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Thursday, August 18, 2011

India view: Brace for flood of money

I must be sounding ridiculous but that is exactly what I expect to happen in near future. If the developed world investors are keen to retain their wealth, which they are, they will want to move to economies where conventional growth is still possible.

Conventional and unconventional growth
Conventional growth refers to well understood process of growth. In the emerging economies, we know what needs to be done. We need to build infrastructure, power plants etc. That investment will trigger efficiencies which will push EM economies on to a growth path. The history of development of the western world provides the understanding of this process and there is ample evidence as to what works and strategies for growth. This is the opportunities wealth retaining funds will eventually seek as compared to unconventional growth in developed markets.

I have argued previously that growth in developed markets will depend on two forces. The first is renewal and maintenance of infrastructure that already exists and second refers to the new kind of infrastructure and development that is essential. The new kind is uncharted territory and requires patient capital the likes we deploy in R&D. Possible candidates are Water-related infrastructure and forestation related investments. I call them Green and blue options. These investments are more of the Private equity variety than what normal funds would like.

The coming money flood in EM
The money eventually has to move to EMs before EM economies adjust their currency regimes reacting to resultant imported inflation. That implies funds will compete to reach EM shores, in all probability, creating a sharp uptick in EM equity markets.

My strategy
I am going all in as the markets decline. My focus is domestically driven revenues. It means I am avoiding Indian IT companies for strategic reasons. I find Indian consumer goods firms a bit over-valued, though I own telecom stocks as proxy for consumption story for short term. My focus is on infrastructure stocks (GVK, L&T) and banks. I am not very sure about Indian asset valuation story so I am staying away from real estate (except for occasional  short term high risk investments in Unitech which appears to be below its liquidation value). I expect the sector to start turning around when housing deals start happening on ground. I believe that should take 3-5 years at least. However, I do like Indian Hotels which, I believe to be a well managed company with sensible management. I do expect domestic auto firms (Tata Motors, Ashok Leyland and Maruti) to become big players in the coming decades and their current valuation provides a good entry point. In all above cases I am betting on liquid names and large volume stocks only.

It is possible that I am early and will need to hang on to the strategy for a little while. Let us see how things go from here.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Tuesday, August 09, 2011

Realignment: Ratings and relative risk stack

Investors think of risk associated various assets (across classes) in relative terms. We have a notional relative assessment - A is riskier than B but C is more risky than A etc. This applies to asset classes and specific assets within them. So Manhattan land parcel may be riskier than NY state debt etc.

Thus, we have a stack of assets. We can imagine this as a deck of cards that the investor carefully aligns according to their risk profiles. On one side, lets say the bottom of the deck of cards, we have less risky and they get progressively more risky as we reach the other end, i.e. the top.

The S&P ratings change signals a change in the order of this stack - sort of shuffling of the cards. Some investors believe that shuffling happened a long time ago and S&P is just highlighting it. Others believe there has been no shuffling of the deck and previous order remains valid.

In essence, each investor is making his or her own assessment. We are all on our own.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.

Saturday, August 06, 2011

Answers to Barry Ritholtz's 10 questions about S&P downgrade

Barry Ritholtz asks 10 questions about S&P downgrade and I answer most of them below:

Here it goes:

1. The change in trajectory of US debt was in service of Banks: It began with TARP, and continued with every other bailout/stimulus/economic plan. What was S&P’s role in creating that crisis?
 S&P is centrally responsible. So are US regulators, banks and those crying hoarse. Let us remember there is plenty of blame to go around for GFC. 
2. How will non-US investors (Private and Central Banks) view the downgrade?
Most non-US investors already discount the news. However, investment strategies will compel some to act if another agency downgrades.  
4. What does the downgrade do to US currency — is that the true impact of the credit downgrade?
Over 5 year horizon I think USD will begin to decline. A declining dollar is in the interest of US. It will reinforce US manufacturing. Immediately, though, flight to cash and commodities seem to be possible options.  
5. Will borrowing costs likely increase for the US? What about consumers?
Borrowing costs for US entities will increase. I suspect the ability to pass on these cost to consumers will remain under pressure. Consumer rates, after accounting for all adjustments, a quite high. It will impact borrowing cost of investors, leverage will be difficult to come by.   
8. Why did the rating agency not wait until the special committee / debt ceiling deal was completed later this year?
I think the rating rationale was more political than financial – more related to “willingness to pay” rather than “ability to pay”. The debt committee would have done more related to “ability to pay”. The statements by politicians about “debt ceiling debates hereafter should be conducted this way”, “maybe default is a good option” etc. makes one really skeptical of US governance. You see such things in banana republics not US – definitely not a behaviour of AAA rated sovereign. 
9. The Rating Agencies were downgraded by Dodd-Frank, with all regulatory and legal references to be removed. Was S&P’s move retaliatory?
I don’t think so.  
10. How will US markets open on Monday in response to the downgrade?
Move to cash and commodities could be a good idea to bet on. Though one can never be adequately sure. 

Impact of the US Rating downgrade

The rumours of a downgrade had started during US trading hours, but the actual S&P announcement came post market hours, so Friday's market closing does not reflect the ratings impact.

Immediate impact - is it the last straw?
With concerns on US growth slowdown and EU debt crisis already troubling markets, this is another nail in the coffin. The immediate reaction should be negative: equities sell off, commodities fall, bond yields rally, dollar weakens, safe haven assets (gold, CHF, JPY) appreciate. However, it is not clear if this impact will persist beyond the near term.

On bond yields 
Some are arguing that since it was well known that the US would get downgraded, this is priced in and that there may not be much lasting impact. Moreover, Moody's and Fitch still have the US at AAA for now. Analysis of the impact of past rating downgrade of other countries on their long-term yields has shown that yields rose in the days before the downgrade and then either fell or were unchanged after the actual downgrade.

Over a few years, one can expect yields to trend upwards, till the US regains its AAA ratings. If the situation deteriorates further, there is likely to be sustained uptrend in the bond yields.

Money moving out of US treasuries
The US downgrade raises two medium-term issues with respect to money movement.

First, the downgrade will accelerate the already ongoing trend of reserve diversification away from the US dollar. Confidence in dollar's reserve status will be tested by the markets. This may be a slow moving process or in the worst case scenario, this can trigger panic reaction.

Second, some funds may start taking money out of US as they are mandated to invest in AAA only. However, a lot of funds rely on ratings of two agencies and not just one, so this effect may be more prominent if one other ratings agency follows S&P.

Further, the question remains, where will they invest? None of the other AAA rated countries have the size and liquidity that the US markets offer. Norway, Singapore, Australia, Sweden are some of the AAA rated countries where investors could flock and put pressure on their currencies to appreciate. 

In such a scenario, people expect this money to move in emerging markets through a diversified investment approach. Thus, post the initial risk aversion shock, they expect EM markets to show positive reaction over the medium term. I do not agree with this. There is no reason to trust Indian or other treasuries over US treasuries.

I think people may shift into commodities. Commodities will start acting like stores of value. Thus, we will see an increase in commodity prices. This will adversely impact EM inflation leading to weakness in EM. EM central banks will be forced to revalue their currencies with respect to USD, triggering the realignment process.

In sum
A lot depends on whether beyond the near-term negative reaction, there is further panic or sanity prevails at some point.

My book "Subverting Capitalism & Democracy" is available on Amazon and Kindle.