2018 was a tough year for investors, in particular for equity investors. Emerging market (EM) equities were down by more than 17 percent led by a 25 percent drop in China’s equity index. European equity markets also reported double digit decline. US markets were also down by 6 percent. Local investors in India had a much better run with equity markets up by more than 3 percent in the year. Foreign investors were not that fortunate as rupee depreciation of 9 percent in the year implied negative returns in dollar terms. Fixed income investors also faced considerable volatility. US yields, which had been inching up since mid-2016 corrected course towards the end of the year as global growth outlook worsened. With change in interest rate direction, global currencies also followed suit with dollar also giving up some of its gains against the EM currencies.
What suddenly changed in the global economy towards the end of the year? And this brings us to a trickier question. What’s in store for 2019? Well the answer to the first is more to do with slowdown in China and dip in US housing sector. China’s economy has been slowing down because of deleveraging and outflows by its residents. Despite a 3.5 percent trade surplus in 2018, China’s current account is just about positive as its residents are increasingly investing abroad. This means lower investment at home and thus lower growth. The US housing sector has slowed down as higher interest rates are hurting demand. While US Federal has indicated its willingness to wait and then move on interest rates, given that US real interest rates are so low, there is hardly any case for monetary stimulus.
Given the above backdrop, 2019 will continue to see further easing by China. Its central bank reduced the reserve requirement ratio by 100 bps in the beginning of the year. Interest rates (10Y) in China have fallen by close to 60 bps in 2018. Further reduction will continue as its central bank fights a slowing economy (domestic and global). Given China’s size, all global economies will be impacted. From the markets standpoint, equity investors will have to brace for another tough year given the recent cut in revenue guidance by Apple. LG (a large maker of memory chips) also reported profits far below estimates due to pricing pressures. Demand for memory chips is a lead indicator of global demand. In other words, China led slowdown is spreading across Asia.
One basis point is a hundredth of a percentage point.
What does it mean for bond investors? With global slowdown spreading from Asia to the rest of the world, yields are likely to be lower than higher. The reason being global central banks will find it extremely difficult to raise rates when global growth is slipping. In 2018, most central banks raised interest rates to maintain differential between US and their benchmark yields. This helped them to maintain orderly depreciation pressure on their currencies. Now, with US Federal looking at pausing its rate increase cycle for a while, global fixed income markets will get a breather.
With US interest rates not increasing in a hurry, the runaway depreciation seen in EM currencies will also come to a standstill. This will boost outlook on EM currencies and markets as global investors can look at investing in these currencies without worrying about hedging their exposure. The inflows into EMs will also boost their growth prospects. Hence, EMs are likely to benefit from the shift in US monetary policy cycle.
More importantly, what does it mean for Indian markets? Indian equity markets will struggle to go up as global equity markets face significant headwinds from a slowing global economy. Corporate earnings in US will be under pressure as benefits of tax cuts fade away. Indian corporate earnings related to export led sectors will also be under pressure (as global economy slows down). However, domestic firms may benefit from an expected rural stimulus by Indian government ahead of elections. In addition, the steadily improving capacity utilisation (now at 76 percent) implies corporate capex cycle will pick-up in the next 12-18 months thus driving growth upwards. Hence, stock picking will be more important than broad market direction.
For bond investors, the much-anticipated change in Reserve Bank of India’s (RBI) policy stance implies upward pressure on interest rates will fade away. However, an anticipated farm stimulus and thus higher government debt issuance will put upward pressure on yields. More importantly, the rising wedge between credit and deposit growth of the banking system implies banks will have to raise interest rates. Hence, while lower global yields and change in RBI’s stance will ensure that interest rates on government securities don’t go up much, underlying interest rates for savers (deposits) will increase in 2019.
Last but not the least, rupee, which had depreciated by 9 percent in 2018 is likely to fare much better. The most important factor favouring rupee is the decline in oil prices from a high of $86/bbl to $60/bbl now. This will drive an improvement in India’s Balance of Payments (BoP) and thus the outlook on rupee. In addition, stable to rising domestic interest rates imply debt inflows will continue. As foreign investors start investing in EMs (India) again in 2019, rupee will find support.
So which asset class may outperform in 2019. Given the context laid out above, it may be the good old gold.
Sameer Narang is chief economist at Bank of Baroda