By: Navneet Munot, CFA, CIO, SBI Mutual Fund and Director IAIP
India celebrated 25 years of economic liberalization unleashed in 1991 and embarked on a new set of liberal FDI policy; while across the continent, Britain’s decision to leave European Union symbolized a crack in post war era of more globalized world. On the domestic front too, Raghuram Rajan’s decision to not seek a second term came as a surprise to the market. The ISIS attacks on Bangladesh and Baghdad are yet another reminder of geopolitical risks looming on the horizon.
UK decided to leave the European Union (‘BREXIT’) based on the outcome of a referendum (public vote) conducted on 23rd of June. Global equity markets faltered sharply the day after the referendum and the British pound fell to its lowest level in over three decades. However, the stability was restored within a week and equity market recouped the losses primarily due to expectation of continued easy monetary policy (and hence cheap liquidity) and secondly, due to unattractive returns in other asset classes.
While Brexit is likely to slow and create some disruptions in the UK and rest of the world in near-term, full ramifications of event will take months if not years to unfold. More importantly, it reinforces our view that market should be ready to brace bigger bouts of volatility going forward.
The genesis of rising global volatility can be traced back to 2008 Lehman crisis. Potential growth collapsed significantly post the 2008 crisis and has not recovered since then. Easy monetary policy and liquidity pumping by the central banks helped in improving the corporate and household’s balance-sheet but failed to revive consumption or corporate investment. The corporate sectors in the west (particularly US) instead, resorted to share buybacks and are hoarding cash instead of resorting to incremental investments.
Post 2008, China became an epicenter of growth and supported the economic activity in other developing economies through its supply-chain linkages. However since last two years, growth in China has faltered leading to an economic slowdown in most other emerging markets.
The lack of investment and growth has led to falling labor productivity across the developed world and, more recently in the emerging markets, thus putting a downward pressure on an already anemic real wage growth.
One of the consequences of the moderating Chinese growth and particularly investment has been its declining appetite for commodities, thus ending the decade long commodity super-cycle and leading to deep recessions and economic disorder in commodity exporting nations. Saudi-Arabia posted fiscal deficit in 2014 after 11 years of being in surplus. Venezuela is facing food inflation owing to its reduced ability to import and Brazil is experiencing rising unemployment, and both countries are confronting political upheaval. In the long run however, the fall in commodities has set a stage for transfer of wealth from commodity producers to global consumers and will have a positive impact on overall world demand.
To make the matter worse continued geo-political tensions in the middle-east and rising terror of ISIS is leading to record rise in immigration from war-torn places to these developed nations which are already struggling from muted job opportunities.
Against such a backdrop, the rise of trade and immigration restrictive measures by the developed economies and events such as BREXIT are just few among many loosely linked developments that hints the potential political and economic disruptions ahead. Slow economic growth undercuts confidence in traditional liberal economics, especially in the face of the dislocations caused by trade and surging immigration.
While the right response to such events may differ across the economies, one thing seems obvious: the policymakers’ needs to take measures which arrests the slowing growth and enhances job creation. Easing monetary stance has run its full course. The rising tide of inward-looking trade policy and competitive devaluation of currency can have very limited impact owing to its inherent flaw of ‘beggar-thy-neighbor’.
The situation warrants government/public sector to commit itself to infrastructure spending, thus bridging the gap of weak private investment and help in return of normalcy. Very low or negative long-term interest rates and soft commodity prices provide a conducive environment and will help the government to keep the project cost low and at the same time, boost demand, productive capacity and generate the much needed employment.
The fundamentals of the Indian economy are relatively better than that of most other emerging market economies. India today, stands at a stark contrast to most other economies. Easing capital account controls (in terms of more liberal FDI policy) even in the wake of global anti-trade and anti-globalization rhetoric is a testament to that. While global markets grapple with savings glut and negative real rates, Indian central bank is focusing on positive real rates to attract more savings and fund its investment needs. The RBI is adding to its foreign exchange reserves at a time when most emerging markets grapple with depleting FX reserves.
The continued inflow of domestic investors’ investment in the Indian equity market has been structurally positive for the Indian equity markets and reduces the vulnerability from volatile foreign flows. That said, owing to the vast trade and other financial linkages, the country cannot be immune to global developments.
Apart from this, the government continued to focus on improving the economic momentum. Hopes on the passage of much-awaited GST bill in the monsoon parliament session have revived. The central government’s approvals to hike its civil servants’ pay by 23% and the prospects of above-normal rainfall have raised the hopes of improvement in consumption demand and consequently improved earnings in the related sectors.
Given the improved earnings and growth outlook, India is now at top-end of valuation range and Sensex presently trades at ~18 times FY17 earning. Continuation of earnings upgrade would be critical for the current valuations to sustain. While we do keep an eye on the macro developments, we remain focused on bottom up stock picking which we believe is the best way to generate alpha on a sustainable basis.
In the bond market, global bond yields touched record lows as worries over economic growth encourage central banks’ to maintain ultra-accommodative monetary policies. Taking cues from the global moves, Indian bond yields have also softened with 10-year Gsec trading at 7.38% currently. While policy space with RBI to deliver further cuts may be limited, global environment of ultra-low bond yields and excessive liquidity is supportive for our bond market in the near term. Our tactical positions in 10-15 year tax-free bonds have yielded very good returns. Otherwise, we remain overweight in 5-8 year bucket of Gsecs that looks attractive from valuation perspective.