Why did the Indian markets correct so sharply?

After a fairly strong close in the month of December, the Nifty and the Sensex have corrected sharply in the last one weak to get close to the yearly lows. While there are positives in the form of robust GDP growth and controlled inflation, the question is what are the reasons for this sharp correction in the markets? That too at a time when nothing much has changed fundamentally in the Indian markets! There are five broad reasons for this sudden crash in Indian markets…

Pangs of China growth…

A slowdown in China has been the one big worry for most of the emerging markets. China has seen its GDP growth taper down from above 10% to a 25-year low of 6.5%. Unofficial estimates, however, put the actual growth figure much lower. China’s growth is important for two key reasons for a country like India. Firstly, China is the largest trading partner for most of the world’s nations and weak growth in China will lead to less demand for commodities. When most of the emerging market currencies depreciate, the INR too will have to follow suit. Secondly, India has the major concern over dumping from China. Already sectors like steel, heavy equipment, tyres and automotive parts are being hit by cheaper imports from China. With the Yuan being devalued, the risk for Indian manufacturers is much bigger. That is one of the immediate worries for the Indian market.

US Fed could squeeze global liquidity…

The Fed rate hike may have appeared to be small at 25 basis points. But when another 100 basis points are hiked this year, the impact on liquidity will start to show. Remember that the US has already stopped its bond buying program more than a year ago and that has already tightened the liquidity in the global financial system. Now UK is moving towards a rate hike. If EU and Japan also stop their bond buying, there will suddenly be a liquidity shortfall in global markets. Typically, emerging markets have suffered the most in terms of currency values and market valuations whenever the liquidity has tightened. After all, the memories of 2013 are still fresh in the minds of Indian investors and the central bank.

Weak commodities and monetary divergence is a major risk…

Weak commodity and oil prices have already taken its toll on a number of economies in Latin America, Middle East and Asia. Even advanced economies like Australia and Canada have been hit by the slowdown in demand for commodities. The problem with weak oil is that the oil-rich nations like Norway, Saudi Arabia, UAE and Qatar are also the nations with multi-billion dollar sovereign funds. Typically, these countries are being forced to sell off their petrodollar investments and wind down their reserve positions to fund their budget deficit. With oil falling closer to $30/bbl, we are likely to see another bout of selling from ETFs and P-Notes that are issued to their SWFs. The trend was already visible last year and in January it is likely to worsen as even the winter demand for oil is missing. Additionally, we have a piquant situation of the US and UK trying to move towards monetary tightness and the EU and Japan moving towards monetary looseness. This monetary divergence is likely to add to the volatility of markets as already evident from the sharp up-move in the CBOE-VIX (Volatility Index). These factors are surely spooking Indian markets. 

Indian profit growth is a major worry…

Of course, global factors impacting the markets are just one side of the story. There are concerns at a domestic level too. For example, the Markit PMI for Indian manufacturing has come in at less than 50, which indicates an economic contraction. Whether this is consistent with a GDP growth rate of 7.5% remains to be seen but surely doubts are being cast. Then there is the worry on inflation as food inflation has been quite sticky in the last year. The OROP payout and the Seventh Pay Commission payouts are likely to put more liquidity in the hands of the people and likely to trigger inflation. These two factors are also raising doubts over the ability of the government to maintain the sanctity of 3.5% fiscal deficit targets. A high inflation would mean that the RBI may not too keen to cut interest rates. That would effectively delay an economy recovery in most sectors. Profit revival is a major worry for Indian markets.

Banking sector could be the big worry for markets…

The banking sector has entered the year 2016 with a total doubtful assets portfolio of $60 billion. That is huge by any standards. The sharpest cuts this week came in banking stocks as investors are worried on two fronts. Firstly, these banks need to get over this NPA problem fast so that they can start lending aggressively and focus on profitability. That is not happening. Secondly, Indian banks need billions of dollars to bring their capital levels to Basel III standards before 2019. That would mean tremendous dilution of equity and impact on EPS and valuations. Banking and financial services has an inordinately high weightage of over 22% in the Nifty. Additionally, with their strong externalities and implications for other sectors, they tend to have an outsized impact on markets.

In a nutshell, the sharp correction this week was a mix of domestic and global factors. The Indian markets lost just about 5% in price and about 4.5% in currency last year. That is a substantially better performance compared to most emerging markets. Year 2016 may be a litmus test. This volatility exemplifies just that!

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