Markets too do need to take profits

Corporate sector profit growth and private credit expansion would be vital for the short- to medium-term outlook of the CSE, while the valuations would become the primary focus in the coming months

he All Share Price Index (ASPI), which rose to 7,406 points, peaked on October 3, 2010 (the highest the index has achieved since the all-time high in February 2011) and started to take a breather in the subsequent days.

The Colombo Capital Market Conference jointly organised by the Colombo Stock Exchange (CSE) and Securities and Exchange Commission (SEC) successfully concluded on October 9 with an impressive turnout of overseas investors.

However, despite the robust marketing activities, a bout of profit-taking was not to be postponed much further and the index decline, which started latter part of last week, continued on to this week with some traders/investors eager to cut losses.

 

Profit-taking bout 

The two weeks of trading leading up to last Friday (October 10,  2014) saw the ASPI gaining 1.2 percent (around 87 points) chiefly on the back of large cap interest and a sharp rise in market activity with the average daily turnover recorded at almost Rs.3 billion.

However, during this two-week period, the foreign investors were net sellers, buying nearly Rs.7 billion worth of stock and selling to the value of nearly Rs.8.5 billion. During last week, the ASPI lost around 86 points (1.2 percent) from the high of 7,406 index value, indicating a bout of profit-taking has started.

With the global markets also remaining dull, the foreign investors too were more so on the sell side, despite no indications of a sharp selloff. Profit-taking spree intensified on October 13, 2014 with the ASPI losing over 136 points within the day and moved down to 7,184 index value.

The contraction in the index was primarily driven by the banking sector and other large cap stocks which gained significantly during the past two months. However, on October 13, 2014, despite the index losing nearly 140 points, foreigners became net buyers to the tune of Rs.284 million.

The current bout of profit-taking was far overdue and in my opinion was necessary to maintain trading momentum, which otherwise could have led to an unwarranted market correction in a month or so. Also, profit-taking at the CSE took place alongside declining global markets. This strengthens the argument which I have been making in the past that despite the lack of strong correlation between the CSE and other global markets, the Colombo bourse is not an island on its own.

International market behaviour and foreign portfolio money flows will have an impact on the local stock market. Markets are sentiment driven and with technology and marked improvements in communications, geographical boundaries are not sufficient to hold sentiments at bay. Long gone are the days where markets and countries operate in a cocoon of their own instead of been influenced by the global economy.
 

State of global economy

All indications suggest that despite many attempts by policymakers the global economy is poised for a slowdown and that casts a big shadow on many markets around the world. Europe is heading towards its third recession in six years; China is slowing in the wake of its credit boom and pulling down many regional economies, including Australia with it.

Despite many efforts to uplift it from stagnation, Japanese economy is contracting. BRIC countries with the exception of India, which is showing some rejuvenation following political change, is also struggling. And only the United States of America is showing some optimism in its economic outlook with the reduction in unemployment.

Therefore, the expected slowdown in the global economy would invariably weigh down on all global markets though the impact on the CSE would be of less intensity and if the local economy manages its finances well the global downturn may have only limited impact on our market.

Global demand is contracting and manufacturing power houses such as China is having a glut of supply. Global oil prices have fallen by around 20 percent during the last four months and this is despite the supply concerns created by the ongoing Middle East crisis, sporadic supply disruptions in Nigeria and the stand-off between Russia and Ukraine.

Other commodities from gold to corn are having downward price pressure. With sagging growth the US policymakers wanting to stall the impact on their economy is most likely to delay rate hikes despite the US dollar gaining strength as the preferred storage of wealth in these turbulent times.

The delay in US rate hikes, if there is any would bode well with the Sri Lankan economy stretching possibilities for policymakers to maintain the low interest rate environment. However, given the lull in local credit expansion an upward revision in US interest rates may only have minor impact on the local interest rate scenario.
Nevertheless, as mentioned in the past, we cannot shy away from the natural depreciation of the Sri Lankan rupee, given the twin deficits, and may end the year with the local currency lose around 3 percent vs. the US dollar.

 

Weary credit growth

However, with market interest rates falling to the lowest during the past two decades or so, I believe even the policymakers are engulfed trying to find reasons why credit demand is not picking up. Individuals can now borrow money at single digit rates and some corporates have the luxury of borrowing at rates around mid-single digit, but still credit growth seems weary and needless to say that this doesn’t pave the way for a buoyant economic outlook.

With limited credit growth in the system, consumption growth would be held back, investments capped and overall corporate profit growth would sag creating pressure on the ASPI and the CSE performance as a whole. With inflation reported at mid-single digit and market interest rates also now having fallen to single rate levels credit growth theoretically should make marked gains, however it is not the case still.

Though reasoning is difficult, the closest I can rationalize would be that the banking system is more concerned about risk and despite the low rates are only lending selectively. However, this is not a bad strategy in the eyes of the banking institutions since they should prioritize risk over growth, which would invariably assist in maintaining financial system health.

Also, consumption growth seems to be hindered, at least among the urban consumers (who have direct access to banking system credit), due to sharp cost escalation of essentials and stalled growth in incomes. Property transactions and subsequent maintenance of property which doesn’t qualify for various benefits are heavily taxed, in order to collect maintenance revenue for various localised state institutions.

Therefore, an inherent reluctance is persistent among the public to transact in property taking advantage of the low interest rates. The drag in settling property-related disputes within the legal system is another bottleneck for property markets to pick up in Sri Lanka, unlike in other emerging economies. Also for corporates, fresh investments most often seem non value adding, given the direct and indirect cost pressure, red-tape involving various approvals and the opportunity cost of time.

Further, the vicious cycle seems to be continuing with the limited expansion in business and fresh investments adversely affecting job creation and growth in salaries, which would lead to lower demand for credit. The state sector increasing its foothold in commercial businesses is also crowding out private sector growth and adding more pressure on the State Treasury to finance the added resources, which would directly affect the fiscal deficit.

Therefore, corporate sector profit growth and private credit expansion would be vital for the short- to medium-term outlook of the CSE, while the valuations would become the primary focus in the coming months.

Also, the prevailing uncertainty (which could be addressed shortly) regarding the national elections are not assisting market sentiment. If snap polls are announced, the market could experience a fair amount of volatility, followed by strong directional movement leading up to the elections, whilst thereafter, focus again would shift to valuations and profit growth.