Europe is witnessing a protracted war; the Middle East has erupted. How do global fund managers view India amid the upswing in geopolitical tensions?
In the case of India, which is playing a neutral role from a geopolitical perspective, it would be a beneficiary of more FDI flows. India remains an attractive investment destination, in particular, due to rising geopolitical tensions. The US remains the main trading partner as well as one of the main sources of FDI. Its neutral geopolitical position has benefited the country in terms of FDI flows and international business. Redirection of FDI into friendly destinations can be seen in the data and India is benefiting in particular relative to China with regards to FDI coming from the US. Again, one thing is hot money, and the other thing is more stable long-term flows like FDI. For hot money, I would say that other countries probably come first. India comes within the top three in terms of potential flows, even if it’s from reshuffling of FDI driven by the new geopolitical equilibrium.You mentioned the realignment of trade towards friendly countries. What are the global patterns playing out?
We are seeing how trade is being redirected towards friendly countries. For instance, if you take a look at the exports of China – they are exporting less to the US, Europe and Japan and are exporting more to the Belt and Road countries. We are seeing how FDI coming out of the US is being redirected away from some countries to others. India can benefit a lot from that. That is going to happen independently of what happened to US rates. Higher real interest rates in the US are always a drag for inflows into EM in general, though this is more relevant for short-term capital flows rather than FDI.
The abrupt transition to higher interest rates globally since last year has caused much turbulence in emerging markets. When can we expect some relief?
From a macro perspective, speaking in terms of emerging markets in general and assuming that our baseline scenario is correct and materialises, probably the sweet spot for emerging markets would be around the second quarter of next year. If we are right that the US Fed will start cutting rates in June, probably they would start telegraphing or communicating that to the market around March and then the market will reprice the easing cycle. If it’s a soft landing, you’re going to have probably the US stock market liking the story because the stock market becomes happier when interest rates go down and earnings are revised up.
But what happens to the emerging markets?
In that scenario, the dollar will weaken. So, the end of the hiking cycle is a necessary condition for emerging markets to trade well. The problem is that the end of the hiking cycle now is contaminated by pressure coming from fiscal policy. So, the end of the hiking cycle is not enough to cause the end of the selloff in US rates. So, you need more. And that more, is the beginning of the easing cycle. Ripples from the volatility in the US bond market are being felt worldwide. With fiscal dynamics giving a structural lift to US bond yields, how much higher can they climb from their current 16-year highs?
There is an ongoing debate whether the increasing real rates that we are observing is driven by a productivity boom in the US or by fiscal policy. It’s true that the curve has steepened. People interpreted that selloff as an increase in what is called R-star (real neutral rate of interest). I am in the camp that this is mostly about fiscal policy. Let’s not forget that the fiscal deficit of the US is going to be around 7.5 points of GDP and that number is really high.
What is the outlook for the US dollar? Globally, policymakers have flagged risks to growth from tighter financial conditions and a stronger US currency.
Since this bond selloff happened, even though the US dollar appreciated relative to other currencies, it didn’t appreciate as much as it would have if the selloff had been driven by productivity growth. It’s a fiscal story and there is a fiscal premium that is obviously negative for the dollar.
The rest of the world is less willing to finance the US fiscal deficit. I would say that China, for geopolitical reasons, is not going to be buying US treasuries. They are actually selling treasuries at the margin. And Japan is normalising interest rates. They will start unwinding yield curve control.
Japan’s recent tilt towards policy normalisation comes after years of ultra-low interest rates. What does this mean for global interest rates?
Japanese lifers (insurance companies) and banks usually were big holders of treasuries. The way they do it is typically hedging the interest rate risk back to JPY. So, the Japanese curve is bear steepening while the US curve is still too inverted or flat relative to the Japanese curve. That means that we should expect, over time, more repatriation into Japan and therefore less willingness to buy US treasuries.