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Rising Global Risk (and its Implications for India)

 

Bullets Nov 2018 image

 

The decade that has followed the global financial crisis of 2008 has been characterised by relatively steady, if uneven global growth.  Economic growth for most major global economies like the United States, Germany, the UK and France recovered to pre-crisis levels within 4-5 years, and China began the transition of its economy away from an export-driven growth model, while avoiding a ‘hard landing’.  Buoyed by these positive macro-economic trends, global equity markets reached all-time highs, and total global wealth reached US$280tn (27% higher than at the onset of the economic crisis).  India also witnessed a recovery in economic growth levels, back to c. 8% levels helped by the global economic resurgence, the reform-agenda of the Modi new government, robust foreign direct investment flows and falling oil prices.  Recently, however, cracks have begun to emerge in the global economy, driven by rising political uncertainty around the world, on-going trade disputes between the United States and China and financial instability across several emerging markets (including Russia, Brazil, South Africa, Turkey and Venezuela).  The combined effect of these risks has driven economic volatility and sharp corrections in equity markets, as investors reallocate capital across geographies and asset classes to manage global macro-risk.  India, given its inherent resilience and growth prospects, has the potential to buck the trend the of global capital flight from emerging markets if it is able to maintain its reforms and growth and thereby reassure investors that it is a relatively safer emerging market than others for international capital.  The key to this will include India mobilising long-term capital, reforming its banking sector and facilitating global trade.  This month’s Sign of the Times examines today’s emerging global risks and their implications on India, and the potential impact on its investment story.

 

2009-2017: A Decade Long Recovery from the Global Financial Crisis

Following the global financial crisis, the economies of the United States, Germany, the United Kingdom, France and Japan all recovered and eventually surpassed pre-crisis levels within three to five years; India’s economy, akin to China’s unlike the G7 economies, did not stop growing, albeit it rebased to a lower long-term growth rate.  While some prominent economies in the Eurozone – most notably, Portugal, Italy and Greece – struggled to bounce back, the overall picture for major economies in the decade following the global financial crisis has been one of steady global economic recovery.

 

2007-2017 GDP Growth for Major Global Economie

 

 

In terms of global equity performance, the picture is even more positive, with stock markets in most major economies quickly recovering to pre-crisis highs within the course of 2009 and continuing to grow to record levels (see chart), thanks in part to monetary stimulus packages introduced to stabilise various economies.  Between 2009 and 2017, the MSCI World Index – a composite index that tracks global equities performance for 23 developed market economies – increased by 112%, while the MSCI Emerging Markets index increased by 96%.  The result of this stock market bull run is a healthy increase in global wealth, which is estimated to have increased by 27% to US$280tn over the last ten years, with c.9m new millionaires being added, and global median income levels rising to a record high in 2017[2].

 

Global Equities Markets Performance 2009-17

 

 

The US is clearly an important driver of growth for other economies and its policies in relation to other economies is a key driver in their performance.  Even under a policy neutral or negative scenario, the lack of US performance would make a negative impact on global performance.  However, it is clear that the recovery that emerged through President Obama’s two terms placed the US on a strong path of growth for President Trump to implement his initiatives.[4]  So, the question arises of what are the policy and other event risks that might impact the continued rise of global markets.

 

Three Key Areas of Rising Global Risks

Over the last 12-18 months, despite rising US equity markets, the global economic boom appears to be ready for a rising set of critical economic and political issues.  These challenges can broadly be classified into three areas:

 

1. Increasing Political Risk and Instability

Key Drivers Populist Politics

 

Key Drivers of Political Risk and Instability:

As a result, global political uncertainty has increased considerably due to a combination of:

  1. Polarisation and inability to build consensus driving political paralysis and potential legislative gridlock in the US
  2. Fundamental policy divisions between the US and its allies
  3. Increased instability of incumbent governments in democratic countries due to volatility in voter behaviour
  4. Emboldened foreign and economic policies from authoritarian regimes in emerging markets
  5. Aggressive US policies moving to shake up the geopolitical chessboard, which may have substantial benefits but are introducing risk and for which the benefits are subject to unintended consequences and Extreme Asymmetric Risk[5]

 

Republican vs democratic attitudes on key issues

 

Key Global Events That Will Drive Near-to-Medium Term Risk

 

Impact on India

India has enjoyed a period of relative political stability over the last four years by virtue of the strong electoral mandate Mr. Modi’s party received in 2014 and its growing strength in state legislatures.  India’s international standing also appears to have improved, particularly in bilateral relations with the US, Japan, Canada, Australia and various Middle East nations or remain largely stable, with countries like China and Pakistan.  Domestically development has resulted in advances in mass financial inclusion, a restructured nationwide tax system, legal reforms and an unintended windfall to the equities markets from demonetisation[7].  With three major state elections next month leading to the general election in mid-2019, Mr. Modi’s party could potentially face anti-incumbency, a more unified opposition, or both.  While recent opinion polls have indicated an erosion in support for some BJP state governments, Mr. Modi’s own personal popularity has remained strong.  Even with the erosion of support and some general election polls indicating that the NDA may lose its majority, opinion polls are all unanimous that the BJP will be by far the largest party, indicating that Mr. Modi appears likely to secure another term as PM, even if he may need to find additional coalition allies to form a government.

 

2. Global Trade Order Under Threat

Key Drivers Protectionism Anti Globalisation

 

Key Drivers of Global Trade Order Risk and Instability:


As a result, the global trade order has been undermined due to a combination of:

  1. A natural correction in the level of global trade following half a century of virtually-uninterrupted expansion from 24% of GDP in 1960 to 61% of GDP in 2011
  2. Increased protectionist sentiments, in developed markets in particular, due to a combination of economic dislocations from trade and politicians who have exploited these fears for political gain
  3. The Trump administration’s explicit use of political power to reset the global terms of trade for perceived domestic economic benefits to make good his campaign promises to his base and, irrespective of significant evidence that this will not benefit the US in the longer term
  4. An escalating trade battle in the world’s largest trading relationship, the US and China, which could result in collateral damage to their own economies and others in their respective supply chains
  5. The failure of multi-lateral institutions like the WTO to effectively mediate emerging and existing disputes due to the undermining of its legitimacy by the US, hitherto its biggest supporter

Global Trade to GDP

 

Key Global Events That Will Drive Near-to-Medium Term Risk

 

Impact on India

India’s export growth has slowed down in the last few years due to a combination of the slowdown in global demand, the lack of a domestic industrial manufacturing base (due to issues around infrastructure and logistics costs) and the slowdown in ‘traditional’ IT services exports where India was a leader.  Therefore, it can ill-afford to take sides or get caught in an all-out trade war with the US (which accounts for 16% of its exports), or China and Europe.  India’s trade relationship with China however has grown significantly and it is now India’s largest trading partner[15], however, with a significant trade deficit.  For China given its deteriorating relationship with the US, market access to India will become more important, and India can use this to improve its own market access to China, including for services exports for its IT, digital and financial services.  In the near term, India needs to increase the pace of bilateral discussions with the US, EU, UK, Japan and China, while carefully managing the US relationship by giving President Trump political wins (e.g. on IP protection) in exchange for concessions important to its export growth (e.g. increased visas for Indian IT service workers).

 

3. Global Capital Flight Driving Volatility

Key Drivers Increasing asset volatility

 

Key Drivers of Capital Flight Risk:

 

As a result, the stability of the global financial system, in particular for emerging markets, is at risk due to:

  1. US monetary and fiscal policy has triggered a flight of capital back to the dollar and safer asset allocations
  2. The rise in global leverage to levels higher than prior to the global financial crisis
  3. The absence of US leadership to help the world navigate complex and inter-related risks
  4. The build-up of debt across many emerging markets (with the notable exception of India) and increased volatility in their currencies and equity markets
  5. Devaluations and defaults across several fragile markets in Latin America, Middle East and Asia, with potentially more to come

 

Change in Total Debt to GDP Ratio

Key Global Events That Will Drive Near-Medium Term Risk

 

Impact on India

Compared to other more fragile emerging markets, India’s debt position is comparatively lower with total public debt at c.62% of GDP and external debt at c.21% of GDP.  Nevertheless, India’s equity markets have seen US$6.5bn of net foreign investor capital outflows between January and September 2018[23], even though domestic capital inflows into equities have been relatively strong during this period.  As a result, India’s benchmark Sensex index has corrected by c. 14% from the peak it reached in end-August, while the Indian rupee has fallen by 15% against the US dollar since the beginning of 2018.  Unlike other emerging markets however, India has seen an acceleration of both GDP growth (from 7.0% in the quarter ended December 2017 to 8.2% in quarter ended June 2018) and corporate earnings, with average earnings growth for BSE500 accelerating from 3.1% (from Sep-16 to Sep-17) to 14.1% (from Sep-17 to Sep-18), providing the country with a stable macro-economic backdrop.

 

The Implications of Rising Global Risks on India

The emerging global risks, given the broader shifts in the world economy[24], makeKey Policy Responses to Elevated Global Risk it clear that the world is transitioning away from the comparatively benign global growth and risk paradigm of the last decade.  Over the last 18-24 months, it has become apparent that the US and some other developed western economies are rejecting values that they previously championed such as democracy, free trade, capitalism and diversity and that upheld the liberal world order.  This has in turn increased political polarisation (and risk), led to major trade disputes, and increased the financial system risk across developing economies.  Some developing countries like Turkey, Indonesia, Argentina and the Philippines have responded to this with short-term monetary and fiscal responses which, rather than stemming the bleeding, has led to concerns over central bank autonomy, and triggered further capital outflows.  The key lesson here for large high growth emerging economies like India is that in this new global context, where global risk levels are rising, the most important policy requirement is to avoid short-sighted political and economic policy decisions such as unsustainable fiscal stimuli and other populist policies which may stem voter angst in the short term but lead to elevated risk to the economy in the medium term.

India seems to be bucking the trend of the emerging market slowdown, driven by a combination of India’s inherently strong fundamentals (demographics, stable democracy, resources) and reforms and fiscal consolidation which has helped growth recover from c.6% to c.8% in the last four years.  Most importantly for India, it has a government which seems to understand the importance of delivering both “big ticket” reforms (e.g. a new national goods and services tax, a new bankruptcy code) and discrete initiatives to improve the ease of doing business, a stable and transparent monetary policy framework to control inflation by the Reserve Bank of India (“RBI”), and a steady build-up in foreign exchange reserves to guard against external risks.  This has made India’s economy more dynamic and business-friendly (for example, with a 42-place improvement in its global Ease-of-Doing-Business ranking) and helped sustain high FDI inflows (US$223bn of FDI since 2014).

 

India vs Other emerging market economies since 2014

 

While the factors above may ensure India’s economy remains stable relative to other emerging markets, a country of India’s size, economic potential and ambitions cannot be satisfied with demonstrating resilience.  India’s opportunity lies in two important interlinked ideas:

I. Emerging Market of Choice. Positioning itself as the investment destination of choice amongst emerging markets with the aim of capturing an outsized share of the emerging markets capital allocation.
II. Enhancing its Soft Power Global Positioning. Given America’s recent bilateralism and China’s “raiding” approach (protection of the homeland from foreign competition while penetrating foreign markets with its own products), India has the opportunity to position itself as confidently open to global business[25].

There are a number of important steps that India must take immediately to capture this window of opportunity (see inset) and, in many cases, this will entail a continuation of substantial structural reforms.  Until recently, this type of ambitious policy response was a ‘nice-to-have’ for India, with its inherent fundamentals and global economic tailwinds sufficient for it to achieve 6-8% growth (and even higher in the pre-crisis period).  In the new global context, it may well become a ‘must have’ as global capital will only be attracted to India if its government can demonstrate that it is indeed serious about solving its most urgent issues (including those which are politically difficult).

 

Conclusions: Implications for Investors

For investors seeking to manage risk while maintaining diversification in times of economic and political uncertainty, India today offers an attractive bet for a number of reasons.

I. Structural Risk Declining. Firstly, India’s structural risk is declining while that of other countries, both developed and developing, is rising, reflected in India’s low inflation, declining fiscal and current account deficits and interest rates and strong foreign investment inflows[26].  And while India has not been totally immune to foreign exchange and equity market volatility, its impact has been far less than in other BRICS economies (19% currency depreciation since 2014 vs. 69% for other BRICS economies).
II. Liberal Stable Democracy and Relative Governance Advances. Further, India’s governance has proven to be source of competitive advantage over other emerging markets.  As a stable democracy being steered by a strong, ambitious and development-focused hand steering it, it stands out both from countries either without or with regressing democracies (e.g. Turkey, Russia, Vietnam) and from countries that appear to be unable to form and execute effective economic policies (e.g. Brazil, Indonesia, South Africa), and so not all emerging markets are the same.
III. Attractive Long-Term Prospects. India’s long-term growth prospects remain strong.  With the reforms of the past four years having repositioned the country for sustained and potentially higher growth, India’s economy is set to continue to expand rapidly, and nothing indicates this growth should not continue, with the potential for GDP growth to hit 10%[27] over the medium-term.
IV. Current Tactical Timing Opportunity. In terms of timing, with attractive long-term growth prospects, India’s depreciated currency and equity markets post the recent correction (see charts), present a good tactical timing opportunity for investors.  Even if further deterioration should occur, India has demonstrated a greater resilience than other emerging markets, providing a source of potential alpha generation.
V. Geopolitical Positioning Favourable. Finally, on a geopolitical level, India stands to gain from the increasing containment of China by the United States. With China increasingly at risk of suffering a potentially significant setback in its ongoing development due to US actions, US-China relations are looking to become increasingly rocky over the next decade or two and increasing friction will open the door to India becoming both a commercial partner to the US and as well as a preferred destination for US foreign investment.

The flow of capital is an important long-term determinant of political power and as India now stands to be positioned where China was about a decade or so ago, global investors are beginning to examine how to allocate their capital.  this analysis will inevitably lead investors to examine the big themes of India’s rise[28] as well as its regions and sectors[29] given the diversity of India’s continent like profile.   High quality assets in India have historically rarely come cheap, and windows of opportunity tend not to last for prolonged periods, however, quality assets have historically consistently delivered strong risk-adjusted returns.

Stepping back, the world seems set to enter a period of greater global risk.  Regardless of whether one holds the view that it is self-inflicted through overly aggressive policy stances or a necessary and long overdue correction of power rivalries, the global investment outlook seems to have shifted away from a pure growth to a risk-managed growth scenario.  Importantly, the key political, trade and capital risks that have begun to manifest appear to be structural, global and longer term in nature, and are therefore ones cannot be ignored or avoided.  As the world adapts to these changes India seems to be on a development and growth track that sets it apart from others and its upcoming election is unlikely to significantly change this.  Given India’s momentum, the country is likely to deliver, even under a marginal coalition, at least more of the same as the last four years in terms of economic growth and potentially deliver far more given the opportunity for the next government to leave a legacy.  Given these factors, it seems clearer that the case for India is being made not only by its own development story but also by the result of the price that global risks are set to exact on the rest of the world.

 

Risk-Return| Indian States | Development Strategy | Indian Investing | Global GDP Growth | Global Economic Crisis | Major Global Economies

1. Source: IMF
2. Source: Credit Suisse Global Wealth Report
3. Source: Capital IQ
4. Of the past seven US presidents, Donald Trump has inherited the strongest stock market, the second lowest unemployment rate and interest rate and the third highest GDP growth rate.
5. See the June 2018 Sign of the Times special: “’America First’ in Asia – The Use of Extreme Asymmetric Risk in US Foreign Policy”
6. Source: www.fivethirtyeight.com, as of 25 October 2018
7. The benchmark BSE Sensex increased 44% between 11-Nov-2016 (when demonetisation was announced) and its peak reached in late-August 2018. Even after the recent correction in equity markets, the Sensex is c.25% above its pre-demonetisation level
8. For example, Foxconn recently announced a US$10bn plant in Wisconsin, its first plant outside Asia (Source: CNN)
9. For example, after President Trump’s recent tariffs on China, Ford decided against moving production for its key hatchback vehicle from China to the US, deciding instead to ship to other countries from its Chinese facility (Source: The Guardian)
10. Source: Brookings, 5 Things to know about USMCA, the new NAFTA (October 2018)
11. Source: The Manufacturing Institute
12. Source: Financial Times, Rising Costs at US Manufacturers Unnerve Investors (24 October 2018)
13. Source: The Economist, The WTO is Under Threat from the Trump Administration (December 2017)
14. Source: International Trade Centre, Trade Map Database
15. Source: Indian Ministry of Commerce (Note: India’s trade with China has expanded rapidly primarily due to the value of Indian imports from China; the US remains India’s largest export partner)
16. Source: World Bank International Debt Statistics (IDS) Database
17. Source: Institute of International Finance, Global Debt Monitor
18. Source: Financial Times, Janet Yellen Sounds Alarm Over Plunging Loan Standards (25 October, 2018)
19. Source: Wall Street Journal
20. Source: PIMCO
21. Source: IMF World Economic Outlook Database, October 2018
22. Source: Yardeni Research, 2017-2019E Earnings and Revenue Growth (24 October, 2018)
23. Source: Moneycontrol
24. Please see the Sign series on the Shape of the World
2. Please refer to GPC’s February 2012 Sign of the Times “India Wide Open – Transforming India Now for 2040” and October 2018, “Transforming India’s Growth Model
26. See the August 2017 Sign of the Times India’s Rising, Risk Falling
27. See the October 2018 Sign of the Times Transforming India’s Growth Model
28. See the June 2018 Sign of the Times: Indian ‘Certainties’ Revisited – and the Changes They Will Drive
29. See the July 2015 Sign of the Times: India States: The India Within India, and the Sept 2017 Sign of the Times: India’s Transition to the Information Age, and the Sectors Driving This