The rise of the prodigal son...in the East!

Japan goes back to bigger quantitative easing; American recovery quickens; European and Chinese inflation also lower and more stable.  Competitiveness concerns may finally force RBI’s hand to lower rates.

In the weekend before Christmas, as the world’s financial markets sauntered into holiday-hibernation, Shinzo Abe - Japan’s Prime Minister-Elect - bettered Santa Claus (or Attila the Hun, depending on your perspective) by declaring that his coalition, which holds an unassailable two-thirds majority in the lower house of the Japanese Parliament, may change the law governing the coy Bank of Japan (BOJ) if it refuses to accept a 2 per cent inflation target at its January meeting. In any case, Masaaki Shirakawa, the relatively hawkish BOJ governor will be replaced with a more dovish, pliable candidate by April 2013. At the December 20th meet, he already declared to engage in more easing by expanding asset-buying and lending program by a tenth to $1.2 trillion, and hinted at an upward review of its 1 percent inflation target.

Japan following Europe in moving from inflation targeting to dual targeting

The BOJ, like the European Central Bank (ECB), is at least in theory an inflation-targeting central bank but Abe wants it to have a dual target of inflation and employment much like its American counterpart - the Federal Reserve (“Fed”). But a year ago, of course, the ECB had de facto reneged on or at least expanded its inflation-targeting mandate by launching its first series of Long Term Refinancing Operations (LTRO) with 489 billion freshly-created Euros, the full (bullish) effects of which took months to play out. The Fed of course must itself be confused about its Quantitative Easing (QE, a term first used in Japan) historiography, with its even larger and multifarious rounds since late 2008 or early 2009 (depending on how QE is defined).

Yet, Japan has no real short-term alternative policy plan given its political economy. October 2012 figures show that CPI or consumer price inflation was negative 0.4% (or deflation), inflation has been largely negative or zero for the last few years and nominal interest rates cannot really go down any more. Differences on monetary easing therefore is on the margins, and imaginative solutions are politically locked as of now – immigrants a.k.a new tax payers are still frowned upon, an aging population creates more fiscal dependents, free trade in agriculture is taboo, and finally there is no political force that can resist the asymmetrical Keynesian orthodoxy in Japan. “Bridges to nowhere” are still being touted as an economic solution, whereas structural supply-side reforms and targeted growth-supporting tax cuts are relatively frowned upon.

All this combined with even slower growth rates since the financial crisis of 2008 has ballooned Japan’s government debt to GDP ratio from 167% in 2008 to 212% in 2012. Yes, interest rates have fallen since 2008 and the flow of debt servicing has been easier to manage. But this huge stock of debt will still be around, when – not if – interest rates rise. Yes, even China’s economic size at market exchange rates (as opposed to purchasing power parity rates which are more favorable to poor per-capita countries like India and China) has now clearly overtaken Japan’s and is almost half of America’s size, yet the Government of Japan’s debt at around 12 trillion USD is comparable to the US Government’s 15 trillion (whereas the American economy is almost three times as large as Japan’s).

The Yen depreciates, re-establishing itself as a carry trade generator?

Moreover, the situation is not radically different in the US or EU, and easing there – along with the continuing slowdown - had forced the Yen up and weakened Japanese exports (Japan posted a larger-than-expected trade deficit in November). While a few large countries or economic blocks could sit together and theoretically stop down competitive devaluation, this is unlikely to happen because democratic governments come to appreciate seigniorage and inflation as hidden taxes that also re-adjust the balance between labour and capital in favour of the latter without having to force the former into nominal wage cuts.

Already, the Yen has depreciated from 79.5 in mid-November 2012 to above 84 before Christmas in anticipation of Abe’s victory and policies. That is a 5 percent short-term competitive advantage for Japanese exporters and manufacturers and will help at the margins.  Such overall Yen structural weakness might mean borrowing in yen and investing in foreign currencies, which might be a boom for Indian and other emerging market (EM) equities, if not commodities (where supply-side booms and demand-side drops due to technical innovations continues apace)

Jump off fiscal cliffs or not, American central bankers will still ease for now.

The current fight over the “fiscal cliff” in the United States exemplifies the inability of the political class the world over to lead its societies to defer more consumption and gratification for the well being of their children and grandchildren. American Democrats would not countenance any stricter criteria for redistribution payments, and many congressional Republicans would not accept any higher taxes on upper-middle class families. Ben Bernanke’s Fed, blessed with America’s size and credit history, is in a unique position to further ease and yet attract lower yields with every economic downturn (including a fiscal tightening), despite the total government to debt ratio having breached 100%. But signs of American solvency – any ratings downgrade hysteria notwithstanding – are inaccurate and overly pessimistic: US GDP increased at an annualized inflation-adjusted rate of 3.1 percent in the third quarter of 2012 (that is, from the second quarter to the third quarter). In the second quarter on the other hand, GDP had increased by “only” 1.3 percent –strengthening the recovery thesis. The Consumer Price Index for All Urban Consumers (CPI-U) declined 0.3 percent in November on a seasonally adjusted basis, hinting at perhaps more room for easing at least in the short run. Over the last year, the overall price index increased by just 1.8 percent.

The Fed therefore said it will buy $45 billion a month of Treasuries (and 40 billion additional dollars worth of mortgage securities) starting in January, expanding its asset-purchase program indefinitely until 6.5% unemployment is not reached, and so long as inflationary expectations one to two years in the future does not breach 2.5%. Total nonfarm payroll employment rose by 146,000 in November, and the unemployment rate went down to 7.7 percent. An additional drop of 1.2 percentage points in official unemployment rates will take at least two more years by current estimates. But why is all this easing not leading to inflation (yet)?

As the financial economist Dr. Scott Grannis writes, the US public holds $6.5 trillion of bank savings deposits (up 64% in the past four years) paying almost nothing – 1.5 trillion of those could be diverted (as they are excess bank reserves) to entrepreneurial activities or consumption. Therefore, while the monetary base has exploded in recent years the M2 measure of money supply in the United States has grown only slightly faster than its long-term average of 6%, partially because the public does not see that many organic or structural investment opportunities.

Moreover, the American economy (and more specifically the housing market) continues to “optimally” strengthen, as Ray Dalio of Bridgewater Capital might say - because of moderate monetary policy led-leveraging (mortgage refinancing help, and demographic expansion) with fiscal policy and private sector partial deleveraging. 2011’s brisk revival was continued this year, with a 22 percent increase in housing starts in the last 12 months.

Whither Europe?

Just like politicians from India to US have not had the courage to pass many genuinely short-term austerity and long-term liberalization measures, Mario Draghi’s ECB has nudged Germany to repeatedly cave in to the demands of smaller, profligate countries like Greece which refuse to fully accept painful restructuring.

The European fiscal union – and indeed the single European nation-state – is being molded and merged in the cauldron of its fiscal, economic and finally demographic crisis; with this dream of the idealists of yore being suitably lubricated by the ECB. In this pursuit, it is being helped by falling inflation (2.2% in November, down from 2.5% in October; last year was around 3 percent)

Moreover, the year-on-year Euro Area industrial production in October also fell by 3.6% (seasonally adjusted) – calling for further creating/printing of new Euros. While the ECB still remains more cautious and conservative than the Fed, it will have to step in even more given the reality of at-best zero-growth-rate economies. The election of Hollande’s socialist party in France has played out as expected – discouraging entrepreneurs, and strengthening government unions. Moreover, the resignation of the reformist, technocratic Prime Minister of Italy, Mario Monti, has put a question mark on another too-big-to-fail European nation. While a Greece and Portugal can be “bought off” for now, an Italy or France or Spain faltering seriously will be the end of the Euro project, which would not necessarily be cataclysmic if managed well (a big “if” that).

China – falling inflation point to monetary easing here too

In November 2012, the Chinese consumer price index (CPI) went up by 2.0 percent year-on-year. The food prices went up by 3.0 percent, while the non-food prices increased by 1.6 percent. In the third quarter of 2012, Chinese GDP grew by 7.4 % year on year and almost 9 % annualized seasonally adjusted quarter on quarter. Therefore, while the annual expansion was one of the slowest since 2009, the quarterly change has shown improvement. On the trade front, like the growth front, also we have mixed signals – only inflation seems to be a relatively clearly indicator.

Structurally, the Chinese growth is chugging along well despite no new major government stimulus and still weak global demand, which is a testament to the diligence of the Chinese people. The property markets of free market havens, Hong Kong and Singapore, have had to take unprecedented protectionist/stamp duty measures to thwart rich Chinese buyers (so as to prevent bubbles) in the wake of Western monetary easing washing up on Asian shares rather quickly. Yet, China has not exactly turned corners. Also, the Chinese national bond regulator has temporarily stopped approving debt sales by governments below provincial level, thereby sending out a signal, however credible, against implicit federal guarantees and thereby strengthening the stimulus reservoir strength at the national level in some future contingency (sub-national Chinese insolvency was causing some prominent investors a lot of jitters).

It seems that while the Americans are expanding the monetary base, but not subsequent layers of credit, the Chinese are to some extent accelerating investment credit outflows through their banking systems while not necessarily focusing on the monetary base per se. This latter plan of action is of course only possible in more tightly controlled banking systems, and has its own downsides in efficiency and corruption. The Chinese economic expert and “bear”, Dr. Michael Pettis, remains pessimistic about China in the mid term noting that “of the dozens of developing economies that have experienced investment-driven growth miracles in the past 100 years, the only ones that have managed the transition to developed country status are South Korea, Taiwan, and maybe Chile” and hence China will have to face a painful transition from its mercantilist, centralized model to a more market-finance based one.

Probable impact of all this on India - short-term equity bullishness

Besides some domestic reforms (FDI policy in retail being passed in both houses of the parliament), the Indian markets have been buoyant for these external factors as well, and this could be the beginning of another mini-rally with higher tops and higher lows. But, India’s monetary policy remains cautious and fiscal policies remain reckless – slowing growth have resulted in advance tax receipts growing by just (annualized) 10.4% in December so far (collections grew even slowly at 7.5% on year between April and December, with the nominal growth rate all along being just shy of 15%, 6 percent growth plus 9 percent inflation roughly speaking).

In a battle of wills between politicians and central bankers, the latter are more likely to blink first. Tax breaks to invest in Indian bonds were declared earlier to attract foreign and/or privative investments, and this is already showing results.  Ennore Port in Tamil Nadu is already issuing bonds worth Rs. 1000 cr within this scheme.  On the other hand, there have been many “deforms” as well. Life Insurance Corporation (LIC) and now even the Employees’ Provident Fund Organization (EPFO) are being raided by the Government of India (GoI) for its fiscal purposes, destroying more necessary firewalls between various quasi-arms of the state. The Food bill, like NREGA, is going to be high on redistributive expenditure and low on allocative efficiency – there is no plan to currently use private retail outlets (existing ration shops would be used)

Indian foreign reserves have been stable at around 300 billion USD for many years even as the economy continued to grow, showing that any dramatic appreciation of the rupee is very improbable now. In fact, our overall macro policies are fairly balanced with remittances providing a solid support that needs to be always remembered given the sticker shock of our trade deficit numbers. India is the only huge nation with a demographic surplus for the next few decades, and emigration should be an “export” for our accounting purposes, just like “gold purchases” need to be considered at least partially as investments. With rating agencies likely to be even more involved because of the government’s gradual and further opening up to foreign financial capital, invariably a fiscal-political balance will also be found. The long term growth story of the capitalist democracy of India is intact, despite the hysterical headlines every now and then.

*A special contribution by Harsh Gupta....Economist from Dartmouth University

Best Regards

Paras Bothra

paras.bothra@ymail.com

+919831070777

2013 - A Year of Declining Interest Rates & Lower Commodity Prices...

This month we choose to put a title “2013 - A Year of Declining Interest Rates and Lower Commodity Prices". This title we have chosen not because we forecast it, but more because we seriously need to see it materializing for the revival of Indian growth momentum. Two most important catalysts for the economic activity to expand are low commodity prices and lower cost of funds. A series of interest rate cut can be predicted with a reasonable degree of certainty in the calendar year 2013 on the premise that sub-par growth in developed countries coupled with China slowing down rapidly and thereby easing actual demand for commodities. It will put pressure on prices and thereby would diffuse concerns of commodity prices escalating. Depressed commodity prices are certainly going to be a boon for Indian economy which is otherwise reeling under high inflationary pressure and higher interest rates. But the moot question is that whether RBI’s hawkish stance on inflation rather than growth is justified or is the policy framework remains reactive only to inflation data? If RBI choose to be reactive on cutting down rates once it see’s inflation coming down, it may have serious ramification. Reason being, the longer the interest rate stays elevated the more it damages the fundamentals of India Inc. Already we are witnessing two pronged losses on RBI’s policy stance, i.e., higher interest rates seriously denting the profitability of companies who are exposed primarily in the power, telecom, construction, infrastructure and other capital intensive sectors. Secondly with deteriorating socio-economic fabrics of the country and because of scams and unethical practices and coupled with it higher interest rates, it has restrained entrepreneurs to commit any fresh capital expenditure and many of the existing investment commitments have been shelved as well. At present Indian private share of capex in GFCF has fallen from 43% in FY-08 to 33% in FY-11 and the overall GFCF has declined to 29% from 36% in 2008. A potential reform will be of key importance if the NIB (National Investment Board) is approved legally. This is will be potential kicker in terms of implementation of key infrastructure projects of national importance and will bypass the hassles of bureaucratic decision making process. NIB will be directly under the control of Prime Minister and hence it will have the power to overrule ministers in taking decisions of national importance and implementing big-ticket investment projects.

It’s almost clear that for the economy to revive and the job condition to improve requires higher profitability and higher growth opportunities for the businesses in general. And a momentum can be gained with capital formation from the private sector coming back. For the last couple of years, capex cycles have been on a declining curve and the new wave of optimism has gained on the consumption story. But, serious questions need to be asked is whether the consumption spiral is because of higher income of the people? It doesn’t seem that the middle class or the upper middle class (which comprises of the majority of the population for consumption bracket) have gained any serious wealth out of wage inflation post the 2008 crisis. Persistent inflation have eroded the value of money and dented the pockets of salaried class, the labor class and the small businessman (be it for any product price or the real estate price). So, probably the consumption spree remains unabated, may be because of the 1>changing consumption pattern of the people and propensity to consume remains high as the savings rate for India have been over and above the 30% mark for many years 2> may be because of the rise in gold price, since gold prices have had a phenomenal run in the past couple of years and Indians have a tendency to buy and hoard gold as a store of wealth. A scanning from various research reports reveals that Indian household hoards gold with estimates ranging from 11,000 tons to 30,000 tons. Even if we take 18,000 tons, it is almost worth USD 1 trillion and is more than 50% of nominal GDP. 3>May be because of higher real-estate prices for those who hold land since ages. 4> Rural wage inflation is consistently growing above 15% since 2010 and NREGA and other social schemes are giving more purchasing power in the hand of rural India. So, it can be concluded that higher consumption may be because of the above factors mixing up and giving a feel good factor to their income status which otherwise is not true in real sense. It’s almost certain that these factors cannot push up the consumption curve higher to infinity and reality may descend at some stage. In a country like India, we are witnessing investments drying up and enough capex is not getting channelized into roads, factories, and infrastructure. Hence this is leading to a constraint in capacity and the demand of final goods for consumption is running short of population migrating into the middle class bracket, changing spending pattern and higher propensity to consume because of the elevated asset prices is inflating the final product prices for consumption. Coupled with it the government favoritism and graft in recent years is further accentuating the demand/supply equilibrium.

Our real focus for 2013 is to see a series of rate cuts and commodity prices coming down. Inflation cooling off in 2013 is not because of RBI’s efforts of last couple of quarters by its monetary policy stance, but more because of slowing economic growth and lower discretionary spend in the hands of people in the Indian context and global commodity prices cooling off significantly because of serious slowdown with the commodity guzzlers of the world. Moreover, supercycle in commodities as per the Kondratieff 30 to 40 year’s cycle has come to screeching halt and it coincides with the Chinese demographic and the slowdown ahead, after decades of huge commodity demand.

Undoubtedly these factors are already in force in a subtle way and may get pronounced in 2013 and will set the stage for a new growth momentum.

ECB Relaxation:

Recently ECB window is being explored by Government. Earlier RBI came up with foreign exchange regulations tweaked with ECB regulations to promote dollar inflow and curb excess weakness in the rupee.

Now government is broadening the ambit of external commercial borrowings and is incorporating a new definition of infrastructure. This will help companies involved in various sectors like the education, hospitals, cold storage, agriculture markets, tourism facilities, capital investment in fertilizer companies and various others to seek funding through ECB route and lower their borrowing cost. Already the government liberalized ECB norms in the budget for sectors including roads, civil aviation, power and affordable housing. Already it’s operational in all except affordable housing which is also expected to be granted notification in coming months. With these actions of the government it’s clearly evident that it is hard-pressed to revive the capex cycle and address concerns with regards to higher cost of funds which is a hindrance to growth. Though the cost of ECB would have three variables 1> Libor rate 2> Premium over Libor rates 3> Exchange rate. Effectively, Libor plus a premium would cost roughly 3.5% to 4% and add to it hedging cost of grossly 5% to 6% (one year dollar NDF market quoting at a premium of 5.6%) will approximately fixate the borrowing cost at around 9%. Generally taking into consideration all the cost a gap of atleast 2% prevails between ECB and the domestic term loan. Though for hedging purpose there are interest rate swaps, principal money swap and cross currency interest swaps to optimize the transaction and it requires better understanding before implementation.

In April 2012, Government allowed power companies to use 40% of the funds raised through external commercial borrowings (ECBs) route for refinancing rupee debt, raised from Indian financial institutions and banks. The rupee refinancing window would be allowed only if the balance 60% ECB funds are used for financing new power projects. Earlier, companies operating in infrastructure sector were permitted to utilize 25% of the ECB loan to refinance their rupee debt. Further in June 2012, the RBI allowed Indian companies in manufacturing and infrastructure sector and having foreign exchange earnings to avail of ECB for repayment of outstanding rupee loans towards capital expenditure and/or fresh Rupee capital expenditure under the approval route. The overall ceiling for such ECBs would be $10 billion. In September 2012, RBI further liberalized norms on ECBs to repay loans, capital expenditure and trade credit availed by infrastructure companies and enhanced limit to 75% of average foreign exchange earnings realized from 50% of export earning in last three years. Infrastructure companies were allowed to use trade credit (up to five years) to import capital goods. However, the trade credit must be contracted for atleast 15 months and should not have element of short term credit roll-overs. In September only, the Indian government reduced tax on overseas borrowings by domestic companies to 5% from 20%, making it easier for local companies to raise funds abroad. However, the reduced tax rate will be applicable to the funds borrowed between July 2012 and June 2015. Liability of the Indian company to withhold tax on such income would also be at the reduced rate of 5%. And now government is also treading the same path which RBI choose in order to effectively promote companies to avail cheap funds from abroad and as well put a break to currency weakness by promoting dollar inflows in the country.

Credit led Investment Cycle:

Last decade, Infrastructure growth was backed by serious investments in power, roads, ports, factories etc. Credits led infrastructure boom witnessed credit growth averaging at 25% a decade and now post the 2008 crisis; it has tapered down to just 14%.

This coincides with the fact that money supply (M3) has fallen at 13% growth rate. Lower money supply is a function of RBI’s tight monetary stance and is a sign of weakening economic activity, and hence may be an argument for lower rates, taking into consideration other signals of inflationary pressures. 

*Source: RBI

A crude rule of thumb is, subtract the inflation rate from the rate of growth of money to estimate the growth of real output. The reason for lower credit growth is because of obvious reason that Gross non-performing asset for banks stays elevated at roughly 3% and restructured assets remains at 5%. So the total bad asset for all the scheduled commercial banks stands at 8%. Though most of it will not turn out to be bad but historically after a decade long credit led strong expansion, outcome of such magnitude is a reasonable expectation. This phase of bad loans takes its own time to clean itself out before which banks would be reluctant to lend aggressively and this phase will last till we see the interest rates ease off considerably and corporate de-leverage their balance-sheet and becomes healthier.

Commodity Conundrum:

China’s massive growth momentum of last decade was its surge in investment share of GDP from 35% to 50%, a level that is unprecedented by any standard. China boomed in an old fashioned way, by building roads to connect factories to ports, by developing telecommunication networks to connect business to business, and to put underemployed peasants to work in better jobs at urban factories. Now it seems that these drivers are reaching a mature stage where the labor pool is fast depleting, factory employment reaches a maximum capacity and highway network reaches a total length of 46,000 miles, just behind the US with 62,000 miles. The favorable demographic profile for China is likely to work its decaying effect on growth in coming years. In 1999, for China to grow its $1 trillion economy by 10%, it had to expand its economic activity by $100 billion and consume 10% of world’s industrial commodities- the raw-material that include everything from oil to copper and steel. Now a $7 trillion economy to grow at the same pace requires $700 billion of economic activity and which is more than 30% of global commodity produce looks an unfeasible growth target. Other important factor which led to expansion after the crash of 2008 was aggressive lending of $4 trillion cumulative loans by banks till 2011 which was almost the size of the economy by that time. Now it is pushing more towards consumption led growth as it sees serious implication to pursue with its investment led growth for a command- and- controlled capitalism of China. China’s growth tapering, Euro-zone fighting with its sovereign crisis, Japan showing no growth and US showing sub-par growth is going to put downside pressure on commodity prices in 2013. It will be hard to predict the course of liquidity seeking the nature of asset classes as Quantitative easing and liquidity injection is thrown at large in 2013. But incremental QE’s and LTRO’s will be less effective in pushing up asset prices beyond a point until we see economic activity ticking higher.

Crude also reflects a bearish outlook if we look at the spot prices and the 5-year future oil price. More logical reason for the bearish outlook in the future market is because of large shale-gas production in US with newer technology is likely to flood the global market with oversupply at a time when the global growth is sluggish and energy consumption is declining.

 *Source: Research reports

Corporate India Result Outlook:

Corporate India surprised the street by posting better results in 2QFY13, amid sluggish macro factors plaguing the country. However risk of further slowdown is still haunting our domestic economy, which clearly reflected on slowing sales growth. CNX 500 Companies excluding Banks and Oil Companies posted a sales growth of 11% on YoY, the slowest growth since 2QFY10.

CNX-500 companies (excluding Banks & Oil companies)

*Source: Capitaline

The decline in sales growth was largely on account of low industrial production numbers, which was hitting new lows in last few months. Softening of commodity prices positively impacted the operating profit of the companies, which surged 20% on YoY as compared to 13% (YoY) posted in 1QFY13. Margins also improved by 100 bps on YoY during the quarter. Muted stance from RBI on lowering interest rates during 2QFY13 has affected the capex of corporate India, which was reflected in lower depreciation growth. Depreciation growth has slowed down from 21% in 3QFY12 to 16% in 2QFY13. Lower depreciation cost coupled with lower interest cost led 25% profit growth on YoY basis for CNX 500 companies (excluding Banks & Oil companies). Interest cost which was growing over 30% on YoY for past 6 quarters rose 19% in 2QFY13 owing to lower credit growth and relatively unchanged interest rates and the de-leveraging effect as well. However there is an expectation that Central Bank on coming policy meet (probably in 2013) could reduce Repo rate, considering the current slowdown in our economy. So going forward, this could be a big boost for corporate India to post better margins and bottomline.

Macro Indicator:

A segmental view of the current account and how it is supported by the capital account flows, specifically the FDI, Foreign Portfolio Investment and the Loans/ECBs. 

*in Rs Crore

FDI in the proposed sector will boost capital inflows and ECB relaxation would take care of the current account imbalances for next year and will act as a stabilizer for weak INR. Government’s proposed reforms are in the right direction, the real effect of which will be gradually felt in the coming years. FDI and FII flows comprise a large part of capital account. FII flows are volatile to predict and are subject to global financial conditions which keeps on changing rapidly with time. So promoting favorable reforms and policies can only attract long-term productive FDI flows. Government is also putting effort to attract capital through the ECB route. These efforts if percolates down to the economic system will help in stemming INR weakness, correcting current account imbalance and promote growth.

Lifecycle of an Emerging Market:Different Phases to Identify

The Boom and the error of optimism give way to a crisis of confidence and fear, the error of pessimism...

The most pertinent question which is asked recently is the fact that whether we are in the preliminary stage of a bull market and whether the economic cycle is turning around for good in India? There are no easy answers as far as the timing of the bull market is concerned. From a generalized standpoint, we know for sure that there are four stages as far as sentiment goes i.e., optimism, euphoria, pessimism and depression and from economic cycle perspective it’s innovation, growth boom, shakeout and maturity boom and for stock market cycles there are six phases which we have discussed in details.

For business cycles and stock markets the most alluring part is that there is always life after death. A new cycle always emerges as if a reincarnation, with newer set of stocks and principles and it always tends to be different from the earlier ones. The only constant in the nature is “Change” and the constant changes which we see or observe over electronic media and travelling in different cities and states and countries gives an impression of the state of economic prosperity we are in, and its culmination into stock markets.

Likewise we have tried to put emphasis on events and symptoms of varying degrees in order to identify the lifecycle and stages of emerging markets. The more extreme the market peculiarities, the more easier it becomes to identify the phase of cycle the stock market is moving into. We have tried to put things in context and have also taken extracts from Marc Faber’s book, where the phases have been well articulated.

Phase Zero- After Crash

• Long-lasting economic stagnation or slow contraction in real terms
• Real per-capita incomes go flat or have been falling for some years
• High unemployement
• Little capital spending and international  competitive position deteriorates
• Political and social conditions become unstable(strikes, high inflation, continuous devaluations, terrorism, border conflicts, etc)
• Capital flight

Phase One- The Spark

• Social, political and economic conditions begin to improve(new government, peace treaties, adoption of market economies and capitalistic systems, introduction of property rights, etc)
• New economic policies(tax cuts and preferential treatment of foreign direct investments, removal of capital gain taxes, currency reforms, lifting of foreign exchange controls, permission for foreigners to acquire 100% of assets including real estate, removal of trade barriers, etc)
• External factors, discoveries of resource deposits, the rise in price of an important commodity, applications of new inventions and innovations
• Improvement in liquidity because of an increase in exports, the repatriation of capital and increasing foreign portfolio flows and direct investments
• The outlook of future profit opportunities improves significantly, as a result of one or several above mentioned factors
• The undertaking of large scale infrastructure projects that improve power supplies, road transportation and port facilities
• The privatization of entire industries

Phase Two- The Recovery Cycle

• Unemployement falls and wages rise
• Capital spending to expand capacity soars, as the improvement in economic condition is expected to last forever(error of optimism)
• Large inflows of foreign funds propel stocks to overvaluation
• Credit expands rapidly, leading to a sharp rise in real and financial assets
• Real estate prices increase several fold
• New issues of stocks and bonds reach peak levels
• Foreign brokers and other foreign financial institutions open offices
• Merger and acquisition activity picks up
• Inflation accelerates and interest rates begin to rise
• There are exceptions, however: When countries suffer from hyper inflation and depression at the same time, the recovery, which is usually brought about by a financial reform, will lead to declining inflation and interest rates.

Phase Three: The Boom

• Overinvestment leads to excess capacity in several sectors of the economy
• Infrastructural problems, bottlenecks and an excessive credit expansion lead at times, via rising wages and real estate prices, to strong inflationary pressures
• The inflationary pressures, however, may not take place for consumer prices
• The rate of corporate profit growth slows, and in some industries it begins to fall
• Usually, but not always, a shock such as sharp rise in interest rates, massive fraud, a business failure, margin call that cannot be met by a large speculator or some external unfavorable event  leads to sudden and totally unexpected decline in stock prices
• At times stock prices decline for no other reason than that they have run far ahead of themselves, and some speculators or insiders – in the know that the boom cannot go on forever and seeing that the profit picture is deteriorating – decide to take profit
• In such cases, it is simply a matter that at some point the supply of equities from the corporate sector and insiders exceeds the demand from the stupid and credulous public who, brainwashed by the bullish statements from the corporate executives and the press, continue to buy at any price

Phase Four – Downcycle Doubts

• Credit growth slows – unless monetary authorities act irresponsibly and attempt to prolong the mania and keep the economy in a state of permanent boom
• Corporate profits deteriorate
• Excess capacity becomes a problem in a few industries, but overall the economy continues to do well and the slowdown is perceived to be only temporary
• After a initial sharp fall, stocks recover as foreign investors who missed stock markets rise in phases on and two pour money into the market and as interest rates begin to fall
• It is not uncommon that foreigners increase their buying of stocks in phase four, since they tend to be latecomers to the investment party
• Some sort of major hook keeps investor interest in the market alive. They hook may be an economy that continues to grow, sharply declining interest rates, corporate profit that are still rising, or simply optimistic statements by business leaders and government officials
• The majority of stocks usually fail to reach a new high because a large number of new issue meet demand( the sellers who are mostly locals who either know better or are strapped for cash)
• However, it is possible that a stock market index driven by just few stocks makes a new high. The advance/decline line and the number of stocks hitting new all time highs will, in such case, not confirm the new high

Phase Five – Realization

• Credit becomes tight, bond spreads widen considerably and bankruptcies soar
• Economic, but even more so social and political, conditions now deteriorate badly. Consumption     slows noticeably or falls (car, housing and appliance sales are down)
• Corporate profits collapse
• Stocks enter a prolonged and severe downtrend and foreigners begin to exit
• Real estate prices fall sharply
• One or several big players go bankrupt (usually the ones who made the headline in phase three)
• Companies are strapped for cash and are often forced to issue shares at distressed prices. This increase the supply of shares and depresses prices even further

Phase Six – Capitulation and the Bottom

• Investors give up on stocks. Volume is down significantly from the peak levels reached in phase three – usually by 90%
• Capital spending falls sharply (error of pessimism)
• Interest rates decline further and reach their lows for the cycle
• Foreign investors lose appetite for new investment and continue to sell
• Rating agencies threaten to downgrade the country
• The currency is weakening or is devalued

It is not necessary that all the events matches in a picture perfect style in all the stages and  we shouldn't become too dogmatic about it. Generally Phase-Three is the most noticeable one and can be easily identified. It’s in phase three that we see once in a decade kind of mania and market completely losing its actual fundamental touch. Money making becomes extremely easy and quick bucks are made with huge volumes and intense momentum. Symptoms generally remains abound with

• Business capital and metro cities resembles a boom town- nightclubs packed with speculators and brokers who made handsome money in the stock market
• Volume of credit expansion explodes in the system and leverages play a greater role
• Corporate tend to make fairly large acquisition with leverages both overseas and domestic at exorbitant valuations
• Buzzwords such as LBO’s, M&A, PE fund, Venture Capital, Rising India, Superpower are used frequently. Speculator tends to remember only the script code rather than the company name
• FII flows hits a crescendo with buzzword like the ETF money, Hedge Funds etc., etc., becomes rampant
• People generally argues for a structural bull market with lofty index and stock targets and gives arguments why the stock market or the property market cannot go down
• New airports are planned for and SEZ, new cities, new industrial zones are planned and developed for. Tall and lavish buildings are constructed.
• Housewives become active in the stock market. People tend to give up full time jobs in order to concentrate playing the markets. New breed of young investors tend to perform better than the seasoned money managers and talks about winning stock market formulas

Generally in this phase even after a sharp decline and major shock, the mood remains optimistic and they tend to buy on decline. Capital loss in first decline is not serious and thereafter further declines put systemic strains and serious havoc among varied class of investors and speculators

Phase four starts thereafter with financial strains. Leveraged speculators are forced to sell. Lending standards are tightened and bad loans begin to climb. Tourist arrivals slow and hotel occupancy rate declines. Brokers continue to publish the most bullish reports arguing of a life time opportunity. Finally political and social conditions deteriorate. The recovery in the phase four happens with selected stocks and sectors, taking the indices higher closer to all time highs or may even conquer it with thin volumes and narrow advance/decline ratio. The powerful recovery generally tends to seduce investors and speculators. Economy continues to do well after a brief pause and corporate continues to post profit growth though the intensity and pace declines significantly.

The transition from phase four to phase five is passive with no major knee jerk reaction. Rather a drifting lower kind of market with symptoms’ such as falling GDP, unfinished construction sites, higher budget deficits, stock brokers laying off staffs or even close down and research reports becoming thinner. Country no longer remains a favorite tourist destination. People generally tend to realize their follies and give up on stocks and any rallies are perceived as an opportunity to sell at the end of phase five rallies and in the phase six.

Phase six becomes the actual climatic phase where interest rate is perceived to hit trough. Negative headlines rules the media, currency weakens considerably on current account imbalances and fiscal deficit burgeoning. Flights, hotels and nightclubs are empty, foreign brokers turns bearish and shut shops. Volumes decline sharply and mutual funds corpus decline with persistent outflows. Post a panic selling or a capitulation on depressed economic and political environment, stock price reaches historical low valuation and negative news doesn’t affect the prices much and hence prices no longer declines and start building base for a next wave of bull market.

The Boom and the error of optimism give way to a crisis of confidence and fear, the error of pessimism.

Identifying the Climatic Phase

As far as Indian market goes, it’s clearly evident from the symptoms in 2006 and 2007, that final run-up to 6300 in Nifty was a phase three phenomenon where money making was quick, volumes were huge and sentiment run euphoric. Thereafter with the massive fall and the bubble burst, led  us to phase four with fewer stocks reclaiming their all time highs by 2010 and indices almost retesting it’s life high. After phase four with market almost kissing 6300 in Nifty, phase five culminates in 2011 with the whole year seeing a worsening of sentiment with scams, slowdown in the economy, interest rates reversing its trend and starts declining, brokers laying off big time and many foreign brokers shutting shop. Phase six generally coincides with further worsening of sentiment and capitulation. Phase five and six are quite tricky in a sense that when phase five converts into phase six is difficult to identify. Phase six generally is the mirror image of phase three. Generally in phase five brokers lay off  employees, leveraged companies resort to fire sale of their assets and depress share prices further, corporate profit deteriorates as had been seen in 2011 and in phase six currency weaknesses reaches a climatic stage, interest rates hits a trough. At present with a series of reforms in India, INR has reversed its trend after hitting 57.32 but interest rates still not hitting trough with repo hovering at 8 %( last registered trough was at 4.75%). Phase six till now has not been clearly evident and a capitulation haven’t happened in any meaningful way and complete. Though the confusing part is that stock specific capitulation has happened and in dollar terms index have declined 40% in 2011. Moreover Political chaos generally continues in phase zero and currency continues to remain weak in this phase with high inflation. So clearly one can construe that we may be meddling between phase six and phase zero and we can conclude the ending of phase six once the interest rate declining cycle gathers momentum and come closer to the troughs and valuation starts looking cheap…

Longterm Economic Cycles with Four phases- Innovation, Growth Boom, Shakeout & Maturity Boom along with demographic spending wave cycles and preference of investment class at different phases

Paras Bothra

paras.bothra@ymail.com

+91 9831070777

Power of Globalization & Market Outlook!

In the 19^th century, the Western power colonized countries with guns, today they do it with McDonalds, Coca-Cola, Starbucks, Hollywood, CNBC, CNN, BBC, Bloomberg, Reuters, Gucci, Armani, Wal-Mart, Reebok, Adidas, Omega, Gatherer, BMW, Mercedes ; massive capital flows at high interest rates, and by doctrine that open markets will automatically lead to prosperity. 

*German ratification of ESM

*QE3 by Federal Reserve of US

*Diesel price hike by Rs5/- and putting a cap on number of subsidized cylinders

*FDI in Multi-Brand Retail, Aviation, Broadcasting, Power Exchange

*Disinvestment in four PSU’s

*Political chaos with TMC withdrawing support from UPA-2

*RBI cuts CRR by 25 basis point

*Withholding tax on interest payment of foreign loan reduced from 20% to 5%

*Rajiv Gandhi Equity Scheme to increase retail participation

*SEB’s debt restructuring of 1.90lac crores

*United Spirits in talks with Diageo

The more the world changes, the more it remains the same. Societies rise and fall; new industries come up and then fade. Wealth accumulates, only to be destroyed. People live longer, but their suffering when sick is prolonged. Wars may not be fought with huge armies facing each other in trenches but through terrorism and with trade embargoes, holding off supplies from the market (oil cartels), defaults on foreign debts, expropriations, computer viruses, etc. And while, in the 19^th century, the Western power colonized countries with guns, today they do it with McDonalds, Coca-Cola, Starbucks, Hollywood, CNBC, CNN, BBC, Bloomberg, Reuters, Gucci, Armani, Wal-Mart, Reebok, Adidas, Omega, Gatherer, BMW, Mercedes ; massive capital flows at high interest rates, and by doctrine that open markets will automatically lead to prosperity. 

We are firmly entrenched in a capitalist economic system and after the dismantling of the Soviet Union communisy economy in the 1990’s, the world is completely ingrained with a system where globalization has put forth varying degree of opportunities in terms of cost arbitrage, labor arbitrage and various other economic prospects. Indian pharma companies in the last decade started producing generics and bulk drugs for exporting to developed countries because the manufacturing cost of Indian pharma companies is around 65% of the US firms and almost half of the European manufacturers and thereby generating dollar income. Information technology flourished in the late 1990’s with the opening up of the sector which generated huge dollar earnings and employment for a different class altogether.  These sectors with skilled workforce have established our credentials in global product/service delivery mechanism.

Likewise in a globalised economy if we can export products and services to global markets then why can’t we allow global players to come with capital and expertise to set forth an efficient business model which will open up a vast array of ancillary business opportunity, employment prospect and economical shopping experience for the people of India?  FDI in retail is going to be similar to IT and Pharma which will put us one step further in league of prosperity. FDI inflows could be huge with the floodgates opening for foreign giants like Wal-Mart, Carrefour, Tesco and many others. There has been a lot of noise for opening up of the sector, but the question remains that who is shouting against it? It’s the politician who in the name of saving the common man, kirana shops, hawkers, mom & pop stores, middleman, is willing to take a political mileage by gaining vote banks.  But no one is talking about the fact that the cost competitiveness will drive prices lower and ultimately benefit the consumers in a big way. Overall employment creation could be 4 million direct jobs and apprx 6 million indirect jobs in next 10 years.

Because of various formats of retail i.e., supermarkets, hypermarkets, shop-in-shop, departmental stores, franchise model, convenience stores,  not only does the price inflation come down but it will also change the shopping experience in India. Biggest improvement will be in the retail infrastructure, i.e., logistics, warehousing etc.  At present in India one major cause of food inflation is the pilferages of the food in warehouse to the extent of 30% to 40% and this clearly indicates that how much India is under invested in its infrastructure. FDI in retail is certainly going to fill these gaps and lapses in retail and at the same time eradicate middleman in the supply chain system and bring down cost of goods with bulk purchases. All these are going to be beneficial for Indian consumers. Moreover Indian retail industry is at present a USD ~435-500 billion industry and in next ten years it will hit USD 1trillion and such a large scale market is bound to accommodate many players and small shops to co-exist.As per PWC, the Indian Retail Industry is pegged at US$ 500 billion and is expected to reach US$ 1.3 trillion by 2020. In addition, the organised retail is expected to reach 25 per cent by 2020. At present the organized retail market is almost US$ 35 billion. There are estimates that India’s organised retail market could attract US$ 15 billion in the next three years. Opportunity remains considerably big in organized retail.

In recent days a totally new economic lesson has emerged, the so called conundrum of de-leveraging by the private sectors and on the other hand huge liquidity infusion by the central banks are exerting powerful asset-price rallies around the world.  The problem with credit/liquidity driven expansion is that credit growth must accelerate continuously for the economic plane to stay aloft. The moment credit growth slows, liquidity and solvency problem arises. These are undoubtedly extraordinary times when there in zero interest rates in developed markets staying for a considerable period of time, ten year govt. yields and corporate yields are at record low level and investors have no other options except to buy equities or higher yielding assets of the emerging markets. People are searching for growth stocks and high yields and credible stories in emerging markets are finding buyers. Economic growth story has wide divergence and is unsynchronized unlike the 2002-2007 phases and every economy has a wide array of its own internal problems to deal with. Financial markets have become a considerably powerful tool in sparking hopes of revival globally and the up moves are termed as “risk-on rallies”. Fiscal cliff is the next global theme which surely the market would start talking about once the presidential elections in US is over.

In India as well capital formation has considerably slowed down in recent years specifically from the private players because of high leverages in hey days of the booming economy. And to make the matter worse, opening up of the scandals has completely shaken the decision making process of the government and the corporate as well. Coupled with it, high inflation and interest rates are putting enormous pressure on the corporate profitability. Recently with the kind of big bang reform announcements, sentiment has improved for the better and now interest rates and inflation needs to come down sharply so as to stimulate the investment cycle which will lead to creation of capacity and a revival of economy. 

All through this phase of uncertainty, one noticeable trend is the corporate India sales numbers which continuously remained elevated since 2009 despite the fact that GDP numbers are slipping thick and fast. For the corporate sales number and nominal GDP, justification could well be given from the fact that inflation remains high and so the sales figure includes the price hike. Despite of higher sales, baring FMCG and Pharma and other defensive companies, pricing power remains very low and interest burden and depreciation for ongoing projects eating into the bottomline and hence profitability steadily declined in 2011. Since the year 2000, there have been two instances when sales dipped sharply and hitting rock bottom was in 2002, 2009 and negative profitability growth was in 2001,2009 and 2011 and at the same time marking significant bottom in the Sensex during those phases. Though this time around in 2011, the PAT decline was sharper than the PBIDT despite the fact that sales remains elevated at 15% to 17%.   Reasons for the divergence are because of leverage in balance sheet and higher depreciation due to capex burden initiated a couple of years back.

It seems that the economy needed a trigger for improvement of the general business climate and last month was historic in every sense with the way the government came out with bold measures highlighted above. First the ECB and FED QE3 announcement of bond buying programme and there after the momentum carried forward with big-bang pending reforms and finally TMC withdrawing support and SP coming in was well taken by the markets and it zoomed up almost 6% in September series.

For a market trend to reverse and embark on a journey of structural uptrend requires

1. Earnings growth to support valuations

2. Liquidity to revive investment spirit

3. Yield curve to steepen

4. Current Account Imbalances starts showing signs of improvement

5. Pessimism all around with strict denial of an economic uptrend resuming

These factors encompasses all the essential ingredients of a bull market, whether a mini bull market or a secular uptrend. Till now valuations for Indian markets were below historical averages and a mean reversion trade was predominately the theme to buy under valuation and sell at a mean valuation. Secondly, liquidity remains abound with central banker’s expansionary monetary policy and Indian liquidity tightness gradually easing off.  Thirdly, Yield curve to steepen to confirm an economic recovery. At present the yield curve remains flat with no difference in short-term and long-term interest rates, is indicative of the fact that economy is experiencing a slowdown. Though we would argue that the market identifies an economic recovery well in advance but still interest rates declines should have precipitated a long way closer to the historical trough, before an economy reversal is called for and a yield curve steepening thereby indicating a recovery underway.  Fourthly, it is perceived that Current account deficit likely to improve with crude oil price correcting on fundamental grounds and import bill declining in coming months on back of INR appreciation. Finally, Pessimism all around was prevalent in 2011 when market marked a bottom around the 4500 mark in Nifty and thereafter making higher tops and bottoms. 

Now the capex cycle needs to turnaround and GFCF (Gross Fixed Capital Formation) should start building up to mark a firm recovery backed by investments and triggered by bold reforms and policy decision by the government. Pieces have started falling in place and we need to see more of it…..

Paras Bothra

Email- paras.bothra@ymail.com

Ph: +91 9831070777