The risk of foreign flows for stock market in 2018
There will likely be some impact of tighter US monetary policy on portfolio flows to emerging markets
Indian equity investors have had a good year. The broad indices are up by a quarter in local currency terms. And they have gone up by a third in dollar terms. Most important markets have done well thanks to a synchronized recovery in the global economy. The recent data on international corporate investment recovery is especially noteworthy. India has participated in the global financial assets rally despite the slowdown in economic activity as well as the sluggishness in corporate earnings. Domestic corporate investment continues to disappoint thanks to excess capacity as well as the inability of banks to lend.
However, the next year will begin in the shadow of doubt. Will global liquidity dry up? And what will that mean for the Indian equity market?
The US has already begun to tighten its monetary policy. The usual assumption is that tighter US monetary policy will hurt portfolio inflows into emerging markets such as India. This tightening is expected to happen in two ways over the next year. The US Federal Reserve is expected to push up interest rates as inflation catches up with the improvement in the labour market. The US central bank will also start reducing the size of its bloated balance sheet in some variant of quantitative easing in reverse. Should Indian investors worry?
They should worry—but not panic. A recent blog post by International Monetary Fund economist Robin Koepke says an internal forecasting model predicts that monetary policy normalization will likely reduce portfolio flows to emerging markets by about $70 billion over the next two years. The reduction of the Fed balance sheet will cut portfolio flows by $55 billion while higher interest rates will have a $15 billion impact. This is in comparison with average annual inflows of $240 billion since 2010. In other words, the expected reduction in portfolio flows will be 14.6%.
India attracted $7.7 billion of global capital into its financial markets in the calendar year till 22 December. It is a modest number when compared to the $29.3 billion that came in 2010 or the annual average of $20.1 billion in the three years to 2014. So the risks of a sudden stop are lower than before. Two other factors are likely to help. First, India has a manageable current account deficit that is being funded by foreign direct investment. Second, domestic liquidity support is strong thanks to the dedicated money flowing into mutual funds each month through systematic investment plans.
The risk comes from sudden surprises like the one delivered in May 2013 by Ben Bernanke with the decision to gradually withdraw from quantitative easing. It is quite possible that portfolio flows will strengthen next year in case the US Fed tightens monetary policy at a slower pace than currently expected; and portfolio flows could dry up suddenly in case monetary policy tightening is more aggressive than expected. The upshot: A lot depends on the ability of the US Federal Reserve to manage market expectations. The surprise in May 2013 should be compared to the more nuanced communication over the past two years.
The upshot: There will likely be some impact of tighter US monetary policy on portfolio flows to emerging markets. China is expected to embrace one of the lowest money supply growth targets next year. However, Europe and Japan continue to maintain their monetary policy in expansionary mode. These crosswinds do not take away from the fact that US monetary policy direction will continue to be key, especially if there are any policy surprises. India will be relatively protected in case of a sudden stop by its low current account deficit as well as strong domestic liquidity.
This sanguine view on liquidity should not distract investors from a more fundamental worry—corporate earnings. Top-line growth has been modest, while profit margins could come under pressure if global input prices increase. Financial parameters such as return on equity continue to disappoint. Investment in new capacity has been nothing to write home about, though some domestic analysts as well as international agencies predict that the corporate investment cycle could turn in fiscal year 2019.
Markets look ahead—and the most important questions for investors in Indian equities will be the changes in global portfolio flows on the one hand and improvements in corporate financials on the other.
Will the tightening of policy rates in the US affect capital flows? Tell us at firstname.lastname@example.org
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