Markets are experiencing a sense of déjà vu, with a quick change in consensus view to a belief that the US Fed’s monetary policy normalization is nearing an end. This is recreating a sense that, in combination with the plummeting global crude prices, the relapse of easy liquidity will propel portfolio flows to emerging markets, including India.
Indeed, Brent crude prices have declined from $84 per barrel in early October to about $60 per barrel this week. The common justification for this is the slowdown in global growth, including in China, and the resulting excess supply. Moreover, world economic growth is likely to ebb in 2019, with the dissipation of the stimulus-driven rebound in US gross domestic product (GDP) growth in 2018 (likely to average at 3.3%).
Therefore, in the changed scenario, the dollar is expected to weaken as the Fed becomes more dovish in response to weaker growth and the correction in US equity prices. In some way, the consensus is also pricing in the rising probability of a recession in the US.
Emerging markets have also seen a reversal in sentiment, which was accompanied by a sharp decline in sovereign bond yields from the peaks around early October 2019 in response to receding inflation fears and the re-emergence of portfolio flows. In tandem, most emerging market equities have exhibited a smart reversal following pervasive negative performance earlier in 2018.
The Indian rupee strengthened from an all-time low of 74.40 on 11 October to 70.5 and 10-year G-sec yield softened to 7.60% from the recent peak of 8.20%. The common logic is that the recent decline in global crude prices has reversed the escalating risk of inflation, external deficits, and fiscal constraints.
The sudden change in consensus view is in sharp contrast with the assessments reflected two months back. So, has the world changed so dramatically in such a short time? The short answer is that the consensus view may be over-extending an orchestrated scenario.
The overt disapproval of US President Donald Trump to Fed rate hikes in 2018 and his allusion to the decline in crude prices as an indicator for the Fed to roll back rate hikes bears out the genesis of the changed market view. Importantly, the decline in crude oil prices may also be associated with aggressive attempts by the US administration to use its Saudi connection to ease the inflationary pressure on the US economy. US core inflation increased to 2% in October, which is the target level of the Fed. Markedly, crude oil prices have eased after the killing of US-based journalist Jamal Khashoggi on 2 October in the Saudi embassy in Istanbul.
Evidently, in response to these developments, consensus expectations now price in only two or three more rate hikes until 2019-end—one in December and two in the first half of 2019. The US 10-year treasury yield has also flattened, with 10-year yield softening to around 3% from the October peak of 3.25%. This contrasts with the Fed’s guidance of four more hikes to 3% by 2019-end. Our estimate of a fair value of Fed is closer to 4% and we expect it to breach 3% in 12 months. At those levels, the Fed rate will still be reaching a neutral level after a decade of over-accommodative conditions.
Fundamentally speaking, the consensus pessimism over US growth outlook for 2019 is in contrast with the on-ground solidity.
Importantly, the combination of tightening labour markets and solid net-worth position of the US household sector is symptomatic of strong growth. The unemployment rate of 3.7% is the lowest since 1968. Initial jobless claims are also the lowest in the past five decades and growth in average weekly hourly earning has steadily inched up to a decadal high of 3.4% in October 2018.
Hence, leading indicators suggest a strengthening in wage growth outlook arising from the tightening labour markets. As the cycle progresses, the wage growth may outpace productivity gains. This will result in higher unit labour cost, thereby pushing up core inflation. Indeed, core inflation has been moving up gradually to 2% from about 1% in 2016. This is higher than the long-period average of 1.7% during 1997-2018 (the average prior to the 2008 financial crisis is 2.2%). While US households have continued to deleverage and have refrained from leveraging on the phenomenal rise in their net-worth to disposable income ratio to an all-time high of seven times, the strong consumption demand appears to be backed by gains in jobs and rise in incomes.
In addition, small-business surveys indicate strong pricing power amid rising wage and raw material costs. They demonstrate a strong intent to hire, pay more wages, and increase product prices. Notably, senior-banker surveys also suggest that there is an increasing willingness of banks to lend to firms and households. The lack of momentum in credit growth in the US contrast with the pre-crisis scenario in which liberal credit standards and over-zealous lending created a boom in the real economy and leveraged bubbles in the financial markets. That clearly is not the case now.
Hence, unless there is an unforeseen exogenous shock to US growth, it will be premature to assume that the Fed is close to the end of the monetary policy normalization phase. A correction in equity prices is unlikely to move Fed’s stance unless it starts impacting household sector and labour market conditions, which, in my view, has been unhinged to the wealth effect. The receding fiscal impulse in 2019 will probably be counterbalanced by improved corporate investments and a pick-up in credit demand.
In sum, the shift in consensus trade assuming a revival in emerging market portfolio flows is froth with risks. A sustained normalization of US monetary policy will likely be followed by tapering by the European Central Bank and the Bank of Japan, thereby sustaining the narrowing of global excess liquidity. Hence, financial conditions for emerging markets, including India is expected to remain tight.
Dhananjay Sinha is head, institutional research, economist and strategist at Emkay Global Financial Services.
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