The job scene is buoyant. It is expected that most of the people seeking jobs would get one and hence the savings they may have accumulated during the taper period could continue/with sustained consumer confidence be used for consumption.
Agarwal has over 27 years of experience in the capital markets, and brings in immense and expertise across domestic and international broking houses. In his previous assignments, he has held senior positions as Head of Equity in Bharti AXA Investment Managers, Head of Equity ABN AMRO AMC and as VP & Head (Strategy and Research) at SBI Capital, where he was the youngest team leader heading a full-fledged research team.The US Federal Reserve (Fed) is expected to taper slowly over a period of time. Expectations are that around $15 billion would be reduced every month out of the current run rate of $120 bn a month of asset purchases. This implies that Fed balance sheet would actually continue to expand deep into the next year. US government deficit financing would also mean a continued expansion of the Fed balance sheet. We see the following panning out:
The US government has stopped giving unemployment benefits to the population. It is estimated that 7.5 million people would have received their last cheques in September. This reduces the fiscal deficit for the government and actually reduces the need for the Fed to continue buying government securities. Hence, in the first few months there is a chance that the yields will continue to remain at lower levels.
The job scene is buoyant. It is expected that most of the people seeking jobs would get one and hence the savings they may have accumulated during the taper period could continue/with sustained consumer confidence be used for consumption. Wages would increase tax revenues and reduce fiscal deficit. It helps that at the start point, the household leverage is lower and savings significantly higher than when taper was last experienced in 2013. The impact on US purchasing power should be minimal.
Fed asset purchases were probably more than what was needed and resulted in excesses around the world. This should be expected to normalize. However, if we see the trend of FPI flows, India has received only normal flows, around $45 bn over a period of 2019 to YTD, an average of around $17 bn assuming we get less than $10 bn in 2021. Versus this, we received $60 bn in 2012 to 2014 period, an average of $20 bn when our economy and markets were much smaller. Global liquidity sloshing around has probably missed India.
Moreover, the impact of foreign flows into Indian equity markets has been reducing over time and the direction of the market is now more determined by Indian money both institutional and retail. Indian money flow into equity has accelerated. MFs have been getting record inflows. Retail demat account additions are increasing at record pace. Given the low penetration vs rest of the world and a younger population, this trend could sustain. Indian markets would be directed by domestic flows vs international.
Reduced supply of money also makes USD scarce and it has a tendency to appreciate against other currency and investments return to the US. This causes other markets to see stagnation in market performance. However, even after taper has started, the US balance sheet would continue to expand for some time as asset purchases continue at a lower pace. Moreover, the balance sheet would contract only when the paper bought is redeemed and this also provides more time. This implies that other countries can also continue to keep looser than usual monetary policy if there is a need for the same.
The Fed has kept yields in check by targeted buying of bonds. If the Fed buying reduces, yields should be expected to increase after the first few months. Market has been tested up to 1.5% yields and once taper starts, it could be higher.
India did witness a sharp currency depreciation in the past taper period of around 27% over 2012 to 2018 period from 55 to ~70. However, our bond yields spiked only briefly and came back into control and dropped from 8.05% in 2012 to 7.37% in 2018. The currency has been very stable between 2018 and present, depreciating by a total of around 4-5% as currency reserves have spiked by $250 bn. This should imply better stability of currency this time. Moreover, with inflation converging with the west, there is a chance that our yields also converge more, as they have over the past 10 years by around 1.5%, over the next few years.
Here, let me point out a good development for India. Indian bonds are expected to be included in 2 major global indices (JP Morgan and Bloomberg) towards the end of 2022. This should result in passive flows of around $35 to 40 bn. This flow should help keep currency stable during taper and keep domestic bond yields soft.
Impact on Indian equity market
Presently, the Indian government finances are in a very good health with buoyant tax revenues and supply of government paper has been lower than anticipated. This provides room to RBI to keep interest rates at low levels and adjust them according to needs of the Indian economy rather than otherwise. Liquidity in the system is at a high level and banks are regularly parking large sums with RBI.
While the world focuses on the point of announcement of taper and the period of reduced bond buying, actually the Fed balance sheet may continue to expand for a considerable period of time and only start to contract as the paper that it has bought is redeemed. This typically happens over a period of a few years and becomes the actual period of reckoning. As the table shows that while the last taper started in 2013, the Fed’s balance sheet continued to expand in 2014 as a percentage of the economy and was at similar levels in 2015 and 2016 vs 2013. Strong decline happened in 2018 only.
If we look at the period of 2013 and 2014, the period when past taper started, in both of these years, FPIs were strong buyers of Indian equity and markets did deliver positive returns. However, in a period of 2018 when the Fed balance sheet shrunk, our returns also were small. Currency did depreciate sharply between 2013 and 2018 while yields continued to soften except for a brief spike. Currency depreciation impacts the offshore leveraged trade but is a positive for the domestic economy. With lesser reliance on offshore money, it could mean a better domestic market in INR terms.
When we examine the performance of Indian markets in the post taper period, it seems to be dictated more by domestic factors vs global money flows. Performance of our markets got impacted on account of banking sector issues which surfaced from 2015, demonetization in 2016, and ILFS crisis in 2018 which impacted liquidity. We believe that the domestic market performance is more on account of domestic corporate profit performance vs any global issues and in any case inclusion in global bond indices would provide the liquidity support. This time around, hence we believe that the impact of tapering would be very limited, and may be different, if the confidence of domestic investors sustains.
In any case, in the period of taper and beyond, the high-quality free cash flow generating, strongly growing part of the market continues to do well. This is a part that we focus on. It helps that in such periods, typically, commodities soften and margins of the commodity users with pricing power expands.