Export less of a drag on growth?

Inflation is likely to continue firming up gradually on the back of higher food and fuel prices but will continue to remain within RBI’s comfort zone, says Abhishek Goenka.

Heading into 2018, we are in a phase of synchronised global growth. Business sentiment and consumer confidence is on the rise, generally across major economies. The year 2017 has been an exceptional year for risk assets, especially equities. Major equity indices have hit new all time highs. Low inflation and wage growth in developed economies, uncharacteristic of this phase of economic cycle has allowed central banks to withdraw accommodation gradually. As a result, global liquidity has been chasing yields and this has resulted in a phenomenal rally in emerging market stocks, bonds and therefore currencies. There is quite a bit in store for the remainder of 2017 that could set the tone for risk sentiment in 2018.

On the global front, the Congress passed a stopgap measure that has pushed the US debt-ceiling deadline to December 22. The bone of contention between the democrats and the republicans to keep the government from shutting down is hike in the non-defense spending cap (that the Democrats are in favor of). The democrats want hike in defense spending to be matched by a similar hike in domestic spending. Democrats are pushing for legal status for undocumented immigrants who were brought to the US as children and for continuing funding of Obamacare insurers. Republicans would need some democrat votes to pass the spending bill for the next two years in the Senate. That would entail some sort of a compromise on either or both of these contentious issues.

The developments around the tax bill would also be extremely crucial. Both, the House and the Senate have passed their respective versions of the bill but the challenge lies in reconciling both the versions, as there are considerable differences. The republicans would have to chalk out a final plan and both the House and Senate would have to pass that plan again. The Senate is constrained by the Byrd Rule according to which the tax bill can only increase the federal deficit by up to $1.5 trillion in the first 10 years and by nil thereafter. Therefore, many of the sops proposed in the Senate version are set to fade out from 2025 onwards.

The house bill on the other hand is likely to increase the federal budget deficit after 10 years according to CBO (Congressional Budget Office) making it unviable under Byrd Rule in the Senate. This is the biggest difference besides many other smaller ones pertaining to start date for corporate tax cuts, mortgage deductions, Child tax credit, Obamacare’s individual mandate, etc. The impact on the USD and US rates would depend on whether the final plan has deficit funded tax cuts or deficit neutral tax reform with the former likely to push USD and US rates significantly higher and the later not changing status quo much.

Deficit funded tax plan would most likely elicit a change in US Federal Reserve’s reaction function and may cause it to normalise policy sooner than currently anticipated. The markets would look forward to the FOMC meet on December 13 to ascertain if there is any change in median dots (indicating expected trajectory of Fed Funds rate of FOMC members). The US Dollar could rally if median dot plot indicates four hikes in 2018 compared to three in the September dot plot. According to the latest non-farm payroll report, the economy added a higher than expected, 2,28,000 jobs in November and unemployment rate remained constant at 4.1 per cent well below the NAIRU (non accelerating inflation rate of unemployment). However wage growth continues to remain tepid. This suggests that most of the jobs that are being added are the ones in industries where median wages are low.

On the domestic front, Q2 GDP came in at 6.3 per cent (compared to Q1 print of 5.7 per cent). Particularly encouraging is the pick up in manufacturing activity. Average manufacturing PMI in Q3 FY18 has been higher than Q2 FY18 which suggests that Q3 growth numbers could be even better. New export orders component of manufacturing PMI has also broken its declining trend, which implies exports would be less of a drag on growth in Q3 unlike Q1 and Q2.

In October, the core sector comprising of eight key industries grew 4.7 per cent, unchanged from August. Inflation is likely to continue firming up gradually on the back of higher food and fuel prices but will continue to remain within RBI’s comfort zone. The RBI kept monetary policy unchanged in a 5-1 vote in its December policy meeting with one MPC member voting for a rate cut. The market senses that with global crude prices sustaining above $55 per barrel mark we could have seen the last of rate cuts in the current easing cycle and that the RBI would keep rates on hold in the foreseeable future. The benchmark 10 year yield has been rising and touched 7.20 per cent in trade as market prices in no further rate cuts and takes cognizance of the fact that global rates could also head higher in 2018 due to increase in supply as central banks trim asset purchases and reduce balance sheet size. Though the trade deficit is likely to widen on account of higher crude import bill and weaker exports, the overall balance of payment situation is likely to remain comfortable if FPIs do not turn net sellers of Indian debt and equity. Drawdowns related to foreign currency funding availed by corporates have kept a lid on up side in USD/INR in the recent past.

The key risk in 2018 for domestic markets would stem from union budget, crude prices, and most importantly US rates. The way US rates pan out would depend to a great extent on the contours of the final tax plan. Tail risk could stem from developments in the Middle East, Korean Peninsula and Italian elections.

The article is authored by: Abhishek Goenka, CEO & Founder at IFA Global