Stock Markets: A disaster waiting to happen

 

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Aditya Goela
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Harsh Goela

 

 

 

 

 

Authors:

After completing school, we found to our disappointment, that there was no degree available in the field of Stock markets which has been our passion. We then decided to drop out of formal education system and completed our education from graduation to  post graduation  through  distant learning  programs. During this time we covered many courses on fundamentals, technical’s and behavioral  finance related to the Markets.

We are self  taught informed investors with the help of  News Media, Social Media, Reading and  Research. Today,  after having studied for five years with our self designed educational plan, we have written this article on the Health of World Economics and how we need to prepare ourselves for future investments.  We have discovered with our Research and Observations that 1)  Understanding the Market/Business  Cycles, 2) Timing of Investment & Disinvestment and finally 3)  Cash Management are key to  WEALTH Creation

We  thank our father for his help, support and guidance in shaping our knowledge systematically over the years. We are grateful to him  for helping us  compile this article together,  with his vast knowledge and experience.

You may write to us for any  suggestions/improvements or any  topic that you desire to have information about. We  will welcome your thoughtful comments. You may upload your comments on this blog.

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Introduction:

This  is a story of  the Global Macro Economy since 2002 to 2016, about how the  economy has moved from one disaster to another, from optimism and expansion (2002-2008) to recession and contraction in economic activity (2008-2016), and now, staring into a even  deeper recession. This is due to the  failure of global Accommodative Monetary & Fiscal Policies which have failed to produce the desired growth targets. We attempt to take you step by step and unfold before you the amazing journey of the World Economy since 2002 to 2016 and beyond.

We must to prepare  ourselves to face the  transformed ” New Normal ”  of the Global Economy and be invested in the right asset classes to maximise our returns

Let me summarize the whole article at the very  beginning  itself. 

“The soft and accommodative Monetary Policies with near Zero Interest rates  have failed to achieve growth. Monetary Policy Transmission has failed. These policies have been in aggressive use since the Financial Crisis of  2008. This tsunami of money which was supposed to provide stimulus to  Consumption and Capital Investments has instead created bubbles in Stock Markets and Real estate valuations. This money has gone into speculative assets instead of productive assets. Huge capacities in manufacturing and services sectors created in 2002-2008 period are still lying underutilized by about 30%. Fresh expansions will not take place till 90 % capacity utilization is achieved. People do not want  to consume and invest but prefer to save because there are a lot of uncertainties in the world which could erupt into crisis. People are unsure about their future growth in income and wealth. This puts a hold on consumption and investment.  So there is a lot of Liquidity in markets but without growth. Further liquidity could end up in Hyperinflation. World is in a Liquidity Trap which means we are addicted to cheap and easy money  but without growth in GDP or individual incomes. Withdrawal of Quantitative Easing and Very low rate of Interests   would instantly crash all markets. If these soft monetary policies continue, it will be like ‘kicking the can of worms ahead’ which will sooner than  later end up in Bubble Bust and a  hard landing, hurting every business and individual.  However if Growth in GDP picks up, it could save us from the problem but it seems very unlikely. No one can predict the future but we can prepare ourselves by being invested in  the  asset class that would perform best  given these global uncertainties. So we, recommend you to buy Gold.


2002-2008 

This period of global economy, saw the rise of emerging markets, where the prices of commodities, oil, gold, real estate  made life  time highs.  GDP growth was phenomenal and stock markets were bullish. As the Per Capita Income and Disposable Income of the world was increasing, Investments in Capital Expenditure & Consumption became robust. As a consequence we saw huge capacities build up in the 2002-2008 period in terms of manufacturing and services. It was  a  period of Commodity Super Cycle. ( Refer to Chart of  Bloomberg Commodity Index in later pages )  Banks all over the world were offering all kinds of loans very aggressively, be it personal, educational or mortgage, as there was abundant liquidity. Everybody was leveraged in investments. So much so, that Loans were being planned to be repaid out of the asset appreciation and not out of income. This was the height of speculation.

A perfect Bubble was building up. Banks employees were selling loans based on a commission system. 2005 to 2007 was a Bubble Boom period where big money was made in stock markets. This led to Subprime Lending for the lure of commissions. High valuations of  real estate, commodities and also equities were becoming difficult to  sustain. The Bubble was reaching its scary peak, ready to burst any time. Ultimately  the global crisis unfolded, asset prices crashed, leading  to the Fannie Mae and Freddie Mac getting taken over by US Government. This was  followed by the collapse of Merrill Lynch, AIG.  The bubble ended up with the collapse of Lehman brothers on September 15′ 2008 all snowballing into a full blown Financial Crisis.

2008-financial-crisis

As a consequence of this collapse, there was a complete credit crisis and a credit freeze with respect to flow of funds between businesses and institutions. Lending stopped as credit worthiness of all became a question mark. We were left with huge overcapacities without demand and NPAs with banks ( Non Performing Assets : assets which are likely to become worthless  ). World was taken over by recession.


2008-2016

This was altogether a new phase of the global economy. During this phase, all countries have  tried to move out of recessionary conditions towards growth. The Central Banks of the World  now came into play, in order to promote Consumption & Investment.  Quantitative Easing  and loans at very low interest rates were issued. In some countries, Interest rates even became  negative.  Negative Interest Rates Policy i.e. NIRP, means  Central Banks charges  to hold cash of  Commercial Banks  and also fixed deposit holders have to pay to  keep their  money in commercial  banks. This policy is to incentivize banks to lend, businesses &  individuals, so that they  spend more, which in turn leads  to higher consumption and investment for the country’s growth.    This did  not produce any growth in Earnings, as money went into speculative investment areas such as equities and real estate instead of Capital Investment.chart-1

Investment & Consumption did not grow because no one was  optimistic about future. They preferred  not to spend but to  save. During the peak of 2008 and onwards, huge overcapacities were built which are still lying unutilized to the extent of 30-40%. So the question of money going into productive areas was unthinkable.

20160319_inc747In the last 2 years since 2015, we have seen bubbles building up  in real estate and equities. As a consequence, we have seen funds moving out of risky assets to safe assets like bonds and gold by some of the smart investors. Due to the heavy demand for bonds, bond yields have become negative.

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We are now sitting on a bond bubble, credit bubble, debt bubble, equity bubble and a bubble in  real estate. The question is where do we invest in the current scenario.

In 2008 we were faced with crisis in Banking System and now this crisis has moved to Central Banks of the world, which could leave even a 10 times greater impact on the economy compared to the 2008 financial crisis.  In 2016 we are staring at a super debt crisis in the Central Banks of USA, China, Japan, EU, etc. The High level  of global  debt which is unserviceable even if the Global GDP  grows to 4 % from the current  2.1 %.

The period from 2002 to 2016 is a perfect example of a full Business / Economic Cycle combined with Market Cycle from bust to boom to bust again. From Recession to Expansion and back into recession. ( Refer graphic below )

business-cycle-graph

-In the First phase from  2002 to 2006, demand was in excess of supply for all commodities, oil, housing, services, manufacturing, gold, equity markets, IPOs etc.

-In  the Second phase from of 2006-2008, we saw large expansions of capacity in supply, out pacing the increase in demand. So this was the expansionary phase,  the bull phase or the boom phase in markets.

-Then came the Third phase of economic cycle where supply exceeded demand or the recessionary phase ( 2008 – 2016). Here commodity and oil prices fell as much as 60 % from the peak of 2008. (Refer to Chart of  Bloomberg Commodity Index in earlier pages )   Interest rate have fallen to historic lows, unutilized capacities are at the highest levels, slowing growth and  falling inflation or deflationary conditions. This is happening in spite of giving steroids to the economy by injecting in trillions of Dollars as Quantitative Easing Money, with loans being offered at near zero interest rates. So what we are seeing is the diminishing effect of debt on the growth. Now how can we save the shrinking global economy. The answer is tricky, because even the Central Banks have no clue  and are groping in the dark for solutions, as they have been seeing failure of Monetary and Fiscal tools over the  years to pull up growth.

What now after the Monetary policies have become ineffective to induce growth ?

Since Monetary Policies have done whatever was possible, the next attempt to stimulate economy could be from the use of Fiscal Policies. When, Monetary Policies start to lose effect, fiscal policies can start the effort to stimulate the economy.  Fiscal Policies attempt to complement the Monetary Policies (Refer ICOR chart below for China). We can see  in 2016, to create ONE dollar of additional GDP we need to invest about SEVEN Dollars and the graph seems to be still rising. In 2007 only THREE dollar were required to create ONE dollar of GDP.

Basically, monetary policies provide stimulus to the economy when Central Banks buy Government Sovereign Bonds or Bonds of Banks to provide liquidity, which are further given as loans by banks to Companies and individuals, to encourage investment & consumption and thereby create demand and employment to push up economic activity.

What is the ‘Incremental Capital Output Ratio – ICOR’

ICOR assesses the marginal amount of investment capital necessary  to generate the next unit of production. Overall, a higher ICOR value is not preferred because it indicates that the entity’s production is inefficient. The measure is used predominantly in determining a country’s level of production efficiency.

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On the other hand what Fiscal Policy does is that Governments spend directly on infrastructure projects like roads, bridges, airports instead of relying on Companies and individuals, as mentioned in above paragraph.

Currently we are passing through irrational market movements as  compared to the economic activity.  Dalal  Street or Wall Street are completely out of sync with the Main Street. While indices of Equity Markets, Real Estate ( other than the Indian Real Estate ) are close to life time highs, the  health of the global economy is at a all time low. Markets in short term may move in divergence to the level of economic activity but in long term the prices in the  markets do catch up with the fundamentals of the economy. So in the current state we will either see earning or growth moving up to justify the market valuations or we will see markets correcting to be in sync with economic activity. Given the current circumstances it is very likely that valuations of assets will correct given the poor macro  economic conditions globally. The markets are only moving  higher due to mammoth liquidity i.e. easy to access money and loans available at zero cost created by the Central Banks of the World. Even the most intelligent and informed  investor needs considerable amount of willpower to stay away from Herd mentality.  Investors are following the herd, hoping that they too would find another fool to offload the shares at higher prices. It is important to mention  here that the markets can remain irrational longer that you can remain solvent but over a longer term value investing is the way to create wealth. While stock markets are making all time highs and still bullish, some smart investors are already feeling jittery and loosing confidence in the valuations & sustainability of stock markets ( Refer to Charts of Stock Market indices in later pages )  at these levels and therefore moving to safer investments like Gold and Sovereign Bonds, pushing yields of Bonds into negative zone. ( Refer 10 year Bond Yield Curves of US, Germany, India and Japan )

 

Wrong action on everybody’s part.

PEOPLE SPENDING BEYOND THEIR MEANS.                                 BANKS LENDING BEYOND THEIR SOURCES

COUNTRIES PRINTING MONEY WITHOUT A THOUGHT             HAS THE WHOLE WORLD GONE MAD


Accommodative  Monetary  Policy  that the Central Banks have adopted to push up Growth.

This is a policy where the Central Bank (likes of Federal Reserve Bank of USA etc) attempts to expand the overall money supply to boost the economy and increase growth. This is done to encourage more spending by consumers and businesses by making money cheaper  by lowering the interest rate. Furthermore, the Central Banks of the world also  purchase Treasuries or Bonds to infuse capital into a weak economy.

Broadly, there are two types of monetary policy for expansion and  contraction.

First,  Expansionary Monetary  Policy that increases the money supply in order to increase production, create more jobs, lower unemployment, boost private-sector borrowing and consumer spending to stimulate economic growth. Often referred to as “easy monetary policy“.

monetary-policySecond  is Contractionary  Monetary Policy  that reduces the  money supply  during inflationary times. Here  the rate of Interest can be increased  to suck out excess money from the system. This results in lower borrowings due to higher interest rates and contracts the economic activity thereby brings an equilibrium between demand and supply and thereby eases inflation.

Central Bank’s key responsibilities are :-

1 )  provide a stable currency for international trade

2 )  keep a balance between growth and inflation

 These functions are managed with Monetary Policies by controlling and maintaining   the  liquidity of money in the markets with the help of Interest Rates, Printing of Money, Sale/Purchase of Government Bonds, and other non conventional policies.

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Money Printing

What if a Central Bank cannot lower interest rates any longer, as is the situation currently. The next option is to Print Money. The concept of “printing money” is same as quantitative easing (QE). Quantitative easing is a mechanism by which The Central Bank can inject more money into the economy, virtually out of thin air. This is done by buying Government Bonds, thereby providing liquidity to Government to spend money and stimulate economic activity. However, this inflates the Balance Sheet of the Central Bank or makes the Balance Sheet Debt heavy. As more printing is needed to stimulate a slowing economy, it ends up in Debt Bubble as is the situation now. So to be precise, the function of the Central Banks of the world is Financial Engineering and Financial Innovation. Their new job seems to be, to create a bubble and then not letting it burst . Their job ends when the bubble bursts, creating widespread financial and credit crisis. Then their job starts again to save the economy.

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Functions of a Central Bank

Now as more and more money is being pumped in by Quantitative Easing with low interest rates (also called Helicopter money), Law of Diminishing returns is being seen on the growth side. In 2008,  each dollar of extra debt gave growth  of about 3 dollars to the GDP in China and now it is close to zero. Therefore more debt is not having effect on growth any more. Now if these accommodative policies are not showing results, then what is the next strategy to save the economy. Even the Central Banks have no answer to that but are continuing  these soft loans policies hoping for a magic to happen. We all know that beyond a point these policies will cause considerable damage to the global economy by  pilling up of Non Performing assets worth  trillions of dollars,  only to be written off some day. Thereby causing financial crisis and credit crisis of a far larger magnitude then the one in 2008 and create havoc in currency valuations as well. The Debt bubble burst is a disaster waiting to happen, however, how quickly it happens, no one knows.world_bomb

As a nation and a world, we have made numerous bad choices, taken the easy road, and ended up in global crisis many times. Now we are faced with a set of difficult choice about our monetary and fiscal policy decisions . History is full of bad choices made by both individuals and nations. Not only are we irrational but sometimes we are predictably irrational. Only time will tell about the impact of this unserviceable debt ( where the income cannot meet the repayment of interest ) that the world is now burdened with.

The World’s Central Banks are very close to the limits of their inability to stimulate the economy.  Global growth is getting weaker. The time has come for  structural changes to meet the problems of debt burden and overcapacities. What is now needed is a coordinated monetary/fiscal and structural adjustments policies to revive growth worldwide.

There is also a Conspiracy between the Central Banks of the World and their  Governments against the Savers, to keep interest rates as low as possible even lower that the Real Interest Rates. This is made possible as Central Banks are always willing to supply unlimited money to the Governments backed with a sovereign guarantee, at low rates ( Repressed Rates ). As government is the biggest borrower because of Deficit Financing, Repressed Rates suits them best to stay solvent. It is a punishment for Savers and a  benefit to Borrowers of  Industry, Governments and Investors. It again fits in best for an Economy that wants to stimulate growth. It is in other words transfer of benefits from Savers to Borrowers. It is a Tax on Savers. This is called Financial Repression. The system wants the money to go into productive assets at low interest rates and not to Savers who seem to be creating interest without taking risk. Money needs to go into risky assets that contribute to the GDP rather than unproductive investments such as deposits with banks. No country can let its money sleep.

Below are charts of USA, India, China, Europe and  Japan that show the trend of Inflation and Interest rates over the last few years, it a  reflection of  the Monetary Policy stance taken by the Central Banks  to support growth.

In Investing, there is no crystal ball for  predicting  an outcome, however we must see indicators and warnings and prepare ourselves for  our future investments.  Therefore  all  events in the world must be observed  closely.  Investor  Mohamed- El-Erian  of  PIMCO popularized the phrase the ” New  Normal” to describe the global economy after the 2008 financial crisis. The ‘Old Normal’  is gone but the ‘New Normal’ has not yet arrived. The Global economy has fallen out of its old equilibrium but has not stabilized in the new one. So  the economy is in a transition phase from one state to another.

This has been well illustrated  by “James Rickards ” the author of  ” The Death of Money ”  by the example of  heating  water till it boils. In the stage between water and steam, we have a water surface which is bubbling and is in turbulent zone before it turns to steam. The Global economy at present is in this turbulent zone, it  may cool down and remain in the water state or turn into a state of  steam.  This transition  period would be very  painful for the investors. Monetary  Policy is a tool to turn up the heat. The Central  Banks believe that it is managing a reversible process, however the economy  has  transited into a  new normal, into an  altogether new state. So we are  unable to predict the future of the economy. Given these large risks,  gold would be the best place to sit on, gold has already given an  appreciation of about 32%   from the bottom it made in the beginning of 2016.  For an aggressive investor who is invested in  equities and  in  real estate, the risk reward ratio is against him, unlike gold.

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Japan

The Lost 25 Years (1991-2016) of Japan after the collapse of the asset bubbles in 1991. Over the period of 1995 to 2016, GDP fell from $5.33 to $4.41 trillion in nominal terms.

Japan’s strong economic growth from 1950 onwards ended abruptly at the start of the 1990s. The Japanese economic system had fueled a speculative asset price bubble of a massive scale. The bubble was caused by the aggressive and excessive loan growth. Japan’s banks’ built up subprime quality debt  regardless of the  quality of the borrower which created bubble in the economy to grotesque proportions.

 Trying to deflate speculation and keep inflation in check, the Bank of Japan sharply raised interest  rates in late 1989. This caused the bubble to burst and the Japanese stock market crashed. Equity and asset prices fell, leaving over leveraged Japanese banks and insurance companies with books full of bad debt and Non Performing assets (NPA). The financial institutions were bailed out through capital infusions from the government, loans and cheap credit from the central bank, and they kept postponing  the recognition of losses, ultimately turning them into Zombie Banks.

zombie bank is a financial institution that has an economic net worth less than zero but continues to operate because its ability to repay its debts is shored up by government credit support. Banks kept injecting new funds into unprofitable “zombie firms” to keep them afloat, arguing that they were too big to fail . Japan’s economy did not begin to recover until this practice had ended. Eventually, many of these failing firms became unsustainable, and a wave of consolidation took place. Many Japanese firms were burdened with heavy debts, and it became very difficult to obtain credit. Many borrowers turned to private moneylenders  and  Non Banking Financial Institutions which gave loans at very high interest rates, made business bad to worse. In 2016, the official interest rate have become negative to -0.35 % and have  remained below 1% since 1994. The question is why did the economy not improve in spite such low interest rates.  Japanese wages have stagnated  and fallen from peak in 1997 by about 12 %.. Japan’s GDP  in 1980s  was growing at rate of 9 %  and has come to the current levels of Zero to Negative growth rates.

Japan’s lost decade is an example of a liquidity trap. Liquidity trap is a situation when expansionary/ easy monetary policy ( increase in money supply )  does not increase the interest rate due to no growth in consumption, investments, income and hence does not stimulate economic growth due to deflationary conditions. If there is no demand for products & services, there is no pressure on inflation to rise and therefore under such deflationary conditions you cannot even think of a rise in interest rate. The liquidity trap is the situation in which prevailing interest rates are low and savings rates are high, making monetary policy ineffective. In a liquidity trap, consumers choose to save because of economic uncertainties, therefore tend to avoid consumption and investment. There is also a fear that interest rates will soon rise and economy may collapse .Consumers do not want to hold or buy  risky assets due to the scare of price fall.  The Bank of Japan increased interest rates in 1990 for concerns over the bubble and in 1991 land and stock prices began a steep decline, within a few years reaching 60% below their peak. Nikkie 225 has declined from 39000 levels in 1989 to 17000 in August 2016, a CAGR % drop of 3% over the last 27 years. That means 100,000 INR invested in Nikkie in 1989 has today been left to 43,937 INR. Had 100,000 INR been invested in bank FDR during the same period at a interest rate of 8% it would have become 798,806 INR.  So, therefore, it is of prime importance to understand the Market and Business cycles, correct timing of Entry/ Exit and cash management  for best returns.

Japan’s “Great Recession” that began in 1990 was a “Balance Sheet Recession”. A Balance sheet recession occurs when high levels of debt cause individuals or companies to focus on saving and paying up debt rather than spending or investing, thus causing economic growth to slow or decline. It was triggered by a collapse in land and stock prices, which caused Japanese firms to  become  bankrupt, meaning that the worth of  their assets was  less than their liabilities. This was there, despite zero interest rates and expansion of the money supply to encourage borrowing. Japanese companies opted to repay debts from their own business earnings rather than borrowing to invest.

Today,  we have again  taken a similar route of Quantitative Easing with prolonged Zero to Negative interest rates that Japan did. After the economy gets addicted to  cheap and easily available money, which has to  stop one day and then with the reversal of interest rates to higher levels, the economy will collapse under weight of debt. It takes a long time to adjust to the new normal. During this transition period, bubbles burst cause the  crashing of the stock markets and real estate. Central banks are continuing  with the QE and reducing interest  rates because probably they have no  choice. They are  kicking the can of worms forward till it bursts on its own.

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Japan Stock Index – Nikkei

Important

Japan’s financial situation over the last 25 years is being repeated once again all over the world. The Problem is THE LIQUIDITY TRAP AND ITS CONSEQUENCES. Currently the World has no option but to continue soft monetary policies till  the reversal of  damage will not be possible and then tightening  interest rates will be next solution after mentally accepting the consequences into a  Financial Crisis and crash of all the markets. Then all excess debt in the form of NPAs would have to be written off to start clean again. This would also have a devastating effect on Currency Exchange ratios and valuations.

Japan’s stock markets have proved that we must understand the Market/Business  Cycles, Timing of Investment & Disinvestment and finally Cash Management which are  key to  sound and profitable investment or else you can loose a lot of money.  Japan has also taught us that Long term investing is not necessarily profitable. WE FEEL BIENG INVESTED IN A TREND TERM MATTERS AND NOT LONG TERM OR SHORT TERM.

It is said, it is all about “Time In The  Market   and  not Timing The Market” that is important to get rich.  However, we  believe  that it is all about  “TIMING THE  MARKET  and  NOT  TIME  IN  THE  MARKET”  that matters.

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China

It was a rosy story of its remarkable success which is now a story of potential disaster. In 1978 the macroeconomic numbers of India and China were actually comparable, except that China was much ahead in key indicators such as education, health and social infrastructure. It achieved rapid growth after 1990 with GDP growing at 10 %. China is today a $ 11 trillion economy which is five times that of India today.

China’s Foreign Exchange Reserves have fallen from $4 trillion in June 2014 to $ 3.192 trillion in August 2016. Exports and Imports  are falling due poor global demand. A huge Housing Bubble is staring into the eyes with a Debt bubble in the Chinese banks and Corporates. Ambitious investments were taking place in Infrastructure during the last 20 years, due to which growth in GDP could be sustained  for over two decades. This led to built up  of large capacities in areas of all economic activities. Today they are faced with overcapacities that are un-utilized and that might take a decade for the demand to catch up. With the stagnation of Investments in Infrastructure development, GDP growth has now slowed down to about 5 to 6% , coming down from as high as 11%. Their demand for commodities and oil has fallen sharply causing the End of Commodity Super Cycle for the Emerging Markets such as Brasil,  Russia ,India,  Australia, and the other Oil and Commodity producing countries. So now we are seeing a long and a painful transition from an investment led growth model in China to a consumption led model. However, China will surely be able to get back its growth in a matter of few years as they have made considerable investments  in  Education, Research, Innovation, Investments in R&D and this  will soon begin to pay dividends,  but in the immediate coming future their GDP growth could fall further to even less than 4 % before it starts to rise. However, even 4% is impressive for the World’s second largest economy to grow at. Productivity of manpower in China is at least 5 times compared to other Emerging Markets like India while labour costs are much higher relatively.

Since the last couple of Years, China’s growth driver has been Real Estate  and Infrastructure development. Infact it is helping the GDP to remain about 6% currently. However, further investments in this sector are not showing positive impact on GDP.  Real Estate has a 8% contribution to the Chinese’s GDP and a slowdown can cause the Chinese economy to have a hard landing. From now on real estate market seems to slow down as the valuations and growth is unsustainable. Chinese banks have a very large exposure to this sector.

China is an economy of transition staring into property and a debt bubble and low Growth.

 So the world’s growth engine has slowed down leading to contraction in global trade and recessions in many countries.  

The glass is always half full or half empty. With regards to China, if it appears full, you are hallucinating, if it appears empty, you are manic depressive.

 

Global Economy’s biggest risk – Protectionism

Since 2008, mostly everyone and everywhere in the world are feeling stagnated because there has been no real growth in earnings, Jobs are  difficult to get, mirroring  a similar  feeling of the 2008 recession . All monetary policy tools including innovative and  unconventional ones have proved ill-suited  to prop up earnings and growth. Macroeconomic outcomes have  repeatedly failed to promote inclusive prosperity. This period of low growth  and rising inequality is now threatening the consensus in favour of globalization and regional integration. As a result , progress on linearization  and cross boarder integration is hitting a wall.

Radical decisions such as Brexit, moving towards protectionism in trade practices  are a direct consequence of the current economic situation. Let us see the outcome of US elections later this year. People are willing to go for changes by  trying altogether new policies even though risk reward ratio is against them.

One  of the surprises of the 2008 global financial crisis is that the ‘ Great Recession’ that followed, did not trigger much of a protectionism wave, even though output collapsed after the financial systems ‘sudden stop’ in the fall of 2008. As the global depression loomed, there were fears that countries would adopt Protectionist trade measures as a way to promote their own growth at the expenses of others. Imposing restrictions on free trade of imports and exports on products such as services, capital, commodities, oil, gold etc in order to create local employment opportunities, to promote locally produced products to generate income and growth. This means cost of production of such products and services could increase because trade without restrictions is always a cost advantage.  Protectionism provides stability to the country’s economy in terms of employment, income and growth. Protectionism implies stopping  import of  goods and services from outside the  country and  giving employment opportunities to the citizens of the country first. But this has overtime been proved ineffective and counter-productive, however, it may look good politically in the short term but over longer period of time it is terrible blow to the  growth of global trade. This is like taking the economy back by 25 years. 

G20 Leaders Say World Economy Is At Risk

g20-china-summit

In a meeting held on 4.9.2016 by the G20 leaders it was concluded that the global economy is being threatened by rising  protectionism and risks from highly leveraged financial markets.

Global economy has arrived at crucial juncture in the face of sluggish demand, volatile financial markets and feeble trade and investment.

Growth drivers of earlier technological progress are gradually fading away, while a new round of technological and industrial revolution has yet to gain momentum. All policy measures including monetary, financial and structural reforms, need to be used in a coordinated way between all the countries to achieve solid and sustainable economic growth. If due to protectionism there is no international trade or no cross boarder investments, if services, capital, people and goods do not cross boarders then it would cause reduction in economic activity for all us which would end up in contraction of economy followed by recession and depression.

ECB’s Mario Draghi has run out of magic as deflation closes in The Telegraph 09.09.2016

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ECB’s  Mario  Draghi  said  large parts of the euro zone are slipping   deeper  into a   deflationary  trap  despite  negative interest rates and  large  quantitative   easing by  the  European Central Bank ( ECB ).   In spite of the freely available cash people are not willing to spend, consume or invest. They are not confident about their future incomes. Everyone prefers to save rather than  take a loan to spend in  spite  zero  rate of  interest. ECB has downgraded its growth forecast for the next two years, citing the uncertainties of Brexit, and admitted that it has little chance of meeting its 2%  inflation target this decade. He said it is now up to governments to break out of the vicious circle. ECB left  its  €1.7 trillion stimulus unchanged. Monetary Policy along with QE has failed to push up growth and inflation in EU.

ECB kept the monetary policy unchanged at 0 % and lowered its growth forecast up to 2018. Investors were expecting the ECB to either expand its multi billion euro stimulus package or extend its tenure but the ECB did neither. Markets fell all over the world. Bond Yield hardened as easy and cheap may be difficult to come now. Bonds were sold across the world and yields rose. Yield on Bonds and price of Bonds move in opposite directions, when Bonds fall, yields rise and vice versa. Rising yields will have a negative impact on Equities and Emerging Markets.  This seems to be the beginning of the end of Accommodative Policies all over the world as these polices have become ineffective for growth.

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United States & EU

USA and EU have been origins of Financial Engineering. All the matters discussed above,  about Accommodative Monetary policies, QE, Zero Interest Rate are extensively in use in USA and EU Zone. What Japan was, in 1989, USA and EU stand there today. Japanese accommodative monetary policies failed through 1990 to 2016. Japan is a example of a Liquidity Trap i.e. Quantitative Money( Helicopter Money ) with Negative Interest Rates, have failed to bring about growth in Consumption & Investment. Housing bubble, Debt bubble, Equity bubble, Fed & ECB Balance Sheet filled with debt. Corporates  are in Balance Sheet Recession and unable to adopt expansionary economic activities. Financial Repression has been adopted in full.

The focus will be on US FED  monetary policy on September 20′ 2016. Though the Fed is unlikely to increase interest rates due to weaker than expected jobs.

It is said in 1815 people wanted to go to Europe, in 1915 USA became the land of opportunity  and  now in 2015  is  China’s turn.

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India

India has been a big  beneficiary of the breakdown of the  Commodity and Crude Oil Super Cycle ( Refer to Business Cycle Chart in earlier pages ) since 2015 as 70 % of our imports are of oil and commodities. Gold too, which is also imported has provided support with price correction in the last  4 years.  This has substantially improved India’s macroeconomic indicators with respect to Foreign Exchange Reserves, Balance of Payments, Fiscal deficit, Current Account deficit, stable Currency and steady growth in GDP. This has made more funds available with the Government for investments in infrastructure projects  and for other social spending schemes.

With Accommodative Monetary & Fiscal Policies the world over, (  Helicopter money ) with near zero interest rates ( NIRP ) to stimulate consumption & investments and to save the economies from entering into recession has proved ineffective. India looks to be the only place where growth is a reality at about  7.1%, capital has no choice but to land in India given its sound macro and micro economic indicators. Globally  money is being invested in stock markets & real estate, instead of the desired consumption & investment. So to sum up India seems to be on the cusp of a liquidity super cycle where big inflows may be coming in,  in the decade to come. We can say India stands today where China stood in 1990. However, it would not be out of place to mention here that, currently, everyone seems to be very bullish on India and when we have a super consensus, it seldom comes true. India is just 2 % of the Global markets, so its growth is surely coupled with the rest of the world.

7
Sensex

Can consumption alone drive GDP growth ?

Growth for China’s new consumption based economy  is also questionable.  Investment without doubt is very important for a sustained growth in economy. Investment cycle  pick up is far from near  as World and India  are all  loaded  with under  utilized capacities that were built during 2005-08 euphoric period.

Following charts reflect the  Macro Economic indicators for the Indian Economy as on July 2016. This data shows government spending contracted in July 2016, suggesting that government consumption expenditure is unlikely to prop up demand. The burden of shouldering growth would now fall largely on the households along with investments from Private Sector, which looks  unlikely  due to pessimism about the  future of economy  worldwide and the  given  under utilized  production capacities.

The above data for GDP confirms the widely held view that a pick  up in Investment Cycle is not looking possible, mainly due to poor Private Sector Investments. Balance Sheets of major Companies are over leveraged  and with weak demand, investment becomes a far off dream. Indian and Global Companies are stuck in a Liquidity Trap which means their focus becomes on savings and reduction of debt instead of building more assets. The problem is compounded by global excess capacity. With growth in demand subdued, capacity utilization rates are low across the world. Like China, the Indian  growth in the near term can only be based on consumption rather than activity in Investment.

It is expected that Private Consumption & Investment might pick up with good Monsoons which will boost farm income. Secondly, public pay hikes under the Seventh Pay Commission will provide liquidity to the markets once implemented.

Further, an Interest Rate cut may not be possible in the immediate term as both Consumer Price Index ( CPI ) at 6.07 % and Food Inflation at 8.35 % in July 2016 is outside the comfort zone of Reserve Bank of India (RBI).

The Indices of Industrial Production ( IIP )  has contracted by -2.4 % ( July 2016 ) compared from 2.0 %  ( June 2016 ) in India.  This was mainly on account of weakness in manufacturing, which contracted 3.4 per cent. Consumer price index-based (CPI-based) inflation stood at 5.05%( August 2016)  versus 6.07% ( July 2016 ). IIP is a matter of concern.

When we say India is doing well, it means India is relatively doing better, amongst countries such as Japan which has Negative growth rate.  Reserve Bank of India ( RBI ) too  says, India is working at 74 % capacity utilization levels.

Ever since India’s business cycle moved to a recovery  in 2014, consumption has done well but Investment has not. Similarly, Non Financial services have done well but Industry has not.

In spite the above headwinds, India is still the fastest  growing economy in the world.  India has become a destination for investments in Stock Markets, being in a structural bull run, however, if problems crop in the world our markets too will correct but those corrections would be a investment opportunity not to be missed.

Indian Market and Business Indicators look strong:

  1. Market Cap / GDP = 73 % (in India) as on August 2016 which is reasonable valuation.
  2. PE Ratio is 24 ( at Nifty level of 8800 on in September 2016) and 19, one year forward. This is on a extremely low earnings base and earnings are expected to rise.
  3. In the last 2 years, the Top Line or Revenues in India have been growing at a low rate of about 5 %. This is what it was about a decade ago. Profits are now at a low double digit growth. This is due to the fact that oil and commodity prices have corrected by more than 50%,  bringing down the cost of production drastically for almost all sectors of the economy. With little rise in demand profits can rise to higher levels of growth.
  4. Nifty and Sensex charts (price / volume ) are in a positive trend. Follow the trend of the charts. As we know the hardest thing to change is the trend till it changes. Charts is  the only truth, as the rest are discussions ,talks, projections , estimates, gossip and predictions which is the livelyhood of  media, consultants, fund managers, brokers, analyst, insurance agents etc.
  5. India has good governance and reforms like GST are being taken up. With implementation of 7th Pay Commission consumption and investment is likely to increase. India has developed good relations with the rest of the world.  Our Government is strong with majority votes and therefore reforms can be taken up with stable policies.
  6. Inflation, Interest Rates, GDP, CAD, BoP, Exports etc all are within limits and conducive for growth.
  7. Indian Indicators are robust in terms of Automobile Sales, Petroleum consumption, Production of Consumer Durables, Airline Passenger traffic ( 18% growth in last 12 months ), gradual revival of demand and good Monsoons will help control inflation and rural consumption.
  8. Auto Sector Clocks robust 26 % growth in August 2016
  9. Mutual Funds’ assets hit a fresh high of Rs 15.6 lakh crore

Some negatives are :-

  1. Government’s Capital Expenditure falls in first 4 months of FY 2017 from Rs 86,026 crores to Rs.71,283 crores. ( Business Line dated 2.9.2016 )
  2. The Indices of Industrial Production ( IIP ) has contracted by -2.4 % ( July 2016 ) compared from 2.0 % ( June 2016 ) in India.  This was mainly on account of weakness in manufacturing, which contracted 3.4 per cent. Consumer price index-based (CPI-based) inflation stood at 5.05%( August 2016)  versus 6.07% ( July 2016 ). IIP is a matter of
  1. Domestic Insurers pulled out $ 1.9 Bn from Stocks. ( Business Standard 6.9.2016 ). Insurers remain sellers for six months in a row, in a sharp contrast to Foreign Portfolio Investors( FPI), Domestic Mutual Funds.
  1. Indian GDP growth slows to 7.1 %. ( Business Standard 1.9.2016 )
  2. Tata Consultancy Services Ltd’s profit warning spreads IT Gloom. Brexit and cutback in US hurting IT spends ( Business Standard 9.9.2016 )
  3. Private sector investment not picking up
  4. Huge NPA problems can only get worse
  5. Corporates are over leveraged to the extent they are in a Balance Sheet Recession
  6. Companies are running with underutilized capacities

India is a long term structural bull run story in sectors such as Consumption and Infrastructure development

Turning bearish too early is also not helpful.

We have been facing large issue as discussed earlier, such as :-

  1. Increase in Interest rates by the Fed Bank in USA and its commentary about future
  2. Brexit and its consequences
  3. Unknown China factor and credit issues
  4. Failure of Monetary policies in the Developed Markets.
  5. Global Debt crisis

We have been able to kick this can of mega issues ahead on the road and postponed the crisis, however, these issues will always haunt us till they burst out open  into disasters. India is also  well integrated with the rest of the world but turning bearish too early is also not helpful. So one can enjoy the market party till it lasts as liquidity is in plenty due to QE and near zero interest rates. This is only for the  very bold and the risk takers. The prudent long term investors will get a chance to enter the markets at very attractive valuation sooner than later, till then  sitting on Bank deposit or being invested in Gold would be the best.

Global market Indicators:

  1. Political uncertainties in Middle East
  1. Economic uncertainties. Brexit. ( Exit of UK from  European Union )
  1. Oil Exporting countries have become cash starved due to fall in oil prices from $140/barrel in 2008 to as low as $ 28 in February 2016 and now around $48 in August 2016. These countries are unable to meet the budgeted social spending such as Pensions etc.
  1. Commodity Export countries are facing a similar problem as the Oil exporters
  1. Global Debt has become a bubble and unserviceable in terms of interest payments. Central banks are loaded with debt due to printing of money and QE. Global banks are under stress as borrowers are unable to pay back even the interest.
  1. Terrorism has taken to roots in Europe and other parts of the world.
  1. US and Europe elections

8, Radical changes in the world like Brexit due to frustration in people no growth in earnings and social unrest and terrorism.

  1. China’s Xi at G20 says world economy at risk ( Business Standard 5.9.2016 )
  2. Oil Traders see another year of pain as glut continues. Bearish mood engulfs the Asia-Pacific Petroleum Conference. 9.9.2016
  3. Tens of thousands of jobs go as China’s biggest banks cut cost ( 9.9.2016 )
  4. World Bank Cuts 2016 Global Growth Forecast to 2.4 percent June 7, 2016

It feels like the economy of 1930s  or feels like pre Lehman Bros period of 2008 is just around the corner.

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Oil Exporters

Oil exporting countries like Venezuela are on the brink of economic collapse. These countries have been hit very hard by the falling oil prices. Price of oil has fallen from $ 140 a barrel in 2008 to current price of $ 46 . Planned and unplanned expenditure  as budgeted by these countries have shrunk to half causing social unrest and there seem to be no hope as Shale Gas becomes viable to produce whenever crude turns $55 a barrel. So one can say there is now a cap on prices of crude oil or dirty oil at $ 55 a barrel. This would be the new normal in the coming years. It other words wealth is moving away from oil exporting countries to oil importing countries like India.

Russia runs out of money after oil crash and sanctions. Russia is burning through its national reserves at an unprecedented rate, amid a deep economic crisis that has plunged millions of people into poverty and wiped out the advances in living standards achieved during President Putin’s long rule. Russian recession in very deep rooted now.( The Times 8.9.2016)

Kenya’s slippery path to oil exports ( Daily Nation 6.9.2016 )

Iranian President Hassan Rouhani says an unstable oil market and low prices will be detrimental to both oil exporting countries.

oil-chart
Oil Price Chart

Oil-exporting countries have been seeking a deal to cap production levels in an attempt to prevent a further drop in global oil prices, which in recent years saw a fall from a high of 147 in 2008 dollars a barrel to a low of around 25 dollars in February 2016. Without it they may get into deep economic depression.

Charts of Countries below reflect  Growth, Inflation and Debt

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Conclusion

Today investors have got into a comfort zone of being invested amidst many economic black swans in  the world. Complacency and a feeling of being safe has crept in the markets as they have remained bullish for about a year now.  A feeling that no matter what, liquidity, due to soft monetary policies will continue to push the markets higher irrespective of the health of the real economy or the fundamentals  of the economy. We now seem to believe that it is a job of the Central Bankers globally to protect the valuations of all assets. Volatility has been nonexistent since February 2016, despite Brexit, the coming US elections or the fading effects on growth of the soft monetary policies. It seems that uncertainty no more matters in investing. Credit is flowing freely  despite a build up of a debt bubble. World has become overleveraged and capacities are underutilized leaving no scope of further Investments. In short, we are in a Liquidity Trap and a Balance Sheet Recession situation. There is only one way forward, that is, we are soon getting into a yet another financial crisis of a far larger magnitude then what we saw in 2008.

debt-bubble

Michael Every of Rabobank believes that the equity market currently is addicted to liquidity,  structurally we need constant increase in  liquidity. If you are putting in x in year one, next year you have to have x plus the growth rate. He sees massive downside risks ahead. Upcoming elections and movement of Central Banks will decide the way ahead. Prefer sitting on cash, in the current scenario.

Mario Draghi’s statement was more of a nuclear bomb than the North Korea one was. So the sword is hanging over our head suggesting that we do not have enough liquidity addition, to continue pushing up equities from what are already very  high levels. So, near-term, until the Bank of Japan ( BoJ ) or the European Central Bank (ECB) surrender and find new ways to  increase quantitative easing (QE), equities are going to correct majorly.
Rise in bond yields does not signal well for the Equity markets. 

So, is the phase of easy and cheap money getting over ? Yes, it seems so. USA’s Federal Bank seems to be clear that interest rates need to be increased by December 2016, as, the US economy is now off its worst level. Unemployment rate have fallen to 4.9 % and they feel inflation will catch up to the 2 % desired level, however, earnings have shown no significant growth. Yet they feel too much of liquidity without growth may end up in hyperinflation. So they need to raise rates before it is too late. If this happens it would be a big blow to the equity markets particularly for the Emerging Markets such as Brasil, Russia, India, China and South Africa, where, funds would start flowing out due to the dollar strength and rising Bond Yields.

Bond Yields in Japan, Germany or USA have already started to rise since July 2016 in anticipation of interest rate rise. This is not a good indicator for the equity markets.

This is yet  another blow to the world economy. Since 2009, QE and NIRP have been adopted by all the developed countries in a very coordinated manner but its seems from 2016 onwards there will be divergence in these monetary policies practiced being implemented in different countries. USA is keen to increase interest rates, EU seems to have stopped  further easing while China and Japan would like to continue with the accommodative policies.

This is kind if being in a completely unchartered or unexplored  territory. Nobody can predict the near future but we can surely prepare ourselves by investing in safe assets.


  If you are  an investor in India and especially in Developed World, the best action would be to cut risk and get into cash, no matter how painful it may be in the short term.

What looks to be calm on the surface is full of turbulence and cracks under. Bubbles building up in Real Estate and Equity markets while growth is slowing down. Short term liquidity overpowers everything else.

USA  in 2007 and China &  EU 2011 are a repeat of what happened to Japan. Why can’t we learn from  history ?  They have all ended badly because of getting stuck in a Liquidity trap. It is like doing the same thing again and again and expecting different results. But this a cycle of BOOM to BUST to BOOM to BUST AND AGAIN AND AGAIN which  will never change. It is a natural Market life cycle. A smart investor must understand this and position his Investments accordingly.

Many of the top investors are bearish. George Soros,  Druckenmiller, Singer are amongst many. Patience and Conviction of Bears will get tested many times but rest assured markets will end very badly leaving no opportunity for the investor to exit the markets. So cut your risky assets and protect your capital for the inevitable bust.

As far as India goes, it is in a structural Bull Run for many years to come but we are closely coupled with the world. We will correct badly when global markets crash. However, these major corrections would become buying opportunities for India.

Also refer to the Stock Market Indices of the major countries to see the trend as discussed in the above pages.

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GOLD

People have considered investment in Gold for three reasons :- 

1)  It is the best currency in the world.

2)  Safe heaven, low risk

3)   Best hedge against inflation

However, we don’t get any kind of income out of Gold Holding like interest, rent , dividend etc. and on top of it we need to  incur costs for holding and  safe custody.

Gold over the period of last 30 years has given us return of 9% in INR and 4 % in US Dollar terms. Volatility risk is minimal relative to the other investment options such as Equity, Real Estate, Bonds or Foreign Currency.

So why GOLD now ?

Gold becomes the best investment when :-

  1. There is weakness in Dollar
  1. In a period when prices decrease i.e. deflationary economic conditions, business activity slows and the economy is burdened by excessive debt. When equity and real estate look risky to invest and Bond yields turn very low as is the current economic environment that we have discussed in this article. In fact due to large QE & NIRP monetary policies adopted over a prolonged period of time, since 2009 which have not resulted in growth have created bubbles in economic system such as of Debt, Real Estate, Credit Crisis and Equity due to their unsustainable valuations caused by excessive liquidity in the system.
  1. Geopolitical instability. Currently we are seeing instable Middle East due to fall in oil prices and the North Korea’s nuclear weapons being tested on and off. On the other side we have had BREXIT and then US Elections are coming up in November 2016.
  1. Countries are actively involved in the  devaluation of  their currencies in order to get a bigger share of trade in the global at the cost of other countries. This is called Currency Wars. During these times currency exchange ration become questionable.
  1. Since 2008 we have seen Economic unrest, Slowing growth, increasing Income Disparity, Political unrest like BREXIT, Unmanageable and Unserviceable Global Debt, coming up elections in USA and Europe, Currency Wars, Negative Bond Yields in Germany, Europe and Japan , Failed Monetary & Fiscal policies, Oil producing countries in recession along with EU and Japan, China the world’s growth engine has slowed down, Commodity exporting countries also in trouble due to low prices such as Australia and Brasil,

 

All these factor are causing anxiety for  Investors and therefore GOLD becomes the only option to safeguard your wealth.

This will the fifth consecutive year with global GDP growth below its long term average of 3.7 % ( 1990 to 2007 ) and 2107 will be the sixth, says a recent report by International Monetary Fund ( IMF ). Low growth amid increasing inequality.

This is still not enough a reason, why I would like to recommend you to buy gold. What is different this time, is the Rise of Gold ETF’s. which has created another asset class for investors and investors.

ETF’s has become a  investment tool since  2005 in the world. Earlier one had to buy physical Gold whereas now it is easy and fast to trade ETF’s on Stock Market platform like any other share. This will create Euphoria and pessimism in valuation due entry and exit of large number of investor, providing a opportunity for the smart investor to profit like in stocks and shares. Herd Mentality will start to play here and will make Gold volatile. Gold has found a new area of application i.e. ETF’s , which has already become a very substantial applicable of Gold. ( Refer data below )

Return on Gold

ETF’s has become a  trigger for a long  BULLRUN for Gold given limited supply of Gold. We could say the Bubble Boom has started which might last till  another 3-5 years. Gold has now become investment option with the rise of ETF’s. Ever since 2008 when the financial crisis ( Start of Economic Uncertainties ) started  Gold has given a Compounded Annual Growth Rate % ( CAGR%) of 14% in Indian INR terms and 9% in US Dollar terms and Gold has entered into Bull phase again after a correction during 2013-15 period, as can be seen in the charts of Gold below. The year 2016 has given a return of about 32 % in India  and 29 % in US Dollar which has been better than Equity.

Gold has been driven in 2016 primarily by investment by Investor in US, Europe and Japan. The investment demand of 1063.9 tons of gold  during the first half of 2016 was 16 % higher than the previous high in the first half of 2009 after the financial crisis. Therefore, rally in gold is likely to sustain because Negative Interest rates and surplus liquidity conditions will continue in the developed world for a longer time.

Holdings of Gold backed ETFs are heading for third quarterly ( Q3/2016 ) gain , the longest  streak since 2012. ETFs backed by precious metals account for just 3 % of the $3.21 trillion of assets held by investors. Signaling that the gold rally will continue.                   One of the largest gold backed ETF in the world is SPDR Gold ETFs

The trend has turned positive for Gold and hardest thing to change is the trend. Gold should continue to give returns better than any other investment for at least the next 3-5 years.

So buy Gold and Exit Equity

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