There’s something strange happening on Indian stock markets. Notwithstanding the losses of the past 10 days, the Sensex is expected to notch up decent gains – some say 20% -- this year. The remarkable thing is that this will happen at a time when oil and gold are falling and other assets like real estate and stocks in major global markets are struggling, a wholesale breakdown of correlations for the first time in years. What’s at play, and what’s likely to happen next?
Let’s take oil. Globally, shares usually move in the same direction as oil, rising when oil rises and falling when it falls. The logic is that demand for crude, and therefore its price, reflects demand for goods. Strong demand for goods is positive for companies’ profits, and therefore their stock prices. But this year, Brent crude prices have fallen 25% while Indian shares had risen by about 8% until the crash of August 24, so that correlation – which held good even in the Asian currency crisis of 1997 -- has gone for a toss.
Indian shares have sometimes had an unusual relationship with gold: while globally, gold prices rise when equities are struggling (people dump risky shares and buy safe gold in times of crisis), even in India’s bear market of the 1990s, gold and shares moved in the same direction. This correlation broke in 2002, 2009 and 2012, and looks to have disappeared again.
From January 2, 2015 to August 1, the yellow metal has fallen 8.5% to near Rs 25,000 per 10 grams on the MCX, against the rise in shares. So as far as their relationship to gold goes, Indian markets have started behaving like their global counterparts.
The correlation with real estate has pretty much disappeared as investors have long switched to stocks from this asset class. A loan-heavy housing sector and financial irregularities have kept investors away from a sector which was a favourite until 2009.
Indian equities also rose and fell in sync with shares in major global markets during other crises such as the US recession in 2000 and the sub-prime crisis of 2008. But in 2015 so far, this pattern has seen a surprising change: The correlation with other global equities -- as with gold and other commodities – has fallen to decade lows. This is evident on the 52-week moving average correlation of weekly returns.
What is happening?
The fall in correlations indicate a strengthening of India’s macro stability – positive numbers like low fiscal deficit, stronger rupee, low inflation, all of which have increased India’s domestic savings. While contrasting correlations with gold, copper and oil have happened before, they never happened in a bear market – and the tenor now is distinctly bearish now -- because apart from the strong fundamentals, India is also now less dependent on global capital flows.
“It’s a great trend although we are unsure how long it would last. The markets have rewarded Indian equities. But to retain such a situation, it is time for policy makers to make the transition from macro stability to growth,” explains Ridham Desai, managing director at Morgan Stanley India. “Then the equity market will retain this newly acquired low beta characteristic. If it doesn’t, correlations will revert.” The push to growth will include fiscal and monetary action, like cutting of interest rates by the RBI.
While the broader Indian stock market index, the Sensex has been affected by upheavals in global markets and the market crash in China on August 24, this has been temporary. It is now down 7.8% on the year, but Morgan Stanley has predicted that the Sensex will likely grow by 22% in 2015.
“It’s the classic case of an emerging market phenomenon where in a V-curve, there is first pain and then gain,” says G Chockalingam, founder CEO of Equinomics Research & Advisory. “When oil fell there was initially pain and equities also fell. After some time, better sense prevailed and the gains were visible as we gain when oil falls,” he added.
Much of the trend of Indian equities in 1997 was linked to the exceptional monetary policy management by former RBI governor Bimal Jalan who through deft measures saved the rupee and the economy from failing. The following crises in 2000 and 2008 saw low trade credit and the commodities cyclical downturn together pull down the Indian indices along with global trends. “Such events are absent this time. No trade credit to divert resources and commodities are seen more as a structural downturn,” says Saugata Bhattacharya, chief economist at Axis Bank.
A key reason in the breakdown of the correlation between oil and shares, is, of course, the changing reasons for the fall in crude. In the 1997 East Asian crisis, the 2000 US recession and the 2008 global financial crisis, the key factor pushing oil prices down was weak global economic growth and slowing oil demand due to recessionary conditions, which resulted in investors reducing their equity holdings. That’s not the case now.
“The current collapse in world oil prices has been triggered by excess supply mainly due to large increases in US production, rather than any recession in major economies, with positive GDP growth still expected in 2015-16 in the US, China and the EU,” said IHS Asia-Pacific chief economist Rajiv Biswas.
While on the subject of correlations: In a feature earlier this year, Reuters posed the question whether the changing gold-to-oil ratio could be a sign of trouble to come. Currently, gold is at $1,140 per ounce, which equates to about 27 barrels of oil. Historically, gold has cost 15 barrels and an increase in this number shows deflation, which brings with it another set of problems for global markets.
There’s another interesting correlation in global markets – when oil falls sharply, gold rises the following year. For what it’s worth, this has happened twice in the last three decades.
Market correlations, or their breakdown, clearly tell a story. How far that is predictive, and how far you can use it to make money, is down to how canny you are.