Liquidity has been the single biggest factor behind the stellar performance of risk assets around the world in the post-GFC (global financial crisis) era. One proxy for positive liquidity towards Indian stocks has been the growth in mutual fund equity assets under management (AUMs). 

There is increasing consensus that this flow into equities is sustainable and unidirectional, ignoring the inherent nature of equities as a risky asset class. With global interest rates once again preparing to go South, the flow into Indian equities looks apparently unstoppable. While the rationale is strong, the correlation of liquidity and sustained wealth creation is far from clear.  

Asset prices

Liquidity can, at best, fatten the bull, no evidence that it can bestow immortality to it. Quite contrarily, Japan continued its long race to the bottom after its economy was swamped with monetary liquidity. The Nasdaq boom and the 2003-07 bull run were lubricated with cheap money. Eventually, markets ran out of steam.

Chinese market is one of the worst-performing large markets though no effort has been spared to inject liquidity. About 94 per cent of equity AUMs in India have been added in the last 10 years, but investors are yet to be tested by a sustained downturn. The cracks are visible in the internals of the boom.

The TINA factor

Since alternative assets are unable to beat inflation on a post-tax basis, stocks will be well-supported. So goes the argument. Free markets don’t owe savers offset for inflation. The embedded corrective mechanism in a market economy is usually primed to do exactly the opposite by punishing participants who push the risk envelope too much. Equity AUMs are now at about 18 per cent of bank deposits, up from less than 6 per cent in 2015. It is entirely possible that the implicit policy support to equities may begin to wane, as authorities may already be running into challenges on system stability. The drought on bank deposits is a case in point.   

The rise of India’s weight

India’s weight in global asset allocation tables has indeed gone up. Outperformance tends to beget more of the same and index makers reward performance.

India’s current high weight in emerging markets (EMs) indices is not a good lead indicator at extremes, if you go by precedents. Japan had about 40 per cent share in the broad global index in 1980s. This is now down to mid-single digits. Taiwan and Korea, which had a market weight disproportionate to their GDP share in EMs, have seen a fall. India’s weight in the MSCI Emerging Markets Investable Market Index has now gone past that of China, while the Chinese economy is about five times as big. Profits as a percentage of GDP is not dissimilar, though India scores over China on some qualitative metrics. The lopsided nature of the numbers suggests that we are reaching an extreme. Instead of continued inflows, selling can cascade if there is a turn in sentiment forcing a mean reversion. What goes in comes out at a greater speed.

Market liquidity

The market volumes are suggestive of healthy liquidity. Dig deeper and you get the true picture. There are block sellers offloading shares at a discount but exercising a choice. Buyers are institutions who have a compulsion to buy as they are deluged with inflows. The discount boosts NAVs momentarily giving a false sense of comfort. At another level, the IPO data show an increase in valuations in the run-up to the event with little change in fundamentals. Post-listing gains create further momentum and participation. The market juggernaut is fattening itself into a system with a great veneer and a hollow core.  

What is disturbing about the one-sided narrative on liquidity is that any possible counterpoint is drowned in an echo chamber of cheerleaders of the bull market. The question now is what can stop the liquidity. It is unlikely to be a known factor because if that were so, the market would have re-adjusted. The accident ahead will likely come without a warning.

The author is Managing Director and CIO, Spark Asia Impact Managers

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