Escalating Geo-political Risks: Rising concerns for Growth, Inflation & Currency Outlook
With the omicron concerns ebbing globally (barring Emerging Asia), February was dominated by rising geopolitical risk in form of Russia-Ukraine war - resulting in risk aversion in financial markets, sharp rally in commodities (especially oil) and volatility in currency market. This geo-political issue, if extended for long, is likely to have implications for global growth, inflation and policy making, along with its impact on fiscal, rates, liquidity & financial markets.
Indian economy is estimated to grow at 8.9%y/y in FY22 (as against previous estimate :9.2%y/y), due to impact of omicron and slowing growth momentum. 3Q FY22 GDP growth moderated to 5.4%y/y from 8.5%y/y in 2Q and 20.3%y/y in 1Q – mainly due to adverse base effect, post pent up demand impact and slowing growth momentum (on global and domestic cues). 3Q print was lower than consensus estimates (5.5%-6.5% range). While private consumption (main engine of growth) moderated to 7%y/y (Previous quarter: 10.2%y/y), capex moderated to 2%y/y (previous quarter: 14.6%y/y). Although both export and imports have picked up, drag from net exports to growth was high due to higher commodities import bill (driven by sharp rally in global commodities) and pick up in core imports.
From supply side, services growth has clearly shown a pickup and now are finally above pre-pandemic level, due to reduction in pandemic linked restrictions. However, contact based industry like trade, hotels, transport & communication is still below pre-pandemic levels. Further, laggards in 3Q print were manufacturing (supply issues) and construction sector.
Jan 2022 Headline CPI print came higher at 6.01%y/y (Upwardly revised Previous month: ~5.66%y/y). This was in line with RBI and consensus estimate of 6% y/y. Sequential momentum in headline was better than the seasonality aided by food and fuel prices. Core inflation remained unchanged at 6.19%y/y only due to favorable base effect. However, there was pick-up in monthly momentum (56 bps in Jan as against 23 bps in Dec).
While the headline number is now on higher bound of RBI’s target range and expected to remain so in Feb-Mar driven by adverse base effect, worsening global macros (in terms of high and elevated commodities, lingering supply chain issues due to Omicron) and domestic factors (rising cost of production, pick-up in demand) are likely to keep prices elevated, although seasonality in food may help in keeping food inflation down.
Globally, the inflation has been at elevated levels over last couple of months - driven by base effect, pick-up in economic activities, broad-based supply issues, rising food, commodities, manufacturing and services prices. Now with rising geo-political risks, supply side issues are likely to persist for longer, making higher inflation more entrenched. In fact, there are increasing concerns about stagflation.
Globally, most central banks have already embarked on the path of normalisation with many emerging economies already done with more than couple of hikes. Now with inflation risk lurking in backdrop of rising geo-political risks, monetary policy tightening is likely to be followed by vigour. Many advanced economies have started process of rate/liquidity normalisation. US Fed has clearly given indication of likely to hike rates from March policy onwards and more rate hikes in 2022 and early start of Fed balance sheet contraction. In testimony to US Congress, Fed Chairman affirmed that while uncertainty related to war is on rise, Fed is committed to bring inflation back to target and would be willing to consider larger hikes if inflation were to remain elevated. Bank of England hiked the key policy rate in Dec-Feb and likely to continue with tightening cycle, given the persistence of elevated inflation likely to sustain throughout CY2022. Bank of Canada also begin normalisation process by hiking rates. So, normalisation seems way ahead for both advanced and emerging economies, with inflation now taking precedence over growth and geo-political uncertainty for policy makers.
Back home, RBI, early Feb policy, preferred to maintain status quo on rates. This was against the market consensus of reverse repo hike. In fact, this is third policy in row that RBI has preferred to keep rates ‘lower for longer’ as against market expectations of rate normalization. With growth outlook improving, RBI believes that it may be too early to withdraw support to economic growth, till it is fully entrenched and durable. Further, the RBI is taking comfort from improving inflation outlook (FY23: 4.5%). While RBI is concerned about rising risk from global factors (inflation, faster rate normalization, etc), RBI’s policy and meeting post policy seems to indicate that domestic concerns drive the policy decision making. Further, Governor also mentioned in post policy meeting that any future rate actions are likely to be calibrated and well-telegraphed and it prefers ‘well-timed soft landing’ of normalization.
April-January fiscal print continued to assert robust revenue growth (driven primarily by tax revenues & RBI dividend) reflecting domestic recovery, increased formalisation of economy and reduced tax evasion. April-January expenditure growth was modest 12%y/y, driven mainly by capital expenditure. Robust revenue growth and muted expenditure has kept fiscal deficit at record low ~60% of budgeted estimates (Normal times: 110%). February GST print was buoyant at 1.33 trn (record collections for fifth consecutive month) indicating pick-up in economic activities. Given the current trend, the actual tax collections are likely to exceed (already upwardly revised) RE FY22 by fair margin. Improved tax collections and better nominal GDP print likely to result in lower FY22 fiscal deficit (% of GDP) than 6.9% (as per RE FY22).
India’s External Sector & Global Update
Crude prices have rallied since start of CY2022 on rise in geo-political concerns. In fact, escalation of tension resulting in war between Russia and Ukraine led to crude staying above 90 throughout the month. While first half of the month saw brent on average US$95/barrel, it rose to average US$97/barrel in second half to close the month at US$100.83/barrel (Jan end: US$90.95/barrel). That said, Crude has increased by 12% m/m in Feb (Jan: 15%m/m), having wider implications for global growth and inflation. Given uncertainty related, low inventory levels, supply issues and war, the crude prices are expected to remain volatile and elevated in coming months.
In the bond markets, US treasury yields have been volatile during the month on account of hawkish Fed governors’ public speak, higher crude prices and sharp increase in geo-political risk. The US 10 Yr Treasury bond yield started the month at 1.81%, touched 2.05% levels mid-month and then eased on global risk aversion to close the month at ~ 1.83% (Jan end : 1.79%, Dec end: 1.52%, Nov end: 1.58%, Oct end: 1.55%, Sep end: 1.52%, Aug end: 1.3%, July end: 1.24%). On risk -off scenario, Dollar Index rose marginally after depreciating in Jan and is likely to stay elevated in rising uncertainty.
Back home, after appreciating in January, INR depreciated against dollar (Avg Feb: 74.96/US$ against Jan: 74.44/US$), taking cues from emerging economies. Going forward, rupee is likely to remain under pressure on global cues. Like emerging economies, India has been witnessing net FPI outflows since Oct 2021. This trend continued into February. Global financial market volatility due to Russia-Ukraine conflict saw net FPI outflows of US5 bn in Feb (Jan: 3.8 bn), driven mainly by equity outflows. The month saw increase in forex reserves to US$632.9 bn by mid-month. YTD FY22 Forex reserves rose by US$55 bn.
Yield Levels & Spreads:
Month saw lot of volatility in rates driven by both domestic and global cues. The 10 Yr benchmark started the month at 6.84% (Jan end close: 6.69%) on account of high fiscal deficit and humungous gross borrowing print in Budget and continued to stay elevated on rising geo-political risk, high oil prices and global risk aversion. Benchmark yields eased to 6.75% and drifted downwards on dovish monetary policy and cancellation of weekly two G-sec auctions. However, escalation of geopolitical risks leading to war resulted in yields moving up. 10 yr Gsec closed the month at 6.77%. 10 Term premium (10 yr over 365 days) rose to average ~ 227 bps (Jan: 222 bps, Dec: 224 bps, Nov: 228 bps, Oct: 244 bps, Sep: 253 bps, Aug: 259 bps) indicating steepness of yield curve.
10 yr SDL rose sharply initially post Budget announcement but drifted downward on dovish monetary policy and lower supplies. In fact, since Feb 10, 10 yr SDL was 7.07%, against 7.31% prior during the month. 10 yr SDL was on average ~7.15% (Previous: 7.14%). It closed month lower at 7.10% (Jan end: 7.24, Dec end: 6.99%, Nov end: 6.81%, Oct end: 6.92). SDL primary supply was Rs. 52,118 cr (Jan: 79,535 cr, Dec: Rs.54,385 cr, Nov: Rs. 43,502 cr, Avg Aug-Oct: 55,000 cr). The spread between 10 yr SDL over G-sec eased to 37 bps during the month as against average 53 bps in January (Dec; 47, Nov: 54 bps, Oct: 57 bps, Sep: 61 bps, Aug:71 bps). Taking cues from SDL curve dynamics, AAA bonds rose initially across the curve post Budget and eased post monetary policy and lower supplies. 10 yr AAA PSU closed the month at 7.02% (Jan end: 7.10%, Dec end: 6.84%, Nov end: 6.88%, Oct end: 6.91%, Sep end: 6.80%, Aug end: 6.93%).
- Going forward, the evolving geopolitical risk is likely to be a dominating factor for growth, inflation, fiscal, trade, currency, supply chain and financial market outlook. Oil prices have already touched multi-year high and heading higher, while other commodities have also rallied. The implication of war/war-liked situation for longer period is likely to have wilder implications, with analysts raising concerns about global stagflation (if crude prices may persist around current levels & higher).
- The actual print for growth may come lower relative to the projections on account of geo-political risk and rising crude prices. Further, sustaining high crude prices may have implications for FY23 growth and inflation and thereby for monetary policy and if government decides to take brunt in form of tax cut, it may have implication on fiscal in form of lower taxes, dividend, royalties, etc.
- Higher Gsec borrowings, along with (slower) rate normalisation is likely to put pressure on Gsec yields. RBI’s OMOs (Open Market Operations) likely to provide support.
- Rate and liquidity normalisation across countries have resulted bit tightening of global liquidity scenario. This, plus Global cues (geo-political risk, elevated crude prices, US Fed rate hike cycle), domestic development (improving growth prospects) has led to a lot of uncertainty for RBI.
- That said, the current steepness in the yield curve along with absolute levels makes the outlook constructive for most debt funds.
Bloomberg, RBI, CEIC, Finance Ministry of India, NIMF Research
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