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India safe EM but Fed hike to make developed mkts safer:UBS

Though the world is bearish on the emerging market (EM) space, India is still better placed, says Bhanu Baweja, Global Head of EM Cross Asset Strategy at UBS in an conversation with CNBC-TV18 from the sidelines of UBS India Conference.

The combination of growth and dollar strength in the US could give the Federal Reserve the ammunition to hike rates in December and could result in more weaknes for EMs towards the year-end. However, since markets have already priced in a 70 percent chance of rate hike, it is unlikely that they will crash, says Baweja.

As an impact of Fed hike, money will leave EMs but not so much from India because India is an equity trade and not fixed income trade like other emerging markets. Same goes for China too, says Baweja. “So, fresh EM sell-off likely but it is not going to be a crisis,” he adds.
Therefore from a risk asset perspective, investing into developed market equities is prefered compared to even safe EM stocks like India and Mexico because the RoE derating in emerging markets has been quite severe, says Baweja.

Below is the verbatim transcript of Bhanu Baweja’s interview with Latha Venkatesh and Sonia Shenoy on CNBC-TV18.

Latha: Global cues are somber, we saw a commodity crash on the London Metal Exchange (LME) overnight, and those inflation numbers in the United States, is it indicating that there is a hike but growth is not in place?

A: Growth is in place if you see the United States, this is something that the Fed has been speaking about for a while. They have said that they are looking for the inflation to go back up and that is why it is time to move monetary policy to closer to normal levels. The problem is that the rest of the world which has basically made its rationale of investment, the idea that US rates were to remain very low for very long is in a very bad place to adjust and India relatively speaking is in a better place but again that is a relative comment and in absolute terms given these level of valuations, I think it is still a problem.

Latha: How should we prepare for fund flows you think up until the end of the year? Should we expect some major turmoil in currency markets especially emerging market currencies and equities, now that this inflation number has come in positive?

A: I think the market is already pricing in about a 70 percent chance of the Fed hiking in December. This is not entirely new news, so I would say that you would not expect crash but markets have already been weakening for some time now. There was a brief spell through late summer probably towards late September till mid-October where you saw a little bit of short covering in emerging markets and I think that is well past. So you will see likely weakness moving towards year-end.

I think to the extent that people will move into risk assets at all and to the extent that people will go into risk assets, I assume they are going to go into DM stocks not even safe EM stocks like India and Mexico because the RoE derating in emerging markets has been quite severe. So I do think that there will be headwinds for EM particularly for equities and for Fx but what is different this time is that emerging markets credit is also slowly but steadily deteriorating.

You were speaking earlier about the problems that EM is going to face on the back of Fed but in addition to that, EM’s intrinsic issues are also coming to the fore, in fact I would say for the bulk of this year, it is EM’s intrinsic issues typified in China that have led the bulk of the move down.

Sonia: You are one of the few who called this emerging market rout when it took place. Although the likelihood of fresh money into the emerging markets is low, do you also get a sense that we are perhaps at the early stages of a fresh sell-off in emerging markets and do you think that a lot of money could be taken out of emerging markets like India?

A: I do think that some money can leave emerging markets but probably not as much from India because India is an equity trade. Yes, there has been some debt money that has come in to India but because these markets are largely closed, India and China, which is the other debt market which is largely closed are pretty much equity trades, not fixed income trades. That is very different from emerging markets as a whole.

The reason we have been quite bearish on emerging markets is because we think that the reality has deteriorated whereas the fund flows have not changed because the bulk of these flows have been fixed income flows. South Africa, Poland, Malaysia, Turkey, all of these countries have not seen any of that fixed income money come out. The equity money has been going out for some time and I think that will continue.

So, there are two parts to your question, you said is there a fresh emerging market sell-off likely. I do think it is likely. Is it going to be a crisis? I think it is a bit early for that. I don’t think we are going to move into crisis mode but certainly the kind of cues that we are getting from China along with as Latha says what is happening in the US that is not a great combination. It is something that should have happened earlier but it is finally happening and I think emerging markets will sell-off even further from out here but markets like India, I think again I would like to emphasize, are only relatively speaking in a better position.

Latha: How are you looking at the dollar index itself? It is almost touching 100. By the year-end or in this run up, you think it crosses 100, what are the levels you are looking at?

A: I think it does. The point is that earlier in the summer, the Fed was actually quite worried about global factors which is when Stanley Fischer, the Vice Chairperson also mentioned the value of the dollar has been quite important and the last statement of the Fed, the Fed did so much to mention international factors and there wasn’t the word dollar mentioned at all. So clearly they are getting more confident about the domestic recovery in their labour market about fixed asset investment improving the US.

So, that means the sensitivity to the dollar while not completely absent has certainly declined and this is the first time in a long time that I can think of that you are seeing two completely different guidance’s from two major central banks the European Central Bank (ECB) and the Fed. The last time it was so different was in 2007 but the roles were completely reversed. If you may remember, the ECB was quite hawkish and the Fed at that time was beginning to get dovish. So, that time of course euro-dollar was touching close to 150 and today euro-dollar is moving slowly towards that parity mark.

So, I do think that the Fed is actually prepared for a modestly stronger dollar because I think they are rightly confident that the US economy is improving now. The US has a major current account deficit whereas the eurozone as a whole is a big current account surplus area so that will limit the extent to which the euro-dollar is going o decline or certainly the pace at which the euro-dollar is going to decline. However, for the short-term, what drives currency is usually its guidance from central banks in terms of the direction of the frontend of monetary policy and the Fed and the ECB could not be more different.


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