2015 Outlook - In a World Driven By Central Banks

Looking through the Dust Storm

Merry Christmas! Santa has come ringing bells for oil importing countries much before X-Mas with gift of almost 50% fall in crude oil prices.  However, the pace of fall in crude prices should ring alarm bells for 'stability' in the short term.  And yes, it did so for Bank of Russia! On 16th December - just four days after the scheduled policy meeting when Bank of Russia raised the policy rates by 100bps - the central bankers hurried for an early morning (1a.m.) emergency meeting and further raised the policy rate by a whopping 650bps to 17.25%. The event reminds us of Black Swan which, once rare, have started frequenting more often now-a-days. Alas! Whether it's a Black Swan, we will come to know only post-facto. One thing for sure, after much of a calm for the whole of 2014, the world has suddenly been covered under cloud of uncertainty and volatility. In this note we have attempted to see through this dust storm and find that, there is no immediate cliff but a short road ahead (my guess is the world will borrow 12-18 months) and that's it is!

Oil at $60! What does it mean to the World and India?

The decline in crude prices is a major boon for oil importing countries on many fronts - lower cost of living, improved consumer sentiments, easing inflation, lower cost of capital, stronger currency and last but not the least, lower current and fiscal deficit for these countries. Clearly, India is one of the biggest beneficiaries of the falling commodity prices. On the other hand, lower oil prices pose major challenges for oil exporting countries from Middle East, Russia and Venezuela the exact opposite would hold true - depreciating currencies, dwindling budget deficit, soaring inflation and higher cost of living. Collectively, these oil exporters account for less than 9% of world GDP (excluding Canada and Mexico as energy sector contribution is not significant to their GDP) and hence mathematically should not derail the world growth story. The cascading effect, however, could lead to some nasty outcomes.  The construction boom in Middle East and global Oil & Gas Capex would be the direct casualties while banks with heavy exposure to these sectors/regions could be the indirect casualties (SocGen's exposure to CIS stands at a staggering Eur24bn or ~60% of its equity). We believe that global economy and financial system is much stronger today and will successful tide over these challenges. The bigger problem is brewing elsewhere.

Welcome to the World of Deflation

	CPI Inflation	Core Inflation*		CPI Inflation	Core Inflation*
US	0.3%	0.1%	Europe	0.3%	0.7%
UK	1.0%	1.2%	- Germany	0.6%	1.1%
Japan	2.1%	2.2%	- France	0.3%	- 0.2%
Canada	2.4%	2.2%	- Italy	0.2%	0.5%
China	1.4%	1.3%	- Spain	- 0.4%	-0.3%
Australia**	2.3%	2.1%	- Sweden	- 0.3%	0.6%

*Core Inflation excludes Food and Energy **as of Sep’14

If we have to simplify the things, with Crude Oil & CRB index as guideposts, there is clearly enough evidence that the animal called inflation seems to be dead, at least for a foreseeable future. Whether the crude will settle at $55, $60 or $70, is anybody's guess. One thing is reasonably sure that it won’t be back to $100 any time soon. CRB index (global commodities’ indicator) is closer to 2008 lows in a world which has moved ahead 6 years. US 10-yr Treasury yields have declined by 30%+ in a year when Fed had wound up QE and experts are discussing timing of first rate hike. The current inflation in most of the countries which would drive global monetary policies is in the range of 1-2% (see Table above) and unless there is dramatic price rise across the asset classes, inflation will continue to slow down gradually to negative zone. And that’s a problem.

Why does Inflation matter?

Price Stability is one of the most important mandates for policy makers world over. Bank of England defines price stability as Government’s inflation target of 2%. European Central Bank states that the primary objective of ECB’s monetary policy is to maintain price stability and target inflation rates of below, but close to 2%. US Fed as well as BoJ also maintain same 2% inflation target. This struggle and desire to maintain a LOW and STABLE inflation environment is for the fact that manageable low inflation is critical for the steady growth of global economy. Inflations at manageable level is also critical for equity investors as it is a key source of corporate pricing power. The economy, as measured by GDP, is mainly composed of wages, indirect taxes and corporate earnings*. In general, wages are linked to inflation benchmarks while corporate earnings are driven by consumption demand.  Falling prices lead to both, lower wages and lower corporate profits and can push economy in a depressive spiral. A question one should ask is, if inflation is manifestation of growth (demand > supply) then isn’t a falling inflation concealing a slowing world ahead? It is! Inflation matters because lack of it can derail the global growth story. Worst, there are not many bankers out there or for that matter Corporates, who have much of prior experience or a clue as to how to respond to a deflationary environment. Deflationary impact on investment and debt are even crippling.

 (*Resource Cost Income Approach Equation:  GDP= wages + rents + corporate profits + interest + Indirect taxes + Depre + Net Income of Foreigners. As a thumb rule wages and corporate profits account for 80-85% of GDP)

In a low inflation and faltering growth will continue to keep interest rate low and fuel market rally

Managing (strong and stable) growth, inflation and currency are the key tasks of a Central Bank. Unfortunately, these are interlinked in such a way that not all of three can be achieved at the same time. Depending upon which one of these three is at a greater risk, goal post for a Central Banker keeps changing.  Given the complexity of equation, most of the market participants fail to keep up with the changing dynamics and therefore fail to see consistency in actions of policy makers. RBI Governor, back home, has refused to drop the interest rates despite inflation falling in the comfort zone. Apart from the fact that he wants more time to conform the fall in inflation is more permanent than temporary, I fear, the Governor, is worried about Fed action on interest rate,  in near term – any hint of or actual rate hike by Fed will send US Dollar in a sharp upward spiral and emerging market currencies could be the biggest casualties. Basically, his goal post could then shift from reigning Inflation to defending Rupee and if things go bad on that front, he won’t cut the rates.

Let’s look at the world of Central Bankers on these three parameters.

Country	GDP Growth	Inflation	Fx	Goalpost	Policy Action
US	Strong - Ahead of expectation, not a cause of worry for Fed	Dangerously poised to derail recovery in economy	Strengthening – not a cause of concern on its own but for inflation	Inflation – up it to targeted 2%	Continue with current low interest rates and don’t let USD appreciate much
European Union	Faltering – if not addressed urgently could lead economy back to recession	Way below target	Depreciating aga USD	Growth – Steer economy away from danger of deflation	Keep interest rates low Plus add stimulus
Japan	GDP decline in Q3 has put economy back in recession	Successfully  upped to 2%+	Depreciating sharply – architected by policy initiatives	Currency – Continue JPY devaluation to up growth & inflation	Continue with Abenomics – increased bond purchases and stimulus
China	Growth below target @ 7% and softening further	Not a problem	Appreciating against competing nations	Growth – Add stimulus and defend Fx competitiveness	Lower the interest rates to support growth and RMB

US is the only country which has stood out over the past 1 year in terms of any signs of sustainable improvement – GDP has bounced back to 3% plus and unemployment down to . However, in an increasingly interwoven world US rates will continue to be guided by competing interest rates, Europe in particular. The table above aptly bring out that lower interest rates would continue in the world and so the support to equity markets, in terms of both – higher valuations due to lower discounting factor (lower capital cost) and higher fund flows due to relative attractiveness compared to other asset classes.

Risks for the world economy going into 2015 will be lower than expected growth rate. If the same gets translated into lower earnings then it could be a dangerous as the onus could shift entirely on lower discounting rate and further stimulus by Central banks to support the market rally. It not only difficult but actually hazardous to peak into the future but still we would do it as a roadmap is necessary to guide through to the destination. If there be storms on the way better be prepared just to improve the chances for survival. That said, to conclude, expect growth to be lower, markets to get support for a while from lower rates/stimulus but then eventually fade away by late 2015 or early 2016. Hopefully India will survive this dust storm and will eventually realize its potential.

Back home, Indian economy still in a cyclical recovery phase & Modi holds the Key

Back home, Indian economy is still not out of woods and consumption continues to be weak. On the other hand, Investments from private sector won’t pick up till current capacity underutilization normalizes and infrastructure sector policy reforms are well addressed by the Government. So ball is now clearly in Prime Minister, Mr. Modi’s court. The good part, India is perhaps the biggest winner in the current oil turmoil. With inflation under control, the government along with RBI can now turn full attention to growth and reforms. Given the lack of majority in Rajya Sabha, timing of these reforms could be tricky and there could be delays but the direction of the change is clear. One aspect however seems to have gone unnoticed. Last week, we visited one of the nearby Government offices and were stunned to see the stark difference around the office premises – the usually dusty premises were neat and clean, dumped old furniture and old files had vanished; there was a certain sense of pride, purpose and professionalism in the air boosting the productivity. We believe, the behavioral change which Modi is driving is far difficult to achieve and has a far reaching consequences, the most important being improvement in productivity and reduction in wastage of valuable resources.

Near-term India equity market could be choppy

The recent equity correction is welcome as it keeps market out of valuation risk-zones and offers better buying opportunities for us. Still, at the current levels of 27400, BSE Sensex trades at 15.9x FY16, which is not cheap. Our recent interaction with management of portfolio companies and in general at investor conference leads us to believe that Consumption continued to slowdown post festival period and has impacted demand negatively across the category – credit growth to industry has slowed down to 7.8% in October 2014 compared to 15.9% last year; credit to services has slowed down to 8.9% compared to 21.7% last year. Though companies will benefit from falling inflation, we believe, there is a risk of negative surprise to Q3 earnings expectations.  

Longer term India now clearly differentiated and on the verge of a secular bull market

On 1^st October 2003, Dominic Wilson and Roopa Purushothaman at Goldman Sachs published their Global Economics paper, ‘Dreaming with BRICS: Path to 2050’. The report moved the global investment flows towards the potential of these four economies but with little differentiation amongst each of them. However over a period these markets have started getting differentiated as global investors’ learning curve and confidence matured over the last one and half decade. The same has been reflected in a more emphatic pricing of these markets.  During 2014, there is stark dispersion in performance* of BRIC markets - India is up 20%+ while Russia is down 48%; China is flat while Brazil is down 18%.  The wide dispersion suggests a clear segregation of individual markets and we believe this trend will continue to build upon.

Indian equity market undoubtedly has far richer mix of better managed and profitable companies – IT, Financials, Consumer Staples, Pharma and Auto companies with ROEs of (15%-30%) account for 2/3^rd of the market. The current weight of India in Emerging Markets Benchmarks is 6.5% compared to 20.4% for China and 14.5% for South Korea. Like the domestic equity participation (a meager 3-4% of savings), global investor allocation to India both direct as well as indirect through higher weight for India in benchmarks is also set to rise secularly. To sum up, with a strong leadership and political stability at the center, accelerated consumption from booming middle class and government effectively plugging in the missing pieces of puzzle – manufacturing and infrastructure – the foundation for multi-year bull market is well under formation. Stay put and add more!

 (*As of 19^th Dece 2014, MSCI Share price index in USD terms)