Are financial markets over-optimistic?

Business Standard, 5 February 2024

Uncertainty rose dramatically in February 2022. In February 2023, my column here in the Business Standard was titled Uncertainty has declined. Many things have gone rather well in the year that followed, and perhaps the financial markets are over optimistic.

Developed markets did rather well

The grand question of the last year was about restarting the economy in developed markets ("DMs") after Covid. Large scale monetary and fiscal stimuli had given a burst of inflation. Unlike the inflation crisis of the 1970s, there was predictability on policy strategy, thanks to inflation targeting. But there was a lot of gloom about the harm to GDP or employment that would be paid to wrestle inflation down.

In the event, things worked out rather well. DM inflation has declined nicely without significant damage to unemployment or GDP growth. We now have a global economy defined by strong growth in the US, low growth in China, and weak growth in Europe and Japan. IMF projections for real GDP growth in 2024 are 2.1% for the US, and 0.9% for the Euro Area and Japan.

The first DM interest rate cuts would be symbolic, saying that the post-Covid inflation phase has ended. The financial markets are optimistic about such events in 2024. Two key uncertainty measures are the VIX and the MOVE. Over the last year, VIX dropped by 29% but the MOVE has been unchanged. If DM interest rate cuts commence in 2024, this could kick off a next wave of strong capital flows into India.

It is an interesting moment in the world economy, to understand the forces at work, to peer into the future, and to think about the implications for us in India.

Why did DM inflation decline so well? The Covid supply disruption ended. Along the way, Russia tried to engage in energy blackmail upon Europe, and that was successfully solved by Europe. The US is now the world's biggest gas exporter. An optimistic interpretation of transitory inflation in the late days of Covid was that firms needed to be given attractive margins for some time, to pay the fixed costs of restarting production.

Why did the US do so well? Partly, it was the recovery from the pandemic, with a dose of good luck. The US labour market has greater flexibility compared with other DMs. The Biden team is a normal DM-quality governing arrangement, compared with the populism that preceded it. Somewhat better thinking, across hundreds of policy decisions, makes a difference.

The defence industrial base in Europe and the US is slowly being cranked up to a higher level, away from the post-1989 slumber, in response to the Ukraine war. While the dollar values of defence spending are as yet small, procurement processes are often triggering new investments in manufacturing capabilities which had otherwise atrophied. What appears to be $1 of procurement is triggering investment at many steps in the long supply chain.

Threats

There are five important threats for 2024.

  1. Many countries go to elections in 2024, and many populists may win. As an example, Viktor Orban's defiance is partly based on his gamble that there will be more populists like him in the EU within a year. Election year incentives will trigger off odd behaviours by many governments. If Trump comes to power in the US, there will be turbulence worldwide through problems like Ukraine and climate change.
  2. Russia's invasion of Ukraine continues to roil the world. If a country can invade a neighbour, there is no international order. This war feeds into global instability in many ways. As an example, it is hard to imagine Iran's aggression in the middle east without the conditions created by the war in Ukraine.
  3. The `third globalisation' -- the phase where access to the core is restricted for countries in the periphery with low foreign policy and military alignment -- is falling into place [idea video recent measurement]. While it improves incentives in international relations, it comes at a price in economic growth.
  4. Very high levels of leverage all around create the possibility of accidents. What is remarkable so far is how little went wrong when DM central banks raised so much. But we are not out of the woods yet.
  5. Model risk is high. As was often emphasised from 2020 onwards, we are in new terrain. Prevailing models and theories are formed out of datasets drawn from more normal times. Whether in the minds of policy makers or financial players, there is a greater risk of making mistakes.

The financial markets have climbed this wall. They display high optimism in their value of the S&P 500 and the VIX (though less so with the MOVE).

An Indian perspective

Turning to an Indian perspective, the best measure of Indian exports is to focus on goods and services excluding petroleum products and excluding gold. By this measure, exports have been roughly flat from February 2022. The unusually good DM performance from February 2022 has not, thus far, fed into Indian exports buoyancy. If DM economic buoyancy continues, will Indian exports revive? If it does not, Indian exports will suffer.

While the fighting in Gaza is not an important high intensity war on a global scale, it is important for India because of the difficulties of shipping through the Suez Canal. The traffic from India to Europe and the American East Coast, through the Suez Canal, suffers significantly higher transportation costs when rerouted through the Cape of Good Hope. Bombay and Karachi are the two ports in the world where the Suez Canal matters the most.

Given the weakness of investment in India, there is no large current account deficit that requires financing. Hence, changes in global financing conditions will not create complexities on the rupee. However, there could be repricing of many assets, e.g. there is a connection between VIX and the valuation of Indian assets.

Back up to Ajay Shah's 2024 media page
Back up to Ajay Shah's home page