Deep Dive

3 reasons why market liquidity will stay robust in 2021

Lokeshwarri SK Chennai | Updated on January 03, 2021

As we step into 2021, investors in Indian equity market have much to be thankful for. While the deep cut in March 2020 — that made the Nifty50 and the Sensex lose almost 40 per cent from the January peak — had everyone losing their head in worry, all the losses were recouped in the following months. The benchmark indices have gained a whopping 79 per cent from the March lows and ended the year with gains of over 15 per cent.

It’s clear that investors are chasing growth, making valuation pricey in select pockets, even as value continues to exist in cyclical stocks. The question that begs an answer now is: will this rally continue in 2021? That depends, to a large extent, on the demand for stocks, also called market liquidity. There are three main reasons why liquidity will remain robust in 2021 as well. While market corrections and sporadic volatility cannot be ruled out, these factors will ensure that the declines do not get too serious.

Interest rates at rock bottom

One of the principal reasons why investors flocked to equity markets after March 2020 was due to the large interest rate cuts by all central banks including the RBI to stimulate the economy. The RBI slashed the repo rate from 5.15 per cent towards the beginning of 2020 to 4 per cent by May; the lowest level in two decades. This made banks lower their deposit rates making fixed income investments unattractive. It needs to be noted the Indian central bank has been consistently lowering rates since 2012, when the repo rate was 8.5 per cent, in a bid to boost growth. This has been one of the drivers of the structural bull-run since 2013.

Other central banks including the US Federal Reserve also similarly slashed rates in March and April. As the accompanying table shows, policy rates of countries such as the US, UK, Canada, Australia, Norway, etc are close to zero; while countries such as Switzerland, Denmark, Japan and the Euro zone have negative policy rates. Maximum global wealth lies in the US and Europe with most FPIs originating from these regions. It is, therefore, not surprising that the hunt for higher returns attracted these investors to Indian stocks.

With global monetary policy expected to be dovish through 2021, the FPI flows in to India equity is likely to be supportive this year.


Dollar movement and global central bank stimulus

Another factor that needs to be tracked closely to gauge liquidity in stock market is the movement of the US dollar. Dollar along with gold is a safe haven with value increasing in times of extreme risk-off sentiments, due to money flowing in to US treasury instruments.

If we track the long-term movement of the dollar index, it can be noted that the index consistently moved lower from 116 in 2002 to 73 in 2008. This was the period of an unbridled bull-run in most equity markets. The period from 2014 to 2016, when the dollar index rallied was accompanied by volatility in global stocks.

The dollar index is once again weak. The weakness is partly on account of the Federal Reserve’s next tranche of stimulus announced recently and the unlimited dollar printing. But it also signifies that there is certain degree of complacency in financial markets regarding the ability of the central banks to keep economies afloat. This is making money move out of the haven of dollar-denominated securities. Continued dollar weakness in 2021 will keep the bias of FPIs tilted towards equities in emerging markets such as India.

The other factor that is supplying liquidity to markets is the stimulus funding being unleashed by Advanced Economies. Some of this money tends to move in to risky assets as the flood of money coupled with lows interest rates in these economies boosts currency carry trades.

Vaccine roll-out, normalisation of economic activity

As far as domestic liquidity goes, there isn’t much to worry about. Though equity oriented mutual funds have witnessed outflows over the last five months, there are other indications that domestic investors have enough liquidity on their hands. One, turnover on domestic stock exchanges has been booming with cash volumes almost doubling since April 2020. Two, the massive over-subscription in IPOs shows that people have surplus on their hands which they are willing to deploy in to stocks.

Also, the Covid-led job losses has not really affected the upper and upper-middle class much. A survey by UBS of 1,508 consumers aged between 18 and 54 found that while 47 per cent of the respondents saw a decline in income in 2020, 49 per cent witnessed stable income or an increase. Also, close to two-thirds of respondents expect income to increase in 2021.

While economic growth is largely expected to contract in the 8-10 per cent range in FY21, most research houses think that growth in FY22 in India will be the fastest globally, around 8 per cent. Revival in activity, of course, hinges on the vaccine roll-out and people getting the confidence to resume activities at pre-Covid levels. With over 56 per cent of the country’s GDP being derived by consumption, success of the vaccine and elimination of the Covid virus would be the key to sustained earnings growth in companies.

One negative fall-out of easing of movement restriction and end of work-from-home would be the inability of the people to trade from offices due to the restrictions in office Wi-Fi and other protocols. This could dampen trading turnover to some extent, though it won’t have a material affect on investing behaviour.

Published on January 03, 2021

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