Lost in the woods

There is a famous song by Tamil poet Bharathiyar starting "Thikku theriadha kaatil...", meaning "not knowing the directions in the forest" (implying "lost in the woods"). Well that probably sums up the current status of our policy makers, both in Mint Street and North Bloc. One would ideally like to be sympethetic to their plight if not for the fact that their woes have been self-inflicted to a large extent.

First, lets rewind back to June /July this year, when monetary policy actions became increasing aggressive with intent to tame inflation. With every successive rate hike, the RBI stated that fighting inflation is of paramount important and its imperative to sacrifice short term growth to achieve this. The stated outcome of the RBI policy actions was to reduce aggregate demand in the economy (in other words, slowdown the economy). The finance ministry officals (including the FM) endorsed this - lots of interviews /sound bites are available on the net - sample one below
http://www.dnaindia.com/money/report_moderating-aggregate-demand-is-critical-to-check-inflation-pranab-mukherjee_1556075

Now that the growth has started coming off, shouldn't the policy makers be celebrating? After all, wasn't this the expected & desired outcome they hoped for to tame inflation? Alas, they didn't truly believe it would happen!

Its not too difficult to see why there are no high-fives....
1. Inspite of this fall in growth, there is no firm handle yet on inflation. WPI is still well above 9% and all the predictions for it to come down to 7% by March are based on base effects which will start to show up from Jan onwards and not due to a firm view that prices will cool off significantly. The truthi is much of headline WPI dynamics are based on food prices, global oil & other commodity prices and electricity prices - all of which are not directly influenced by the RBI interest rate actions. So, though growth has slowed down as expected, there is no guarantee inflation will fall dramatically as a direct effect. The question then is why was the RBI so aggressive with its monetary policy actions to bring down demand if much of headline inflation are not directly correlated? In their defence, they were fighting potential generalisation of inflation through wage spiralling and also importantly overcompensating for an expansionary fiscal policies of the Central Government. Still, one cannot but wonder if a wrong medicine of wrong dosage has been used to fight the inflation ailment.

2. The other reason why there are no high-fives is because the way global growth outlook is looking, the current moderation in India cannot be seen as being temporary. If exports were to come off sharply, then the growth moderation can be pretty sharp as well and that would be difficult to arrest. It is here that the recent policy actions have been more difficult to understand. The global issues have not cropped up suddenly overnight. They have been brewing for the last 6 months and thats been obvious to probably all earthlings. Many emerging market central banks across the globe have actually taken easing steps in the last 3 months (Australia, Brazil, Turkey, Israel, Indonesia, Thailand have all cut rates recently, to name a few) to facilitate domestic growth amidst the global downturn. Yet, the RBI continued with its hiking policy as late as end October with specific intent to reduce growth, inspite of knowing the lagged effects of their policy. In other words, when a central bank hikes rates in end October, its intent is to slow growth atleast through the next 2 quarters (ie Q1 2012). In the face of the global headwinds, the Indian monetary policy has been focussed on pulling down growth atleast till beginning of Q2 next year!

Now its probably more clear as to why there are no celebrations nor claim of credit. See how the fall in growth is being quickly explained as due to global factors - "hey, weren't u guys tom-toming about need to bring down short term growth to achieve long term price stability? congrats folks - what u don't want to accept them?" If growth slowdown is due to "global reasons" and sticky inflation is due to food & oil prices, one wonders what the successive aggressive monetary tightening measures from June to October were for?

The recent Indian policy actions have been very unique & isolated compared to the rest of the world and was portrayed as essential given India's unique domestic driven economy and to reduce domestic demand pressures. Yet, there is a sudden fear that the precarious global scenario will cause an even sharper fall in domestic growth, especially given that full impact of the monetary policy actions have not yet played out. The real question is why this could not have been foreseen atleast 3 months back, when the global issues were apparent to all & sundry. Thats a question only the policy makers can answer and have to answer.

The only silver lining in all this is there is more scope for monetary actions on the reverse side as well - the more you hike, the more you can cut to foster growth. One can hope that such a course correction will happen sooner than latter.

Taking Stock

its been a long time again; am setting myself to writing atleast once a month in the future - lets see.

So where do we stand now in terms of the markets ? I had mentioned in my earlier post in May that massive liquidity is starting to drive asset prices & if it continues then it would only be creating a further mini-bubble & postponing the inevitable. Or if the rally gets quickly nipped, it would pave the way for a range-bound markets. Well, clearly the former has happenned. The govt measures especially in the US (cash for clunkers & home buyer credits - which btw, seems to have created a big scam!) coupled with the liquidity deluge & inventory restocking ensured continued good data improvement & that has supported further rally into all assets - stocks, gold & commodities. They have hit near 60-80% of previous highs or as in case of Gold, vaulted to new highs.

In terms of views on 'what next' am going to be a bit more specific about each asset class rather than broad economic views. So here goes....

US stocks - 10500 pretty much seems as best as it can get for the dow. Already there seems realisation that 4th quarter GDP will not be as good as the 3rd in the US. If the govt does not extend these programs like cash for clunkers then likely that consumption will drop & that will automatically impact the GDP growth. 10500 is only 25% below the alltime high level of 14000 in Sep-oct 2007. I don't know about the S&P valuations (& I don't think many people know given that many companies are shifting from full year Losses to Profits), but I think 25% off the peak is a fair value by any optimistic assessment given the uncertainity & unemployment situation & sheer over value by a more pessimistic assessment. Verdict: Short; stop at dow 11000; s&p 1200

US Bonds - this is one market which is rallying belying all expectations. Am still betting on eventual inflation & hence would like to short the long end Treasuries...but the bond market & US rates have resisted bravely the euphoria declared by the equity markets over the last month & more & over the last 3-4 days have fallen substantially. This market still continues to be betting on deflation rather than inflation. I'm not sure of this, but I think US Bonds will go out of favour at some point & hence slow accumulation of TBT/PST is in order

Oil - Unless you believe in double-dip recession in Y 2010, this market is headed higher. Buy on dips would be the call. There is a nice consolidation in the 70s which could form base for next push higher. If 70s break, though we could oil into the 50s. That would be a great buy.

Gold - In my Feb post, I had mentioned a few indicators which would play out before end of crisis. One of which was that the central banks will buy Gold as part of reserve holdings. Thats commenced & Gold has zoomed to 1200. But I think this is just a start & with worsening fiscal situation everywhere, paper money has already lost the battle & Gold will become a crucial store of value & reserves. Keep buying on every dip.

Emerging equities - again buy on dips is the call. There are 2 risks -
1. The western economies go through another crisis like late 2008. Especially these East European economies are still dodgy. A sell off from such crisis can impact all. IF that happens, great, BUY big time;
2. China surprise - while I think its too early & low probability (but not NIL), there is always a potential China surprise. I say this for 2 reasons - one, there has been so much hype & hope about China even in the face of compelling consensus on non-transparency from the country; this means there is some amount of guesswork in all the hype & thats always dangerous. Two, its a fact that China did prop up the commodity markets earlier this year purely hoarding at low prices not supported by actual demand. Such hoarding driven strategy can work if actual demand catches up within a reasonable time frame. If not, a 2nd crash may not be far away especially for commodities. A China surprise can hit Emerging market stocks big time & could really crash all assets across the globe actually - stocks, commodities, currencies, gold too. Only bonds & USD will benefit. As I said probability is low & hence no point planning for such an eventuality now.

Currencies - Theme is still sell USD & long EUR, GBP & AUD. I would be a little cautious in putting fresh trades though, since am bearish equities. With present market correlation being so high, any equity fall will lead to USD gains. So, you may get better levels to execute these short USD trades. One final point on currencies - JPY went to about 86.5 yesterday. Watch out here...I think 84 would form a big floor & that would probably be the best JPY would see for some time. Shall explain why in my next blog.....

hope its sooner.

cheers

Prayer in March, Hope in April, Conviction by May

Its been a long time.....post the initial burst, didn't feel much enthused to keep writing, what with the rather sullen mood through March & early April.
But yo, am back ...much like the markets.

so whats happenning? suddenly the world seems a brighter place & all the prophecies of doom have disappeared! Now we hear the bulls starting to speak & shortly we may see them roar as well.....

Here's my take on this turnaround - a primary driver has been the massive, coordinated stimulus by Central Bankers globally releasing a flood of liquidity into the system over the last 6-9 months. Most of this was waiting in the wings for a rightful investment. The mood in early March was grim with grey clouds hovering. It all started with an innocous memo from a very unlikely Indian, post US market hours on the 9th of March - Vikram Pandit, the beleagured CEO of Citigroup wrote a memo of how his company was profitable through the 1st 2 months. Before people could twitch at the news, other banks said 'me too', making people take notice - there was some hope after all!

(If you don't believe me, see this link below or search for "Vikram Pandit memo to employees" on google & see the results.
http://www.businessweek.com/bwdaily/dnflash/content/mar2009/db20090310_761018.htm?chan=top+news_top+news+index+-+temp_top+story
and go back to see the low for most of the equity markets world wide -9th March 2009 closing)

Shortly some good data from China further scattered the doomsday clouds. Its somewhere at this point that I think the surfiet of liquidity started to flow into assets.....since April, slowly but surely its been washing away the clouds, making people pray for sunlight. That prayer has since turned into a hope in May and it seems now the hope is turning into a conviction! People seem surer of the recovery around the corner.

What next ? Next 3-4 weeks could be very important. If the conviction strengthens and markets rally even further, then I think we will have a problem. It will lend credence to my theory of easy money driving value & will create sort of a mini-bubble. The crash then could be even harder.
If the conviction drops & markets trade range bound, it would give time for real economy to catch up with markets. Then it would be possible that strong central bank actions have averted the economic collapse & slowly, with initial unsteady steps but getting surer, the economies would limp back to some normalcy and hopefully start walking & jogging by 2010.

I hope for the 2nd; but something tells me it could be the first. There could more shock & awe in store! Get a little bit more impersonal about the markets & enjoy the rollercoster play between human greed & fear from a ringside view. It could be lots o fun.....

Before i sign off, just one thought. Rather than continuing to invest into equities, its probably better to invest into inflation. More about that next time.

cheers,

Turnaround - too early!

I was in Chennai last week & most people I met came up with the same question - when will things turnaround? 2nd half of 2009 or 2010 or will it be later? My answer to them was simple - its too early to be talking about turnarounds! The question to be discussed is really is how worse will it get? Especially in India. So far we have seen the impact mostly in newspaper headlines & in stock markets. The real economy is still to witness anything remotely bordering catastrophy. True, corporate numbers have taken a hit & Govt finances too are reflecting the strains. But when things start to deteriorate at the ground level, we will see the more hard-hitting signs - builders defaulting & real estate prices crashing, fear to purchase any new underconstruction projects, people selling assets (property, cars) to pay off debt, reducing life styles & affordability, a more pronounced demarcation between the true rich & the middle class pretenders of the last few years, and so on....we are seeing the early signs of some of these but more pronounced play is ahead of us.

But even as all & sundry predict gloom (which is the easiest to do), whats the endgame? Definitely the world won't end and there will be turnaround & boom once again within our life times.

One way of predicting the timing of the turnaround is probably to look at things which should have happened by the end of this downward cycle....its a very tricky way of forecasting, since certain policy actions can shape the turn of events & hence this approach is essentially either predicting the policy actions or ignoring their effects altogether. But I'll try.

The following are likely to happen by the time we are done with the worst of this crisis -
- End of quite a few large US & European banks in their current private ownership form & stock prices go below $ 1 or 2;
- auto majors in the US declare bankruptcy or merge or are bought over;
- Euro currency is abandoned or atleast a few countries walk away from it or new guidelines on fiscal deficit levels & monitisation of deficits for Euro countries are defined;
- a couple of European countries default;
- a couple of middle eastern countries are bailed out within GCC;
- unemployement becoming a big issue in Asian countries & with atleast 1 round of political unrest in China;
- Central Banks publicly acknowledge purchase of gold for reserve holdings;
- stock market valuations hit their lowest point ever (below historic low points);
- new international agreements on trade, post trade wars among a few large countries;
- reverse migration of labour from western economies to Asia;
- issue of new accounting norms for MTM, derivatives, etc;

I have mentioned the above since these are the problems which have to be dealt with presently & or in immediate future & till these events come to pass & have been dealt with, the turnaround will be much ahead of us. In a perverse way, the faster these happen the better;though the pain will be huge.
Unfortunately, but definitely understably, Policy actions procrastinate reaching these end points. Its the right thing to do to avoid a carnage & collossal damage. Its like treating a patient with terminal disease - even if the inevitable is known, its the job of doctors to keep treating & trying to fix the disease rather than just go for the leathel injection. A slow death is preferable to instant death. And ofcourse there are miracles as well. So, you keep trying & hoping.
Thats pretty much whats happenning now to the western economies. The 'economic doctors' are trying some fixes & hoping for miracles, even if they known the disease could be fatal. But we should see the reality for what it is - a slow approach to an end game. And that end game would see some or many of the above predictions. And once that happens, one can hope for the turnaround. Till then, the only option is to pray for the miracle!

Capital crisis

Starting out as sub-prime crisis, the present economic crisis is now called "credit crisis". And thats making central banks push commercial banks to begin extending credit. Presently only a moral suasion, its possible it may take form of more direct regulations soon. And this push for more bank lending (& thereby more assets) seems to be a case of "cause for disease taking the form of cure"!

But is this paradoxical solution because of the wrong name for the disease? To me, the issue is more of a 'capital crisis' rather than credit. Due to years of rather low interest rates, chase of yields, globalised flow of funds, limited regulatory supervison on capitalization & ability to get assets quickly off balance sheet - all meant that banks & instituions have put up huge amount of assets backed by limited owner's equity. And that equity has nowhere been close to sufficiency for stress losses, which is what is leaving them completely naked and inadequate now. As someone said, practically most of the western financial world is technically insolvent.

Now that high losses are happening, how do you balance the balance sheet? Someone has to fund them right? Initially, private capital did come in, as they thought sufficient first loss (expected loss) had been absorbed by the original equity holders. But unfortunately, very soon it dawned that they were only funding more losses. So that route stopped. 

And the losses continue....and someone has to fund it. Enter the Governments.....

If you look at it, due to the bubble across, all assets were overvalued. Which means correspondingly, on the other side, liabilities too were over valued. While market prices of stock can correct quickly, on the balance sheet, there is only so much equity (at book value). Which means other liability holders also have to bear the losses as well. Thats what happened to Lehman debt & bond holders. But obviously, Govt does not want deposit holders to bear these loses, as that would question the basic tenant of banking system. So, they step in to fund the losses.

As long as Govt capital is only going to fund the losses on existing assets, there is no way banks can start fresh lending. Its not a question of willingness; its a question of ability. They simply do not have sufficient capital on basis of which they can provide loans. Any impression that TARP & other governments' capital should be used for lending is an attempt to look away from the reality. And if banks are forced to do so, it would only mean they will have to capitalised again at not so distant future....remember there are losses still to be funded. 

Thats why, this is not about lack of credit. Its about lack of capital.

WorldyViews.com - the economic Chakravyuhah

As I read reports of further stimulus packages, new bank bailout plans in the US & UK etc., a shudder passes thru me.....have the Fed & Western Governments gotten themselves into a Abhimanyu situation - deep inside the Chakravyuhah without knowing the ways to escape alive?

Seems we are in clearly uncharterred territory. The massive amount of balance sheet the Fed is taking & yet the amazing rally in bonds (& fall in interest rates) are a clear evidence of this fact. Clearly something has to break. And even if rates continue to fall & bonds continue to rally, there would be some serious damage in the long term. Am not expert enough to predict what that would be, but its only logical to assume that currency will be devalued significantly since these bonds will be funded through printing of notes. And that could either result in massive inflation at a later point or a complete loss of confidence in currencies (Gold could be beneficiary).

Related Links:
http://money.cnn.com/news/specials/storysupplement/bailout_scorecard/index.html
http://www.moneymorning.com/2009/01/14/hyperinflation/

Another interesting point I noticed is how the focus in recent Bank results have turned to credit growth & amount of new loans disbursed. Seems the Fed is forcing Banks to ensure they use the govt funds to lend to various customer segments. British PM, Gordon Brown, yesterday is supposed to made a statement stating 'Lack of credit growth" is the "biggest issue today". This seems a bit puzzling to me. Its apparent Banks across the world grew extremely large on the back of very limited capital & while this is good in normal times, when the assets are turning bad, the sheer lack of capital is taking them to the doors of bankruptcy.
More than lack of credit, the clear & simple issue facing the financial industry today is lack of Capital. And that will be the topic of my next blog shortly.

cheers

WorldlyViews.com

Under this title, worldlyviews.com, shall be putting up views on the markets as I see it...

Jan 13th....there are ominous signs as seen in Oct /Nov period, when dow fell to 7500 levels....led by strains in the financials, 4th quarter results are expected to show how bad the economic scenario in the developed markets are & could form the basis for massive selling & new lows in the markets......
markets tested the 9000 levels & various views were getting formed that markets were forming a positive foundation & with Obama coming in & announcing a new stimulus, the markets could gain in the short term.
That positive formation is definitely broken.....markets could not hold onto the 9000 levels & momentum has decisively turned around...
Last time around, markets just about held to a huge support level - 7800 on the Dow & 750 on the S&P....With further bad news from Banks (watch our JPM cues, there could be -ve surprises), Autos, telecom & Retail companies, markets could test those previous lows.
These levels ofcourse are huge support levels....if they break, it could really be a free fall. I would bet that such a scenario would happen sometime this year. Not sure if it would happen so early in the year - maybe a fresh Govt policy whether stimulus plan or other Fed solution may help in holding to these levels. If not, then brace for some huge falls in the market.
USD/EUR could hit 1.24 & if that breaks, it could really march towards parity. And possibly good to buy Gold as well below 800.

Trading views for now.

cheers