The year is about to pass, and we embark upon the customary year-end. The title we have picked this time is “Unsure” given that unsureness continues to characterize a lot of macro and market discussions, even as the much-looked forward rate cuts have started in key developed markets. In India, this is still awaited but with more anticipation now than ever. And yet there seem as many reasons to be unsure about as there were this time last year. But that should perhaps be forgivable, given that the pursuit of surety probably ranks right up there amongst the philosophically unachievable like lasting peace of mind or (for yours truly) learning to play the guitar.
Thus, foretelling remains just as hazardous as it was the year before when, extrapolating from the famous Fed pivot of December last year, one would have been emboldened to predict that the phase of bond and currency pressures were firmly in the rear-view and the global monetary easing cycle had well and truly begun. Hardly had a month passed of the new year, however, that US data turned up, rate cut expectations receded, the dollar started to re-strengthen, and treasury yields began spiking again. But then the tides changed once more, data flow softened, and rate cut expectations came back. Towards last quarter of the year, hold on to your hats, there was yet another turn: US data hardened again and treasury yields rose.
While the intra-year gyrations were considerable, had you been away for a year and just come back you’d wonder what the fuss was about. Point to point, the starting and ending levels for treasury yields for the year are within shouting distance of each other. And indeed, the Fed has commenced a much-awaited easing cycle, though after an initial phase of quick adjustments, the speculation now has turned towards how much more may be left in the tank. This is especially given the current extrapolations on what was said on the campaign trail by the incoming US administration. This, if taken at face value, implies even higher US fiscal deficit, a rebound in inflation on higher tariffs and a reduction in labor force. All this has logically led markets to conclude that US rates, especially at the long end, can go even higher. While the initial reaction of the bond market after the election outcome is much more sanguine, there is enough reason to be quite unsure for now.
The Unsureness Framework
Before we delve deeper into macros and markets, however, we take a metaphorical minute to assess a behavioral question: Do you have to act when you are unsure? Converted to the current investment context the question can be asked as: Why take any sort of risk when the outlook is uncertain? Why not wait for the uncertainty to pass? We offer the following points as help in reaching an answer:
1> Unsureness or uncertainty will likely never go away, as has been shown time and again over just the recent past itself. It is then a very long wait one may be subjected to.
2> The unsureness may at some point temporarily abate but only to reel you in before it comes back. This would have made your entry point more expensive and thus your valuation cushion much thinner, without having solved for your underlying objective for waiting. Indeed, this also has been shown in the recent past.
3> Even if there is a potential more permanent ‘regime switch’ coming that drops the general level of unsureness, the opportunity cost of waiting may be very large given that market pricing may have already changed significantly in the run up to this shift (the absence of the proverbial ‘free lunch’, in other words).
Having visited the case that it may be worthwhile to try and appropriately quantify unsureness rather than consider it a blanket order against action, we turn next to assessing the global macro environment.
The Unsureness From US Exceptionalism
The defining feature of the world economy in this post-Covid phase has been US exceptionalism that has till date refused to abate. It started with the exceptionally large fiscal and monetary response that was thrown in as response to the pandemic’s output loss. This allowed the US to claw back lost growth quickly. Subsequently, monetary policy was slow to normalize and fiscal deficits, though rationalized from the pandemic highs, were sustained at much higher than previous run rates. By the time the Fed caught up, it was with a quantum of rate hikes that should have put brakes to the economy reasonably quickly. But for a variety of reasons (higher fiscal deficit, productivity jumps, expansion in labor supply via immigration, and longer- term private sector liabilities combined with lower general leverage blunting effect of rate hikes), this did not happen. As the year closes, and more than a year after the Fed finished hiking rates by upwards of 5 percentage points, the US economy still seems to be chugging along at a real growth rate of between 2.5 to 3%, significantly higher than what has been thought of as trend growth rate for that economy.
That said, there has been enough below the line cooling including an easing up in the labor market, so that by itself the mighty dollar would have been looking to take a breather for now. However, there is now an administration change coming that is expected to bring higher tariffs and thus higher inflation, tax cuts and thus higher fiscal deficit, lower labor supply and thus higher wage costs, and more deregulation that may blunt the overall negative impact on US growth even as the aggregate growth rate for the world comes off. If all of these come true, then US exceptionalism gets yet another leg up, global liquidity continues to gravitate towards that country, and the mighty dollar keeps going from strength to strength.
While the above summary does nothing to ease any bit of the unsureness at play for the rest of the world, there are decided points to consider that may help to do so. Some of these are behavioral and some analytical. We visit each of these in turn, starting with the behavioral. To clarify, the discussion here is from a fixed income perspective only.
Visiting Extrapolation Bias…
Not so long back the charts of interest where the proportion of global debt that is negative yielding and the prognosis generally was this is likely going to be the shape of things to come for the foreseeable future given longer moving trends at play. Quite in contrast, the discussion today is whether we are stuck now in a higher for longer rate regime where even 4.5% odd yields earned on US dollars for the long term while taking theoretically zero credit risk is not good enough.
Admittedly, there is a reason things have changed. At the same time, one cannot help but note that it looks very likely the needle is now moving a bit too much in one direction and, while difficult to predict when, it will invariably pull back. It is also a given that long period extrapolations proliferate in just such a set up. This isn’t offered as a putdown to such forecasts but as an observation that it is probably time to start looking for offsets that will help identify some sort of inflection point that may be coming for the US exceptionalism trade. If prima facie this pursuit seems futile, one can find courage in the following market data point: 30 year bond yields in Japan are currently higher than those in China. Till just a few years back this would have been deemed unfathomable. But this is what inflection points do.
Emboldened thus, we turn next to look for analytical offsets that may help navigate some of the unsureness at play today.
… And Analytical Offsets Available
The US headline strength no longer pertains to the whole economy. Specifically, the more vulnerable sections of the society are feeling the pinch from high prices (even as the rate of change, or inflation, may have started to come off) and high interest rates. Mortgage rates are in the vicinity of 7% which are contributing to the relative freeze in the housing market. Given this, it is hard to envisage that the new administration actively pursues policies that further accentuate these issues. This is especially so as there is a narrative that the recent election was at least partly lost on these factors. It is to be noted that the level of prices, inflation, and interest rates were quite a bit lower the last time around the Trump administration had imposed tariffs.
A similar argument can be considered from a fiscal standpoint as well. For one, projections being made currently are basis what has been said on the campaign trail and subject to large modelling variations. Two, the expenditure cuts being considered by analysts thus far are quite modest in relation to revenue loss on tax cuts, though admittedly most expenditure items are considered inflexible to cut. However, the point still holds that US fiscal flexibility now is much more constrained as is already seen in meaningfully rising interest cost as a percentage of GDP. Note that the point under consideration is not that there is any risk from debt servicing perspective but rather that more the combination of high real yields and strong dollar sustains alongside the current fiscal deficit, the worse flexibility on budget becomes. Also of importance is the fact that the incoming US Treasury Secretary has strongly advocated fiscal consolidation.
This brings us to the strength of the dollar and the prognosis for its continued rise. The trade weighted US dollar has already strengthened quite significantly and is much higher that where it was when last time tariffs were imposed. Apart from trade competitive issues, either or both of the stronger dollar and higher real yields have to correct if fiscal sustainability is to be restored without meaningfully undertaking budget consolidation.
Next to consider is the fear with respect to the rise and rise of US treasury yields, courtesy the triggers mentioned above. Apart from the US specific offsets discussed here, it is also important to appreciate that this isn’t 2022 – 23 when most major central banks were hiking rates and thus there weren’t any relative offsets available. Today, as an example, the situation is very different in Europe where even without tariffs the base case on growth has weakened considerably and the ECB is widely expected to therefore ease rates aggressively. Relativity matters and will likely cap US yields as well.
Finally, a potential problem closer home. A fear is that in response to tariff escalation, China will devalue the yuan in order to offset erosion of competitiveness and that India may have no choice but to follow suit for the same reason. While a risk worth considering, this is quite unlikely in our view, at least in a meaningful way. First, with the previous devaluation China experienced heightened pressure of capital outflows. Thus, it is unlikely to pursue any aggressive currency weakening as a policy measure even as some depreciation may very well happen as a combination of policy choices and market forces. However, in our view, the risk of more acute yuan weakening was much greater if the set up was that of a year or so back when the real estate market was still backsliding and Chinese authorities had yet not put their fiscal and monetary plans in place. Also, India is unlikely to match any depreciation in the yuan step to step, given our own focus on relative currency stability and the historic evidence that RBI only follows a loose band between the two currencies.
India Bond Story Is Surer
So far we have established why it may be worthwhile to evaluate unsureness rather than be immobilized by it and how when one looks at the current global environment, which at first blush looks very unsure, there may be some important offsets available. Next one turns to the Indian context, where there are some additional buffers in play as well.
It is generally appreciated that India is one of the least impacted major emerging market from both the standpoint of direct growth impact from tariffs, as well as transmission of financial market volatility from a stronger dollar and higher US rates environment. To clarify, we aren’t immune but less impacted and thus the first level of analysis above of hunting for global offsets was important. India’s relatively ‘low beta’ status has been well in evidence over the past couple of years of dollar and US rate volatility as well, and is by now well recognized and appreciated by global investors. This also allows for some degrees of freedom when conducting macro policy for the domestic economy.
We expect growth to slow cyclically with leveraged consumption slowing and business sentiment perhaps facing more uncertainty given the proposed new tariffs and pressure from China exporting away its excess capacity. Inflation outliers will likely subside soon enough and should allow the RBI to start a shallow monetary easing cycle from early next year. Core system liquidity has depleted substantially, and if balance of payment won’t post meaningful surpluses for the near future, then the RBI will likely have to buy bonds to shore up permanent liquidity. Thus, the bond market may have tailwinds from both OMOs and rate cuts in the year ahead.
The more medium-term story for Indian bonds looks equally good. The macro story is strong: current account dynamics have been transformed with the rise in services trade surplus, the government’s fiscal discipline and framework are credible, and the RBI is well recognized by now as a conventional guardian of macro-stability. All this is now happening at scale, we are the 5th largest economy already, and thus can’t be ignored by serious global institutional investors. Foreign investors still own just about 3% of central government bonds outstanding and there is a lot of ground to cover here. We expect this class to be a significant source of additional bond demand over the next few years. Domestically, insurance and pension funds are gaining might as intermediators of savings into long term bonds. Thus, a strong narrative is being met with incremental flow and should continue to lead to valuation expansion. In the case of bonds, this gets reflected as stable term premia and eventually lower real positive yields.
Our Masks Of Sureness
As the year turns yet again, unsureness remains our constant companion. Nevertheless, and most of the time, we are wary of this all-weather friend. The face that looks back at us from the mirror first thing in the morning tells us of our unsureness and vulnerabilities. Mostly, we don’t like what we see and we paint it over with a mask that we carry through the day. The mask has a purpose, don’t misunderstand. The role-play of sureness indeed lifts us and prevents us from succumbing to our worst doubts and fears.
But sometimes we wear it for too long, are too reluctant to set it aside at the end of the day. Just as the mask has a purpose, the face within has one too: to remind us that we are not defined by our unsureness and that it is alright to be kind to ourselves. As we bring in the new year, here’s to try and appreciate the face behind the mask.
Wishing You A Very Happy New Year.
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