State of the financial markets - June 22

How should one play the financial markets going into the next 2-3 months?

Lets start with the US markets. The key here is the direction the Fed takes in its interest rate tigtening campaign. Two scenarios are possible:

A) Inflation readings keep coming high, so the Fed keeps on increasing rates beyond 5.5%. This would cause markets to go down - in the US and abroad.

B) Fed stops at either 5.25% or 5.50%. This would likely cause the US markets to move up. And as all asset classes have recently become correlated with the US markets, this would also push up commodities, emerging markets (for most of whom commodities are the main exports) etc.

This would also cause the dollar to start weakening against the Euro and Yen - where the central banks have indicated that they could raise the rates soon. As commodity prices are inversely related to dollar, this would cause them to go up, further pushing up commodities and emerging markets. So the world markets best hope is that Fed stops.

However, if prices of commodities start rising, inflation expectations are going to start to creep up again. Also, a weaker dollar would increase import prices, further fueling up inflation concerns. These could be offset by slower growth in US in the coming months due to the past Fed rate increases, which take effect with a lag. If Fed stops raising rates but US economy keeps its strong trajectory, then inflation would again raise its head tomorrow, prompting rate increases. So the best hope for world markets is that Fed stops, and the US economy slows sufficiently (which would reduce demand for commodities and imports) so that inflation remains contained.

To the extent that a weaker dollar hits export oriented Japan, Nikkei might take a hit (which could bring emerging markets down). However, if the dollar decline is smooth rather than abrupt, it is possible that the incipient economic growth and domestic consumption in Japan is able to offset weaker exports. It would enable the Japanese central bank to raise rates - which is essential for the long-term health of that country. How does that impact the so called carry trades is a billion dollar question.

Could the past 10 day rally have been predicted? The rally started the day futures started pricing in a 100% probability of rate increase on June 29th. The US economy grew at 5.8% rate in 1Q06. Add in 3.6% inflation, and the nominal growth rate was 9.4%. To the extent some of it carried over in 2Q06, the earnings numbers are going to be beat estimates - as has been shown by all brokerages, Fedex etc. So if I had an earnings calendar with me, I might have been able to play it. But what now?

The Fed meets next week on June 29th, July 4th is a 4 day weekend, and after that the CPI report that will be out around July 9th would again enchant everyone. Considering that interest rate futures are not pricing in a 100% probability of rate increase in August, the markets might again stall till these futures price in a 100% probability. This time however, corporate earnings announcements might act as a buffer. Lets see how this plays out.

Is it a good time to buy Indian stocks - Not really!

Recently, the Indian market has suffered a rather painful correction for anyone who was invested there. And now there is a dilemma for investors: Is this the bottom, or is there more to go?

The Indian story is unique in certain aspects. First, it is driven in a large part by domestic consumption (unlike investment and exports as in China). Second, high commodity prices are not the primary cause behind the prosperity of the last few years (unlike Middle East and Brazil, where commodity exports make up a big chunk of the economy). As such, even if US economy slows and commodity prices soften, the Indian growth story should remain untouched to a large extent.

But when we talk about stocks, things are a bit different. For stocks are impacted not only by underlying fundamentals, but also by liquidity flows. And that is where the concern lies.

Currently, foreign investors are key players in the Indian markets, through various emerging market funds and hedge funds. And so, if the foreign investors were to yank money out of these emerging market funds, these funds would be forced to sell securities that they hold, including Indian securities. So while the Indian story is different, it is clubbed together with other emerging markets for investment purposes. So where goes the emerging markets, so will go India.

And so the key question becomes - are the US, European and Japanese investors going to withdraw money at a rapid clip out of the emerging market funds?

I doubt whether anyone knows the answer to that question for the next two months. The next Fed meeting is on June 29th. Till that time, I think the US market is going to get conflicting reports on where inflation and economic growth are headed. So while there will be a lot of volatility in the US markets, there will not be in any direction.

After June 29, the focus will shift to when the Bank of Japan raises its short-term rates. It could happen anytime between July and September, which would create another uncertainty in the markets. So I think that investing in Indian stocks would remain a risky proposition at least till July. But the growth story exists in India - between January and March 2006, the economy grew at 9.3%. So when the time is right, stepping into the market could produce a number of winners. That time is, however, not now.