Moneycontrol Pro Weekender: Complacent marketplaces are easy prey

Moneycontrol Pro Weekender: Complacent marketplaces are easy prey

Indian equities are susceptible to shocks due to their high valuation and rising oil prices, but thus far, inflows of local capital have proved a lifesaver.

Greetings, Reader

After Israel bombed the Iranian embassy this week, investors braced for a worsening of the Middle East crisis, which sent markets into freefall. The Fed's head, Jerome Powell, continued to indicate that given persistent "last mile" inflation, interest rates could need to stay higher for longer, adding gasoline to the fire in the ongoing US policy rate drama.

In the most recent Global Financial Stability Report (GFSR), released this week, the IMF provided policy recommendations that Powell seems to be reiterating. "Central banks should refrain from premature monetary easing and appropriately counteract overly sanguine market expectations for policy rate cuts that may contribute to the loosening of financial conditions and impede the final mile of disinflation," the statement reads.

However, the fact that the markets were too comfortable may be the GFSR's most significant takeaway. It notes that premiums for shorter-dated volatility risk are now at a position that is close to the beginning of the tightening cycle in 2022. With the world economy continuing to get stronger and the expectation that the global hiking cycle is coming to an end, volatility has dropped to multi-year lows for the majority of asset classes. According to the analysis, the market's low degree of volatility is an indication of complacency that might be upset by shocks. In light of the high degrees of macroeconomic and geopolitical unpredictability, volatility is too low.

Indeed, this week saw a dramatic return of international unpredictability. We had said that Iran's strike on Israel was the most recent illustration of the growing global peril. We had thoroughly examined the consequences for Indian markets, the threats to the country's natural gas supply, the geopolitical ramifications, and the future of crude oil prices. We conducted a scenario study for investors, examining the behavior of the market during previous conflicts.

Warm wishes that the US, the only nation capable of holding Israel accountable, would act as a responsible superpower in response to the assault on the Iranian embassy dissipated when the US chose not to denounce the incident and kept arming its partner. It made its position quite clear when it vetoed a UNSC resolution that called for Palestine to become a state.

Will the Middle East's growing turmoil have an impact on international markets? The GFSR highlights the very strong correlation between markets and asset classes. According to this, there is a significant average connection between the indexes of advanced economy and emerging market stocks, bonds, credit, and commodities. The study mentions a number of causes. "Pasive investing vehicles, like exchange-traded funds (ETFs), have become increasingly popular," it states. "ETFs that target high-yield and emerging market bonds are more sensitive to market-wide proxies, like S&P 500 returns, than their respective underlying indices." Another explanation is that "hedge funds seem to have moved from selecting individual securities to more heavily trading index-level securities, like futures, options, and ETFs—sometimes as contrarians to the broader market, thereby supporting asset price differentiation." Due to this change, hedge funds are now more vulnerable to general financial market shocks than to the fundamentals unique to individual assets. Because markets and asset classes are highly correlated, shocks and unpleasant surprises may result in simultaneous price reversals and contagion, as changes in one asset class immediately affect other asset classes.

Although a gentle landing is the IMF's basic assumption for the economy, it was previously factored in. In fact, according to Bank of America's most recent study of global investment managers, 36% of them think that a "no landing" scenario is possible. Fund managers have little cash on hand and are more optimistic about stocks than they have been since January 2022. Thus, it makes sense that risk assets are strategically much more susceptible to negative news than positive news, according to the BofA poll.

The market's anticipation of a gentle landing has been a significant driver of asset values. The GFSR reports that investors' increased risk appetite and better profit predictions seem to have contributed about equally to the S&P 500 index's growth. The cryptocurrency markets have reached unprecedented heights, virtually solely due to risk appetite. Both the US and European corporate bond markets have moved in tandem with the recent surge in the stock market, with borrowing spreads for both high-yield and investment-grade issuers significantly decreasing.

Financial conditions have eased as a result of these factors, which also include confidence in a soft landing, reduced long-term rates, and rallies in the stock and corporate bond markets. According to the Chicago Fed's Adjusted National Financial Conditions Index, the state of the US economy is now as favorable as it was in February 2022, before to the start of rate increases.

The market's hazards are readily apparent. One major issue that might affect markets, according to the GFSR, is the discrepancy between investor expectations and central banks. The article states, "It is unclear whether central banks in these nations will be able to implement the level of monetary easing that investors are currently anticipating, as the disinflationary momentum has slowed more recently in a number of countries." In reality, "The great bet on rate cuts—and it was enormous—is dead," according to this FT report that MC Pro users may read for free.

The GFSR notes that "the valuations of many risk assets are increasingly stretched, predicated on investor expectations for a relatively brisk monetary easing that may be tested by the bumps along the last mile." This statement is in light of the markets' complacency. The benign disinflation narrative that is popular in markets and among policymakers may be called into question by unexpected increases in inflation, such as those brought on by supply-chain disruptions and spikes in commodity prices.

What does this signify for developing economies like India's? The Indian market is prone to shocks due to its high valuation and susceptibility to rising oil prices, although these have been mitigated by inflows of local funds.

In response to the query of whether fund outflows would result from developing market central banks starting to reduce rates and reducing rate differentials, the GFSR states that this won't happen since markets have recognized that these banks have effectively combated inflation. The research does, however, issue a warning: "If policy rate differentials prove to be narrower than what is currently priced in, especially if advanced economies keep rates higher than anticipated to fight stubbornly high inflation," external pressures on emerging markets may materialize.

According to the Bank of America poll, geopolitics and inflation are the two main tail risks facing the markets. Thus, the sharp increase in gold prices is not surprising. Gold is traditionally a buffer against inflation, as this FT article states. However, investors sometimes use it as a last resort if they have concerns about the stability of the status quo. It will wait for decades before emerging at a significant turning moment in the globe, like this one.

Salutations,

Manas Chakravarty

Other than our technical recommendations for the equities, commodities, and FX markets, here are some of the articles and analysis we released this week in case you missed them:

Stocks

Infosys, GM Breweries, Va Tech Wabag, Senco Gold, Repco Home Finance, ICICI Lombard, Max Healthcare, Capital Small Finance Bank, Weekly Tactical Pick, Bajaj Auto Q4, TCS, and Discovery Series: Cello World

MarketsRate cuts in the US seem like a far-off fantasy, and India's stock markets are in for a difficult period.

The weather may be hotter than climate bonds.

Digital deceit may cast a shadow over India's financial future.

A silver bull case

If India gets its politics and policies right, it should expect $3 trillion in capital flows in the next ten to fifteen years: Q India's Arvind Chari (UK)

Rarely do elections affect long-term stock performance.

The Financial Times

Concentrated authority at the top of companies is a cause for concern.

The global banking system's unnoticed dangers

Do higher rates contribute to inflation?

Understanding Economics

What effects would the Second Cold War have on investment and trade?

Businesses and sectors

Despite aircraft grounding, IndiGo's market share remained stable in Q4.

It's back to the days of high costs and little flying alternatives for Indian travelers.

Health for all is still a far-off goal, despite lofty polling pledges.

Two warning signs for Indian IT from TCS's Q4 outcomes

Should the RBI start to worry about small business loans?

US pharmaceutical exports exceed COVID highs.

India will see a surge in PV electrification.

The future seems bright for cotton spinners.

Finance

How can India's exports of products gain momentum?

The tax complexities arising from the disgorgement of unlawful gains

IIP data indicates a sustained drop in the output of capital goods.

Demand for steel worldwide in 2024

Global trade: the only certainty is ambiguity

For RBI, the silly season begins early.

Prosperous Economic Monitor