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Monday, December 29, 2014

2015: Images from the Crystal Ball!

We are at the threshold of 2015 with US posting one of the record quarterly earnings, FED talking of tightening, Russia and China on the brink of their own respective crises and some rather tricky security flashpoints - information security breaches and physical security breaches by ISIS, Boko Haram and the usual Al Qaeda and Taliban.

From the markets perspective, we have rather exhilarating ride. Oil prices have hit $60 from $100+ just a year back. Gold prices have softened, US markets are touching all time highs. EU is on the thresholds of a QE for itself. Japan has voted Abe back. Seems like good times are here!

Well they are! The recovery is thanks to the US Fed and so long as Fed does not tighten or initiates another form of QE, we can enjoy the benefits. It is time to make money and build up a solid rainy-day reserve. 

The cycles and volatility are our friends
The year promises to be as cyclical and volatile as previous if not more. This year though I am expecting at least 3 full equity market cycles - as compared to 2.5 (3 peak-2trough or vice versa) I expected last year. Unlike last year though, there will not be a secular up-trend. Thus last year if we missed a peak it was easy to recoup the lost gains by simply waiting. This time we may see some losses in such scenario.

US and developed markets
In general I agree with the Jeremy Grantham's forecast that US markets may move till 2300 -2500 before any correction. His analysis is worth a read. Secondly there is nothing that can shake up the US markets in present circumstances. The shock, if it must come, must be substantial. I think the Fed must continue to be on a pause till the employment outlook improves. This will allow for the growth to get traction. In the early '30s US withdrew the stimulus too soon with disasterous effects. Therefore I presume they will err on side of caution this time around.

The EU on the other hand still sustains itself on internal trade and consumption. EU stimulus, when it comes will be of great benefit. Let us hope to get the mechanics of this stimulus right as EU is more vulnerable to a currency run than USD. 

Indian Markets
In general, emerging markets will follow US markets. India should be special, and in general flight to quality to US should affect Indian markets to a lesser degree. Indian markets should have similar pattern like that of US - about 3 cycles over a secular uptrend. It seems 35K on Sensex does not seem out of reach. Within the broad Indian market uptrend we should see some sector rotation. Infra stocks should be back in favour along with asset intensive industries. Expect to see higher volatility in the markets thereby allowing for higher gains than the 27K-35K interval suggests. However, buy and hold will be a risky bet given sector rotation and global risks.

The nature of risks from shocks
The year while positive is fraught with risks:
  1. End of ZIRP?Yellen's comments in the last Fed meeting have prompted analysts to pencil in a Fed rate hike in calendar 2015. I find that hard to believe. In the very least we should see a prolonged ZIRP pause. We should expect a shock only around June if at all Fed decides to hike.
  2. Draghi - Will he won't he?: What Draghi does and when he does it will naturally have a lot of bearing on the nature of cycles. I suspect EU will ease before US tightens. The qantum of QE is likely to be lesser and more directed than US.
  3. Japan - Abe it is!: Japan has done quite a bit quite quickly. I think they will have to continue with it and make the stimulus, QE more directed using policy interventions. Japan will be more aggressive on investments across the world.
  4. Chinese growth: Analyst expect the Chinese growth to surprise on the downside. I am not sure about China but most likely the numbers may be better than analyst estimation. Lower Chinese growth implies easier commodity prices - sort of a QE by itself.  

My Strategy for 2015
The buy-and-hold era ended in 2008. These days the best buy-and-hold stocks never reach the broader markets when there is still money to be made. They sit tight with PE or angel investments. The stock markets are being used by promoters as a sort of exit option. So indeed we must sort and sift through the stocks and keep churning as soon as they fall out of our valuation metrics.

Infra stocks: Infra stocks seem well set to make a comeback. I have been investing in them since 2011 hoping for Indian infra turnaround. The situation is more conducive than 2011 but I have been wrong before.

Commodity stocks: The China crisis seems to have sent some commodities in a tail-spin. Therefore I am not inclined to interfere with metals and non-perishable commodities. Other commodities - like sugar are weathering the oil price shock resulting in lower alcohol demand coupled with excess supply. Sugar should turn around soon. I have been investing in sugar since early part of this year. I will continue to add to my positions.

Banks and Commercial Vehicles: These stocks are leading indicator stocks and I have liquidated my positions in banks and will soon do so in Commercial Vehicles space as well. These two sectors are in for period of good growth and repairing of their balance-sheets. In that sense if there is any correction I will take substantial positions in these. They should turn around pretty quickly once the shock wears off.

Gold: Gold is the only buy and hold thing I can think of currently. Only if you are in a currency that has potential for appreciation vs the USD then you can ignore gold for short term. The current USD strength is good for buying gold. The currencies of economies where the private sector and consumer is not leveraged and public sector is reasonably benign will ultimately appreciate in relation to USD.

In Sum
The year promises to be exciting year, a rare patch in a lifetime where we can ride multiple cycles within a year itself. The experience of recent past tells us to be nimble with a healthy respect for cash. Let us see how we can capitalize on this coming year.

Sunday, November 30, 2014

To RBI: A Case against Rate Cut

The Reserve Bank of India (RBI) is under considerable pressure to reduce its benchmark interest rates in its upcoming monetary policy meeting. However, prudent monetary policy needs to keep rates at the current level rather than a premature easing for various reasons.

First, the present high inflation problem was caused by supply-side constraints combined with demand-side factors induced by rural wage growth. Over the past few months, rural wage growth has moderated and the government is also prudent and is not increasing MSPs. This has eased demand-side pressures and hence the recent inflation strength can be attributed primarily to supply side factors. 

Our strategy to counter supply-side inflation has been to boost supply through increased infrastructure investment coupled with measures to improve ease of doing business. To make it work, we must let supply overtake the latent demand by such a margin that any easing thereafter should unleash a positive demand catch-up spiral. The risk with a premature rate cut is that it creates demand even before supply-side catches up, in turn pushing the inflation trajectory higher. Therefore it is better to err on the side of caution and reduce rates later rather than risk another inflation spurt.

Second, higher interest rates combined with lower inflation augur well for positive real savings return. This has twin benefits. On one hand it redirects household incomes away from consumption into savings; and on the other hand it will creates a corpus of domestic saving that can be re-invested into the economy making Indian investments less dependent and more resilient to external / global shocks. 

Third, high asset prices, particularly real estate prices, are a more substantive burden on economic growth than interest rates. A premature cut can re-invigorate the real estate cycle, adding to the countries financial vulnerability. As the BIS has stated, central banks should focus not just on the business cycle, but also the financial cycle. Higher real interest rate will maintain a pressure on asset prices thereby creating beneficial conditions for sustainable economic growth.

Fourth, higher interest rates (more capital inflows) coupled with exchange rate sterilization measures are helping the RBI create a war chest to counter any external currency shocks. This was indeed the learning from the South East Asian crisis of 1990s – make hay while the sun shines. The RBI, rightly so, expects the near future to be tumultuous in light of US Fed tightening and changes in divergent monetary policies in developed countries. Higher rates will ensure that the RBI has enough dry powder in case of a global economic shock.

In sum, calling for the RBI to cut interest rates – just when the inflation battle is being won- is premature, short-sighted and tantamount to declaring a victory even before the enemy has been defeated. In a world where global central banks are creating conditions for future instability, the RBI should remain a beacon of stability.

Saturday, November 01, 2014

What we need to estimate effects of multi-country QE?

I was thinking about ways to estimate impact of QE on potential offered by different equity markets in general or asset markets in general.

Currently we do not have money inflow metrics (i.e. indexed price and volume data) for all asset classes. Nor do we have an exhaustive asset class database (types of asset classes e.g. art). Without these metrics it is difficult to construct a true impact of QE on global markets in general and specific markets in particular. Maybe someone can construct some sort of blended index.

I suspect when we do construct some quasi-indicators we will find that M3 has grown disproportionately with GDP and the difference can be explained by blended asset class inflation.

Once the global effect is understood, the specific country level effect can be understood using a parametrized gravity model. Such model will tell us how the excess liquidity will move. 

Wednesday, July 23, 2014

Employee Costs of firms Firms, Free Agents and Talent Market Exchange that could be LinkedIn

Thomas Piketty's book "Capital in twenty-first century" talks about increasing income polarisation. One of the reasons for this has been the dumbing down of jobs available in the market. There is also a lot of debate about whether robots will take over our jobs. These debates deal with two forces acting on the firm. First is constant need to reduce employee costs and their need to engage with highly skilled talent. The confluence of these two forces can be extrapolated into robots taking over our jobs, polarised incomes or in a utopian view an era of free-agents. But that era has not yet arrived. So what keeps us away from realising an era of free agents? Well let us look at it from our firm model view.

Over the past 250 years we have moved from fairly simple, independent value chains to highly interconnected complex value chains. This means that expertise developed in one value chain has diverse applicability and therefore higher value across multiple value chains. However, from the view point of the firm, their value is limited. Consequently the employee groups developing these capabilities feel underpaid and switch jobs frequently. While there is a marked rise in their pay, I think this is miniscule compared to the value they can potentially create. I believe it makes sense to organise these individual clusters of competencies into tradable units - either as mini suppliers to various value chains or as free agents' agglomeration. 

The agglomerations will need efficient markets wherein you can know, hire and enter into contracts with these entities. In LinkedIn I see a potential market quite similar to equity markets where the buyers are firms and sellers are these micro-agglomerations or even individuals. 

A market where each person is like a listed entity seems ominous. Yet, it is not one market. Specific skills by themselves are a market. So LinkedIn needs to create multiple markets within their entire database. The parallels with equity markets and supplier discovery engines are ever more relevant. The amount of energy LinkedIn spends in validating their "listed entities" is nowhere close to the energy spent in the equity markets and supplier discovery engines. LinkedIn will have to create algorithm based bots to do that effort so that these bots can make the markets relevant to the buyers and sellers.

The responsibility of creating such a market is not simply that of LinkedIn or some such other job site. But it is responsibility of every individual, teams and also of HR departments wanting to leverage their human resources to maximum extent.

The outcome of such developments can unleash substantial benefits in rising pays and lead to healthy development of free-agent marketplace. The ancillary benefits could be substantial development in ideas that these free-agents focus on which may receive a boost because of focussed effort. Lastly, it will lead us to enriched lives of people.

Note: I have used value chain as it is generic word, but readers of the book "Understanding Firms" can appreciate this concept better with Resource Transformation Chains which is explained in the book.

Thursday, July 10, 2014

Welfare v/s Austerity - India's issue

Many people including some experts, attribute Indian growth of about 5% to the welfare schemes of the UPA government. Their honest belief is that UPA government's welfare schemes helped alleviate some of the harshness of the global economic slowdown. They also point to Chinese stimulus as something to emulate. Thereby they believe Modi's promised subsidy rationalisation (euphemism for reducing welfare) is not a good idea. I disagree. 

First, there is a difference between global issues and Indian condition. Global economic engines have stalled, while India's remain switched off for want of fuel (investment and clarity in policy making). 

Second, fixing the engines requires fuel which is currently diverted to subsidies. Thus, if there were an ideal subsidy level, current burden is most likely higher than this level. Therefore, naturally, to bring sanity back this will have to be rolled back. 

Finally, what is required is to push-start the engines is additional effort which will eat away more subsidy than generally required. Thus, push-starting this engine will cause subsidy to dip below this ideal levels. The blame for this does not lie with present government but with UPA which killed the engine long time ago.

Fix the engines and Indian engines can hum along for quite a while creating economic growth and surplus necessary to smoothen the income disparity in later years. Acche din aane wale hain!

Reducing Importance of the budget

The first budget of the new Indian government is scheduled to be announced in a few hours. However, I believe budget announcement has outlived its excitement value.

I would rather see the past expenditure analysis session and a strategic planning session replace what is currently made into a single event. 

There is absolutely no discussion about effectiveness of past expenditure as against their objectives. I don't want to see how welfare expenditures have contributed to the economy as it would be too premature to so such analysis making the budget useless. I would rather see how effectively were the cash transfers were made, what was the loss, what was the cost required to transfer that cash, etc. I also want to know that how fiscal deficit target was achieved using cash accounting jugglery by simply delaying payments. 

Similarly, we do not have a strategic planning session. The presidential address to both houses intends to do that but is hardly ever used that way. The election manifesto is the strategic plan we look to. I think that is inadequate. However given the level of understanding in the houses of the strategic issues, one wonders if it is better to not let the parliament do strategic planning. Most of the MPs are "knowledge proof" as the popular adjective goes. 

In sum in a few hours you will see much hula boo about a non event. Let us hope Arun Jaitley breaks another norm. 

Thursday, March 27, 2014

Make or break elections in India

As the election nears, the political discourse has become shrill, divisive, rhetorical but seldom, if at all, insightful. From the economy and markets perspective, there was never a turning point as pronounced as this. 

The market favours Narendra Modi, BJP’s prime ministerial candidate. However, the electoral numbers present a challenge. The BJP is strong in North and West, marginal in East and almost absent in the South. As per recent opinion polls, North and West are firmly backing BJP. The East will be crucial test for BJP’s party machinery while South will depend upon alliances. 

At the same time, opponents are getting their act together. Aam Admi Party despite its ludicrous politics, enjoys continued support amongst its followers. If not anything AAP may limit BJP’s seat share below the 180 mark. Congress may gain from its many populist gifts to rural India in the past decade. Congress is a shrewd tactician at election games and can still ratchet up 150+ seats simply because of it truly national presence. The third front is realigning itself to increase the bargaining power at the time of government formation. The lack of coherent leadership within third front makes it a target for alliances and partnerships, legitimate or otherwise. 

A rational result hints at BJP winning 190-200 seats. This number was adequate to run stable coalitions in the past. However, Modi’s polarized image may present a problem and a lot will depend on tally of other parties. If Congress wins 150+ seats, there is a reasonable possibility that BJP may be sitting in opposition even after winning 180 seats. BJP needs at least 230-240 seats to decisively win the mandate.

From market’s perspective, there are three likely outcomes of this national election – a coalition led by strong BJP, a coalition led by weak BJP and a indecisive-mandate.

The first case will allow Modi to implement a model of economic reform he has articulated. It is a big challenge as there is little time to address the breadth of issues facing the economy. In case of a weak BJP-led coalition, things will become uncertain. We must realize that the national mood is pro-Modi and not exactly pro-BJP, and BJP continues to be riddled with its old problems even today. In a weak coalition Modi-detractors may not allow a broad-based economic reform. This situation will test the political ability of Modi to maintain stability, something Vajpayee achieved with help of Brijesh Mishra.

However, in case the electorate throws up an indecivisive-mandate, we are positively doomed. Our present predicament leaves less room for experimentation or populist adventurism. It will result in a lost decade and some of the damage caused may leave deep scars. A lack of coherent policy may make low growth endemic and entrench our structural problems.

There is hardly any margin of error this time but then Indian voter has demonstrated surprising political maturity in the past. So let us hope for sanity.

Thursday, January 30, 2014

Banking and the Post Office

Double whammy of withdrawal of funds from emerging markets

In the past few trading sessions, there has been a considerable withdrawal of funds from the emerging markets. We can attribute this to two basic reasons.

Firstly, we have seen reduction of QE from $85 billion to $65 billion in the last four months. Secondly, we have seen an upward pressure on interest rates in the developed world. These two factors have combined to create A double whammy. At the time when funds are scarce, we have a reverse potential difference that is pulling money towards developed markets. This perverse situation will lead to substantial abatement of money flows from emerging markets to the developed markets.

In addition, there is already in place, an incentive to emerging markets sovereigns to invest in developed market treasuries for mercantilistic reasons.

I believe, these three forces will lead to substantial correction in equity markets in developing countries. Hence, we will see drastic correction in Indian equity markets. I also think, the same logic will hold for other developing countries.

I will be trying to close my open positions as soon as I can. Let us hope that we are able to ride out this turbulent phase. However, I do not think that this turbulence will last more than three months. Therefore, it is essential to get into the market say around end-April.

Friday, January 17, 2014

Saturday, January 04, 2014

The globalization puzzle

Dani Rodrick has an interesting post about globalization here :

The essential argument is institutional in nature. The institutional development Prof. Roddick argues depends on democratic choice expressed by various countries. He therefore concludes that full globalisation is almost impossible. I beg to differ slightly. 

I agree at this point in time it is difficult to achieve full globalization. However, it is neither impossible nor unlikely in the future. Prof. Roddick allows for such situation in extreme long term so I may have gotten it wrong. 

I think two main forces are working towards that goal. 

First internet and technology is making us realize how similar we are as peoples of the world. In older times we were skeptical of other people - they spoke different language, worshipped different gods, had different skin colour, ate different things, etc. There has been even starker change in people's perception of other counties from pre-1960s where non-western was exotic and a global traveller was a privileged person. Well, no longer is that true. We now have people interacting globally with each other across time zones and across cultures. This is a potent unifying force. We see often than this urge to communicate, trade, intermingle often crashes with the political borders and norms developed to keep peoples separate. No longer are we threatened by those of other culture. 

Second the world human and environmental rights movement is creating a template for global legal alignment. The UN human rights movement is creating a lowest common denominator set of rights that countries and their people are eagerly adopting. This methodology gives us a template that can be used for developing set of common rights which can expand gradually. 

Of course there needs to be a certain convergence between economic development of various countries to make it easier. But this convergence is not as strict a requirement as it was before the internet era. Today the world is  truly and rightly coming closer into a global village. And I sure hope this happens in my lifetime.