The year 2020 will go down in history as the year that brought the global economy to its knees. It will also go down as the year when NASDAQ had the fifth-highest return since inception on top of 35 percent return last year. Despite record contraction in global growth, commodity prices and oil retraced from the lows as demand resurged. Benign liquidity conditions added to the rally in commodity prices. Oil was up 155 percent from its low, copper by 67 percent and agriculture prices by 34 percent.
Central Banks stepped up monetary stimulus to unseen levels thus helping finance unprecedented borrowing by governments to mitigate the impact of the pandemic on the economy. The resulting liquidity is one of the factors driving equity markets, precious metals and Bitcoin to unseen levels. The fiscal and monetary response along with higher demand for manufacturing products led the US FOMC to upgrade its growth and inflation estimate for this and next year in December 2020.
With risk-free yields hitting rock bottom (as much as US$ 18 trillion of global bonds have negative yields) bond investors switched to equities and EM debt. In the US, as much as US$ 200 billion of funds switched from bonds into equities. Most of the investment went into tech stocks. FPI investors sold Indian bonds and bought Indian equities. Technology stocks in India outperformed gaining from the global march towards digitisation.
Will 2021 be any different? Yes and no. While there may be episodes of risk-on and risk-off depending upon episodes of spread and containment of Covid-19, confidence will generally go up as a larger population gets vaccinated. Hence, volatility in financial markets should be less than last year.
Global central banks will continue to buy government debt (quantitative easing) to keep rates low and support growth. Thus global equities have room to move even higher. US$ will be under pressure against EUR and Asian exporters. With a third of the earning of US firms from outside the US, a lower currency is supportive of earnings and thus equity markets.
US fiscal and monetary policy is supportive of domestic growth. The US is a consumption-driven economy which will benefit Asian exporters. Indian IT firms will see more work flowing from the digitisation of the global economy. India will see additional benefit from the PLI scheme launched by the government which will give a boost to manufacturing and exports. Domestic consumption too will pick-up as contact intensive service activity normalises. Thus India’s growth is likely to pick-up from a low of (-) 8.2 percent this year to 8.8 percent next year. A low base and normalisation of demand will help.
As growth revives and RBI’s restructuring scheme is implemented, the central bank will look at ways to reduce domestic liquidity. Recent MPC minutes show members already discussing the impact of liquidity on asset markets. While inflation across the world is falling, supply-side factors have driven India’s inflation higher. Thankfully, India’s retail inflation is expected to come down to 4.5 percent next financial year from 6.5 percent this year as food inflation falls which gives the central bank room to hold rates at these levels. However, higher commodity prices next year are likely to put upward pressure.
Indian yields thus seem to have bottomed out and yield curve will flatten as short-term rates move up faster than long-end rates. The trajectory of long-end yields will depend upon the government’s fiscal policy. The fiscal deficit is expected to fall from current levels of 7 percent of GDP to 5 percent of GDP next year. A higher fiscal deficit implies the yield curve will shift upwards thus driving all yields higher.
RBI’s liquidity operations including open market purchases have been instrumental in keeping government yields lower. Spread of good quality corporate debt over sovereign has compressed with banks flushed with liquidity and few opportunities to invest. As economic growth revives and credit demand picks up, banks will find alternate opportunities. Thus India’s low-interest-rate environment will see a reset in 2021. Lessons from the past suggest that India should wind down its expansionary policies ahead of global central banks and governments.
The most pertinent risk to global and Indian economy remains another wave of COVID-19 virus such as what we have seen in the UK in late December as vaccinating a large percentage of population may take time. In all likelihood, 2021 will be the year of great normalisation.
—Sameer Narang is Chief Economist, Bank of Baroda. The views expressed are personal