Vijay Kumar Gaba

 A recent Reuter’s article (see here) drew attention towards some ominous signs emanating from the bond pricing of emerging markets that are more vulnerable to default on their sovereign obligations. Noting the signals like weakening currencies, bond spread widening beyond 1000bps, and dwindling Fx reserves, it concludes that a record number of developing economies might be “in trouble” now.

More than US$400bn worth of sovereign debt could be facing default. While the countries like Russia, Sri Lanka, Lebanon, Zambia etc. have already defaulted on their obligation, the usual suspects like Argentina and Pakistan etc. appear on the precipice of a default. The serial defaulter Argentina (US$150bn); Ecuador 9US$40bn); and Egypt (US$45bn) may actually default much sooner. If the war drags on for a couple of more months, Ukraine may also default on US$20bn debt payments.

Of course, the sovereign defaults are not new and the US$400bn default might not look massive in the context of trillions of dollars of new money created in the past one decade. Nonetheless, so many countries defaulting in a short span of time could have serious consequences for the global financial system. For one, it could trigger a contagion if some large global institution like Lehman Brothers collapses under the weight of such default. The worst however would be if the ‘default’ loses the moral stigma attached to it, and many profligate nations find it convenient to default and start afresh.

It is pertinent to note that the Bank of Japan (BoJ) owns more than 50% of the debt taken by the Government of Japan. This effectively means that Japan has borrowed about USD one trillion from the JPY printing press in the three years 2020-2022. Considering the deteriorating demographics and anaemic growth over the past three decades, it is obvious that Japan is ‘riding a tiger’. Many developed countries like Italy and Greece are also trapped in a vicious low growth high debt cycle. Obviously, getting out of this trap is not feasible in the normal course of business.

The most relevant question at this point in time therefore ought to be “how the global economy gets out of this extortionate high debt-low growth trap?”

Historically, the following methods have been used by the governments to break out of the low growth high debt trap:

1.    Currency debasement by stimulating high inflation for long or devaluing the currency.

2.    Financial suppression by keeping the real rates negative for long.

3.    Fiscal tightening by increasing taxes disproportionately and/or reducing public spending.

4.    Incremental improvement by gradually tightening the monetary policy.

5.    Defaulting on debt obligation and negotiating waivers with the lenders.

 Markets in 1H2022 – As tough as it could be

The first half of the current calendar 2022 was perhaps one of the toughest six month periods for the global markets. In fact, for global equities, the 20% fall in MSCI All Countries index 1H2022 during 1H2022 is the worst ever on record.

The global government bonds are also having the worst year in 150years, as the global central bankers reversed the course of monetary policy. Indian benchmark yields have risen 14.5% during 1H2022.

Energy and Food prices have risen in this period, largely due to war between Russia and Ukraine; but other commodities like industrial metals, steel, and precious metals have mostly shown a downward trend. Gold (-1.3%) is trading marginally lower while silver (-15.6%) has lost in line with industrial metals.

The new age assets like cryptocurrencies have also been decimated in the global melee. The bellwether bitcoin lost over 58% of its value during 1H2022.

USD has gained close to 10% during 1H2022, while JPY and GBP have been significant losers. INR has been a relative outperformer.

 Equity Markets in India

Indian equity markets had their share of pain during 1H2022. Though the benchmark Nifty50 fell ~9.5%, outperforming many major global markets, the pain felt by the investors was significantly deeper.

The market breadth was extremely poor. Only 35 stocks registered gains for every 100 shares declining. The smallcap Index was down ~25%. Besides, the sectors where most exuberance was seen in the past couple of years, namely, IT Services (-28%), Realty (-19%) and Metals (-16%) underperformed the benchmark index materially.

The net institutional flow to the secondary market was marginally positive, though the foreign institutional investors were major sellers (Rs2.25trn).

Anecdotally, non-institutional and household investors usually have largest exposure to the sectors that are showing highest momentum; and hence may have lost much more value than the benchmark Nifty may be indicating.

The market activity has diminished materially in 2Q202, further indicating that the non-institutional and household investors that played a major role in the secondary market in the past couple of years, might have withdrawn to the fringes.

Nifty yielded positive return in 9 out of past 10years

Notwithstanding the global problems (Grexit, Brexit, Taper Tantrum, Covid-19) or local issues (Demonetization, GST, drought, slowing growth, Covid-19), Nifty50 has yielded positive return in 9 out of 10 years (2012-2021). The negative return in 2022 (if at all) must be seen in the light of strong performance in 2020-2021.

First episode of major FPI selling in Indian equities

The foreign institutional investors were major sellers in the market. As per the final figures released by the SEBI, the Foreign Portfolio Investors (FPIs) sold INR2.25trn worth of Indian equities in the secondary market during 1H2022. The selling particularly accelerated in 2Q2022, as the war between Russia and Ukraine intensified and Fed committed to larger rate hikes. In Asia, as per the Strait Times, the foreign investors sold USD40bn worth of equity in 7 Asian markets; of which India accounted for ~USD14.5b.

In the past, FPIs have been net sellers in three out of the past 20years. In the past 10years, they were net sellers only in 2015 and 2021. However, in no case the selling was major in relation to the total market or the total FPI holding.

Nonetheless, the net institutional flows in Indian markets remained positive for 1H2022, as the domestic institutions pumped INR2.32trn into the market. There has been no instance of net negative institutional flow in the Indian markets so far.

Global markets

The global markets are arguably witnessing the worst meltdown since the global financial crisis. The pain is visible across asset classes like equities, precious metals, bonds, cryptocurrencies and industrial metals. Only energy and agri commodities have yielded positive returns.

The developed market equities led by USA and EU have been the worst performers, followed by emerging markets and Japan. Volatility has spiked sharply.

Reversal of monetary policy direction has resulted in sharp decline in bond prices, leading the yields higher. USD has accordingly strengthened.

Though inflation has been one of the top concerns, the traditional hedges like Gold and Swiss Franc have not been in demand, as has been the case historically. The decoupling of traditional hedges from inflation trajectory has substantially complicated the trading strategies. Obviously, the jitteriness and bewilderment is materially accentuated as compared to the previous episodes of global market corrections due to macroeconomic factors.