DON’T BE AFRAID OF FED TAPERIING, WELCOME IT

Over the last few weeks equity markets world over, especially in the emerging markets have corrected sharply, mainly due to the bogey created around the Tapering of Asset Purchases by the US Federal Reserve and the impact of that on global liquidity as well as flows into emerging markets. Not only have equities sold off, we have seen a selloff in bonds, EM Currencies as well as most other assets. Amazingly in this entire melee the one currency that has held out has been the Euro which has rallied against most currencies including the US Dollar. It is only a year back when most EXPERTS were arguing for a collapse of the Euro to parity with the USD and there were bets being made as to how many countries will be out of the Euro currency over the next one year. Not only has the Euro zone survived till date without any country having to move out, the bond markets in most of the troubled countries i.e. Greece, Spain and Italy have stabilized and bond yields have fallen substantially from where they had reached around a year back.
In order to understand the phobia that is being created around the Fed Tapering we need to revisit some of the other events over the last one year to see what actually transpires vis a vis expectations.  The first major event has already been mentioned by me in the first paragraph where there was no doomsday either due to the European Credit Crisis or on the last date of the Mayan Calendar (ha-ha).
The second major event that was used to create a scare was the forced spending cuts in the US, i.e. SEQUESTRISATION. This event which happened around 3 months back was again built up to one that would cause a collapse in the US economic growth trajectory and the country would again go back into recession. Not only has growth held up, the employment position has also held up well till date and most economic indicators in the US continue to improve. As such the perceived fear was much greater than the actual impact of the event.
The latest fear factor is being built around the Fed Tapering event. However what we need to see is the actual impact versus the perception. When the US FED started the QE1, asset prices globally were highly undervalued, be it equities, commodities, currencies, bonds etc. As such the first level of money printing led to a normalization of asset prices to levels that would be unsustainable just by pure demand-supply economics but were necessary to bring about some confidence into the global economy. As such this event did not lead to a huge emergence of inflationary pressures in Emerging Markets although it led to asset and commodity price inflation.
The disastrous consequences for Emerging Markets started with the start of QE2, where the money printing went into speculative moves in commodities and prices of most commodities shot up so much that it created huge inflationary pressures in EM’s especially for countries like India. The spike in commodity prices led to a huge build up in inflationary pressure as well as put a huge stress on the Current Account Deficit for a country like India. For example, Brent Crude oil prices shot up from $ 80 to $ 125 over the six months since the start of QE2. Similarly gold prices shot up from $1300/ounce to $ 1900/ounce over the 10 months since the start of QE2. These factor s eventually had an impact on the currencies where the INR started falling sharply from April 2011 and over the next six months fell by over 20%. Not this started a vicious cycle where the falling INR led to even higher inflationary pressures & increasing CAD in combination with that led to the RBI’s hands being tied with regards to taking any action to revive the slowing economy. The subsequent decline in commodities post Mid 2011 could not be captured into bringing about lower inflation due to the significant sell off in the currency.  High interest rates, losses on forex exposures combined with an inactive government trapped in various scams led to 2011 being one of the worst years for equity markets in India.
Eventually as the markets realized that incremental money printing was not leading to a higher consumption of commodities and the assets of commodity hedge funds, gold ETF’s etc ballooned to unsustainable levels incremental money printing by the US FED has not led to any spike in commodity prices, infact we have seen a significant selloff in commodities. The slowdown of artificially propped by Chinese growth has also played a role in this phenomenon. However the huge liquidity flow did lead to a large number of EM currencies and bonds rallying to unsustainable levels, which has corrected over the last few weeks.  Factually, in my view it is also true that the prices of some commodities are still elevated due to the excess liquidity in the system and as Tapering takes place, even as economic growth picks up we should see commodity prices remain subdued.
In the Indian context a 10% decline in just two commodities, i.e. Gold and Crude would reduce the import bill by $ 20 billion which is equivalent to the total inflow of FII’s in a year. This would also reduce the inflation and Fiscal Deficit, lead to lower interest rates and higher growth. As such from a pure economic growth perspective we would rather have lower commodity prices than some incremental liquidity flows. This will be true for most other EM’s, except China where the currency has appreciated and inflation has been under control till date.
FED Tapering is not only a necessity for reducing long term inflationary pressures but it is also important from a macro economic standpoint as the US FED’s balance sheet is becoming unsustainably huge. On the other hand the printing press of the Bank of Japan has just started and should go on for the next two years at least. Under the circumstances liquidity in any case is not going to go away anytime soon. The other major point is that reduced pace of asset buying does not mean that short term rates will be increased anytime soon, this will happen after 18-24 months only.  As inflation reduces and the economy moves on a recovery path money will come into the country in any case if investors find value in India assets. FDI has totally collapsed over the last 2 years due to uncertainties on government policies as well as lack of investment. As and when the government turns pro growth we will see huge FDI flows too, which are more durable and long term.  In the year 2007 the US 10 year bond yield were in the range of 4.8 to 5.2% but that still did not stop flows into EM’s.  One can argue that there has been deleveraging and risk moderation after that; however huge liquidity has also been generated along with short term rates in most Developed Economies being in the range of 0-0.5%.
In conclusion I am of the view that FED Tapering will reflect confidence on the part of the US FED on the sustainability of economic growth and will be a long term positive rather than a negative. It will reduce long term inflationary pressures on EM’s and will aid higher economic growth.

MARKETS

The see saw in the markets have continued with the greater action being in the currency markets where we have seen most EM currencies and some DM currencies sell off. However in the Indian context this has happened at a time when the inflation trajectory is on its way down and is likely to fall further going forward. The Fiscal Deficit seems to be in control and growth has bottomed out. Government policy inertia has also peaked out. The probability of a significant incremental weakness seems to be low going forward. The monsoons season has started off with a bang; let’s hope it stays this way as it is important from a food inflation as well as agricultural and rural economy perspective. Good moisture content also is helpful for the more important winter harvest. Growth has bottomed out; however in the absence of any significant revival in the investment cycle will remain subdued this year. However higher government spending as contrasted with the contraction of last year should add at least 1% to economic growth. As such if last year ended with a growth of 4.5% this year should be at least 5.5%. Any improvement in the investment cycle or reduction in interest rates will add to growth incrementally. As I wrote in my last article we are now into the best period for the markets on a seasonal basis where 15th June to End September normally provides strong returns. Given that we are actually negative YTD we should actually see markets pick up going forwards. Valuations, except for the consumer good space are reasonable and provide a downside protection to the markets. Overall the second half of the year should make up for the non performance in the first half. 

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