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The Fed continues to keep the market guessing on the QE3 rollback. What do you think would be the roadmap?
We are currently in a situation of extraordinary monetary policy. We have never exited a QE. So, there is no roadmap for this. Investors need to appreciate that this is uncharted territory. One thing the central bank has introduced is the idea of forward guidance. The problem at the moment is that if it hints at ending the extraordinary monetary policy, the market tightens. I don’t believe the Fed when it the minutes of the May 22 meeting had intended to increase mortgage rates. They were forced to backpedal and introduce ambiguity rather than focusing on specific targets.
It’s an experiment for central banks. Currently, the 10-year yield is at 2.5 per cent and the Fed fund target rate at 0.125 per cent. The destination is neutral policy, which is five-six per cent on US 10-year bonds and four per cent on the Fed fund target rate. I am not sure when they will reach that destination. Maybe 2016 or 2017.
Do you expect the process of QE unwinding to be turbulent?
The Fed is experimenting. The initial part of the experiment in May did not work very well. It blindsided the market which took a long position on bonds after the Bank of Japan governor (Haruhiko) Kuroda’s speech about quantitative and qualitative easing on April 12. Investors, including us, incorrectly concluded that the BoJ QQE is bullish for bonds. It was actually bearish for bonds. So, markets are badly set-up for the hint of tapering.
And, I don’t need to explain to someone in India as to what happens to an economy running up a current account deficit (CAD) when a change in QE is hinted. There is a great fixation on the extent of tapering. But, what is more important is the signal of the start of an unwind of QE. At the moment, it looks like the second quarter of next year is most likely. The logic is that the (US) debt ceiling and budget debate have been kicked into January. So, it’s quite possible that in the first quarter of its FY14, the US economy is weak due to the policy uncertainty. If they resolve the debt debate in that quarter, we could see a strong second quarter. The Fed has said it’s data-dependent. So, the market should also be data-dependent.
How are emerging markets (EMs), including India, broadly placed to deal with this scenario?
We are overweight on EMs on a global basis. EMs, after such substantial underperformance, have discounted structural problems. We are seeing a more resilient earnings profile than what was expected. So, I am quite constructive on EMs. For countries with a high CAD like Brazil, India and Indonesia, the next few months will hopefully see the CAD declining, central banks building forex reserves, central banks telling companies they should not have any unhedged liabilities.
How vulnerable are India and other EMs to Fed tapering?
The vulnerability here is more from bond markets than equity markets. The Indian bond market is relatively closed. In Indonesia, 35 per cent of the bond market is owned by foreigners; in Malaysia, it is 40 per cent. If we enter a bear market in bonds, EM bonds would be part of it. That’s where the vulnerability is. India is better placed because balancing of the CAD has been through equity and FDI (foreign direct investment) flows. What the market wants to see is whether the delta on its CAD is narrowing. Pushing through energy reforms will be crucial, due to the size of crude oil imports. The other point is what happened on May 22 was a big wake-up call. The markets over-reacted to it. Now that we had a recent experience, markets’ reaction should be more considered.
Is the worst over for the CAD and the rupee?
At the moment, the CAD is moving in the right direction. But, it is correct to be cautious about short-term optimism here. I would be happy if the rupee moves in the 62-65 (to a dollar) range. I don’t think the rupee weakening a little bit from here is a bad thing because it is a form of stimulus, though it is hitting the economy in the form of higher subsidy bills.
How are foreign investors approaching India, with elections around the corner?
Foreign investors have very little confidence in predicting the outcome of elections next year. If there was a consensus, it could be that the Congress party would form a very weak coalition. But foreign investors do not come to India because of governments and policies. They come because companies have developed businesses which are, to some extent, less dependent on policies compared to companies in China. Foreign investors will continue to buy Indian equities if these offer growth. And, earnings growth next year is expected to accelerate. Even in a bad year, it is better than other EMs and developed markets. The relevance of politics for foreign investors is lower than what it is for domestic investors.
What will be impact on global liquidity once Fed tapering begins?
We have QE from the European and Japanese central banks. And, there are no signals from them that they are going to stop it. So, there could be a migration of carry trades to Japan and Europe.
At this point, which market do you prefer, India or China?
We are neutral India and underweight China. We are a buyer of India, as of now. China’s leadership is talking about reform. I think people underappreciate what that really means. It could mean a significant slowing in the Chinese economy, which is good because it builds a stronger foundation for the long term. There is a perception that China has very high growth but I think that model is coming to an end. China’s debt to GDP is circa 200 per cent. China needs to stabilise this.
China is not as economically important to other countries as many people think it is but it is important for EMs (in terms of portfolio correlation).
