Liquidity into EMs equities to continue post taper: Experts

Q: That knee jerk reaction we saw in the US equity markets because of which most markets have sort of held out today with the exception of India. Do you think that is likely to change over the next few days as they suddenly realize that USD 1 trillion flood of dollars that has been coming in is going to slowly end by the middle of next year or end of next year?

Sinha: I was surprised by the reaction of the US markets because I think that it is almost like probably more was factored in and therefore this came as a relief that it is not going to be huge. Also if you look at it it's still going to be a large amount of liquidity coming from bond purchases, it is not USD 85 billion it is USD 75 billion. So, there is a lot of liquidity still coming.

However, this is probably going to be negative for debt markets and so the allocation from debt to equity is likely to continue. However I do think that this was a bit overdone.

Q: How would you read it? Yesterday interestingly on CNBC we had some calling the announcement hawkish because of what he did on the taper, others saying dovish because for what he announced on interest rates. Where do you stand?

Das: I would be in the dovish camp. The Fed and Chairman Bernanke in the last few months and culminating yesterday succeeded in changing the market perception of the taper in two dimensions. One, the view starting May 22nd this year was that the taper was kind of a switch. Either you are doing QE or you are not, so that has been changed.

Chairman Bernanke and others have indicated and it was indicated yesterday as well that it is data dependent and the pace of asset purchases can be slowed down or speeded up again, lowered or increased depending on how the economy behaves. So instead of being binary it is a lot more nuanced than it was in the market perception. So that is one issue.

The second issue is that the forward guidance about rates also succeeded. Earlier when they started to introduce forward guidance, it did not really work. People did not buy into it. Yesterday's dovish talk around the taper went so far as to point to a range of forecasts as you showed in your quote, the long-term unemployment rate of 5.2-5.8 percent and that was buttressed by the statement that rates would be kept on hold, essentially at zero, well below the previous 6.5 percent threshold. So I think a lot of things were said in the press conference and a lot was done in projections and the verbiage around those issues that have convinced the market that it does not need to worry about the taper. In a certain sense this is correct, because really the Fed is the only game in town; the US economy is recovering for a lot of good reasons, but also because of the Fed. What the Fed has now succeeded in doing is convincing people that if the damaged financial portfolios is going to impose certain cost on the real economy that it will undermine the recovery that it will not happen. So the reaction reflects that in United States and in countries that are very closely geared to what is happening in US.

There are other things going; the fiscal cliff, the improvement in governance that took place by ending the filibuster; that has removed the tail risk. The eurozone tail risk has been suppressed and Japan is recovering. So there are lot of good things going on outside the Fed, but the Fed has really taken the driver's seat here and convinced the market of its true intentions and its approach.

Q: Would you agree with Arnab Das because I would say that Ben Bernanke has been saying this for the longest time, please dissociate any beginning of taper with any increase in interest rates. He said it is not a trigger, he said all we are saying is till things don’t move - till unemployment doesn’t drop to 6.5 percent we are not going to even consider an interest rate hike. So, I am not sure what really was substantively different yesterday which is why I come back to the point are we going to see global markets correct here onwards and hence what then happens to equity markets here in India or in other emerging markets as well?

Sinha: I do agree with Arnab Das that the way the tapering was announced, a) the amount we discussed and b) the nuanced way in which it was announced. So, there is now no fear that it is kind of going on its own path; it is going to be very much data dependent. They are going to watch what the economy is doing. So, there is a floor on the economy not doing too badly because the moment it does badly you are going to stimulate. So, that is a very positive sign.

With respect to interest rates, even though they have said that they will keep zero interest rates, I think the markets might push the rates. So, we would see some of that happening naturally just by market forces.

Q: How does this change the way you would allocate assets?

Sinha: Historically, US investors have put about 40 percent of their assets in equities and about 60 percent or so, in debt. As of last year that allocation was as low as 25 percent. So equities were under-allocated as compared to fixed income. So this shift from fixed income to equities which started earlier this year is going to continue, because now you know that there is a not a whole lot opportunity left in the fixed income markets and this kind of gives you that signal and that reallocation is going to still pump a lot of liquidity into equities.

Of course US equity markets are not that attractively valued anymore in terms of just the simple valuations and the developed markets have done exceedingly well compared to emerging markets. So, emerging markets are trading at a huge discount still to developed market. I think this flow of fixed income into equities will continue and that might in a strange way filter down to emerging markets.

Q: Would you agree with that that in a strange way we might see this rebalancing of portfolios between debt and equity help emerging market equities as well?

Das: There is some truth to that. The points that we have just mentioned are all correct and I would very much agree with them. In addition the global environment has improved, the developed world growth is picking up and very negative expectations about emerging market growth have materialised and now things are improving in many places. The kind of initial emergency between May and September has passed, so there is not going to be a wholesale withdrawal of capital by the developed world from the emerging world. So, things are going to be better in that sense.

Having said all of those good things this is a double-edged sword. Particularly in the US it is mainly about generating wealth effect that should eventually trickle down to income effect. The Fed and chairman Bernanke in particular has been quite transparent about that and that is good so far as it goes but that is one of the main reasons together with the removal of tail risks that the multiples in the equity market have gone up.

Overtime as people do allocate away from bonds to equities and as the Fed dials down the QE over a period of years interest rates structure in the US is going to starts to rise. So, the discount rate on equity market and other kinds of cash flows in US and by extension in global economy, the discount rate is going to go up. So, at some point this rise in the valuations of equities has to be validated by an increase in revenue and earnings. That is not what's been happening.

However, what's been happening is that corporate profits in the United States in particular have been buoyed by cuts in costs for labour, cuts in the cost of capital, that is one way the discount rate plays right in and a lid and then an eventual decline in the cost of commodity inputs and also improvements in the usage of all of those inputs – labour, capital and commodities.

So, that’s made corporations super profitable, they have leveraged up to some degree and they have managed their liabilities very well in this low interest rate environment but the one ingredient that has been missing to validate all of this increase in the valuations is a big increase in earnings and in topline. Since that is not happening the Fed is going to go very slow in the taper because the wealth effect is the main game.

I said it is double-edged sword because it means that we are sort of creating a bubble. We may not be there yet but we are heading in that direction. Eventually, bubbles if they form they will eventually burst. When that happens either because the economy has healed enough that the Fed tightens or because the bubble crashes of its own weight because of something else that goes wrong as happened with the housing bubble there is going to be a problem for emerging markets and there is going to be a problem for India in particular because it is my impression that all the good things that India is doing so far are really about managing the financing shocks rather than the underlying structural problems.

Ofcourse it is election season and may be this will change in the future but a long period of easy money that has been there and that lies ahead means that the pressure to make all those changes are going to be much less than otherwise and much less than desirable.

So, we are in a period where one has to sort of go with the flow, do this reallocation away from bonds towards equities and from less risky to riskier assets because you cant stand in the face of that. However one also has to be judicious in recognizing that not all is well with the world and infact keeping these assets prices high is reducing the pressure to fix the underlying problems and India is no different in that regard, it may even be worse.