Back in November, a typical headline was: Stocks fall on Chinese rate hike jitters. After the recent Chinese rate hike on Tuesday, the headlines were: Copper ends up, market digests China rate hike and emerging market (EM) debt, currencies strengthen despite China rate increase. Both the Shanghai Composite and the Hang Seng indices were up on Wednesday in spite of the rate hike. Clearly, the mood towards China and towards EMs has changed dramatically.
That is pretty obvious from fund flows. While foreign funds went out of emerging economies into the developed markets between November and February, they came roaring back in the second half of last month. As of 5 April, the MSCI India index was up 11.2% three months to date, MSCI China was up 6.3%, while MSCI US was up 3.7%.
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Here’s another thing that has changed—the price of crude oil. The problem is it has changed for the worse. When Brent crude was ruling at around $100 a barrel in late January, the talk was all about its adverse impact on inflation, on the current account balance and on the fiscal deficit. Now that Brent crude has shot up over $120 a barrel, those fears seem to have been banished.
Has the outlook on interest rates changed then? A couple of months ago, it was the fear of high inflation leading to monetary tightening and therefore slower growth that led to funds being withdrawn from EMs. On Tuesday, Reserve Bank of India (RBI) deputy governor Subir Gokarn gave an excellent speech in which he laid out the central bank’s position on the relationship between growth, inflation and investment. The crux of his argument is that acceptance of a higher rate of inflation as the new normal—an inevitable consequence of rapid growth—will raise risks of accelerating inflation. In turn, this is likely to weaken incentives for investment, which will threaten the sustainability of growth. This is a vicious circle of high inflation, low investment and slowing growth.
In other words, RBI will do what it takes to lower inflation, because sustainable growth can only come about through low inflation. What is the inflation rate compatible with sustainable high growth and investment? Gokarn says the growth-maximizing rate of inflation for the Indian economy is unlikely to be much higher than 5%. That suggests the tight money policy will continue.
So if crude oil prices have risen, if inflation is only a bit lower and if rate hikes are going to continue, slowing the economy, why is foreign institutional investor money rushing in?
Could it be that the prospects in the developed economies have dimmed? After all, it was stronger growth in the US that was in part responsible for the rotation away from EMs. Data coming out from the US has been mixed. Among recent data, while the job report has been good, new home sales have fallen. The Institute of Supply Management’s index of non-manufacturing businesses decreased a bit in March, but the reading still shows a high rate of month-on-month expansion. Europe continues to see a two-speed economy, with Germany and France doing very well, while the southern economies languish.
But there has been a change in the outlook, best illustrated by Goldman Sachs’ recent justification for a re-look at EMs. This is what it said: “We believe that the growth/inflation balance should improve in EM. The early part of the tightening cycle is over in EM and the growth momentum is likely to accelerate for the rest of the year. Meanwhile, DM (developed markets) in their majority have yet to see an acceleration in the tightening process. We expect the ECB (European Central Bank) to start its hike cycle in April while the BoE (Bank of England) should make its first move in May.”
So what is the market betting on? The first will have to be lower crude prices. The second is a re-look at the slowdown hypothesis. The HSBC PMI indices for India suggest growth continues to be robust. Exports have spurted, growing 50% year-on-year in February. Non-oil imports have bounced back. Automobile and cement sales in March have been good. Capital goods companies have seen a few large orders and beaten down infrastructure stocks have been rising. Credit growth has been strong. Liquidity has returned to the money markets.
The markets are betting that inflation will come down, the peak in lending rates has already been reached and that growth will therefore continue to be robust, aided now by previously sluggish investment demand. The guidance by companies after declaring their March quarter results will give some indication of how valid these expectations are.
It’s a lot to be betting on and there are many contradictions. Why, for instance, should investors be pouring funds into Russia if they believe crude oil prices are headed for a correction? Doesn’t the hawkishness of recent RBI utterances contradict the optimism about growth and inflation? If inflation is going to rear its head in the US, why is the yield on the 10-year US treasury note where it was in mid-December 2010?
Perhaps the move back into EMs is just a rotation by fund managers, simply because positions in EMs had been savagely pared earlier and fund managers were sitting on lots of cash, as brought out by the Bank of America-Merrill Lynch survey of fund managers in March. Loose global liquidity has led to funds moving in and out quickly into various asset classes, greatly increasing volatility.
Manas Chakravarty looks at trends and issues in the financial markets. Your comments are welcome at email@example.com