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]