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9/11: 2006 v/s 2001!

Sep 11, 2006

Today is a day that will mark the fifth anniversary of the deadly attack that brought down the world trade center, the symbol of the American economic might and the one that forever left an indelible mark on the American psyche. The repercussions, however, were not just political.The attacks completely knocked the winds out of the sails of US economy, which was already reeling in the aftermath of the tech bubble burst. Something had to be done to prop the consumption levels, which had hit quite a low since people opted to save rather than spend, as uncertainty loomed large before them. US central bank, more popularly known around the world as the Federal Reserve, then took the all-important step of slashing interest rates and bringing them to virtually zero, thus egging the US consumers to not just spend but splurge. And splurge they did! Armed with one of the lowest interest rates in decades, they went about buying anything and everything that came their way and in the process gave a much needed boost to the US economy.

Elsewhere in the Far East, an event not as visible as the travails of the US economy, but equally important, was fast unfolding. With robust economic growth in the region of 9% to 10% behind it, China was finally coming into its own and was asserting its newfound economic importance on the world stage. With cheap labor force in abundance and ruthless utilization of economies of scale, the country was fast acquiring a reputation of being a factory to the world. However, maintaining the growth momentum required massive amount of investments in its infrastructure and the country soon turned into the world's largest consumer of a lot of industrial goods and services. In fact, more than half of world's total output of a lot of commodities was gobbled up by China in order to feed its ravenous appetite for manufacturing driven growth.

Thus, the world economy fast turned into a two-horse chariot, with both the US and the Chinese economy perfectly complementing each other. Buoyed by rock bottom interest rates, the US consumer bought cheap Chinese goods by the truckloads and the Chinese manufacturer in turn utilized the money by investing in capacity expansion and sprucing up the country's infrastructure. However, neither was China going to be able to meet all its demand for commodities internally and nor was it the only market the US consumers relied upon. This bought other nations and their respective companies into focus and the economic revival, which was kicked off by the US consumer, and the Chinese manufacturer soon spread its tentacles far and wide.

As the bottomlines of companies across the globe improved on account of this economic revival and their value became apparent, cheap money that was locked somewhere in the US bank account soon found its way into the equity markets. Infact, prices of all the assets started moving northwards. This period soon turned into one of those extremely rare cases in history where prices of almost all the commodities witnessed a simultaneous rise.

Although India's contribution to this revival was not that significant, this period coincided with one of the best ever as far as acceleration of the economy was concerned. This obviously whetted the appetite of fund managers across the globe and the same cheap money that found its way into other emerging market asset classes also found its way into India. Soon, the extremely well regulated and technologically savvy Indian equity markets witnessed an unprecedented buying interest. Notwithstanding a few bumps in the interim, the Indian benchmark indices have witnessed a more than three fold jump in their market capitalization over the last 3 to 4 years and turned quite a few people in millionaires and billionaires.

Another important factor that contributed to this global economic boom was the re-emergence of Japan, the land of rising sun. After spending almost a decade in economic wilderness, the world's second largest economy finally shed the garb of its ultra-conservatism and is currently heading for its longest expansion in the post war period, one that has already lasted more than four years. Here again, exports to the US and China, like elsewhere, played a crucial role. Of late though, the Japanese consumer has also started spending liberally, thus leading to internal consumption also contributing towards its GDP growth.

Thus, while the rate cut by the Federal Reserve did help boost the world economy, the role of China in taking it to the next level cannot be understated. However, the step that was taken to boost the US economy started to backfire. Infact, a worry of exactly the opposite kind started haunting the US Federal Reserve. The consumption binge that Fed itself kicked off has risen to quite an alarming level and has left a gaping hole in their deficit. Before situation threatened to spiral out of control, it stepped in and did a U-turn by resorting to 17 consecutive quarters of interest rate hikes to stem reckless spending by the US consumer. The impact has been positive so far, as due to demand slowdown, prices of some commodities have indeed fallen. However, not wanting this to have a hard landing effect on the economy, the Fed is currently adopting a wait and watch approach.

As far as the impact of this on India is concerned, we believe that unlike China or its South East Asian counterparts, growth in India is pre-dominantly internal driven and as such, it stands lesser exposed to the risk of a global slowdown. However, the capital market perspective does not go in lock step with the economic perspective. While there is no denying the potential of the country as an attractive investment destination, the role of FIIs in the recent bull run cannot be overlooked. Thus, as seen on a couple of occasions in the past, any pull out of funds by them is likely to spark a much broader sell off in the Indian equity markets. Moreover, at the current valuation levels, the relative attractiveness of the Indian equity markets vis-a-vis the US interest rate is considerably lesser than in the recent past. Hence, we would advise investors to exercise caution at the current juncture with regards to their equity investments. Although the India growth story is still intact, most of the sectors currently seem to be overbought and hence vulnerable to Foreign Institutional Investors (FIIs) outflows. A proper study of risk-reward ratio is of the essence!

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