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The great reflation and the coming boom

BY  Saurabh Mukherjea
The combination of unprecedented monetary stimulus and economic stablisation in the West is creating the recipe for a boom in stockmarkets around the world.

Leaving aside domestic policy developments in India (which continue to be encouraging), the evolution of ultra-loose monetary policy in the West and the stabilisation of the Western economies points to a great reflation and potential boom in stock markets. 

The major Western central banks are abandoning inflation targeting

As we noted in our 7th Jan thematic, “…monetary policy in the West is likely to remain ultra-loose over CY13 as fiscal authorities would urge or force monetary bodies to compensate for the lack of fiscal support for the economy. In fact, the central banks in the Western World, in a meaningful deviation from the trend in the past two decades, experienced two profound changes in CY12. Firstly, this 12-month period saw governments explicitly declaring their intention to purge central banks of even mildly hawkish central bankers. Be it the Japanese Prime Minister’s open directive to the Bank of Japan’s (BoJ’s) Governor to mend his ways or be it the British Chancellor’s surprise decision to bring in the first non-British governor in the Bank’s 318-year history of the Bank of England (BoE), the broader theme is eerily identical (refer to Exhibit below) and has significant positive ramifications for equities in CY13.

Secondly, CY12 saw Western central banks beginning to officially abandon the traditional mandate of managing ‘economic growth and inflation’ in favour of ‘reviving economic growth alone’, as is evident from the Federal Reserve’s abandonment of the Taylor rule, the British Chancellor’s plan to scrap inflation targeting or the possibility of the BoJ doubling its inflation target.

Besides these two changes that signal an era of definitively dovish central banking in the West, the Big-4 central banks have explicitly indicated their decision to maintain an aggressively loose monetary policy stance in CY13 and beyond (refer to Exhibit below).”

Investment implications

The combination of unprecedented monetary stimulus (if you omit the six months post-Lehman, we have never seen central banks’ Balance Sheets expanding at the rate we are seeing at present) and economic stablisation in the West is creating the recipe for a boom in stockmarkets around the world. To quote the legendary economist John Taylor (he of the “Taylor Rule” which the central banks are now abandoning):

“…the new quantitative easing announcement [by the Fed] implies a gigantic increase in the size of the Fed’s balance sheet and thus effectively an amplification of the policy risks and uncertainty…The Fed now plans to purchase $85 billion a month of longer-term Treasury and mortgage backed securities until there is substantial improvement in the labor market, which requires a completely unprecedented increase in reserve balances…”

John Taylor goes on to argue (convincingly in my view) that the Fed is now aiming to set interest rates so low that it is likely to create boom akin to 2003-05 (i.e. the period when rates were “too low for too long” and thus fuelled a credit, economic and stockmarket boom).

With borrowing costs and energy costs for US companies now at all time lows and with labour in plentiful supply, the script for a US economic recovery is almost written. However, what does all of this mean for India? I will focus on four separate aspects of the incipient recovery in India:

  • FII flows into India are likely to stay strong: With the VIX currently at 12 and with history suggesting that history suggests that FII flows into EMs improve when Western GDP growth picks up, interest rates in the West are low and risk aversion levels are moderate to low (say, below 20). Arguably, each of these conditions are likely to be satisfied in CY13 with risk aversion levels currently at levels well below the long term average of around 23.
  • ECM recovery: With FII flows in rude health, the ECM market, which opened with the M&M Financial’s QIP in November ’12 is likely to remain open. The frontline banks (IIB, Axis, Yes) are likely to lead the ECM recovery but I reckon by early summer we will see the better managed Power, Infra and Real Estate companies also raise substantial amounts of capital (Prestige Estates has already executed a successful IPP).
  • Manufactured exports: India’s manufactured exports growth that have been growing at a faster pace than China’s manufactured exports (see exhibit below) are likely to benefit disproportionately as global GDP growth ratesrecover. As highlighted in our note titled Megathemes 3.0 dated November 20, 2012, we expect India to emerge as a lucrative exporter of light industrials and engineering goods owing to: (1) the improvement in India’s price competitiveness with INR depreciating to the tune of 49% since CY07 against the remnimbi, and (2) India’s natural competitive advantage in manufacturing knowledge-intensive and capital light products.
  • GDP growth recovery in India: Our Economist, Ritika Mankar, has shown in several of her notes that once ECM market opens in India, within two quarters GDP growth picks up thanks to investment growth recovering by at least 100bps. This suggests that by summer, India’s GDP growth should start rising decisively. Furthermore, as highlighted in the previous bullet, the rise in exports should also give Indian GDP growth a fillip. We reiterate our forecast for 6.3% growth in FY13 and 7.1% in FY14 (both of these estimates are significantly higher than the “very fluid” estimates published by our rivals).

One final point, I have heard some other brokers say that because of the revival in the Chinese economy, FII flows into China could dampen flows into India. I find such an argument strange not because I doubt the veracity of the Chinese recovery (the recovery could be a figment of the Chinese authorities’ imagination but I will leave credible China watchers like Andy Xie to comment on that) but because it suggests that investors have a finite pot of capital to allocate to EM equities (and they allocate that pot of capital across various EMs). In reality, the bigger driver of flows into EMs is the allocations of funds between various asset classes: Bonds, Equities, Commodities, Real Estate, etc. From that perspective the ongoing rotation out of bonds (with US Govt and corporate  bond yields at record lows) and into Equities should result in all EMs experiencing significantly higher flows in CY13 than they saw in CY12.

(Saurabh Mukherjea is the Head of Equities at Ambit Capital. The views expressed here are his own and not Ambit Capital’s.)

Comments

CV
Saurabh: Rob Peter to pay Paul!!, is how I would define in short. I agree in principle with the ramifications of massive stimulus/monetary loosening programs finding their way into emerging markets and creating the waves. Most of the advanced economies want a certain growth of inflation which they are unable to produce owing to record unemployment levels; and hence their strategy appears to be hitting the emerging and less developed economies to bear the burden of inflation growth owing to cheap liquidity and thus prep the advanced economies for higher demand especially in the capital and IP intensive areas when the demand in emerging economies goes over the roof and those economies cannot support themselves without an intervention by advanced economies. What is surprising is a lot of people are looking other ways when they know this is a total disregard for the vast majority of global population that still lives in emerging economies and so as the middle class in those parts of the world pays more for every litre/gallon of oil, food, etc., they are ripped off of their savings. Back in 2009, there was a lot of chatter on decoupling economies to sensible levels for having a certain sustainable growth in individual economies but more than 3 years later, looks like that those were mere blurts from some hashish smoking convention!! Also, the downward dip on Chinese exports while appears to be encouraging from the standpoint of increasing Indian exports, we have to really zero-in on the factors of seasonality, outsourcing of IT, the hedging practices in Supply Chains that might have come into play above and beyond the currency depreciation ratios; but remember Chinese exports are still almost 10 times higher than ours, and they have a lot of surplus-cash on hand to fast develop their indigenous demand cycles especially with the known massive investments in infrastructure. So not so soon can we write off China, but instead adapt to the current reality of utilizing cheaper liquid thru FII/FDI for infrastructural growth to get a momentum on economy that can last for at least next 20-30 years and that's they key here.

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