After ten continuous months of inflows into the equity markets, foreign institutional investors finally seem to be pulling out of the stock markets.

Over the past two months, FIIs sold stocks worth Rs 1,800 crore (Rs 18 billion) and the markets gave a meagre 1 per cent return. Not withstanding the fact that stocks surged 4 per cent in the last two weeks on heavy purchases by domestic mutual funds and some reversal in FII flows, there is nervousness in the stock markets.

Will FIIs continue to keep faith in emerging equities, and in Indian stocks?

The good news is that the performance of Indian equities does not look to be an aberration when viewed in the context of the global markets. And the bad news is that concerns on liquidity drying up and dampening equity performances are very much real.

How global markets fared

Markets -- developed and emerging - across the globe have been non-performers. Emerging markets have fared more or less in line with developed markets -- while MSCI's World Index has lost 1.94 per cent year to date, emerging markets have been marginally in the positive territory with a return of 2.5 per cent.

MSCI's Asia Index recovered last week with returns just above 3.3 per cent. In fact, India and China have posted returns of 1.46 per cent and -- 1.99 per cent; while China continues to be in the negative territory, Indian markets relented last week.

It is interesting to note that most emerging countries (like Taiwan, Thailand and Malaysia) that have been growth stories have seen their markets deliver near negative returns just as developed markets like US and Japan (see table on returns).

Global equity returns The Emerging Markets Index and the World Index have moved more or less in tandem Returns (%) as on June 3, 2005
Countries & indices	Month to date	Quarter to date	Year to date
Brazil	5.05	6.35	10.82
Korea	0.92	0.7	10.5
Russia	-0.88	0.28	5.19
Mexico	2.58	8.01	5.14
EM Asia	0.85	1.24	3.32
EM Index	1.39	1.29	2.51
India	1.15	3.97	1.46
Taiwan	1.33	4.03	0.5
USA	0.42	1.534	-0.97
The World Index	0.52	-0.39	-1.94
China	-0.9	-1.63	-1.99
Thailand	1.07	-4.22	-4.1
Malaysia	0.52	-1.76	-5.74
Japan	0.51	-2.98	-5.84
South Africa	0.97	-5.15	-12.68
Source: MSCI

Around the same time in 2004, emerging markets had lost 6.4 per cent while China and India led the pack with negative returns of 19.43 per cent and 16.3 per cent.

The world index, however, had kept its neck above the water with a marginal 0.73 per cent positive returns. Nothing much has changed in the past one month either -- continuing confusion over oil, interest rates and currency revaluation is perhaps the cause.

The World Index has delivered 1.56 per cent while emerging markets have delivered 2.17 per cent and emerging Asia has given 1.94 per cent. India has managed to give some decent returns in the month - 7.32 per cent - while China has been the biggest loser with 2.88 per cent.

Fed rates and fund flows

Behind the performance numbers is probably the fact that US investors are not backing emerging markets anymore. The Fed has raised the benchmark interest rate to 3 per cent after announcing eight hikes in the past one year.

This hike in interest rates in the US has already begun to take its toll on emerging markets.

According to Emerging Portfolio Fund Research, money has flown into US bonds at a record pace. The US benchmark 10-year yield has increased about 80 basis points to 4.07 per cent.

"The spread between the short and long rates of US bonds is narrowing, indicating that the risk appetite is declining," says Chetan Ahya, executive director, J M Morgan Stanley Securities.

Another indication of the declining global risk appetite is the narrowing spread between Indian and US rates. Last year before the Fed started its tightening regime, the difference between the bank rates was 500 basis points (India at 6 per cent and US at 1 per cent) and now it's about 300 basis points (India remains at 6 per cent while US is at 3 per cent).

"Another hike will mean spreads getting almost negligible and that is why we are witnessing a slow down in liquidity," reiterates Ahya.

In other words, he says, falling 10-year yield in the US also implies that growth confidence is waning. In such an environment demand for risky assets declines.

A hike in US rates has also brought about an increase in forex reserves across countries, thanks to increased coupon income from US treasuries. Forex reserves with most countries are ruling close to their all-time highs.

Some experts predict that Japan, China, South Korea and Taiwan - the four countries with the world's largest foreign reserves - may start selling US-dollar-denominated assets if concerns about the sustainability of the rise in US interest rates and the dollar value surface once again.

Which way funds could flow

Fund flows to the merging markets are set to deteriorate further, according to experts. The Institute of International Finance expects that after reaching an 11-year high of $38 billion in 2004, emerging market portfolio (equity) investment is projected to decline a fraction this year to $37 billion.

Despite the continued upward trend in prices, the P/E ratio on the broad index of equities is still low. The Asia/Pacific region is expected to account for over 90 per cent of total equity portfolio flows to emerging market countries this year.

In China net inflows could increase this year to $15 billion from $12 billion in 2004. Inflows could be constrained by concerns over corporate governance and the true state of firms' balance-sheets, as well as the general health of the financial system.

In emerging Europe, net portfolio equity investment is expected to decrease this year to $5.5 billion from more than $7 billion in 2004.

Latin America is expected to show a net outflow of portfolio equity investment of $4 billion in 2005, following an outflow of $7 billion last year; Chile will account for the bulk of outflows. There is also expected to be a slowdown in total financial flows to emerging countries this year.

Growth to drive performance?

Factors that may work in favour of emerging markets are the growth in the respective countries.

According to IIF estimates, growth in 2005 across regions is expected to slow down with Latin-America posting a GDP growth of 3.9 per cent from 5.7 per cent in 2004; Europe is expected to grow at 5.2 per cent from 6.7 per cent while Asia-Pacific is expected to grow at 6.9 per cent from 7.3 per cent (see table).

GDP growth GDP growth rate (%) in emerging economies continues to be strong
Regions	2005f	2004e
Latin America	3.9	5.7
Europe	5.2	6.7
Africa/Middle East	4.1	4
Asia/Pacific	6.9	7.3
Countries
China	9.5	9.5
India	8	6.9
Korea	4	4.7
Thailand	4.5	6.1
Source: IIF

China is largely expected to grow at a similar pace -- 9.5 per cent -- while India is ahead of the pack with a forecast growth of 8 per cent against 6.9 per cent.

Consequently, valuations in the Asian markets look attractive. Based on FY06 earnings estimate, India (12 times) and China (10 times) still look cheap and cheaper compared to others.

Will this ensure more fund flows to the region and better stock market performance?  While emerging economies are still outpacing developed markets in terms of economic growth and the structural story as well as the equity valuation look attractive, the performance of equities in emerging markets may still be linked to that of the developed markets.

In the debt markets, emerging markets and developed markets are showing some signs of decoupling. There has been a widening gap between US high-risk bond (junk) yields and emerging market yields. After the S&P downgraded General Motors and Ford Motors to junk, US junk bond yields have risen while emerging market yields have not moved as much.

The yield on US junk bonds, which are perceived to carry the same risk as that of emerging market bonds, has risen over 60 basis points in the last three months to about 8.3 per cent while emerging market yields remained lower at about 4 per cent.

That the two have not moved in tandem implies decoupling. Could this happen in equities also? Chetan Sehgal, portfolio manager, Templeton Emerging Markets Group, rules out the possibility of a decoupling.

"As companies become more and more global, the linkages will get stronger, diminishing the chances of a de-coupling," he says.

Other worries

There are three significant worries stemming from global markets. A) Could commodity prices come crashing in the event of a Chinese slowdown? B) Could continued rise in oil prices impede growth and depress profitability? C) What would the re-valuation of the Renminbi mean for markets? Here is a brief look at how each of these factors will play out.

Commodity prices: Commodity prices are ruling at all-time highs. If the cycle turns, commodity companies will face cost pressures and lower realisations. Commodities may be in a long-term secular bull market but the cyclical outlook is bearish, according to BCA Research, an investment research firm based in Canada.

"In commodities, long-term peaks have been achieved, supply and production have gone up, demand is drying and therefore prices are bound to fall," says Sehgal.

Futures prices of non-ferrous metals on the London Metal Exchange are already trading at a discount to their spot since the beginning of the year. With global growth having moderated and the Chinese authorities continuing to rein in the pace of capital spending, commodities may well be something to steer clear of.

However, a fall in commodity prices may spell good news in the form of easing pressure on raw material prices and hence profit margins of user-industries.

Oil prices: Oil prices still remain a cause of concern as it could increase corporate costs, depress earnings apart from seeping in inflation into the global economy. The Brent crude oil price has increased 35 per cent to levels of $49.61 per barrel.

This is even after a drop of 11 per cent from levels of $56 that it touched in mid-March this year. While there are reports of oil surging ahead to levels of $60 (even $100) a barrel, there has been some respite with supple concerns easing.

"Despite global inflationary pressures easing, oil prices may send in bouts of pressure which remains a worrying factor," says Sehgal.

Revaluation of the Renminbi: US wants China to revalue its currency by at least 10 per cent to aid the US curb its burgeoning trade deficit.

However, according to Merrill Lynch's Asia-Pacific's economics team, China's trade surplus with the US is unlikely to fall much. A surprise revaluation may be in store, according to experts. The denial by Chinese officials has been seen as a move to curb speculative activities. China will sooner or later yield to pressures from the US, say experts.

According to BCA, a higher Renminbi is not expected to have any major impact on other Asian currencies as the revaluation news is already factored. So, the revaluation will not bring about any significant economic benefit to the Asian countries.