Talking Points This Week: No Stopping RBI, ECB, And Biofuels In India

In ‘Talking Points This Week’, Niraj Shah studies how top business leaders and market makers are navigating the fast-changing financial landscape.

In a week punctuated with a very wide range of newsflow – from the World Bank painting a gloomy stagflation picture or Beijing inching closer to zero Covid-19 cases and easing restrictions, the monetary policy deliberations at the Reserve Bank of India and the European Central Bank, to Boris Johnson narrowly surviving a confidence vote, Elon Musk threatening to end the Twitter deal over lack of information on bots. While you can read about India’s MPC outcome and opinion in detail here and here, this newsletter focuses on the ECB, equity market outlook, and biofuels.

Is The ECB Hawkish Or Dovish?

The European Central Bank ended asset purchases and telegraphed a rate increase for next month. Note that the Eurozone economy has been incredibly resilient in recent months, absorbing the dramatic spike in food and energy prices without any serious injuries. The unemployment rate is at its lowest since the euro came into existence, business surveys point to solid growth this quarter, and inflation expectations remain historically elevated. In light of all of this, it was widely anticipated that this meeting will probably be used as a stepping stone to prepare the markets for a rate increase in July. And it lived up to that billing, by telegraphing a 25-basis point hike and laying the conditions for another 25, if need. And therein lies the issue. While there are positives, not everything is rosy. Business and consumer confidence metrics have fallen sharply, while demand for European exports is dwindling with Chinese cities shut down. Hence, even though the sun is still shining, storm clouds are gathering, and the time window to tighten monetary policy is limited.

Sun And Shade

Prices for shipping containers, semiconductors, and fertiliser have come down in recent months, potential signs of relief for consumers around the world as the cost of both producing and moving goods may be moderating. It would also be good news for the Federal Reserve, as it seeks a soft landing. That said, U.S. Treasury Secretary Janet Yellen said on Tuesday that she expects inflation to remain high, for now. After cutting its forecast for economic expansion in 2022, World Bank President David Malpass warned that several years of above-average inflation and below-average growth—or stagflation—lie ahead, with potentially destabilising consequences for the less wealthy economies of the world. The K-shaped outlook rears its head again.

Market Kya Lagta Hain

It’s the most asked question. Let’s try and put this in perspective through a couple of angles. I stand on the shoulders of some smart minds to dissect this. Neelkanth Mishra of Credit Suisse observes that in past U.S. recessions—which have on average lasted 10 months with a 2% drawdown—GDP impact in APAC countries has been 1.0-2.5x the fall in U.S. GDP. However, APAC market drawdowns due to U.S. recessions are longer (2-20 months) and deeper (falling 26-60%) than for GDP. As a result, the recent correction, 20% over 12 months, may be too early for an expected U.S. recession. Instead, it is likely to be a valuation reset, given the rise in risk-free rate and equity-risk premium (higher uncertainty). EPS cuts are now the gravest risk to the market. Mishra notes that APAC EPS fell 20-45% in past U.S. recessions.

Saion Mukherjee and Neelotpal Sahu of Nomura say the Indian market has corrected 11.5% from its peak in October 2021 and currently trades at 18.4x one-year forward earnings. Historically, there has been a modest correlation between yields and valuation multiples, and a correction to 16-18x remains a possibility. The contrast was provided by Devina Mehra of First Global, who mentioned that most of the very near-term negatives are in the price and in the absence of any further negative surprise, and in the case of a proper re-opening of the Chinese economy, equities might have some tailwinds for a bounce. We will know in the weeks to come.

Biofuel Programs In Danger? Not In India

Food supplies have shifted rapidly from surplus to shortage, and the United Nations has again warned about the heightened risks of world hunger. Henry Boucher, partner and head of investment strategy at Sarasin & Partners writes in a Reuters article that even though supply disruptions in many parts of the world are severe, and policy solutions are challenging, western governments do have the opportunity to reverse the rising cost of food through the simple scrapping of biofuel mandates. This, according to him, would remove a very large non-food demand for crops and turn the current grain shortage into a surplus, easing the pressure on inflation.

This view also helps us bring a different prism to assess the ethanol movement in India. While the increased use of ethanol in auto fuels has helped producers, a close eye also needs to be kept on what it does to water levels in India, and possible diversion away from other land use. Sugarcane is a water-intensive crop, with some estimates averaging at 1,600-2,000 litres of water for the cultivation of each kilogram of sugar and one litre of ethanol from sugar requiring about 2,860 litres of water. Sugarcane and paddy combined consume 70% of irrigation in India, prompting the NITI Aayog to advise providing suitable incentives to farmers for shifting some of the area under sugarcane to less water-intensive crops.

This will be a difficult task, given that sugarcane is a profitable cash crop for cultivators. The government's argument is that the push for ethanol poses no threat to India’s food security because the government has enough stockpiles of grains at warehouses of the state-run Food Corporation of India. Even in 2021, state reserves stood at 21.8 million tonnes of rice, against a requirement of 13.54 million tonnes. Companies that BQ Prime spoke to have told us about using damaged foodgrains as well. One can argue that in a utopian and efficient India, foodgrains won’t get damaged, and thus every ounce of crop produced will be utilised to address domestic hunger or for exporting to other countries. While that's not where India is, the biofuel program may face more opposition elsewhere in the world than in India.

By The Way...

I would just like to end with a small observation around the market expectation of the RBI policy and the nuance around it. Remember, it was anyway widely expected that the RBI would remain front-loaded on rate hikes, after un-anchoring markets’ policy expectations in April and May.

"Inflation management is tricky as the real repo rate is deeply negative at -3.4% (4.4%-headline CPI at 7.8%). Thus, to arrive at a neutral real rate of 1% RBI will have to substantially increase the repo rate and tighten liquidity. Assuming that core inflation softens to 6% in the next 12 months the short term rates will have to be at 7% from the current level of ~4%".

This comment was made by a keen watcher of macros and markets, and is evidence of the markets possibly pricing in an eventual repo rate of 7%. Does that suggest it is a little over-prepared for tightening? Any reprieve due to crude price correction prompted by a resolution to the war in Europe will be a positive surprise. Mind you, the smaller issues around supply chain management notwithstanding, the biggest bugbear remains crude, and thus, from an Indian perspective, it remains the key commodity to watch.

Niraj Shah is Markets Editor at BQ Prime.