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October 2010

Amidst the prevailing skepticism on global economy and markets, September turned out to be one of the best months for equities globally. On the back of massive liquidity flows, Indian markets had a decent move up with Sensex posting a gain of 11.67% during the month and closed above the psychologically important level of 20,000. Equity Indices are very close to the all time peak witnessed in January 2008. Foreign investors chasing higher growth poured $ 6 billion in a month and their year to date investment in equities is now at $ 19 billion. Domestic investors remained net sellers.

One of the noteworthy features of the rally over the last 18 months has been high premium for quality stocks. Companies with better quality earnings, balance sheet profile and good corporate governance are trading at significant premium to rest of the market. If liquidity flows continue at the current pace and the momentum leads to wider participation then we might see this premium shrinking as investors chase higher beta.

Robust capital flows led to sharp appreciation of Rupee against the dollar. It gained 4.5% during the month and closed below 45 levels against the dollar. Rupee had been under pressure on concerns about record Current Account Deficit, however, the trend got reversed last month with massive FII flows in equity market. Sentiments about rupee got a boost from government’s decision to hike the FII ceiling in bonds by $ 5 billion each for investment in corporate and government bonds. Given the interest rate differential and positive view on currency, we may expect higher flows in fixed income markets over the next couple of quarters.

While higher risk appetite has led to a rally in global equities and commodities, bond yields remained depressed. The 10-year US treasury yield is trading around 2.5% on demand for safe haven assets. Bond yields in developed countries are at levels last seen in Dec 08 when fears of a depression like 1930s were looming large. The financial crisis had its genesis in excessive credit risk and high leverage so reaction of investors of all herds could be termed as natural to flock towards something that is ‘risk-free’ as far credit risk is concerned. Investors have been overweight equities and having burnt their fingers so badly (over the last 1, 3, 5, 10 and 20-years, ‘risk-free’ treasuries have delivered better returns than US equities) are now trying to correct the asset allocation in favor of a performing asset. However, those paying excessive price for a predictable cash-flow and buying insurance against deflationary threats must also keep in mind the state of public finances and ultimate burden of unfunded pension and Medicare liabilities on the sovereign. Given the nature of debt deflation cycle, overnight rates at close to zero and current thinking of monetary policy makers, bond investors are justified in their super bullish views, however, one must keep a watch on valuation as margin of safety against ‘price risk’ is diminishing. Betting on mean reversion may not pay off always; ask anyone who shorted Japanese bonds anytime in last 20-years. So don’t get tempted to go against the tide early, still it could be long way to go. We may be long way off, but it is almost certain that a few years later, we would look back at some great bubbles of this decade including the ones in government and high grade bonds, precious metals and some of the currencies like Japanese Yen.

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