West Asia tensions have flared up again over the past couple of days. Oil prices are up more than 15% from the lows touched earlier in the month. With this, the not so recent market anxieties are back as well. Strictly from a market’s perspective, we list below some of our observations with respect to the current phase.
- The US 2-year treasury yield is higher than the recent peak, clearly showing factors beyond oil prices in play with respect to US rate expectations. The new Fed chair, at least from first appearances, has come across as more hawkish than earlier market expectations. Underlying economic data continues to be generally resilient led by AI capex. Consumer spending also looks robust, even as savings rates are not particularly high, employment growth is uneven, and the year-beginning tax stimulus is largely fading away. Additionally, even as oil prices had fallen materially fuel products prices had not, owing to constraints on refining capacity. Thus, while the US consumer seems to be weathering headwinds for now, there are some doubts about the same pace continuing in the future.
- The AI trade seems to be under pressure over the past few days, with some of the frontline stocks showing heightened price volatility. Meanwhile, the narrative with respect to cost of adoption being a headwind also seems to be steadily gathering pace. One also recently sees commentary from a few global asset managers around the need to diversify a bit away from the AI investment theme. If the need to diversify were to broaden, then India can start seeing some revival of capital flow as well. Indeed, incipient signs can be seen in recent data though it may be too early to start extrapolating this to the future.
- Should the above recent narrative on AI gain ground, it may conceivably also show in some reduction in associated capex intensity. Should this happen (and we recognise that this is mere speculation as of now), then it would constitute one more trigger for some redistribution of global capital; as well as (hopefully) ease some pressure from global interest rates, particularly in the US.
- In the period of recent calm in West Asia, the extent of fall in oil prices had surprised most of the market. Despite the need for inventory rebuilding, Brent had almost retouched USD 70 to the barrel, while reports of a large surplus from next year have been doing the rounds. If true, then this is an important point to remember in this renewed period of escalation. It is to be also noted that, in its latest projection, RBI has assumed USD 95 for oil while it is still at USD 85 at the time of writing.
- RBI / MPC’s assessment and consequent reaction function is now better understood. There seems to be a general sense to be patient and watch for second order effects before acting. Thus, core inflation ex of valuables seems an area of focus. To be clear, considering this measure doesn’t mean that the MPC is no longer targeting headline inflation. Rather, this only means that it is looking for the persistent aspect of inflation in what is otherwise a period of heightened volatility in food and fuel prices. To that extent, looking at core inflation is also consistent with the described approach for waiting to see whether second round effects are forthcoming for inflation or not. It is also to be noted that unlike, say, in the US, core inflation pressures in India remain quite benign. Thus, our view remains that RBI / MPC will not hike more than 50 bps in this cycle and not before the October policy. The negative assertion is intentional since we aren’t fully sure yet whether those 50 bps hikes will also happen.
- RBI/government have taken substantial steps recently to put at least a temporary floor under our balance of payment issues. Just as the measures are notable, so is the underlying intent. Thus, shoring up capital flows seems a policy priority now. Consistent with this expectation, one looks forward to more steps under this theme in the weeks and months ahead. The AI trade abating may also be a tailwind for capital flows, though this is obviously an uncontrollable variable from a domestic policy standpoint.
Our net assessment from the above is to stay overweight market risk with continued preference for up to 3 – 4-years maturities on the corporate bond curve, and 14 years and above on the government bond curve. As always, this represents our current thinking which may change in the future. Points 5 and 6 above give immediate comfort in holding this view, whereas points 2,3,4 are grounds for potential optimism even though they are currently not. Point 1 above is one of downright concern from a global rates perspective thus far. At any rate, the current phase of renewed volatility is a timely reminder to not get too tactical with the market and keep due investment horizons in mind.
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