glass

Through The Looking Glass, Darkly What To Look For In 2016

Sanjeev

Sanjeev

 Any ‘looking glass exercise’ is fraught with a lot of danger these days, because of the possibility of sudden, cataclysmic events that cannot be forecasted, and can certainly not be assumed.

Declaimer: This article was originally in February 2016 and some of the data points may be outdated.

Greece, for example. You can rest assured that it will spell trouble again…..its central problem is an economic culture that clashes with dynamic Germany. The fracturing of Europe is inevitable, the question is when. What is the likelihood that Greece, or Italy for that matter, will change its work culture, or that Germany will, come together in an economic union with a diverse set of work cultures?

The elephant in the room is China, but there are many Chinas, and we seem to be looking at them only one at a time. Manufacturing and Investment Demand in China is slowing it is in a deflationary death spiral, and the only way out of it is a downright closure of the units involved, with a write-off of the related debt. This doesn’t look easy unless the initiative is centralized into the hands of Beijing, rather than being left to the provinces.

Consuming and services China is doing well, given the circumstances. They now account for more than half of GDP, about 52%, and are growing at more than twice the other part referred to above.

Banking China will see a schizophrenic future, feeling the long-term depression and debt deflation of the commodity sector, while at the same time benefiting from the buoyancy that comes from a fast-growing consumer sector. The Govt will also see the same, getting a pick-up from lower commodity prices, while suffering from the collapse of many of its SOEs and the bailouts that it may have to fund, or the ancillary costs of unemployment.

So how will this many-faced giant present itself to a world-facing global recession? We don’t know really, but things don’t look good and recovery will take time.

Another big problem will be the after-effects of the various versions of Quantitative Easing (QE) prevailing around the world. The immediate market reaction to any fresh bout of QE has always been to mark down the issuing currency and generally behave in a manner that suggests that liquidity is increasing. The flaw in the view is that it assumes that if the stock of money is increasing (and sometimes by a huge amount, a doubling of the Monetary Base even), the velocity of money will stay the same, and therefore the entire increase will result in an increase in economic activity.

But what has actually been seen repeatedly is that the conditions that cause a QE also cause a sharp dip in sentiment, which lowers the velocity of money disproportionately, resulting in a drop in economic activity and the onset of deflation. After the initial knee-jerk reaction, the currency rises because deflation sets in,  further compounding the depressed scenario. So the “Chicago Response” of pumping in money and loosening monetary policy does not work. This has been seen in Japan in 1992, the US in 2008, then the US in 2011.

The obverse happens, as we can see part of the story playing out in the US just now. As interest rates rise, and the era of loose money comes to an end, the conditions that trigger such a phenomenon also lead to an increase in economic activity and therefore, an increase in the velocity of money. This results in GDP growth and the increase in the velocity of money leads to an increase in inflation. So after a knee-jerk uptick, the currency depreciates….something we are seeing playing out just now. And this is the reason for my bearish call on the Dollar for this year….that all things remaining the same, the Dollar is now set to decline.

The mistake most people make in understanding the cost of credit is to see it as an ordinary ‘product’, i.e., when the price of credit drops, demand for credit should go up. That works under normal circumstances, but not under deflationary situations, which is when QE programs are launched. The velocity of money is not just dependent on the price of money but on your view of the future. A deflationary situation makes you postpone any decisions, certainly debt-fuelled consumption/ investment.

Why do Central Bankers (and markets) get it wrong again and again? Because people always live in hope and like to be seen as ‘doing something’. Markets don’t have accurate (or otherwise) forecasts of the velocity of money, even the current (or recent) velocity is itself an estimate. Since this is too nebulous (like Implied Volatility in Option Pricing), it is never accurately factored into the market’s view.

But if you take this topsy-turvy view of the future, you will look out for bad times in China, one last death spiral, before the still-alive part starts to get talked about and expectations about China go rock bottom. And it means similar outlooks for Europe and Japan, even the Emerging Markets like Russia and Brazil (with the honorable exception of India).

Which brings us to India, the point of this whole article. Yes, we are on the right side of the commodity trade, and yes, we have had excellent Monetary Policy management (thanks to our rockstar Governor at the RBI; he both stood like a rock and self-started India in the right direction), so we don’t have the QE problem. And yes, our Fiscal is under control and moving in the right direction. India has much fewer problems than almost the entire world, perhaps except America if that.

That belief, which is now an iron-clad consensus, is itself the problem. A crack in the consensus could create its own ‘Lehman Moment’, which could trigger huge trouble for India. Remember, while the consensus P-E ratio has historically been 14-15 (fluctuating around the long-term average Nominal GDP growth rate, and this is not a coincidence), it is now running at 20, EVEN as the nominal GDP growth rate has sustainably dropped to the 10-12% range. How long can this divergence hold up, even as the country continues to face significant headwinds in trying to break out of its straitjacket? In a world in absolute (global) recession, a country is trying to post its highest growth rate, which is what is needed to justify the current P-E valuations…..something has to give, and usually, it is the market valuation. The moot point is whether it is going to happen in the short or the long term.

So adjusting to the ‘new normal’ will be relatively painless for India, because it has the right mix of good fundamentals, good policy, and ongoing reforms, even as the only constant seems to be a growth-averse global environment. So on a relative basis, India looks attractive, but that itself will be the source of a lot of trouble.

No discussion of the future can be complete without some comments about oil. This is a structural, irreversible change whose unintended consequences will reverberate through the world, some good, some bad (depending on which point of view you are taking). This is generally true of all commodities, where what started as a cyclical downturn linked to the Great Recession of 2008, has turned into a structural downturn, which will be hit by a permanent drop in the cost of energy.

Oil is in “a positive deflationary spiral”, i.e., its cost is being driven down by an increase in productivity. This will not stop, and this trend is taking away economic power from a large part of the world, leading to a steep drop in their Purchasing Power Parity (PPP). As this drops, new demand for new goods is not coming up, and such as it is, it is not happening in the same place where the (economic) vacuum has happened.

What is worse, is that we are still in the middle of this trend. New shocks will come from renewables, particularly solar. This will increase productivity, especially the productivity of virgin resources. The problem is that legacy assets in these sectors have to be marked down to zero and the related debt is written off. And those losses are not being made up by new tangible assets coming up elsewhere in this deflationary (world) economy.

Another dichotomy has to be resolved. The supply-siders look at the various QE programs unfolding and scream about the coming hyperinflation. They seem to be ignoring the falling velocity of money and (hopefully) they are wrong. The demand-siders point to the aging developed world and the spread of technology, and point to these potent deflationary forces operating as undercurrents in the global economy. This creates a ‘backwash’ in economic trends, which can catch markets and investors off-guard.

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