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

Thursday, 30 May 2013

Indian Stocks: The QE Surge



Having imbibed heavily at the Ben & Kuroda bar, foreign investors continue their advances towards the Indian stock market. They put $3.8bn into equities until 29th May which is just shy of the record $4.1bn put in May 2009 which caused a 28% gain that month. The results this time around have been less spectacular because unlike May 2009, the locals are happily selling to the “informed” FIIs. Then net domestic MF inflow was INR23bn (with FIIs putting INR186bn) compared to a net outflow of INR33bn now (all sold to that QEasy gentleman in the suit putting up INR207bn). The two graphs below show the disconnect between local and foreign perceptions on Indian equities.

Graph 1: India shines brighter the further away one is from it

Graph 2: Selling it to the tourists

The fact that FII flows are the prime driver of equity markets is not in doubt. However, the cause of this euphoria is certainly puzzling as I’ve stated previously. On a fundamental level, Indian stocks do not appear to be undervalued. NIFTY, the Indian stock market index, has a P/E ratio roughly around the average of the last 14 years and a dividend yield which is lower than the 14-year average (Graph 3). The macroeconomic picture is clouded by political uncertainty and instability with corruption scandals booming even as the economy stalls.

Graph 3: Assume a growth story to justify the price

The current rally seems forced also in light of the divergence between the stock market and USDINR FX rate. As graph 4 shows, recent stock market rallies were associated with INR strengthening (2006-08 and 2009-11) as FIIs piled in believing the India/BRIC/Decoupling story. Conversely, stock sell-offs were correlated to INR weakening (2008-09 and 2011-12). However around the beginning of 2012 the stock market has rallied yet the INR remains near its all-time-lows. Certainly the burgeoning current account deficit (Graph 5) doesn’t help but the inability to attract foreign investment to make up the gap through the capital account and consequent reduction in RBI’s FX reserves points to a bleaker environment ahead. Foreign investment almost regained its pre-crisis level of 5% of GDP in 2009-10 but fell to 2.7% in 2011-12.   

Graph-4: Different this time - rising stock market with falling Rupee

Graph-5: Indians love imported goods
Source: Bloomberg

Whatever reasons foreign investors have for rushing into Indian equities, at least they have no competition from the locals who foolishly seem to be despondent about their country’s outlook (Graph-6).

Graph-6: Politicians have succeeded in deflating innate Indian optimism
Source: RBI

Ben & Kuroda’s open bar may have fuelled foreign investors’ desire but it is likely to take away their performance.

Sunday, 26 May 2013

Edgar Allan Poe Markets



It has been a fairly fantastic May for those long risky assets despite the wobble in the second half of last week.
  • US, UK, German stock markets are near all-time-highs
  • European peripheral bond yields are near their recent lows and even insolvent Greece seems to be in favour
  • Junk bonds continue to eagerly sought by yield hungry investors
In short, risky asset markets are exuberant.

In contrast recent economic data doesn’t paint a picture of smooth sailing ahead:
  • US economy is limping towards a recovery and the employment situation is only slowly improving (based on jobless claims and unemployment rate). However participation rate is low which flatters the overall unemployment reduction numbers.
  • Data from Europe is disappointing with the core starting to splutter even as France and periphery sink deeper.
  • China is slowing and the much awaited instantaneous rebalancing towards domestic consumption doesn’t seem to be occurring.
  • Japan’s shock therapy is yielding undesirable results on the JGB front and mixed ones on the real economy (GDP printed higher but trade deficit widened).
The current market ebullience resonates with Edgar Allan Poe’s marvellous and macabre short story, ‘The Masque of Red Death’ (read here but be warned if you haven't read Poe before, he is not everyone’s cup of tea). Central bankers have become Prince Prospero and created a walled surreality within which the chosen few rejoice at having beaten the inevitable post-boom adjustment. Unfortunately, like Red Death, economic reality is going to gatecrash the party. Rather than chase yield, the time is to protect against an erosion of capital. The probability of survival is far greater outside of the central bank party.

Saturday, 11 May 2013

Wall Street's Back - The Anthem


Inspired from the Economist's cover
Sung to the tune of Everybody (Backstreet's Back)

Everybody, yeah
Want some QE, yeah
Everybody, yeah
Want some QE right
Wall Street's back, alright

Hey, yeah
Oh my God, we're back again
Bankers, Regulators, everybody sing
Gonna prop trade, won’t tell you how
Gotta loophole for your better regulation now, yeah

Am I To Big To Fail?
Yeah
Am I the only one?
Yeah
Am I essential?
Yeah
I want everything you have
You better give us QE now

Everybody
Yeah
Want some QE
Yeah
Everybody
Want some QE right
Wall Street’s back, alright
Alright

Now throw your caution up in the air
Chase yield around like you just don't care
If you wanna party let me hear you yell
Cuz we got it goin' on again
Yeah

Am I To Big To Fail?
Yeah
Am I the only one?
Yeah
Am I essential?
Yeah
I want everything you have
You better give us QE now

Everybody
Yeah
Want some QE
Yeah
Everybody
Want some QE right
Wall Street’s back, alright
Alright

So everybody, everywhere
Don't be afraid, don't have no fear
Ben’s gonna tell the world, make you understand
As long as there'll be money, we'll be comin' back again

Everybody, yeah
Want some QE, yeah
Everybody
Want some QE right (Want some QE right)
Wall Street’s back
Everybody (everybody)
Yeah (want some QE)
Want some QE (everybody)
Yeah (everybody want some QE)
Everybody (everybody, want some QE)
Want some QE right (everybody)

Wall Street's back, alright 
 

Thursday, 9 May 2013

Schism-o-meter: Measuring the State of European Disunion



Is Europe past the worst or is it edging closer to the cliff? Vehement arguments are made on both sides with each trumpeting data points which confirm their view of Europe’s future. The optimists latch onto any number which comes out better than expected (eg. German industrial output) while the pessimists do the opposite (eg. French industrial production). However in the din of daily data and news releases, the difficult task of constructing a larger picture from these jigsaw pieces is often left unfinished. Moreover, the task itself has been made seemingly unnecessary by the magnanimity of central banks. After all, only a fool would sit and solve jigsaws when the bar is open.

Crack central bank corps with papier-mâché bazookas have kept vigilantes at bay and convinced the market to advance without thought to what lies on the other side of the hill. To policymakers victory must seem inevitable as Italian 10-year yields have smashed through 4%, Spanish are about to follow and even Portugal has regained access to bond markets. However looking beyond the liquidity-fueled surge, internal stresses within the Eurozone are growing stronger.

These stresses which are forcing the Eurozone towards breakup can be classified into financial, economic and political. These exist in every country and intensify during recessions. They are due to the divergent outcomes for people, groups and regions in a capitalist system. It is not the size of the pie but how it is shared which results in conflict. For example, within the UK there is financial stress due to the difference in the ability of SMEs and large companies to borrow. There are also economic stresses between the more prosperous south and the less prosperous north which are captured by unemployment and growth numbers. These lead to political stresses which are reflected in support for differing policy prescriptions. In addition, some political stresses are rooted in cultural differences such as the demand for Scottish independence.

Purely the existence of stress does not imply that a country is destined for breakup since cultural and social commonalities exert a much stronger binding force. Analogous to an atom, these commonalities are the strong force keeping the atom intact over the electrostatic forces of repulsion. However, the Eurozone is not a country and there are few cultural similarities between its members, eg. Greece and Germany. It is akin to an artificially constructed unstable isotope. During the boom, stresses were reduced and the Eurozone not only stayed intact but expanded. With the advent of the financial crisis, the external integrating force has weakened even as stresses have strengthened. Thus the probability of disintegration has risen significantly. History shows that pan-European empires have crumbled with the decline of the dominant integrating power at that time. This time is not much different.

Since numbers captivate more than words, a Schism-o-meter can be designed to measure the internal stress within the Eurozone1. Financial stress can be measured by the divergence in borrowing cost to households, companies and sovereigns. Economic stress can be measured by looking at the divergence in per-capita GDP growth, employment and cost of living (inflation). Unfortunately, political stress is not as amenable to quantitative capture as these two. There is no index of diplomatic bonhomie amongst nations, nor is there any reliable indicator of public sentiment. However since financial and economic stresses usually lead and manifest themselves politically, a Schism-o-meter based on these is still useful.

The graph below shows that stresses, although elevated, have reduced after Draghi’s “whatever it takes” reassurance.

Graph: Schism-o-meter points to reduced stress in Eurozone post Draghi
Source: Data from Eurostat, Author’s calculations

However, before the Nobel Prize is awarded to the ECB, it would be instructive to check what’s going on behind the headline. The improvement is mostly due to the rally in sovereign bonds which easy monetary policy has engineered. The divergence in access to funds for companies and households, except mortgage borrowing, haven’t improved (the broken transmission mechanism worrying ECB). Not surprisingly, employment outcomes are diverging across the Eurozone and so is per capita GDP (albeit slowly). Convergence of inflation outcomes might have been encouraging were low absolute levels of inflation not indicating a risk of deflationary collapse.

Although the Schism-o-meter points to elevated levels of stress, both optimists and pessimists can interpret it as they want since it provides little guidance on the future evolution of stresses. Is it a start of re-convergence or a temporary central bank hopium shot? To complete the picture it is imperative to consider the political dimension. Despite difficulties in measurement, political stresses have increased as shown by the rise of Syriza, Movimento 5-stelle, Alternative für Deutschland, etc. Moreover the sniping between North and South has increased with cracks appearing even in the much vaunted Franco-German partnership. Ultimately, as happens so often in life, one has to move beyond data and reach a subjective assessment. For the Eurozone one gets a sense that Draghi et al. are singing ‘Solidarity Forever’ even as the stage starts to sway.

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Footnote:
1. Schism-o-meter is an average of the linear combination of coefficients of variation (rebased to 100 on Jan-2003) for (1) Annual percentage rate of charge on consumer loans to households (2) Annual percentage rate of charge on housing loans to households (3) Annualised agreed percentage rate on total new business loans to non-financial corporations (4) EMU convergence criteria bond yields (5) Seasonally adjusted quarterly GDP per capita (6) Unemployment rate (7) All items HICP 12 month moving average. (1) – (4) are weighted by national GDP while (6) & (7) are weighted by population. This ensures that divergence between bigger/more populous countries is given more importance.

Friday, 3 May 2013

Euro's Extraordinary Resilience



Many a bear has perished shorting the Euro but the currency still stands. Various reasons for the Euro’s strength have been expounded but believed only half-heartedly. Ignoring short-term price fluctuations caused by sentiment driven flows (Euro is doomed! No Draghi has saved it!), a longer term picture suggests that it is in a downtrend (Graph 1). Although it may be like a slowly sinking ship but most traders are too impatient. Reporting periods are too short and investors too unforgiving for them to weather the volatility and stick around until the end.

Graph 1
Source: Oanda.com

Short-term ups and downs are mainly sentiment driven responses to policy actions. Extreme blundering has led to sharp falls which have usually reversed by anodyne statements and empty deeds. But the reason that the Euro has remained resilient even in the face of so much negativity is because the Eurozone’s balance of payments situation has been supportive. Starting with the onset of the sovereign debt crisis in 2010, the balance of payments (current account + capital account excluding central bank reserves) has seen an increasing surplus (Graph 2). This has offered natural resistance against short-selling.

Graph 2
Source: Eurostat

Since the current account, being much larger than the capital account, is responsible for most of the Balance of Payments deficit/surplus, therefore an increasing surplus should be cause to cheer. After all, it seems to indicate that the Eurozone is becoming more competitive. However as Graph-3 shows, the surplus is mainly due to a stagnation and decline in imports. Export growth is moribund and below trend which would not have been the case had a rapid improvement in competitiveness occurred.

Graph 3
Source: Eurostat

Austerity and the straitjacket of the single currency seem to be killing off demand. This is quite apparent looking at trade in consumer goods. While exports of consumer goods have regained the trend growth path, imports from outside the Eurozone have been stagnant since middle of 2010 (Graph-4). Moreover intra-Eurozone trade in consumer goods is also stagnating which means that there is little import substitution (Graph-5).

Graph 4
Source: Eurostat

Graph 5
Source: Eurostat

Therefore the current account surplus is due to demand destruction rather than competitiveness gains. Merely looking at the headline may seem to indicate that the policy of austerity and internal devaluation is working to generate export-led growth but the reality is different. Paradoxically, by contributing to Euro strength, it only increases the pressure for further internal devaluation.

The current backlash against austerity is quite understandable since it is an untenable situation where living standards are stagnant and unemployment rife. Unless a weak Euro policy is pursued, the currency will continue to confound sceptics despite growing tensions within the Union. But resilience always has a limit.