It is a bipolar world in the global asset markets, where a stronger US dollar shall provide the mother’s milk of carry flows to financial assets but on the other hand, the same stronger American currency would continue to pose structural dangers for the emerging markets.
The reason we call it bipolar, is due to the chasm between financial assets and hard assets. It reminds us of the 1995-99 cycle, when the world went gaga on financial assets, flying on the bandwagon of TMT boom and at the same time, hard assets and hard currencies became an anathema for the global speculators. The divergent trends lasted for multiple years, before the convergence was triggered by the bursting of the TMT bubble. Right now we are in liquidity tsunami, created by the central banks and governments, through a monetary experiment which can be labeled as one of the “greatest monetary experiments” recorded in the economic history. Stocks markets and debt markets continue to benefit immensely from the policy levers as they are the “anointed ones” to become conduit of resurrecting a global growth paradigm. The ongoing “currency war”, where global economic giants look to devalue their currencies to gain trade share and the “oil war”, between OPEC and Non-OPEC have benefitted India immensely. The petro-war has shortened our list of immediate macro worries and the currency war has created an investment flow and carry flow boom.
The sharp swings in the Rupee over the past week was well anticipated by us as we were able to spot the danger in time, through our inter-market and technical lenses. There has been a very sharp contraction in the spread between offshore and onshore USD/INR forwards. As a case in point, during the end of November, one month and two month outright, quoted a discount of 15 and 25 paise on average. Now that has narrowed to almost zero. We have also seen the longer dated 12 month forwards in the offshore harden by nearly 40/45 paise, at a time when the onshore 12 month eased further. It could be due to the sharp reversal of the Long INR and Long Bonds trade which got squeezed as it had become overcrowded. As a result Rupee almost threatened to depreciate past 64.00 handle but thanks to alleged hand of the sovereign it remained sub 63.50.
2014 has been a year of primarily low volatility and high returns, where easy money flow from central banks and commodity nations had greased the wheels of financial assets classes. Even the EM currencies, the vulnerable block, have remained stable, barring the last few weeks. We believe things could change over the next year. We started the article with the line which hinted at the duality of the US Dollar. Let us delve deeper on that issue. It is estimated that between USD 5-6 trillion of US Dollar denominated EM debt is outstanding but we do not know how much of that is unhedged for currency risk.
US Dollar remains a favoured currency due to the US economic divergence and end of the QE from the US Fed. Therefore, as the US Dollar strengthens it can pose risk to the unhedged US Dollar denominated debt floating in the system, especially from countries and corporates with weak balance sheet and dependence on the global commodity boom. We in India have to be mindful of this risk, as high FII ownership in domestic assets have increased India’s linkages to the global emerging markets. At the same time, with commodity boom in the phase of a bust, we would not be surprised if flows from private sources and public sources from these nations slow considerably.
Therefore, world financial markets and our own stock and debt markets, which is dependent on the liquidity driven risk on flow, might be over dependent on carry flows emanating from Yen and Europe. If history is any guide, then it can be said that carry flows are fickle in nature and they can expand and contract within a short span of time. Hence, we can safely assume that the overall volatility in financial assets and currencies could be much higher than what they were this year.
Over the past week, while the world was busy watching BOJ, ECB and the US Fed for the clues about any new stimulus plan, a lesser mortal, Swiss National Bank dropped the monetary bomb by promising to charge banks who decides to park overnight liquidity with the central bank. SNB wants to keep the Swiss Franc weak against the Euro and as a result of that it stands committed to buy unlimited amount of Euro at or above 1.20 rate. In a way SNB is engaged in an unlimited QE of Swiss Francs.
US economic news was largely mixed as industrial production rose in November but flash manufacturing PMI fell and so did the regional economic survey called Philly Fed Manufacturing Index. There was not much surprise in the US FOMC’s stance and none was expected. However, financial markets, looking for an excuse to move out of the funk of a Grinch Christmas, took in a positive light and produced the green shoots of a Santa rally. US Fed added the phrase, “can be patient in beginning to normalize the stance of monetary policy”. Overall an expected dovish stance with sprinkle of confidence in the US economic recovery. We believe it will be quiet an uphill task for the US Fed to normalise monetary policy as risk of upheaval in financial asset remain significant due to over dependence on cheap money over the years.
In China, The flash HSBC/Markit manufacturing purchasing managers’ index fell to 49.5 in December from November’s final reading of 50.0. Drop in news orders was responsible for the drop in PMI. Economic news from Euro zone was mixed as well, as flash PMI readings for Germany and France showed underlying weak economic trends, where producers and service providers are looking reduce prices to sell produce. However, German investor sentiment survey from ZEW and economic survey from IFO for the current month was more upbeat.
It seems a sharp fall in oil prices and benign conditions in the financial markets are keep the mood relatively positive. In UK jobs report of last month held promise as labour earnings grew at a faster clip and unemployment claims dipped more than expected.
Indian economy saw some strong policy moves from the government. The Cabinet on Wednesday approved the Constitutional Amendment Bill on the Goods and Service Tax (GST), paving the way for the legislation to be introduced in the current winter session of Parliament, which will end on December 23. The Bill is said to have sought to include petroleum within GST, but the Centre would be allowed to impose excise duty on it and the states value-added tax (VAT) for initial years. GST compensation to states for five years will be part of the Bill. Centre will provide full compensation for three years and then progressively reduce it.
At the same time, GST to subsume the entry tax. After that the actual GST Bill will be tabled to be discussed and passed in both Houses of Parliament. State legislatures will also have to table and pass their own state GST Bills. At the same time, GOI unveiled the coal auction policy where bidding for coal blocks will now have different methodologies for the power sector and for other users. Where the end use is generation of power, there will be a reverse auction to prevent a cascading effect on power tariffs. For captive power generation, steel and cement sectors, there will be a forward bidding model.
In other economic news, In India, till date advance tax collections from 84 listed companies in India has shown a growth of 6% in December quarter as against 10-15% growth seen in the recent past. The uptick in advance tax payment is on account of higher remittances by banks and the financial institutions. At the same time, India’s Wholesale Price Index (WPI)-based inflation fell to zero in November, compared with 1.77 per cent the previous month, primarily on account of a sharp fall in global commodity prices. India’s trade deficit widened to the highest in 18 months in November as strengthening demand for gold pushed up imports. The deficit swelled to USD 16.86 billion, compared with USD 9.57 billion a year earlier and USD 13.35 billion in October. Imports rose 26.79% at USD 42.82 billion, i.e. an increase of USD 9.45 billion, out of which 51% contribution came from surge in bullion imports. Oil imports fell by 9.7% at USD 11.71 billion and hence non-oil, non-gold imports or core imports rose by nearly 30% at USD 25.5 billion. Such a sharp increase in core imports could be on account of mine shutdown and or improvement in the economic activity. Thanks to record collapse in oil prices, Indian current account is under control.
Over next couple of weeks, liquidity is expected to become thinner as yearend draws closer. We wish our readers a very happy Christmas. As far as Rupee is concerned, we remain in the camp that upside for Rupee remains limited. At a time, when there is growing downside pressure on EM and Asian currencies against the US Dollar we do not see sovereign too happy about a way too stronger Rupee. Since June of this year, we have seen the base of the USD/INR shift gradually upward and we believe now that the base of the pair might be between 62.00/62.50 on spot, which means importers can consider covering their import obligations on sharp declines below 63.00 levels on spot.
With oil prices weaker we would not be surprised if RBI allows the currency to gradually drift above 64.00 and eventually head towards 65.00 levels on spot. However, if the global risk aversion makes an ugly recurrence then we can see depreciation happen faster. We do not see a weak Rupee as a sign of gloom and doom but rather as a reflection of the strategic shift towards US Dollar that has happened in the world now. To the question how long US Dollar can continue to appreciate, we would say till the US economic growth remains strongly divergent to world growth. It is a fact that there will be adverse consequences on US economic growth from falling investment in shale oil and has projects but that we have to compare with the disposable income boost that the consumer will get from lower oil prices.
Therefore, for the short to medium term, US Dollar will continue to behave differently against different pairs. Against the carry currencies of Euro, Pound and Yen a risk-on risk-off phase will dictate whether the Greenback remains strong or weak. At the same time, against the commodity currencies it can continue trade strong due to hard asset deflation and against the rest of the world, it will depend on what country remains attractive and unattractive as a macro theme. For Rupee traders, EUR/INR and JPY/INR are largely carry sensitive currency pairs, which can fall during times of upbeat mood in financial assets and vice a versa. GBP/INR can stay in a broad range as relatively strong economic data underpin Pound but next year’s uncertain election outcome caps much upside.
By Anindya Banerjee, Analyst, Kotak Industries