We enter the second half of the year still positive on EM (emerging market) assets and look to be cautiously positioned for a recovery. The slew of headline risks over the past quarter has brought heightened awareness of tail-risk events, such as Europe, and ongoing regulatory changes. The potential impact of these unknowns has increased and represents a much fatter tail risk than before the crisis. This has generally led to a light positioning in EM Asia assets. Countering these trends is China?s currency reform, announced just as we are finalising the quarterly. This may be the catalyst that sparks a rebound in risk-taking in Asia.
Among tail risks, regulatory changes continue to weigh on investor confidence. The final form of the US and UK banking regulations are still under development. In Asia, we are seeing increased attention towards FX (foreign exchange) and banking regulations. In particular, Indonesia and Korea recently imposed regulations aimed at reducing FX volatility and speculative inflows. Neither regulation will have a meaningful impact on foreign investments in bonds. Our concern lies more with the signals the measures send and the state of future regulations.
Position for the recovery: Despite these tail risks, we do not discount the positive news coming out of the region. Economic indicators continue on an upward trend, with improvements in growth and employment, and closing output gaps. Should there be another dip in the global markets, it is likely to be short-lived.
Corporations and financial institutions are better positioned for a downturn than previously. Earnings are on a positive trajectory despite limited appreciation in equity prices. This implies P/E (price-to-equity) valuations are looking more attractive. Also, corporate balance sheets have been built over the past one to two years, reflecting stronger capital bases, increased cash positions and reduced funding risks from lengthened funding profiles. In addition, financial institutions are generally underweight on risky assets.
Indian markets positioning for the pause: Even as inflation remains a policy concern in the near term, lower food prices on the back of normal monsoon are likely to prompt the RBI to pause and take stock of its tightening cycle beyond the October policy review. With rupee being overvalued on the REER (real effective exchange rate) and a higher current account deficit, we expect $/Rs to rise to 46.50 in 12 months. As the economic recovery gains momentum in India, inflation is set to remain a policy concern in the near term. Even though we expect WPI inflation to remain above 8% until August, inflation is likely to come down gradually in H2FY11. Even though manufacturing inflation is likely to rise in the coming months, we expect manufacturing inflation to start declining sequentially from Q3FY10 as supply bottlenecks ease in the manufactured food and textiles sector. We expect WPI to decline below 6% by December, thus giving RBI enough policy room to finish its current rate hike cycle, likely at the October credit policy review, in our view. We now expect RBI to hike the repo and the reverse repo rate by a further 75bp by October.
We do not expect any additional increases in the CRR (cash reserve ratio) in the next six months, given that credit growth has risen significantly over the past three months and liquidity conditions remain tight. Indeed, the next leg of monetary tightening will depend upon the pace of credit growth. If credit growth remains strong, we believe RBI is likely to begin hiking rates again in FY11-12, possibly from the April 2011 credit policy review. Meanwhile, the outlook for economic growth remains favourable. The strong momentum in industrial production and normalisation of agricultural output is likely to support GDP growth hitting 8% for FY10-11 with a bias to the upside. Even with production momentum in autos, textiles and consumer goods coming down to more sustainable levels, capital formation and consumption are likely to remain supported. Yet, with the government withdrawing fiscal stimulus, the fiscal impulse for the economy should turn negative. The fiscal picture has improved considerably. We remain comfortable with our forecast for the central government fiscal deficit of 4.5% in FY 10-11 for now.
?Barclays Capital