Chinese tightening is the best thing for equity markets

Over the last few days we have seen stock markets globally correct sharply. This fall started with news flow from China regarding monetary tightening and reining in of loan growth. This has been followed up by news flow from Europe regarding deteriorating position of guess who, off course countries like Greece and Spain. The top up has come from the news flow from the US regarding controls on risk taking by large banks.

All this has created a huge uncertainty in the markets and we have seen them coming off. I wrote a few days back on the likelihood of increasing volatility after the great degree of complacency that had set into the markets with VIX falling to very low levels. The bump up in the value of the US dollar has also led to some risk being taken back and there has been some selling in the commodity and equity markets.

I believe that the excessively loose monetary policy of China was the biggest risk to the world as it was creating a scenario of runaway commodity prices and thus very high inflationary pressures. As per the news reports Chinese authorities are looking to control bank lending to around USD 1.1 trillion vis a vis USD 1.4 trillion of last year. Although inflation has been largely controlled in China till now it is very clear that the economy is starting to overheat and property prices are also moving up in a manner which can lead to a speculative bubble. Given the fact that China is not allowing its currency to appreciate they have to largely control fiscal expansion and monetary expansion in order to control inflation. The level of USD 1.1 trillion also is very high given the size of that economy, however given the fact that it is around 20% below last years level and also given that the Chinese economy has grown around 10% last year it should cool down economic growth to some extent.

The biggest positive of the Chinese intent will be to control the runaway rise in commodity prices, especially of commodities like Copper, Aluminum, and Steel etc where prices have moved up despite growing inventories. Given the fact that economic growth numbers from most Western economies are muted at best, moves by the Chinese will lead to a stabilization if not a fall in the prices of industrial commodities. This combined with (hopefully) better weather conditions in the current year for agri commodities will lead to a lowering of inflation in the later part of the year and thus reduce pressure on Central banks to tighten.

We have already seen that for some crops like Wheat, Soybeans and Tea the production seems to be bouncing back now and is leading to prices coming down. Going forward prices of commodities like Rice and Sugar etc. should also stabilize with increasing production. Sugar is likely to be a bumper crop (specifically in India) for the next sugar season and this will lead to a 20-30% fall in sugar prices in the second half of the current year.

Specifically for India the revival of growth has happened with very low bank credit growth and the Non Performing Assets are well under control for the entire sector. Next year the bank credit growth is likely to pick up and this should support economic revival. If inflationary expectations remain anchored (after the 9% kind of inflation that we see by March/April) is will reduce the pressure on the RBI to tighten aggressively. Given the fact that the recovery process in the US seems to be slow with consumer spending not picking up and credit availability still constrained. The bank results have also shown greater credit card write-offs which should keep credit constrained with tightened credit card norms.

The results season is moving along pretty well with most companies across sectors except for the Capital goods companies delivering strong results. Results of companies in other parts of the world also continue to beat expectations. Key positive surprises in the Indian context have come from Banking, Technology and Auto sectors.

Over the last one month I have traveled to meet a lot of investors all over the country and the degree of skepticism about the market rally and the economy. A large majority of investors are facing a huge reinvestment risk today after deploying a vast majority of their financial savings in various kinds of fixed income or debt instruments in the last quarter of 2008 and the first quarter of 2009. The 9 months from March – Dec 2009 has seen investors pull out money from domestic mutual funds, PMSes and also selling out a lot of their equity investments and today after having done that at levels much below the current levels there is a clear resistance to invest in the markets. However as the confidence on economic growth prospects grow over the next few months flows are likely to come back. The next two months are also likely to see huge flows into insurance companies which should provide a liquidity support of USD 8-10 billion to the markets.

Fundamentally the markets seem to be well positioned to continue the uptrend and the downside seems to be restricted to 4-5% after the 6-7% correction we have already seen.

When I was young I thought that money was the most important thing in life; now that I am old I know that it is – Oscar Wilde