Dark Clouds and Silver Linings on the Economic Horizon
Nobel laureate economist George Stigler once famously remarked that “abnormal is when everything is normal”. Everything turning favourable 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. What is the state of the economy and markets? What are the likely trends, going forward? Let us take a look at the looming clouds on the economic horizon and the silver linings in the midst of them.
THE CRUDE SURGE
India has a structural economic issue – that is the current account deficit (CAD), which, in turn, is hugely impacted by the price of crude. The surge in crude has impacted the CAD, which is likely to be more than 2.5 per cent 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 per cent. This can be problematic for the economy. Crude price is presently being dictated by a whole host of factors, including geo-political issues.
RISING US BOND YIELDS
The US bond yields, 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. And now, since the US economy is back to high growth, the Fed has to normalise 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 per cent, but the dollar index has moved up to around 95 and the 10 year yield has shot up to above 3.2 per cent. 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 per cent. 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 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 per cent. 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 favourably 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 per cent 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.