NIFTY: How Much Fundamental and How Much Expectation

the IMF is out with a new paper which shows the worrying slowdown of fundamentals in Indian economy, especially investment component of GDP.

If you look at the GDP break up it is indeed not very encouraging. But at the same time, the equities in India has seen the best performance by any emerging market. So here is an interesting way to take a deeper look at the recent stock market performance

Markets can either perform based on solid fundamentals, or in a cyclical reactionary manner in response to sentiments and inflows and similar. I model the NIFTY over the years as 

NIFTY = F + R

Where F represents the fundamental component and R represents the reactionary component. Then these components are further modelled as below

F = random walk component  + inflation + economic activity (industrial output as proxy). 

The assumption is that the fundamental improvement (or change) will be persistent, more so in case of an emerging market where the economy has much room before reaching technology upper limit of potential. The other component, R is modelled as below

R = auto-regressive component + FII flows + INR + JPY

Here again the intuition is the cyclical component of the index is ideal to be modelled along with short term signals that market will react to, which are themselves cyclical. JPY captures the overall global risk sentiment (a high correlation with NIFTY in recent time).

And here we are with the model estimates - the graph shows the levels of NIFTY over the years split in to these two components

Notice how the fundamental trend (F) lagged the actual levels during the 2000-01 recession and in the exuberance of 07-08, and also notice how the market became to pessimistic after the Lehman failure, trading below fundamental trend. 

Which of course it did catch up. And then some more. Since 2011, the fundamental component has flattened out. Nevertheless NIFTY had a strong rally, totally dominated by the reactionary component

So does that mean now that the market trading way ahead of itself, it is going to correct? Well mostly it is expectation I would say. Will the fundamentals match the expectation already priced in? Anybody's guess. But sooner or later one is going to catch up with the other. I hope it happens in the happy direction!

Shadow Rates : When the Central Bankers Hit The Bottom

A very interesting concept

Basically it determines the equivalent short rate in an economy where policy rate has hit the Zero Lower Bound (ZLB). The methodology uses a standard Gaussian affine term structure model, augment by two equations. The first one in which the ZLB is covered by modelling the short rate r as r = Max(z, s), where z is the lower bound on the short rate, and the shadow rate s. This of course non-linearize the term structure model. The second tweak is to approximate the resulting forward rates in to a closed form solution, which make the model very much tractable. 

This still requires extended Kalman filter to solve the system (becuase of the non-linearlity), and hence needs writing explicit code unfortunately. Most of the standard packages will have only linear Kalman filter implemented

Nevertheless, this is a very useful way to extract the implied short rate, as the market prices in various conventional and unconventional policy measures. The plot below cleatly shows the shadow rate effectively shadow the policy rates in a non-ZLB world. And once the policy rate hits ZLB, the shadow rates breaks free. The significant moves of the shadow rates also implies the information content which is lost in the policy rates stuck at zero

And looking at the figures it becomes explicit how the lack of ECB action has been effectively a large tightening in the Eurozone. From 2013 beginning the shadow rate for Euro area has tightened by more than 200bps. That is a LOT of tightening for an aneamic economy strucggling to find green shoots

The US case also interesting, as it shows recently the shadow rate has ventured in to further negative territory. And the UK I would have expected a bit more tightening from mid of last year than the model values suggest. I do not have any explanation for either currently. I will have a closer look as soon as I can manage to get some decent code for extended Kalman

Cross Asset Correlation

The cross market factor correlation as it stands now

This shows spot as well as rolling (for last 1 year, upper diagonal plots) weekly correlation among asset classes (based on Principal Component Analysis. For all asset classes, only the first factor is used, except rates, where first 3 traditional factors - level, slope and curvature/ fly - are used. The analysis covers all developed countries fixed income and currencies, equities for major developed and emerging markets and a selection of commodities and also consider volatilities as a different asset class itself )

The main observation from the recent changes are as below -

However, all these will change as soon as rate hikes comes back in to the picture. Which I think, not withstanding market reaction since this week's FOMC, a while away from now.

Nevertheless, the rate level vs. curvature correlation still going strong and expect to continue still the timing of the hiking cycle becomes clear to the markets.We also have seen a significant increase in correlation on cross market rates, especially of JPY and SCANDI long end rates to USD rates. However, the story in different in curve slopes, which has strengthened in correlation for JPY but weakened in EUR, reflecting the resilience of EURO curve steepening bias on expectation of ECB action. 

The strong correlation of SCANDI FX (especially NOK) to USD rates seen middle of last year (attributable, perhaps, to a knee-jerk reaction to taper last May) has vanished more or less. And overall the rates vs. equities correlation flipped sign, perhaps because market is now in a much better position to handle a sell-off. Also there has been an increased correlation between the swap rates and the break-even inflation swaps, signifying a more stable real rates in a relative sense 

NIFTY : The Election Upside (And Downside In Case You Forgot The Possibility)

Since middle of Feb, NSE Nifty has totally broke off from the general emerging market performance. Before that, both were in lock-step as far as you look back. Presumably this is all about the 16th general election 2014 and an expected Modified result. We already have a strong anticipatory rally, and May 2014 options implied vols have shot up to historical highs. So I take a quick back-of-the-envelope look at different scenarios to gauge upside and downside potential once the results are over

I run 6 different scenarios - the first once simply assumes we repeat the 2009 performance. Before the lections, Nifty rallied 43% in recovery since the bottom on March. After the election, Nifty rallied 20% after the results were out and sustained to another 7% rally till the peak on June. So total 27% approximately. The next scenario considers the possibility that a part of this rally is already anticipated by the markets. In 2009 it was a kind of surprise. The 3rd and 4th scenarios involve a rough event study on past elections, taking in to account the change during the election period and also past 12 month performance. I see a strong relationship there (see below figures) and forecast the expected returns based on these models

the 5th and 6th takes a different approach and looks at the relative valuation. It compares relative P/E to MSCI EM index and S&P500 Index. And both indicates a significant downward correction

So it is no surprise the May options implied volatilities are at historical highs. And given everyone expecting a rally, the skew is trading relativly cheap, not far from historical lows.

It is wise to remember 2009 was perhaps a comeback rally following the blood-bath during and after the Lehman crisis. And every single market was rallying, including emerging ones. This time, even the optimists on steriods will not conclude that way. Tt is not very clear if the BJP led NDA will have enough seats to avoid a troublesome coalition. And if the Congress led UPA is able to form a government the market will react negatively with a good chance. It is wise to keep a perspective. But I would say any sharp correction after the rally will be a significant buying opportunities for the value investors. In the end, irrespective of who comes to power, India will need significant reforms to keep alive the BRIC story. And I am hopefull if the people demand it, it will be delivered

By the way, here is an interesting look at the vulnerability of other emerging markets from a serious Chinese slowdown.

NIFTY: This Time It's Different?

Indeed!

The present bull run is quite different, compared to the recent ones we have seen. In terms of the relative performance of large cap (NSE NIFTY 50) vs mid cap (NSE NIFTY MID CAP 50), it rather resembles the recent bear phases

Usually, in recent times, a bull run meant mid caps outperforming the large caps, and opposite in a bear. But so  far in the present bull run, It is a story of large cap outpacing the mid cap. I am yet to check (will probably follow up on this later), this perhaps means defensive/ dividend over value. And hot money vs retail. This is far from a solid all round bull run. 

Perhaps when you see the mid and small caps catching up, then you know it is a view on economic upside, rather than the tyranny of asset allocation. In the mean while, stay cautious. Or better still, pick value. There are plenty of value left in the market if you can hold on to them come what may

The Innards of the Bumble Bee

The euro has been on a roll in recent time. Ever since Draghi's "whatever it takes" in July 2012, it has appreciated close to 15%. Even this year, it is up from the March pre-ECB lows, and trading at multi-year highs (last seen Late 2011). And there are worries about it in some quarters

Given the current economic situation and some serious disinflation in the Euro area, the last thing one would want a strong currency. Export competitiveness is one issue, another is importing deflation. Not particularly helpful for an economy struggling to maintain positive growth and inflation

But I think, may be, just may be, this is a bit over-blown. See below the trade patters of Euro area and major countries within it

Eurozone countries have thrived on trades. One of the most important non-political reason that Eurozone exists in the first place is trade. Reducing trade friction was a major motivation for the monetary union. However, the important thing to notice is Eurozone countries have thrived on trades mostly done with each other. Within the monetary union

This makes the impact of euro exchange rate on export competitiveness and deflation importing much less severe. When Spain trades with Germany, it is exporting disinflation through wage growth (or rather lack of it) and not through Euro.

And that's why it is so important to move the correct lever in a disparate moentary union. Even if ECB cuts rate in subsequent meetings, it will be mostly symbolic, and will work, if at all, through the expectation channel. The rate cut that will have any real impact will drive the policy rates to deep negative territory. So the way out, and I think the only way out, is directly targetting credit growth

NIFTY All Time High - Should You Worry?

Well, after adjusting for inflation or FX, is far cheaper than it was when it hit the similar highs back in 2007. It is cheap in real term (inflation adjusted), in terms of fiat currencies (like USD) or gold

And it is cheap in almost all valuation metrics

Overall, emerging markets investors will be cautious. Irrespective of the softness of data from the US, I do not think we are going to see any stop in taper from the Fed, unless the data is real bad. So staying cautious is always a good idea, but I think no need to go massive short. IMF Direct Blog has a very interesting recent piece out on EM economies (The Trillion Dollar Question). India has probably a much better positions among other emerging market economies with much lower levels of external debt and debt to GDP ratio (although am sure these calculation excludes India's need for oil import, which is more or less inelastic to price, and hence should be treated as obligation and should be added to external debt for most economic purposes). Plus there is a good chance of an upside after the elections in May

I only wonder will that upside come too early and will the market correct after the election results are out

Inflation Trends in Developed Economies

Across developed economies, food inflation and housing related inflation remains contained (even in UK!!). Energy related components have been on a downward trend as well.

UK CPI Harmonized  - In recent time, UK HICP has been mostly dominated by housing, education and eat-out costs. Food and beverages inflation has been steadily decreasing, and the rest totally subdued

US CPI (Urban Consumer)  - Similar story in the US. CPI mostly propped up by Housing, and Health Care components. F&B going down steadily. Rest negligible

Germany CPI  - In Germany, Housing against is a significant component. Followed by food and beverages and recreation.

Euro-Area MUICP - Euro Area MUICP contraction has been way below ECB target. The major propping up component for other regions, i.e. Housing , seems to give in in case of Euro Area

Japan CPI (Nationwide) - The recent spike in inflation in Japan mostly driven by import and energy related cost. More closely linked to yen depreciation and Fukushima closure than a case of consumer demand driven one

As most recovering markets nears the unemployment rate thresholds of the central banks, inflation will once again become the focus. And any divination based on past data continues to make a case for “Low for Long”. We have seen little evidence of strong productivity growth. In UK, actually improvement in unemployment has been accompanied by fall in productivity. And consumer credit growth remains weak. Without gain in productivity, there will be little wage pressure to drive demand-driven inflation. However, we think the surprise , if any, can come from the US.

The Job Of A Central Banker

I have always said the ECB under Draghi has been a markedly different institute. But it still remains ECB, central bank to a disparate bunch of nations. Back in 2011 and 2012, when the US economy kind of hit the bottom, the Fed did not relent because it was stabilized. It chased with all-in QE to bridge the output gap. In Eurozone, the ECB admits the very high output gap and unemplyment rate. But still fails to act, as "medium to long term inflation expectation" remains "well anchored" 

The ECB perhaps suffers from too much of its own credibility. Ever since it took over the charge from the revered Bundesbank, the inflation expectation remained well anchored. Much in line with Goodhart's Law

 In a world where inflation is well anchored, is it anymore valid to have it as a policy target? Unlike the Fed and others, the ECB does not have any dual mandate. So legally it is bound to target price stability at the expense of everything else. But what about that generation that will be lost because their grandpas demanded price stability. What about human costs 

Any central banker at Draghi's place would be personally motivated to act. If he gets it right he will be a hero. If he gets it wrong, well, all other central bankers doing it anyways. And no, I dont expect any deflation in the Euro area. Unlike Japan in late 90s, inflation is more of a global phenomenon these days. So perhaps in the long run, whether the ECB acts or not will have no or limited impact on the Euro zone inflation  and inflation expectation. But the impact on the lives of thousands of unemployed or under-employed will be profound