Be prepared for new lessons – IS the Dollar index heading towards 110 and Rupee 71.00
Globally, the year 2016 would go down in history as the one when, world witnessed two landmark political outcomes in two major, developed economies that made a complete mockery of popular perception. Anti-globalization and nationalism became the new buzzwords post the Brexit Referendum in UK and the presidential elections in the US. Domestically, 2016 would be remembered for crackdown on black money through income declaration scheme (IDS) and the unprecedented move of demonetization.
Looking ahead into 2017, there are quite a few ‘known unknowns’ that traders and investors will have to grapple with on the global and domestic front, besides of course the ‘unknown unknowns’ which have become increasingly common off late.
‘Trump’ onomics to Take Center Stage
The fiscal and foreign policy of the new US President would be extremely crucial, as it will impact not just the US monetary policy but also global trade and commerce. Tax cuts, infrastructure spending, trade and immigration restrictions together with changes in the Middle East policy would be closely followed by the market. While trade and immigration restrictions if imposed would have a direct impact on a few emerging market economies like Mexico, rising US 10-year yields and a stronger US Dollar would have an indirect, yet equally significant impact on most emerging markets on account of capital flight. Aggressive fiscal policy would be inflationary and would reduce room for monetary accommodation, causing the US Federal Reserve to hike rates faster than currently anticipated. It would lead to a spike in US yields which may cause fiscal strain at a time when global central banks are cutting down on their holdings of US Treasuries at a record pace. It would be interesting to see whether the domestic appetite for bonds can fund the massive fiscal stimulus. Without support from the US Federal Reserve (in the form of funding deficit spending by buying US Treasuries), it could lead to ‘crowding out’ of private investment and push public debt to unsustainable levels. Concerns over ‘debt ceiling’ and ‘fiscal cliff’ may resurface in 2017.
Dragon on Shaky Ground
China would continue to be a source of global systemic risk in 2017. The Chinese economy seems to be in a quagmire. Rising US yields would make it difficult for China to put a lid on outflows. Intervention by the People’s Bank of China to halt the Yuan slide would result in further depletion of FX reserves and suck out domestic liquidity, leading to higher domestic yields, which in turn could hurt growth. The weakness in the Yuan is likely to rub on to its Asian peers as well. Depreciation of the Yuan which could possibly hit 7.3 soon could increase the likelihood of imposition of trade restrictions by the US, which would further hurt exports.
Fear of Frexit Looms
The markets will closely track developments surrounding the French and German elections. Growing popularity of the right wing nationalist leader Marine Le Pen in France would be seen as a threat to the existence of the European Union as she has promised to hold a public referendum on whether France should continue to be a part of the EU if she comes to power. Though not a major threat currently, there is growing resentment in certain sections in Germany against Chancellor Angela Merkel’s policies of giving asylum to refugees. If the sentiment snowballs, it could pose a threat to her reelection, for the fourth time. This would be negative for the overall risk sentiment, in general, as it would give rise to various uncertainties.
‘Brexit’ Blues Likely to Continue
The markets will also keep an eye on the UK Supreme Court’s verdict on government’s royal prerogative and subsequent progress of Brexit negotiations with the EU after invocation of Article 50. Of particular significance will be whether UK is able to retain access to the EU single market under the newly negotiated trade treaty.
Mounting Geopolitical Tensions and Digital hacking is in Vogue – The new Unknown Unknowns
Escalating diplomatic tensions between nations on account of protectionist measures fuelled by national interests and consequent repercussions could be a major ‘unknown unknown’ heading into 2017. Digital hacking and cyber attacks have the potential of compromising highly confidential data pertaining to national security, crippling government machinery and turning election outcomes on their head. Though the probability of any such event is still very low, it could trigger a tremendous bout of risk aversion if it actually materializes. Recent instances of alleged Russian involvement in rigging US elections or that of China seizing a US drone bear testimony to the escalating tensions between superpowers.
India’s Union Budget 2017-18, Battle for UP and execution of GST. Modi’s credibility at Stake.
On the Indian front, the Union Budget would be extremely crucial. After the RBI’s decision to keep benchmark policy rates on hold in its most recent monetary policy, the budget is most likely to be expansionary to offset the drop in private consumption that is likely to occur as a result of demonetization. The quality of expenditure will be crucial given that the budget precedes the all important UP election. Employment generating, infrastructure focused capital spending will be appreciated by the markets as opposed to populist revenue expenditure. It will be interesting to see what fiscal deficit target the government sets for itself for FY 18.
Another important domestic event would be the UP-state elections. The outcome of the UP election would be viewed as a referendum on demonetization. It would be a gauge of popular sentiment for the government ahead of the 2019 general elections. Uttar Pradesh is key swing state as it accounts for the most number of seats in the Lok Sabha i.e . 80
The implementation of GST and its impact on government finances, inflation and logistics, once it is implemented will be also be closely followed by the markets as it would be a major overhaul of the indirect tax system in the country.
Where is the Money – What opportunities do we seek?
Overall 2017 is likely to be an action packed year for traders and investors. Global liquidity would continue to chase yields. As of now it is a bipolar world, with US looking to hike rates and rest of the major central banks looking to keep their policies accommodative.
US yields are likely to continue moving higher and as a result the US Dollar is likely to strengthen against major currencies. We could see the US 10 year benchmark moving towards 3.4% and Dollar index touching 110 levels. The Euro could trade as low as 0.96 against the US Dollar. Risk to the global economy emanating from China cannot be overstated. The Renminbi could depreciate to as low as 7.30 against the US Dollar. The recent revival in commodities could be short lived. Crude could however be an exception, not on the back of a surge in demand but more likely on account of supply constrains due to further OPEC production cut agreements or supply being hit on account of geopolitical tensions in the Middle East or there could be selective pockets of strength in emerging markets. Those emerging markets that reduce their reliance on global demand and try and make the most of out of domestic demand would be the ones that would do better. If the global risk sentiment remains supportive, India would continue to remain a sweet spot relative to other emerging market economies. Though Rupee is likely to be one of the better performing EM currencies, one can expect to see a new all time low for the domestic currency against the US Dollar in 2017. Historically, a US rate hike cycle has been a drag on Emerging Markets. A test of 71 for USDINR within the year would not come as a surprise.