Equity markets have done very well over the summer, with the old adage of “sell in May and go away” not working out to plan. The MSCI World equity index is up almost six per cent year-to-date and we are only about a per cent away from an all-time high. This is a far cry from January, when global markets were down six per cent and everyone thought that China would bring down the global economy. The market reversal has been led by emerging markets (EMs), up almost 15 per cent, driven by Brazil (up 65 per cent), Latin America more broadly, and other laggards, such as Russia (up 25 per cent) and South Africa.
There seem to be two main factors driving this EM rally and the move in equities more broadly. The first is the stability in the US dollar, which, contrary to all consensus wisdom, has stopped appreciating. The second driver has been the drop in interest rates. More than a third of all sovereign papers globally are now yielding negative rates, and rates across all EMs and corporate assets have come off. There is a mad rush for yield. Just witness the demand for masala bonds! EM debt issuance is breaking all records. The conventional view is that rates globally will remain low forever, and thus, one must chase yield and take whatever yield is on offer, no matter how risky.
Price action in the equity markets is also throwing up contradictory signals. Financials have been rising in the face of falling yields. Since July, financials have outperformed quite significantly. Maybe it is a dead cat bounce, but normally, financials should not do well with flattening yield curves. Similarly, the bond proxies, utilities, real estate investment trusts (REITS) and telecoms have done poorly through the summer, as yields have dropped. Again, not what you would expect if rates are going to stay low forever. Bond proxies should rise – not fall – with falling yields. This price action only makes sense if equity markets are sensing that rates are headed higher. There seems to be a clear divergence between the bond and equity markets. Bond markets and their investors are saying that low yields are here to stay for the foreseeable future and yields can only go lower. Take whatever yield you can get, wherever it may be, and sit tight. Equity markets seem to indicate through their sectoral price action that yields may be headed higher. Who is right? Given the current consensus, my bet is that yields will rise, if even for a short period.
A fixed-income shock will rattle equity markets as well. Interest rates will rise, at least temporarily, and the dollar may once again strengthen as investors herd into safety assets. Both the pillars of the current EM rally, falling yields and stable dollar may reverse in the short term. The damage will be short, sharp and swift. In any EM correction, India will also fall. The damage in the mid-cap space can be quite intense. While India remains in a structural bull market to my mind, one should be careful in the short term. Positioning and consensus globally seem too much one sided. No one can even contemplate rates rising. That is probably why they will.