Feeling the way in a wobbly world

In 2019, the dominant global theme will be quantitative tightening, with major central banks draining systemic liquidity after a decade. This comes at a time when global growth is sluggish and interest rates are rising. Consequently, we expect a shift to relatively dovish stance as central banks feel their way through ‘wobbly data’.

Soft commodity prices on the back of sluggish growth will also support lower inflation. Commodity-importing emerging markets (EMs) like India can heave a sigh of relief as macro stability has returned, and the worst is behind. Nevertheless, we do not rule out ‘panic attacks’ in EMs, given tightening global liquidity. Moreover, India will also have to deal with domestic political uncertainty in 1H2019.

Domestic growth will also be under pressure in FY20 with GDP growth expected to just about touch the 7 per cent mark, from an estimated 7.2 per cent in FY19. Slowing global growth, the overhang of NBFC liquidity crisis, and domestic political uncertainty which may weigh on private sector investment sentiment will be a drag on growth.

Rural income

Meanwhile, rural income also remains under pressure on excessively low food inflation. Low food inflation is likely to keep Consumer Price Index or CPI inflation below the 4 per cent mark in FY20. Therefore, we see scope for a 50bps rate cut in FY20, bringing real rates to around 2 per cent. Slowing growth and rural distress is likely to encourage revenue expenditure at the cost of capital expenditure, even as Goods and Services Tax or GST revenues fall short of budget expectations.

Consequently, we expect the fiscal deficit to breach the budgeted target of 3.3 per cent of GDP and come in at 3.5 per cent in FY19, and also in FY20. Bond yields are likely to trade in the 7 per cent to 7.5 per cent range, with the room for a rally below 7 per cent limited by global rates, relatively tight liquidity and fiscal risks. A rising credit-to-deposit ratio, however, implies that the near-term pressure on lending rates will sustain.

The current account deficit or CAD is likely to moderate to around 2 per cent of GDP in FY20 on account of lower crude oil prices, but services and remittances are likely to come under pressure as the cyclical recovery stalls. The rupee will continue to trade with a depreciation bias, but lower CAD emanating from benign crude oil prices, contained inflation, and a more dovish US Federal Reserve are likely to alleviate the depreciation pressure.

FPI flows are also likely to return with a ‘cautiously optimistic’ view on India after witnessing largest outflows among EMs in 2018, with elections being the key risk factor. Moreover, stretched equity valuations in India also warrant caution. A stable government bodes well for FPI flows into India, particularly in equities, even as domestic flows hold up. However, the room for significant appreciation may be limited by the Reserve Bank of India or RBI intervention to recoup foreign reserves. We have revised our USD-INR average forecasts to 70 for FY19 (from 72 earlier); 72.1 for FY20 (from 77 earlier), and 74.5 for FY21.

The main risks in 2019 will emanate from excessive global liquidity tightening, escalation in trade wars, reversal in crude oil prices on account of geo-political risks, and domestically the risk of an unstable coalition government.

Follow the flow

In 2019, the dominant global theme will be quantitative tightening. The European Central Bank (ECB) will join ranks with the US Federal Reserve in ceasing asset purchases, while the Bank of Japan has also been quietly reducing the size of its balance sheet. After pumping in over US$10 trn over the last decade, G3 central banks will now be withdrawing liquidity. In 2018, asset purchases had slowed to a trickle as the US Federal Reserve’s quantitative tightening was more than offset by the ECB’s asset purchases. However, as we enter 2019, G3 central banks on a combined basis will be withdrawing liquidity.

Emerging markets

Emerging markets have been no mean beneficiaries of quantitative easing (QE) over the past decade. According to International Monetary Fund or IMF estimates, in the pre-crisis era, only 20 per cent of global capital flows went to emerging markets while their share increased to 50 per cent in the post-crisis era. Rough estimates, based on data covering 14 emerging markets indicate that these markets received over US$2.1trn of flows between 2009 and 2017 in an era of quantitative easing. Of this, India received about 8 per cent of flows or about US$170bn.

GDP growth is likely to slow to 7 per cent in FY20: Domestic growth is likely to be under pressure in FY20 with GDP growth just about touching the 7 per cent mark, from an estimated 7.2 per cent in FY19. Slowing global growth, the overhang of NBFC liquidity crisis, and domestic political uncertainty which may weigh on private sector investment sentiment will be a drag on growth. In addition, farm incomes and rural wages are under pressure, thereby posing headwinds to private consumption.

Global and domestic growth

Global growth is already facing headwinds with growth in the European Union slowing, and the impact of late cycle fiscal stimulus in the US beginning to wane. Chinese growth is also under pressure, and economies from East Asia to Germany are feeling the impact of trade wars. Quantitative tightening and rising US interest rates imply that global growth could come under further duress. Moreover, slowing global growth also impacts commodity-exporting emerging markets.

For commodity importers like India, falling global commodity prices are a boon. However, domestic growth generally moves in tandem with global growth. At best, global growth is estimated to remain flat at 3.7 per cent in 2019, according to IMF estimates, implying that there will be no tailwinds for domestic growth from global growth. Moreover, global growth in all likelihood will witness a slowdown in 2019, adding to the downward pressure on domestic growth.

Slower global growth will impact export demand for goods and services, including in the IT sector. Lower commodity prices will also affect remittances, 50 per cent of which come from oil-exporting gulf countries. Overall, slowing global growth will act as a drag on private consumption and domestic growth.

Capex recovery

Over the past few quarters, there has been a secular recovery in the capex cycle, as indicated by the rising share of gross fixed capital formation (GFCF) in GDP. Although initially, led by public capital expenditure, private capex also witnessed a pick-up with improving capacity utilisation. Nevertheless, as elections approach, government capital spending is likely to come under pressure as the government prioritises short-term revenue expenditure. In fact, there are already signs of government capital expenditure slowing. In addition, domestic political uncertainty is likely to weigh on private sector investment sentiment, resulting in a temporary slowdown in secular capex recovery.

CPI & WPI inflation

CPI inflation is likely to be under 4 per cent in FY20 for the third consecutive year: Food prices have been in deflation in recent months, pulling down headline inflation. With rural income under significant duress, there is likely to be policy support, resulting in mean reversion in food prices. Nevertheless, food inflation is likely to remain muted in an environment of excess supply in case of most food crops. Low food inflation is likely to keep headline inflation below the RBI’s 4 per cent target, while helping anchor inflation expectations, even as core inflation is expected to remain sticky above 5 per cent.

WPI inflation is expected to average 2.5 per cent in FY20, down from an estimated 4.8 per cent in FY19. Softness in prices of industrial commodities including crude oil will contribute to benign WPI inflation. Muted food prices, and a higher base will also keep inflation in check.

Monetary easing

Real interest rates measured by policy rates and one-year ahead CPI turned positive as Raghuram Rajan took over as governor of the RBI and averaged around 2.8 per cent over the past five years. This is above the RBI’s stated intent of real interest rates in the range of 1.50 per cent to 2 per cent. Therefore, with CPI inflation expected to below the RBI’s 4 per cent target for the third consecutive year, there is scope for some reduction in real interest rates in India.

CPI inflation is expected to average 3.8 per cent in FY20, after averaging around 3.6 per cent in FY18 and FY19. In our view, the US Federal Reserve may pause its rate hike cycle by mid-2019, aiding the shift to a more accommodative monetary policy in India. Consequently, there is scope for rate cuts of up to 50bps in FY20.

Fiscal support may be inevitable; fiscal deficit likely at 3.5 per cent of GDP in FY19 and FY20: An accommodative fiscal stance is likely in FY19 and FY20, with the fiscal deficit pegged at 3.5 per cent of GDP in both these years. GST revenues are also facing a significant shortfall, even as the government has reduced the tax rate on a number of items.

Moreover, ahead of elections, the government is expected to prioritise revenue expenditure with a short-term impact over capital expenditure resulting in fiscal slippage, breaching the target of 3.3 per cent of GDP.

In FY20, irrespective of the party in power, rural distress is likely to warrant fiscal accommodation even as revenues remain under pressure on the back of sluggish growth. In addition, some of the expenditure slated for FY19 is likely to spill over to FY20 in a bid to meet the fiscal deficit target. Consequently, the fiscal deficit target for FY20 is likely to breach the 3 per cent target.

Bond yields

Bond yields are expected to trade in the range of 7 per cent to 7.5 per cent in FY20. Easing crude oil prices and expected rate cuts will cap the rise in yields.

At the same time, the floor for Indian bond yields will be set by global bond yields. The India-US yield spread has narrowed to 4.7 per cent currently, from close to 5 per cent levels, and is now trading below comparable EMs like Indonesia and Philippines. Fiscal risks and tight liquidity also limit the room for a rally. Moreover, the pace of open market operations or OMOs will slow in FY20, from over Rs 3 lakh crore in FY19. Nevertheless, this may be offset to some extent by the return of FPI investors into debt, which could also keep yields under check.

Bank credit

Bank credit growth is currently running at around 15 per cent levels, while deposit growth is lagging at 9.5 per cent. A rising credit-to-deposit ratio limits the scope for an immediate reduction in lending rates.

Bank credit growth may witness a slight slowdown by mid-2019 on disintermediation. As yields have declined, a pick-up is expected in disintermediation through non-banking channels, particularly the bond market, through the course of 2019. Moreover, according to new regulations put in place by the Securities and Exchange Board of India (SEBI), large corporates having outstanding long-term borrowing of at least Rs 100 crore and credit rating of 'AA’ and above are required to meet 25 per cent of their borrowing requirement through the bond market, beginning FY20.

Consequently, bank credit growth may slow from the 15 per cent level currently to around 11 per cent to 12 per cent. Soft commodity prices also typically pull down credit growth. In addition, NBFCs which have been leading bank credit growth may also return to the market for their funding needs. At the same time, corporate bank credit – which has been languishing – may witness a slow rebound led by lower rated issuers, as the nonperforming asset problem gets resolved and capex plans revive.

Services exports

At the same time, slowing global growth and lower commodity prices imply that the cyclical recovery in services exports and remittances is likely to stall. As global growth stalls, IT exports, which constitute over half of India’s services exports, are likely to witness a slowdown.

Travel and tourism-related receipts may also face sluggishness. Over 50 per cent of India’s remittances come from the Gulf region which swings in tandem with crude oil prices, while remittances from the US – the second-largest source – are again tied to the IT sector. Therefore, while easing crude oil prices provide some respite; this will be to some extent offset by slower services exports and remittances. As a result, the structural dependence on capital flows will remain.

Given the rising dependence on capital flows, the rupee is likely to remain volatile and trade with a depreciation bias. Yet, a lower CAD emanating from benign crude oil prices, contained inflation, and a more dovish US Federal Reserve are likely to alleviate the depreciation pressure. FPI flows are also likely to return with a ‘cautiously optimistic’ view on India, after witnessing the largest outflow in 2018, with elections being the key risk.

A stable government bodes well for FPI flow into India, particularly in equities. However, the room for significant appreciation may be limited by the RBI intervention to recoup foreign reserves. We have revised our USD-INR average forecasts to 70 for FY19 (72 earlier); and 72.1 for FY20 (77earlier). Our forecast for FY21 stands at 74.5.

Where does India stand in the world? From a growth perspective, India remains the most attractive market. Real interest rates (based on Bloomberg consensus estimates) are also comparable with other emerging markets, although not the highest. However, currently India’s valuation seems to be high, both from an equity and bond market perspective.

Equity market valuations are the highest in our sample of developed and emerging markets, indicating that FPI investors are likely to be cautious. India’s yield spread with US bonds are also lower compared with other emerging markets like Indonesia and Philippines, suggesting that India may not be the most attractive market even for FPI investors in debt. Lower yield spread with the US also suggests limited room for a further rally in Indian bonds at the current juncture.

Three key risks

*Excessive tightening of global liquidity: Excessive tightening of liquidity by global central banks along with rising US interest rates can prove to be a lethal cocktail for global markets with repercussions for global growth, including in EMs. Excessive monetary tightening along with a late cycle fiscal stimulus in the US could mean that the upward pressure on US interest sustains, which does not bode well for emerging market assets.

*Domestic policy uncertainty: General elections are scheduled to take place in India by May 2019. An unstable coalition government would be viewed negatively by markets, and is likely to increase the political risk premium for India with attendant impact on equities, bonds and the rupee.

*Trade wars and geo-political risks: As we enter 2019, the US and China seemed to making progress towards a resolution on trade wars. Any escalation in trade wars is likely to exacerbate risks for global growth. In addition, geo-political risks, which result in a significant reversal in crude oil prices adding to upward pressure, would adversely impact a commodity importer like India, thereby posing a risk to macrostability.

Source: Nirmal Bang