Since I could not think of a specific topic to talk on I just thought that I will talk on some random thoughts I have.

Sovereign rating downgrades start – I had written on my blog on the 23rd of April on the Sanctity of Sovereign Ratings where I had argued that the process of rating countries seems to be badly flawed and is based on past performance rather than future outlook whereas future outlook should be the most important thing. Like when buying stocks on looks at the future rather than the past the same should be the case in ratings. Finally the process has started with Japan and United Kingdom now on a rating watch due to their deteriorating finances and increasing debt burden and I believe soon the USA will follow. India post elections now is in an unenviable position where lot of rating agencies have put out positive comments based on the expected stability on the political front. Finally I believe that things are moving in the right way.

The US dollar and the Indian rupee – I had talked on the “Dollar Conundrum” in March where I had talked on the reasons for the strength of the dollar and the fact that a collapse was just around the corner. The dollar has continuously been losing value over the last few weeks and the US Dollar Index has fallen from a level of 89 in March to 80 now a fall of nearly 11% percentage. Currently the dollar looks oversold and can appreciate to some extent over the next couple of weeks, however the long term charts technically looks very negative. The rupee did not appreciate much before the elections and actually underperformed most emerging market currencies. However now the Indian Rupee has done a catching up and is up nearly 10% against the dollar since March 2009 and nearly 6% of this move has happened in the last one week itself. Overall the trend is towards a sharp appreciation of the rupee vis a vis the USD. I believe that given the strong pressure on appreciation it will be a tough job for the central bank to control the move of the rupee given the state of most export oriented industries and the job losses they have seen over the last one year. A sharp appreciation should be avoided through big time intervention as the liquidity that it will pump into the economy is not harmful at this stage given the fact that inflation is very benign. However given the state of the US Dollar, the long term prospects of huge inflows into emerging markets has gone up significantly.

VIX – The volatility index which is also mentioned as fear gauge after spiking to 89 in October 2008 fell to a level of 26 last week. At these levels VIX is looking heavily oversold and should bounce back. This also reflects complacency coming back into the markets which eventually leads to a reality check. Given the inverse relationship of markets with VIX this should also lead to a correction in global markets over the next few weeks.

Emerging Market Inflows and decoupling – After seeing continuous outflows form the early part of 2008 Emerging Market Funds have been seeing continuous inflows from March onwards. The inflows which started as a trickle have now grown now to billion dollar inflows per week. Globally only 4% fund managers were overweight on emerging markets in March which has gone up to a record level of 46% currently. This phenomenon is due to a combination of factors. One is that in general now most people are now more positive on the outlook of growth of larger developing countries. The other is that the general left out feeling, excessive pessimism and underweight positions are now getting corrected. Euphoria is now building into emerging market investments. Decoupling is also happening at a rapid pace with the Morgan Stanley Emerging Market Index up by 60% from the early part of March and most developed markets up by 25-30%. Given the long term economic outlook decoupling and the strength in emerging market currencies decoupling will gather strength over the next few years.

Rising Government bond yields and falling corporate bond yields – Another interesting phenomenon is the sharp rise in the yields of US and European government bond yields since the beginning of the year. Emerging market government bonds have also followed. This is also a flow through of the huge borrowings proposed in these countries and the fact that repayment and oversupply will become an issue in the long term. I believe that the gap in yields of Govt. of India bonds and US Govt. bonds will compress over the next few years as the Indian economy grows strongly and the sovereign rating moves up. On the other hand due to the sharp fall in LIBOR as well as falling corporate bond spreads ( for a 10 year AAA paper this has come down from 400 bps to 150 bps now) has made borrowing cost cheaper for corporates. Similarly retail borrowing costs and available liquidity for the same has fallen sharply over the last three months. This should help in aiding economic recovery. As investors realize over the long term that the risks are lower in strong emerging economies vis a vis stressed developed markets the cost of borrowing for governments as well as corporates in emerging markets will go down further.

Market technicals – Markets are in a euphoric phase and look heavily overbought for the near term. Given the strong fund inflows the correction in the markets might start slowly and then gather steam. Markets should correct at least 38% of their up move from the October 2008 lows. However given the confidence that has now come back into the markets individual stocks and sectors will continue to outperform. Market performance can also get tempered by the surge in QIP fund raisings that have suddenly stared. Given the size of the proposed equity raisings it can suck away liquidity from the markets very fast. Investors need to be wary of this.

Overall I still maintain a cautious stance on the over all markets in the near term. Morgan Stanley emerging markets index should show a correction of 15% from the top and most individual markets should also follow. However it’s a buy on dips market now and that’s how it should be treated.

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