Riding on Fizz...

Indian stock market has outperformed practically every other market in the world in 2012. This is not very surprising. India was among the worst performing markets in 2011 and relief rally has seen many beaten sectors/stocks recover some of the lost ground.

The surprising part is the speed of the rally, failure of most of the big players to spot it well in time and the relative paucity of good explanations on why India is suddenly booming. Most of the people I speak to are just dumbfounded. Barely 8 weeks ago, the India story had gone bust, the infrastructure sector had caved in, power plants did not have fuel, policy didn’t have direction and government didn’t have the tenacity needed to stand up and deliver. The question is, what has changed in a month or two?

The sad part is, nothing. Fundamentally, we are exactly where we used to be. To the extent that behind the veneer of a booming stock market and a massive inflow of portfolio dollars, even the liquidity situation is as tight as November, prompting hints from the RBI on another CRR cut. Falling car sales, slowing tractor and durable goods sales in the rural sector, ballooning real estate inventory; all the elements are the same as before.

This leaves few explanations for the ongoing rally. One of the plausible few is the fresh glut of liquidity in the wake of the Greece crisis. Equities worldwide have gone up as a result and India has received a good chunk of the money. The precipitous fall of the rupee last year provided an added incentive. Strong defense of the currency by RBI and past experience would have convinced many that rupee weakness was unlikely to last for a long time. Stocks looking doubly cheap on a dollar basis would have added to the temptation. Indeed, if you invested in dollar terms in December, you would have already made a 16% on the stocks and another 16 on the currency, quite an unbeatable package.

But where do we go from here?  The answer is not very clear. Once again, my bet is on commodities. Stock markets across the world may be rising, but their ability to absorb the excess liquidity is going to be limited due to poor fundamentals. Bond yields are also likely to continue to stay low globally (and high in India, more on that later). It is very likely that a good chunk of liquidity will flood commodities, causing an upward spiral all over again.

This does not augur well for the Indian market. High commodity prices, particularly oil, will further worsen the fundamentals. Coupled with Government’s inability to implement policy reforms (we have not even been able to sort out whether luxury cars should get a fat diesel subsidy or should finally bear the cost of fiscal and environmental damage they do), this will only worsen the pressures the economy is facing. The market is currently riding on fizz and it is hard to tell how long the fizz will last.

Government Debt and the Role of RBI… Back to the Future?

Governor D Subbarao’s musings about government debt and need for a cap on borrowing hark back to an era that we have almost forgotten in India. Not so long ago (say, till late 1990s), the primary role RBI played in balancing monetary policy was managing the government’s borrowing needs against the monetary needs of the economy.

Government borrowing in India has historically crowded out the private sector, there is nothing new about it. Till late 1990s, the traditional monetary policy tools were more or less ineffective due to this. For the banking sector, the primary tool RBI deployed was 90 and 180 day T-bills. Banks were more or less relying on their T-bill purchases to meet their reserve requirements on every reporting Friday. The catch? RBI used to measure their reserve adequacy only on reporting Fridays and the bills could be discounted freely by the banks. The highlight of this policy setting was that more than 99% of the T-bills bought by banks were discounted the following Monday. In essence, banks were keeping their funds in T-bills for only a few hours over the entire fortnight for which the reserves supposed to be maintained.

Bank rate, similarly, continued to be totally ineffective tool for a long period of time. Banks could technically borrow from RBI at the bank rate, but only to the extent of a small fraction of their incremental deposits, in effect making the bank rate practically useless for managing monetary policy or interest rates in the economy.

This situation prevailed primarily because the RBI was tasked with managing government’s debt requirements. Thus, whatever deposits the banks raised, a large chunk of that went into government bonds as the SLR component. In a cash starved economy, it meant that there was little liquidity left in the system for the private sector and banks. The result, a farcical situation in which banks needed to game the system to meet the liquidity needs and RBI did not have choice but to turn a blind eye to it.

The situation changed dramatically in the 2000’s. Falling fiscal deficit, rising growth rates and flood of global money meant that India was suddenly had a deluge of liquidity. Private sector could access capital internationally at far more competitive rates. Liquidity started chasing yields, which meant government bonds became attractive and banks started keeping more money in gilts than SLR required. With this flexibility, RBI, perhaps for the first time, gained true control of monetary policy and its tools gained a true bite.

All this can change dramatically again, if the government allows the current fiscal mess to continue and its borrowing needs start crowding out the private sector. And many signs are pointing in that direction. International money is no longer flooding India the way it was in the middle of the decade, borrowing internationally is becoming more difficult and costly, and RBI is forced to tighten domestic liquidity due to inflation concerns. Though the situation has eased somewhat with January inflow of portfolio dollars, it is the only source of liquidity at the moment and its drying up could suddenly lead to a drought of money.

In this situation, RBI could find itself in the same dilemma again. In a tight liquidity situation, government borrowing will start crowding out the private sector. Interest rates, in that case, would be driven more by the ‘going rate’, rather than tightly controlled by the RBI. Hence, the comment by the governor assumes significance.  

What does it mean for the markets? One key factor to keep in mind is that if liquidity starts drying up again, the assumption that interest rates will fall no longer holds true. RBI will be hard pressed to inject liquidity into the system but will be constrained by inflation rearing its head again. Token rates may fall, but with no money available at those rates, private sector will be forced to borrow at whatever rates money is available. Not a great situation when most of the sectors are reeling under less than stellar outlook and growth has started hurting. The only hope lies in the government being able to manage its finances better and letting the economy be.

Rising Support for Yuan as a Reserve Currency

CHINA VS. INDIA

More than one year ago, I had written on this blog regarding the global ambitions of China; in particular its push to get Yuan accepted as international reserve currency (Of Triffin's Dilemma and China's Ambition , April 6, 2009). Since then, things have moved slowly, but almost surely in favor of this move. The latest voice to be added to this growing 'movement' is that of Asian Development Bank, which released a report this Thursday suggesting Yuan 'has the potential' to become an alternative to the US dollar (Yuan can become alternative reserve currency to US dollar-ADB).

At this point, it is not known how long it will take for the Yuan to "internationalize". That is irrelevant. What matters is the reality of China becoming more and more important in the international financial system and its implications.

China has emerged as a stabilizing force over past 18 months in the aftermath of the global financial crisis. It has done favors and most likely would have been promised rewards in return. Furthermore, China's continued cooperation is important for the world to avoid lurching back into the deep, black hole that was barely missed about 18 months ago. In other words, the timing is just right for the dragon to stake its claim to its rightful place in the world.

That brings us to the next question: what is dragon's rightful place in the world? That question gets answers as diverse as the 'color depth numbers' on the latest LED TV models; right across the spectrum. There are those who just can't stop loving China, staking everything on its economic juggernaut. There are those who just can't help being skeptics. Then there is the newer, emerging view that China is just like Japan in the late '80s; overrated, but just a spent force about to go belly up.

Truth is likely to stranger than all these punts. Punts they are because it is hard to know China despite all those 'research dollars' being thrown at it by consulting firms, investment banks and brokerage houses, trying to make sense of the puzzle that China is. Instead of relying on these 'house views' and 'in-depth studies', it is better to simply look at the growth curve of country and something rather simple: human behavior.

And the human behavior dictates that the internal consumption story in China has not even woken up yet to its full potential. Per capita GDP numbers hide a vast gulf of disparity between China's elite and its have nots. The have nots have kept quiet so far due to the ability of the system to deliver and the system has been delivering. Why should they put their faith in anything else? As soon as their turn comes, an army of consumers will rise. There is nothing to stop them.

There is a historical precedent to it as well. Much to the chagrin of purists, the US of A provides the prime example of an economy in transformation; exactly one hundred years ago. The economy had just been finding its feet after a 50-year growth run with per capita incomes of about $5000 in today's terms (about $1000 higher than today's China, but then you can't be exact about this stuff). What happened after that is anybody's guess. Runaway growth, wild capitalism, rampant bull runs; only to be tempered by a Wall Street crash and global depression twenty years later.

Folks, the dragon has barely begun. More on this later.

Ciao. And apologies for disappearing for so long.

Why We Need a Stop Loss

TRADING PSYCHOLOGY

My favorite piece from Zen literature.

Master Caotang Qing said:

    The fire that burns a meadow starts from a little flame, the river that erodes a mountain starts drop by drop. A little bit of water can be blocked by a load of earth, but when there is a lot of water it can uproot trees, dislodge boulders and wash away hills. A little bit of fire can be extinguished by a cup of water, but when there is a lot of fire, it burns cities, towns and mountain forests….

When people of old governed their minds, they stopped their thoughts before they came up… Therefore the energy they used was very little while the accomplishment they reaped was very great.

- Zen Lessons, translated by Thomas Cleary, Shambhala Books, Boston

I don't think I can say it any better than the Master said. So I will just shut my trap and let you meditate on it.

Confirmation pouring in: We are in the middle of a commodities boom and a dollar flood

GLOBAL ECONOMY; GLOBAL MARKETS

I did not expect confirmation of my yesterday's views so early. Of late, confirmation has generally been arriving pretty soon for what I have been observing. On NIFTY breakthrough (Violent and Brief), it took the market barely one day to cross the long held resistance.

There is sporadic evidence emerging for the hypotheses I proposed yesterday (Recovery : Final Confirmation, Twin Deficits and Rising Inflation). Broadly, my argument is on the following lines.

• Recovery in the West has been underway for some time and now we are seeing final confirmation of the same.
  
• At the same time, this confirmation is of little use, mainly because what brought the recovery is going to be a massive drag from here on.
  
• The large US budget deficit is also going to create a massive trade deficit. This means:
  
  • Higher purchases of US treasuries by foreign governments; this will fail to absorb the entire trade deficit.
    
  • Additional dollar supply flooding the market; since there is no penalty for the US for letting the world slosh in its money. Exactly one year ago, I was ranting about the same thing and why China and even EU want piece of the action (Of Triffin's Dilemma and China's Ambition). It is funny how an old rant can seem new sometimes.
    
  • Commodities on fire; the dollar flood is going to simply push commodity prices out of the stratosphere.
    

A cursory glance at Bloomberg page today brings the following news.

Rise in Treasury Yields Slowed as Currency Reserves Grow Fastest Since '08

Oil Surges to 17-Month High on Signs of U.S. Economic Growth

Copper Advances to Highest Level Since August 2008 on Recovery

Financial journalism tends to put a spin on everything. Right now the spin is 'recovery'. Well, there is another explanation that is far simpler; dollar flood. And then there is the Euro flood that is almost as big. And then, there is the Pound flood that is the biggest of all in relative terms (just measure the relative sizes of the budget deficits to the economies). The "gainers" of this not-so-hard earned money, on the other side, are also easy to identify. Export powerhouses like China (who incidentally refuses to let the currency appreciate) and commodity dependent economies. Japanese yen is around 93 (you can bet the Japanese are not very happy about it but will keep quiet because it will rise to probably sub-80 levels if they let it go free), Australian dollar is heading towards parity again and Brazilian Real is at 1.76. The evidence is all over the place.

To avoid confirmation bias, am still looking for that one bit of contradicting news which can disprove the hypotheses. If you come across something, please do throw it in.

Recovery : Final Confirmation, Twin Deficits and Rising Inflation

INDIAN MARKETS; GLOBAL MARKETS

Much has been made of the recent job growth numbers out of the US. They are a very positive sign of course. But what does it augur from markets' point of view?

Not very much, not at least from the US markets' perspective. Here is why. In any typical recovery, most of the indicators start registering a positive long before growth starts showing up in job numbers. As an indicator, growth in jobs is probably the one that lags the farthest behind. The reason is not difficult to see, no matter how rosy the outlook starts becoming, you will always want to check twice before you add those extra workers to your payroll. If you have any doubt, you will most likely opt for paying overtime or other such temporary measure.

Hence, the value of the indicator is in confirming that a recovery has actually taken place. Yes, it makes not a very convincing confirmation since the number has been positive only twice. But if you are waiting for further confirmation, you are already way behind the curve.

It does not augur necessarily well for the US stock markets. Much of the move has already happened and there are major challenges going forward. The toxic assets that caused the problem in the first place are still stuck somewhere in the system. The large stimulus, even though it drove the recovery, is going to be a major drag in the form of fiscal deficit in the US.

For emerging markets, there are many positives though, particularly for India. India came out of the shock with relatively little 'stimulus' and whatever has been provided has been rolled back. Fiscal position is looking good. Hence, the growth is solid. Furthermore, even financing crunch (due to lack of liquidity) is likely to ease, as explained below. All looks well for Indian market, except that inflation is going to be a complete pain.

Rising liquidity

Huge budget deficit in the US is going to drive a huge trade deficit too (they are two sides of an equation, no matter how much hot air US policy makers blow, there is no way you can eliminate one without eliminating the other). Which means the world is going to get inundated in dollars too. Whether you like it or not, a dollar flood with continuously falling interest rates is inevitable over next one year. Some of it will go back to the US as Central Banks buy US treasuries, some of it will simply be funded by excess money supply. Such is the prerogative of those supplying the reserve currency of the world.

Commodities again

No turning back the commodity inflation cycle from here. Once again, the rollicking days of ever rising commodity prices are here. That is likely to be the situation for next one year. If you bought some of those metal stocks here when they were going cheap, you are going to be rich pretty soon! Jokes apart, we are looking at a repeat of the late '70s here, nothing less.

Violent and Brief

INDIAN MARKET

So we did have a dip from the 5300 levels afterall (Waiting for the Breakthrough) on the NIFTY. Nothing very surprising there. The market has bounced back from its minor correction (if you want to call it that). We are back on the gates of the 'zone de résistance' and things might get stuck here again.

Or they might not. I do not know whether the bearish side of the market has had its fill of adventure or not. If not, we will see another skirmish. But at some stage (possibly in this very move), the zone is likely to be overrun.

And it is likely to be overrun in a big way. This is not the first time that this level is working as a major resistance. Post the Lehman dip, this level has alwathings might get stuck here again.

Or they might not. I do not know whether the bearish side of the market has had its fill of adventure or not. If not, we will see another skirmish. But at some stage (possibly in this very move), the zone is likely to be overrun.

And it is likely to be overrun in a big way. This is not the first time that this level is working as a major resistance. Post the Lehman dip, this level has always held. It was not broken during the post election rally, held out once again against medium term trend and is proving tough to breach for the medium term trend move.

The strong resistance means that a break is likely to be fairly forceful and swift when it happens. There is a lot of pressure built up that is likely to be released when the breach comes. All the doubtful bulls sitting on the sidelines will jump in at the sight of a convincing breach and that will make the move quite sudden.

For those salivating at the thought of making a quick buck in the move, here is a sobering thought. Given that a large chunk of the market is now dominated by robo-trades, there is no way exact timing of the move can be predicted. Going aggressively long has its risks, as you can get caught in the 'sucker bet' downmove generated by automatic algorithms. At the same time, there is no telling when the market may make a sudden breakout. In all likelihood, it is going to be a very violent affair, and a very brief one. Given the nature of trading in the market, it may be over before you can say "gotcha!!!"