Rising Global Risk (and its Implications for India)

The decade that has followed the global financial crisis of 2008 has been characterised by relatively steady, if uneven global growth. Economic growth for most major global economies like the United States, Germany, the UK and France recovered to pre-crisis levels within 4-5 years, and China began the transition of its economy away from an export-driven growth model, while avoiding a ‘hard landing’. Buoyed by these positive macro-economic trends, global equity markets reached all-time highs, and total global wealth reached US$280tn (27% higher than at the onset of the economic crisis). India also witnessed a recovery in economic growth levels, back to c. 8% levels helped by the global economic resurgence, the reform-agenda of the Modi new government, robust foreign direct investment flows and falling oil prices. Recently, however, cracks have begun to emerge in the global economy, driven by rising political uncertainty around the world, on-going trade disputes between the United States and China and financial instability across several emerging markets (including Russia, Brazil, South Africa, Turkey and Venezuela). The combined effect of these risks has driven economic volatility and sharp corrections in equity markets, as investors reallocate capital across geographies and asset classes to manage global macro-risk. India, given its inherent resilience and growth prospects, has the potential to buck the trend the of global capital flight from emerging markets if it is able to maintain its reforms and growth and thereby reassure investors that it is a relatively safer emerging market than others for international capital. The key to this will include India mobilising long-term capital, reforming its banking sector and facilitating global trade. This month’s Sign of the Times examines today’s emerging global risks and their implications on India, and the potential impact on its investment story.

2009-2017: A Decade Long Recovery from the Global Financial Crisis

Following the global financial crisis, the economies of the United States, Germany, the United Kingdom, France and Japan all recovered and eventually surpassed pre-crisis levels within three to five years; India’s economy, akin to China’s unlike the G7 economies, did not stop growing, albeit it rebased to a lower long-term growth rate. While some prominent economies in the Eurozone – most notably, Portugal, Italy and Greece – struggled to bounce back, the overall picture for major economies in the decade following the global financial crisis has been one of steady global economic recovery.

In terms of global equity performance, the picture is even more positive, with stock markets in most major economies quickly recovering to pre-crisis highs within the course of 2009 and continuing to grow to record levels (see chart), thanks in part to monetary stimulus packages introduced to stabilise various economies. Between 2009 and 2017, the MSCI World Index – a composite index that tracks global equities performance for 23 developed market economies – increased by 112%, while the MSCI Emerging Markets index increased by 96%. The result of this stock market bull run is a healthy increase in global wealth, which is estimated to have increased by 27% to US$280tn over the last ten years, with c.9m new millionaires being added, and global median income levels rising to a record high in 2017[2].

The US is clearly an important driver of growth for other economies and its policies in relation to other economies is a key driver in their performance. Even under a policy neutral or negative scenario, the lack of US performance would make a negative impact on global performance. However, it is clear that the recovery that emerged through President Obama’s two terms placed the US on a strong path of growth for President Trump to implement his initiatives.[4] So, the question arises of what are the policy and other event risks that might impact the continued rise of global markets.

Three Key Areas of Rising Global Risks

Over the last 12-18 months, despite rising US equity markets, the global economic boom appears to be ready for a rising set of critical economic and political issues. These challenges can broadly be classified into three areas:

1. Increasing Political Risk and Instability

Key Drivers of Political Risk and Instability:

• US Internally Divided. In the US, populist and nationalist politics have risen to the fore under President Trump and his rallies appear to have been highly effective at maintaining support for himself and his agenda among the core of his base, while deeply alienating his opponents who have mobilised under mass movements (such as Antifa, Black Lives Matter and #MeToo). The combination has resulted in exacerbated political divisions and polarization on key issues
• European Far Right Assertion. In Western Europe, far-right political movements, focused on immigration as a core issue, have gained traction across the continent, leading to the Brexit vote and gains for populist parties in France, Germany, Italy, Austria, Poland, and others
• Resurgent Autocracies. Across China and several other large emerging markets (Russia, Turkey, Egypt), nationalist and authoritarian leaders have tightened their grip on power and become unipolar drivers of economic and foreign policy
• US and Allies Divided. The US seems at odds with its traditional allies on fundamental political and economic issues ranging from Iran, Russia, Saudi and China and this poses a threat to the perceptions of the moral leadership of the US
• Destabilised Middle East. In the Middle East, a combination of political discontinuities is set to play out in US-Iran relations, Saudi Arabia’s position, Yemen, the GCC, Syria and the role of Russia and China in the region
• Broader Destabilisation of US-China Relationship. In Asia, China has begun to see the US position on Taiwan as a threat, North Korea remains unresolved and perhaps a pawn in the US-China relationship, China’s actions regarding the Uighurs is under increasing international scrutiny and China’s territorial and cross-border aspirations can easily trigger a US response
• Longer-Term Continuity of US-China Political Conflict. The US will seek to contain China until it feels the time is right and this will likely happen regardless of who’s in power in the US or China

As a result, global political uncertainty has increased considerably due to a combination of:

1. Polarisation and inability to build consensus driving political paralysis and potential legislative gridlock in the US
2. Fundamental policy divisions between the US and its allies
3. Increased instability of incumbent governments in democratic countries due to volatility in voter behaviour
4. Emboldened foreign and economic policies from authoritarian regimes in emerging markets
5. Aggressive US policies moving to shake up the geopolitical chessboard, which may have substantial benefits but are introducing risk and for which the benefits are subject to unintended consequences and Extreme Asymmetric Risk[5]

Key Global Events That Will Drive Near-to-Medium Term Risk

• US Midterm Elections. While Republicans are expected to hold the Senate, polls suggest Democrats may well capture control of the House of Representatives (see chart). Any change in the leadership of the House will likely lead to increased investigative scrutiny of the Trump administration and make passing any major legislation very difficult, much as Republicans did for the final term of the Obama presidency
• Mueller Investigation Findings. With a number of close advisors already implicated, and in some cases convicted and cooperating with Mr. Mueller, any findings of conspiracy to collude with Russia could undermine the administration’s credibility and potentially trigger presidential impeachment proceeding in a Democrat-controlled House of Representatives (if that transpires)
• Middle East Polarised. A polarisation of the relationships in the Middle East between Saudi Arabia and Iran, with Saudi Arabia maintaining only US support in the face in global credibility loss over its actions and policies and Iran facing continued US opposition despite continued rapprochement from the rest of the world, risks upsetting the careful balance of powers and interests in the Middle East, with potentially significant implications on oil prices and flow of the trillions of petrodollars amassed in the region
• Unresolved China Hotspots. The US, having previously avoided hitting China’s regional buttons such as its territorial disputes, island building programs in the South China Seas and the One Belt One Road initiatives, has recently raised the stakes by escalating its engagement with Taiwan, perhaps the hottest button of all. Further escalation of any of these issues risks opening a new front in what has to date been purely a trade war between the powers, significantly expanding the scope, and therefore the implications of any conflict between the two powers
• Brexit Negotiations. The EU seems to have ensured that the UK’s leaving position will not be enviable to other members considering exits of their own and recent indications that an independent UK will not be able to secure a favourable set of WTO terms makes a net positive exit scenario for the UK unlikely, potentially leading to further political upheavals in the UK

Impact on India

India has enjoyed a period of relative political stability over the last four years by virtue of the strong electoral mandate Mr. Modi’s party received in 2014 and its growing strength in state legislatures. India’s international standing also appears to have improved, particularly in bilateral relations with the US, Japan, Canada, Australia and various Middle East nations or remain largely stable, with countries like China and Pakistan. Domestically development has resulted in advances in mass financial inclusion, a restructured nationwide tax system, legal reforms and an unintended windfall to the equities markets from demonetisation[7]. With three major state elections next month leading to the general election in mid-2019, Mr. Modi’s party could potentially face anti-incumbency, a more unified opposition, or both. While recent opinion polls have indicated an erosion in support for some BJP state governments, Mr. Modi’s own personal popularity has remained strong. Even with the erosion of support and some general election polls indicating that the NDA may lose its majority, opinion polls are all unanimous that the BJP will be by far the largest party, indicating that Mr. Modi appears likely to secure another term as PM, even if he may need to find additional coalition allies to form a government.

2. Global Trade Order Under Threat

Key Drivers of Global Trade Order Risk and Instability:

• Retrenchment in Trade. After declining sharply during the financial crisis, global trade increased back to pre-crisis levels (exports at c.30% of global GDP) until 2014, however, trade has started to decline over the last three to four years, primarily due to the slowdown in China’s trade-driven investment model, but also due to governments seeking to cancel or renegotiate trade agreements (see chart)
• Stoking Domestic Anxiety, Not Tackling Transition Away from Low Value Industrial Economy Jobs. Donald Trump’s presidency has fuelled anti-trade sentiments in the US, channelling economic anxiety over lost manufacturing jobs and stoking nationalist sentiments to buy American goods, while pushing companies to bring jobs back to the US. The process has challenged some corporations to think again, especially on their investments in China, to the benefit of the US[8] while others have not found economic merit in the “nationalist” approach[9]. The measures do not seem to be ones that will help the US transition more broadly from an industrial to an information economy
• US-China Trade Conflict. In the last 12 months, this has erupted into an escalating trade war with China with c.US$300bn of tariffs levied on each other, with the US signalling its continued willingness towards even further escalation
• US Trade Conflict with Allies. The US has also sought to renegotiate the terms of trade with key allies including the European Union (with a 20% duty imposed on imported vehicles), Canada and Mexico (where a new agreement to replace NAFTA has been agreed, with only marginal changes[10]), and Japan (where the US is seeking to renegotiate its existing trade agreement)
• US Manufacturing Competitiveness Weakened. US manufacturing competitiveness had already declined significantly with manufacturing costs 20% higher than its major trading partners even after excluding the cost of labour[11]. Increased input costs from the newly-introduced tariffs stand to make it even more uncompetitive as US manufacturers look to pass the cost of tariffs on to consumers
• Undermining of the WTO. While China has sought to refer its recent trade issues with the US to the World Trade Organisation (WTO), President Trump has been largely unilateral in his policy decisions and sought to undermine the WTO – even labelling it a “catastrophe” for the US and calling for America’s withdrawal from it during his campaign[13] – thus impairing its ability to mediate the rapidly escalating trade battle between the world’s largest exporter and importer, as well as others
• UK Leaving EU with a Worsened Trade Agreement. The likelihood that the UK’s terms of trade with the EU will deteriorate in the final Brexit deal is high insofar as it discourages similar movements in other member states from following a similar strategy of stoking nationalist sentiments and using referenda to leave to the Union. However, the Brexit nevertheless represents a challenge to global trade given the importance of the UK in world trade, as well as the importance of trade to the UK economy itself (with exports accounting for c.30% of country’s GDP)

As a result, the global trade order has been undermined due to a combination of:

1. A natural correction in the level of global trade following half a century of virtually-uninterrupted expansion from 24% of GDP in 1960 to 61% of GDP in 2011
2. Increased protectionist sentiments, in developed markets in particular, due to a combination of economic dislocations from trade and politicians who have exploited these fears for political gain
3. The Trump administration’s explicit use of political power to reset the global terms of trade for perceived domestic economic benefits to make good his campaign promises to his base and, irrespective of significant evidence that this will not benefit the US in the longer term
4. An escalating trade battle in the world’s largest trading relationship, the US and China, which could result in collateral damage to their own economies and others in their respective supply chains
5. The failure of multi-lateral institutions like the WTO to effectively mediate emerging and existing disputes due to the undermining of its legitimacy by the US, hitherto its biggest supporter

Key Global Events That Will Drive Near-to-Medium Term Risk

• Further Escalation of US-China Tariffs. Both Presidents Trump and Xi have fired their opening salvos in the trade war, and it now remains to be seen whether this will continue to escalate, with potentially disastrous consequences for both economies, or whether it will trigger a new trade framework for the world’s largest bilateral trading relationship
• US Conflict with Other Major Trading Partners. President Trump has already taken action against the EU (vehicle imports) and agreed a revised framework for the North American Free Trade Agreement with Canada and Mexico, and if he expands his focus to other major trading partners like the U.K., Australia and India, this could result in increased tariffs across the world without a substantial net gain to the US
• Intra-Asia and Non-US Trade with Aim of Longer-Term Reduced Dependence on US as a Trading Partner. Intra-Asia trade has grown at a 9.5% CAGR in the last 15 years to reach US$4.2tn in 2017 (from US$1.0tn in 2001)[14], and could see a further boost in case of a further deterioration in the US-China trade relationship, with China and others more aggressively diversifying trading partners in favour of regional trade and the EU, Canada and Australia
• Bilateralism Becomes a de facto Solution. Given the US, as the historic trading partner of choice for the international community is practising bilateralism, bilateral trade becomes an accepted mode of conduct. This has moved rapidly, in two years, from the preference of nations considered to be pariah or predatory ones to the “new normal” of the US and so its ascent can be expected to continue beyond the US

Impact on India

India’s export growth has slowed down in the last few years due to a combination of the slowdown in global demand, the lack of a domestic industrial manufacturing base (due to issues around infrastructure and logistics costs) and the slowdown in ‘traditional’ IT services exports where India was a leader. Therefore, it can ill-afford to take sides or get caught in an all-out trade war with the US (which accounts for 16% of its exports), or China and Europe. India’s trade relationship with China however has grown significantly and it is now India’s largest trading partner[15], however, with a significant trade deficit. For China given its deteriorating relationship with the US, market access to India will become more important, and India can use this to improve its own market access to China, including for services exports for its IT, digital and financial services. In the near term, India needs to increase the pace of bilateral discussions with the US, EU, UK, Japan and China, while carefully managing the US relationship by giving President Trump political wins (e.g. on IP protection) in exchange for concessions important to its export growth (e.g. increased visas for Indian IT service workers).

3. Global Capital Flight Driving Volatility

Key Drivers of Capital Flight Risk:

• Flight to Perceived Safety. Since the beginning of 2018, continued monetary tightening by the US Federal Reserve and corporate tax cuts announced by President Trump have driven a flight of capital away from emerging markets and towards asset classes such as the US and debt, which are perceived to be safer. Recent corrections in US equities have wiped out the year’s gains and reflect unease regarding what is emerging as the global scenario
• Rising Global Indebtedness. Since the onset of the global financial crisis, total external debt has increased by over 90% from US$14.4tn in 2008 to US$27.7tn in 2016[16], while total public debt increased from US$172tn to US$247tn, or 318% of global GDP[17]. The key challenge now vs. 2008 is the absence of the US’s global leadership, including through multilateral forums to help the world navigate a response to a potential debt crisis, given its ‘America First’ posture and the resulting inability for it to function as an ‘honest broker’ which could help at-risk countries[18]
• US Debt Crisis Risk. From a geo-political power rivalry perspective, a debt crisis that damages America, especially if it is severe, would provide China with an opportunity to shrug off US trade conflicts and seize huge ground in its international positioning
• Emerging Market Leverage. The sharp increase in emerging market leverage since the financial crisis – emerging markets’ US$ borrowings have increased by US$3.8tn between 2008 and 2017 – has increased servicing burdens and risk across several emerging markets (see chart). Given rising interest rates in the US, servicing floating interest loans could present a challenge to some of these countries
• US Manufacturing Competitiveness Weakened. US manufacturing competitiveness had already declined significantly with manufacturing costs 20% higher than its major trading partners even after excluding the cost of labour[11]. Increased input costs from the newly-introduced tariffs stand to make it even more uncompetitive as US manufacturers look to pass the cost of tariffs on to consumers
• Wave of Devaluations, Defaults and Bailouts. Unsustainable levels of leverage combined with the failure to reform or consolidate fiscally have pushed several mid-sized, high potential markets, including Venezuela, Turkey and Pakistan, into sharp devaluations and bailouts, while others such as Hungary, South Africa, Indonesia and Russia could be at risk of default[19]
• Rising Dollar. The Euro has fallen 5% in the 2018 relative to the US dollar, while emerging market currencies have fallen by a median of 15%.

As a result, the stability of the global financial system, in particular for emerging markets, is at risk due to:

1. US monetary and fiscal policy has triggered a flight of capital back to the dollar and safer asset allocations
2. The rise in global leverage to levels higher than prior to the global financial crisis
3. The absence of US leadership to help the world navigate complex and inter-related risks
4. The build-up of debt across many emerging markets (with the notable exception of India) and increased volatility in their currencies and equity markets
5. Devaluations and defaults across several fragile markets in Latin America, Middle East and Asia, with potentially more to come

Key Global Events That Will Drive Near-Medium Term Risk

• Monetary Policy Responses. With US ten-year treasury yields crossing the 3% “psychological line in the sand”[20], how central banks across emerging markets respond in the coming months to increased volatility in currency and equity markets will be a key determinant of whether they fall into a vicious cycle (e.g. Turkey) or are able to ride out the storm
• Reckless Fiscal Sops and Stimulus. Slowing growth and declining asset prices will place significant pressure on governments to provide fiscal stimulus, and further increase leverage levels. While these measures may assuage near-term political concerns, capital markets will likely punish indiscipline with further capital outflows and higher costs of borrowing
• Earnings and Growth Recoveries. Economic and earnings growth could drive a reduction (or increase) in risk by reducing the effective servicing burdens for corporates and countries. With global GDP growth expected to remain in the 3.6-3.7% range[21] and global corporate earnings projected to decelerate from 17% in 2017 to 10% in 2019[22], countries which fail to drive strong economic and earnings growth could be at increased risk
• Global Investment Flows Curtailed and Threaten Global Growth Dynamic. Returns on US dollar funds have been undermined through the dollar appreciation and has resulted in a fall in US dollar allocations to non-US and emerging markets. This clearly may be exactly what President Trump seeks to achieve but if it continues, it has the potential to undermine global growth which in turn would result in slower demand for the major US multinationals that drive the US economy

Impact on India

Compared to other more fragile emerging markets, India’s debt position is comparatively lower with total public debt at c.62% of GDP and external debt at c.21% of GDP. Nevertheless, India’s equity markets have seen US$6.5bn of net foreign investor capital outflows between January and September 2018[23], even though domestic capital inflows into equities have been relatively strong during this period. As a result, India’s benchmark Sensex index has corrected by c. 14% from the peak it reached in end-August, while the Indian rupee has fallen by 15% against the US dollar since the beginning of 2018. Unlike other emerging markets however, India has seen an acceleration of both GDP growth (from 7.0% in the quarter ended December 2017 to 8.2% in quarter ended June 2018) and corporate earnings, with average earnings growth for BSE500 accelerating from 3.1% (from Sep-16 to Sep-17) to 14.1% (from Sep-17 to Sep-18), providing the country with a stable macro-economic backdrop.

The Implications of Rising Global Risks on India

The emerging global risks, given the broader shifts in the world economy[24], makeKey Policy Responses to Elevated Global Risk it clear that the world is transitioning away from the comparatively benign global growth and risk paradigm of the last decade. Over the last 18-24 months, it has become apparent that the US and some other developed western economies are rejecting values that they previously championed such as democracy, free trade, capitalism and diversity and that upheld the liberal world order. This has in turn increased political polarisation (and risk), led to major trade disputes, and increased the financial system risk across developing economies. Some developing countries like Turkey, Indonesia, Argentina and the Philippines have responded to this with short-term monetary and fiscal responses which, rather than stemming the bleeding, has led to concerns over central bank autonomy, and triggered further capital outflows. The key lesson here for large high growth emerging economies like India is that in this new global context, where global risk levels are rising, the most important policy requirement is to avoid short-sighted political and economic policy decisions such as unsustainable fiscal stimuli and other populist policies which may stem voter angst in the short term but lead to elevated risk to the economy in the medium term.

India seems to be bucking the trend of the emerging market slowdown, driven by a combination of India’s inherently strong fundamentals (demographics, stable democracy, resources) and reforms and fiscal consolidation which has helped growth recover from c.6% to c.8% in the last four years. Most importantly for India, it has a government which seems to understand the importance of delivering both “big ticket” reforms (e.g. a new national goods and services tax, a new bankruptcy code) and discrete initiatives to improve the ease of doing business, a stable and transparent monetary policy framework to control inflation by the Reserve Bank of India (“RBI”), and a steady build-up in foreign exchange reserves to guard against external risks. This has made India’s economy more dynamic and business-friendly (for example, with a 42-place improvement in its global Ease-of-Doing-Business ranking) and helped sustain high FDI inflows (US$223bn of FDI since 2014).

While the factors above may ensure India’s economy remains stable relative to other emerging markets, a country of India’s size, economic potential and ambitions cannot be satisfied with demonstrating resilience. India’s opportunity lies in two important interlinked ideas:

1. Emerging Market of Choice. Positioning itself as the investment destination of choice amongst emerging markets with the aim of capturing an outsized share of the emerging markets capital allocation.
2. Enhancing its Soft Power Global Positioning. Given America’s recent bilateralism and China’s “raiding” approach (protection of the homeland from foreign competition while penetrating foreign markets with its own products), India has the opportunity to position itself as confidently open to global business[25].

Conclusions: Implications for Investors

For investors seeking to manage risk while maintaining diversification in times of economic and political uncertainty, India today offers an attractive bet for a number of reasons.

1. Structural Risk Declining. Firstly, India’s structural risk is declining while that of other countries, both developed and developing, is rising, reflected in India’s low inflation, declining fiscal and current account deficits and interest rates and strong foreign investment inflows[26]. And while India has not been totally immune to foreign exchange and equity market volatility, its impact has been far less than in other BRICS economies (19% currency depreciation since 2014 vs. 69% for other BRICS economies).
2. Liberal Stable Democracy and Relative Governance Advances. Further, India’s governance has proven to be source of competitive advantage over other emerging markets. As a stable democracy being steered by a strong, ambitious and development-focused hand steering it, it stands out both from countries either without or with regressing democracies (e.g. Turkey, Russia, Vietnam) and from countries that appear to be unable to form and execute effective economic policies (e.g. Brazil, Indonesia, South Africa), and so not all emerging markets are the same.
3. Attractive Long-Term Prospects. India’s long-term growth prospects remain strong. With the reforms of the past four years having repositioned the country for sustained and potentially higher growth, India’s economy is set to continue to expand rapidly, and nothing indicates this growth should not continue, with the potential for GDP growth to hit 10%[27] over the medium-term.
4. Current Tactical Timing Opportunity. In terms of timing, with attractive long-term growth prospects, India’s depreciated currency and equity markets post the recent correction (see charts), present a good tactical timing opportunity for investors. Even if further deterioration should occur, India has demonstrated a greater resilience than other emerging markets, providing a source of potential alpha generation.
5. Geopolitical Positioning Favourable. Finally, on a geopolitical level, India stands to gain from the increasing containment of China by the United States. With China increasingly at risk of suffering a potentially significant setback in its ongoing development due to US actions, US-China relations are looking to become increasingly rocky over the next decade or two and increasing friction will open the door to India becoming both a commercial partner to the US and as well as a preferred destination for US foreign investment.

The flow of capital is an important long-term determinant of political power and as India now stands to be positioned where China was about a decade or so ago, global investors are beginning to examine how to allocate their capital. this analysis will inevitably lead investors to examine the big themes of India’s rise[28] as well as its regions and sectors[29] given the diversity of India’s continent like profile. High quality assets in India have historically rarely come cheap, and windows of opportunity tend not to last for prolonged periods, however, quality assets have historically consistently delivered strong risk-adjusted returns.

Stepping back, the world seems set to enter a period of greater global risk. Regardless of whether one holds the view that it is self-inflicted through overly aggressive policy stances or a necessary and long overdue correction of power rivalries, the global investment outlook seems to have shifted away from a pure growth to a risk-managed growth scenario. Importantly, the key political, trade and capital risks that have begun to manifest appear to be structural, global and longer term in nature, and are therefore ones cannot be ignored or avoided. As the world adapts to these changes India seems to be on a development and growth track that sets it apart from others and its upcoming election is unlikely to significantly change this. Given India’s momentum, the country is likely to deliver, even under a marginal coalition, at least more of the same as the last four years in terms of economic growth and potentially deliver far more given the opportunity for the next government to leave a legacy. Given these factors, it seems clearer that the case for India is being made not only by its own development story but also by the result of the price that global risks are set to exact on the rest of the world.