Kryptonite

Superman came to earth from planet Krypton when he was just born. He grew up realizing his extraordinary powers. Only when he interacted with a holographic image of his father he realized that there was one thing which was lethal to him – Kryptonite, remnants of his long dead home.

Central banking is relatively a young profession. As they have grown up they have realized their extraordinary power. The first taste of the fatal flaw was inability to work magic on the Japanese economy post the massive collapse in the 1990s. Now they have again brought their fatal flaw upon themselves in US, Europe and Japan – zero to very low interest rates and expanded central bank balance sheets to unprecedented levels.

“The tenth amendment said the federal government is supposed to only have powers that were explicitly given in the Constitution. I think the federal government's gone way beyond that. The Constitution never said that you could have a Federal Reserve that would have $2.8 trillion in assets. We've gotten out of control.”

As they reduced interest rates they reflated bond portfolios from junk to g-secs, housing prices and equity markets globally as risk free rates collapsed. The Japanese stimulus which they expected will grow their exports will take a long period of time as local corporates have over the period spread their manufacturing globally (i.e. Honda in US). So question is will corporates restructure in response to the stimulus or global economy booms to rapidly expand export demand or the time runs out when Japanese pension funds with the adverse demographics are unable to keep up with the expanding budgetary requirements forcing up interest rates. Unfortunately, they do not have much of a choice.

The US Federal Reserve is reversing the stimulus as jobless claims decline. But the risk of miscalculation with the market expectations is high. At the same time the European Central Bank is turning on the stimulus tap worried about potential tightness the US Federal Reserve may cause in the markets and the strong Euro which is resulting marked declines in manufacturing surveys since January this year (France below 50 and Germany at 52, print below 50 represents a contraction).

Massive amounts of capital have been invested by pension funds and life insurance companies into government securities. This capital has no choice but to suffer the increase in interest rates. So let’s assume a bond maturing in 2020 trading at 19% premium to Face Value giving currently 2.5% yield. If interest rates were to become 5% for the residual duration the bonds would suffer a 7% decline. Bonds which trade on basis points, 7% change are a massacre. In response, I understand, the German life insurance industry has reduced bond duration to 6 years to protect against interest rate increase creating an asset-liability mismatch (“ALM”). How do central banks expect to plug this hole?

In India external borrowing to GDP has expanded from 4% to 18% taking advantage of low rates in the international markets and easy availability. This and potential risk on portfolio flows which finance the CAD has got Raghuram Rajan to call for coordinate action to limit liquidity issues. As interest rates rise, it will increase the risk-free impacting equity valuation and hurt property valuation including those of dollarized markets like Dubai, Singapore and Hong Kong.

Only alternative central bankers have to manage the scale of the adjustment is to keep running behind market expectations - too much perfection to achieve. But if this is the likely goal they will be incrementally cautious and run much more behind expectations. Consequently, precious metals and agri commodities (and healthcare driven by aging) will gain with oil becoming more dependent on geopolitical events as global economy is tempered by increasing rates.

Postscript:

Corn  trades at 3.7 (CBT $/bu), Soybeans at 10.8 (CBT $/bu), Wheat at 5.4 (CBT $/bu) and Sugar at 0.17 (NYF $/lbs). These are running at multi-year lows or 40-100% off last 5 year peaks. Implication: invest in a global agri commodity fund, processed food companies which have benefited from the decline will face cost pressures as the cycle turns and global inflation numbers have been benefiting from this decline.

US earnings will see a 2HCY14 rebound driven by low inventory levels which is running at 4 year lows and new order are showing a significant rebound in the last quarter.

Cracking Eurasia while India re-builds

I have been off the air for a while and enjoying our holiday. However, there have been significant linked movements in the mid-section of Eurasia and evolution of events in India.

Mathematically, discrete items maintain their character when separated - i.e. quarter of a tree or an atom is no longer a tree or an atom - but in political events they have a life in both forms discrete and linked.

Iron Dome

And again hostilities have broken out between Israel and Hamas and again each side is looking for ways to break the stalemate. While Hamas has managed to smuggle despite oversight significant rocket stock into their territory which are hidden in the deep underground tunnels, Israel has been relying on its Iron Dome system to negate the rockets launched thus far. The stalemate stemmed from the fact that Israel will need to launch a significant ground offensive (means more casualties) to eliminate this threat for a time period as Hamas can always smuggle in more (beat the Israeli and Egyptian intelligence again). However, Israel has now taken the call to launch the ground offensive. If the current situation endures Hamas may be tempted or forced to launch enough rockets which may overwhelm the Iron Dome system. The Iron Dome system gives Israel a sense of security and which is more near-term until new attack mode emerges and anyways the tunnels which hide these rockets get re-built faster than Israel hopes.

MH17

Ukraine continues to fester as the Russians are and will not be willing to let Ukraine at any cost slip into the western orbit. It is too strategic politically, geographically and from a food security perspective. The Malaysian crash piles significant pressure on the Russians but will it change the way the view the situation – unlikely. Can anyone make them change the way the deal with the situation – again unlikely at least in the next 2-3 years. Russia has and will be a difficult country to deal with.

Mesopotamia

The lands of Mesopotamia which the British divided arbitrarily are coming apart with the Syrian and Iraqi crisis. With the unsettling of the status quo when Saddam Hussein was dislodged, it has come to today’s situation as the Americans were unable to re-build state capacity while Iran manoeuvred to get the upper hand in the situation

It is an extremely difficult situation given that it comes in the aftermath of the Arab spring and American withdrawal in Iraq and now in Afghanistan. It is important that a new status quo is built in the middle-east and that is where the two regional powers Turks and Iranians and the global superpower America will need to carefully play their hands. The Iranian-American rapprochement will play an extremely important role and carving out regional influence will be on the table. Saudis will be in for an extremely difficult time as American no longer need to rely on their oil but the Saudi’s have no other benefactor to turn towards.

With regard to Ukraine the world has no alternative good choices as European energy requirement from Russia makes any significant action extremely difficult. It will be important to restrict Russian ‘illusion for retrospective determinism’ as they will try to bring ex-Soviet countries into the customs union or modify political landscape. Poland with its significant but under-developed shale reserves (as an alternate to Russian energy supplies partly) and location will be a critical country for the Americans and the Europeans. It has been the land route for all significant military interaction that has taken place with the Russians.

While all this and more (China in South China Sea) happens it is critical that India remains neutral or does not get involved while it puts its economy and military back on the rails. It may, anyway, have its share of issues as American withdrawal is completed by December 2014 from Afghanistan

Meanwhile, economic sentiment in India continues to improve as does the stock market. The budget unfortunately was a whimper possibly because of upcoming assembly elections and likely need to understand the full depth of the issues. Besides that there has been no significant bummer from the new government. Stock market continues to expect significant action from the government to drive economic growth and corporate earnings. It is likely in the near term as the Fed stops asset purchases we continue to see strength in the dollar helping exporters (IT, Pharma). It is clear that optimistic budget assumptions will not work out restraining government push on infrastructure. The government needs to figure out a mechanism to attract capital to fund core infrastructure. With banks being undercapitalized and low domestic savings, channelling international savings (if possible on a rupee basis given where global interest rates are likely to head) is the only option. Companies supplying into infrastructure asset creators (like equipment lessors) or as factories ramp up capacity their consumable suppliers (like refractories or gas suppliers) will be initial beneficiaries.

The events in the Middle-east and Ukraine connect to India in 2 important ways – Middle-east is the largest supplier of energy and Russia is the largest supplier of weapons – and India needs both in an uninterrupted manner.

Politics….Linked….Discrete….Linked….Mathematics