US Fed winding down its balance-sheet won't dent sentiment: Robert F. Baur

Interview with chief global economist, Principal Global Investors

With the US Federal Reserve (US Fed) deciding to wind down its $4.2 trillion balance-sheet starting October, US-based ROBERT F. BAUR, chief global economist, Principal Global Investors that has around $431 billion worth of assets under management tells Puneet Wadhwa that global equity markets can continue to move up in tandem as long as the (corporate) profit growth is strong, economic growth is robust and interest rates don't get too high. Edited excerpts:

What are the implications for the global financial markets once the US Federal Reserve starts winding down its balance sheet?

I don't think there will be too much reaction initially. There are two other central banks - Bank of Japan (BoJ) and the European Central Bank (ECB) - that are continuing to increase their balance-sheet. So, if one adds the US Fed, BoJ and ECB, the $10 billion a month winding down by the US Fed is just a drop in the bucket. I don't think the markets' reaction will be too much.

My judgement is they will wait and see how the markets react to this before raising rates again. The odds are 60:40 that they won’t raise rates till March 2018. December is also a possibility, but Janet Yellen has stated that the hike in rates will be gradual and will not cause any market interruptions.

Once the ECB starts to taper next year and the BoJ raises the interest rate on the 10-year JGB (Japanese Government Bonds) to zero, it is then the markets are likely to react. Then long-term interest rates across the globe will start to have an upward pressure. We have already seen this in Germany where Bund went up from 20 basis points (bps) to 60 bps. Over time, it may move up to 0.75 - 1%, which will then allow the US to take some pressure off the 10-year US treasury bonds.

What is your forecast for global growth?

If we look at four major economic areas - the US is looking at 2.5 - 3% economic growth for the next several quarters. There will be some rebuilding after the recent hurricane, capital spending is also coming back and capital goods orders have been quite good. That apart, business and consumer confidence is almost at record levels. Same is the case in Europe where the business confidence is the highest in nearly a decade. United Kingdom is in the middle of an economic expansion. Though China's growth has slowed, I think it will stay around 6.5% range for the rest of this year. Japan, too, can see a growth of 1 - 1.5% over the next several quarters. All these contribute nearly 60% of the global gross domestic product (GDP). Other developing countries, like Australia and Canada, also continue to witness a good growth.

What about India?

I think growth will pick up in India. There has been a lot of confusion after the demonetisation and implementation of the goods and services tax (tax) bill. With commodity prices now well above the lows of last year, emerging markets as a whole should do well going ahead. Global growth is in the best shape it has been in many years. All this augurs well for the financial markets as well.

How long can the global equity markets continue to move up in tandem?

I think it can continue as long as the (corporate) profit growth is strong, economic growth is robust and interest rates don't get too high. In the US, reported earnings growth on a trailing basis is up nearly 20% year-on-year (y-o-y). This is the third consecutive quarter of positive y-o-y growth after nearly two-and-a-half years. Globally, the stock markets will follow earnings.

That said, stock prices and interest rates can rise in tandem for a while, but at some point if the long-term interest rate and 10-year treasuries get to around 3 - 3.25%, it will be a real headwind for the stock market. However, I don't see that happen for several more months. It is quite possible to see mid-to-high single digit rise in equity markets before a correction sets in.

What are the key risks to the global financial markets, especially the equities?

The global financial markets have been in a lot of malaise since 2007 to 2016. There has been a continuous financial crisis - first in the US, followed by Europe and China. During that time, growth was really slow. Everyone was scared of deflation. However, since then, we have moved into a synchronised transition and we now have much more normal growth trend as business confidence is coming back. What is not normal is the interest rates in the developed countries. We may be in a period where it will take two - three more years for interest rates to normalise. Interest rates will then be almost equal to the nominal growth rates. If that happens, it might be a huge headwind for the stock markets across the globe and may generate a significant correction at some point. This, I think, can happen in calendar year 2018 (CY18).

What about the Indian stock markets?

I understand investors are worried about the price-to-earnings (PE) ratio here; but, in part the high stock prices is because there has been a lot of optimism about India given by Narendra Modi government and the reforms that will have long-term implications. Earnings, on the other hand, have been under pressure given the uncertainty given the demonetisation, which was a sudden shock, and the GST bill implementation. There was some destocking ahead of GST implantation, and I think there will be restocking now. With global growth in good shape and capital spending rising around the world, I don't think why India will not be a part of that capital spending expansion. This, in turn, will lead to some more upward movement in stock prices.

We recently saw foreign investors take money out of the markets. What explains that?

Money has been going into markets / economies of commodity exporters as (commodity) prices bottomed out a few months ago. So, within the emerging markets, India is a user of commodities and not a net exporter. That partly explains the outflow. That said, there is healthy flow from the domestic institutions, which I believe is a good sign and is a more stable support to the stock market. From a tactical standpoint, investors can continue to stay invested and watch interest rates as a key to when there might be some sort of correction.

What are your views on demonetisation and GST?

From a long-term standpoint, the GST enables companies to do business across states with the tax rates already known. It makes it easier for the government to find corruption and address it. The demonetisation exercise was supposed to bring in a lot of 'cash economy' into the light and get taxed. Though the measures will create disruption in the short-term, it will settle down going ahead.

What is your outlook for interest rates in India and the rupee's trajectory?

A lot will depend on inflation. The RBI has lowered interest rates over the past few months and will continue to do so in case inflation remains under check. Rupee, on the other hand, will behave according to how the dollar performs and the global growth. A robust global growth is negative for the dollar and I don't see the US dollar starting to particularly soar again. With growth likely to pick up in India, it makes sense that the currency remains stable and a little stronger.

What about oil prices?

Oil prices could stay around $45 - 60 / barrel range for some time now. For decades, Saudi Arabia was the marginal producer of oil. However, they have indicated to keep production cuts in place well into the next year.

Which other regions do you like from an investment perspective given the macro-economic indicators?

India has the best demographic profile of any country across the globe. The government is now focussed on trying to make structural changes that will be positive for the long term. Therefore, I am optimistic on India. From a tactical standpoint, I also like European stocks. The strength in the euro has kept the markets under check. I also like Japanese stocks. While EM stocks have done well and have outperformed most other regions over the past few months, the outperformance can continue as long as the interest rates remain low.

What are the key risks to the Indian growth story?

Our portfolio managers remain overweight on India due to the structural changes going on in the country. The concerns would be that the structural changes that have been contemplated either do not come through or the current government is not able to continue on the path of doing business easier. Non-performing loans (NPLs) in the banking system are another issue, but the authorities are already addressing this. Banks have improved their loan provisioning. So the problems that existed a few years ago, have reduced.

The government will present its last Budget next year. How will the markets react to a trade-off between fiscal discipline and to prop-up growth?

A large fiscal deficit has been a problem for India in the past. However, there has been a significant improvement in the fiscal and the current account situation since then. I think maintaining fiscal prudence is better than borrowing to make growth faster today at the cost of deceleration in growth in the future.