Rising dollar may be market trendsetter in 2015: Ewen Cameron Watt

Interview with Global chief investment strategist, BlackRock Investment Institute

December has been a difficult month for global equities. Besides a fall in crude oil prices, growth concerns, especially in key economic regions like Russia, China and Japan, have had investors running for cover. But the steep fall in crude oil prices remains the biggest concern, London-based Ewen Cameron Watt, global chief investment strategist, BlackRock Investment Institute, tells Puneet Wadhwa. Indian markets, he says, have run ahead of the time table and the gains they have seen in 2014 could be difficult to replicate in 2015. Edited excerpts:

Amid a weak show by global equity markets this month, what do you think might be the biggest risk to global economies and markets in 2015? And which economy — Russia, China, euro zone or Japan — do you see it emanating from?

People are most concerned about the enormous decline in crude oil prices over the past few months. Some of this is attributed to an increase in (shale gas) supply in America and some regions, such as Libya, producing more than expected. There also is considerable debate about oil price decline because of a slowing global economy.

Bond yields, on the other hand, have rallied significantly, consistent with growth concerns. So, I think the main concern people have at present is about the impact of the fall in oil prices over the past six months — from $100 a barrel to $60. You cannot have such a big fall in the world’s most-traded commodity and see no major positive or negative impact.

Most people’s expectations from Europe are low; they are generally optimistic about the US. Also, they do not know much about China but hold a view that country will be the single largest contributor to global growth in 2015.

How do you see economic growth across key geographies in 2015? How do you extrapolate that to the likely trends we might see in the financial markets going ahead?

The global recovery from the 2008 financial crisis has been an unusually tepid one. Nominal growth in 2015 is expected to be below the 15-year trend in most economies — the US and Japan being notable exceptions — according to International Monetary Fund (IMF) forecasts.

Divergent economic growth and monetary policy underpin our 2015 base case. We expect tightening financial conditions in the US and UK due to a pick-up in growth and improving labour markets. Lacklustre growth and low inflation expectations support looser monetary policy elsewhere. Falling oil prices should support growth in most countries and hinder it in a few.

The second half of 2014 gave a possible glimpse of the future. Small-cap equities and high-yield bonds started to fall, just as the US dollar took off. Large-cap equities stumbled, but recouped all of their losses, and more. A rising US dollar should be the trendsetter for financial market in 2015. This means a de facto tightening of global financial conditions because the greenback is still the world’s premier funding currency.

Should the emerging markets (EMs) like India fear the dollar’s rise? Do you see a trend reversal in flows from the EMs to the developed world?

EMs typically bear the brunt of a stronger dollar, as funding sources dry up. Subsequent buying of local currencies to prevent those from sliding might effectively tighten domestic financial conditions. EMs will likely compete for liquidity by raising rates. This will cause slowdowns and currency gyrations. Plus, short-term asset price movements are often about flows and investor sentiment — both of which can turn on a rupee. The good news, however, is that EM currencies and equities were relatively cheap when the dollar started rising. A lot of adjustment has already happened.

Which regions in your opinion are likely to see good economic growth in 2015? Where does India stand?

Let us distinguish between real GDP (gross domestic product) growth, which excludes inflation, and nominal GDP growth (activity plus inflation). The big problem facing policy-makers right now is that there is no inflation, but there is deflation in a number of regions, particularly Europe. Prices in India, too, are weakening, led by a decline in energy and food prices. Policy-makers will be looking at nominal GDP, and it is nominal GDP that links to the bond yields.

In the first half of 2015, we will see nominal GDP strengthening in the US because of the stimulatory effect of a decline in oil prices; it can be slightly better than very low expectations in Europe. We could see a little higher nominal GDP in Japan, partly because of imported inflation created by a decline in the yen. It will probably be okay in the UK, particularly in the first half of 2015; and it will continue to slow down in China under the impact of zero inflation and the impact of fixed asset investment at the moment.

In India, I guess, we will see a rise in real GDP because of a pick-up in investment intention, but not a huge change in nominal GDP because of the deflation created by a decline in oil prices.

What is your reaction to the recent inflation (retail and wholesale) numbers and the index of industrial production figures for October, in the Indian context? Do you expect the Reserve Bank of India (RBI) to slash rates sooner than expected?

RBI has already signalled it will lower rates in the first quarter of next year; and I would think these figures confirm that point. I think the question now is whether RBI will drop rates by 50 basis points (bps) or 100 bps over the course of next six months.

The 15-year median rate for Consumer Price Index (CPI) in India is 6.2 per cent. The consensus estimate for CPI-based inflation in India in 2015 was seven per cent; there is scope for it to be a lot lower than the 15-year median. So, perhaps the surprise in 2015 will be how much inflation drops by.

The one thing where there might be a setback is the rupee, if it weakens against the dollar. That will means a certain amount of inflation will be imported through the exchange rate. So, a surprise could be in RBI remaining more dovish in 2015 than people currently expect.

How do you evaluate the first six months of the new government in India against expectations?

The thing about structural reforms, something on the promise of which (PM) Narendra Modi came to power, is that it takes a lot of work to get things underway. After one gets a big election mandate, as Mr Modi did, one still needs to deal with the methods.

So, for the first six months, it is easy to say a lot more should have been done, but I do not think this is unusual. Markets will look at what comes through in the winter session of Parliament.

One should not underestimate the fact that structural reforms take a long time to actually be delivered. One needs to change the spending patterns, incentives, people’s way of dealing with rules — all of that takes time. Ronald Regan was re-elected in 1981 but supply-side economics was not impacted well until the mid-1990s.

The problem is that the markets at this stage might move ahead. I suspect the Indian markets have run ahead of time table now and that might be one of the reasons why we are seeing a bit of weakness for the past few weeks. So, it is not that the government has not done anything; things will take time.

How long will the market participants continue to attach a ‘Modi premium’ to index levels? Can the markets replicate the gains of 2014 next calendar year?

Well, there is one thing that people should be clear about — there will be no repeat of 2014 in 2015. And there is a very good reason for that. In the beginning of 2014, it was reasonably apparent that the Bharatiya Janata Party (BJP) would win the election. The scale at which it won was a surprise in the end, though. At the end of 2013, there were some residual concerns that about the exchange rate and the current account deficit.

A year on, the expectations are much higher. The chances of a 30 per cent rally in 2015 are quite low. However, I think it should be a decent year for Indian equities because interest rates are likely to fall during the course of the first six months — and that helps. I think we will also see a gradual pick-up in activity and, most importantly, we should see corporate earnings accelerating as we move into 2015.

Which sectors in the Indian context do you see putting up strong and weak performances over the next 12 months?

My colleagues at DSP Blackrock see quite a lot of interest and value in mid-cap stocks now, and I feel positive about the private-sector financial sector. While we agree India needs to increase expenditure on infrastructure significantly, the public-sector banks (PSBs) are stuck with bad infrastructure loans and they need to recapitalise.

The way money will be found in infrastructure over time will be through the bond market. For that to happen, RBI will have to open up the bond market more to foreign investment, and that is a difficult thing to do politically. I think that is one of the challenges because of which the infrastructure stocks, which have done well so far, might start looking expensive.

On the other hand, the domestic consumption stocks look more interesting. The other thing that is happening is that the internationally traded comparable Indian stocks, especially in the software business, are trading around the way their Wall Street peers trade. I think it will be domestically oriented stocks that will do fine in 2015.

What should be the asset allocation strategy for 2015?

My colleagues at DSP Blackrock will say Indian equities. But a lot depends on the profile of the investor concerned and the investment objective. If interest rates continue to decline more than the markets think, long-duration government bonds in India will be in demand. If interest rates fall, rate-sensitive stocks will do well. I think the allocation least likely to work for an Indian investor probably is holding cash, because a decline in interest rates will eat into the rate of return. So, we will see more interest in the Indian bond and the stock markets in 2015.