Please help understand the end of US exceptionalism and India's position!

"The only thing certain is that the level of uncertainty is higher."

As global markets reel from Trump's sweeping tariffs and heightened economic volatility, investors worldwide are grappling with fundamental questions about the future of global trade, currency dynamics, and investment strategies. In this moment of exceptional uncertainty, understanding the mechanics behind these shifts has never been more crucial.

In the latest episode of "Please Help Me Understand," I sat down with fixed income expert Suyash Choudhary of Bandhan AMC to decode what's really happening behind the headlines and explore what these seismic shifts mean for India and global investors alike. Our conversation revealed insights into the changing nature of the global economic order and why certain traditional assumptions no longer hold.

Heightened Uncertainty: The New Normal

According to Suyash, the current economic environment is defined by unprecedented uncertainty that affects decision-making at every level:

"Imagine you are a company wanting to, let's say, up plant and machinery investments for the next five years. You need a relatively stable policy environment... but in the economic template of today, it's virtually impossible for any company to make that call."

This uncertainty operates through several channels:

1. Delayed investment decisions by companies

2. Increased precautionary saving by consumers

3. A general growth slowdown, varying in intensity by country

For India, the direct trade correlation with the US is not as strong as for other export-oriented economies, providing some insulation—but not immunity—from global turbulence.

The End of US Exceptionalism?

One of the most striking developments is the potential unwinding of the "US exceptionalism" trade that has dominated global capital flows for years. Suyash identified three key pillars that have supported US outperformance:

• Massive fiscal stimulus that expanded the US deficit from 3% pre-pandemic to 6.5-7% of GDP currently

• Tech and AI revolution centered in the US, driving capital expenditure

• Strong immigration that expanded the labor force and created fresh demand

However, all three pillars are now weakening: immigration is slowing, tech innovation is spreading globally (including to China), and while deficit levels remain high, incremental fiscal stimulus is flatlining.

Perhaps most tellingly, the US dollar is weakening during a risk-off period—contrary to historical patterns.

"In the current risk-off, you have actually seen the US dollar weaken... our sense is because it represents the net effect of two factors. One is flight to safety where the dollar tends to strengthen. However, because there was a very strong ownership of US assets... there may be some reallocation or diversification happening away from the US."

This dollar weakness is actually beneficial for emerging markets like India, reducing the risk of capital flight that typically accompanies periods of market stress.

Financial System Shifts: Debt, Dollars, and New Dynamics

The conversation turned to the sustainability of US debt—an eye-watering 30 trillion dollars with persistent deficits of 6-7% of GDP in peacetime. Suyash acknowledged this is clearly "not a sustainable path," but noted a fascinating market response:

"One of the things that is already happening is that, let's say emerging market bond yields to US bond yields spread has narrowed and investors are fine with it... currently India to US 10-year yield spread is only 200 basis points... and investors are fine."

Rather than triggering capital flight from emerging markets, this fiscal situation is causing a reassessment of relative risk. Investors recognize the changing fiscal dynamics in the US, allowing countries like India to enjoy lower yield spreads than historical norms would suggest.

Additionally, we're seeing a remarkable fiscal pivot in traditionally conservative countries like Germany, providing an "auto balancer" for global investors looking to diversify away from US assets.

China's Role: Devaluation Risks and Trade Implications

A critical question for global markets is whether China will devalue the yuan in response to tariffs. Suyash offered a decisive view:

"We don't think intentionally via active policy, China will devalue the yuan. We just don't think that... In fact, in the recent past, 10 years back, China had intentionally devalued the yuan... the trade benefit of the devaluation was more than offset by the capital account outflows."

This assessment is crucial for India, as a Chinese devaluation would put pressure on the rupee and increase the risk of capital outflows. The distinction between normal market-led depreciation versus an active policy choice for devaluation is key to understanding potential currency movements.

India's Position: Structural Strengths and Policy Space

Despite global headwinds, Suyash highlighted two significant structural advantages India possesses compared to previous cycles:

• Clean balance sheets: "We have been through our credit and NPA cycle... credit risk or balance sheet stress is not a macro problem." This provides resilience to withstand growth slowdowns.

• Transformed current account dynamics: "India used to be almost a 2.5 to 3% current account deficit country. Now we are largely a 1% current account deficit country." This is primarily due to the expansion of services trade surplus from $6-8 billion monthly to $15-18 billion monthly.

"It's nothing short of a services revolution that we have seen here... the kind of GCCs [Global Capability Centers] that are getting established here now are not just low-tech back-end work. It is the whole value chain."

These structural strengths, combined with the RBI's proactive stance, position India well to weather global uncertainty. The RBI's recent rate cut and stance change signal readiness to support growth, with Suyash predicting the terminal repo rate could reach 5.5% or lower, depending on growth conditions.

RBI's Proactive Approach: Liquidity and Monetary Policy

A significant development Suyash highlighted is the RBI's decisive shift in approach to liquidity management and monetary policy. This represents a marked change from late 2023:

"The context is very different from what it was October to December compared to what it is now... you had a very large run up in the US dollar and a very sharp beginning of the rupee. And therefore, the RBI had to intervene in order to manage the pace of depreciation. Also, inflation was still much above target."

Today's environment is dramatically different:

• The dollar index is weakening, reducing pressure on the rupee

• Inflation has fallen below target with forecasts indicating it will remain at target

• Growth pressures are becoming more apparent

In response, the RBI has "really swung into action" regarding liquidity creation, buying sizable amounts of bonds under Open Market Operations. This proactive approach, combined with the rate cut and stance change, signals the RBI's readiness to support growth through this period of global uncertainty.

Suyash now predicts the terminal repo rate in this cycle will be 5.5% (lowered from his previous 5.75% estimate), with potential to go even lower depending on growth conditions. This monetary policy space gives India a significant advantage in addressing cyclical challenges while the government maintains fiscal discipline.

The Four Critical Questions for Fixed Income Investors

Suyash identified four critical questions that fixed income investors must answer in the current environment:

1. What will the Fed do? With both sides of the Fed's mandate under pressure (inflation facing a one-time shock from tariffs and growth slowing with rising unemployment), Suyash believes the Fed will prioritize addressing growth concerns:
   
   "Our sense is that the Fed will decide in favor of addressing growth because... in an environment where heightened uncertainty is leading to economic growth slowdown and therefore higher unemployment, almost by definition, the tariff shock will not have second order effects because demand would have weakened."
   
   He expects markets are correct in pricing 4-5 rate cuts from the Fed over the next year, with the risk tilted toward even more cuts depending on the severity of the growth shock.

2. What happens to the dollar? The unusual weakening of the dollar during a risk-off period represents the net effect of two opposing forces: traditional flight to safety versus diversification away from heavily-owned US assets.

3. Will China devalue the yuan? Suyash strongly believes China will not intentionally devalue the yuan through active policy, having learned from the negative consequences of capital outflows following their 2015-16 devaluation.

4. How much policy space will RBI have? With inflation at 3.3% (well below the 4% target) and growth facing headwinds, the RBI has significant space to act through rate cuts and liquidity management.

These four interconnected questions form the analytical framework Suyash uses to navigate the current uncertain environment. For fixed income investors, the answers suggest significant opportunity in Indian bonds as global rates begin to decline.

Historical Context: Why This Time Is Different

Suyash provided an important historical perspective on why India is better positioned now than in previous global economic downturns:

"From a medium term standpoint, I think India today has two very large advantages that it did not have in the previous cycle."

The first crucial difference is the state of balance sheets across the economy. Unlike the run-up to 2020, when many entities were still working through credit stresses, today "credit risk or balance sheet stress is not a macro problem." While individual business models may still face challenges, the overall financial system is more resilient.

The second transformative change is in India's external position. The shift from being "almost a 2.5 to 3% current account deficit country" to "largely a 1% current account deficit country" represents a fundamental improvement in India's macroeconomic stability. This is primarily driven by the dramatic expansion in services exports:

"On a monthly basis, India used to post a services trade surplus of $6 to $8 billion, which is now on a monthly basis $15 to $18 billion."

This "services revolution" has not only compressed the current account deficit but also created substantial opportunities within the domestic economy, including expansion of commercial real estate markets.

These structural improvements mean that even as India experiences some cyclical slowdown from global headwinds, the country has "inherent resilience that will mean that we can very easily withstand that period." This historical context explains why Suyash maintains his optimism despite the heightened global uncertainty.

The Transformation of India's Bond Market

A fascinating development Suyash highlighted is the evolution of India's government bond market, particularly at the long end of the yield curve:

"There was once a time not so far back when we used to think about 30, 40, 50-year bonds as very exotic part of the yield curve. And we never used to think about venturing there because we thought that part is illiquid, that part is riskier. All of that is changed."

This transformation has occurred due to several factors:

• Growing institutional participation: Insurance companies, pension funds, and provident funds have increased their allocations to government bonds

• Global investor interest: With India joining global bond indices, foreign portfolio investors have begun discovering Indian government bonds

• Macro stability: India's consistent fiscal discipline and well-managed monetary policy have built credibility

The result is a more mature, deeper bond market that offers opportunities across the yield curve. While Suyash notes there can still be "quirkiness" in the long end as institutional flows "ebb and flow," this part of the curve has become a viable investment option for real money investors with appropriate risk appetite.

This transformation is still in its early stages. With foreign ownership of Indian government bonds at just "three points something" percent compared to double or triple that in comparable emerging markets, there is substantial room for further development. Suyash expects "the FBI [Foreign Bond Investor] discovery of India bonds" to continue for at least the next five years, providing ongoing support for the market.

Investment Implications: Fixed Income Opportunities

The conversation highlighted significant opportunities in the Indian bond market:

• Underowned by global investors: FPI ownership of Indian government bonds is just above 3%, compared to double or triple that percentage in comparable emerging markets.

• Growing structural demand: Insurance, pension, and provident fund participation has increased, providing stability to the bond market.

• Long-end transformation: Once considered exotic and risky, 30-40-50 year bonds are now viable investment options due to structural changes in the market.

Suyash emphasized that fixed income should have a permanent place in investor portfolios, not just as a tactical allocation:

"We think the FBI [Foreign Bond Investor] discovery of India bonds is only at a very nascent stage and we'll see much more of that over the next five years."

Conclusion: Navigating Forward with Cautious Optimism

Despite the heightened global uncertainty, Suyash maintains a positive outlook for India, predicting growth will settle around 6.5% (plus or minus depending on cyclical factors).

While he acknowledges the broader global growth template is now "weaker than before" due to factors like "gradual de-globalization," "greater climate volatility," and "greater levels of debt," India's position remains relatively strong.

The key to continued success? Maintaining macro stability and fiscal credibility:

"We remain quite optimistic. We do think India is at the cusp. And if we continue to keep our macro house in order as we have in the past, then there's every reason to be optimistic about the next few years."

For investors, particularly in fixed income, this environment creates opportunities. While acknowledging that Indian investors "tend to be much more impatient than global investors when it comes to buying debt," Suyash emphasizes that "fixed income should have a permanent place in your asset allocation table." The weightage may change based on market cycles, but the structural improvements in India's bond markets should not be overlooked.

As global capital potentially diversifies away from US assets, India's well-managed macro position, improving bond market infrastructure, and growth potential make it an increasingly attractive destination—provided it maintains the fiscal and monetary discipline that has brought it to this point.

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This article only captures a portion of our wide-ranging conversation. In the full podcast, Suyash explores:

• How regulatory tightening affected credit growth and why that's now changing

• The nuanced relationship between fiscal policy and monetary policy in India's growth strategy

• The potential challenges and opportunities in India's manufacturing sector

• Why bond markets reflect the confidence global investors have in India's economic management

• The detailed dynamics of how tariffs affect global trade flows and growth prospects

Listen to the complete episode for Suyash's comprehensive analysis of navigating these uncertain economic waters.