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.

Hope for...

We have begun 2016 with deep falls in global markets driven by fear of the Chinese ‘unknown’ and the crushing impact of commodity prices on earnings and the financial system (loans and derivatives backed by these commodities) and in the backdrop of sharply rising schism between Saudi Arabia and Iran with the execution of a Shia leader by Saudi Arabia followed by diplomatic reprisals. With this it is difficult to invest in hope, but hope we must. So what I write about below are some developments if they were to occur or begin in 2016 would augur well for the future. Given their importance some I have already talked about in the past in depth so will discuss it briefly and refer to my earlier articles.

Economic

1. My previous article on Imbalance had highlighted the lack of internal demand in key countries like Japan, Germany and China (http://poleconomyindia.blogspot.in/2015/12/imbalance.html). The scale of these excess savings can only be absorbed by the US. And, the only way to do so productively is to embark on the next round of infrastructure creation by giving fiscal incentives and policy impetus to private companies.

The U.S. ranks #16 globally for infrastructure, according to the World Economic Forum:

• U.S. air travel is the world's most congested, due to "a shortage of airports runways and gates along [with] outmoded air traffic control systems";
• Only 2 of 14 major ports on the eastern seaboard will be able to accommodate the super-sized cargo ships that will soon be coming through the newly expanded Panama Canal;
• Almost one-third of the major roads in the U.S. are in poor condition;
• There are more than 14,000 miles of high-speed rail operating around the world, but none in the United States;
• US ranks #35 in Maths and #26 in Science globally (Based on average scores of 15 year olds taking 2012 Program for International Student Assessment);
• The last mile bandwidth has substantial copper coaxial cables which mean a slowdown in bandwidth speeds as they transition from fiber optic layer.

There is substantial opportunity to up the productivity of the US economy through these investments and consequently also help generate second order demand for commodities and other manufactured products.

2. Germany has always been a formidable export engine with its engineering might. But these exports to the European countries were subjected to the vagaries of exchange rates prior to the Euro. Once the Euro came in Germans benefited the most, not only did the export uncertainty to the Eurozone go away the Euro was the weaker than the Deutschemark as it was sum total of Europe rather than just Germany, thus helping exports to the world. Along with this Germans kept productivity adjusted wages much lower than most countries in the Eurozone, almost to the point it was 20-30% below Spain, Italy and France. This enhanced the competitiveness of their exports. While household wages did not grow fast enough restraining consumptions, the Germans used the export surpluses to finance the consumption in the Eurozone. Unless this process reverses where the Germans allow the rest of the Eurozone to become competitive by becoming less competitive and consuming more, the risk to the Euro continues. Greece, Spain, Portugal, Italy and others cannot continue to just internally adjust in the form of lower wages or fiscal savings or lower employment. The recent pressure of immigration has only increased the stress.

3. China has no choice but to face the adjustment. The high investment to GDP and leverage in the system has to be unwound and I have written multiple times about the same. This adjustment will result in very low GDP growth barring a crisis. But the political reality of China is still creating high growth in leverage relative to nominal GDP. Their inability to manage market expectations with regard to their currency and their stock markets is causing heartache in global markets. But there response has been rather elementary - putting circuit breakers on the stock market, getting the banks to expand leverage to market participants, getting the banks to intervene in the offshore yuan market to drive up borrowing costs to astronomical 67% among others. It is important to address some of the core issues which will expand domestic consumption markets – free labor markets to enable movement of people and their costs, paying real rates of returns to the savers and steps to address income inequality. Higher interest rates domestically will also ensure stabilization of the currency. But this will mean significant pain for the corporate sector, impacting wage costs, interest cost and for the first time they are managing currency risk. And, unless the market believes there is a two-way risk on the currency the pressure on forex markets and domestic liquidity will continue – China has lost almost a trillion dollars of foreign exchange reserves.

4. The UK’s referendum for withdrawal from Eurozone is scheduled before 2017 and it may happen in 2016 itself. The key sticking points have been immigration and overwhelming EU rules on areas like trade, environment, transport or consumer rights. If the UK elects to step outside of the EU, politically it may impact its say in global affairs and business will have to them comply with an alternate set of guidelines to access the European markets. Britain’s exclusion from the EU single market could expose exporters to external tariffs - cars imported at 10 per cent tariff, with food and beverages facing surcharges of, on average, at least 20 per cent. Some Japanese firms having European headquarters have already said that they may need to quit or shift substantial operations to the mainland. This exit will have also have implications for London as a center for European financial services – the companies may have to establish subsidiaries on the mainland for their operations to additional taxes. In all this will impact the levels of trading in sterling.

5. Over the last few years, India’s public debt has been declining owing high nominal GDP growth rates and inflation. If real GDP continues at >7% and CPI inflation stabilizes in RBI comfort zone of 4-5% (and positive real interest rates) and GDP deflator stabilizes in the positive 2-3% zone, then the debt will decline to comfortable levels. But GDP deflator has been low to negative since January 2015 given the low global commodity prices. If this situation continues India should then push for a more aggressive fiscal deficit correction. The second big issue is the level of bad assets in the financial system – NPL are at 4.8% and stressed assets another 6.2%. The number may be in reality as high as 15%. The government needs to get the revised bankruptcy act through, push recap of banks as a combination of state and public fund raise, expediting stuck investment projects and finally better governance at PSU banks.

Political

1. Ukraine is very important for Russian security in more ways than one (http://poleconomyindia.blogspot.in/2014/10/global-disorder.html) – Black sea provides the only access to warm waters of Mediterranean, gas pipeline infrastructure, food security that Ukraine grain production provides and geopolitical space. That Russia would respond to a Western influence enhancement in Ukraine was inevitable. While lower oil prices is sapping Russian capacity but Russia in the end only thinks geopolitically. Despite the economic situation it has launched its act in Syria. It does not care about Assad but finally having a seat at the table for the settlement where it will look to extract concessions for its core interests. There is already a significant constituency forming in Germany to lift the sanctions led by ex-Chancellor Schroder but it is the Americans that the Russians want to reach a settlement with. I think this settlement may elude in 2016 but it is one of the crises sapping energy of multiple players.

2. The most urgent political crises facing the world are the radicalism, sectarianism and revisionism of the Middle-East (http://poleconomyindia.blogspot.in/2015/10/1979-and-middle-east.html). It is a very difficult situation with no easy answers. The first step in this affair will be dialing back the insecurities of the Saudis and reaching a settlement on Syria. A settlement on Syria will take Russian active intervention out of the equation, limit the space for Islamic State and address to an extent the European immigration situation.

3. The internal economic and consequently political pressure will keep rising in China as the social contract undergoes stress. But it is important they do not redirect public attention through external belligerence. This has already led to neighboring states Japan and Vietnam to increase defense spending dramatically. The nine-dash line issue and the building of artificial islands is creating significant friction across the countries bordering the South China Sea. I had written in September 2015 how China should look at the model of Bismarck’s Germany to restrain itself (http://poleconomyindia.blogspot.in/2015/09/total-recall.html).

As you will notice China finds a mention twice – economic and political - in the above article and will continue to be the #1 risk for 2016. The Middle-East is the other powder keg. Both have begun the year reaffirming that status but the hope is it won’t end that way.

“We must accept finite disappointment, but never lose infinite hope” – Martin Luther King, Jr

…2016

Imbalance

“Life is like riding a bicycle. To keep your balance you must keep moving” – Albert Einstein

In my October 2014 article (http://poleconomyindia.blogspot.in/2014/10/deflation-and-liquidity.html) I had pointed how the global imbalance in savings and investment was at the heart of the global slowdown. I had written “The other side of this coin of global slowdown and imbalances as I have pointed earlier is the saving-investment (S-I) mismatch. Globally, Savings has to be equal to Investments. But as country, if savings is greater than investments it manifests itself in the country having a current account surplus (exporting capital) and vice versa.” Another way of arriving at current account is (X-M)+NY+NCT, where X and M are respectively the export and import of goods and services, NY the net income from abroad, and NCT the net current transfers. The table below shows the trends in current account balances since 2007:

Country / CA ($bn)	2007	2012	2015E	2020E
US	–718.6	–449.7	–460.6	–746.9
Euro Area	10.6	154.1	364.6	326.8
Germany	232.5	240.8	286.3	270.3
France	–8.0	–32.0	–5.2	–7.9
Italy	–31.3	–8.9	37.0	10.1
Spain	–142.9	–3.8	10.6	22.4
Japan	212.1	59.7	124.3	130.7
UK	–81.3	–98.2	–135.8	–86.1
Other Advanced	192.8	266.6	319.7	312.7
Russia	71.3	71.3	61.8	80.5
China	353.2	215.4	347.8	95.3
India	–15.7	–88.2	–30.4	–86.5
Brazil	1.6	–84.4	–72.8	–78.2
Mexico	–14.7	–16.4	–27.9	–31.9
Larger Middle-East	264.9	419.1	–113.4	–14.2

Source: IMF

Quick takeaways on the past trends:

• US, UK, India and Brazil continue to be the demand centers of the world of which US is the outsized buyer of global demand;
• With the German imposition of fiscal discipline in the Euro area demand in the southern European states have contracted dramatically;
• Japan’s change in balance has been more due to the nuclear power shut-down post Fukushima and consequent increase in energy imports;
• Russian oil exports will contract dramatically but so will imports leaving the balance in place but with a contracting GDP;
• Middle-East will play out very similar to Russia only to the extent that given the outsized social spends they may not be able reduce imports as fast;
• China growth decline is having an outsized impact on metal exporting countries and the declining currency should continue to counteract the desire to rebalance towards a consumer economy. The data below plays out the dramatic impact of China’s slowdown will have on the commodity exporters:

Bilateral Metal Trade (US$ m)	2002	2014
Australia	1,043	52,153
Brazil	605	12,851
Canada	90	2,496
Chile	784	15,249
Peru	196	5,621

Just as an aside, this decline in global commodities will cause a dramatic shrinkage and asset problems in financial balance sheets across the globe.

Where I disagree with the IMF forecasts for 2020 is on four key linear un-said assumptions underlying these forecasts:

• Americans will continue to tolerate their demand being used by other nations to allow things to revert to 2007 (despite shale oil) and will not turn protectionist or have preferential trade deals (i.e. TPP is designed to exclude the Chinese and therefore changing supply chains);
• Technology innovations like additive printing or solar energy will make no impact on manufacturing locations (Germany, Korea, Japan) or on energy producers (Middle-east);
• Chinese will be able to generate significant domestic consumption in a short period of 5 years despite adverse demographics, currency decline and inequality (http://poleconomyindia.blogspot.in/2015/08/china-everything-overdone.html);
• Southern European countries will continue with the German mandated fiscal bounds and bear the high unemployment and internal cost adjustments (i.e. wage deflation).  

As we can see the global imbalances continue to be substantially where they were in 2007. A quote from T. S. Eliot summarizes it wonderfully, “We shall not cease from exploration, and the end of all our exploring will be to arrive where we started and know the place for the first time.”

Post-script

Oil ($)*	1997-2006	2007	2012	2014	2015E	2016E
	31.2	71.1	105.0	96.3	51.6	50.4

Source: IMF, *Simple average of prices of U.K. Brent, Dubai Fateh, and West Texas Intermediate crude oil

Oil prices have been on a downward tear since 2014 crushing inflation across the globe causing an estimated shift in resources exceeding $1 trillion. Current price for this resource in under $40, markets looking to push it under $30. This may, however, turn out to be the savior of global central banks if it completes its correction in 2016 and rises enough to boost global inflation to 2%. If it overshoots, it turn out to be nightmare but there is always cover available under Core CPI which the central banks may use but I as a consumer do not care.  (US example - “The BLS does track Energy as a separate aggregate index, which in recent years has been assigned a relative importance of 8.030 out of 100.”)