A time for worry on the equities front?
by Arjun Parthasarathy
The recent falls in commodity prices has led to sharp decline in the Sensex and equally sharp recoveries. The Sensex fell by around 3% on Monday on the back of steep falls in commodity prices. Brent crude has fallen over 15% from highs, gold has fallen by over 8% from recent highs of $650/ounce, and others metals such as aluminum and copper have fallen in the range of 5% to 7% from their near-term highs. The Sensex, however, recovered equally fast, wiping out almost all its losses over the last two days.
So what caused the sharp fall and the equally fast recovery?
Can the markets continue their strong run seen since the big plunge of May 2006?
Why have emerging markets taken the brunt of fall in oil and commodity prices?
The answer can be given through a question — How come equities rallied in spite of rising oil and commodity prices? Common economic theory suggests that rising commodity prices have a negative effect on inflation, interest rates and demand. But this did not happen and we saw a sustained rise for three years across all asset classes. The reason is the cycle brought about by current account surpluses and deficits. The US, a large consumer of oil and commodity and a net importer of manufactured goods, ran up large trade deficits as the George Bush government and the Federal Reserve pumped in money through loose fiscal and monetary policy to boost a weak economy.
This resulted in strong consumer spending, leading to large trade deficits and weakening of the dollar, leading to outflows of greenbacks, which found their way into asset classes of emerging market equities, property, commodities and oil. The oil and commodity exporting nations in turn ran up large trade surpluses on higher prices and these surpluses found their way once again into emerging market equities, commodities, oil and property. This led to a sustained rise in all asset classes.
The central banks’ response to such large asset price inflation was classical — raise interest rates and tighten liquidity. However, the momentum of asset prices was so strong that rates hikes had to be continuous. And after a long period of rate hikes one to three years across geographies, the effects are currently being seen. The effects are that high asset prices, coupled with high interest rates are beginning to slow down economies. The first indication was the fact that interest rates as measured by bond yields have fallen sharply by 40 to 70 basis points across the globe— except Europe, which is still to catch up on hiking interest rates. Equities initially reacted positively to falling interest rates, betting on soft landing for economies and the first week of September was positive for all major emerging equity markets.
However, the beginning of this week of September 11 saw the sharp falls in gold and other commodities leading to a sellof in equities across emerging markets. The markets bet on the fact that falling commodities will end the chain of events described above, leading to unwinding of long positions across all asset classes of equities, oil, property and commodities. Typically, traders including hedge funds lead the front-running of the markets and the market fall was sharp due to unwinding of leveraged long positions and short positions being created. The sharp recovery over the last two days is explained by the fact that US equity markets had good gains on Tuesday, helped by the reasoning that falling oil and commodity prices would lower inflation and keep interest rates in check, leading to further consumer spending.
The large trade deficit numbers for July 2006 corroborated the fact that US consumers are still buying and this lent cheer to the markets. Emerging equities followed suit, helped by short covering in a rising market. On the other hand, oil and gold continued to fall, while base metals were steady. The question to ask is whether this pullback will lead to further gains ahead, continuing the long-term uptrend.
The market has to recognise the fact that there are curves that are indicating a slowing down of economies. Falling bond yields, falling oil prices, falling gold prices and peaking out of other commodity prices are definitely a sign of economic slowdown. In the near term the falls are due to long positions being unwound. However, in the longer term, these are indications of higher supplies, inventories and slowing down of demand. The fact that now there will be less money flowing into these asset classes will also lead to uncertainty on further price rises. The markets will now be more of demand supply led rather than speculative led. The speculative element could amplify on the short side, if traders and funds short commodities in recognition of slowing down of demand.
Given the high levels of the Sensex and concerns on global growth, oil and other commodity prices it does seem prudent to take money out of equities until there are firm signs that the immediate concerns have passed or have been negated to some extent.
