Volatility and Intervention

“A certain amount of volatility and drama can be healthy and keep things fun and interesting if you're willing at any moment during a fight to say, 'This means nothing. I love you, let's forget about it.”

― Anthony Kiedis, Scar Tissue

Since the Global Financial Crises of 2008, the tempo of intervention has only increased. First the Fed’s intervention came as a response to the deep destabilization caused by the decline in housing prices in the US and transmission of this shock globally broke the honeymoon of the Eurozone where the Southern European countries were being funded by the Northern Europe principally Germany in a unsustainable way. This led to decline in demand in developed countries. European Central Bank and the Bank of Japan also launched unconventional easing in response. It propelled China to intervene and propel a never before expansion in credit. This resulted in commodity and oil exporting markets growing dramatically since 2009-2010 in symphony with Chinese credit expansion. In the last 2-years a persistent decline in commodity and energy prices in response to the slowdown in China and expansion in shale production, have led to further decline in global growth. Consequently, the fight for demand and initiatives to boost consumption for global production has become even more acute. In addition the pressure of significant leverage is pushing central banks to unchartered territory to generate inflation. This is more than evident in the trend of interest rates across markets – even the Fed recently signaled that they may back off from the expected 4 quarter point hikes in 2016.

Since the Global Financial Crises, the lead has been taken by central banks to manage the system while the various political constituents have been largely dysfunctional in this sphere with attention taken up by the developments in Ukraine, South China Sea, Middle-East, Migrant crises, potential break-up of EU among other issues. In essence the intent of the central banks has been three-fold:

• Generate inflation;
• Push asset prices to generate wealth effect and propel consumption;
• Devalue the currency to capture external demand.

Given the benign commodity prices, excess industrial capacity and population decline inflation has been running below the target range of 2% run by ECB and the Fed. The currency decline as one can see from below has been largely absorbed by the USD and asset prices gains having reversed to markets now to 2014 levels. The funding currencies - Euro and Yen - appreciated in 2016 as Fed rate increase curve turned benign resulting in significant unwinding in the asset markets besides hedge fund margin lending running at all time high levels. The market positioning has been a bigger driver in decline and asset prices adjusting faster than change in fundamentals.

Country	Depreciation vs USD			Stock Market
	2014	2015	YTD 2016	2014	2015	YTD 2016
US				13.4%	-1.3%	-7.2%
Euro / DAX	12.7%	11.2%	-1.2%	3.5%	8.1%	-12.9%
Britain	5.9%	4.9%	3.9%	-2.1%	-5.4%	-4.5%
Japan	14.4%	0.1%	-6.3%	10.1%	5.3%	-14.9%
China	2.5%	3.8%	0.9%	50.3%	14.9%	-21.2%
Russia	64.2%	32.1%	10.1%	-42.7%	-6.7%	-6.1%
Turkey	7.6%	25.9%	1.4%	33.0%	-12.7%	-1.6%
Brazil	14.2%	47.9%	2.7%	-2.2%	-12.2%	-6.3%
Australia	9.2%	11.4%	2.8%	0.9%	-2.1%	-4.7%
India	3.0%	3.6%	4.1%	29.9%	-4.1%	-8.3%

The central banks, after an estimated 637 actions of rate reduction, easing, asset purchases etc since the financial crises globally, are now pushing the next frontier via negative interest rates in Sweden, Denmark, Eurozone, Switzerland and Japan. This represents a very large proportion of the global economy. With flattening of the yield curve and the shorter end going negative, the banks are practically at sea – international bank stock prices have corrected dramatically (15-30%). Imagine this being taken to the next phase of customers being charged for keeping money in the bank – it may restart a business of vaults.

I had pointed in my December article (http://poleconomyindia.blogspot.in/2015/12/imbalance.html) on how deficient global demand is at the heart of the current crises. We are likely to see increased intervention by central banks and increased resistance from the markets which are increasingly wary of implications of these moves – BOJ starts negative rates and the yen appreciates or Fed backs off from interest rate increases and the markets decline in response, PBOC assures the market of its USD3 trillion firepower but the foreign exchange markets react in disbelief. With practically no solution in sight central banking experiment to transmit policy through asset markets that are controlled by asset managers of whom central bankers have limited experience is beginning to fail.

The fact that USD has been weaker against the Yen and Euro is a temporary phenomenon. Mario Draghi has already said he willing to take the next steps while BoJ may wade to increase the stock of JGB’s and stock ETFs – it was anyway their actions which drove significant USD strength in 2015. Japan’s economy is weak facing a significant decline in exports and currency led gains by the corporate sector has not resulted in any investment or wage increases. Eurozone continues to grapple with the two big crises of migrants and Brexit besides the inherent weakness of the financial system. For example, Italians have been liquefying their banks by doing sale and lease back transactions of government assets which are then pledged with the ECB for liquidity lines as they have sovereign guarantee cover. The Chinese will not tolerate significant bleed of the foreign exchange reserves with just US$3trn left in pocket (US$1trn is illiquid, US$1trn is required for short term debt repayment, $200m is monthly import bill). Given the global pressure on China against devaluation and potential capital flight driven by fear of devaluation, some element of capital controls is likely during the year.

The central banks unfortunately have no real solution to the issue at hand – aggregate demand – but their unprecedented actions, while keeping the system alive, are infusing volatility. The pace of intervention will only increase in 2016 as global growth declines.

Indian Banking

What was thought of as an old man’s game with limited excitement, Indian banking at cross-roads with 5 key aspects impacting it at the same time:

• Technology – The advent of tech disrupters which will eat incomes of the banks by directly selling wealth products or life insurance policies, bring greater transparency to retail loans or offer payment solutions on cheaper platforms;
• Non-Performing Loans – The system NPL’s are exceeding 11% with true number possibly in the 15% zone, the PSU and Corporate banks are seeing massive write-offs and share prices being pummeled. With real capital levels being extremely low, growth and equity raise are becoming a challenge;
• Macro – Banks are in unknown territory, they have never possibly witnessed industrial good deflation in their living memory causing significant dent to corporate lending business. In addition, excess global capacity is ensuring no significant private capex. Residential real estate and rural are also in deep slowdown while exports suffer due to decline in trade weighted competitiveness;
• Regulatory change – We are witnessing an aggressive regulatory regime - advent of CPI based real interest rate regime, aggressive focus on cleaning up NPLs, change in competitive landscape, attempt to push longer term lending to the capital markets, base rate being set as per marginal cost…  
• Shifting Competition – The competitive landscape has added payment banks, small finance banks and tech start-ups in the recent 2 years with significant capital and entrepreneurial energy. 

While the current environment will offer significant opportunities in multiple spaces, the better risk adjusted strategy would be investing in assets with significant moats rather than creating one in an environment of unprecedented change. For example, HDFC Bank is following a simple strategy of staying in low risk corporate assets while pushing to double the retail bank on the back of already scrubbed customer base – of the 35m odd customer a third (~13m) are high quality based on track record but the bank has significant asset relationship with only 4m. In addition pushing the customers to digital assets will reduce costs. Another example is Cholamandalam, a strong understanding of the commercial vehicle (CV) segment with ~70% of AUM in the segment rides on the uptick in CV cycle. While valuations maybe high for such players, in this period of excess liquidity and market participants with ever lower cost of capital, quality growth at low volatility will always command a premium.