We often say that the current world we live in is an open one. Things and places are more accessible than ever before. People, goods and capital can freely flow within countries. Though the instantaneous thought that comes to us is that it’s a positive thing that now countries can benefit from each other’s specialized goods, services and knowledge, there are cons to it too.
Interdependency is a good thing, but should be navigated carefully. If not handled well, it can have disastrous effects. Let us understand how India and the world interact with each other, especially economically.
International trade: One of the major factors determining the economy of a country is trade. Simply put, when countries exchange goods & services with each other, they are exposed to demand and supply factors guiding the whole world, not just their own country. Thus, countries tend to produce more of what they specialize in and what can be produced relatively cost effectively. They depend on imports for other goods. For example, India exports cloth since skilled labour is cheaply available here and depends on certain cloth types (raw material) from Bangladesh. If prices of cloth is Bangladesh rise, our costs in producing cloth will rise too and profitability will be negatively affected. Poor results can cause stock prices to fall. I hope you understand why oil prices are such a concern to so many analysts.
Foreign Exchange: Such examples often have more severe impacts than illustrated, especially on GDP and foreign exchange. When we can export goods at cheaper prices, we earn more revenues and foreign exchange. This leads to an appreciation in the domestic currency. With a stronger currency (and more wealth in inflation adjusted terms), we can see a rise household income and more people investing in equity. It also creates high demand. In contrast, if our imports increase too much, the domestic currency depreciates. This however, makes our exports seem cheaper, and we may get an inflow of foreign capital amid improving GDP. Foreign capital inflow has known to shot up Nifty in the past couple years.
World Market Timings: Investor sentiments are guided by earnings releases of companies, commodity prices, foreign exchange rates and a whole lot of other factors. Information technology has equipped people with real time data, which has given them the power to make faster decisions. And not all markets are open simultaneously. Therefore, one can gauge investor sentiment by looking at market movements of stock exchanges in foreign countries and impacts of different news issues can also be anticipated.
The below chart explains how correlated the BSE Sensex and Dow Jones is:
The domino effect
An example will be helpful in explaining the contagion and interdependence of countries. Let us take the 2008 financial crisis. Home financiers started lending to borrowers without conducting a proper creditworthiness check in America. Though more houses were being bought, the inherent default risk of such accounts was high. But this was neglected by credit rating companies while analyzing investments backed by these loans, to ‘protect relations’ with these finance companies. False ratings encouraged investors to invest in securities backed by these loans. Number of investments were built on such a false asset. And the most feared scenario took place. Home owners couldn't pay their dues on time. What was once considered to be a safe investment by people, investment banks and pension funds betting on such mortgage backed securities, lost millions. This situation also lead to bankruptcy of the famous Lehman Brothers, one of the largest financial institutions in the United States. People lost wealth, credit became expensive, companies (including their foreign branches) were shut down and many lost jobs. With the economy in a slump, imports reduced and also affected the countries that exported goods and services to America. The collapse of a superpower country like the US resulted in highly volatile interest rates globally. Investor confidence tanked, and the financial markets went downhill, across the world. Look how a miniscule unethical practice like this can present a recession like situation to the world. It took more than 2 years to recover from an economic fracture like this.
The below diagram may be a time saver:
Your investing strategy
The success of an active management strategy is not in anticipating the markets, but in responding to given situations in the best possible way.
An event can affect domestic and global markets in many ways. While you try to understand how important an event is, consider these factors:
Effects on demand and supply: Consider what effect an event can have on demand-supply dynamics of the world. If oil prices rise, you know that the profitability of industries using it as a raw material wood go down. Inflation is also likely to kick in.
Interest rates: If an economy is in recession, it is likely to spread to other countries. Governments slash interest rates at such times to encourage economic activity. Companies look to expand since credit is cheaply available and the stock markets do well because investors expect better returns on capital. The opposite is true during high inflation periods.
Innovation: The world is dynamic. Technology is constantly evolving and innovation has proven to give solid returns. Elon Musk's electric vehicles has opened up a new industry altogether with several investing opportunities. Many domestic companies replicating that model due to knowledge spillover promise of a bright future.
Knowing the current world affairs and interpreting its effects on the market is an ongoing activity, but awareness can certainly improve your understanding.