Equities and bonds: a tale of two markets
The equity market has seen its best month before a Union budget in more than a decade. The bond market has had a more rocky ride. The sharp contrast between the euphoria in equity trading rooms and the more circumspect mood in bond trading rooms is in some way a reflection of one of the main messages of the Economic Survey released by the Union finance ministry earlier this week: The story of the Indian economy in 2018 will hover between the themes of revival and risk.
The equity market seems to be more focused right now on the economic revival theme. It has good reason to do so. The Indian economy is clearly on track to accelerate. The effects of the twin shocks from demonetization and the messy introduction of the goods and services tax (GST) seem to have dissipated. The early corporate results announcements for the third quarter also show profit growth is picking up, albeit from a low base in the same quarter last year.
The bond market seems to be more concerned about the macro risk theme. Bond yields have moved around a fair bit on fears that the government may have to borrow more to fund its fiscal deficit. The yield curve has also steepened because of the prospect of higher inflation this year. The recent statement by chief economic adviser Arvind Subramanian about how interest rates are now aligned with inflation realities also suggests that the finance ministry is now in agreement with the cautious stance of the Reserve Bank of India, leaving behind at least two years of disagreement. In other words, domestic monetary easing is now almost definitely off the table.
The trajectory of Indian asset prices over the next year should be seen not only in terms of the change in domestic economic fundamentals but also against the backdrop of global developments. The output gaps in developed economies are expected to close for the first time since the advent of the North Atlantic financial crisis in late 2008. Tighter labour markets will push inflation in these economies closer to central bank targets.
It is thus no surprise that the US has already begun to normalize its monetary policy, in terms of shrinking the central bank balance sheet as well as moving towards higher interest rates in the year ahead. The former is perhaps of greater importance to countries such as India. The International Monetary Fund has estimated that capital flows to emerging economies will reduce by $70 billion over the next two years—$55 billion because of the reversal of quantitative easing and $15 billion because of higher interest rates. Compare this with the $240 billion in average annual capital flows to emerging economies since 2010.
The other source of global risk is the recent increase in crude oil prices. India could be heading towards a negative terms of trade shock that mirrors the positive shock it benefited from after 2014. Higher global oil prices will not only feed into inflation but also widen the current account deficit.
Sajjid Chinoy of investment bank JPMorgan estimates that the current account deficit could widen to a five-year high of around $75 billion—a gap that needs to be funded at a time when global capital flows are likely to shrink following monetary policy normalization in the developed world.
There is no doubt that the improvement in corporate profits will provide more solid support to current share prices. India is nowhere near either the overvaluation or inflationary pressures of early 2008. There is no reason for equity investors to panic, especially the steady investors who have signed up for systematic investment plans.
However, all euphoria must be tempered with the macro risks that lie ahead—higher domestic interest rates if inflation moves up substantially, some demand compression in case the current account deficit becomes uncomfortably large, the prospect of lower global capital inflows—or even a sudden stop—as US monetary policy normalizes.
The bond market has been more sensitive to these macro risks in recent weeks while the equity market is steaming ahead. Panic is definitely unwarranted. Yet, it is time the euphoria in the equity market is balanced with a sense of sober reality.
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