Stock mar­kets and ru­pee have lim­ited cor­re­la­tion

His­tor­i­cally, the im­pact of cur­rency de­pre­ci­a­tion on eq­ui­ties has only been for a lim­ited pe­riod

Business Standard - - YOUR MONEY - ASHWIN PATNI

In­dia once again finds it­self caught in a global cur­rency mar­ket turmoil. The ru­pee has fallen a lit­tle over 12 per cent against the US dol­lar this cal­en­dar year. While the de­pre­ci­a­tion had been steady in the first half of the year, the sec­ond half saw a sharper fall.

The chal­lenges within the cur­rency mar­ket have af­fected sen­ti­ments in other mar­kets as well – both eq­ui­ties and fixed in­come. Specif­i­cally, the eq­uity mar­ket – af­ter seem­ingly hold­ing firm in the first half – has seen a sharp correction in the past two-three months, mir­ror­ing the acute phase of the cur­rency de­pre­ci­a­tion.

In­dia is no stranger to cur­rency de­pre­ci­a­tion. We have seen sharp sell- offs a few times in the past cou­ple of decades. We had last ex­pe­ri­enced a large cur­rency de­pre­ci­a­tion episode about five years ago in 2013 caused by the US Fed’s talk of ta­per­ing bond pur­chases. The ru­pee had then cor­rected more than 28 per cent against the US dol­lar. Look­ing at the his­tor­i­cal cor­re­la­tion be­tween ru­pee de­pre­ci­a­tion and the stock mar­ket can give us an idea of how the cur­rent sit­u­a­tion can shape up.

It's not as bad as it looks Analysing the Real Ef­fec­tive Ex­change Rate (REER) over time gives some clue about the cur­rent sell- off. The ru­pee had ral­lied sharply dur­ing 2016-17, and as a re­sult, had be­come over­val­ued. The over-valu­a­tion started re­flect­ing in some loss of com­pet­i­tive­ness for the econ­omy – as ev­i­denced by a ris­ing cur­rent ac­count deficit. This cou­pled with is­sues in­clud­ing the US rate cy­cle, a broader sell-off in emerg­ing mar­kets (EM), ris­ing crude oil prices, and an over­all risk-off sen­ti­ment, pre­cip­i­tated the sell- off in the ru­pee in the cur­rent year.

Also, while the sell- off has been sharp against the US dol­lar, when com­pared with other cur­ren­cies the ru­pee has held up bet­ter. The ex­tent of the out-per­for­mance dur­ing 2016-17 means that de­spite the cur­rent sell- off, the ru­pee re­mains one of the top per­form­ing EM cur­ren­cies over the past five years. Note long-term ru­pee de­pre­ci­a­tion

If we step back from the cur­rent mar­ket en­vi­ron­ment and look at the ru­pee against the US dol­lar over the long term, we will see that the In­dian cur­rency has con­sis­tently de­pre­ci­ated vis-a-vis the US dol­lar over the past 20 years. Over this pe­riod, the an­nu­alised de­pre­ci­a­tion rate comes to 3 per cent a year. When one looks at the trend in de­tail, it be­comes clear that the de­pre­ci­a­tion has not hap­pened in a smooth line.

The cur­rency mar­kets tend to be sta­ble for a num­ber of years and then wit­ness a sharp de­pre­ci­a­tion episode (much like the cur­rent one) that re­sets the cur­rency’s trad­ing level.

Eq­uity mar­kets are re­silient Let’s iso­late pe­ri­ods dur­ing which we wit­nessed sharp cur­rency sell­offs over the past 20 years and ex­am­ine how the eq­uity mar­kets be­haved dur­ing those times. Also, let us see how the cur­rent episode com­pares with th­ese older data sets.

Since 1998, there have been five in­stances where the In­dian ru­pee has lost at least 12 per cent (against the US dol­lar) within a pe­riod of three months. We plot­ted the stock mar­ket along with the cur­rency move­ment dur­ing th­ese phases, also in­cluded the mar­ket’s be­hav­iour in the three months af­ter the cur­rency sell-off.

Four trends are clearly ev­i­dent from the his­tor­i­cal data. One, pe­ri­ods of acute cur­rency de­pre­ci­a­tion are gen­er­ally ac­com­pa­nied by a sell-off in the eq­uity mar­kets. Two, ex­cept for the Global Fi­nan­cial Cri­sis (GFC), th­ese episodes saw In­dian eq­ui­ties fall by 10-15 per cent in ru­pee terms. The GFC sell­off was, of course, much sharper. Three, in­ter­est­ingly, the eq­uity mar­ket bounced back sharply (in ru­pee terms) in the sub­se­quent three months once the cur­rency sta­bilised. The ex­cep­tion seems to be the GFC where the bounce back took longer. Fi­nally, the re­cov­ery in stock mar­kets does not seem to be af­fected by whether the cur­rency bounced back as well or whether it sta­bilised around its lows post the sell-off.

Cur­rency im­pact is short-lived Over the long term, it’s in­fla­tion and growth that de­ter­mine the tra­jec­tory of the cur­rency. In the case of In­dia, the per­sis­tently high in­fla­tion over the years meant that our cur­rency had to de­pre­ci­ate over the long-term to main­tain its real value.

In the short-term, any rel­a­tively open emerg­ing mar­ket that runs large trade deficits that get prin­ci­pally fi­nanced through more volatile port­fo­lio flows (as in the case of In­dia) opens it­self up to pe­ri­ods of sharp cur­rency sell-offs re­lated to global sen­ti­ment shifts. Eq­uity mar­kets are driven by sen­ti­ment in the short-term but fun­da­men­tals in the long term. We have seen that over the medi­umto long-term cur­rency move­ments have not had a sig­nif­i­cant ef­fect on cor­po­rate earn­ings, that is, the fun­da­men­tals of the mar­ket. How­ever, in the short term, cur­rency de­pre­ci­a­tion af­fects sen­ti­ment, es­pe­cially for for­eign in­vestors, but also for the do­mes­tic ones, as me­dia com­men­tary fo­cuses on the im­me­di­ate neg­a­tiv­ity.

While th­ese have led to a short­term re­ac­tion in the eq­uity mar­kets, his­tory seems to sug­gest that the im­pact is more tran­si­tory and the mar­ket moves on once the cur­rency sta­bilises. From a re­tail in­vestor’s per­spec­tive, there­fore, it is es­sen­tial not to get swayed by the short-term correction in the eq­uity mar­ket and macro noise, and stay the course with their longterm fi­nan­cial plans.

Th­ese episodes also il­lus­trate the im­por­tance of risk man­age­ment in in­vest­ment port­fo­lios. Strate­gies that can with­stand such shocks and gen­er­ate more sustainable per­for­mance should be val­ued and pre­ferred over other fair­erweather strate­gies.

The writer is head (prod­ucts) and fund man­ager at Axis Mu­tual Fund


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