Financial markets over-optimistic?

Finance has made peace with the five big threats

Uncertainty rose dramatically in February 2022. In February 2023, my column here in Business Standard was titled “Certainly, uncertainty has declined” (https://mybs.in/2cCJLMS). Many things have gone rather well in the year that followed, and perhaps the financial markets are over-optimistic.

The grand question of the last year was about restarting the economy in developed markets (DMs) after Covid. Large-scale monetary and fiscal stimuli had given a burst of inflation. Unlike the inflation crisis of the 1970s, there was predictability on policy strategy, thanks to inflation targeting. But there was a lot of gloom about the harm to gross domestic product (GDP) or employment that would materialise to wrestle inflation down.

In the event, things worked out rather well. DM inflation has declined nicely without significant damage to unemployment or GDP growth. We now have a global economy defined by strong growth in the US, low growth in China, and weak growth in Europe and Japan. Projections by the International Monetary Fund for real GDP growth in 2024 are 2.1 per cent for the US, and 0.9 per cent for the euro area and Japan.

The first DM interest rate cuts would be symbolic, saying that the post-Covid inflation phase has ended. The financial markets are optimistic about such events in 2024. Two key uncertainty measures are the VIX (volatility index) and the MOVE (Merrill Lynch Option Volatility Estimate Index). Over the last year, the VIX dropped by 29 per cent but the MOVE has been unchanged. If DM interest-rate cuts commence in 2024, this could kick off a next wave of strong capital flows into India.

It is an interesting moment in the world economy, to understand the forces at work, to peer into the future, and to think about the implications for us in India.

Why did DM inflation decline so well? The supply disruption caused by the pandemic has ended. Along the way, Russia tried energy blackmail upon Europe, which successfully solved it. The US is now the world’s biggest gas exporter. An optimistic interpretation of transitory inflation in the late days of Covid was that firms needed to be given attractive margins for some time, to pay the fixed costs of restarting production.

Why did the US do so well? Partly, it was the recovery from the pandemic, with a dose of good luck. The US labour market has greater flexibility than other DMs do. The Joe Biden team is a normal DM-quality governing arrangement, compared with the populism that preceded it. Somewhat better thinking, across hundreds of policy decisions, makes a difference.

The defence industrial base in Europe and the US is slowly being cranked up to a higher level, away from the post-1989 slumber, in response to the Ukraine war. While the dollar values of defence spending are as yet small, procurement processes are often triggering new investments in manufacturing capabilities which had otherwise atrophied. What appears to be $1 of procurement is triggering investment at many steps in the long supply chain.

There are five important threats for 2024.

1. Many countries have election in 2024, and many populists may win. As an example, Viktor Orban’s defiance is partly based on his gamble that there will be more populists like him in the European Union within a year. Election year incentives will trigger odd behaviours by many governments. If Donald Trump becomes US President, there will be turbulence worldwide through problems like Ukraine and climate change.

2. Russia’s invasion of Ukraine continues to roil the world. If a country can invade a neighbour, there is no international order. This war feeds into global instability in many ways. As an example, it is hard to imagine Iran’s aggression in West Asia without the conditions created by the war in Ukraine.

3. The third globalisation (https://mybs.in/2b0dn6w) — the phase where access to the core is restricted for countries in the periphery with low foreign policy and military alignment — is falling into place. While it improves incentives in international relations, it comes at a price in economic growth.

4. Very high levels of leverage all around create the possibility of accidents. What is remarkable so far is how little went wrong when DM central banks raised so much. But we are not out of the woods yet.

5. Finally, there is the model risk. As was often emphasised from 2020 onwards, we are in new terrain. Prevailing models and theories are formed out of datasets drawn from more normal times. Whether in the minds of policymakers or financial players, there is a greater risk of making mistakes.

The financial markets have climbed this wall. They display high optimism in their value of the S&P 500 and the VIX (though less so with the MOVE).

Turning to an Indian perspective, the best measure of Indian exports is to focus on goods and services excluding petroleum products and gold. By this measure, exports have been roughly flat from February 2022. The unusually good DM performance from February 2022 has not, thus far, fed into Indian exports buoyancy. If DM economic buoyancy continues, will Indian exports revive? If it does not, Indian exports will suffer.

While the fighting in Gaza is not an important high-intensity war on a global scale, it is important for India because of the difficulties of shipping through the Suez Canal. The traffic from India to Europe and the American East Coast, through the Suez Canal, suffers significantly higher transportation costs when rerouted through the Cape of Good Hope. Bombay and Karachi are the two ports in the world where the Suez Canal matters the most.

Given the weakness of investment in India, there is no large current account deficit that requires financing. Hence, changes in global financing conditions will not create complexities on the rupee. However, there could be repricing of many assets, eg there is a connection between the VIX and the valuation of Indian assets.

The writer is a researcher at XKDR Forum