emerging markets: Why are central banks turning dovish and what does it mean for equities - The Economic Times

Why are central banks turning dovish and what does it mean for equities

Fed had set the ball rolling in December policy by toning down interest rate projection.

Updated: Apr 23, 2019, 03.42 PM IST

There has been a major change on the monetary policy front in most developed economies, with some of the major central banks turning dovish in their latest outlook, on the back of expectations of a global growth slowdown.

It seems not only is the rate hike cycle behind us, some of the central banks are even contemplating to engage in monetary easing, going forward. This reversal in stance from last year has been beneficial for emerging markets like India.

The US Federal Reserve (Fed) had set the ball rolling in its December 2018 policy by toning down its interest rate projection for 2019 to two rate hikes (from three rate hikes earlier), and also by cutting the median target rate for 2020 and 2021.

In its January 2019 policy, the Fed turned more dovish by saying it would be 'patient' in future adjustments of Fed fund rate, and also indicated that it is prepared to adjust balance sheet normalisation. In the March 2019 policy, the tone became more dovish, as the Fed cut its interest rate projection for 2019 — indicating no rate hike in 2019, and also cutting the median Fed rate for both 2020 & 2021 substantially to 2.6 per cent from 3.1 per cent earlier.

Simultaneously, the Fed announced that it would start moderating its balance sheet normalisation from the current total of $50 billion per month to $35 billion per month from May 2019, and altogether end the balance sheet normalisation in September 2019.

In the March 2019 policy, the Fed further cut US GDP growth forecast in CY2019 to 2.1 per cent (from 2.3 per cent in December 2018 projection), and for CY2020 to 1.9 per cent YoY (from 2.0 per cent earlier). The US economy had grown by a healthy 2.9 per cent YoY in CY2018. On the inflation front, the Fed's preferred inflation gauge – PCE Core Inflation – dropped from 2 per cent YoY in July 2018 to 1.8 per cent YoY in October 2018, and it last stood at 1.9 per cent in January 2019 (below the Fed's 2 per cent target).

Meanwhile, headline consumer inflation in the US has dropped considerably from 2.9 per cent YoY in July 2018 to 1.5 per cent YoY in February 2019.

The European Central Bank (ECB) has also turned dovish in its statements lately. The central bank, which was tapering its quantitative easing (QE) programme, ended it in December 2018, and had earlier indicated that interest rates would be kept unchanged at least through the summer of 2019.

However, in March 2019, ECB also turned quite dovish: it cut inflation and growth forecasts, and said interest rates would be unchanged at least through the end of 2019. Other central banks around the world like those in China and India have also been engaging in monetary easing lately, with inflation being under control, and some growth concerns arising.

Global bond yields fall sharply
As a result of the dovish statements, global bond yields have fallen sharply from their 2018 highs. US 10-year yield has fallen from above 3.2 per cent in late 2018 to below 2.4 per cent in March end — making the yield curve inverted. German 10-year bond yield entered the negative territory for the first time since 2016. Japan's 10-year yield also followed into the negative territory again.

Dovish monetary policy stance has been beneficial for EMs
This dovish monetary policy stance has been beneficial for some emerging markets, including India, after the risk aversion that we saw for most of CY2018. Emerging market (EM) flows, currencies, equity markets and to some extent bond yields have benefited from this change in stance.

Among Asian EM market peers, India has seen one of the highest foreign equity flows so far this calendar (a bulk of it came in March), after registering an outflow along with other EM peers in CY2018. The rupee has also recovered substantially from its 2018 all-time low of ~74.5 to the dollar, and it has been one of the top performing currencies in March (amidst a sharp uptick in FII flows during the month).

Most other EM currencies have also recovered over the past few months. With the return of global risk appetite, most emerging and Asian equity markets have also seen a recovery so far this year.

FII Equity Flows Trend across Asian EM Markets (USD in million)

Conclusion:
There have been some predictions lately of global growth slowdown, with some segments of the markets speculating the possibility of a recession in the US. Past data does show that a sharp inversion of the yield

curve (indicated by the spread between 10-year yield and 2-year yield) is usually followed by a recession, but it's difficult to tell 'when and if' it will actually occur. The chart also highlights that the recession period lasts usually for a short timeframe, even if we consider the recession that happened during the global financial crisis of 2008.

It remains to be seen whether the current pre-emptive dovish monetary policy stance of the US Fed will help prevent the possibility of a recession and provide some support to the US economy.

US (10Yr – 2Yr) & (10Yr – 3mth) spread Vs recession trend

Even amidst the expected global growth slowdown, India's economic growth is projected to pick up in FY19-20 (albeit we may see some minor downward revision in growth rate going forward). International agencies like the IMF and World Bank have projected India to be one of the fastest growing major economies over the next two years.

Stronger economic growth potential, higher ROE for Indian equities and a stable currency put India in a relatively better position than most of its EM peers, thus helping it command one of the highest overweight positions (relative to the benchmark index) in emerging markets and Asia (ex-Japan) equity fund portfolios.

However, an eye needs to be kept on the magnitude of global growth slowdown, and its impact on global risk appetite — as a more severe slowdown than the one anticipated will have an impact on emerging markets (including India) in general.