If last time it was Uncle Sam, this time it’s the Dragon who has literally sent financial markets across the globe in an awkward quandary. China is plagued with variety of problems right now. Shrivelling exports, cooling domestic demand, burgeoning debt (with Debt to GDP over 280%) and bleak prospects for economic growth have marred Chinese economy. Investors seem to be unconvinced with efforts of Chinese Government and those of People’s Bank of China (PBoC) in response to devolving situation in world’s most powerful manufacturing hub.

The relentless fall of the Chinese stock market, and devaluation of currency have got investors across the globe nervous resulting in a sell-off. On Monday it was mayhem, but the following trading day brought in some relief amidst rampant volatility. Hence, which direction would equity markets head remains the question.

There is a fear that devaluation of Chinese currency might just be the tip of the iceberg or could be the beginning of the grievous currency war. Hence various markets such as equity, commodity, currency and bond have faced the brunt of dragon’s tail.

Tough times ahead?
Data as on August 25, 2015
Note: India VIX indicates the investor’s perception of the market’s volatility in the near term
(Source: ACE MF, PersonalFN Research)

The fall in the Indian equity market is majorly on account of huge selling by Foreign Institutional Investors (FIIs). India is a part of emerging market indices which means, if there are outflows from emerging market oriented offshore funds, fund managers will dump Indian equities as redemption pressure mounts.

As far as currencies are concerned, when Yuan loses value against the U.S. dollar; other emerging market currencies too lose value against the U.S. dollar for two reasons: one, the basket of emerging market currencies get weak against the U.S. dollar and two, on account of the possible impact of these adjustments on domestic macroeconomic variables of a nation.

The potential impact of the headwinds from China would be:

• Dim prospects for China would mean crushing impact on commodity prices. India being one of the major importers of commodities (including crude oil) stands to benefit from sombre outlook on commodities
  
  
• Indian manufacturers may find the environment challenging as China begins to dump goods
  
  
• Indian exporters may feel the heat, if China goes out of the way to save its exports and wages a currency war on other exporting nations.
  
  
• Instability in the value of Yuan may make Indian Rupee vulnerable
  
  
• If dollar continues to gain on account of devaluation of Yuan; investors may decide to shun emerging markets and take refuge under “double D” (Dollar and Dow)
  
  
• The period of risk-on may recede and the flows to emerging markets could be affected
  
  
• Yield sensitive global bond investors may find Indian bonds unattractive if bond yields in the U.S. rise and they perceive promising prospects there
  
  
• The FII flows would be subject to how the situation takes shape further and their risk perception to each emerging market economy
  
  

Careful analysis suggests that the response of investors in equity markets so far is soppy in nature with sell-off and recovery witnessed. This is not the first occasion when the Indian markets have been submissive to global pressure. It has happened in the past as well in 2008 and 2013.

But the basic difference in India’s position now and then is…

• RBI is now more responsive to the movement of the Indian rupee owing to external factors. At present India’s central bank has been hawk-eyed. It continued to buy the U.S. dollar when inflows of foreign capital were strong. As the Indian rupee started falling, Reserve Bank of India (RBI) governor has been prompt-enough to announce willingness of RBI to utilise close to U.S. $380 billion worth reserves to maintain stability of the Indian rupee.
  
  
• India was facing a threat of runaway inflation and declining corporate profitability in the past. Market valuations were high in 2008, but were reasonable in 2013. At present, it seems corporate earnings may have bottomed out and capex activity may get back on track. India looks well-placed on inflation front for now, while the recovery in corporate earnings might be some way from now.
  
  
• The central banks in the developed economies are adopting an easy monetary stance which would go on to be supportive for emerging and Developing Economies (EDEs) and India is likely to be beneficiary of the same, provided the domestic macroeconomic environment is conducive and reforms are speeded. There are some brownie points of the Government such as:
  
  

• The focus on infrastructure development to clock better economic growth and substantial earmarking of funds in union budget 2015-16 for the same;
  
  
• Launch of three major urban development initiatives: AMRUT (Atal Mission for Rejuvenation and Urban Transformation), Smart Cities Mission and Housing for All;
  
  
• Improved ease of doing business;
  
  
• The launch of Digital India programme (which is designed to be a game changer and may go on to transform into a digitally empowered society, knowledge economy and bring good governance through synchronized and co-ordinated engagement of the entire Government);
  
  
• Passage of Black Money Bill (which holds the potential curb flow of black money in the economy, which can also aid the country in bridging the fiscal deficit);
  
  
• Path to fiscal consolidation charted by the Government;
  
  
• Determination to fight the inflation bug (and even have a contingency plan in place to handle effects of sub-normal monsoon); and
  
  
• Efforts taken by the Government to improve bi-lateral trade relationships (with China, Japan, U.S., Germany, Canada, amongst a host of other countries);
  
  

An easy monetary policy adopted, would facilitate money to move to risky asset, but investors would be rather cautious and exuberance would recede, especially with the global headwinds in play.

All the same, there are a few domestic risk factors to watch out…

• Although threat of inflation reaching double digit rate has subsided (thanks to corroborative efforts of the Government and RBI), inflation may go up if monsoon turns out to be deficient. Good monsoon is not only essential to keep food price inflation under control, but equally important to keep demand from rural areas strong.
  
  
• There is a huge expectation built-up in stock prices. If India Inc. fails to meet earnings expectations, valuations for many companies may soon start looking unjustified.
  
  
• Asset quality of Indian banks and quality of corporate balance sheets in India is definitely in bad shape as compared to that in 2008 and 2013.
  
  
• Getting crucial Bills through has been a tough task for NDA Government so far. Complete failure of monsoon session of the parliament highlights how reforms would derail if the Government fails to win support of the opposition for all important Bills.
  
  
• The Government would need to clear the smoke over alleged scam stories unfolding, because after all the electorates have voted Modi-led-NDA Government on hopes on Acche Din and in want of transparency in Governance.
  
  

What should investors do?
The PBoC has recently cut rates by another 25 basis points (bps) as measure to provide impetus to China’s economic growth. But to us, it appears that it may not provide much respite and arrest the stock market fall. There could be more in the offing and another instance of devaluation of Yuan too cannot be ruled out. At present, the dragon is gasping for fresh air after running at a ferocious pace for almost 3 decades.

In such a scenario, the Indian equity market would pave it path on how global headwinds take course and there could be rampant volatility. But PersonalFN believes that with the reform agenda charted by Modi-led-NDA Government and the prudent monetary policy actions of RBI, India is better prepared to absorb the shocks and holds promising long term potential.

Investors should avoid speculating during volatile times as it could hazardous to wealth and health. To manage volatility better and mitigate risk, opting for the Systematic Investment Plan (SIP) mode of investing can be considered as it would facilitate good rupee-cost averaging and power your portfolio with the benefit of compounding. During the downswing if proportion of equity assets in your portfolio has gone down, you should consider restore it and pay attention to the asset allocation that’s appropriate for you.

While taking exposure in diversified equity funds, you may consider value style funds and / or opportunities style funds. However the portfolio allocation of the fund you invest in should be across market but large cap biased, so that you can benefit from the recovery. Given that the U.S. dollar has the potential to strengthen and signs of economic vigour depicted by the U.S. economy, you may also invest a petite portion – say upto 5% of your overall portfolio – in U.S. based offshore equity funds to diversify your portfolio geographically. However, while selecting mutual funds for your portfolio, prefer the diversified equity funds which follow strong investment processes and systems, and invest with a long-term horizon of at least 5 years.

From an asset allocation point of view you may also invest about 10% of your overall portfolio in gold ETFs. One should look at gold as a portfolio diversifier and a monetary asset (rather than mere commodity), which can help you reduce risk to your overall portfolio with its trait of being a store of value in times of uncertainties. You should ideally invest in gold with a longer investment horizon.

At PersonalFN we believe that your investment discipline and asset allocation would decide your success in investing.

Do you think Indian markets will sustain this global sell-off? Please share your views here.

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