Its not a Chinese sell-off!

For the past week, global markets have taken a fancy to the slowing of Chinese economy. It could be envy of watching a defiant surge in Chinese markets without any hiccup what so ever. This story, it appears, has nothing to do with China and more to do with Yellen. China somehow was an opportune discovery. 

The American economy, its size, and its global linkages make it core factor in asset price calculations. The US is a primary exporter of capital to most of the important markets of the world. It is also usually the most important sizeable end-consumer for many including China. Comparatively China is less inter-connected.

A US asset price rerating will affect everyone.

There is a risk hierarchy of assets explicit or implicit in the mind of the investor.  When other central banks do such a thing their Government bonds move along the asset risk-hierarchy but other assets do not get impacted. When the Fed modifies the interest rates the whole hierarchy moves up - it affects all the asset classes. With the impending rate hike by one of the biggest economies in the world we are looking at asset price rerating across the world. 

Hike pushes investors into action

Generally a reduction in rates allows existing investor more room as prices tend to increase in case of the rate cut. However, when the Fed hikes the interest rates, the riskier asset prices depreciate. This effect tends to push marginal investors into selling thereby creating an opportunity for broader sell off. 

The current sell-off seems more likely to be such a sell-off. It is unlikely that this sell-off has anything to do with China. China unfortunately slowed down at that very time and to top it off indulged into some anti-market moves that further spooked the markets. Naturally that has prolonged and aggravated the current sell-off.

Meaning of slowing China

China is highly export driven economy. The GDP contribution from investments was growing substantially. Post the 2008 crises two things happened - China increased the investment spending - investment to GDP ratio was ~ 40%, and did it in face of tapering consumption demand. The underlying assumption being that China hoped developed market demand will take-off in coming years.

Had demand returned China GDP would still look robust. It means developed world demand has not returned - despite reasonable GDP growth in developed economies. THAT to my mind is a bigger scare than simply China slowing down. 

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Lesson from Grexit

Grexit teaches us something fundamental.

Two Approaches to debt

There are two fundamental approaches to debt.

First is the Capitalistic Approach. It says creditors must make investment with eye on risk and should their assessment be wrong, they must take hair-cut. The counter-burden on the debtor is that debtor is forced into austerity so that they make adequate efforts to get the creditors adequate return on their investment. Thus a debtor who made a risky investment is required to pass higher hurdle in the future to prove that his new investment is not as risky. Market adjusts the risk premium to reflect borrowers prudence. A prudent borrower gets lower interest burden while a profligate borrower is required to pay higher.

Second is the Creditor Protection Approach. It protects the creditors to greater extent. The protection afforded comes from various methods. In emergency government could assume private debt (as in EU crisis private debt was assumed by ECB, in 2007-08 crisis even privately owned equity was assumed by the US government). This approach is taken when the creditors are low-risk seeking pension funds or other instrument supporting social benefits. The counter-burden here is not on the debtor, it is on the Government bailing out the creditor. The bailout is only complete if the debt burden is reduced thus, here, the Government takes the hair-cut. This is an approach that promises debt jubilee.

The essentials

We may note that hair-cut is an essential ingredient of both approaches. The question is only as to who takes the hair-cut. When ECB assumed private debt, it assumed the hair-cut as well. Denying that renders the approach useless. This is from the creditor side.

Reducing debtor's burden is also essential feature, with different extent in each model. The Capitalistic Approach favours reducing as against eliminating the debt. Thus, the debtor continues to bear the debt that he can sustainably bear. Conversely, in Creditor Protection Approach the almost the entire debt is waived. So, Greece was right to ask for debt reduction.

The Grexit Model
The EU model fares poorly against either of these approaches. It does not have any essential elements and have worse aspects of both models. It is a sort of mixed model. 

The EU/ECB dilemma is that if Greece is allowed a Debt reduction, other PIIGS will be next in line. The current mixed approach will imply that ECB will be left holding the bag for all the PIIGS. Now in a normal sovereign, the central bank and sovereign are two facets of same entity. But in EU's case it is not so - primarily because the peoples of EU are not politically united. Thus, ECB is "owned" by Germany and other non-PIIGS a different sovereign than debtors. Can peoples of EU be politically mature to forge EU into a political union? If they do it will fructify the original EU dream.

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Hussman's timing may be wrong again!

John Hussman predicts epic stock crash in his recent newsletter. He says:

The financial markets are establishing an extreme that we expect investors will remember for the remainder of history, joining other memorable peers that include 1906, 1929, 1937, 1966, 1972, 2000 and 2007.

He follows up with another gem:

Enlightened members of the FOMC should even question the theoretical basis for their actions. The Phillips Curve is actually a scarcity relationship between unemployment and real wage inflation – basically, labor scarcity raises wages relative to the price of other goods (see Will The Real Phillips Curve Please Stand Up and the instructive chart from former Fed governor Richard Fisher in Eating our Seed Corn). That’s the only variant of the Phillips Curve that actually holds up in the data, and there is no evidence that this or other variants can be reliably manipulated through monetary changes.

Only long-term sustainable, predictable employment creates a turnaround. Till this I agree with him. Now comes the crucial issue of timing. Here he says:

They want to believe that the Federal Reserve has their backs; that as long as the Fed doesn’t explicitly hike interest rates, the market will move higher indefinitely. We saw one question last week that asked “What if the Fed doesn’t raise rates for another 20 years?” Let’s start with an aggressive, optimistic estimate. If we assume that despite conditions warranting two decades of zero interest rates, nominal GDP and corporate revenues will grow at their long-term historical norm of 6% annually over the coming 20 years, we would expect the total return of the S&P 500 to average about 5.5% annually over the next two decades (see Ockham’s Razor and the Market Cycle for the arithmetic behind these estimates). Even in this optimistic scenario, to imagine that this path would be smooth would have no basis in history, requiring the absence of any external shock for the entire period (and I’ve already demonstrated, I hope, that many of the worst market declines in history have been accompanied by Federal Reserve easing).

If Fed hikes, it will interfere with the risk equation causing "a breakdown in market internals" as Hussman calls it causing precipitation. But it is unlikely that Fed will hike. Fed may experiment with a token hike but may quickly reverse. Or, more likely, Fed will signal a prolonged pause (lasting more than a year or two). 

If Fed does not hike, things won't be as simple as 5.5% annual growth. It will be more. The past data behind this calculations comes from low monetary expansion era. When there is a flood of money, prices should inflate commensurately. Thus, if Fed does not hike,  S&P may average annual growth of ~10% or more for few years. 

Hence, S&P may double from here before Hussman's prediction comes true. We, no doubt, are establishing an extreme. We are confounded by its extremity.

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The Boring Banking Industry?

Two of the leading voices in finance Frances Coppola and Yves Smith are in a disagreement - sort of a pseudo-disagreement if you ask me - over whether banking should be boring or not. The question itself is the reason for the confusion. Banking should be boring was endorsed by Elizabeth Warren too.

I think Banking should be my kind of boring. By boring I mean two things - it should not be unnecessarily complex, and it should be capable to meet the complexity inherent in banking. Retail banking is not boring - for wrong reasons. It confounds the public with products that are too complex for their needs. At the same time, the back end that supports these products (read - corresponding asset liability matching mechanism, hedging etc.) is not as sophisticated. Investment banking on the other hand is too boring - meaning it does the complex shit right but it passes that shit to people who have no clue without retaining any skin in the game. 

Banking has multiple facets:

First there is a probability management that allows banks to take deposits for different terms and make loans for different terms and manage the asset-liability gap. This is similar to the insurance industry managing premiums and payouts. A smaller part of this is managing float which is a skill by itself. This is more like extremely short term trading.

The second aspect of banking is your ability to make loans that will pay a decent return without going bust. It is often known as the essence of banking. Borrowers whetting, background checks, credit history check etc. forms part of this aspect of banking.

Third aspect of banking is about sales of a variety of investment products. Here the retail staff of the bank tries to meet its sales targets by selling complex investment products to unsuspecting customers. The customers, most often, are meeting these sales-people to get some transaction done - they are not there to seek investment products.

Fourth aspect is support services which can be totally outsourced. This aspect covers your cheque-book issuances, mailing the account statements, keeping the personal records up to date. Issuing certificates for taxes, etc. On the asset side - it deals with record keeping, and procedural stuff. It is fairly automated and most customers can be empowered to do it themselves as well.

Understanding banking:

We cannot classify banking into retail and investment banking and expect to gain any new understand. We need to cut banking up into two chunks - transaction management and investment management.

Transaction management should be boring - like telephone exchanges or something. It should simply be WYSIWYG. It is also similar to McDonalds - it is basic and simple but you need to have skills to pull of the quick delivery at low cost. Meaning it is more a function of skill (can be acquired by repetition) than expertise (research, experience and insight are essential)

On the flip side, the investment management side should be complex. Now loans are debt investments and so is float. Selling investment products is as different from transaction management as chalk and cheese. You need experts to sell those products and ensure that they are not mis-sold. This part has been wrongly simplified. This part requires expertise.

What is boring?
Currently what is boring is selling investment products - which shouldn't be. Most people I know - yes most - do not understand the risks with any of the investment products they buy. It can be insurance policies, term deposits, mutual funds, debt funds, real estate or whatever.

Now basic risk management tells us that just because you buy different products does not mitigate your risks - sometimes your risks may go up. This risk compounding is not even understood by the practitioners let alone the customers. The sellers of these products, to use a popular phrase, get a salary to not understand them.

Now credit cards and over-drafts are not simple transaction management products. They are in fact loan products and deserve to be sold professionally. Most of the unnecessary complexity lies here. People who go for credit cards do not understand the terms of loan they are entering - and Warren has highlighted it time and again. Same goes with OD - while it is not as bad as credit card terms - hereto people do not understand what they are getting into.

There is quite a bit of complexity in term deposit side as well. If we really examine, most of the depositors do not make as much from their deposits as they should. The optimisation is never explained and never understood. It is in the interest of banks that depositors do not understand this - CASA (current account - savings account) helps keep the cost of capital low.

These cannot be boring - quite the opposite. These issues need to be explained - some by the banks selling these products, others by general education.

What is not boring?
Conversely, the transaction management is unnecessarily complicated. Real time settlement should have been a norm now - yet banks do enjoy settlement floats on many payment mechanisms. These represent the money the banks use after the debit the account and before they credit the account of the beneficiary.

One source of complications in transaction is authentication and identification. These cannot be eliminated as they exist to keep your bank account safe. However, all other sources of complexity are available for simplification.

Transaction fees are pretty complex, sometimes they are waived other times you get charged for using some facility during a holiday or something like that.


In sum
Banking is simple and complex at the same time - just not in the right places. It is time to rewire banking - simplify it just as much as required and no more.

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Austerity V/s Stimulus, Government Spending and Greece

Sometimes it is worth repeating something that is actually right. Let me say this again:

Stimulus works best when you need to push-start the demand engine. Note that it implies that stimulus won't do the work of engine - it will only push-start it. The engine must be in working condition otherwise. 


Austerity works best when Government borrowing is crowding out private investment. Usually Government is borrowing too much because it is spending too much. New investment is required to put a new engine in place.


In Greece's case - their engine is not working and their Government is spending a bit more than required. A combination is required when economy stalls - i.e. Government must reallocate/realign the spending targeting it into essential things. It also needs to increase spending once the new "engines" are set up. 

In a nutshell - neither Austerity nor stimulus alone will work in Greece's case. A combination of sane reforms and practical stimulus is required. Till such time...

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Why deflationary forces are so unrelenting?

Despite good GDP numbers and PMI data the deflation does seem to give up. Here are the reasons:

1. Incomes have fallen and are not rising again: Since 2009 there has been a fall in incomes resulting from retrenchment and layoffs and consequent oversupply. While employment numbers have improved (unemployment is falling), incomes are not rising. In fact they have settled well below their previous highs.
2. Consumption goods prices continue to fall: The fall came from two sources - improved productivity (from about 1990 to about 2000) and thereafter from combination of productivity gains and exchange rate dynamics. The QE era flooded the world with low-cost  capital leading to reduced interest rates across the world. This low-cost debt is transposing low-capital-cost-but-high-running-cost human employment with high-capital-cost-but-very-low-running-cost robots. Today the US consumption good prices are still at the mercy productivity gains and exchange rate dynamics but the pressures are more aggravated. The new productivity gain mechanisms are putting exceptional pressure on employment and wages. Further the exchange rate dynamics have morphed into all out currency wars.
3. Investment goods prices are deflating too:When you reduce the interest rate, you increase the prices of assets usually by setting the yield or return scale lower thereby pushing risk-averse investors into risky assets thereby inflating asset prices. Secondly, we coupled lower interest rates with ingenious financial engineering leading to improved credit availability which also advances demand from decades ahead and packs it into short timeframes. The converse is that there is prolonged period of lacklustre demand phase. I believe we are in that phase or may be entering that phase.

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What happens when passion for transformation meets attachment to bureaucracy?

It often so happens that your passion to transform the organisation meets with the organisation's love for its status quo. The meeting is like "unstoppable force meets an immovable object". So then how do we transform organisations.

Well, to start the resistance comes from systems - but more from people who love certainty of those systems. These people, called bureaucrats in the book, haven't bought into the reason for change. The selling of change / transformation needs to be increased. The other reason why people resist change is because they see uncertainty beyond the change curtain. Bureaucrats hate uncertainty. 

There are four types of personalities in the organisation - Scouts, Commandos, Bureaucrats, and Leaders. Leaders are those who can flip between the working styles and deploy respective talents properly.

Change makers are usually commandos or scouts - both hate process driven approach. It is the nature of their make-up. These people often operate in uncharted waters therefore they are tuned to working without maps and processes. The resistance they pose comes from premise that they believe the change will not work or that it is ill-conceived. These people are more or less in agreement with need for change but have doubts as to the directions.

When processes seem to be fairly visible you can bring in the bureaucrats. Till such time, bureaucrats are better assigned to working the established lines of business creating window for change.

Some times mistakes happen when we are not looking. 

For example, during the change process if the finance department is fairly tightly controlled by bureaucrats then change is doomed. Expect tough fight for budget sanction and deviation to be questioned seriously. To avoid this, it is better to sandbox the venture.

OR

Another mistake occurs when scouts are left in charge of process formulation. Scouts are absolute worst with this job. They lose interest pretty quickly and resulting process are a mess - a bureaucrat's nightmare. The venture with successful proof of concept goes down the drain as bureaucrats are unable to replicate the success of the commandos.

OR

When change-makers make the change they leave the process formulation to other commandos who may not have bought into the concept of change. It is important that process formulation is done by commando team which has completely bought into the concept of change and/or feels confident enough to make necessary changes in the course of action.

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