Words ought to be a little wild, for they are the assault of thoughts on the unthinking
- J.M. Keynes

Monday, 29 April 2013

The European Exuberance Conundrum

The Euro and European sovereign bond yields continue to bemuse. The headlines are by and large negative but the inexorable hopium-fueled climb continues. Apart from cheap money, the three shots of hopium being imbibed at present in Europe seem to be:
  1. Italy has formed a “reform minded” technocratic government
  2. The doctrine of austerity has been dealt a blow allowing growth oriented policies to be put in place
  3. Even if all else fails, the ECB won’t
It would be great were these true. Alas, hope springs eternal.

Italy and “reform”
Italian politicians failed to decide on a president and backroom political machinations led to a “technocratic” government, i.e. a government of vested interests, by vested interests and for vested interests. Investors hoping for deliverance (and smoking the Economist’s hopium are likely to be disappointed). First, this is a government formed not to reform but to perpetuate the power of the elite by excluding the mavericks of the 5-star movement. As Greece and the coalition led by New Democracy has shown, it only succeeds in kicking the can down the road. Unfortunately, Italy is not Greece and it would be extremely costly to perpetuate the charade. Second, this is not the elected Romano Prodi government of 1996-98 which committed the original sin of reforming just enough but no more to get Italy into the Euro. Third, the present situation is far removed from the success of 1996-98. Those reforms were made when the global economy was in a phase of “irrational exuberance” unlike the current comatose state with central bank life-support. Moreover, the public wanted to join the Euro which provided impetus to Prodi’s reforms. Now the reforms which investors and austerians wish to foist onto Italy are deeply unpopular. Political trouble looms even as investors decide that 4% for ten years is more than adequate for this leveraged super senior Eurozone tranche.

Less austerity, more growth
The increasing pushback against austerity shows that realisation has finally dawned, perhaps too late just like the Titanic’s order of full-speed astern. First it is still mostly the southern Europeans making the case to an unyielding Germany. Second, it is highly doubtful that the dosage of austerity will be meaningfully reduced especially before the German election. Third, data from northern Europe points to weakening economies. Unemployment went up to 6.4% in recessionary Netherlands, it is also increasing in the moribund Finnish economy and even the mighty German engine is sputtering as shown by contractionary PMI data. Recessionary times seldom lead to acts of generosity especially from the morally righteous who believe in austerity. Fear of meltdown will ensure adjustment periods are lengthened and loan terms extended but southern Europeans looking for fiscal support may have better luck finding that pot of gold at the end of the rainbow.

The ECB put
The bazooka keeping the vigilantes at bay is the OMT, a policy of great advantage but no one to know what it is since the ECB refuses to publish details. This certainly helps in dealing with the German Constitutional Court challenge. After all, how can OMT be illegal when there are no details to judge upon? The true details if and when published are likely to disappoint since investors are presuming that OMT is fiscal support through the monetary backdoor. More likely it is the old, failed SMP with a new name since anything aggressive will be immediately challenged judicially and politically. Remember the famous promise of “breaking the vicious sovereign-bank loop” through direct ESM capitalisation of Spanish banks without burdening the sovereign?

The props are hollow and the probability of a cataclysm keeps increasing as Europe stagnates and drifts apart. Even as North and South blame each other, southern Europe continues to deteriorate with unemployment rising to record levels (Spain and Greece both at 27.2% with youth unemployment around 60%). Worse, the number of unemployed is the highest since records began for the “core” economy that must not be named for it cannot be ESMed and OMTed (Hint: Its 10-year bonds yield 1.75% given the "strength" of the economy - 2012 GDP growth was 0%, deficit was 4.8% and debt-GDP north of 90%).

Low growth and high unemployment, especially youth unemployment, are key ingredients for social upheaval. Further there has been a massive increase in distrust of a dithering and out-of-touch EU in the six largest EU economies (4 largest Eurozone ones). More than half the people in Germany (59%), France (56%), Italy (53%) and Spain (72%) tend not to trust theEU as an institution. This is manifesting itself through populist, Eurosceptic and/or extremist political movements which further reduce the scope for compromise between elected national governments.  

The die seems to have been cast but ignored due to hope, fear of missing out and the accompanying perennial belief of getting out in time.

Monday, 8 April 2013

Indian Stocks: The FII Optimism Puzzle

It is fairly well known that the Indian stock market is driven by foreign investment where FIIs have created their own reality by blindly buying into the “India” story (apoint I made earlier this year). Graph-1 illustrates this quite nicely.

Graph-1: FIIs boldly rush in
Source: www.nseindia.com, www.indiainfoline.com, Author’s calculations

Prior to the sub-prime financial crisis, domestic investors had caught the equity bug but now they seem to have developed immunity as graph-2 shows. From a high of 408bn Rupees, domestic mutual fund investment is now -154bn, i.e. domestic investors have withdrawn more than they put into the market since 2006. In the same time period FIIs have put in 4,536bn Rupees.

Graph-2: Domestic investors not impressed by the cult of equity
Source: www.nseindia.com, www.indiainfoline.com, Author’s calculations

Apart from their traditional reluctance to engage in an insider’s game, Indian retail investors may probably be looking through the money illusion. Real returns from the stock market have been negative (Graph-3). Since 2006 beginning, investors have lost 14% on a total return basis with the index down 20% in real terms.

Graph-3: Indian equities don’t seem to be an inflation hedge

The strange element in the story is that returns for FIIs measured in US Dollars are worse. The total return index in Dollar terms is back to end-August 2007 levels and down a third (33%) from the peak in beginning of 2008. The index itself is down 37% from the peak (Graph-4).

Graph-4: The bold rush hasn’t panned out
Source: www.nseindia.com, www.oanda.com, Author’s calculations

Therefore the question comes up again: What is the basis of FII optimism? Is it because of belief in:
  1. BRICs - Since the developed world isn’t looking too great it’s better to roll the die in EM where growth potential is higher (but GDP growth and stock market performance are weakly correlated)
  2. Indian version of the ‘great rotation’ - It is only a matter of time before domestic investors flock in (but what would change decades of habit especially in the face of poor performance?)
  3. RBI rate cut "magic" - Just as the Greenspan-Bernanke Fed supports equity markets with easy money, so too can Subbarao (but the structural factors of the two economies are quite different)
None of the three reasons is compelling but the fact is that money continues to roll in (helpfully funding the current account deficit). It’ll be interesting to see how this unfolds.

Friday, 5 April 2013

Rahul Gandhi's Inspirational Speech to CII

Reading news articles about the great Mr. Rahul Gandhi’s speech to CII one might think that one was reading the Onion or The Daily Mash. The quotes were so deep and meaningful that they could not have been made by a real person. But amazingly they were and the entire speech is well worth watching (video embedded at the end).  

Mr. Gandhi’s opening was brilliant. One never knew that 100-200 years ago India was not a nation but energy. Highly cerebral, Rahul Gandhi must have been making a deep comment about Einsteinian mass-energy equivalence applied to the Indian landmass. But such genius can cause confusion especially in lesser minds when it goes on to equate energy to force. Middle school children with average intellect know that energy and force are very different and may even have committed lèse-majesté by reminding him of the two basic formulae: Force = Mass x Acceleration (Newton’s second law) and Energy = Force x Distance. Thankfully there were no children in the audience to impertinently shout that the emperor knows no science.

After such an opening nothing less was expected of such a master orator than his subliminal reminder that the entire basis of his appeal and power lie in the past. His great-grandfather may have built temples of modern India but according to Mr. Gandhi hydel-power projects were already in existence 1000-2000 years ago on the Ganga, Yamuna and Saraswati. It is outrageous that no history book mentions these startling facts. Moreover, the experts are clearly off by at least 2000 years about Saraswati drying out between 3000-2000 BC (For instance this baseless report from what can only be a third rate source: http://news.bbc.co.uk/1/hi/world/south_asia/2073159.stm).

He continued the high level of the discourse by making a cracking analogy about the enormous amount of undeclared money being moved to havens abroad. It is worth reading in original: “We have built structures which are allowing this energy to rise, to explode…as this energy moves from India and goes abroad, you are the cutting edge, you are the people on the first line and you are the people who are our ambassadors and you are the people to tell the world what this energy is all about”

What is amazing is the fact that all of this wasn’t even part of the formal speech. The actual speech began with: “It was a dark night some years ago when my team and I got into Gorakhpur Lokmanya Tilak Express and travelled across India’s heartland”. Critics may carp that it is not quite in the same class as “Long years ago, we made a tryst with destiny” but one has to make allowances for the audience.

As he started on his narrative, disaster struck. Somebody forgot the canned laughter when he made this hilarious joke: “…moving from the dust of Gorakhpur to the glitter of Mumbai. It took us 36 hours. It’s called an express.” He couldn’t hide his disappointment at the pin-drop silence but still continued bravely.

He then took about five minutes to carefully state the fact that Indians are optimistic. Lesser men take it as an obvious fact but that is purely their intellectual sloppiness. This talk of optimism made him suddenly return to the scientific theme he started out with. “Democracy and technology have triggered a non-reversible chain reaction in India.” Such striking analogies are as rare as reversible chain reactions. He stressed that “This reaction is now unstoppable”. And for the idiots in the audience he reiterated “Nobody can stop it”. It shows great magnanimity to lower one’s genius to the intellectual level of one’s audience.

Since great minds mix metaphors, he cleverly juxtaposed a tidal wave onto a chain reaction. “We are now sitting on an unstoppable tide of human aspiration, a tide so great that it is going to move forwards regardless of what we do.”
“But for this massive movement of people and ideas to be truly transformational we need to nurture it. We need to make it harmonious. We need to make it happen smoothly. We need to use the energy generated by this movement of people and ideas, the force that this movement is generating and we need to use it to empower everybody. Not one person, not almost everybody but everybody.” What a master rhetorician!

He inspired people to “provide the roads on which our dreams are paved”. The startling admission that “government cannot build this infrastructure alone. We are incapable of doing it alone. We need your help” was an inspirational break from Nehruvian tradition and a complete abdication of responsibility. He clearly is his own man. Critics may carp pointing at the economics of PPP (Public-Private Partnership) projects and the patchy experience of other nations but they clearly don’t grasp the intricacies of economics and finance as Mr. Gandhi does.

It was delightful to note that realisation finally dawned after 60 years of governing that “our problem is not joblessness, it is a lack of training and skills”. Since it was Mr. Gandhi and not some party apparatchik stating the obvious this could not have been the usual lip service to expansion of educational access and modernisation of the curriculum. Later in the speech he appreciated Kapil Sibal’s pioneering work in the area by stating “Let’s stop wondering how many colleges can we build and let’s start discussing what we can do so that the very idea of a college, the very idea of a university is transformed.”

After inspiring with his visions of optimistic and aspirational Indians, he became serious and thoughtful. He revealed the biggest danger the country faced and what kept him awake at night was “excluding people”. How true! Who wouldn’t like to be involved in those highly profitable land deals in Haryana and those concessionary loans from large building companies? He said “a rising tide doesn’t raise people who don’t have a boat”. What a great man. John F Kennedy must be weeping with envy at this witty turn of phrase. And what concern he showed for those outside his "ACeed" court who can’t visit the Riviera in their own boat.

Unfortunately the inspirational speech was taken off-track by quasi-corporate waffle about a “rights based paradigm”. It must have been the speechwriter’s sop to the corporate audience. It was clear that Mr. Gandhi didn’t much care for it since he skipped over the part only to lose his place on the written document. While fumbling to find his place he said he wanted “to go back to the women”. The faithless might have mistaken it to be a cry for help to Sonia and Priyanka Gandhi but it was the beginning of the next anecdote. Once he found his place and composure he again launched into his deep intellectualism. “The work they [Indian women] do right now as we sit here in this nice ACeed hall, they are building not only our boats but they are the waves”. Explaining the deep philosophical meaning of the statement is beyond the scope of this article.

The final minutes were a masterful performance in stream-of-consciousness speech. A couple of nuggets should suffice to showcase to the reader this intelligence beyond the ordinary:
“Our economic vision must be about more than money. It must be about compassion” – A bold and daring vision to go beyond the narrow definition of “economic”
“Inclusive growth is a win-win for everybody” – A tautological masterpiece

In the end one was left wondering whether one “incremental” vote would be enough for this “exponential thinking” leader.

Thursday, 4 April 2013

Stock Markets During Quantitative Easings - A Historical Parallel for QEasy Investors

In an era of “quantitative and qualitative” monetary easing, how do stock markets behave?

History may provide a lesson. Let’s look at the German experience post World War I when the circulation of the Reichsbank (monetary base) tripled in two years from 1918 to 1919 and went up ten-fold by 1921-end. Compared to Rudolf von Havenstein, Kuroda’s aims of doubling the monetary base are certainly more humble. And Ben Bernanke seems to be a paragon of tight monetary policy with M1 in the US increasing by only 78% since beginning of 2008.
The graph below shows that the real performance of German stocks was enormously different from their nominal performance which tracked the growth in money supply quite closely (The pundits who tout the ‘wealth effect’ should take note). While in nominal terms the index had returned in excess of 10 billion percent from 1918 to 1923, in real terms and in dollar adjusted terms it had lost almost 70% of its value.

The stock market was subject to considerable gyrations leading to fortunes being made and lost. Even though the present environment is currently deflationary, the rhymes of history lead to some startling observations. It is best to read some illuminating excerpts from Constantino Bresciani-Turroni’s masterful exposition of the German hyperinflationary episode (all emphasis mine, except where indicated):

…gradually the internal situation improved and a social revolution seemed more and more improbable. Also, towards the end of 1919 and in the beginning of 1920, the depreciation of the mark had given a strong stimulus to exports; the wheels of industry began to move round again, and the number of unemployed rapidly decreased.

The public once more began to have confidence in shares. Also, having learned from the very rapid depreciation suffered by…all securities with a fixed yield – the public began to consider shares as the representatives of an “intrinsic” value…whose price in paper marks must increase when the German exchange depreciated.

As the depreciation of the mark proceeded, this phenomenon began to be understood by the public, who, for a long time, assured by official explanations, had attributed the decline in the purchasing power of the paper mark, not to the continuance of note-issues, but to the rise in prices caused by the war, the revolution, and the economic crisis. The public now saw that the paper mark could no longer fulfil the function of the "store of value." In 1919 there began that speculative fury which characterized the Bourse during almost the whole of the inflation period.

Because of the dearness of living which lowered real incomes, many classes of people were forced to try to supplement their incomes by speculation on the Bourse. Also industrial and commercial firms considered the purchase of shares not only as a form of investment for reserve capital, but also as a temporary use for liquid resources – a use which guaranteed the preservation of the working capital which was threatened by the continual monetary depreciation.

It was observed in Germany, as also, indeed, elsewhere, that the circle of speculators was greatly enlarged. Shares were held by speculators in a much larger measure than formerly, when they were for the most part had been held longer by investors, who considered them as permanent investments.

Owing to the close connection between the dollar exchange rate and the prices of industrial shares, which was established in 1920 and 1921, the prices of securities had ceased to be the barometer of the general political and economic situation. Political events…had scarcely any influence on share prices, and what effect they did have often was exactly the opposite to what would have been expected under normal conditions. Events which were unfavourable to Germany, by causing a fresh depreciation of the mark, indirectly caused a rise in the prices of industrial securities.

After the ominous “black Thursday” (December 1st 1921) the public, badly hit by the fall of share prices, realised that not even the purchase of shares was a safe means of investing their savings. Until then many believed that the risk of buying shares was less…because they were able to judge more easily the conditions of this or that industry, rather than the whole political situation…

But another cause even more potent helped to depress still further the prices of industrial securities, and that was the alteration in the conditions of the money market. During the whole of 1921…[there was] an abundance of money in the market. But in 1922 a scarcity in the means of payment began to be felt…Deposits in the banks diminished rapidly…that obliged the banks to restrict credit. The new taxes, approved in the spring of 1922, helped to limit the liquid resources of industry.

Several other causes, besides the conditions of the money market, helped to depress the prices of industrial shares. Already in the spring of 1922 the Bourse began to discount the approaching end of the period of relative prosperity of German industry, which had begun with the depreciation of the mark and with the establishment of a great divergence between the internal value and the international value of the German currency. It was realized that the artificial stimulus given to German industry by the continuous increases in the foreign exchange rates could not act indefinitely.

It is certain that a great lack of confidence spread among the German people in the summer of 1922…Abroad for a long time the conviction was held – and manifested in the purchases of fabulous sums of paper marks – that the German economy would be rapidly revived. But in the summer of 1922 even foreign confidence…was at last shaken, after the collapse of the mark…

Together with the lack of confidence in the political and economic situation of Germany, the low income from shares certainly helped to keep the prices of them low during 1922.

Also the “invisible mortgage” weighing on German industry because of the payment of reparations contributed to the uncertainty of the future income from shares. It was known that in the end German industry would have to adapt itself to bearing its share of the burden. [Public debt and unfunded liabilities of government today can be considered akin to reparations that Germany was expected to pay]

Towards the end of October and at the beginning of November 1922 the situation in the money market once more changed rapidly. The rise in price of shares…was closely connected with the Foreign Exchange decree of October 12th, which fixed strict limits on the purchasing of foreign exchange. Numerous classes in whom was fixed the habit of investing their available resources in foreign exchange, could do nothing but return once more to the share market

As new decrees surrounded the purchase of foreign exchange with greater difficulties, the public bought shares, which they once more considered “real values.”

There was now no longer any curb on note-issues. The quantity of paper money increased with a continually rising rhythm…By such means certain classes of society secured an enormous amount of purchasing power, which they employed in buying shares.

In the first half of 1923 the prices of shares not only reflected the dollar exchange rate, but actually rose more rapidly than the latter…This was the first time since the war that there had been such a decided rise. And this occurred while the political situation created by the occupation of the Ruhr continued and while Germany was threatened by an economic crisis, the gravity of which was widely realized, and the onset of which was marked by the rising unemployment figures.

The paradoxical situation…is revealed in the following extract…“There have been extraordinary rises in the quotations for all shares, the chief cause being the catastrophic [original emphasis] change in the economic situation”

In the summer of 1923…The Ministry of Finance thought of changing the system of assessment and collection of taxes by putting the whole on a gold basis. The accounting of the entire economic system was thus rapidly revolutionised…The veil – thick for the majority, but transparent for the minority of shrewd people – which the inflation had cast over all economic phenomena, was now rent aside and it became apparent that the enormously inflated paper prices often signified, when reduced to terms of gold, prices much below those of 1913. And then the watchword for the securities market became: revaluation of shares, and speculation anticipated a rapid rise in quotations, which were thought to be much below the “intrinsic” worth of the shares.

The vicissitudes of share prices were the cause of heavy losses for some, and of conspicuous chance profits for others, during the inflation. The movement of share prices contributed very much to those serious displacements in the distribution of wealth which occurred during the years of the paper inflation.

And we all know what happened due to those “serious displacements”. Central bankers’ pretence of knowledge is likely taking us along the road to serfdom.