International investors are expecting swift results: Paul Donovan

Interview with Global economist & managing director, UBS Investment Bank

Weak recent US jobs data, released on Friday, at the lowest level since December 2013, have led to some hope the US Federal Reserve (US Fed) might delay an increase in the interest rate. Paul Donovan, global economist & managing director, UBS Investment Bank, tells Puneet Wadhwa he expects the US central bank to begin raising the policy rate in September. As regards India, he suggests the foreign investors who bought into the reform story and were interested in India are expecting swift results. “UBS is overweight on India in a regional (Asia) context and among (emerging-market, or EM) peers,” he says. Edited excerpts:

Why do you thing the global markets have not reacted with much enthusiasm after the outcome of the US Federal Reserve’s (US Fed’s) latest meeting? How long do you expect the Fed to remain patient?

There still is considerable confusion over the Fed’s outlook. That adds a risk premium for financial markets. It has signalled its desire to raise interest rates in 2015 but the Federal Open Market Committee (FOMC) members’ comments at the March meeting clearly show a division — or a series of divisions — within the FOMC, on the timing and speed of a rate-tightening cycle. We believe the Fed will begin to raise rates in September but there is still a possibility of a rate increase at the June meeting.

Do you think a rate increase has the potential to upset the equity rally and macros of major economies across the globe, especially the EMs?

Our house view is that major markets (of countries in the Organisation for Economic Cooperation and Development, or OECD) are unlikely to be significantly disrupted by a policy tightening in the US. Typically, equity markets view the initial stages of a tightening cycle as a positive signal, validating the signs of better economic activity. Rate increases deliberately aimed at slowing economic activity are not the same thing as rate increases aimed at maintaining a sustainable pace of economic activity.

If the Fed were trying to squeeze inflation out of the system, rather than seeking to keep it within acceptable bounds, its policy actions would have the potential to be negative for risk markets. The risk around this view is the reaction of the US treasury market, in which volatility at the longer end of the yield curve might increase the risk premium attached to other assets.

What are the key risks that global economies now face?

Given their relatively low levels of liquidity and poorer domestic fundamental outlook, EMs are less secure in the event of a rate increase, though it is worth noting there is considerable divergence among EMs. At EMs with a legacy of poor domestic policy decisions, the increase in opportunity cost represented by higher US interest rates creates significant vulnerability.

Given the recent rise of the dollar, could this be a beginning of a full-blown currency crisis?

A currency crisis by definition affects a specific currency and not the world economy (one cannot have a global currency crisis, as currencies are relative value measures). Do we have a currency crisis in the real or the rouble? Yes, recent moves can fairly be called a currency crisis. Do we have a crisis in the euro? Clearly, no. The euro is perhaps slightly below fair value, having been slightly above that earlier. There is nothing especially surprising in any of the recent moves. It is noteworthy that European exporters have not reduced the dollar prices of their exports and US exporters have not raised the euro prices of their exports. This would suggest the recent currency moves are within acceptable bounds and the world economy is well placed to deal with the euro’s move.

What is UBS advising its clients globally and in India as portfolio investment strategy?

UBS is overweight on India in a regional (Asia) context and among EM peers. We are positive on Indian markets directionally, though near-term correction or consolidation is also likely as markets factor in the reality of weaker growth recovery. We are overweight on banks, as we think lower interest rates will drive stocks; the oil & gas sector, as some companies should benefit from reforms initiated by the government; and telecom.

How is India placed as an economy and an investment destination?  

Global capital flows have declined substantially as a share of global gross domestic product, in the wake of the global financial crisis. And, with financial repression and home country bias becoming increasingly dominant trends, it seems unlikely there will be a substantial increase in international capital flows. A further challenge is presented by the low oil price, encouraging fund repatriation to oil-producing countries and substantially reducing the role of such countries as sources of capital flows to EMs.

What is your reaction to recent economic data from India, such as those on inflation and the current account and fiscal situation? How much elbow room do they give the Reserve Bank of India (RBI) to slash rates?

We think the low oil prices will continue to help keep India’s inflation low. The low oil price environment also raises the prospect of an Indian current account surplus. These developments should allow RBI to further reduce interest rates in a measured way. The current account surplus might also support a credit expansion in the Indian economy.

How do you evaluate the new government’s progress so far on promised reforms?

Anecdotal evidence suggests the international investors interested in India bought into the reform story, and are expecting swift results. There has been less new interest in India in recent months. The key question is whether the implementation of reform is successful (not in terms of legislation and regulation but in terms of producing desirable economic consequences), and whether it is successful quickly enough to reassure the international investors who invested in India in the belief of reform implementation.

At what level and how soon do you see crude oil prices bottoming out? Are the global economies and markets fully factoring in the worst?

Oil prices are probably relatively close to the bottom, though this is slightly dependent on the dollar stabilising (in trade-weighted terms) as a proportion of the move in the oil price that can be attributed to the dollar move.

To a large extent, global markets have factored in lower oil prices but might not be sufficiently factoring in the upward effects on inflation in some economies as the oil price stabilises/rises later this year. Investors might be surprised by the upward bias to both headline and core retail inflation rates in the late December and March quarters. However, this is not the case for India and we continue to expect inflation to decline.