Indian markets have had a good start in 2012. The Nifty and Sensex are up by over 15 percent, the rupee has gained over 6.5 percent and bond yields are down 30 basis points from end-December 2011 till date. Market sentiment, which was extremely bearish in 2011 (Indian markets were among the world's worst performers in 2011), turned and the mood is now mildly bullish.
Experts who were warning of further falls in Indian markets in 2012 have now turned around and betting on more upside in the markets ahead. Investors will now be inclined to sell on this market uptick on the back of "expert" predictions.
It is definitely not the right time to sell and stay out. There is a lot of liquidity being pumped into markets by central banks. The Bank of England has announced extra bond purchases of 50 billion pounds for this year while the European Central Bank is expected to lend up to one trillion euros in its fund auction end of February 2012.
The US Federal Reserve has also pledged to keep rates at all-time lows until late 2014 and keep pumping liquidity into the markets given below-normal labor market conditions.
In India, the Reserve Bank of India has been doing its bit by buying around Rs 80,000 crore of government bonds this fiscal.
The liquidity being pumped in by central banks is lifting markets in India and across the globe. Foreign institutional investors have invested close to $7 billion in equities and debt since the beginning of this year to date, which has resulted in rising market momentum.
It is difficult to fight liquidity and investors should ride the momentum while keeping a keen eye on risks.
Here are the five macro risks that could derail markets in the short term:
Election results in states: The largest state in India (Uttar Pradesh) is going through elections, and if the ruling party does not gain ground in the state, it will impact a good budget in which reforms on subsidies and fiscal deficit are expected.
Global liquidity and the threat of inflation: Indians cannot go through another year of high fiscal deficit as markets do not have the appetite for bonds from a government unable to contain its fiscal deficit.
The fiscal deficit is forecast to have gone up by 1 percentage point from the budgeted level of 4.6 of GDP for fiscal 2011-12 and the government has to announce reforms to bring down the deficit. A poor budget will derail the market rally, as the global environment on governments running high deficits is extremely negative.
The liquidity pumped in by central banks can impact inflation if it (the liquidity) does not go to the right places. India has seen inflation at over 9 percent levels for most of 2011 and if oil prices, which are up by 10 percent since the end of December go higher, the inflation outlook will turn negative.
Austerity measures in Europe: Europe is not out of the woods. Governments from Greece to Italy are cutting public spending, and these cuts in public spending are expected to tip such countries into recession. Demand in Europe is weak as seen by the guidance from major steel makers and exporters to Europe. Weakness in the eurozone will impact businesses across the world and India will be no exception.
Weak monsoons: Monsoons are always a threat to India and 2012 is no exception. Weak monsoons will impact food prices leading to rising food price inflation that will lead to wage price inflation and then general inflation. The government's subsidy bill will also shoot up on a weak monsoon.
More economic headwinds for China: China's inflation for January 2012 came in at 4.5 percent against the December figure of 4.1 percent. China cannot ease monetary policy to improve its economic growth, which is seen faltering as the country grapples with over-investment, bad loans and rising inflation. Weak growth in China will affect the world as world trade falls sharply and India will face the repercussions of a fall in global trade.
Markets are looking at liquidity right now and as yet, macro risks have not come to the fore. But once markets get uncomfortable about their levels, they will turn back to macro issues for direction, and if risks emerge, the fall can be sharp from the highs.
So, keep in mind the macro risks highlighted here.
Arjun Parthasarathy is the Editor of www.investorsareidiots.com, a web site for investors.