Why are stock markets so gung-ho?

Easy money policy of global central banks is a prime driver behind markets’ performance

There is no dearth of bad news for global stock markets — a feeble global growth that has been delivered a setback by Britons voting to leave the Euro Zone, continuing problems with European banks in countries such as Italy and Portugal, the massive overcapacity and slowing demand in China and geo-political risks — to name a few.

Yet, these worries are having little effect on stock markets. While there was a mild bout of turbulence following the UK referendum, stock markets have been quick to get on their feet again. US benchmarks such as the Dow Jones Industrial Average, the Nasdaq Composite index and the S&P 500 index managed to move to a new life-time high this month. Other benchmarks such as the FTSE 100 of UK, Jakarta Composite Index and the Sensex are less than 7 per cent away from their life-time highs.

Volatility under check

The more interesting factor is the extremely positive signals being emitted by the volatility indicators. The CBOE’s VIX indicator, which captures the expectation of traders based on the option premiums in S&P 500 options, has traded below 20 for the most part in 2016. The lower the reading, the more positive the sentiment; for instance, in October 2008, following the Lehman crash, the indicator had spiked to 79. This level has not been reached since then. The VIX reading has been mostly below 20 since 2012; such readings are typically seen in strong bull markets. This sentiment is being mirrored in Indian equity markets too, with the India VIX, based on the option premiums of Nifty, trading below the 20 mark since 2014. This is despite the earnings of Indian companies being quite patchy in this period.

The VIX based on Euro STOXX 50’s option premiums is, however, slightly more elevated over the last two years, trading between 20 and 30, highlighting the higher risks to equity returns in this region.

The preferred regions

While many equity markets have rallied in 2016, if we consider the movement since the 2008 crisis, there is a large variance in performance. Only select indices such as the Dow Jones Industrial average, Nasdaq Composite Index, Jakarta Composite Index and the Sensex are poised more than 30 per cent above their 2008 peaks. The economies of these countries have been much more resilient to the economic slow-down; perhaps making them more attractive to investors.

On the other hand, benchmarks such as the Shanghai Composite Index, the CAC and the Bovespa are still over 20 per cent below the peaks formed in 2008, in line with the performance of their economies.

Easy money policy

It’s not hard to guess the prime driver behind the strong performance of these markets post the 2008 crisis and the manner in which the volatility indices in these regions display unwarranted optimism. The slew of money pumped in by the global central banks, including the Federal Reserve, the European Central Bank and Bank of Japan, have flooded the market with money that is clearly being quite discerning and chasing assets that have better prospects.

It’s not just the funds pumped in through quantitative easing, but the near-zero interest rate policy (ZIRP) followed by central banks since the 2008-crisis that has also aided the up-move in stock prices in select regions. Such policies give rise to carry trades as investors borrow in countries with low interest rates to invest in assets across the globe. Currently Japan, the Euro Zone, Sweden and Switzerland and the US have rates close to zero.

While the yen and the Swiss Franc were the preferred currencies for carry trades prior to 2008, the dollar carry trade has grown substantially in the last 6 years. According to the Bank for International Settlements, dollar carry trade to borrowers outside the US has increased from $6 trillion to $9 trillion since the financial crisis. This number is large compared to offshore euro credit ($2.5 trillion) and yen credit ($0.6 trillion).

This cheap money is resulting in corrections getting quite shallow; the Sensex and the S&P 500 have been making higher bottoms since 2009, with every dip perceived as an opportunity to buy. The complacency reflected in the VIX is also a result of this easy money.

The reaction of central banks to stock market tantrums has instilled confidence in traders that central bank policies will not revert to normalcy any time soon; and even if that happens, it will be very gradual and after sufficient warning. There is also the ‘central bank put’ that is bolstering trading sentiments. In the past, central bankers such as Greenspan have taken strong measures to stem stock market falls through central bank intervention. It is expected that Janet Yellen will also do the same if stock markets crash.

What next for India

The Indian market has been at the receiving end of this money flow, with FPIs pumping in close to $116 billion in to Indian stocks since 2009. The worrying factor is that investors from US are pumping in more money in to India, of late. According to SEBI, these investors accounted for over one-third of incremental flows in 2016.

That puts the Indian equity market, too, at risk once the central banks begin hiking rates as it will lead to outflows triggered by carry trade unwinding. Liquidity can also get tighter if these banks start selling the bonds they have accumulated through the QE programs. But with the full impact of the Brexit yet to unfold and the global recovery in a nascent stage, it could take at least a couple of years for central banks to aggressively hike rates or take back the liquidity. It is hoped that the inherent strength in the Indian economy — higher growth, domestic consumption-led economy and favourable demographics — will help in reducing the fund outflows; when policy normailsation begins.

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