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Sunday, January 30, 2011

Inflation in terms of income and prices

Inflation has emerged as one of the key challenges of the world at this time. However we tend to reflect on inflation in terms of prices of basket of products and services. I think such a metric serves us to understand only a part of the problem.

Inflation, as we measure it today, does not measure social benefits when job scenario is difficult. The theory behind inflation posits that when the inflation becomes known wages should adjust to reflect the same. If wages are stable and prices start rising, inflation rightly triggers alarm bells. However, if prices are stable and incomes are falling then inflation data tends to mask the underlying decline in living standards.

Generally, policy makers use two variables, inflation and real average income growth, together. However, rarely do we see both variables in same discussion. The problem arises because of difference in measurement techniques of prices and wages. However, limitations of measurement should not be a cause for erroneous policy.

I think we need to define inflation as difference between wage rise and price rise. Or we may use another metric that measures this difference. I believe it should give a proper indication of the on-the-ground situation of the economy. 

Thus, in the developed world, with economies losing jobs, we expect this metric to expand conveying the increasing difficulty in sustaining a lifestyle. This comes over a decade of falling prices with stable incomes which we may parallel with deflation. 

How such a variable will influence policy response is a difficult question. However, it should definitely improve our understanding of the realities.

Thursday, January 27, 2011

Market Timing Anxiety

During the start of the year I had written about wanting to move to cash. Indian equity markets subsequently crashed and are staring down a possible decline to 5400 levels on the Nifty. I did move into cash but just in nick of time. The result is that my gains are lower than what could have been had I exited without hesitating like I did.

Now I am faced with exactly opposite conundrum. A lot of stocks have started hovering around the "buy" level. But the Nifty is still at 5600 level with still about 200+ point decline a distinct possibility. I am waiting with baited breath. But waiting has it anxious moments. The high volatility implies that market moves in dramatic fashion making it difficult to watch. There is no apparent reason (one that has materialized since beginning of 2011). 

At such moments the noise on TV and within research reports is further unnerving. Goldman Sachs recently revised the target price of few stocks down by 20-35% and still rates the stock buy. Some stocks are already above their revised target price. I don't know if research quality has declined to this extent or is it my nerves. 

The TV anchors are busy retrofitting explanations to the market movements. I read three on tueday. Half an hour after the RBI policy markets gave it a thumbs up, an hour later markets behaved as if they had already priced-in the rate hike and by end of day RBI rate hikes had caused catastrophic slide in Indian equity markets. I think reporting levels have dropped beyond redemption. It may make sense to free up the bandwidth these channels occupy.

Anyways, are you waiting too? And do you feel as anxious?

Wednesday, January 26, 2011

Why RBI could not raise interest rate more than 25bps?

Yesterday the Reserve Bank of India (RBI) announced hike in Repo and reverse repo rates by 25bps each. Some commentators argued that RBI is behind the curve and should be aggressive in rate hikes. I disagree.

India is not entering the Volcker age
The question of aggressive RBI puts the Indian economy in some ways (not in magnitude) similar to US when Paul Volcker became the Fed chairman. There is high demand side pull and supply side needs catch up. But there is a key difference in India's position.

India needs investments in supply infrastructure
India needs more than INR 2 Trillion worth of investments to de-bottleneck the supply side. I am not talking about creating supply but simply reducing wastage and time lags to ensure supply gets to consumer. This investment is required in roads, cold-chains, food processing, storage and markets etc. This infrastructure is government responsibility. Either government create this infrastructure or create conditions in which private player can create it. Without this not much can be achieved on supply side.

Interest rate puts pressure on this investment
By increasing interest rates in arbitrary manner RBI will create uncertainty that will impact these investments in two ways. First, it will postpone the investments because of uncertain business environment. Secondly, it will increase the cost of capital and thus reduce profitability of these investments.

Hence, I believe, the RBI acted prudently to signal inflation concerns but allow markets to steadily adjust to higher interest environment. 

Tuesday, January 25, 2011

Why did the US leverage itself so much?

There has been some discussion in the blogosphere about Peter Thiel's interview Back to the Future with Peter Thiel - Interview - National Review Online. One of the central question in the discussion is Why US leveraged itself to this extent - referring to the excess debt carried by US households. 

The question reminds me of an Aesop's fable about donkey and goat. A man is leading a donkey on a leash when a few people decide to play a prank on him. In turns one of them would appear to pass down the road and ask him why he is walking his goat instead of carrying it on his shoulders. After a few passes the person is convinced that his donkey is actually a goat and tries to carry it over his shoulders.

The same is situation with US consumers. Over time people have been telling the US consumer that loans to them are most safe. Over time US consumers were convinced that they can safely borrow more as future growth will take care of the repayment. The situation worked well for a generation and there was no reason to assume it was broken. So they never stopped even when the future growth was no longer certain. In fact US consumer continued borrowing despite evidence that with current policy (marked down exchange rates and export-oriented growth models) US is nearly certain to have de-growth.

As I mention in the book, the blame for the last leg of overextending consumer was the result of big-money. Big money required paper to play with and creating the paper implied creating real assets even when there was no demand. I think that makes Gary Shilling's ideas, particularly the one of selling consumer financiers, make lot of sense.

Friday, January 14, 2011

Adjusting money supply in aftermath of a crisis

The rapid expansion in monetary policy in the aftermath of current crisis was criticized by many. However, I believe it was necessary (combined with other things).

In my book I explained that inflation is a tax against status quo. It is designed to make it costly to simply hoard money. A crisis, often, results in inappropriate(1) accumulation of money. The accumulation often uses mechanism that do not create value. Inflation, in aftermath of such a crisis, may all those with genuine value creation mechanisms to rise above the scamsters.

Thus, increase in money supply seems desirable as it will nudge inflation while allowing money to move to value creators. However, this is contingent on a premise that new mechanisms are genuine and not simply new scams. The US has failed in ensuring this. That is why unemployment is high and rising while money sloshes around without effect.

(1) How we define inappropriate is another question for other time.

Tuesday, January 04, 2011

2011 - Images from Crystal ball!

Welcome to the new year! I wish the new year comes with merry news and prosperity more than your expectations. Let us look at what we should expect in 2011. I will not bore you with ideas like fall of Europe, growth in US etc. Commentators and analysts have already tackled those. I would like to leave you with some other ideas related to the markets.

First, the very short term - we are likely to have at least 2 mini cycles in 2011. By that I mean that, most likely, we will have two bottoms and three tops during 2011. Depending on how you look at the cycles, we had 2 or 3 of them last year. Consequent to the cyclicality, portfolios will have to churn thus leading to healthy performance of the brokerages and investment banks. I would expect asset managers to have a decent year again.

Second, we will see return of genuine Keynesians. By genuine Keynesians I mean focus on jobs rather than income, focus on employment certainty rather than uncertain stimuli, focus on sustainability rather than pump-priming. Like churchill said, we will eventually do the right thing after we exhausted all other options. It means a further crisis in housing markets may be addressed differently than previous ones.

Third, we will start discussing infrastructure in developed world. In India, 2011 promises to be year of infrastructure. After lackluster performance in 2010 and surge in demand, I expect Indian infrastructure  companies to be back with a bang. But more important is discussion about infrastructure will happen in the west. In these discussions we will find the seeds of future infrastructure companies and ideas. New cities in context of internet and social connectivity, infrastructure of future in terms of public transportation, lower energy consumption and good old core infrastructure like power, water etc should emerge by end of 2011.

Finally, this year may, in all probability, mark the beginning of the age of the Miser. Depending on how you look at it, we are close to the end or already past the age of consumption. The age of saving and hoarding money is upon us. The age of consumption lasted more than 30 years. So like many investment managers, I have not seen the era where people were scrambling to hoard money. This period is likely to throw up many different surprises for us.
  1. Return of the garage: Over the 60s to 80s People spent innumerable man-hours in their garage fixing things extending the usable life of the product. The 80s and 90s changed the products in the garage but the spirit remained. If 60s was about cars, farm and household machines, office appliances then 80s was about computers and cell phones and microprocessors. The importance of the garage has gradually diminished from 60s to 00s. This may change over the next 20 years. I expect the usable life of products will be enhanced.
  2. The return of services: The revenue models of many firms depends on the use-and-throw model. The service aspect of the product is reduced to minimum. If we see a return of the service model, we may see rework of business models. It means more consulting and organizational restructuring.