The worst case would be a crisis peak-to-trough drop of 17-18%
On Friday, August 14, I watched the news (which I don’t usually do) since I was concerned that if the Dow Jones fell sharply, it would signal that markets were terrified about China and it could be the beginning of a major rout. In the event, nothing happened and, like most others, I took the sucker punch that perhaps what the Peoples’ Bank of China said was true. Ha! Live and learn forever.
Last week , of course, brought the two of the one-two. The yuan remained under pressure, and markets all over the world—even including the unheard of Kazakhstan tenga—shook like many leaves in a storm. The rupee tanked on Thursday; the Dow fell that night. And Friday, bloody Friday, the rupee slipped further, threatening to reach 66 to the dollar.
I watched the news again Friday night—the NDF closed north of 66 and global equities also took a bath. The S&P 500 dropped 3.2%, the most since November 2011, to below 2,000. The index is down more than 7% from a record after sinking below a trading range that has supported it for most of the year. The Dow Jones Industrial Average fell more than 500 points, as is down 10% from its record high in May.
Could this be the start of the Big One that many, including myself and, I believe, Dr. Rajan, have been anticipating for nearly a year now? Significantly,
Amid the selloff, the S&P 500 is trading at 17.5 times earnings. That’s down from 18.9 times a month ago, which was near a five-year high, though still exceeds the five-year historical average of 16.1 times profit.
This suggests that another 8% drop would simply take the S&P to its historic average, but as we all know, markets over- and under-shoot when they are in a rage. Thus, it would not be unreasonable to expect a further fall of, say, 15% in US equities.
What this would do to emerging market—and, importantly to us, Indian—equities is pretty straightforward.
But, the prognosis for the rupee may be more nuanced. Yes, it will fall. Yes, RBI will be in full battle regalia “controlling the volatility” as it has been trying to do forever (it seems).
And, when the smoke clears, it will recover a la 2013, when it fell from 54.50 in mid-May to 69 in early September (a decline of 26%), before recovering to 62 by end-September. It remained strong after that reaching a level of 59 after the Lok Sabha elections in April 2014. The cause of the shock collapse was the comment from Fed Governor Bernancke about “tapering” off of QE; this triggered a further rally in the dollar and the rupee’s early decline was exacerbated by a huge overhang of unhedged short positions, whether buyers’ credit imports or ECB’s.
We note that the “apparent” trigger for the recovery was Dr. Rajan coming in as RBI Governor on September 5, but the larger truth is that the decline had more or less exhausted itself. One of the Deputy Governors at the time pointed out to me that while we had fallen 18% (he was starting from 59, where the rupee had briefly stabilised—on the way down—in July 2013) despite all RBI’s efforts, other “freer” currencies like the South African rand had only fallen by 21% with no action from their central banks.
Coming to today, the situation globally is substantially worse than in 2013. There is little doubt that China is slowing rapidly and the shock waves travelling out from there are the result of the proverbial “hard landing”; while the US is looking steady, the rest of the world is going to hell in the growth handbasket with commodities leading the way. In many senses, this is closer to the fallout from Lehman in 2008, when the rupee collapsed from 42 to 50 (again 20+%) in a matter of 3 months. Once again, it recovered, slowly reaching 44.50 or so by early 2010.
And then there was the next step down in 2011, when the Euro crisis first hit – this time, the rupee fell from 45 to 57 in 2012 (again, 26%, but in two steps). Then, came 2013. And, of course, today.
The good news, if there is any, is that domestically India is much, much stronger today both in terms of reserves but also the continuing belief (with some validity) that the Modi government is getting things done—slowly, of course, this is India, after all. On the other side, there are still very large uncovered short positions in the market—even accepting RBI’s comment that 41% of ECBs are hedged, that still leaves more than half of these plus huge buyers’ credit imports, not to speak of FPIs who want to exit.
While there is no real way of knowing, all this suggests to me that the overall drop will not be as much as we have seen in past traumas. The rupee has already fallen from around 58 to 66 (about 13% since May). I would—sticking my tortoise-like head out—say the worst case would be a crisis peak-to-trough of 17-18%. This means we would see not more than another 3 rupees or so, taking it back to its all-time low of 69.
Note, however, that this move, if it happens, will be quick—in, perhaps, a matter of another week or so. Any meaningful recovery will, of course, take time, although there could be a quick small snap-back in early September.
Once the crisis in the market abates, which could be several months, India’s attractiveness as an investment destination will again begin to show through, particularly as global interest rates will remain low, and the rupee could get back to 63 to 64 in a year or so. However, there will continue to be a downward bias since global growth will not recover till such time as governments in developed economies understand that they need to structurally change their approach to fiscal policy. This could take a long time—sub-60 levels may be gone for the foreseeable future.
The author is CEO, Mecklai Financial