Informed Investor demystifies global market wisdom

Over the past couple of weeks, we have been talking about various asset classes and how to go about investing in them. CNBC-TV18�s special show The Informed Investors with Mitali Mukherjee will simplify jargons that are often thrown.

So that is going to be the focal point of this conversation just demystifying the global jargon and more importantly making that defining line between what impacts our market and what may not. Mark Matthews, Equity Research at Macquarie Capital Securities and Shane Oliver, Head Investment Strategy & Chief Economist at AMP Capital Investors will demystify the global jargon and more importantly make that defining line between what impacts our market and what may not. Here is a verbatim transcript of their comments. Also watch the accompanying videos. Q: The two crucial terms that we hear very often, EMs and DMs, what kind of universe do both these terms straddle and why is it important for someone who is investing in the Indian market to understand what an EM or DM is? Matthews: Both of them are indices that have about anywhere from 25 to 35 countries in them and they are indices that are managed by several different companies. So I am sure these names are familiar to our viewers, S&P, Dow Jones, FTSE but the biggest one is MSCI. MSCI was the first company to create a global index over 40 years ago and then they created various sub-global indices including emerging and developed markets and very simply the difference between emerging and developed is one of maturity and both income, developed markets. One prerequisite is that they should have high incomes per capita and also in terms of the maturity of the market itself. So the foreign exchange market should be open, short selling should be allowed, minority shareholders rights should be enforced and protected in developed markets. In emerging markets � it is not to say that some emerging markets don�t possess this attribute ofcourse some do but a lot of countries do end up in emerging markets because short selling is not permitted or the foreign exchange market is not open or fully convertible. But the general rule for an emerging market should be that it is a high growth low income economy. In other words, it is a polite term for third world and infact less developed country. It was a term that was more popular until around the 1980s and then that was seen as maybe a little bit politically incorrect. So emerging markets was termed by a World Bank economist named Antoine van Agtmael. Q: India would fall under that category you would say, India is an emerging market? Matthews: Yes, in all four of the indices, as I said, there is S&P, FTSE, Dow Jones but the big one for the most institutional fund managers is MSCI than four of those India is represented. Q: There is a sub-representation then within the emerging market region which is called the BRIC universe, what countries does that involve and why was this bracket made of just the BRIC universe within the EM context? Matthews: That was invented by one individual named Jim O�Neill, economist at Goldman Sachs and I think it was ten years ago in 2001 he wrote a report where he created this acronym. So it stands for Brazil, Russia, India, China and it is curiously not an acronym that has developed into a full asset class of itself in terms of fund management. There are a few BRIC funds but it never took off as much as emerging markets did but what is interesting is politically, there seems to be an evolution on this concept. Q: Aside from the technical qualifications between these markets, are there other ballpark generalisations that people tend to make? For example, the opinion is or the observation is that emerging markets tend to be more volatile, more high beta than a developed market, can those assumptions also be drawn when you are looking at the two clusters? Matthews: Yes, generally speaking they are. Why is that? One very simple reason is because they are less developed countries therefore they have � their middle class as a percentage of a total population is smaller and therefore the amount of domestic individuals investing in the stock market is lower in percentage terms than it is in developed marekts because there isn�t as much of a middle class yet. So in the absence of a large domestic investor base or atleast I should say a fairly sophisticated one, there are big domestic investor basis obviously in places like China and India but they tend not to be very sophisticated, they tend to be momentum followers and speculative as opposed to investing in stocks for the long-term. What I wanted to say is in the absence of that, foreign institutional investors assume a much greater directional influence on the market and India would be probably the best example I think in the emerging market space. Q: We have talked about emerging markets, developed markets, the BRIC universe but the one which has suddenly become on top of mind is the MENA region, what region of the world does that capture and why has it become so important especially when we are talking about crude oil and the implications on the equity market? Oliver: The MENA region is essentially the Middle East (ME) and North Africa so it is countries like Libya, Egypt, Nigeria, Tunisia, that part of North Africa and ofcourse the Middle East, which includes Saudi Arabia and the Gulf states. Obviously that part of the world has always been very important because it is a key supplier of global oil but in recent months, it has hit the headlines because several countries in that region have seen political unrest starting in Tunisia, which has been led to problems in Egypt and then ofcourse more recently in Libya and although Tunisia and Egypt aren�t that significant in terms of world oil supply, Libya certainly is and Libya has broken at a civil war which has affected supply world oil that ofcourse has pushed up oil prices. There has also been tensions in some other gulf states into a less degree in Saudi Arabia so as a consequence, investment markets have been looking at that part of the world recently as to gauge to how far oil prices might rise and whether that in turn might adversely impact global economic growth. _PAGEBREAK_ Q: The second part of this entire global demystification is what the data means, the one term or the one issue that most global markets are working with right now is that of inflation? You hear so many forms of these thrown about, WPI, CPI, core PPI, what is the key numbers to be watching at both from the US as a region and indeed from Asia as a region when you are trying to understand inflation trends?

Matthews: I think that many countries in Asia still base their prime interest rates on the US because they want to remain competitive in their exports. So if they raise their interest rates too much and the US is not, their currencies will appreciate and they will not be able to sell as many things to the US or to the rest of the world because the American dollar is still the reserve currency of the world. Therefore the key inflation number is still got to be that of the United States. It is also the largest economy in the world still so that kind of makes sense but when it does get to a certain level that the Federal Reserve is satisfied with, the next step will be for interest rates to rise there and there will be many follow-through-effects on various assets around the world including in Asia.   What is important about China is that it is growing so quickly that it is the end user of many of the things that are being produced in Asia outside of the manufacturing sector. China is definitely the marginal buyer that influences the direction of those commodities and so if China is raising its interest rates very quickly then people tend to worry that China�s growth will slowdown or if it cuts them too fast, people worry that its growth is accelerating too much. In general what I would say is that China�s growth is in a sweet spot for the rest of the world right now.

Q: Post the financial crisis that we saw, suddenly a lot of eyes became focused on US specific data and there is so much that comes out from that particular economy and market, what would you say are the two-three key things you watch out for? For example, we look a lot at what happens with jobless claims, we look at what kind of consumer data is generated from there, what would you say someone sitting in a whole other market should track in terms of important data points coming from the US as a market?

Oliver: I think there are two bases of monthly data, which are the most important figures coming out of the US. The first one is the non-farm payrolls figures, which were released on the first Friday of each month in the US. That give a good a guide to the US labour market and at the same time that those payroll employment figures come out, we also see the US unemployment rate. The reason the US labour market is so important at the moment is that if the US labour market starts to grow again, that will help household income in America and therefore help get the US economy back on to a sustainable path.   The other of the two indicators I referred to is the ISM index which refers to the institutive supply management�s monthly survey of manufacture, it is often released around about the same time as US payroll employment figures. It provides a good guide to business conditions in the US and recently business conditions as surveyed by the ISM are being quite strong. If that remains the case and we continue to say pick up in US employment figures then that would be a good sign for the US economy going forward. It is also worth looking at the jobless claims figures because they give a good short-term updates on the US economy.

Q: There is another term which has risen to the fore over the last year or so, which is QE. It started with one and now there is two and as on a lighter note, many people call the post Japan issue, it is QE3, the gush of money that came into many emerging markets. What does QE stand for and why is it so important for liquidity issues into markets like us?

Matthews: QE stands for quantitative easing and it is an economic term, which refers to when Central Bank in this case the Federal Reserve is buying bonds in the market to take those bonds out of the system in exchange for cash. It is injecting cash into the system and that creates a lot of liquidity.
Q: These are the terms that have more watertight descriptions to them but what about the ones with rougher edge? Is that we can club together and call a trend? For example on the concept of flows, where we try and track what is happening with emerging market flows across many markets and then reach a conclusion about what kind of inflows or outflows one specific market has? How would you rate those trends and how important is tracking these flows in order to understand both global equities and your own market?

Matthews: Like I said earlier, the absence of very developed sophisticated investor base in many of the emerging markets has foreign institutional investors a greater significance than they frankly and probably should and the way that a lot of people like to keep a track of what those foreign institutional investors are doing is by monitoring fund flows. So you can do that either by looking at data, which is disclosed from the stock exchange because many stock exchanges in Asia do provide on a daily basis, the net buying and selling of local investors into foreign investors or if there are some companies which specialize in gathering data of foreign funds.   Foreign funds will tell them the inflows they have had into people buying their emerging market funds every week and then these companies will amalgamate all of that data to show a trend in purchases of emerging market funds around the world. Generally speaking, these fund flows do have trends.

Q: There is another threat that people tend to link a lot of markets is weekly trends. For example, if we see all Asian markets rising on a weekly basis, we tend to submit that as the fact that Asia is now beginning to outperform or underperform as the case might be. Can those generalisations be made in terms of equity market performances across different parts of the world and that they are moving in the same direction or in different directions?

Oliver: Share markets around the world simply go through these prices, where everyone is feeling heavily take on risk, investors are putting their money into markets, oil tend to rise ofcourse if you wait slighter or few months later, the oil come back down again in some sort of correlated pattern. That correlation is not perfect but generally speaking, you find when the Asian markets are rising, most of them tend to be rising albeit to a different degrees. That is at the same time, the US share markets also rising and likewise markets across Europe and Latin America and elsewhere and then ofcourse when they fall, the oil tend to fall together. So I think it is fair to decide that markets have become more correlated in recent times.   _PAGEBREAK_   Q: If you were to step back in history, what kind of linkages would you say are drawn between equity markets? For example is it that all markets tend to fall and rise at the same time, are they all impacted by an event equally for example the crisis in Japan, would it hit every part of the world equally? What does history suggest in terms of these rough linkages that we have with each other? Matthews: There has been such an acceleration of information � the speed at which information is developed that markets tend to absorb and price in news flow much more quickly than they did before. More importantly the second reason why they become more correlated, which is I think the advent of exchange traded funds (ETFs) as well as depository receipts and many of those are listed in US and they are called � American Depository Receipts (ADRs) - and so the exchange traded funds are basically securities, which provide you access to a security that you might normally have difficulty buying directly. For example, India if you are an American individual and you would like to buy stocks in India, it is quite difficult to do that unless you want to fly to Bombay and open up a securities account with the broker and then open up a custodian account with the bank and do all your registration with Sebi. Now it is very easy to buy an Indian ETF and those as the world has gotten out that India is a high growth economy with many good companies. Indian ETFs have become very popular and so if American investor buys an ETF then that ETF would go and buy on behalf of him stocks in India. So these have the big impact on the market as well because that American investor might get afraid if he sees something bad going on in his own market like a recession and he might think �oh, I better raise cash, I am worried - even if the Indian economy isn�t directly related to it�. Unfortunately, when people panic, they always have a home bias. So that has also led to a big increase in correlations. Q: Give us a final word on that one other crucial liquidity situation or liquidity link which is called carry trade, why is that important and why is it that someone even sitting in India needs to understand where the dollar-euro is trading at or where the yen-dollar is trading at, why do these currencies acquire so much importance for most other markets? Oliver: The carry trade basically refers to a situation where an investor can go to Japan or the US borrow very cheaply in either Japanese Yen or US dollars, the interest rates are close to zero and then take that money and put it into high yielding currencies like the Australian dollar, like the Brazilian real or even in many Asian currencies like the Indian currency and that is designed on the part of the investors to pick up a high yield. Ofcourse in recent times we have seen the carry trade commits again particularly following the move by the G7 that might just Central Banks and finance ministers around the world to stop the yen from rising. So people have been feeling more confident to borrow in Japanese yen and put that money into other high yielding currencies around the world. That ofcourse then has the effect to pushing those currencies up in value. So it is an upward pressure on Asian currencies including the Indian currency, it is an upward pressure on the Brazilian Real and also the Australian dollar. An investor who might have taken some money that an Indian investor might have put some money into the US or put some money in the Japanese share market has to be very conscious of the carry trade because if it suddenly picks up and they have got their money in that other country on an unhedged basis then they could make a currency loss which might wipe out any gains they got in that share market by invested in.  I think investors do need to be very conscious of the carry trade because it can cause a lot of volatility in exchange rates and therefore affect the valuation investments in various countries around the world.