Liquidity to support equities; see no major cuts: HSBC

A risk-off sentiment has reemerged in markets everywhere due to the return of eurozone’s debt crisis. This time, however, there is an additional factor of political uncertainty that is scaring investors to the sidelines.

Arjuna Mahendran of HSBC says he doesn’t expect significant cuts in equities right now. “We won’t see anything more than 5-10% downside from current levels on most major indices,” he said in an exclusive interview to CNBC-TV18. He goes on to say that global liquidity will come in at these lower levels to support equities. Specifically with regards to India, Mahendran says the retrospective tax amendment will not cause as damage as expected because governments world over are looking to sequester more in terms of taxation. “So I don’t think India is really going to suffer as a result of this,” he said. Below is an edited transcript of his interview with Udayan Mukherjee and Mitali Mukherjee. Also watch the accompanying video. Q: The market seems to have become quite nervous about the news flow from Europe. How do you read it and do you think it has the potential to cause a big cut in equity markets again? A: To answer your last question, I don’t think there will be a big cut in equity markets. If you remember, the long term refinance operation (LTRO) has had one signal effect which is that it has staved off the collapse of a big European financial institution or bank. This so called counterparty risk, where large financial institutions fail, banks feel the collateral impact of that and the whole financial system freezes, I think that outcome has been staved off. So to that extent, I don’t we see anything more than 5-10% downside from current levels on most major indices. Having said that, I think the markets are nervous of the sovereign issue, which is the default of a country. Remember, country defaults have happened serially for several decades. We have had most recently countries like Argentina and Russia defaulting and that really hasn’t taken a big toll on financial markets because other countries have been doing very well and that’s offset this. So if a big European country were to get into difficulty, Spain in the near-term or even Italy in longer term, I am sure there would be some sort of a band aid that could fix it. To that extent, I think this nervousness in markets just reflects the uncertainty about how governments are going to impose taxes. Remember, a lot of these governments that agreed to this fiscal stability pact last December are now facing elections or outright defeat like what happened in the Netherlands. In the case a government collapses, it means that as a signatory to the fiscal stability pact, its contribution is no longer valid. We have the French elections in two weeks and we don’t know whether Mr. Sarkozy will survive. So this whole fiscal stability pact is coming away in pieces and this is I think the uncertainty that’s really roiling the markets. Q: Do you think the outcome in May for Europe will hinge around these political issues or it could be financial issues? Spanish yields have been rising and that started off the first few negative rumblings from Europe a couple of weeks back? A: Obviously Spain will be the embodiment of this current uncertainty because those spreads mean that the fiscal situation is again becoming untenable. Instead of contracting, their debt is expanding and at the basis of all this is the fact that the Germans are imposing a harsh fiscal regime on the rest of Europe which is making Europe growth slower, if not eventually contract. This means that unless you grow your way out of this fiscal morass that we have across large parts of Europe there really is no solution. So at the end of the day, it’s a question of how the Germans will respond to these growing fears of disequilibrium in countries like Spain and eventually Italy. The faster the Germans react positively to this by shelling out more cash the better it will for the markets. But obviously the Germans have their own political constraints. So in a sense, the whole thing is now clarifying which way the Germans will move and until that happens the markets are going to remain uncertain once more. Q: How important will the outcome of the Fed meet be for markets? Do you expect to hear anything at all with respect to QE3? A: Not yet, I don’t think so. The Fed by its own statutes is bound to be responsible in terms of the inflationary consequences of its actions and to the extent that US leading indicators still haven’t really deteriorated significantly, I think it would be perhaps uncharacteristic of the Fed to be very aggressive at this stage. I think they will certainly lay the groundwork for some announcement around the third quarter which is when incidentally I expect more aggressive action from the Chinese as well in terms of stimulating the economy through cuts in CRR. In China for instance, the reserve ratios are 20.5% of bank deposits compared to an average of 5% over the last decade. So they have lot of scope for cutting in China which could actually be more significant than a QE3 announcement from the Fed. But if all that comes together, sometime post July in my view, that could be a big staging post for another rally in risk assets globally. Q: What’s the general perception on India now and the emerging markets or the Asian basket? A: Interestingly this whole question about retrospective taxation of foreign assets etc. all that I think is dovetailing into a general global mood whereby governments really want to sequester more in terms of taxation. That is the general mood globally, so I don’t think India stands out like a sore thumb in that respect. Globally governments have to get hold of more cash. In America you are having a big debate about this in the run-up to the presidential elections and in Europe you can see that all these governments are collapsing or threatening to fall over because of this issue of taxation. So I think globally the mood is that taxes are going to rise. We have to take that for granted. India is just being a democratic country in Asia and so large it is in a sense spearheading that charge. But I think it doesn’t really sort of pale in comparison with the other emerging markets and if anything it’s probably setting the tone for emerging markets going forward. So I don’t think India is really going to suffer as a result of this.