Vijay Kumar Gaba

The recent RBI bulletin (April 2024) contains an interesting article on the current state of the economy. The article is written by officers of RBI and does not represent the official views of RBI.

Wishing all the readers, family, and friends a very Happy Diwali. May the Lord enlighten all of us and relieve everyone from pain and misery. 

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The growth is slowing across the world. The engines of global growth - India and China – are also expected to slow down in 2024. Most European countries are flirting with recession. Canada is technically in recession. The US growth is stronger than estimates but not enough to support the

Growth decelerating

As per the latest World Economic Outlook report released by the World Bank, global growth has slowed down to 3% in 2023 from 3.5% recorded in the year 2022. The global economic growth is expected to further decelerate to 2.9% in 2024. The advanced economies have grown by 1.5% in 2023 against 2.6% in 2022. Their growth is likely to further decelerate to 1.4% in 2024. Economic growth in Emerging economies is also not accelerating. These economies are expected to grow at the rate of 4% in 2023 and 2024, against 4.1% in 2022.

Though the likelihood of a hard landing in the US may have receded, the risks to the growth still remain tilted to the downside.

Inflation persisting

The growth slowdown could be largely attributed to the effects of the monetary tightening measures taken since 2022. However, despite the sharp growth deceleration, global inflation is likely to stay above 5% in 2024 also. The World Bank expects global inflation to ease to 6.9% in 2023 and 5.8% in 2024, against 8.7% in 2022. In recent weeks, the inflationary expectations have risen again and could contribute—along with tight labor markets––to core inflation pressures persisting and requiring higher policy rates than expected. More climate and geopolitical shocks could cause additional food and energy price spikes.

Geoeconomic fragmentation – risks rising for emerging economies

The rising geoeconomic fragmentation is seen as a key risk to global growth and financial stability. Intensifying geoeconomic fragmentation could constrain the flow of commodities across markets, causing additional price volatility and complicating the green transition. Amid rising debt service costs, more than half of low-income developing countries are in or at high risk of debt distress.

No room for policy error

Given the still high inflation, unsustainable fiscal conditions and high cost of disinflation, there is little margin for error on the policy front. Central banks need to restore price stability while using policy tools to relieve potential financial stress when needed. effective monetary policy frameworks and communication are vital for anchoring expectations and minimizing the output costs of disinflation. Fiscal policymakers should rebuild budgetary room for maneuver and withdraw untargeted measures while protecting the vulnerable.

However, if we juxtapose these economic realities with the market performance, the dissonance is too stark. Formulating an investment policy that balances the macroeconomic and market realities is extremely challenging under the current circumstances.

I shall share my thoughts on this after the Diwali break. I will post next on 17^th November.

 I have often seen that when we fail to find solutions to our problems with the help of science and economics, we tend to look towards the heavens and seek to find answers in philosophy. It is not uncommon for businesses, administrators, and policymakers to seek divine intervention when science and economics are not helping to resolve a problem. The global policymakers and administrators seem to have reached such a crossroads one more time, where the conventional practices, accumulated knowledge, and past experiences do not appear to be of much help. Their actions appear driven more by hope than conviction.

The war in Ukraine; the economic slowdown in China; and the monetary policy dilemma in the US and India are some examples of problems where the administrators and policymakers seem to be hoping for divine intervention. I see the recent speech of the US Federal Reserve Chairman Jerome Powell at the Jackson Hole symposium and the minutes of the last meeting of the monetary policy committee of the Reserve Bank of India in this light.

After 16 months of aggressive monetary tightening, the Fed is not confident whether they have done enough; or they have overdone with tightening or they are lagging behind. He reiterated that the policy is restrictive enough to anchor inflationary expectations, but still expressed fears that the high inflation might get entrenched in the economy and may require treatment at the expense of higher unemployment. Chairman Powell indeed sounded more like a sailor trapped in a storm, when he said, “We are navigating by the stars under cloudy skies”.

The situation in the US, as I see it from thirty-five thousand feet above sea level, is as follows:

·         The US Federal Reserve has hiked the key policy rates from near zero (0.25%) in March 2022 to 5.5% in August 2023. This is one of the steepest hikes in the past four decades.

·         The US financial system faces a serious challenge as MTM losses on the bond portfolios are accelerating; retail delinquencies have started to build up;

·         The positive real rates in the US are now 2% or higher. Despite these restrictive rates, the economy is not showing much sign of cooling down. The probability of growth acceleration in the US economy in the next couple of years is therefore remote.

·         Inflation continues to persist above 4% against a committed target of 2%. The household savings may therefore continue to shrink at an accelerated pace.

·         The mortgage rates are well above 7%, the highest in two decades. Housing affordability is at its worst in history.

·         The US government is paying close to US$1trn/year (about 20% of revenue) in interest on its borrowing, which is an unsustainable level.

·         The cost of borrowing (and interest burden) for the US government shall continue to rise for a few years at least as the Fed reduces its balance sheet, foreign governments cut on their demand for the US treasuries, and the rating of the US government’s debt face further downgrades. The fiscal pressures thus remain elevated.

·         The money supply (M1) in the US at US$19trn is about 4.5x of the pre-Covid levels. It may take years to normalize at the current speed of quantitative tightening (QT) by the Federal Reserve.

·        
The “Lower for Longer” narrative has metamorphosed quickly into “Higher for Longer”. However, analysts, economists, and strategists who are in their 30s may have never witnessed a major rate or inflation cycle in their professional careers. Their assessment of peak rates and peak inflation may be suffering from some limitations.

….to continue tomorrow

 The Reserve Bank of India made its last policy statement of 2022 on Wednesday, 07 December 2022. The next policy statement of the RBI is scheduled in February 2023.

 In the current year 2022, inflation in India has consistently remained above the RBI tolerance band of 2-6%. For the month of August Consumer Price Inflation (CPI) was 7%, led primarily by the food inflation of 7.6%. Both rural and urban inflation recorded a MoM rise in August. Unfavourable weather conditions apparently led to sharp rise in the prices of vegetables, fruits, spices etc. However, the core inflation (CPI ex food and fuel) has also persisted over 6% since the past many months; emphasizing the persistent pricing pressures. The IIP growth in July also moderated to 2.4% led primarily by consumer non-durables – indicating pressure on household finances. The sharp rise in household debt, especially the expensive credit card rolling credits, also corroborates the rising stress on household finances.

In view of the elevated price pressures, the Monetary Policy Committee (MPC) of RBI is expected to keep raising rates in line with the global peers. The market consensus is expecting the policy repo rate to rise to 6% (currently 5.40%) by the end of 2022. In his latest statement, the RBI governor stated that he does not expect moderate hikes in policy rates and elevated prices to hurt the growth materially and the economy may still retain the momentum to grow 7% in FY23.

The RBI estimate of growth may be optimistic in view of the poor Kharif crop estimates; challenges to exports; rising interest cost and poor consumption growth outlook. The risk of a global energy crisis in winter is also looming large and could have some negative implications for our inflation and growth outlook.

Inarguably, the claim of the finance minister that India faces zero chance of a recession is tenable. But a growth of 5-6% on a low base would be nothing to celebrate in our circumstances.

Obviously, the financial markets are disregarding the macroeconomic conditions and focusing on micro opportunities, especially the ones driven by policy impetus. In particular the following are some identifiable drivers of the stock markets in the recent up move.

1.    Strong emphasis on enhancing local defence procurement, especially in view of the global sanctions on our largest supplier (Russia) and elevated Chinese threat. The global sanctions on Russia have also presented an opportunity to Indian manufacturers to gain some foothold in global defence equipment and missiles markets; where the efforts of Indian entities, made in the past many decades, have started yielding results. The stocks of the companies that could be potential gainers from higher local defence procurement are favourites of investors as well as traders.

2.    Realignment of global supply chains in the post Covid world is expected to trigger a new capex cycle in Indian manufacturing sector. The potential beneficiaries of this capex cycle like capital goods manufacturers are also gaining traction with market participants.

3.    The most favourite sector in Indian markets is the financial sector. The cleaned up balance sheets after years of efforts and increased margins as the rate cycle turns up are attracting massive investor interest to the sector.

4.    The energy crisis in Europe and the US is also creating opportunities in Indian markets. For example, prohibitively higher energy cost has rendered significant industrial capacities (especially in high energy consuming sectors like chemicals) unviable. Closure of these capacities is allowing some Indian manufacturers to gain market share as well as better pricing power.

5.    The trends in energy security and climate control (green energy, electric mobility etc.) are also leading greater investor interest in the related businesses.

6.    Given the poor growth outlook in Europe and China, the FPI flows have turned towards emerging markets like India. Significant positive flows over the past couple of months have also helped Indian equities to outperform its global peers.

It seems the divergence between the equity market performance and macroeconomic conditions may continue or even widen in the short term. However, over a longer period, say 12-15 months, both invariably converge. Till then its happy times for the investors and traders.

The debate over whether “equity investing” is an art or science is never ending. There are arguments on both sides, but none of these appear strong enough to settle the debate. Almost all episodes of this debate usually end with the compromising statement - “Equity investment is both an art and a science.”

The application of quantitative research and financial models does give it a scientific color. But use of quantitative methods and financial models is highly influenced by the personal preferences, experience, estimates and prejudices of the user. Invariably, the forecasts of fundamental analysts vary based on what parameters they have used in forming their respective opinions. For example, a 50bps difference in weighted average cost of capital (WACC) used by two analysts could give dramatically different assessments for the fair value of a stock. As someone pointed out, fundamental analysis of equity stocks is like navigating a car. While all the cars are designed scientifically, the drivers have distinct styles of driving and the results – time to travel a defined distance, safety of the passengers and vehicle, fuel mileage obtained from the vehicle etc. – largely depend on the style and experience of the driver.

The “art” side of equity investing is even more complicated. Most investors view a particular stock from the vista point they are standing at that particular point in time. Their decision to buy or sell stock depends on their financial, psychological, and social condition at that particular point in time. The decision (and therefore view on a stock) can change dramatically if they move to a different vista point, i.e., their financial, psychological and/or social change.

For example, an investor who invested in a portfolio of stocks 10yrs ago for children's college fees, he/she will sell the portfolio as soon as the children get admission in college, irrespective of the future outlook of these stocks.

Parallel to the debate of ‘science” vs ‘arts”, a lot of mythical investment strategies are also commonly discussed and marketed. The investors, analysts and money managers use terms like “value vs growth”; “cyclical vs defensive”; “large cap vs midcap”; “financials vs technology”, which are mostly mythical and have no scientific basis.

·         Most large IT Services companies count BFSI as their primary customer segment. Most large financial firms are reporting spend on technology as their primary capex. How could possibly the investment in these two sectors be alternative.

·         Auto, Energy, and Banks sector equities have given positive returns over the past 3yr, 1yr and YTD2022 horizon. This period saw one of the most pervasive socio-economic disruption globally and triggered a global recession. Whereas, media, pharma and IT services are the sector that are down on 1yr and YTD2022 basis, though IT and Pharma sectors have given strong returns over the past 3yrs. The question is how would define what is cyclical and what is secular or defensive in this scenario.

·         Midcaps have outperformed Nifty over past 1yr and 3yr timeframe. So what is the relevance of largecap vs midcap debate?

The point I am trying to make is that the investors must avoid these mostly redundant and mythological distinctions and debates and focus on their investment objectives and strategy to achieve those objectives.

 “No brainer” or “mo’ brainer”

What should an investor make out of a situation - when the RBI governor makes a public statement, two weeks before a scheduled monetary policy committee (MPC) meeting, asserting that it’s “no brainer” to expect that the committee will hike rates in the meeting? Especially when this assertion comes a day after the government has taken some very effective fiscal measures to control inflation and less than 3 weeks after the RBI had announced an unscheduled rate hike.

To me, at first it sounded like a confident Central Banker in full control of the situation. He exuded confidence that (i) the external situation of India is strong and the RBI shall be able to manage the current account deficit (CAD) comfortably; (ii) the central government might not have to revise the fiscal deficit target projected in FY23BE since revenue collections are strong; (iii) there are clear signs of growth reviving as reflected in rise in imports despite higher prices and strong exports; and (iv) the RBI is in control of the yield curve and INR exchange rates.

However, on second thought, I feel that the RBI is perhaps as perplexed by the current economic situation (global and domestic) as anyone else. In fact the Governor himself admitted that the situation is volatile and dynamic. Till the February 2022 MPC meeting, the Committee assumed that the inflation is transient and there is no need to tighten the policy but the Russia-Ukraine war changed the dynamics and in April 2022 meeting it was decided to (i) withdraw accommodation; and (ii) hike the effective reverse repo rate by 40bps (that immediately lifted overnight rate by 40bps). Within one month the RBI made an unscheduled 40bps hike in Repo Rate, palpably to preempt INR exchange rate slide in view of the imminent US Fed Rate hike.

The question is when so many external variables, which are not under control of RBI, are operating at different levels, having unpredictable impact on the Indian economy, how could the RBI term a future policy decision “no brainer”?

The Governor admitted that for now inflation is top priority and not the growth. The government appears to be in full agreement with this stance of the RBI. The government has recently diverted Rs one trillion of capex (Road and Infrastructure) allocation towards price maintenance to calm fuel prices. The government has also raised export duties on steel and restricted the export of wheat. The government has also taken measures like hike in subsidies on LPG and fertilizers. Reportedly, the government is also considering limiting sugar exports. Higher cotton prices have reportedly hurt textile exports in the past few months. Recently, the government has also extended the free food scheme for 90million households by six months till September 2022.

Juxtaposing all these, I could deduct the following:

(a)   To control prices, the RBI and Government have decided to sacrifice growth. Higher rates may further delay the private investment recovery. This means the supply side constraints may continue to hinder the growth for longer than previously anticipated.

(b)   The measures taken by the government may hit exports and therefore widen the already worrying CAD.

(c)    The Forex reserves are already down by US$50bn in the past six months. Keeping yields lower and INR stable may require more USD selling by RBI, at a time when CAD is vulnerable. Obviously the external situation might not remain as comfortable as the Governor is asserting.

(d)   The primary factors driving the inflation, viz., extreme weather conditions; global supply chain bottlenecks; Russia-Ukraine war; and Sino-US tensions etc. are beyond the control of the RBI and might continue to put inflationary pressures on Indian economy. So it could very well mean marked stagflationary conditions for a wider section of the Indian economy.

In my view, we all lie in a flux and there is nothing which is “no brainer” at this point in time. The situation is too dynamic to predict anything with reasonable certainty.

Presently, there are two diametrical opposite views about the evolving global situation.

As per the first view, there are conspicuous signs of global growth slithering down as the inflation has begun to destroy the demand, except the food for which demand is largely inelastic. In the recent readings of composite leading indicators have expanded for only one fifth of the countries (vs over 90% in April 2022). PMIs for most developed countries are nearing July 2020 levels. The growth engine of the world, i.e., China is stuttering with the latest growth forecasts fading to 3.9 to 4.5%. The monetary tightening by a number of central bankers has already started to show some results. Consequently, the commodity prices have started to cool down and inflationary expectations should ease going forward. It is therefore likely that the present monetary tightening cycle may reverse much earlier than previously forecasted. This view thus assumes a broad status quo on the present global order.

The second view however assumes a radical shift in the global order. As per this view, the extant global order that is characterized by deflation, independent central banks, globalization, minimum government, rising share of corporate profits in GDP, longer cycles and lower volatility is coming to an end. The emerging global order is remarkably different. It shall be characterized by regionalization, larger socialist governments, pricing power with labor and commodity producers, lower corporate share in profit, high real rates and inflation and poor equity returns.

I am struggling to form a view that lies in between these two extremes.

(mo’ brainer (noun): A situation or puzzle or predicament that is more difficult than it at first seemed; the opposite of a "no brainer"; something that requires more than one person (i.e. mo' than one brain) to figure out.)

After US electing a “leftist” Biden to occupy the White House; Germany elected social democrat Olaf Scholz to the office of Chancellor, France reelected left of center Emmanuel Macron (first reelection of a president since 2002); Italy reelected Christian leftist Sergio Mattarella; and now Australia has elected a leftist Anthony Albanese as the prime minister. The ruling right of the center New Democracy party in Greece has been consistently losing support in opinion polls for the elections scheduled to be held in October later this year.

A number of Latin American countries like Chile, Mexico, Argentina, Bolivia, Peru, and Honduras have elected leftist leaders to lead their respective countries. The opinion polls are indicating that Columbia and Brazil are also most likely to elect leftist leaders in the elections to be held in May and October respectively. In Asia, the Chinese communist regime under President Xi Jinping has strengthened its position.

Moreover, to counter the egalitarian agenda of left of center parties, even the right of center parties like conservatives in UK, BJP in India, LDP in Japan and Yemina in Israel are increasingly resorting to socialist agenda to retain power.

The emerging trends clearly indicate that the rising income and wealth inequalities are driving the political narratives globally. Obviously, this narrative will gain further momentum as the monetary corridor tightens further and fiscal constraints begin more pronounced.

The recent cuts in excise duty on transportation fuel announced by the government of India must be viewed from this angle also.

Over the weekend, the finance minister announced a cut of excise duty on petrol (Rs8/ltr ) and diesel (Rs6/ltr) to cool down the inflation and provide relief to the stressed consumers. The finance minister stated that this cut will have a Rs one trillion impact on the central government budget. She also mentioned that the entire Rs one trillion will be met through reduction in Road and Infrastructure Cess (a part of Central excise on transportation fuel). It is pertinent to mention that the cut of Rs5/ltr in petrol and Rs10/ltr in diesel made in November 2021 was also met entirely through reduction in RIC. The November 2021 cut had an infra budget implication of rs1.2trn.

The union government has levied a Road Cess on sale of petrol and diesel in the union budget for FY99 to create a dedicated fund for construction of roads. The fund was later adopted under a law named Central Road Fund (CRF) Act, 2000. In the Finance Act 2018, the cess was rechristened as The Road and Infrastructure Cess (RIC) as the scope of the fund was widened to include infrastructure.

The Road and Infrastructure Cess (RIC) is collected and levied on specified imported goods and on excisable goods as specified in the Sixth schedule of the said Act. The said goods are motor spirit commonly known as petrol and high-speed diesel oil. The objective of RIC is to provide dedicated funds for development and maintenance of National Highways, railway projects, improvement of safety in railways, State and rural roads and other infrastructure.

The reduction in RIC means almost 10% cut in Rs.11.06trn provided for capital expenditure in FY23BE. This is equal to 75% of the allocation made for NHAI in FY23BE.

Obviously, the immediate relief to the poor from inflation is a higher priority than growth. As things stand today, the tighter monetary and fiscal conditions will continue to challenge the growth ecosystem in near future. This implies that supply side challenges that are threatening the global economy may continue to persist till a new growth paradigm emerges. In the meantime, the economic policy will continue to be a constant struggle to avoid stagflation.

 In its latest policy statement, RBI has reiterated its unwavering commitment to growth, ignoring the concerns about it missing the inflation curve. There are not many precedence in past two decades when the RBI has shown such unwavering commitment to growth despite mounting inflation concerns and global tightening pressures.

The decision of the Monetary Policy Committee of RBI to maintain status quo on policy rates and keep the policy stance “accommodative” despite mounting inflationary pressures has provided some relief to the financial markets. However, it has divided the experts on the mid-term economic impacts.

The bankers have generally welcomed the RBI’s policy stance as credit and growth supportive. However, economists believe that this leniency on inflation may not end well. They believe that this profligacy of RBI will leave it much behind the curve and force it to make disruptive tightening in mid-term.

There are some questions over the autonomy of MPC also. A small section of analysts believes that the government may have hijacked the MPC agenda, forcing it to ignore its primary mandate of price stability; and support the government through continuing monetary stimulus.

In my view, the monetary Policy Committee (MPC) and RBI have taken the most appropriate path by staying focus on growth.

There is no conclusive empirical evidence available to indicate that RBI has been able to influence prices through monetary policy. On the other hand, the monetary stimulus (lower rates and accommodative liquidity) has invariably shown positive results. This is particularly true in episodes of inflation with negative output gap, implying underutilization of capacities.

There are ample indications to suggest that RBI is working in close coordination with the government. Sharp cut in duties on transportation fuel 2 weeks ahead of MPC meet shows that the government is addressing the RBI concerns on prices.

RBI’s lower inflation forecast for next quarter, when the US Federal Reserve Chairman has indicated that the inflation may not be transitory as believed earlier and OPEC’s resolve to maintain prices around present levels, further indicates that RBI is comfortable with the government’s assurance to reign energy prices.

The latest Monetary Policy Statement of MPC also does not seem to concur with the US Fed assessment on inflation. It continues to believe that inflation is transitory and it will ease in next few months.

To summarize, RBI has made it clear that the monetary policy shall remain consistently growth supportive for next many quarters. It will wait for conclusive evidence on stabilization of growth trajectory before changing its policy stance. Any changes till then will be implemented by managing the liquidity through open market operations.

The governor highlighted in his press statement that “the Reserve Bank has maintained ample surplus liquidity in the banking system to nurture the nascent growth impulses and support a durable economic recovery. This has facilitated swifter and more complete monetary policy transmission and the orderly conduct of the market borrowing programme of the Government. The Reserve Bank will continue to manage liquidity in a manner that is conducive to entrenching the recovery and fostering macroeconomic and financial stability.”

The latest GDP data released by the government has evoked mixed reactions. While less than contraction (-7.3% yoy) in overall FY21 real GDP is a matter of comfort, sharp contraction in private consumption and continued weakness in manufacturing (-6%) is a subject to be worried about. The better than expected economic performance has mostly been outcome of strong government consumption expenditure and large subsidies extended as part of various tranches of stimulus.

In the last quarter of FY21, India’s real GDP witnessed a growth of 1.6%. This is in spite of a poor base of mere 3% growth in 4QFY20 (disruption started in the base quarter) and significant relaxations in lockdown restrictions. This clearly indicate that normalization of economic activities might take much longer than earlier estimated.

I have always stated that quarterly growth data has little relevance for investors. It may hold some relevance for the policymakers to assess if any course correction is needed, but for a common investor it virtually has no meaning.

I also believe that extrapolation of annual real GDP growth data to immediate future years may also produce misleading results. The large projects that started in a year contribute to GDP through Gross Fixed Capital Formation (GFCF) head. However, the second and third round impact of these projects takes years to reflect in GDP growth; whereas the second round impact of consumption expenditure are usually visible relatively in lesser time. It would therefore be appropriate to judge the longer term trend in GDP growth to assess the likely growth trajectory in short term, (1-2years). I usually use 5year rolling CAGR in GDP to assess the likely growth trajectory of GDP in next couple of years.

This trend forewarned of a prolonged economic slowdown as early as FY11-FY12 (see chart). The long term (5yr CAGR) growth trajectory slipped below 6% in FY20, even before the pandemic induced slowdown was triggered. If we adjust the growth for FY21 and FY22 for sharp fall in FY21, and assume a 9% real GDP growth for FY22, we may end up with almost no growth during two period of FY21 and FY22. Assuming a further 8% growth for FY23 and 7% thereafter, we shall be able to attain the long term 6% growth trajectory only in FY27. A higher trajectory would be possible only post FY27. This essentially implies the following, in my view—

1.    The fiscal leverage with the government will become incrementally lesser. So unless the government decides to shed its inhibition and increase the capacity of its printing press, sustaining higher government consumption expenditure will become increasingly challenging.

2.    The private consumption demand might not improve materially in next couple of years as real household income remains stagnant. Discretionary consumption growth will particularly be impacted.

3.    The manufacturing growth will largely depend on exports and capacity building for import substitution. Technology leadership would be more important than the capacities.

4.    Construction and construction material sectors will overwhelming depend on government expenditure on capacity building.

5.    For next couple of years agriculture would remain mainstay of economic growth.