Markets At Crossroads: Factors Beyond Geopolitical Conflict
While the world was already grappling with issues such as the current geopolitical conflict, supply chain disruptions and rising commodity and food prices that led to the rise in interest rates, has also subsequently been seen to have kicked in "risk-off" mode
The most certain thing about global markets is uncertainty. While the world was already grappling with issues such as the current geopolitical conflict, supply chain disruptions and rising commodity and food prices that led to the rise in interest rates, has also subsequently been seen to have kicked in "risk-off" mode.
There is a reason behind the concerted actions of central banks across the world. The Reserve Bank of India increased rates before the US FOMC meeting to not only tame inflation but also to keep the Indian rupee balanced against the US dollar. India is vulnerable to high energy prices due to its significant reliance on imports. In times of already high energy prices all of which are in USD, managing the stability of the rupee becomes even more critical. Also, the timing was just right as the mega issue of LIC had decent anchor participation and subsequently a fully subscribed status.
The US has been experiencing multi-decadal high inflation over the last few months. The massive quantitative easing that started after the first wave of COVID-19 resulted in enhanced corporate liquidity and sustained consumer demand. However, this also resulted in high wage growth and high property prices. Add to this supply chain bottlenecks and higher oil prices post the start of the Russia-Ukraine conflict have all resulted in skyrocketing inflation. Inflation is the one horse every central bank wants to tame. Faced with this dilemma, the Fed has no other option but to increase rates, even if this negatively impacts growth.
So, the question that is on everyone's mind is whether inflation has peaked and also when will it come under check? Irrespective of the opinion, the easiest weapon central banks have is increasing interest rates. An interest rate increase by US Fed makes US dollar appreciate against every currency including the rupee. So essentially, the US dollar has appreciated against all currencies and it's not just the rupee that has depreciated. Take this example, Canada is the 5th largest exporter of oil and gas in the world. The oil prices are higher by 50 per cent compared with last year, still, CAD has depreciated by almost the same extent as USD in the last year as the INR. The increase in US interest rates makes US treasuries more attractive and hence investors flee emerging markets to the perceived safety and attractiveness of US fixed income. FIIs have taken out almost INR 6400 crore from Indian markets for this reason in May. Japan, at the same time, has seen the Yen depreciating to a 20-year low recently after the Bank of Japan announced a permanent program in which it will continue to buy an unlimited quantity of government bonds at 0.25 per cent for an indefinite period. Collectively, all these developments are further making USD and US treasuries a safer haven.
All these developments have significant consequences for investors. Rising interest rates will increase the cost of capital. The closure of the Fed's bond-buying program by $95 billion per month will reduce the easy liquidity and cheap money which has fueled asset prices. Add to this a slowdown in global GDP growth and it is no wonder that the S&P 500 has been on a losing streak continuously for 5 weeks. Big Tech companies that were major beneficiaries of low-interest rates and ample liquidity have seen significant corrections in stock prices. Nasdaq is down by 24 per cent from its peak while many tech constituents of Nasdaq are down by 30-70 per cent. Indian markets have witnessed heavy selling as well and are down 10 per cent from the highs of this year.
In times like these where markets are at crossroads, we like owning companies in India and globally that are debt-free, generate free cash flows and have pricing power. These businesses have a low recovery period and coupled with their financial performance; make a strong case for being owned in any portfolio. At this juncture, we find comfort in maintaining the strategic asset allocation across Indian equities, US equities and US fixed income. The approach of maintaining at least 10-15 per cent cash allocation is ideal for such scenarios. To conclude, diversification across lowly correlated asset classes and keeping a cautious stance will enable portfolios better manage this period of uncertainty.