First a bit of context on China’s stimulus-driven rally.
This is not the first time that China has extended a stimulus “carrot” to entice investors. Back then in Feb-March, China announced series of stimulus measures targeting property sector and infrastructure investments. It did trigger a rally in Chinese markets with the Shanghai index moving up by over 17% then. However, the momentum quickly fizzled out as the impact on the ground was limited.
Now, in October, a new round of stimulus has been announced with a broader scope, emphasizing domestic consumption over infrastructure. Interestingly, both rounds of stimulus coincided with Chinese markets hovering around the 2700 level, prompting rallies both times. This time, markets initially responded with a stronger rally of over 25%+, yet they now trade just 4% above the peak reached post-March stimulus. This repeated pattern raises concerns of a potential “hope-disappointment” cycle, where markets might return closer to previous lows as initial excitement fades, unless the Chinese government instils greater confidence through stronger and more targeted consumption measures that have a higher degree of success in turning around growth prospects on the ground.
Now, turning to the impact on the Indian markets, we are noticing an interesting shift in the market dynamics from the month of August. The tenor and structure of the markets have undergone a dramatic change over the last few months since August. Prior to August, markets, esp. the broader ones had a one-way bull run. FIIs action did not have much of an impact on the markets. It was less sensitive to global news-flow and global developments. It was charting its own course, more driven by domestic flows, domestic support and domestic growth story.
That was the case till Aug. It is no longer the trend now.Beginning in August, it has become more sensitive to global news flow and developments. FIIs action is having a larger impact. For example, in early Aug, fears about yen carry trade unwinding and fear of US recession set off a huge volatility in Indian markets. Post that once the data from US pointed to stronger job and retail numbers, things settled, and Indian markets began to move up. Now, in Oct, a series of stimulus measures from China has made FIIs to rethink on China allocation. With Chinese markets witnessing a sharp rally, EM funds that are hugely underweight on China so far, have been forced to rebalance quickly to protect them from China driven underperformance which led to massive sell-off by FIIs in India. Expectedly, this resulted in a huge meltdown in Indian markets, especially in the broader space.
Circling back to the shift in dynamics since August, it may be fascinating to decipher what has caused this change in dynamics. Why have markets become more sensitive to global news-flow and FII action now?
Here is where India’s current cyclical slowdown comes into the picture. So far, till Q4 last financial year, India’s growth outlook and hence corporate earnings story were pristine and promising. But that changed in the first quarter of the current financial year. While economists and analysts initially dismissed the Q1 slowdown as a mere blip due to the heat wave and general elections, the persistent slowdown in Q2, reflected in high-frequency indicators, challenged their initial optimism. Then came the serious of sluggish corporate results for Q2 which firmly put an end to the debate on the slowdown. Now the only question that remains is whether the ongoing slowdown is cyclical or structural. In all probabilities, it is likely to be cyclical driven by unseasonal rains and a temporary slowdown in consumer spending exacerbated by slackness in Govt. spending.
Now, connecting the dots, weak corporate earnings probably are the culprit we are looking for, which has most likely triggered the shift in dynamics for the markets since August this year. Buy-China trade coming on the back of slowing corporate earnings in India must have exacerbated the sell-off in India. Still, it doesn’t fully explain the quantum of FIIs sell-offs. FIIs have sold over $12 billion this month, and the figure continues to rise. Even during the height of the COVID crisis, selling only reached $8.5 billion. Is there more to this than just the China factor? We believe there is.
The headwinds from rising U.S. yields and the strengthening dollar index play an added, but significant role. Back in August, concerns centred around a potential U.S. recession fuelled by weakening job numbers, leading markets to anticipate more aggressive rate cuts.
The Federal Reserve did implement a 50-bps cut in September, resulting in a sharp decline in the 10-year yield and a dip in the dollar index.
At that time, the prevailing thesis suggested this would attract more flows into emerging markets. However, the narrative has surprisingly turned a full circle. With a stronger-than-expected growth outlook for the U.S., markets are recalibrating their expectations for the pace and magnitude of rate cuts. This shift has contributed to rising yields and a firming dollar index, adding further pressure on capital flows as emerging market currencies come under strain.
In summary, the current sell-off in India is far from a straightforward narrative. It has all the thrilling elements of a successful Bollywood script. It begins with China-buy trade. Then the plot thickens from sudden and surprising slow-down in corporate earnings in India. But the final punch for the plot comes from the Uncle Sam whose surprisingly robust economic strength adds to the twist. When we piece it all together, the script takes a nasty turn for India. Now, the intriguing question on everyone’s mind is this: Will it end with a time correction or a significant price correction? Since sharp price damage typically requires a major crisis—either domestic or global—the most likely scenario is that Indian markets will move sideways (after the initial price damage) as they digest this temporary slowdown and await improved growth visibility. Thus, the climax is likely to be a time correction. However, a nasty ending involving sharp price damage cannot be completely ruled out, as markets can be as unpredictable as the whims and fancies of Bollywood storytellers. Can’t wait to watch the end!
