Yeah! On Brexit!

Yeah Brexit is a reality! Signifies a few things:

1. Politicians have misused / abused the Brexit debate
1. The political and ruling classes are disconnected from the realities faced by the worker class. A sort of marxist dream has come true. Not only can't the politicians talk reasonably with the masses but they also don't seem to care. John Mauldin highlighted Peggy Noonan's protected v/s unprotected rationale - it is playing out now. Necessary corollary - we might be looking at a Trump victory.
2. A sub-set of the worker class problem is the migrant issue. The migrants coming into do have a group of anti-community / anti-EU society that has entered EU creating social tension. While, most of the migrants are male - a statistic that is queer for war-related migration. I would have thought it should be more women and children (as per UN 62% of all migrants out of 800,000 that have traveled to Europe in 2015 are men). 
3. Sadly, this has confused the domestic worker class about rational economic threat to their incomes and political threat to safety and well being. The first is short term set-back but results in long term prosperity. The second is a bit scary. The pro-Brexit vote is more because of second than first.
2. Media hasn't done its bit to inform the average person.
1. Media's lack of responsibility since the crisis has been alarming. But the polarised opinion on Brexit put up by media are disappointing. 
2. The irrational rabble rousing has overwhelmed the thoughtful assessments and complexity of the issues has been trivialised. 
3. Common people in developed countries are going to loose
1. The discrepancy between easy capital mobility and difficult labour mobility affects the working class. If left unresolved, we will end up with capital controls. (Yeah it is a long way away but we are on that road). Alternatively, we can hope that labour mobility will ease up and people will realise their folly. 
4. Our lack of understanding of economics has come to haunt us.
1. Currently, only low income-low skilled people from under-developed countries want to migrate to developed countries because these people are squeezed to be producers in their own country. Similarly, the developed country people are tickled into consuming more than they can afford so that the status quo continues. The developed world citizens do not want to impair their life-style by migrating to developing countries. (That is because developing countries make it difficult to get the same life-style as developed countries - I mean in terms of law and order and quality of education etc.). This one-way traffic had to stop some time.
2. With cheap capital, replacing a low-skill worker by expensive robots is feasible. This pains the working class no end. These people are caught between rock and hard place. They are being forced to go down to low-skill but on-site jobs. (the famous McJobs!)
3. It is this anxiety that has been exploited for Brexit. So part of the blame goes to the economist and finance experts too. These are the very people who look shocked at Brexit vote.

After Brexit what next?

1. In an age of increasing inter-connectedness a Brexit vote is first step trying to reverse the globalisation. There are reasons why anti-globalisation forces have followers - I wrote about this messy intermediate globalised system that is straining the worker class. But advantage really lies in globalisation and not protectionism.
2. Unfortunately, the competitive raising of protectionist barriers will only increase. Marine Le Pen is demanding referendum for France. The northern EU members and Germany will soon be left looking stupid. So instead of PIGS defaulting and exiting - non-PIGS will drop off the union.
3. The war on globalisation had to fought on "sovereignty" issue. It is a political war connected with Swiss bank hidden wealth, Tax havens and other "loop holes". 
4. Once successful politically, these initiatives will turn on economic policy. The good work of integrating the world will be undone by economic and fiscal policies. 

Brexit will be a slow poison

The consequences of Brexit are far more dangerous but they will take time to play out. That means markets and asset prices will remain volatile. Consequently, long term investment in future shall remain the exclusive domain of governments. Add to this the renewed focus on austerity - 1937 looms all over again.

So it is said - may you live in interesting times.

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Buy my books "Subverting Capitalism & Democracy" and "Understanding Firms". 

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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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.

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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.

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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. 

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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.

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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!

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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. 

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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.

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Banking and the Post Office

Yves Smith blogged about post office providing banking services. Here is my take on it.

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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.

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Money Supply and GDP growth

Here is a chart I made showing money supply v/s GDP growth of top 4 developed economies. Tell me what do you think about this.

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The globalization puzzle

Dani Rodrick has an interesting post about globalization here : http://blogs.lse.ac.uk/politicsandpolicy/archives/38743

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. 

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NIFTY in 2013 chart

The Nifty over in 2013 did something expected - it did three peak- two troughs ~ 2.5 cycles in one year as shown in the chart below.

NIFTY over 2013 calendar (Bloomberg.com)

Following are the interesting points to note:

Firstly, the amplitude of the first cycle is smaller than second cycle. I see this increasing over the next year. Thus, in 2014, Nifty will have at least 2.5 cycles each with amplitude at least as much as the second cycle of 2013. It means a lot of volatility which is positive or negative depending on how you look at it.

Secondly, the time between the two cycles is quite small and there was a muted volatility (bearish lull between End Jan to Mid April and bullish lull between end oct to Dec). I see this muted periods getting compressed. In effect we may have crudely speaking one more cycle in 2014.

Thirdly, if you see the underlying macro/micro data it has generally worsened over this period though we are near to all time highs. It is quite parallel to US equity markets.

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