A fast rising US economy could pose a risk to the reflation trade as a stronger dollar puts fund flows to emerging markets, including India, at risk. The changing complexion of US corporate earnings will also have a spillover effect on certain sectors. While traditional export sectors such as pharma, IT, and global cyclicals could get a lift due to US growth, pure domestic sectors such financials and consumption could see increased choppiness due to sluggish foreign flows.
In the first quarter, the US economy accelerated at 6.4 percent Y-o-Y, its second-highest growth since 2003. Consumer spending in the US has surged as stimulus cheques drove household incomes. This acceleration comes at a time when a devastating second wave of COVID-19 has put the nascent economic recovery in India at risk.
We can already see it in the divergence between the Dow Jones Industrial Average and the Nifty 50. Both delivered gains of about 90 percent in local currency in the past five years from end-April 2016 to April 2021. But so far in 2021, the Dow Jones has clearly outpaced the Indian markets in returns, delivering 10.68 percent returns to the Nifty 50’s 4.64 percent. Till recently, the US market was even making new highs.
A growing gap
If the recovery in the US economy is any indication, this gap could expand in the coming months.
Several factors appear be swinging in favour of the US. It helps that people in the US have been getting stimulus cheques which has increased personal spending; in the first quarter, personal consumption rose 10.7 percent, the second-fastest since the 1960s. The rapid increase in vaccinations is also helping re-open the economy much faster than anticipated.
And further impetus for the US economy is coming from additional fiscal stimulus measures. The US is working on a stimulus package to fund infrastructure and healthcare spending by another $ 4 trillion. This is in addition to the increase in spending already announced by the US government.
All this will help expand its economy in 2021, perhaps even more than what the GDP could have been had the pandemic not happened, note analysts. In fact, the US economy is expected to lift global growth too. Europe is also likely to get a fillip.
Some of that cheer has been building up in US stocks. Till recently, the US markets were hitting all-time highs, driven by rising reflation spends. The only hitch for US stocks was whether a new capital-gains tax on the wealthy announced by President Biden will further play spoilsport with the market’s rise. Even so, these could spell negative implications for the Indian markets.
A risk to reflation trade
To veteran market watchers, the rise in the US economy poses a risk to the reflation trade, which can be seen from a rising dollar. A weak dollar has been one of the key drivers of emerging market equities. Further, sharper swings in stock markets could be on the cards if US investors react adversely to the capital-gains tax.
“The US economy would now be at the centre of global growth and, therefore, would attract more attention from global investors. Some emerging market flows over the past year could shift back to the US. Already, emerging markets have been feeling the heat of outflows,” said market expert Ajay Bagga.
Back home, the strains of the second COVID-19 wave are beginning to show. New COVID-19 restrictions are already hampering the movement of goods and services, and analysts have already started to lower India’s GDP growth estimates for FY22. Analysts at Citi have already cut India’s GDP growth estimates for FY22 to 12 percent from an earlier 12.5 percent. A worsening in the current COVID-19 curve could further tilt the economy to the downside, as analysts could slash GDP growth expectations.
Earnings risk in India
This could also pose a risk to the first quarter earnings, say analysts. Already, some initial damage is evident in the auto sector with April sales skidding considerably month-on-month for many auto companies. This could spill over to sectors such as auto ancillaries.
A slowdown in new COVID-19 cases would be welcome news, especially after the havoc it has created in the markets. That could help the Indian markets stabilize. But that looks to be some time away.
Nevertheless, an expansionary US is good news for some domestic sectors such as IT and pharma. The US infrastructure stimulus could further drive cyclical sector demand over time. The US housing sector is also showing good growth. That should support growth for global steel and metal companies. US household savings have increased by over $ 2 trillion in additional savings so far, which provides ammunition for increased consumption spends. As a result, consumption sectors such as home textiles, gems and jewellery, and other export-oriented sectors could gain, note analysts.
“Infrastructure spends will lead to more jobs and a bigger surge in spending in the US economy. Next year we expect 22 percent growth in earnings in the S&P 500. Reflation trade is clearly happening. However, the US earnings complexion will change. Cyclicals will drive earnings as opposed to work-from-home or internet stocks. For India, it’s not a very rosy scenario save for some cyclicals and consumption and export categories that benefit from the US recovery. The US market could further consolidate gains as well, while we could slip as happened in April. If new COVID-19 case rate drops in the next 2-3 weeks, then the domestic reopening trade holds promise,” said Bagga.