Everyone wants a playbook

Michael: Did you explain school to him?

Elliott: How do you explain school to higher intelligence?

Michael: Maybe he's not that smart. Maybe he's like a worker bee who only knows how to push buttons or something.

Elliott: He is too smart. 

Michael: Okay, I just hope we don't wake up on Mars or something surrounded by millions of little squashy guys.

[E.T. The Extra-Terrestrial]

 

US Election

I had written last year in July on the basic human need for certainty and how it has only become deeper (http://poleconomyindia.blogspot.in/2015/07/desire-for-certainty.html). When Donald Trump got elected, the world was aghast on how a complete outsider with no experience in government got elected. But the larger issue was the global elite have no clue on how he would respond on varied issues from trade, climate or security. Politicians globally recognize that what is stated in election, and Trump made many extreme statements, is one thing and governance is another. But the larger problem is they have no inkling of style of governance and decision-making except what they had read of his brash in-your-face business style. But running a country with a deep institutional culture like US as a CEO of a corporate is impossible, deep embedded structures and policies don’t alter radically.

All politicians promise astonishing things at election time, they also tap into popular issues of the populace. But does the promise of delivering extraordinary things make the person getting elected super-human. It is more the events that subsume them – Obama wanted to end the wars and revive the economy and neither have played out, George Bush had no desire to get the country into wars in the middle-east but 9/11 happened or Reagan never planned the demise of the Soviet Union. Just as an example Trump would like to take US out of NAFTA, first the President cannot do so without Congress approval and given the significant interest states like Texas, California, but also North Carolina and farmers across the Midwest have this is near impossible for the Congress to approve leave alone security interest in keeping a stable hemisphere which the US defence establishment will push for. Another stark example of a President’s limitation, in the ultimate analysis Obama’s legacy is Trump, as much as he wanted to even towards the death of the elections to have it otherwise…

The chart below represents the single most important reason for Donald Trump’s election:

Household final consumption (US$)	2014 (bn)	% of US HFC
United States	11,866
China	3,954	33%
Japan	2,788	23%
Germany	2,112	18%
United Kingdom	1,934	16%
France	1,572	13%

Source: Worldbank

The US single-handedly consumes as much as the next 5 countries of the globe and 26% of total global consumption or 5% of the globe’s population consumes >25% of global production. It has added in the last 8 years 3x debt for every dollar added to GDP. I had discussed this in an article in December last year in greater detail (http://poleconomyindia.blogspot.in/2015/12/imbalance.html). Which means the US economy provides jobs across the world to support its consumption while middle America production belt suffers. The pullback was inevitable only the timing was suspect. This is the point on which the Euro will break, Germany produces and maintains high employment levels and exports to Southern European countries under the Euro (not inflation adjusted local currencies) while the Southern European countries maintain very high levels of unemployment. At some point the cycle breaks. This pullback strikes fear in the elites of exporting nations like Germany, China or Japan and commodity producers like Saudi Arabia or Australia.

Demonetization

Not to be overtaken by the US election events, India launched its demonetization program. In one stroke 86% of the currency in circulation has been declared void and needs to be exchanged by 30 December 2016. This currency represents ~$200bn or 10% of the Indian GDP. To handle and replace old notes RBI spends ~$6bn annually. Also, according to some reports almost $100bn had never turned up at the RBI at any time in the last 3 years. There are multiple reasons for having taken such a step:

• Hit fake currency and reserves of terrorists, separatists, smugglers and Naxalites;
• Target hawala networks that fund terror and enable businesses to do under/over invoicing;
• Force the economy to shift to a more banked / electronic currency;
• Impact real estate making ‘make in India’ more viable;
• Curtail inflation and reduce interest rates to revive manufacturing;
• Enforce better tax compliance;
• The savings or excess taxes from such a scheme could be pushed to recap banks, infra spending or health depending on how RBI and government would like to manage the one-time gains;
• Also, political gains from recovery and impacting electoral finances.

The economy will see a contraction in December quarter and then turn marginally positive by March quarter by when the system would have fully stabilized. Brokerage houses have already started pushing the index targets by a year. And, how the impact plays out in the respective sectors is still hazy. Businesses may see many differing issues impacting their financials in the next 2-3 quarters:

• Genuine consumption impact due to both cash constraints and psychological impact from wealth loss;
• Inflating sales to hide previously accommodated black money;
• Advance payment of expenses in cash;
• Emergence of true economics of products - as lack of currency makes over/under invoicing impossible;
• Emergence of a true balance sheet as the balancing item (cash) is not available for the coming December quarter.

The cash hoarders have felt this deep impact for the first time in their living memory. It is causing people to find ingenuine modes to deploy this cash – from getting factory workers to stand in queue to exchange their money, buying gold or dollars or watches at inflated prices, buying property with builders doing the cash adjustments across their network. Whichever transaction one looks at there will be a significant loss to the current owner. Also, the taxman and accountants should be able to note many anomalies in the next 2 quarters. Finally, any illiquid black money in gold, real estate or offshore needs domestic cash liquidity. Once cash is cut-off the structure of the pyramid of which cash is the base has to alter.

That people would try and beat the system or political parties will oppose the move in some form or the other was a given. But it is the audacity of thought and the political courage that is amazing! Implementation of any such scheme is difficult. With over 100,000 bank branches, 200,000 ATMs and many banking correspondents, post office points or petrol pumps; there are enough points of presence. Assume 250 million wanting money even once a week, means 50m people a day, divided by even 250,000 functional distribution points means 200 customers per point per day…difficult but manageable. The distribution is relatively easier than the printing of notes or managing the logistics (both cash and ATM recalibration) to rural areas.

Bubble

“If possible, avoid being a bubble; for a bubble, even the gentlest touch is fatal.”  ― Mehmet Murat ildan

• The 35-year bull markets in bonds have suffered debilitating hit in the last few weeks with over $1.5 trillion of losses, imagine the impact on pension funds and insurance companies;
• With bond rates and USD rising so rapidly, the question is the impact on US corporate earnings and rising cost of capital makes buybacks less accretive. The US stocks face a wall;
• Over $3 trillion of non-bank loans to emerging markets in dollar terms is under pressure as dollar index continues to strengthen. This is happening in tandem with USD monetary base shrinking almost 4.5% last quarter. This will lead to tightening of trade conditions for exports.;
• Multiple bubbles continue to breed in China:
  • Property – October price increase was 12.7% YoY and September was 11.7% YoY. The total household financing in YTD August in China increased ~$1.1 trillion. In the same period, residential sales were $1.56 trillion of which 78% was party paid. Almost 100% of the property could be debt financed!! Current stock of property under construction is 7 bn sq meters of which 4.8 bn sq meters is residential and in Tier 1 cities pricing for 20% down-payment is already between 10-20 years’ income.
  • Commodity markets – Christopher Balding, Associate Professor, HSBC Business School in Shenzhen recently analysed the steel and coal markets from Dec. 15 through the end of October. Coal prices surged 114 percent and steel rose by 47 percent, more than making up for the previous year's losses. But such increase in prices have no basis in supply deficit but rather driven by excess liquidity in the system with credit increasing at 2x nominal GDP. A recent (November 2015) increase in fee and deposit requirements have resulted in some positions being sold off though.
• Reserve bubble – The yuan has depreciated by 7.3% in the last one year and is already at its all-time low. The expectation is that it will cross the 7 per $ psychological mark before the end of the year, putting more pressure on the currency and reserves. Yuan is depreciating at ~7% while its official GDP is expanding at 7%, the dollar GDP has not moved!! Given the state of the economy, currency depreciation (and deflation export) could continue for a while to manage the domestic economic pressure. Similarly, Saudi Arabia’s reserves are declining as will the German one as the Euro zone frays.

The Fed script could play out in the following way. They could tighten over the next few quarters driven by unemployment rates and inflation. At which point or likely earlier, the stock markets may wobble driven by rates and higher USD (consequently lower profits) leave alone a recession, it’s been 8 years since the last one. But given Trump’s plan to spend in excess of a trillion which will come into play in 2018, the Fed will be under pressure to keep stable / low the financing rates. Also, US budget was already on track to turn negative post entitlements, defence and interest rates by 2019, regardless of Trump infra plan. In all likelihood, we may see a turn in interest rates or expectations again in say 12 months pushed by Fed action. However, the rise in the USD in the next few months will put significant pressure on China and emerging markets. Consequently, next 8-12 months should be difficult for global markets.

 

Captain Yugi Nagata: We're going to die!

Alex Hopper: We are going to die. You're going to die, I'm going to die, we're all going to die... just not today.  

[Battleship]

Restatements

“A lie can travel half way around the world while the truth is putting on its shoes.” ― Mark Twain

In today’s hyper media world, news creates its own “mirage of reality”. The challenge is understanding the historical, cultural and technological aspects that underlie the behaviour and continuously reinforce this reality.

We continuously see in the media that we may see the end of American military and economic dominance very soon. This is extremely unlikely any time in the next half a century if not more. It is the most economically vibrant open economy having one of the best demographics in the developed world with a culture of immigrations. Despite the extreme budget stresses, it faces, it is within its power to manage those by altering the social security, healthcare and other benefits it has committed to its people. For example, it can simply change the retirement age. The current election season may seem to suggest that practically everything has broken down in America but that is the resilience of the structure. Imagine the Chinese or Russians having such a noisy debate without tearing the system apart. The constitution gives the President great latitude internationally but his domestic agenda is subjected to approvals of the Congress and the Senate. The system is designed for creeping changes with consensus almost similar to the drag the Indian system imposes. See how much time the GST took to get this far. The notion that all hell will break loose if either candidate get elected is extreme. Obama wanted to end the Afghanistan and Iraq wars much sooner, but could he? Dollar denominated funding remains the core of the global economic system. This works beautifully as persistent current account deficits and deep finance markets in New York keep the global system well supplied with dollars. The USD has continued to decline with these persistent deficits except for 2 intermittent periods. The first rally in the early 1980s driven by Volcker interest rate regime causing the Latam crises, the second was in the mid-1990s when the Asian Financial Crises played out. Both these crises were caused by over-dependence on foreign capital. We are in the 3^rd leg of the dollar uptick with global economies not having recovered yet. Where this will cause a crisis is anyone’s guess? American’s spend over US$600bn on the military more than 4 times the next kid on the block with a completely dominant position on the hemisphere it occupies allowing it massive global displacement power maintaining over 700 bases, with the ability to effect balance of power at any point on the globe. Thucydides made two amazing observations in his book 2,400 years ago, “Your empire is like a tyranny: it may have been wrong to take it; it is extremely dangerous to let it go.” The transition between empires is typically marked by wars. But, however, it is it will be surely less suffocating than the absolutism that would mark a Chinese or a Russian empire. The second observation was, “In other ways, too, the Athenians were no longer as popular as they used to be: they bore more than their share of actual fighting, but this made it all easier for them to force back into alliance any state that wanted to leave it.” The Americans have been involved in every major war across the globe since the 20^th century or have started it. Think the last time the Chinese or the Japanese fought a war, new technologies and postures are only developed during that period. The Saudi’s despite the massive spend on expensive equipment are fighting a war in Yemen and proxy war in multiple other Middle Eastern states and they are being tested to the point which got a senior US official to comment that they are afraid of committing their troops unlike the Iranians for the fear of a significant defeat and its impact on the Royal family. Taiwan is 90 miles from China but the Chinese fear changing the status quo and not because of Taiwan I am sure! At some point all empires decline but now is not that time for America…

In December, 2014 I had written, “China is likely next year to follow with its own depreciation given the impact of lower yen on competitiveness, a sharply declining factory production and increasing real rates.” I had then written an article in August 2015 on China’s economy (http://poleconomyindia.blogspot.in/2015/08/china-everything-overdone.html). Since then the capital outflows have accelerated, the credit cycle has added an estimated US$4.5 trillion (yes the number is right) more than US, Europe and Japan combined in the last 12 months. This expansion continues to finance almost US$5trillion in investment every year in industry and real estate even while it seeks to shut excess capacity in industries like steel. Who will put any capacity anywhere else? Maybe the Chinese authorities are adding 100m urban units in the quest to house all of us also in China!! This credit expansion is already feeding into crazy house prices and accelerating car sales. A UBS report showed the ratio of house prices to household disposable income in first-tier cities had risen to 18 to 20 times from 14.7 times at the end of 2015. "This puts China's tier-1 cities' affordability close to Hong Kong and more expensive than London," the report said. Beijing is looking at the household sector to up leverage backed by real estate to help the corporate sector deleverage, down payments for property have been cut to 20% from 30% in June. Mortgages were up 71% in July and August. Home prices have risen ~28% in Beijing, 33% in Shanghai, 37% in Xiamen and 47% in Hefei in the last year. This happens at a time when US$ continues to rise against the yuan at almost the same pace as the nominal growth keeping GDP trapped at the same levels. As the Fed threatens to raise rates, the yuan weakness will only intensify and one is seeing a surge in Chinese purchases internationally which they are increasingly facing more opposition including American real estate (a trend very similar to Japan in the late 1980s). Excess capacity and continued depreciation of the yuan complicates the global picture, where countries are seeking inflation to reduce the debt burdens. While the economic picture plays out, Xi is consolidating power to rival that of Mao. Such consolidation of power is a sign of weakness and the scale of challenge China faces. From adverse demographics, pollution (https://en.wikipedia.org/wiki/Pollution_in_China#Pollution_statistics), economic health, an increasingly more hostile external environment and a more suspicious suffocating internal politics. Any rapid decline in economic well-being will threaten the legitimacy of the communist party and that is what is causing this ever-precarious balancing like an engineering project unlike a natural healing process that a democracy can adopt. The Soviet Union and Japan both tried to manage this centrally and failed but the communist party knows know other way.

I will not cover the other three significant geographies (Middle East, Russia and Europe) which I have written over the last year which face almost an “End of their known World” kind of situation:

• Middle East (http://poleconomyindia.blogspot.in/2015/10/1979-and-middle-east.html). This spasm which began almost post 9/11 may take over a decade as the three-way fight between Saudi Arabia, Iran and Turkey establishes a new balance;
• Europe (http://poleconomyindia.blogspot.in/2015/04/european-gauge.html);
• Destabilization of Eurasia’s four principal areas – Middle East, China, Russia and the European Union (http://poleconomyindia.blogspot.in/2016/04/power-shortage.html).

In India, the BJP is seeking to revive the ancient glory of the Mauryan dynasty that spread to Iran, Hindu Kush mountains, present day Bangladesh to the southern extremities that ended in present day Andhra Pradesh and Karnataka, not as much in terms of occupying those lands but in terms of dominant influence. This had been the inspiration for Sardar Patel as he sought to unite the various princely states. The Dravidian kingdom have always been elusive for Indian empires until the British. The initial phase post-independence the Congress, as it took over from the British, ruled the state of Tamil Nadu until 1969 when a Dravidian party came to power as the old cultural and historical lines came to the fore and since then no national party has ruled the state. India as we know is a land of extremely diverse cultures and languages united by the geographical enclosure of the Himalayas and ocean of all other sides. It could almost mimic the many cultures and nationalities enclosed in the European peninsula. The national integration of India is project that is work-in-progress and the election of national party to the seat of Tamil Nadu will be an important marker in this project – the day when the populace there believes that a national party can represent their voice. In March 2014, I had stated that, ”India's geography creates the sense of 'self-containment' leads it to exist with itself but we are no longer in 1,000 BC, we are part of the global economic system and technological advances have reduced the physical space in both the economic and militarily dimension.” The current government by the bent of ideology and facing the multiple pressure points of demography and geopolitics is seeking to reshape the geopolitical destiny as Curzon, British Viceroy of India, saw it, "The central position of India, its magnificent resources, its teeming multitude of men, its great trading harbors,... all these assets are of precious value. On the West, India must exert a dominant influence over the destinies of Persia and Afghanistan; on the north it can veto any rival in Tibet; on the north-east it can exert pressure on China, and it is the guardians of the autonomous existence of Siam (Thailand)." I will not comment on the Indian economy which I have written in my previous article (http://poleconomyindia.blogspot.in/2016/04/power-shortage.html).

We are witnessing a rapid aging of the society in the next 25 years across the world. While the current method of measuring dependency restricts is below 15 years plus above 64 divided by those in between or the working age. One can argue that people, given, can medical advances work beyond 64 but so do people start working much later these days almost in their mid-20s. So I will continue to use this method. The remarkable aging will create over-supply in many areas like housing, sports equipment or kid clothing but short supply in labour, military personal and nursing staff. It will also cause an automatic deleveraging of the financial system as people draw down on their savings and do not take consumption loans. This is also one of the reasons why central banking policies are not as effective as in the past. As one can see below, the Germans and the Chinese will see the most dramatic impact play out.

Dependency Ratio by Country	2015	2040	Change
China	37.4	59.1	58%
Germany	52.2	77.7	49%
Japan	63.1	81.2	29%
Russia	42.5	53.8	27%
France	58.1	70.2	21%
UK	54.7	65.8	20%
US	52.5	62.5	19%
Mexico	51.6	51.0	-1%
India	51.8	46.4	-10%

 

The US continues to consume (-$460bn) and the German (+$286bn) and Chinese (+$348bn) continue to export. The oversized role on both sides of the scale continues. But at some point, the impact on American industry and labour will play out, as it is doing now in American elections. At some point, the Chinese gaining competitiveness via devaluation to the rising cost internally will become an issue with other developing countries, although that point maybe some more time away. And, at some point the German export engine just becomes too overbearing not only to the Americans but also to the Euro Area, which has happened quite some time back and Brexit and constant disillusionment of the European voters with mainstream parties is all part of this continuing situation. This is the core point (China and Germany maintain employment at the cost of other countries) leading to rising protectionism across the globe.  

The fourth industrial revolution is coming. This will see the convergence of many technologies which have the ability to change the face of many industries. Internet of Things, Artificial Intelligence, 3D Printing, use of Big Data, nanotechnology and space based technologies will change the way we live to the way of war. Group of Head of Innovation at HSBC stated, “It is possible to imagine multiple ways in which IoT can enhance banking – for example, wearables could provide biometric authentication, payments can be embedded within household items and geo-targeted offers could expand into a more personalized service while providing more security.” DARPA, US defense research government outfit, (same that invented ARPANET the basis for future internet) is already working on space based solar technologies to power battlefield units like tanks and laser weapons held by soldiers or potentially developing space based precision guided projectiles. Not only the cycle time of the change be much shorter that we have witnessed before, given the globalized (telecom, MNCs, news…) world, we will witness much more rapid deployment.

The more these changes threaten the past rhythm of our daily lives, the more we shall look for inner forces to stabilize ourselves…

And, finally global leadership will be tested like never in this period of great upheaval. In December 2013 I had pointed out, “The ability of true leadership is to negotiate the constraints put by the system. There will be compromises and promises broken but states are not given firm direction by idealists but by realists and great leader is one who is a realist led by ideals.”

“Accidents happen. Our bones shatter, our skin splits, our hearts break. We burn, we drown, We Stay Alive.” ― Moïra Fowley-Doyle, The Accident Season