Rupee and equity markets remain resilient despite weak fundamentals; will the strength continue?
On the domestic front, growth seems to have stalled, private investment and credit off-take is feeble, inflation seems to be bottoming out and turning upward, current account situation is not looking too promising, FPI inflows into debt and equity have slowed, and fiscal deficit situation of states is grim
By Abhishek Goenka
There have been quite a few macroeconomic developments on the global as well as on the domestic front in the recent past. (Though they are not quite reflected in the rupee, which has just been sticky around the 64 handle!).
On the domestic front, growth seems to have stalled, private investment and credit off-take is feeble, inflation seems to be bottoming out and turning upward, current account situation is not looking too promising, FPI inflows into debt and equity have slowed, and fiscal deficit situation of states is grim.
Despite the aforementioned factors, rupee continues to remain strong against the USD and equities continue to outperform. This raises the question as to whether the asset prices are diverging from fundamentals and if so when are they expected to fall in line. We examine each of the above factors in a little more detail below.
Q1FY18 growth numbers were disappointing with the GVA, or the gross value added, coming in at 5.6 percent. Market participants would be keen to ascertain whether the disappointing growth in Q1 was due to transitory factors such as demonetisation and GST or whether there are structural factors at play.
There are silver linings such as a rise in core GVA (GVA excluding agri and public services), a rise in July IIP (at 1.2%), pickup in activity in the cash-intensive sectors, pick up in rail freight and containers handled by ports.
However, there is a second school of thought as well, which suggests that growth slowdown could be structural. With demonetisation and rollout of GST, a number of informal industries have now been forced to enter the formal setup.
The competitiveness of these industries stemmed from transacting in cash. Bringing them into the formal sector renders their business model unviable and to that extent, demonetisation and GST have left a void in supply and resulted in a supply shock.
Since these unviable businesses would be stripped, sold/restructured, existing players in the formal sector have not invested in building up capacities to fill this void.
Instead, the void is being filled up by imports and this is distorting our trade balance as well.
Contrary to the belief so far that relative appreciation of rupee against Chinese yuan would have resulted in an influx of cheap Chinese substitutes; China’s share of our imports has not increased materially.
There has been a broad-based increase in imports, across trade partners and not specifically China. Imported goods range from chemicals and plastic products to electronics.
A rise in manufacturing imports coupled with a slowdown in industrial activity is definitely not an encouraging sign for the economy.
As the FPI limits in G-sec and corporate bonds are close to full utilisation, incremental flows into capital markets are likely to dry up and would not be funding the widening trade deficit.
Also, as the latest CPI and WPI numbers indicate, inflation is likely to head higher and we could possibly have seen the last rate cut in this cycle.
The yield on the 10-year has headed higher towards 6.60 percent and recent OMO (open market operations) sale results indicate the market is averse to holding duration.
There are concerns on the fiscal front as well. The Centre meeting its fiscal deficit target of 3.2 percent of GDP would be contingent on disinvestment proceeds being realized as budgeted.
The government would also be receiving a lower dividend from the RBI to the extent of Rs 30,000 crores and would have to fill that void too.
A bigger concern is the situation of state finances as a result of an implementation of recommendations of 7th central pay commission and farm loan waivers.
Issuance of SDLs (state development loans) has increased to fund these expenses. These expenses are revenue expenses. State Capex has been constant.
The spread of SDLs over comparable maturity Government securities have widened as a result. SDLs are crowding out the market for corporate bonds.
Spreads on corporate bonds are also elevated and therefore, there has been a little transmission of previous rate cuts by the RBI.
This would restrain corporates from tapping the debt markets, which could otherwise have been a preferred alternative at a time when bank balance sheets are stressed.
As far as global factors are concerned, US Aug core CPI came in better than expected at 1.7% YoY and 0.25% MoM. The probability of a December rate hike increased from 38% to 43% post the data.
The FOMC meeting statement and press conference on September 20 would shed some light on Fed’s assessment of evolving inflation trajectory.
It would set the tone for December rate hike expectations. Balance sheet reduction is also likely to be announced in the forthcoming Fed meeting.
The impact it would have on the far end of US rates would drive the US Dollar to a great extent. US 10y yield is currently at 2.20%. Any uptick towards 2.35% would likely result in US Dollar index bottoming out in the near term.
The risk to the US treasury rates stems from geopolitical tensions as US treasuries are considered safe haven instruments.
In the event of a major risk-off scenario, the correlation between USD/Majors and USD/EM currencies would get distorted which implies though the USD would weaken against majors, it would strengthen against EM currencies.
The US Debt ceiling has been kicked down the road but concerns are likely to resurface in December. The euro is well supported at 1.1830 and remains a buy on dips till 1.1830 holds.
An announcement of a reduction in asset purchases is likely by the ECB in its October policy meet. If the ECB maintains status quo in October, it may result in the unwinding of euro longs and we could see a correction to 1.1680.
But as a partial rollback of stimulus is already in the price, the move higher for the euro is likely to be gradual, unlike the move from 1.14 to 1.18.
The Bank of England sounded hawkish in its latest policy as was anticipated owing to mounting inflationary concerns due to a weaker Sterling.
The hawkish stance followed by comments from a BoE MPC member that a rate hike would be needed in some months sent the Sterling sharply higher towards 1.36 from 1.31 levels.
If Sterling manages to hold on to its current levels, inflationary concerns would subside to a great extent and that would give the BoE headroom to wait until H1’18 to hike rates.
Developments around Brexit seem to be unfolding in a manner more consistent with what appears to eventually result in soft Brexit rather than a hard one. This too should see the Sterling being supported. 1.3350 would now be a good support on the down side.
Taking into consideration the evolving domestic macroeconomic factors, the downside for USD/INR looks limited. Technically, 63.60-63.80 is a support zone whereas 64.30 is a strong resistance.
Break of 64.30 could result in a brisk move higher towards 65.50 by year-end. Downside risks to USD/INR stem from global factors and overall weakness of the US Dollar against majors and EM currencies.
The correlation between USD index and US rates with USD/EM needs to be tracked closely.Disclaimer: The author is Founder and CEO of IFA Global. The views and investment tips expressed by investment expert on moneycontrol.com are his own and not that of the website or its management. Moneycontrol.com advises users to check with certified experts before taking any investment decisions.