Global financial markets continue to wilt under a growth scare. In mid September, China said its industrial output grew by just 6.9 percent in August. That is the lowest level since 2008.
German industrial output slid 4 percent 4 percent in August, the biggest fall in 5.5 years. Last week, the IMF pulled down global growth numbers for 2014 to 3.3 percent from 3.4 forecast in June and 3.7 forecast in April.
As these data kept pouring in, commodity prices tumbled rapidly. Crude suffered the most, both Nymex and Brent have lost over 20 percent from recent highs. From month-ago levels, they are down 14 percent.
The chill then spread to equities. The S&P 500 which had been scaling all-time highs till mid September fell by 6 percent in October. European indices saw sharper falls. The DAX has been down 7.6 percent, the CAC 9.2 percent, the Athex 11.6 percent, the Portugal index 12.5 percent. Some emerging-market commodity countries saw their indices falling even more.
India was the rank outperformer with the Sensex and the Nifty losing only 2 percent in October. The commodity fall, despite the occasional jitters it has caused to Indian equities, appears to be largely positive for India.
Is the growth story going to get worse for the remaining part of 2014 and for 2015? The answer to that question will also determine whether commodity prices are going to fall further and whether India will once again have that clement environment where global crude prices and other important commodities are going to be cheaper.
Is India going to benefit from this global scare? To discuss these, CNBC-TV18’s Latha Venkatesh caught up with Sanjeev Sanyal, Global Strategist at Deutsche Bank AG and Manoj Pradhan, Chief Economist at Morgan Stanley Research.
Below is the transcript of the interview on CNBC-TV18.
Q: Let me start straight away with the central topic of our discussion. There has been a growth scare in all financial markets over the past four weeks and the IMF too has scaled down its growth forecast. But it is hoping that next year is going to be better at 3.8 percent. What is your own take, are there going to be more growth downgrades?
Sanyal: The fact is that while growth may not have got the traction that some people may have expected, growth is happening. The US is gathering pace, unemployment in the US is declining. Yes, there is softness in Europe but again it is hardly sliding into crisis.
So while I think, there is some softness in the growth trajectory, I don’t think there is anything to panic about. The real problems are about the long-term issues related to a savings glut rather than with the current trajectory of growth.
Q: Then why are all commodities falling? The commodity indices, have fallen by over 10 percent in the past month, crude is in bear market terrain, do these markets know something that we don’t know?
Sanyal: I think what you need to do here is to think about the nature of growth. That is what is changing. So far what was driving all of this basically a very heavy investment driven growth in China. Now China is going to from hereon shift to a different growth strategy, its investment rates are going to decline.
It may still generate reasonably good growth rates but this spiralling demand for all kinds of commodities that is becoming softer and unless some other country takes this on, there is not clearly going to be the kind of demand that many commodity projections of the past were trying to show. So, I think what you are seeing is the nature of growth changing rather than anything else.
Q: So are you saying that we are entering a new normal for commodities like iron ore, coal and metals and other commodities linked with infrastructure? Will the 2006 to 2012 levels not at all be scaled for the foreseeable future?
Sanyal: It is fair to say that as the nature of growth changes particularly in the case of China, you should expect this rebalancing to happen. Now, this doesn’t mean that every asset class should suffer because of it. In fact, there are countries like India for example, which benefit from declining commodity prices and of course from the fact that as China shifts its growth model and becomes much less of an investment driven growth model, what will happen to its capital outflows.
I think there will be a huge amount of savings that China will be exporting to the rest of the world, which will make capital very cheap perhaps for as long as the generation. Long-term capital will remain cheap and that is beneficial to countries like India but of course as far as bond yields is concerned, it means that even if the world’s central banks tighten, long-term capital will remain cheap.
Q: Will 2015 continue to be a year of soft prices for commodities, will the down-cycle continue?
Sanyal: I think that is fair to say as the US has gone from being a huge importer in energy to becoming if anything a small exporter and if China is not sucking in as much commodities as it was in the past and is becoming less of a materials driven growth engine then yes, it is fair to say that the commodity prices will be soft.
Even if India goes through this transformation and begins to grow fast, the fact is that India is still too small to influence the whole thing.
Q: Let me now come to the report that you have just put out on October 15. Although bond yields have crashed now, very soon bond yields in the US at least in a year could rise because the Fed is bound to raise rates sometime next year but in your theory, the report says there is so much of surplus global capital especially coming out of China that rates or the cost of capital is bound to remain cheap, can you give us a little more colour about this argument?
Sanyal: This is the exact point about the report, which is that even if the central banks of the world begin to tighten, the amount of capital that could be emanating out of China could keep long-term capital cheap for a very long time and in fact, in an extreme situation could even lead to inverted yield curves.
So this is the point I am trying to make is that there is going to be a lot of cheap capital on this planet and who is going to absorb this is the crux of — if you are going to get a sustained phase of economic growth globally then we need to know who is going to absorb this capital.
Q: Since your note is for the longer time, over the next five years, what would be your one-two best equity capital markets?
Sanyal: If you are taking locally, this is a very positive environment for India. If it can take advantage of it, fabulous because you are going to get a prolong period where commodity prices are soft and capital is cheap. Prime Minister Narendra Modi has the correct economic model. So this is great for India if it can make it happen.
Q: Do you think that this growth scare that we are seeing in the global economy is warranted. IMF’s 3.3 percent — is there a danger of it getting scaled down even further?
Pradhan: I think there is an element of expectations not being met. So what we have seen is when the IMF numbers have come off relative to our recent forecast numbers almost everywhere universally — developed and emerging markets — their downgrade still remains above the numbers that we had as our base case.
So what that is telling is that the reaction to that downgrade given how pronounced it has been tells us that the investors expectations about growth might have been a little too strong and those are getting scaled back and hence in the minds of investors, the lofty numbers that they had are probably not being achieved and that is giving them some cause for concern.
Q: Where exactly is the growth concern emerging? Is it in the US itself because the latest factory output data and jobless claims came in stronger. So is it US or is it China where is the growth scare?
Pradhan: The growth scare has been primarily concentrated on the very sharp drop that we saw in the numbers in Germany, which has been something that people have paid a lot of attention too. One of the others part of the world that is worrying people a lot is the property market in China.
Besides that, what is happening is that we are seeing signs as we always do that the world is interconnected and so when US growth remains strong and that points to an exit from loose monetary policy for the Federal Reserve that may be a little sooner than many had expected.
That leads to perhaps a stronger US dollar and something that we have been worried about is that there has been an export of deflation that many policy makers have tried.
With the dollar rising, it gives the US the role of becoming the sink in some senses. So when the dollar rises, it ends up importing more deflation then it would perhaps have liked and hence that scales down people’s expectations of how quickly the economy can recover to what they call a normal level.
Q: We will come to this point yet again and how the Federal Reserve is likely to respond but first the commodity markets. There as well we have seen what a 10 percent fall in the general commodity, from recent highs and commodities like crude have got into a bear market with 20-30 percent fall from recent highs. So is the commodity cycle likely to see even further softness because according to you the growth could be even lower than IMF?
Pradhan: There are three parts to the commodity story. The very near-term story, economists are not very good at talking about, so let me give you the structural backdrop the way we see it. The first is the large consumption of commodities has primarily come from emerging markets and that slowdown as we have been discussing for a while, we have been talking about this for two and half years now that story is still unfolding according to us. So if the downside risk structurally to emerging markets still remain in place, the downside to demand for commodities will remain in place.
The second point is there is some — rather than calling it offshoring — there is some change in the way developed markets are growing and that they are producing more at home themselves. And if that is the case, developed markets tend to be more efficient in the use of commodities for two reasons; number one they are very high labour cost so they have to be very conservative on how they use all other inputs. Second thing is they don’t need infrastructure, the emerging markets guys need infrastructure. So structurally speaking, there is a shift away from demand.
In the meantime over the last five years of very high commodity prices there has been a structural increase in the supply because of more production getting online. So we are seeing these dynamics play out, most recently it is the growth scare that is putting a significant downspin on commodities.
Q: Do you see 2015 also as a year of soft commodities that will depend on your idea of how much growth recovers as well in 2015?
Pradhan: It is very true and how growth recovers is most important. So we are not expecting to see a large uptick in growth that’s coming out of emerging markets. The second thing we are also expecting is that where the US remains resilient is where the energy story is playing a large role. And that energy story playing a large role turn the US into a manufacturer of sorts.
So if more of the productions is coming on as I said from the developed market side, you don’t see a large uptick. Now bounces in commodities that come off scares like these, those are things that no one should rule out. But the structural price change at least is not something we should factor in for 2015.
Q: Let me come back to the US. What are the chances of a rate hike in 2015, will it still happen but not in mid-2015?
Pradhan: Our expectation is that the Fed does not hike in 2015. We think it hikes in early 2016 precisely because of these dynamics. As the US economy shows resilience or it shows continuous strength not massive amounts but just on an upward trajectory, markets start thinking about this. They start pricing in either a June hike or a hike in the second half of the year and that leads to the dollar or the 10-year or perhaps both rising a little bit faster than the US economy can handle. Once that happens as we have seen in the recent past, you get a pullback.
Now we have something very interesting from our strategy team called months-to-the-first-interest-rate-hike. What we have seen in the last few weeks from that metric is that markets do seem to have pushed the first interest rate hike two months further into the second half of 2015.
Q: Next year, where might you see bond yields in the US, it fell sub-2, same time next year are yields likely to be closer to 3 percent because you are smelling the rate hike?
Pradhan: In our view, I don’t think they will go that far but the economics behind that at least suggest that there are two ways to think about this. Being an economist, we have to present both. The full side is your standard story, the US economy is better, you are getting closer to a hike, people start pricing in a series of hikes and that is what leads 2-year and eventually slowly 10-year. The 2-year is where most of the stress lies in the market and the dollar moves along somewhat with that.
There is another element to that. Some of our teams have also pointed out that look what has changed about the dollar is that it looks a little bit less like a funding currency now and it looks a little bit more like an investment currency. So if it is now attracting investment flows, you have a bid for the dollar but that keeps perhaps the interest rates from rising very aggressively.
So you have to think about that – both those combinations are open. In our view, a steady rise in the currency value, a steady rise in the interest rate will not bother the Fed too much if it becomes aggressive, then I think that unsettles them.
Q: How do you look at India in the whole picture? Your worldview is that commodities are not going to get very expensive neither is global capital is going to get very expensive. So is this going to be a sweet spot for India? What is your estimate?
Pradhan: This is the world trying to use automatic stabilisers to its own advantage whenever things go out of kilter, there are many things that we call automatic stabilisers, commodity prices are one of them, interest rates another, currencies are the third. These always tend to stabilise and play off the economy so that it doesn’t go out of whack too much.
As far as India is concerned, we believe it has turned the corner. Last December, we have become more constructive on it, obviously after the set of reforms that we have seen over here and the way India’s dynamics seem to be shaping out, one point that we had made is given that India has not an over-allocation of capital problem but an under-allocation of capital, which is easier to fix.
The fact that when you add capital to improving demographics, you get a production function, which is charged on all fronts and the fact that you have low hanging fruit which my colleague Chetan Ahya has been talking about a lot, you put that combination together.
It is not that hard to revive growth in India but it is one of the few places here and what we see working for it is the fact that you are able to use these conditions to advantage.
When US interest rates starts rising, I continue to believe that emerging markets will have to face a fair share of their burden with the rising real rates, with the currency that tends to become a little difficult to manage but India has done quite well. So whether it is from a cyclical point of view, whether it is from a structural point of view, it does look like at the comfortable pace.
Of course the two caveats always are a disruptive global mechanism is not something that India is immune from by any standards and the second thing is even these thresholds that we are seeing are relatively lower because of India’s low per capita GDP, even those have to be met. So you do have exceed the bar that has been set in order to realise the growth that is coming but as far as we can see, it looks like over a five-year horizon, it is on a good course.
Q: What India does with its own raw material of population, demographics and resources remains one of the key determinants of growth but the global environment is largely likely to be clement to India, is that the point?
Pradhan: I think that is the point and credit to India’s policymakers they have dragged themselves out of a precarious situation. So if you looked at them last summer, it wasn’t rosy at all, they were very much on the backfoot along with Brazil with South Africa, Turkey and Indonesia and they were in a club of the five most exposed economies.
End of last year, we had already argued that they have done a lot to get out of that club. So they are in a much more resilient position. The cyclical situation helps them but exactly as you said, what they do with their own destiny is up to them.