See mkt correction if fisc cliff remains unresolved: Citi

Emerging market exchange traded funds or ETFs have seen tremendous foreign inflows in the last few days. John Woods, MD & Chief Investment Strategist, Citi Private Bank said the risk appetite is delicately poised at the moment. Although, the markets appear to be slightly complacent at this point in time, there could be meaningful correction in the offing if the fiscal cliff is not resolved soon, he opined.

Also read: Indian equities set for decent year-end rally: Kotak
Woods further stated that the possibility of a relief rally or a risk based rally cannot be ruled out in the event of a resolution for the fiscal cliff and this could eventually benefit the emerging markets. He also said that a market consolidation in December will not be worrying for him. Meanwhile, the tail risks emanating from Greece have also diminished, added Woods. Here is the edited transcript of the interview on CNBC-TV18. Q: There has been tremendous inflows into some of these emerging market exchange-traded funds (ETF), what have you made of it and do you think that it has been pushed to create a big year-end rally or is the bulk of it behind us?
A: I think what is driving it is still the expectation that a deal will be done in United States to resolve some of the challenges about the fiscal cliff and as a consequence, we will see something of a relief rally and risk based rally whereby emerging markets will benefit.
It is unusual that suddenly the S&P hasn't fallen meaningfully over the last few weeks despite the fact that we have had no real progress, publicly at least, on the discussions. I would say that risk appetite is delicately poised at the moment. If these ETF flows continue into Asia in general and the emerging markets in particular, we need to see some sort of a reasonable progress in this debate. Q: Do you think the markets are being over optimistic in this kind of a liquidity gush into most markets and the way they have held up despite very conflicting comments coming in from the US politicians?
A: That is absolutely right. I think that is a very good point to make. Compliancy is possibly a better word to describe market behaviour. We have seen peak profit growth in United States and profit growth is now rolling over. We have seen either decelerating profit growth in Asia or negative profit growth in some instances which suggest what flows are doing in the first place.
But my sense is that there is a lot of expectation priced into current market prices at current levels. If we were to see even the slightest implication of that over the next four weeks, we will fall off the fiscal cliff and I am very worried about a meaningful correction in risk pricing.
_PAGEBREAK_ Q: Would you say that the probability of a correction going in to the end of December is higher than the possibility of a year-end rally which the market seems to be sniffing?
A: In many respects we have had a reasonably good push into the fourth quarter. I do think they are seeing positive gains. For example, last month Asia, ex-Japan, posted a 3 percent rally. Japan posted a 5.3 percent rally and Europe picked up 2 to 3 percent.
So, we have had some reasonably good performances during October and November. If we get some sideways trading or slowdown in December, that won't particularly worry me. What would worry me obviously is the tone and shape of risk appetite in the first quarter of next year. That will be clearly dictated by events starting from January 1. Q: Most people seem to expect a long protracted negotiation at this point and things could falter right into the middle of the year in terms of discussions on the fiscal cliff. What kind of an impact could that have on equity market performance?
A: If the US economy were to fall over the fiscal cliff and to be fair, I don’t think that is the market scenario at the moment. But if we were to see fiscal tightening, either through spending cuts or tax increases equivalent to three to four or possibly five percent of gross domestic products (GDP), in other words you would expect to see a meaningful negative growth in the first quarter GDP in United States before the markets and the economy begin to recover.
That would have a very powerful effect on sentiment, particularly towards emerging markets and all of it will be negative. Again, this is really the key factor now driving sentiment. If we get a so-called compromise solution, a solution where the can is kicked down the road for maybe 12 to 18 months, the markets will take that particularly positively and it is probably the likely outcome as it stands at the moment. Q: Is that down to being the central risk for global markets though, for other issues like what is happening in the euro zone or the growth slowdown in China, are people feeling more sanguine going into next year?
A: I think China has shown some stability in September, October and the numbers published over the weekend for November shows the expansion of the Purchasing Managers' Index (PMI) also. I think there is a sense that the momentum of growth in China is slowly stabilizing and slowly picking up. To that extent, it moves off the centre of risk radar screens. The deal in Greece is yet to be done. We have to go through the debt buy-back programme. That is still reasonably contentious, not least for the banks and pension funds holding Greek sovereign risk.
We will get more information or more details about that today. However,I do think the tail risks in Greece have diminished and to that extent again it can move off the centre of the radar screens. In the front and centre however, is the fiscal cliff. I agree with your point that it is the central concern the markets have to focus on. Q: How do you see currency market shaping up from hereon? So far the euro has done well, it has moved back to 1.3 to the dollar. The dollar index has not made much headway. In the events unfolding through December how do you see the currency complex being left at the start of next year?
A; It is absolutely a binary outcome, isn't it? If we do see a positive deal signed, a deal that prevents the economy from falling off the cliff then it will be positive for dollar weakness. We would expect to see surplus economies in Asia in particular, outperforming the deficit economies or I should say, surplus currencies and deficit currencies. Therefore, all those positive current account surpluses will outperform the deficits.
But, the flip side is also the case isn't it? If a deal is not struck and if the US economy falters and falls off the cliff, obviously we will see dollar strength across the board and Asian weakness across the board as a consequence. Obviously, it is different to those linked to the dollar such as Hong Kong dollar, Renminbi and to an extent the Singapore dollar.