A magazine enlisting important features of economics. Part of the Fundamental issues weekly.
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APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY India - Great Expectations Fundamentals: INSIDE: Market overview: Equities surges and bond bubbles Snapshot: UK housing - One Direction? UK forecast: Inflated opinions In what is proving to be a challenging year for many emerging markets, India stands out as an economy with both strong and improving growth prospects. India is in fact set to become the fastest growing major economy in 2015. In this edition of Fundamentals, LGIM Emerging Market Strategist, Brian Coulton, examines the medium-term outlook. in the ‘Fragile Five’ group of countries. By contrast the rupee has been one of only a few global currencies to have remained broadly steady against an otherwise surging US dollar since last October. LUCKY GENERALS There is no doubt that some of this shift in fortunes is down to luck. In particular, India has benefitted greatly from the massive decline in global oil prices. India’s net oil imports were USD102bn or 5.4% of GDP in 2013-14. Lower oil prices have seen India’s gross monthly oil import bill fall to USD7bn in early 2015 from USD14bn in September 2014 and the overall trade deficit has improved by a similar amount (figure 1). In addition to improved external balances, lower global oil prices have helped bring down inflation and reduce the scale of fiscal subsidies required to keep retail energy Few countries have seen as rapid a turnaround in global investor sentiment as India over the last two years. In mid-2013 the Indian rupee was one of the weakest performing emerging market currencies as a large current account deficit, declining foreign currency reserves, high inflation and sluggish growth placed India firmly Global investors are constructive on India. Improved macro balances support this view. But structural reforms will take time.
Transcript
APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY
India - Great Expectations
Fundamentals:
INSIDE:
Market overview:Equities surges and bond bubbles
Snapshot:UK housing - One Direction?
UK forecast: Inflated opinions
In what is proving to be a challenging year for many emerging markets, India stands out as an economy
with both strong and improving growth prospects. India is in fact set to become the fastest growing major economy in 2015. In this edition of Fundamentals, LGIM Emerging Market Strategist, Brian Coulton, examines the medium-term outlook.
in the ‘Fragile Five’ group of countries. By contrast the rupee has been one of only a few global currencies to have remained broadly steady against an otherwise surging US dollar since last October.
LUCKY GENERALS
There is no doubt that some of this shift in fortunes is down to luck. In particular, India has benefitted greatly from the massive decline in global oil prices. India’s net oil imports were USD102bn or 5.4% of GDP in 2013-14. Lower oil prices have seen India’s gross monthly oil import bill fall to USD7bn in early 2015 from USD14bn in September 2014 and the overall trade deficit has improved by a similar amount (figure 1). In addition to improved external balances, lower global oil prices have helped bring down inflation and reduce the scale of fiscal subsidies required to keep retail energy
Few countries have seen as rapid a turnaround in global investor sentiment as India over the last two years. In mid-2013 the Indian rupee was one of the weakest performing emerging market currencies as a large current account deficit, declining foreign currency reserves, high inflation and sluggish growth placed India firmly
Global investors are constructive on India. Improved macro balances
support this view. But structural reforms will take time.
02APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY
prices (diesel, kerosene and LPG) at centrally administered levels. Serendipity has also struck in the form of recent large upward revisions to real GDP growth, as India’s statisticians have revamped the national accounts data.
But it would be churlish to put the majority of India’s turnaround mainly down to good fortune. Firstly, macroeconomic policy settings have improved in the last couple of years, helping to reduce previous imbalances. Secondly, the new political landscape ushered in after the May 2014 election raises the chances of growth-enhancing structural reforms being implemented.
UNINTENDED CONSEqUENCES
While it is easy to criticise policy with the benefit of hindsight, it looks as if macro policy was eased too much in the wake of the global financial crisis. On the fiscal front, the federal government primary balance swung from a surplus of 1% of GDP in 2006-7 to a deficit of 3.2% of GDP in 2009-10. IMF estimates of the cyclically adjusted primary deficit (at the wider general government level) show a huge 5% of GDP deterioration between 2007 and 2009 (figure 2). This deterioration was much larger than the average across the G20 countries and occurred despite economic
growth in India rebounding very rapidly after just one weak quarter in Q1 2009.
The fiscal easing had important consequences for the balance of savings and investment (figure
3). Private sector savings and investment ratios did not move dramatically in India after the global financial crisis. This was in contrast to many advanced economies where household and corporate deleveraging pressures saw private savings rise and investment fall after 2008. The upshot was that the fall in public sector savings contributed to a widening in India’s current account deficit, increasing the economy’s reliance on foreign financing.
The rise in current government spending also increased inflationary pressure. One component of the rise in spending was an increase in the coverage of the rural
employment guarantee scheme (known as “MGNREGA”). This scheme aims to ensure 100 days of paid work per year for one adult in each volunteering rural household. According to RBI research, MGNREGA wage rates were above market wages in most of the key rural labour markets. The indexation of scheme wages to prices may also have exacerbated the second round inflationary impact of global food price shocks. Rural wage inflation increased sharply after this scheme was rolled out nationally in 2008 (figure 4). Further inflationary fiscal support to the rural sector was provided in the form of large increases in Minimum Support Prices (MSPs) for farm produce over 2008-12.
In principle, the inflationary consequences of these redistributive policies could have been contained by a strong monetary policy framework. But the reality was far from this. Policy interest rates were persistently negative in real terms between 2009 and 2011, inflation and inflation expectations were in the double digit range and the monetary framework was eclectic. The RBI followed a ‘multiple indicator’ based approach with little clarity about which inflation measure – wholesale or consumer
Federal Primary DeficitIMF cyclically adjusted primary deficit (general government,calendar years)Federal Current Spending (RHS)
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prices – was the most important. Uncertainties about the monetary framework contributed to pressure on the rupee in 2013.
REDRESSING ThE BALANCE
Macro policy has, however, taken a decisive turn for the better over the last two years. Firstly, the federal fiscal deficit was brought down to 4.1% of GDP in 2014-15, in line with the target despite a 3% shortfall in nominal GDP growth. The deficit has been in line with budget targets for three consecutive years now and has fallen from 5.7% in 2011-12. Secondly, current budgetary spending has been reduced to below 12% of GDP, the lowest since before the global financial crisis. The decline in fuel prices has helped a lot, but the government also took the opportunity to remove diesel subsidies completely last October. While the 2015-16 Budget announced a slower pace of consolidation than entrenched in previous medium-term plans, it embedded a further decline in current spending and an increase in capital spending, a less inflationary mix.
Fiscal pressure on rural inflation has also been scaled back. The increase in MSP prices for agricultural products has been much lower in the last two years. And as figure 4 illustrates,
spending on rural employment guarantees has declined as a share of GDP. Rural wage and price inflation have fallen sharply.
Most important of all, there has been a major reform of the monetary policy framework with the introduction of a formal inflation-targeting regime based on the consumer price index (figure 5). The RBI started to re-orientate its policy communication in early 2014 after an internal committee proposed shifting to a 4% target with bands of +/- 2%. With actual CPI inflation around 10% at that time, the committee proposed a ‘glide path’ for approaching the target of 8% by January 2015 and 6% by January 2016. The government recently formalised the framework in line with the proposals.
The new arrangements got off to a good start – CPI inflation fell to 5.1% in January 2015 and looks set to be below 6% by the
beginning of next year. Declines in food and energy inflation have played a big part in lower headline CPI but core measures have also been falling. Household inflation expectations fell to their lowest level for five years in Q4 2014.
ThE LONG ROAD TO STRUCTURAL REFORM Prospects for structural reform have improved since Prime Minister Modi’s sweeping victory in the May 2014 general election. The new government has a strong pro-growth and development bias and has demonstrated a lot of determination to push ahead with change. However, political realities mean the process of implementation is likely to be protracted. The key supply side challenges lie in infrastructure constraints – particularly the power sector, labour market restrictions, inefficiencies in food distribution and wider barriers to internal trade. Labour laws, which strongly discourage individual firms from employing a large workforce, are a barrier to India developing the sort of low value-added manufacturing export industry that has been a key driver of growth and urbanisation in East Asia.
The Modi government has made some important progress to date. Legislation has been introduced
Source: MOF, LGIM
Figure 3. Savings and investment balance deteriorated in 2009
-10
-8
-6
-4
-2
0
2
4
2003-04 2005-06 2007-08 2009-10 2011-12 2013-14
% G
DP
India: Gross Savings and Investment
Savings Minus Investment, National (= Current Account Balance exc. Errors andOmissions)Saving Minus Investment, Public Sector
India: Public spending on Rural Employment Guarantee Scheme and Rural Wages
Public spending on rural employment guarantee scheme (MGNREGA) as % GDPRural wage inflation (RHS)
04APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY
to allow for more inward foreign direct investment in railways, defence, real estate and insurance. State-owned Coal India recently sold a 10% equity stake and mining laws have been amended to allow for more transparent auctions of mining rights and to allow the mining of coal by the private sector for commercial sale. In addition, the 2015-16 Budget prioritised infrastructure spending, particularly on roads and railways. Ongoing fiscal constraints mean the share of public government investment in GDP will remain low, but efforts are underway to encourage state firms and the private sector to double-up on the federal government’s efforts on infrastructure. At the micro level there appears to be a strong effort to encourage a more business-friendly approach in the public sector to help reduce many of the inefficiencies that currently constrain investment – a measure recently passed to reduce the power and discretion of labour inspectors was a good case in point.
However, the political context dictates that progress in many of the key reform areas will need to be built slowly and carefully. In particular, many of the laws and regulations which have constrained the
supply side are wholly or jointly under the purview of state level governments. This is true, for example, of labour legislation, food distribution arrangements and consumption taxes. While Modi has a large majority in the Lower House he lacks a majority in the Upper House where MPs are chosen by state legislatures. Modi’s BJP party directly controls only eight out of 29 state legislatures and while his popularity remains high, the timetable of state elections prevents a rapid turnaround. Moreover the perception that rural producers – a key electoral constituency – could be ‘losers’ from structural reforms could complicate Modi’s effort to win hearts and minds on the benefits of reform.
There are, however, grounds for optimism. The government has demonstrated an awareness of the importance of the states to the wider reform process and shown a determined pragmatism. In the area of labour reform it has encouraged states to enact their own changes and taken measures to facilitate this. Several states, led by Rajasthan, are moving forward in raising the threshold of employees above which firms have to consult the authorities on firing decisions.
More significantly, the latest budget announced a move towards increased fiscal federalism, with states given a much larger degree of control over total government revenues than before. These moves are part of an effort to secure agreement on the Goods and Services Tax (GST) which will require a constitutional amendment and hence consent by the Upper House and a majority of state legislatures. The GST would help to broaden and simplify India’s indirect tax base and would pave the way for a single domestic consumer market. Academic research suggests the GST would increase India’s growth by up to 1.5% per annum. Passage of the GST by the national parliament later this year – which looks increasingly likely – would be a major achievement.
GREAT ExPECTATIONS
India has no doubt benefitted from factors beyond its control. But the improvement in macro balances also reflects better economic policies. Fiscal policy has been tightened, inflationary fiscal support measures in the rural sector have been scaled back and the monetary policy framework has been enhanced dramatically. These changes should help India achieve growth rates of 7% to 8% over the medium term. Structural reform will inevitably be a slow and complicated process, but there is a good chance of material changes being implemented.
Source: RBI, DAtastream, LGIM
Figure 5. Clearer inflation targeting, based on CPI bands
Jan 2014 Mar 2014 May 2014 Jul 2014 Sep 2014 Nov 2014 Jan 2015 Mar 2015
S&P 500 Nikkei 225 Eurostoxx 50
FTSE All-Share MSCI Emerging markets
Last month, we mentioned the return of volatility, which has continued into March. Equity strength shows no signs of abating as Chinese equities reached a 17-year high, Japanese markets hit a 15-year peak, the German Dax rose above the 12000 points mark and the US was also up, despite some intermittent volatility. Meanwhile, corporate bond spreads have continued to compress while government bond yields in Europe are also lower. Indeed the ongoing firmness in bond markets has reignited concern from some investors about bond bubbles.
Market overview:
Equity surges and bond bubbles
Figure 1. Global equity markets
Source: Bloomberg L.P. chart shows price index performance in local currency terms
UK
Consumer spending growth
US
Weaker data
The combination of lower inflation, oil prices and mortgage rates with higher wages and employment levels is resulting in a stellar environment for UK consumer spending. Survey data and GDP growth have stabilised recently in the UK, with growth expected to move sideways throughout the rest of the year. Osborne’s latest budget announcement passed with little controversy as the political race begins to heat up ahead of the general election in May. In the interim, domestic equity indices have continued to climb and government bond yields have again moved lower as the annual inflation rate fell to zero in February.
focused on whether the Federal Reserve raises rates in June or later in the year. There seems to be rhetoric that supports both sides, with some FOMC members calling for earlier rate hikes in order to avoid dangerous bubbles whilst others are more sanguine, referencing weaker wage growth as justification for lower rates for longer. The higher levels in US equity markets may represent the reassurance investors find in current data’s ability to quell the Fed’s rate increase at a gentler, moderate pace.
With the notable exception of the labour market, economic data from the US are generally running below expectations with the economic surprise index now at its lowest level since 2009. The market is
Political instability in Europe continues to be the most prominent risk for investors as support for anti-austerity parties in the periphery and core countries will keep political pressure high. Indeed, the latest Spanish local election results showed a swing towards anti-austerity parties. However, as Draghi defends the merits of quantitative easing in Europe, factors such as better credit demand and availability,
EUROPE
Austere politics
06APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY
Figure 2. 10-year government bond yields
Source: Bloomberg L.P.
0
1
2
3
4
5
6
7
Jan 2014 Mar 2014 May 2014 Jul 2014 Sep 2014 Nov 2014 Jan 2015 Mar 2015
Germany US UK Italy Spain Portugal
FIxED INCOME
Lower yields
the boost from lower oil prices to consumption and the increase to export competitiveness provided by the weaker euro could improve European growth. Government bond yields have fallen once again across the curve, as equities continue to trade at, or around, near-term highs.
Emerging markets have fared badly from the oil price decline. Russia and Brazil look vulnerable in particular. Russia’s rapid currency depreciation and stronger balance sheet may prevent a full-blown crisis, even in the face of sanctions, but Brazil has no policy space left and its economy is expected to contract this year. On the other hand, policy easing in China is set to cushion the slowdown in investment as it rebalances towards a consumer led economy. Indeed, China cut rates again this month, its second cut in just three months. India is set to be a global growth leader this year as its reform progress gathers pace.
Oily repercussions
ASIA PACIFIC/EMEA
Government bond yields across the developed world were lower month-on-month (in the opposite direction to prices), with the moves particularly pronounced at the long end of the curve. This may be down to the ongoing rate brinkmanship as the Federal Reserve remains the focus for bond markets. Once again, corporate bond markets have made further gains with many companies – particularly from the US – taking advantage of the particularly low yields in European markets to issue new debt. In the secondary market, bonds such as Nestle have dipped into negative territory, an inconceivable situation just a few years ago.
JAPAN
Equity strength
The most recent purchasing managers report release from Japan was subdued but there are some positives signs too. Exports have increased in both yen and volume terms and wage inflation has increased with unions expected to push for even larger increases this year. Against this backdrop, Japanese equities have continued to post new highs and government bond yields have continued to fall.
07APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY
Snapshot:
UK housing – One Direction?
The UK housing market appears to have reached an inflexion point. After shooting higher in 2013, mortgage approvals reversed course in 2014, wiping out most of the previous year’s gains. Various culprits were blamed: the mortgage market review was formally introduced in the spring of 2014, making it more arduous to get a loan. The Bank of England added to this over the summer by introducing a cap on the share of high loan-to-income ratio mortgages. Two MPC members also began to vote for higher interest rates.
Offsetting this was a stronger domestic economy, with unemployment falling rapidly. The government’s “Help to Buy” scheme saw a return of low-deposit mortgages. And deflation fears in the euro area led to gilt yields – and UK mortgage rates – hitting record lows. The government also cut stamp duty for 98% of homebuyers in December.
The rot seems to have stopped. Data from both banks and estate agents suggest housing activity has bottomed in recent months (figure 1). We expect this tentative recovery in demand to continue – but the pace remains uncertain. On the positive side, with inflation significantly below target, the Bank of England is unlikely to hike interest rates this year, and the ECB’s QE programme should also keep gilt yields low. But May’s general election brings political risk: fears of a hung parliament, mansion tax and EU referendum will cast a shadow over the market.
Figure 2. UK house prices vs RICS sales-to-stock ratio
Source: Reuters ecowin
Figure 1. New estate agent buyer enquiries vs mortgage approvals
UK Nationwide house prices, 6-month annualized growth rate (LHS) RICS sales:stocks ratio (RHS)
25,000
35,000
45,000
55,000
65,000
75,000
-30
-10
10
30
50
70
09 10 11 12 13 14 15
RICS survey - net % balance of agents reporting rising new buyer enquiries (LHS)
Number of mortgage approvals - official BoE data (RHS)
Number of mortgage approvals - preliminary British Bankers' Association data (RHS)
Despite falling demand, house prices continued to grind higher last year. Homebuilders were quick to cut housing starts in line with sales. With supply also constrained by falling unemployment and record-low interest rates, estate agents continued to report demand outstripping supply last year. The ratio of the number of sales relative to the number of properties on their books remained above average in 2014, consistent with solid real house price gains (figure 2).
Looking forward to 2015, we suspect strong fundamentals will ultimately outweigh political risks and both housing turnover and house prices will edge up together in one direction.
08APRIL 2015 ECONOMIC AND INVESTMENT COMMENTARY
Inflated opinionsUK forecast:
Source: Bloomberg L.P. and LGIM estimates*Consensus forecasts are for end of q2 2016
‘GDP growth expected to move sideways’ is not an inspiring headline. But after several quarters of modest acceleration, albeit not always smooth, we think we’ve reached a plateau in UK GDP. As a result, for the first time in two years, we are no longer expecting the UK economy to defy expectations.
The main reason is oil. As we highlighted in ‘Beyond Goldilocks’ February edition of Fundamentals, lower oil prices will result in lower investment. For an economy with a significant oil and gas industry, that fall in investment will have a negative impact on GDP. As well as a weaker investment outlook, sterling strength and weak growth from OPEC and Russia mean that the prospects for exports are also underwhelming.
One area where we are more positive is consumption. Cheaper energy, coming at a time when more people are working and wages are increasing, means we all spend more. Wage growth is now starting to come through at the highest levels seen in two years and we expect this to continue to grind higher in 2015 as unfilled vacancies fall and recruitment difficulties continue. However, we would expect wage growth to be slower in 2016 as after a year of near zero inflation, wage demands are more likely to be muted.
There’s a lot of excitement with inflation reaching such low levels, and frequent comments that we could be heading into a Japanese-style deflationary environment. We don’t see that happening. If we look at headline inflation, the fall in oil is probably the single biggest factor – falling some $50 per barrel over the past year, pushing consumer energy prices down by around 16% from Feb 2014. To repeat that same effect over the next year, oil prices would have to fall towards zero!
However, this technical effect on headline inflation is not the only one to look for. Wage growth may be increasing, but productivity is not. Productivity is a term that gets used a lot when looking at any economy. In the case of the UK, ‘productivity’ is usually preceded by ‘weak’. This perhaps gets taken for granted, but it’s worth noting that productivity growth is currently near zero. Even with our expectation that this recovers somewhat, we expect wage growth to outstrip this by around 2% – which feeds directly into unit labour costs and ultimately to core inflation. So while headline figures may bump along at or near ‘deflation’ levels, we’d expect this to be relatively short-lived.
The forecasts above are taken from Bloomberg L.P. and represent the views of between 20–40 different market participants (depending on the economic variable). The ‘high’ and ‘low’ figures shown above represent the highest/lowest single forecast from the sample. The median number takes the middle estimate from the entire sample.
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