The US and China are breathing fire over trade tariffs. The Federal Reserve (Fed) is giving enough signals for raising interest rates. Crude oil is rising (50% in one year) leading to strengthening of the US dollar and a significant rise in costs for emerging economies. A natural corollary of these developments is that emerging market returns are all over the place. The MSCI Emerging Markets index has witnessed negative dollar returns over the past one year. We try and establish a causal linkage between these developments and the valuations in emerging markets. The underlying principles being that valuations are driven by cash flows, growth prospects and risk perception (read: discount rates).
Increase in global trade, driven by the opening of borders, has contributed materially to global economic growth post World War II. However, the institutions and mechanisms that promoted the proliferation of global trade are now being questioned as nations (read: US) look inwards. In its efforts to reduce its trade deficit, the US is imposing tariffs on Chinese imports and China is retaliating. The same steps are being taken with the EU and Canada as well. A full blown trade war could affect volumes of trade and may well lead to companies holding back their global investment decisions for lack of confidence or policy certainty. This is likely to punch a hole in global growth (read: reduction in valuations), which has otherwise been strong in the last five years or so.
Higher crude oil prices have two primary impacts. One, it directly increases the costs for companies (lower valuations) which use crude oil and its by-products as raw material. Further, costs rise for all and sundry, as fuel is used for transportation, leading to a rise in inflation. Two, we import a significant portion of our crude oil requirement, which accounts for a large part of our import bill. This price rise, on the macroeconomic front, adversely impacts the current account deficit and fiscal deficit. Rising inflation and increases in the twin deficits have spillover effects on monetary policy, consumption and investments for emerging markets like India. Demand is down (higher prices), RBI raises interest rates (to tame inflation) and corporates can’t make efficient investment decisions (due to inflation confusion). All these factors lead to lower valuations, while it is pertinent to note that emerging markets, which are energy surplus (oil producing nations), are likely to be gainers on account of rising crude prices.
Since the liquidity crisis, witnessed in the US in 2008, the Fed has adopted an accommodative stance, which helped revive businesses that were starved of capital. However, recent tightening of rates by the Fed, as indicated, is likely to result in a flight of capital from the said emerging markets, putting their currencies under significant pressure. We have seen the peso/lira depreciate significantly in the last few months, with the rupee also coming under some pressure. Foreign investors seek investment opportunities in emerging markets for higher investment returns. However, these investors are seeking dollar returns, and in case of depreciation of the respective currency vis-a-vis the USD, the dollar returns diminish or turn negative.
In the Indian context, monetary tightening by the US is likely to reduce the attractiveness of the Indian market, resulting in a flight of capital, putting further pressure on India’s fiscal position. This deterioration in fiscal health would necessitate a rise in benchmark yields (read: interest rates and lower valuations), and we have seen that happening, with yields on 10-year government bonds increasing by more than a percentage point over the past one year. There are some upsides as well, such as IT companies benefiting from a depreciating rupee.
Another factor to reflect upon is the level of valuation impact of these economic developments on small caps, mid caps and the large caps. Over the past six months, while the aforementioned developments have taken shape, the BSE small cap index and mid cap index have dropped by 17% and 13% in comparison to the large cap index, which has more or less remained neutral. A fleeing portfolio investor is likely to exit the small caps and/or midcaps first. Adverse raw material/and/or foreign currency markets are likely to affect the small and/or mid caps much more. To summarise, these economic developments create uncertainty and nervousness in the minds of investors, resulting in confusion, affecting growth, causing inflation and investors moving funds to safer investment havens (such as gold, US dollar, amongst others). The flight of capital in such a scenario negatively impacts the local currency and the local bond markets. Benchmark domestic bond rates are likely to increase, pushing up investor return expectations and decrease valuations.
Going by the tone of US president, Donald Trump, on tariffs (and the recent developments on their implementation), it looks like uncertain times are here to stay. Please moderate your return expectations.
Amit Jain
Partner, KPMG India