Sell America, buy India?

The French Bank, BNP Paribas, known for its formidable currency strategy research, brought out a report last week called 'Sell America'. The title in a nutshell captures a sudden shift in sentiment in global asset markets. Should it persist, it could keep emerging market currencies and equities ticking a while longer.

'Sell America' refers to the following phenomenon -- the 'anti-dollar' currency trade (that had virtually disappeared for the past six months or so) is staging a rather dramatic comeback.

Currency traders and investors are beginning to dump the dollar to reflect their anxiety over the US's structural problems, particularly the need to finance its large budget deficit. They were, until recently, buying dollars with a vengeance to hedge risk even though the source of risk was the American economy and the financial sector. That has changed.

Last week saw fairly heavy dollar selling following rating agency Standard and Poor's downward revision in outlook for UK's sovereign bonds. Investors assumed that the US was next in line, given its massive budget deficit forecast to be about 13 per cent for 2009 and likely to grow bigger.

The pound sterling, strangely enough, gained after this news but the dollar took a heavy beating.

As investors dump dollar assets, they are looking for alternatives. One clear alternative is the capital markets of the emerging world, including India. Thus, while local factors such as election results have played a role in ramping up the markets, shifting sentiment towards the American currency could abet this, going forward.

 A little piece of economic history might help understand this better.

Over the past three decades, global recessions have usually been accompanied by a dollar appreciation. American assets, particularly US government bonds, have always been the default safe haven that investors flock to whenever risk surges.

The data also shows that it didn't really matter whether the global recession was led or driven by the US. Global investors almost invariably flocked to the greenback whenever there was a crisis.

The current financial crisis was no exception. Despite the fact that the US housing market and banking was the epicentre of the global economic crisis, money actually flowed into the US, driving the dollar up against other currencies. This led to a somewhat ironic situation where the US was actually rewarded rather than punished for its sins.

There seem to be essentially three reasons why this is changing.

First, there appears to be a genuine improvement in risk appetite riding on the perception that the global business cycle has bottomed out.

Second, the notion of decoupling (or at least a variant of it) is coming back into vogue, with investors beginning to bet on the fact that some parts of the global economy will recover faster than the others.

Finally, the structural problems of the US, particularly the humongous government budget deficit, are getting the emphasis they deserve. Besides, with the rise in risk appetite and the emergence of attractive alternatives, investors are in a position to express their apprehensions about the US more aggressively.

The risk, of course, is that dollar sentiment could turn positive again if there are signs that the global economy, particularly the G-7 economies, dip again. It is possible that, as the doomsayers are fond of pointing out, the apparent improvement in macro-data is just temporary, driven by a phase of re-stocking and inventory adjustment and not by any increase in core demand.

Were that to happen, the green shoots of recovery and emerging markets could wilt.

The pessimists also emphasise the fact that the process of balance sheet repair that US households are going through and the US government will be forced to undertake in future should lead to economic contraction. Thus, as long as household savings continue to rise and the government tries to fill its fiscal gap, demand will contract and rein in US growth.

In the absence of any major pick-up in the US, it is impossible for the emerging world to bounce back. In short, we are in the initial phase of a drawn out W-shaped recovery where the current euphoria will gave way to another bout of despair before things start improving again

The jury is still is out on this and it would be naive of me to suggest, with any degree of certainty, that the pessimistic scenario will not pan out. For my forecasts, I am however working with the assumptions that, a) the developed world will see a very slow but sustained recovery; and b) emerging economies like India or China that have a large domestic demand pools will recover substantially by the middle of 2010.

My more immediate concern about the Indian markets relates to the valuation that the market indices are trading at. A price-earnings ratio of about 16 times one-year forward earnings isn't exactly cheap. Thus the case for a fair bit of price correction is strong. As commodity prices pick up on the back of positive global growth cues, there could be growing concerns about India's current account deficit.

There could be disappointments with policy as well, especially if the government announces plans to raise taxes to bridge the deficit. These could be temporary brakes on the market's momentum. However, if funds continue to leave American shores to seek better yields, the upward trend in India's stock market could just sustain.