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This Time It’s Different… : Some Things Will Never Be The Same Again

Sanjeev

Sanjeev

Most marketmen believe in the Principle of Reversion to the Mean. What goes up, must come down and all that. From that comes the other pattern, that at the top of a market, comes this consensus that “it’s different this time”. This is to sustain irrational valuations, till the parcel has been passed onto the biggest fools…..then bam!!! The bubble pops, and the (dead) rabbit falls into your lap.

Declaimer: This article was originally in November 2015, and some of the data points may be outdated

As I said, this is mostly seen closer to a market top, while I am bringing this up closer to what looks like a market trough (if not a bottom). Sensible people are talking about a global recession next year (i.e. <2% global growth, with many economies slipping into negative territory). While the US seems to be coasting along, China could pull the world into recessionary territory. In small increments, most forecasts for global growth are shifting down to 3%, and it will take just some small aftershocks from China, to bring the world crashing down into its first recession after the GFC 2008.

The market’s long-term average Valuation

Most traders tend to believe that what goes down must come up, and almost all markets are at or below their long-term average valuations, whether in P-E or P-BV terms. Bottom fishers would tend to believe that the market has bottomed, but they would do well to keep in mind that the commodity supercycle has troughed, but it may not come back.

Most of the damage is in the commodity sector, which has been decimated by the Chinese Deflation- Depression scenario. The global All Commodities Index is at a 40-year low, back where it started in 2003. Profitability in most (commodity) sectors is at historic lows, reaching the point that debt servicing is possible only if debt levels have been kept moderate. Peak-of-the-cycle investments, including M & A, are not going to be repaid if they have been funded with debt; current profitability does not allow for that. So any investments made between 2006-2010, will see haircuts in debt repayment. The pre-boom investments will pull through mainly because half the debt repayments have already been made. In every case, if a company is pulling through, it is because of the ‘past equity’ embedded in the older projects, which are still generating Free Cash Flow, which is being used to subsidize debt repayments on the new projects. A rational decision-maker would want to evaluate each project and see whether that particular project is meeting its Cost of Capital; but in the real world, each company will want to protect its ‘baby’ with whatever it has. So Hindalco will use its Renukoot cashflows to subsidize the Novellis acquisition, rather than evaluate whether saving the baby will kill the mother. In medical ethics, it has now been clearly established the life of the ‘unborn child’ is secondary to the life of the mother. However, the same principle is not used to manage the business cycle.

This has been happening in companies, even sectors for time immemorial, but this time, it is happening at the level of countries, which is going to affect macro-economics. Most of the surplus capacity in the world is in China. In Aluminium, China accounts for 56% of world production, while the world surplus is about 10-15%. ‘Surplus’ is defined as that part of world capacity, that must close down to bring sectoral profits back to the point where they can service the Cost of Capital (which, needless to say, would include the servicing of debt). If that number is 10%, it means some 20% of Chinese capacity must close down. In a normal, fragmented, perfectly competitive, ‘commoditized’ sector, this would happen on its own, with the bottom 20% dropping out. But this is not going to happen because China’s directed investment and its coordinated maneuvering will ensure that its weakest players will ride out the bottom, while the weak players of other countries will close down.

the peak-of-the-cycle Chinese investments

So in Aluminium, it is the American Alcan is closing down its iconic 130-year-old smelter capacity. In steel, it is European/ British steel plants, and the Indian minnows, that are closing down, while the peak-of-the-cycle Chinese investments will survive because China will subsidise the carrying cost of these plants. The natural Darwinian Laws of “Survival of the Fittest” will be vitiated because too much of the capacity that needs to be mothballed, lies in the hands of an ‘irrational’ player. This capacity overhang of the weak players who refuse to die will likely ensure that the recovery will be weak, anemic, and short-lived.

The regular injections of; liquidity, whether newly printed money (QE) or the recall of their savings parked abroad (Forex Reserves selling), should ideally be used to promote consumption, which would be value-accretive. But it is likely to go into holding up zombie companies in the commodity sectors, which will be value-destructive. If too many of these (Forex) Reserves end up in malinvestments, it could push China into Depression and the world into recession. China would be the next Japan, with its zombie steel and metals sectors, for example, while the world passes it by.

An increasingly irrelevant China is not just going to step back and watch. It will become a serious geo-political threat, which, if it precipitates a couple of serious wars, could create enough diversion and destruction…..to the point that this time, there might not be a Planet Earth waiting for us at the end of it all.

So these 2 major points must be kept in mind, about the end of this commodity supercycle. One, it might not be played out completely at the micro-economic level, and two, the macro-economic dimensions might spin out of control into the geo-political space, with disastrous consequences. For most of us, the first is of importance, while the second is of not much interest because we are all dead anyway.

Watching this play out, will give us important insights into major tectonic movements in the currency markets. One, China’s offer of a viable counterbalance to the Dollar, in fact, an alternate Reserve currency, will be just another Ramlila Show. After the fireworks, there will be nothing worth reporting except the fireworks themselves. And outsiders, like the Martians, will not understand the point of it all.

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