The global market is experiencing a rally today, marking a recovery from the carry trade that rocked global equity markets last month. While this relief rally could continue in the short term, its momentum could be tested unless there are further strong triggers. The assumption that the carry trade problem is behind us is justified in the short term. However, given the significant size of the strategy and the potential for long-term appreciation of the Japanese yen due to tight monetary policy, the risk remains.

Importantly, the ongoing rally is also being driven by expectations that the Fed will begin cutting interest rates at its September meeting. The BoE has already taken a step in this direction, cutting interest rates by 25 basis points to 5%, a historic high. It is crucial that these rate cuts are substantial and implemented promptly. Otherwise, the stock market may struggle to maintain its current momentum as a weakening economy and falling corporate profits could weigh on investor sentiment.

Over the past four years, the global economy has been supported by expansionary fiscal policies, with governments increasing spending, leading to high budget deficits. The stock market in particular benefited from the dual impact of low interest rates and robust government spending. Now, inflation and interest rates are high, reducing spending. Moreover, the loose fiscal policy is expected to reverse as governments face the challenge of maintaining high deficits. This is expected to lead to a slowdown in economic and earnings growth. However, given the high inflation and budget deficits, market returns are not expected to decline significantly. Given the high valuations trading globally, a time and price correction is due in the short to medium term.

As for the carry trade, the market is currently trading safe, believing that the issue is over for now. However, given the differing policy views of the FED and BoJ, it is possible that the spread between US and Japanese bank rates will narrow. This will impact medium to long-term carry trade positions and new FII inflows, especially in yen. The FED is expected to cut the interest rate to 3.85% in calendar year 2025 from 5.5% today, while the BoJ is expected to raise it to 0.5% from 0.25% today.

Asian markets

Last month, Japanese, Taiwanese, South Korean and US tech companies were hit by carry trade issues. India was barely affected. Data suggests that India benefited from the carry trade, which flourished from January 2023 when the Japanese currency depreciated from 127 to 162 against the USD. An estimated 23% of yen-denominated inflows went to India, with 25% of this amount invested in midcaps. This makes India vulnerable if yen-based selling resumes in the future. However, the impact is likely to be limited as Japanese assets held in custody in India are small at 3%. While the impact on midcaps may be large, the most influential factor for India is that the trend of the global equity market and the inflow from domestic investors, both institutional and retail, are likely to continue.

Given the risk of global economic slowdown in calendar year 2025, FII inflows will come to a halt due to high inflation and high interest rates. In the short to medium term, it is advisable to be cautious in the market. It may make more sense to prefer value stocks over growth stocks, which have performed well in the last four years. Going forward, sector rotation will be important to generate returns in the current market environment. Sectors considered safe havens such as FMCG, consumer, pharma, IT and telecom may have an advantage as the market lacks momentum due to high prices in new growth areas. The manufacturing-based sectors are the long-term drivers of the Indian story where stock-specific approaches and valuations should be reviewed by adopting an accumulation strategy.

Author Vinod Nair is Head of Research at Geojit Financial Services.

Disclaimer: The views and recommendations contained in this analysis are those of individual analysts or brokerage firms and not of Mint. We strongly advise investors to seek advice from certified professionals before making any investment decisions, as market conditions can change rapidly and individual circumstances may vary.