Jan Dehn, Head of Research, Ashmore Investment Management (Source: BloombergQuint)

Emerging Market Assets Will Rally On Trump’s Fiscal Policy Failure, Says Ashmore

Central banks globally are unlikely to take a strong directional stance on the debate over balance sheet unwinding and raising interest rates just yet as they wait for more incoming data, according to Jan Dehn, head of research at Ashmore Investment Management.

Dehn is not expecting any decisive changes in outlook based on what happens in Jackson Hole, he said on BloombergQuint’s weekly series Thank God It’s Friday. But given that asset prices are at “bubble levels”, central banks are more likely to focus on gradual balance sheet reduction rather than raising interest rates, he added.

Here are edited excerpts from the conversation.

Wait-And-Watch Mode

Would the Jackson Hole symposium be a forum for Fed Chair Janet Yellen to signal the timeline for the Fed balance sheet unwinding or is the market unduly worried?

We should not expect any major pivotal announcements. It’s more likely that they will be using as a forum for discussing the internal uncertainties about the outlook. It’s a big debate right now about whether we will continue to have soft inflation and if not whether we should go for rate hikes or balance sheet reduction. Question marks still hang over these issues.

I don’t think we should expect a major decisive change in the outlook based on what happens in Jackson Hole. I think they need more time to be sure that the economy is moving one way or the other before they take a strong directional stance.

What could be the implication of low inflation for the policies of central banks?

As we approach full employment, there are two concerns for central bankers. One is inflation, which does not appear to be a major problem right now. That suggests to me that interest rate hikes become less likely than what is currently priced into the market. On the inflation side, that’s the main implication. On the other side, we have pumped in an enormous amount of liquidity into financial markets and asset prices are extremely elevated.

You can argue that even though inflation is very low, asset prices are at bubble levels. Even Fed officials have indicated that partially. That suggests that if we are going to see any monetary policy action, it is more likely to be focused on a gradual reduction in the balance sheet rather than raising interest rates.

Emerging Markets’ ‘Trump’ Card

How are you reading the Trump administration’s impact on the U.S. economy and what does that mean for the fund flows into emerging markets?

Trump’s performance has been dismal. The market bought into the idea that he wanted to make material changes to the U.S. economy with lots of structural reforms, taking into account that he controls both Houses of Congress. But he has not been able to deliver anything. Particularly, he has not been able to deliver the border adjustment tax and repeal Obamacare which means there is very little room for fiscal stimulus. That suggests to me that we will have very soft growth and very few rate hikes. In that environment with relatively soft U.S. growth and few rate hikes, I think the dollar looks expensive. The main implication is that the dollar will continue to decline which is generally positive for the emerging markets.

The implications for emerging markets of the failure of the Trump administration so far to implement major fiscal stimulus is that we will see a continued rally in emerging market assets.

Indian Equities Vs Debt

In India, fund flows into equity markets have tapered while fund flows into debt markets were strong until last month. We are looking at some amount of contraction there. What do you think is causing this?

The very near-term fluctuations in flows should not give rise to too much concern. It’s important to remember that we are still in the holiday season in the Western financial markets and small events can have big repercussions in some market price action. There are a lot of major institutions which are not putting money to work. They’re sitting on the sidelines. The short-term volatility is not a source of great concern. Indian equities look a bit expensive relative to Indian fixed income. The currency backdrop for India is okay. Bonds do look more attractive than equities right now and that may explain why with that volatility you are seeing greater interest in the bond side over the equity side. India still has very significant barriers to entry for foreign investors into the fixed income markets. But such barriers do not exist in equities. To the extent that investors want fixed income more than equities, you should expect that overall flows into the area declines because India’s government itself limits how much we can invest in Indian bonds.

If the Indian government lifts the curbs on foreign investment in Indian government debt, will you be looking to invest a lot more?

We certainly would and not only us. India, given the very large size of its domestic bond market, in fact, it is the second largest bond market among the emerging markets, would immediately be given a weight of at least 10 percent in the main bond market indices and all investors in the world who are benchmark investors would at least, on average, adopt a 10 percent weight for India and, I imagine, many others would have been overweight. You should expect to see a very large amount of money flowing into India. That will strengthen the currency and that will put downward pressure on inflation and enable the RBI to cut interest rates which will help stimulate Indian growth. It will be good for the Indian economy. One of the big questions many foreign investors are asking for many years is what exactly are the special interest groups that are preventing India from making this obvious and logical step.

RBI’s Next Move

Has the RBI’s monetary easing come to an end or is it taking a long pause before going ahead with another rate cut? Where are you positioned as far as Indian debt is concerned?

We are more in the longer tenure and our view is RBI is not going to be cutting very much if at all. The primary reason for this view is we have seen a deterioration in fiscal policy in India recently. That is always a red flag and it should be a red flag for the RBI. If you go back not so far into the past, we have seen that, traditionally, loosening fiscal policy and excessive reliance on fiscal stimulus has been the root of all evil for investors.

Whenever fiscal policy gets loose, the RBI needs to be very vigilant and be ready to not cut rates. My impression of the RBI is it that it is quite a vigilant and prudent central bank, so we will probably not get as many rate cuts as the market is expecting.

Room For Reforms?

We saw demonetisation last year. This year we have seen a big tax overhaul with GST coming in. Will reforms take a backseat in the near term as the government starts preparing for elections in 2019?

That would have been my base case. But we had a recent local election in India which went very much in favour of the government which suggests that the government has more political capital that perhaps people were expecting just a few months ago. That suggests there is a small possibility that further reforms could take place.

The most important reform which should be done right now, with GST and demonetisation out of the way, would be to finally focus on the capitalisation of public sector banks.

This may be one of the genuine reasons for not opening up the bond market because foreign investors in the bond market would require well-capitalised and solvent public sector banks as market makers and so on. It would be wise for the government to speed up its reform of the public sector banking system. A healthy banking system is absolutely key to get the credit cycle going and therefore to sustain the pace of growth. To the extent that Modi’s political capital is a little bit higher than maybe expected at this point in the cycle, there is a small possibility that they will make progress in this area. But, in general, I would expect that the pace of reform should slow down as we head into the next political season.

Portfolio Strategy

What have you done with your Indian portfolio holdings over the last 1-2 months?

We are being a little more cautious in the equities portfolio. We do think that the valuations are very high in absolute terms but also relative to valuations you get in other markets. We are becoming more selective, focusing more on genuine value propositions and scaling back a little bit of our exposure in the cyclical stocks.

Indian Banks: Selective Approach

What’s your view on the Indian banking overall because many banks are staring at multi-year low credit growth and are ridden with stressed assets?

It is very important to be very selective in Indian banks. There is considerable weakness in a number of Indian banks. But there are others that offer good value and you need to be quite selective where you go in. The fact that credit growth is relatively low is ultimately a good starting point. There is room for some banks to increase their market share and to broaden their activities in financing the private sector. But the banking sector as a whole, is still being held back by the vulnerabilities of parts of the public sector banking system.