Foreign investors could warm up for Indian equity markets again amid risk of US stagflation

No one knows what form such a stagflation roadmap will take, but one thing seems certain: it will include some emerging market assets.

Stocks and bonds of poorer countries have fallen this year amid Federal Reserve tightening and runaway consumer prices, and could sell even more if the global economy grinds to a halt. Yet in emerging economies there are antidotes to stagflation: faster growth, accommodative policies and inflation-adjusted yields. That could unlock opportunities in everything from Indian equities to Brazil’s currencies and Chinese bonds.

“Stagflation will force investors to look for growth areas in the world, and emerging markets will be first in line, especially those more immune to dwindling global demand,” said Trinh Nguyen, senior economist at Natixis SA. booming domestic markets that not only protect their economies from a global recession, but also benefit from it, will fare particularly well.”

The probability of a recession in the US has risen to 50% for the second time since the 2008 financial crisis. Inflation in the world’s largest economy is showing signs of peaking, but is expected to remain well above the Fed’s target of at least 2% through 2024. Consumer prices are still rising in the UK and the rest of Europe, while an energy crisis is likely to trigger an economic contraction.

That is uncharted territory for a generation of traders. Since 1982, growth and inflation risks have gone hand in hand as recessions reset economies with lower prices. But now consumer price indices and growth have decoupled, both are deteriorating at the same time and calling for a whole new trading paradigm.

Risks of Stagflation in the US

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Risks of Stagflation in the US

The main themes of such a strategy, according to money managers, will be:

Domestic Growth Heroes

While stagflation in the US and Europe may act as a barrier to export-dependent emerging economies, it could favor countries with strong domestic consumer demand and less reliance on Western markets. That would benefit countries with domestically oriented companies and India stands out in this regard. The country, which derives only 12% of its gross domestic product from exports, is expected to grow the fastest of the major economies by 2023. The stock market is one of the few to make headway this year.

Indian equities continue to exist

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Indian equities continue to exist

Less globalization, please

In general, countries that offer some sort of relative isolation from Western economies are likely to spark investment interest. This could take the form of a lower vulnerability to imported inflation, less need for foreign capital or divergence of monetary policy. Sue Trinh, Asia Head of Macro Strategy at Manulife Investment Management, cites Indonesia, Malaysia and Vietnam as examples. Investors have already started favoring these countries’ dollar bonds, pushing their sovereign risk premia to their lowest levels in seven, nine and two months, respectively.

“Economies most isolated from the negative demand shock are net exporters of food and energy, which are less dependent on foreign capital and still have policy room,” said Sue Trinh. relatively lower weight for food and energy in their consumer price indices and import baskets.”

Stimulus is not dead

China’s preference for looser monetary policy, a hot topic for global investors since the beginning of the year, may become even more compelling. The push in factory inflation, a collapse of the real estate sector and a fragile recovery clouded by Covid outbreaks keep policymakers committed to further easing. That makes spreads on Chinese government bonds close to 200 basis points against Treasuries – compared to a historical average of 135 basis points – looking like a bargain.

“Some, but not all, emerging markets have the potential to outperform as stagflation hits developed countries,” said Eugenia Victorino, head of Asia strategy at SEB AB. “China, a key driver of emerging markets, will be unique in pursuing supportive policies amid the tightening of bias around the world.”

Advantage of large yield

Brazil is an oasis in Latin America, a continent where the general mood is one of pessimism about continued inflation and stunted growth due to policy tightening. Consumer price growth in the country declined in July in response to one of the most aggressive growth cycles in emerging markets. That leaves Brazil with a real return of 3.68 percentage points, the highest inflation-adjusted percentage of the countries tracked by Bloomberg.

Given that stagflation could leave most countries with low real interest rates, the Brazilian yield is a potential draw for carry traders. China and Vietnam could also give their positive returns an edge.

But all this does not mean that emerging markets are immune to stagflation in advanced economies. It will, in effect, be a blow to the overall asset class, fueling portfolio outflows and sending investors to the safety of the dollar. It’s just that even in that turmoil, the only place where investors can get some growth, some stimulation and some returns is the developing world.

“A true global stagflation shock is unlikely to spare emerging markets, but as far as stagflation-like risks are a spectrum, opportunities in emerging markets can help hedge developed markets risks,” said Vishnu Varathan, head economics and strategy at Mizuho Bank.

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