At the start of the year, things were different. No war, no energy shock, inflation was considered transitory. It looks like the table settings have changed 180 degrees. Now we are working with an energy shock and the Fed is considering tightening interest rates. What does the rest of the year have in store for us?
The IMF has started calling it a crisis upon a crisis, and we’ll hear more about it when the IMF releases its Global Economic Outlook report later this week, in which it’s likely to significantly reduce growth. worldwide. I would say it’s a very challenging environment globally and for India and maybe more for India than for countries outside of India on average.
I say difficult because this is a sort of stagflationary shock where inflation is clearly on the rise and rising risks to growth are on the downside. It will be very difficult for policymakers to determine how much of this money the central bank should put on inflation versus growth, as well as for businesses and households.
Is the world ready for a recessionary shock given that energy prices are high? The US Fed will raise rates when the cycle reverses. It is not known how big the reversal could be?
Yes, it’s a question I often get asked: what are the chances of a recession occurring? I would say a few things; Looking at typical recession indicators such as yield curve measures or labor market indicators, the risk of a US recession in the next 12 months still looks relatively low. I would put it at 15% or less than that, based on those metrics. But the other point I would like to make is that the probability could change quite quickly. What could really change the risk of recession are the markets themselves.
If we can imagine a scenario in which the Fed starts raising rates quite sharply, say 50 basis point hikes – we expect three consecutive 50 basis point hikes – and if that starts to really weaken the stock market and to drive down corporate credit spreads widen, especially corporate credit spreads, then the risk of recession begins to increase rapidly. A lot really depends on the Fed and how the markets react and in some way the Fed can cause the recession.
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Very recently, you spoke of emerging signs of economic nationalism in emerging markets. You’re also now talking about foreign portfolio investors looking to increase allocation to emerging markets at the expense of developed markets. What does this mean and wouldn’t India become one of the biggest beneficiaries of this trend?
India could potentially benefit from growing economic nationalism, especially in emerging markets. I would note a few points; first, the foreign portfolio exposures of the United States have increased significantly, particularly foreign holdings of US stocks and not just because of foreigners buying US stocks, but also because of price appreciation since the financial crisis global and all the QE, the value of the shares has increased substantially.
Emerging market investors collectively hold a very large share of US portfolio liabilities, nearly two-fifths of total US equity and debt portfolio liabilities are held by emerging market investors. So there are plenty of opportunities for emerging markets to diversify outside of the United States. If you add that to the fact that financial sanctions are being weaponized against Russia and who knows where the US is using its economic power to achieve its ends.
Arguably, emerging markets might start wanting to diversify to reduce this risk. For example, central banks in emerging markets may wish to diversify some of their foreign exchange reserves held in US dollars. And then, as commodity prices have surged, climate change is happening, do emerging markets want to store more of their commodities? Energy and food stocks are high. It’s all part of economic nationalism and you could see regions like Asia wanting to collaborate even more with each other and not just trade but also invest. I think potentially if China is targeted more by certain advanced economies, we could see India benefit from this economic nationalism.
What started late last year, the way foreign investors pressed the sell button, they sold more than they did during the 2008 crisis. We started to see the FII make their comeback. Will it speed up?
I’m talking about economic nationalism and emerging markets investing more in themselves. Thus, intra-Asian trade will also be intra-Asian investment. It’s not something that’s going to happen in the coming months or even in the coming quarters. This is a medium term trend. I’m talking about the next two to three years. So I want to be very clear on that.
I would say that in the short term, emerging markets are facing significant challenges and an aggressive Fed hike cycle and the Chinese economy which is currently under considerable pressure with growth unlikely to meet the government‘s target. of 5.5% this year, is quite negative. For India in particular, our concern is that the central bank is behind the curve. We have raised the inflation forecast for FY23 to well over 6% now, well above the RBI’s target for the full year.
India has very high inflation expectations. It has twin deficits – current account and fiscal – – so it’s really important for the RBI to catch up here and that’s what we expect. We expect 200 basis points of rate hikes by the RBI, essentially 25 basis point rate hikes at each of the next eight meetings.
What’s the best way to make your portfolio inflation proof?
It is not easy. We are going through a very difficult period for investments. Of course, there are inflation hedges. But many of them are already quite expensive; commodity prices, for example. So it’s not easy. It’s not just equities, but debt markets are also vulnerable. Credit markets haven’t really widened significantly at this point, but that’s the risk of slowing down in this year or next.
So it’s a very difficult environment. I am not an investment adviser. I’m an economist so I shouldn’t advise you, but I would just say that this is a very unusual environment and what makes it very difficult, especially for many young investors, is that we are in a new regime where inflation is well above the target of the world’s largest central bank. We are used to the politics of Ben Bernanke, of Yellen, of Powell. But now we will have a tough Fed. The Fed won’t bat an eyelid and will continue to raise rates to at least reach some, probably tight, neutral territory until it is confident that it has indeed put the inflation genie back in the bottle.