Upcoming US midterm election could potentially halt the rally in USD and reverse the flows from US markets to relatively better-placed EMs like India
US markets and the economy have thrived under the Trump administration. The unemployment rate is at record-low levels, inflation has picked up but remains contained and the US stock market has been pushed to all-time highs amidst record earnings.
Good news for US markets was a nightmare for emerging markets. The fallout of Trump administration policies, including rising trade tensions, higher treasury yields and a stronger US dollar, have led to sell-off in EM currencies and markets.
This compels one to investigate whether EMs, especially India, could get relief from these trends in near to medium term and the likely catalyst for the same.
Moneycontrol Research decodes the events that led to strengthening of US dollar and expects that upcoming midterm US election outcome has a potential to change the EM woes in the short term, at least.
US dollar strength governed by Fed's hawkish stance
US dollar strength for greater part of this year had taken market participants by surprise. Dollar index has climbed about 9 percent from the lows in the early part of the year. Dollar appreciation with respect the rupee has been much more acute at about 18 percent this year. Reasons which led to strong pull for the dollar had primarily been hawkish US Fed policy leading to steepening of US treasuries yield curve.
Strong domestic macro data as well contributed to the scenario. Particularly steady takeaways from the recent non-farm payrolls data, record unemployment rate (3.7 percent) and improving wage rate acted as a catalyst for US 10-year yield. The US 10-year yield is now hovering around 3.17 percent slightly off from the 3.26 percent level reached couple of days back.
Ongoing trade war weighed on EM growth outlook and currencies
EM currency depreciation with respect to dollar was also aided by weakening in global trade and growth outlook. Latest PMI reports underline that business optimism has declined to its lowest in two years. Not surprisingly, IMF has revised down global growth outlook (Oct update) to 3.7 percent each for 2018 and 2019.
Macro factors resulted in reversal of fund flows to the US from EMs
Favorable interest rate differential and relatively strong macroeconomic situation in the USA led to reversal of fund flows from emerging markets (Ems) like India. Till last fiscal year, higher yield advantage had attracted fund flows to EMs but there has been a reversal in this phenomena this year as the US Federal Reserve advances ahead with interest rate normalization cycle.
As per Care Ratings report, so far this fiscal year, net foreign outflows in India have been $13.7 billion which is in contrast with the net inflow of $15.3 billion in FY18.
Outflows were broadly in same range for both equity ($6 billion) and bond markets ($7.7 billion) in India.
Can EM flows resume?
We think EM sell-off is overdone and far too indiscriminate. First, the fears surrounding a small number of EM countries have morphed into concerns about wider EM contagion, which pushed down valuations across the board. Today Argentina and Turkey loom larger in investors’ minds. However, the good news is that none of the other established EM countries especially India share unfortunate combination of economic circumstances similar to these two countries, therefore contagion risks are close to nil. The EM selloff has been stronger than the deterioration in the earnings trend. This could pave the way for a tactical rebound.
Secondly, investors feared that the strong rally in the US dollar, which is into eighth year (2010 -2018) would continue forever. But we think that upcoming US midterm election could potentially halt the rally in USD and reverse the flows from US markets to relatively better placed EMs like India.
Upcoming US midterm elections can be a catalyst
In the upcoming US Midterm elections on November 6, there are high expectations of divided Congress, with the Democratic Party taking control (modest majority) of the House of Representatives and the Grand Old Party (GOP)/ Republicans retaining control of the Senate.
Basis of a divided Congress expectation
First, as witnessed in past that during midterm elections, the electorate has tended to swing against the incumbent party. Midterms are often viewed as a referendum on the party in power. And even though President Trump's name won't be on the ballot, there is little doubt that he will be on the minds of most voters as they walk into the voting booth. Historically, when a President’s approval rating drops below 50 percent, the ruling party performs poorly (loses seats) in the House. According to recent average of polls, Trump’s approval rating has fallen to 40.5 percent as on September 9.
Second, cues provided by the betting markets is also for a divided Congress. As of September 21, speculators betting in hypothetical election futures markets have priced in a probability of a Democratic House and an equal probability of a GOP Senate.
Implications of gridlock
Let us understand implications of gridlock for markets and flows. Republicans have already struggled to pass legislation with their current make-up, and a gridlock would further restrict their legislative possibilities. Having said that, it is important to note that the next Congress is very unlikely to undo the major market-impactful legislation that has already been passed under President Trump.
The fiscal stimulus from tax reform and increased government spending boosted US equity markets in 2018. Under the gridlock situations, US equity investors will not be able to rely on current reform agenda to support higher equity prices. Instead, the focus will be on corporate earnings growth. While US corporate earnings momentum could continue in 2019, the growth rate could be approximately half of what we expect in 2018 due to the absence of any additional tax benefits. Hence, US equity returns could be modest at best under a gridlock scenario driving flows to EMs.
In such a scenario, it wouldn’t be unreasonable to expect the USD to depreciate. A gridlock could lead to portfolio outflows from US equity and fixed income markets that would be USD negative.
And lastly, the most extreme scenario could see a stalling of Trump legislative agenda, aggressive investigations of Trump and his inner circle and finally the prospect of impeachment. The fear of such extreme scenarios would also help put brake on rallying dollar.
Implications for India
Weak portfolio flows along with high oil prices has adversely impacted India’s balance of payment putting pressure on rupee.
However, emerging markets in general and Indian market can possibly get an interim relief from weakness in US dollar. This in turn can provide some respite to portfolio outflows and can potentially lead to inflows given the stretched technical.
The outlook for the US dollar in the medium term is negative for the reasons outlined above. However, currencies can be notoriously volatile. Also, political outcomes can be significantly different than widely expected. While better days are anticipated in coming months, intensification of rhetoric on trade war can keep EM on edge.Follow @nehadave01
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