What is fueling Stock Market
By: Amit Lal
Tags: Opinion, Indian Stock Market

That’s the penultimate question I have come across in all my recent meetings. It has become quite an interesting topic to debate on since most of the micro and macro numbers are not looking that encouraging( Although things have started improving).

So before we take a dig on what is fueling the current rally, lets understand couple of inter-related terms.

Why does Inflation increase ?

Most of us feel its because of higher demand and lower supply but guess what , That’s not the only factor. Imagine there is a shortage of Mobile phones with respect to demand but there is no liquidity in the market( as in people don’t have money), will the price of Mobile phones still go up? Answer is NO….

So, Inflation takes place because the demand supply situation is accompanied by liquidity, people have the money to spend and hence the prices go northward. Inflation does not take place only because of the demand supply gap.

How Central Bank act on such situation?

Its Central Bank’s job to keep inflation under check. RBI has expressed its comfort in keeping inflation between 2–6% in current scenario. So if Inflation increases, how can RBI control it? The only tool available with RBI to control inflation is by controlling the liquidity in market. If RBI is able to reduce liquidity from the market, less money will chase the goods and hence Inflation can be expected to stabilize.

Now the question is how do RBI do it? As liquidity is provided by Banks ( Through lending), RBI tries controlling banks by increasing interest rates( Repo Rate). It expects that if Repo Rate goes up, the spiraling effect will reduce the liquidity .

Repo rate is the rate at which Banks borrow from RBI. If Repo rate increases, the cost of funds for Banks will go up. This will ultimately push the lenders to increase their lending rates. With increase in interest rates , people will borrow less….

So if Inflation goes up, efforts are made to increase interest rates and this will push common public to reduce their borrowing. Since lesser money will chase the products so the demand will reduce and this will make inflation stabilize.

The reverse is also true, when inflation falls , interest rates are reduced so that loans become cheaper and demands for products will increase and hence inflation can increase over a period of time( we are going through this phase).

What’s happening across the major economies ?

In the fear of crisis, all major economies(including US) are providing Stimulus so that purchasing power of individuals remain intact. They are also keeping their interest cost close to Zero so that people and entities can borrow more and demand can be pushed. Many economies are buying Bonds regularly, this is giving cash to the market.

Now Individuals, corporates and even financial institutions have access money. What will they do with it? Either will keep it in bank or will invest somewhere.

Interest rate in these countries is close to Zero so people can’t make money there. The only option left is investing in equity and commodities.

Now when people have the option to invest locally( US stock market is close to all time high too) then why would they choose to invest in Emerging Markets like India ? Why does the liquidity flow to emerging markets?

The answer is slightly weaker Dollar. Lower dollar propelling this equation.

Before we understand how the lower/ weaker Dollar propel emerging market trade, lets understand why does the Dollar fall in the first place ?

If the Fed is continuously printing Dollar and supplying it to their market, the supply of Dollar is high and hence Dollar falls. More the Dollar printed, lesser the value.

Lower Dollar is positive for emerging markets. Companies from emerging markets who have taken loans in Dollar will have to pay less rupees ( from 75 earlier to 70 now) and hence increase in profitability.

Similarly imagine FIIs investing when 1$ = 75Rs. So they convert 1$ to 75 Rs and invest those rupees here. Lets assume the investment of 75 has become 82.5, 10% profit. While taking the investment back, FIIs will convert 82.5 Rs into Dollar. Since Dollar has fallen to 70, they will receive 1.18$ instead of 1$.

1$ invested and 1.18 receives is 18% return on investment whereas in rupees return was 10%. This is why a falling Dollar is a big boon for FIIs.

Wouldn’t the falling Dollar make Indian exports uncompetitive?

For every Dollar in export companies were making Rs. 75 but now it has come down to 70.

RBI has reacted here and started Dollar buying spree which is leading to create liquidity in local market. The more RBI buys the Dollar, the more support it gets from falling. RBI has bought $97Bn since April. So when RBI buys $97Bn, it gives to the market close to 6 Lakh crores of Rupee liquidity and that’s RBI way to infuse liquidity in the system.

This global and local liquidity is driving the stock & Commodities market.

The situation is way more lucrative for Indian market than 2008. 2020 has seen six times more liquidity than 2008. Every point drop in Dollar Index is worth at least $3Bn in FII inflows.

This rally is not going to stop till Dollar starts moving up !