to be like a Grinch when world is too doped to expect only a Santa and vice versa . World over we are seeing just the opposite. BIS goes on to say that, “At present, according to BIS calculation, the finance-neutral natural rate is positive, even as the realized real rate of interest is negative. Monetary policy is thus presently leaning with the wind, not against it, so amplifying instability. That’s the bad news.”
As long as RBI stands like a wall soaking up the flow of Dollars into the local economy, Rupee may find it difficult to appreciate much from current levels against the US Dollar. But we need to keep in mind that the governor is changing and with the new governor stepping in, could we also see a change in the way Rupee is managed. Under Dr. Rajan’s tenor, Rupee has been managed perfectly where the trade-off between relative value and stability has been amazingly well balanced. Therefore, we as market participants need to be alert to changes in the exchange rate management policy. The larger question, would we now see a more hands-off approach from the central bank post August, or would the existing ways continue? The answer would determine the way we manage our Rupee risks and also the trade the same, especially against the US Dollar.