The Hindu Business Line : <I>Method behind market madness? </I>

Mid-way in June, with May safely away, it may be good time to ponder over what happened that month. World over, why did all the asset markets, most visibly the equity, suddenly go topsy-turvy? Was there a method to this madness?

The attack really began around May 10, when the Fed signalled a rise in the core inflation in the US. The markets reacted by anticipating an interest rate hike, a fairly common feature of the recent US monetary policy stance. There was news of the US Federal Reserve as well as central banks in Europe and Japan planning interest rate hikes in response to the higher oil prices. And as Asia is increasingly aligning its policy stance and growth outlook to global benchmarks, this implied that most emerging Asian economies would raise rates, perhaps with some lag.

This view was further strengthened by the power performance of India and China over the past two years. This meant slower growth rates for the very same economies on whose markets the FIIs had been betting. Also, oil prices continued to harden based on the usual May holiday high and due to the factoring in of the hurricane season effect. All this led to an initial slide in metals and mining stocks as well as their commodities futures; the immediate gainers were energy stocks.

Higher risks lead to better returns

With the earlier two years seeing benign growth rates and booming corporate profits in Asia, it was no wonder that hedge funds, investment banks and other institutional investors were heavily leveraged in Asia. More interestingly, in the good phases, with high growth and low volatility, fund performances across-the-board tend to be good, thereby creating more appetite for slightly differentiated portfolios with higher risks but with higher relative returns. This story carries ample evidence from the 1997 South-East Asian crisis.

Thus, it is the good times themselves that create investors that are not only heavily leveraged, but more exposed to riskier assets. Once volatility makes a comeback, for whatever reason, the value-at-risk suddenly increases; making the investors cut the long positions move to safer stocks. FIIs suddenly emerged net sellers in Asia and markets such as India and South Korea, where the exposure was the maximum, were hit the most. The Sensex was on a topsy-turvy ride with sharp intra-day troughs and surges so that the total fall remained limited.

Rebound capacity

The currencies of the emerging markets have also lost some value. The rupee declined throughout May, the Indonesian rupiah fell 0.7 per cent and the Brazilian real dipped 2.6 per cent. Interestingly, the rupee, which was trading at an average of around Rs 44.9 to the dollar in the first week of May, breached the Rs 45-mark only on May 11. After falling continuously for the entire month, it again breached the Rs 46-mark on May 30.

Over May, the losses have been certainly less than any single intra-day loss, indicating rebound capacity. However, asset behaviour is normally auto-correlated not only in the levels, but also in the variances. This implies that high volatility periods are more likely to be followed by other volatile periods. The May madness has certainly broken the complacence of the markets. It is time for wiser and sounder investments.

(The author is Economic Advisor, Mahratta Chamber of Commerce, Industries and Agriculture, Pune. She can be contacted at manasip@mcciapune.com)

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