Nobel laureate economist George Stigler once famously remarked that “abnormal is when everything is normal”. Everything turning favorable for the economy and markets is very rare. When it happens, as during 2004-08 for the global economy and markets, it is not likely to last long; euphoria will be followed by crisis. Cyclical upswings and downswings are normal for economy and market.
If the macros of the economy do well, the micros (profitability of companies) also will do well, sometimes with a lag. During 2004-07, both macros and micros were good for India. But those good times ended with the Global Financial Crisis of 2008. The ‘taper tantrums’ of 2013 impacted India’s macros and this led to sharp correction in the markets. In 2014, the election outcome boosted expectations and markets, but the macros didn’t improve as expected. The consequent PE expansion made markets very expensive. By Q1 of FY2019, we reached a stage where micros had started to improve after a long gap. But this positive turn around has been impacted, hopefully temporarily, by the surge in crude and the consequent damage to the macros.
What is the state of the economy and markets? What are the likely trends, going forward? Let’s take a look at the looming clouds on the economic horizon and the silver linings among them.
The crude surge
India has a structural economic issue – the current account deficit – which in turn, is hugely impacted by the price of crude. Even a quarter century after the initiation of economic reforms in India in 1991, we have not fixed our Balance of Payments, which continue to be at the mercy of crude. The near 50 percent increase in the price of crude this year has worsened the CAD, and since the government is committed to the fiscal deficit target of 3.3 percent for FY 2019, the government doesn’t have the fiscal space to cut the tax on petroleum products and give relief to consumers.
The surge in crude has impacted the CAD, which is likely to be more than 2.5 percent this year. There is the risk of crude surging again, as some fear, beyond the $ 90 mark, in which case, the CAD will rise to 3 percent. This can be problematic for the economy. Crude price is presently being dictated by a whole host of factors including geo-political issues. The possibility of crude declining sharply also is bright. If this happens, India’s macros will get a boost with the beneficial effects spreading to the market too.
Rising US bond yields
The US bond yield, particularly the 10 year yield, is perhaps the most important global index, from the financial market perspective. Rise and fall in the US bond yields have the potential to unleash capital flows profoundly impacting financial markets across the globe. The ultra loose monetary policy implemented in the US following the Global Financial Crisis of 2008 led to historically low levels of bond yields in the US, which in turn, led to capital flows to Emerging Markets like India boosting their asset prices, particularly stock prices. And now, since the US economy is back to high growth, the Fed has to normalize its balance sheet and they are doing that through gradually raising the rates. After six rate hikes of 25 bp by the Fed, the US Fed funds rate is still low at around 2 percent, but the dollar index has moved up to around 95 and the 10-year yield has shot up to above 3.2 percent. As I write this, the 10-year yield has eased to around 3.15. It is important to understand that 3.15 percent risk free return is hugely attractive for institutional investors, particularly in the context of depreciating EM currencies. Since the US economy is firing on all cylinders and is at near full employment levels, the risk of inflation moving up is high and therefore the Fed is likely to tighten rates if signs of inflation emerge. Therefore, watch out for the US 10 year bond yield.
The INR depreciation
The crude surge and capital outflows to the US had impacted EM currencies this year, particularly those with vulnerable CAD. The INR, which has been stable during 2015-17, depreciated sharply this year by almost 15 percent. Currency depreciation is not a disaster; in fact controlled depreciation (India has a ‘managed float’ exchange rate system) is desirable since it boosts exports and brings about an automatic adjustment of trade and current account deficits. Also, from the corporate earnings perspective, INR depreciation is good since it boosts the earnings of exporters. But, the flip side is that it accelerates capital outflows, further depreciating the currency. There is also the risk of ‘imported inflation’ and rising cost of foreign debt servicing. Currency depreciation, in tune with the REER (Real Effective Exchange Rate) is desirable, but sharp depreciation can be problematic.
The IL&FS crisis
An unexpected crisis that hit the market was the IL&FS crisis. Default by IL&FS and the consequent liquidity crisis threatened to become a contagion impacting markets. But prompt action by the Government, OMOs (Open Market Operation) by the RBI and liquidity infusion by the SBI through loan buying helped contain the crisis even though it is too early to say that the crisis is completely behind us. The IL&FS crisis raises some valid questions, which need to be satisfactorily answered, to prevent the occurrence of a similar crisis in future. The role of the management, independent directors and rating agencies need to be probed. Financial stability is hugely important in financial development and economic growth.
Apart from the above headwinds, there are challenges arising from the change in monetary stance of the RBI from neutral to ‘calibrated tightening’. Tightening stance, along with the liquidity crunch, will raise the cost of funds, impacting particularly the NBFC sector.
The silver linings
The silver linings amongst the clouds need to be appreciated. Despite the macro headwinds, India’s GDP growth rate this year will be impressive at around 7.4 percent. It is important to appreciate the fact that this will be the fastest growth rate among the large economies of the world. And India is favorably placed to sustain and improve this growth rate, going forward. A bright silver lining in the Indian economy presently is the benign inflation (CPI inflation is at 3.77 percent in September), which is within RBI’s comfort zone. The fuel inflation and depreciating currency has, so far, not translated into higher headline inflation. Also, the fact that the government has taken the unpopular but courageous decision to pass on the increased cost of fuel to consumers reflects its commitment to stick to the fiscal deficit target.
To conclude, the economic and market environment will continue to be volatile, going forward. Market volatility will provide opportunities for investors.
