The Nikkei India Manufacturing Purchasing Managers Index (PMI) for June, a survey of private sector manufacturing companies, shows business conditions improving at the strongest pace this year, but business sentiment is at its weakest since last October.
This divergence between strong current growth and low business expectations is not limited to India. The flash PMIs for both the US and Europe for June also show good growth, but fragile business confidence.
Global financial institutions, too, have pointed out the risks ahead. The Bank for International Settlements (BIS), in its recently issued annual economic report, says the past year was a vintage one for the global economy and global growth was at par with pre-crisis long-term averages. Moreover, it predicts the expansion will continue in the near term. But it also says the impact of an escalation of protectionist measures could be very significant, if they were seen to be threatening the open multilateral trading system. Those fears are dragging down sentiments.
In a recent speech, International Monetary Fund (IMF) deputy director Mitsuhiro Furosawa said while global economic growth was seeing strong momentum, there were several risks to the outlook. He said the prospect of trade restrictions and counter-restrictions threatens to undermine confidence and derail global growth permanently. It is this lack of confidence that is affecting markets.
What about emerging markets? Strong US growth is good for the dollar. As the US dollar appreciates, fund flows to emerging markets slow down or reverse. Says the BIS: “While supported by improved growth, financial conditions in EMEs (emerging market economies) largely mirrored the depreciation of the dollar. They eased significantly until the early months of 2018, as indicated by the large drop in the spreads on local currency bonds as well as dollar-denominated bonds. Then, in the first quarter of 2018, as the dollar reversed course and started to appreciate and the US long-term yields rose, conditions tightened considerably, with EME currencies coming under pressure, especially those of countries with weaker current account and/or fiscal positions." Reserve Bank of India governor Urjit Patel has pointed out how an increased US government borrowing, in conjunction with the Federal Reserve shrinking its balance sheet, is leading to a dollar shortage.
What could be the extent of the outflows? The IMF’s financial stability report has some numbers. The report said that, assuming the Federal Reserve’s balance sheet reduction proceeds in the manner announced and the federal funds rate is raised to 3.6% by early 2020, portfolio flows to emerging markets are estimated to be reduced by an average of $40 billion a year in 2018–19. It goes on to say that if this tightening is accompanied by a bout of risk aversion of the intensity seen during the yuan devaluation of August 2015, portfolio flows could be reduced by a total of $60 billion a year over the same period, equivalent to a quarter of annual inflows during 2010–17. This scenario has already started to play out. The June survey of global fund managers by Bank of America-Merrill Lynch found that allocations to EMEs have fallen dramatically, with the funds shifting to the US.
What about the Indian markets? We have seen selling by foreign portfolio investors in India, too, particularly in the debt markets. With higher twin deficits, a falling rupee, higher crude oil prices, stagnant exports, rising inflation, skeletons tumbling out of bank closets, political risk and high valuations, India has a lot of factors that go against it. If the Indian equities market has performed relatively well, compared with its peers, the reason is that domestic growth remains strong and there are the glimmerings of increasing investment demand.
But risks loom ahead. Market breadth has been narrowing. Investors are already discounting a big rise in corporate earnings this year and beating elevated expectations is going to be very difficult, in view of the headwinds mentioned above.
This is a time for the government to pursue prudent policies and fiscal restraint. Unfortunately, in an election year, that’s easier said than done.
Manas Chakravarty looks at trends and issues in the financial markets. Respond to this column at email@example.com