Do it yourself

Reportedly, Israel and Hezbollah (Lebanon) have successfully negotiated a 60 days ceasefire to the latest round of hostilities which started with Israeli forces invading Lebanon on the 1^st October 2024. The deal involves withdrawal of Israeli troops from Lebanon and deployment of a UN peacekeeping mission and establishment of a US led international monitoring group.

This is an important development in global geopolitics. The Hezbollah group was overtly supported by the Iranian government. Israeli invasion into Lebanon had evoked a direct military response from Iran; threatening a much wider escalation of a hitherto localized Israel-Palestine conflict. The ceasefire deal, which has been welcomed by Iran, diminishes the probability of an immediate wider escalation of the Israel-Palestine conflict. However, since the deal does not cover the ongoing Israeli attacks in Gaza Strip, it does not offer any durable mitigation of the threat.

If the outgoing president Biden could pursue Ukrainian president Zelensky to also negotiate a similar ceasefire deal with Russia, it would be considered a great parting gift for the president-elect Trump.

From the economics viewpoint, presence of the UN peacekeepers on the ground and direct involvement of the US in the region may temporarily help in restoring normalcy in the Red Sea marine traffic, thus normalizing the global trade to a certain extent; and the volatility in oil prices may also subside. A restrained approach from both sides would provide a durable solution.

This is definitely good news for India. An uncertain and volatile oil price environment, higher logistic cost due to disruption in the Red Sea, and a conflict involving Israel (supported by the US) and Iran (supported by Russia and China) are investors and policymakers’ nightmares.

Another thing that may be of immense interest to the Indian investors presently is Scott Bessent’s (Trump’s designated treasury secretary) views on USD and US treasury yields. As a hedge fund manager, Scott has preferred a weaker USD strategy, against raising tariff barriers, for the US manufacturing renaissance. Scott believes “tariffs are inflationary and in turn would strengthen USD. On the other hand, a weaker USD would make US manufacturing competitive. A weak dollar and plentiful, cheap energy could power a boom. A stronger USD should emerge only at a later stage if the US reshoring effort is successful”.

It may not be great news for the global hedge fund managers who are overwhelmingly long USD. As per the recent survey, presently, long USD is the most crowded trade globally.

If Scott sticks to his extant views, we may see USD weakening, US yields falling and US energy production & exports rising in 2025. This trifecta may delight Indian markets and our emerging market peers.

One question that begs the answer is “against what USD will weaken?” The US Fed is not keen to cut rates materially from the current levels. EUR cannot afford any strength, especially when German and French economies are tethering. Both China and Japan have shown no inclination to leave their currencies to the market forces. Strength in emerging currencies, including INR, is like a tiny insect bite for an elephant like USD; makes no difference. A peaceful middle east and Europe and cheap energy may take much of the shine out of gold.

I would be pleased to hear the views of readers on what would USD weaken against, if it does?

One of the key factors that may influence the performance of Indian equities in the current year would be how the global asset managers rebalance their portfolios in light of the changes in interest rate trajectory, movement in USD and JPY, geopolitical tensions, disinflation/deflation, etc.

2023 has seen significant disinflation in most developed and emerging economies. Most central bankers are well on course to achieve their inflation targets. Global growth, especially in advanced economies, commodity-dominated emerging economies, and China has taken a hit.

Presently, many European economies are struggling with stagflation. Japan is witnessing positive real rates after a decade. US COVID stimulus has faded, leaving consumers vulnerable. Higher positive rates are impacting discretionary consumption and investment in many other economies.

It is to be watched whether the current trend stops with disinflation or pushes the major economies to a state of deflation. Particularly, since the strong deflationary forces like the use of artificial intelligence to replace semi-skilled and skilled workforce; aging demographics, dematerialization of trade and commerce, etc. continue to gain strength.

If deflationary forces gain material ground, we may see the policymakers loosening money policy to calibrate controlled inflation. This will see the Japanification of major economies like China, the US, and the EU. Emerging markets and independent currencies (e.g., Bitcoins) could be major beneficiaries in such a case. The asset managers might therefore change their allocation strategies for EM vs DM, Equity vs Debt, China vs Japan, Physical Assets vs Financial Assets, Gold vs Bitcoin, etc.

Presently a majority appears to be favoring soft landing (no recession), gradual rate cuts (50-100 bps in the US), lower bond yields, and strong earnings growth. Equity valuations and allocations are congruent to this view.

In recent years, domestic equity flows have materially increased in India. The relative importance of the foreign flows has thus diminished. Nonetheless, for the overall growth of the Indian capital markets, global flows remain important.

Many global investment strategists have indicated their preference for Indian equities in recent weeks citing resilient economic growth, stable macro indicators, supportive political regime, and robust earnings growth momentum as the primary reasons for their positive view. This augurs well for the optimism over foreign flows and supports the positive view of domestic asset managers and strategists.

In this context, it may be pertinent to note that—

·         Emerging market equities have massively underperformed the US equities in the past decade. The current relative underperformance of emerging equities as compared to US equities is the worst in fifty years.

·         Emerging markets are about 40% cheaper as compared to their developed market peers, and the earnings momentum is likely to gather more pace.

·         The sharp rise in the EM discount relative to DM is driven to a significant extent by China’s low valuations. Ex-China, however, EM discounts are in line with the 10-year average. Currently, the price-to-earnings (P/E) ratio for the MSCI EM Index is trading at approximately 12x over the next twelve months, or slightly above its long-term average of 11.3x.

·         Within emerging markets, Chinese stocks have recorded their worst-ever performance. Currently, Chinese equities are at the lowest-ever level as compared to their emerging market peers.

·         Indian equities are presently trading at a significant premium to their emerging market, especially Asia ex-Japan, peers.

·         The earning momentum is expected to slow in India over the next couple of quarters, while Developed markets ex-US, offer attractive valuations.

 In a recent research report, Goldman Sachs estimated that “energy bills will peak early next year at c.€500/month for a typical European family, implying a c.200% increase vs. 2021. For Europe as a whole, this implies a c.€2 tn surge in bills, or c.15% of GDP.” The bank believes that repercussions of this “will be even deeper than the 1970s oil crisis.” Obviously, a problem of the magnitude would require an impactful policy intervention that could have wider and deeper implications for decades to come.

The policy interventions could involve partial suspension of free market mechanism; rationing of energy consumption; fiscal subsidies; deferment of climate goals and increased use of coal and/or accelerated shift to renewable sources of energy etc. Besides, there could be serious geopolitical implications also.

In another interesting paper, McKinsey & Co, outlines how inflation may be flipping the global economic script. In the paper McKinsey’s experts have examined many of the strategic implications of inflation. The key points highlighted in the paper could be summarized as follows:

·         In the past six months, inflation has far exceeded December 2021 expectations. In many countries, actual rates have doubled projections. European countries are particularly affected. Asia is seeing a less severe change: Indian inflation is about 7 percent, only a bit above projections; and South Korea is at 5 percent. In China and Japan, inflation remains muted.

·         In response to inflation’s alarming rise, central banks worldwide are raising their core bank lending rates. So far, however, rate raises in most countries have not matched the pace of inflation. The rising rates are expected to ease demand and lower prices for two critical components of headline inflation: housing and commodities such as energy and metals.

·         The lift-off in fertilizer prices, supply chain snags, drought, along with other fallout from the war in Ukraine, has pushed prices for basic foods much higher. Since 2021, food prices have risen to their highest level since the United Nations’ Food & Agriculture Office began its index. Prices today are considerably higher than in past surges in 2008 and 2011.

·         As economies stabilized and reflated post Covid, real wages began to creep higher again. But rampant inflation checked that growth, rising so fast that it has diminished the purchasing power of people’s take-home pay. For example, workers in the United Kingdom today have seen their real compensation fall by roughly 8 percent year-on-year.

·         As prices soar, and show few signs of abating, the risk is that inflation becomes entrenched and central banks will have to raise rates more assertively to slow demand. The growth may slow down much more than previously estimated.

The global economy is therefore entering a prolonged phase of correction and realignment. For many these corrections may be extremely painful, while for some it could provide an opportunity to enhance their position in the global order. India, being one of the least impacted countries in this global turmoil, hopefully would fall in the latter group. Amen!