Dubai World scare, a trigger for correction?

Is Dubai World's debt repayment problem merely a delayed aftershock of last year's credit crisis or a fresh tremor likely to shake up the financial system? Opinion may be divided on this; but the event is certainly reason for stock market investors to turn more cautious. For this may be just the excuse the market is waiting for, to launch into a much-needed correction.

The initial stock market reaction to the Dubai World crisis has been to batter down companies which have their fortunes directly tied to Dubai or its troubled investment arm.

The stock of Spicejet, in which a subsidiary of Dubai World owns a 13.4 per cent stake, has been marked down and so have the stocks of Bank of Baroda and SBI, which have admitted to retail and corporate loan exposures in Dubai. History, however, suggests that investors need not worry too much about how these individual stocks may fare because of the crisis. The Dubai entities do not have a significant portfolio exposures to Indian stocks. Even if they hold indirect stakes, the past two years have seen numerous instances of troubled financial giants liquidating their stakes in Indian companies.

Despite recurring investor worries about `Bear Stearns' stocks, `Lehman' stocks, `Merrill Lynch' stocks and recently `Galleon' stocks, the impact of the holders' troubles on stock prices has been quite shortlived.

Stocks with good fundamentals have rebounded to pre-crisis levels, finding ready buyers at lower prices. Stocks with little claim to fundamentals have remained battered.

Given that Indian banks emerged relatively unscathed from the much larger credit crisis of last year, investors in banking stocks may have little to fear from the Dubai scare.

SYSTEMIC RISK

It is the broader market ramifications of this event that stock investors need to worry about. Some financial experts are betting on this crisis being quickly contained through a bail-out of Dubai World by other UAE nations. But if this scenario does not play out, it is feared that this may trigger a fresh bout of risk aversion on the part of lenders around the world. Going by what followed last year's credit crisis, this could lead to a sharp spike in the borrowing costs for businesses (and countries) with inferior credit ratings and a drying up of the now-ample liquidity.

This certainly cannot augur well for the many Indian companies which are now relying heavily on foreign funds to repair their debt-leavened balance sheets. This stock market rally has been led mainly by highly leveraged companies from the commodity and realty space, making such a scenario worrisome.

PROFIT-TAKING TIME?

A phase of risk aversion, once it starts, can also have a big impact on the overall liquidity flows into the emerging markets, India included. Remember that it was returning risk appetite on the part of global investors which laid the foundation for this entire stock market rally.

It is rising risk-taking which has prompted global investors to abandon the safer developed markets and money market funds, and to pour money into all manner of risky assets - commodities, emerging market bonds and emerging market stocks - over the past eight months. The returns from these assets have by now exceeded everybody's wildest expectations.

The temptation to take money off the table and lock into those sizeable profits, is, therefore, bound to be quite high. The Dubai scare has also cropped up at a time when the global markets are being assailed by fresh doubts about the sustainability of the ongoing economic recovery. Will governments be able to exit from their big-ticket stimulus spending?

Will the "recovery" sustain once the props of stimulus are removed? Is consumer confidence robust enough to carry the baton from here on? If the answer to any of these questions turns out to be a "No", then the current stock market rally, which is built on optimism, would certainly be due for a pause.

Indian investors also need to weigh a few additional factors on the scale. At over 21 times trailing earnings, the BSE Sensex is already quite close to the inflexion point at which previous bull markets (of 2007- 08 and 1999-00) halted. With topline growth proving elusive for many companies, even in the recent September quarter, doubts are beginning to emerge on whether Corporate India can deliver on these high expectations.

But, most important, irrespective of how its own corporate or economic fundamentals look, India has always proved to be a high Beta market in the global scheme of things. It races ahead of most other markets when the going is good, but takes a merciless battering when liquidity flows suffer the mildest blip. That may be reason enough for Indian stock market investors to take some money off the table now.

via BL