The week of October 25th: Conspiracy Theory

The G20 meeting of finance ministers and central bankers concluded last weekend on a somewhat predictable yet positive note. The markets had been looking for confirmation of a commitment to reduce the chances of global imbalances being a constant impediment to growth in the developed world. With the VIX volatility index seen to be at the lowest levels since April in the past weeks, investors got a confidence boost at the proposal of a 4% cap on current account surpluses and consequently US equity markets traded higher on Monday morning. 


Although some commentators complained that there was no overt effort to address the currency issue like in the Plaza Accord that the US signed with Japan in the eighties, I see no rational justifications for laying down such regulations. Japan can indeed blame some of its stagflation miseries on the sharp Yen appreciation following the Accord which managed to reduce the dollars value against the Yen by over 50% between 1985 and 1987. This Accord served to reduce the trade deficit problems the US was facing with the other signatories; West Germany, France and Britain, but not with Japan (due to inherent structural imbalance problems).


A sharp correction was due in the S&P 500 this week, but that correction never came. There was a minor sell-off on Thursday but one which was nowhere near levels that were expected, chiefly because of the unsure nature of the upcoming Fed announcements about further stimulus on Wednesday. 


I have a conspiracy theory about what happened before the G20 meeting between the US and China. I have a strong feeling that in the weeks leading up to the meetings in Seoul, an under the table deal was made between the two key economic players.


In the week before the summit, China raised its interest rate by 25 BPS, which caused a flight to safety in equity markets. It changed rates for the first time since it cut rates in December 2008. It was a small change which had a substantial sell off effect in the DOW and S&P. Further, it was a discretionary move, one which was completely unforeseen by the markets at large, much unlike the way the Fed goes about doing things.( The debate between the utility outcomes of having a transparent system like the Fed does and a discretionary system such as the PBOC, has been going on for some time now in monetary economics. What was amply clear with this rate change by the PBOC though was that for short term reactions in the market, discretionary moves have a  much bigger impact, while on the other hand, potential rate changes by the Fed are priced into the market based on announcements and FOMC minutes way before the actual change is made.)


In my opinion, this slight rate hike by China was part of a deal made with the US, which entails more such rate hikes over the medium term in exchange for a mellower stimulus policy which will push down the value of the dollar in small increments. After listening to the various Fed members speak over the last few weeks, it has become pretty clear that the stimulus is going to be of around $500 billion initially and then more further asset purchases will occur on a monthly basis upon reassessment of the prevailing economic conditions. 


This week on Friday, the advanced reading for the last quarter's GDP in the US came out in line at 2%. This was a result that disappointed traders as they were hoping for a number which was not in the predicted range. In the end it turned out to be quite the snooze fest on day which had been built up for the past week as a great opportunity to trade. The number further consolidated the chances of stimulus (as if there was ever any doubt), since it was not much better than predicted. Goldman Sachs had the most bearish consensus at 1.5%, but overall, it was at an average of 2%. Rumours that the Fed was also making inquiries about investor demand in the big institutional players also help consolidate expectations for QE2. 


There is little uncertainty that the Fed is going to announce a stimulus on Wednesday. The uncertainty is about the amount of initial stimulus and the projected goals. Last Sunday, Economists at Goldman Sachs came out with the projection that an injection of $4 trillion was needed to prop up the US economy; a number only GS is capable of projecting! I am sure that the Fed will keep in mind that China is playing along in this game of mutual reassurance and acceptance, and will choose to announce a smallish initial stimulus so that the dollar does not weaken too much too fast. In either case this coming week will prove to be an exciting time for the markets, and only time will tell if this conspiracy theory unfolds the way I think it will.

Tiger tiger burning bright

It is ironic that a recent issue of the economist depicted a sprinting tiger, to indicate that India is soon going to out-pace China. Cut to 1972: the total tiger population in India was dwindling, and alarm bells finally began to ring when the tiger census reported the existence of only 1800 tigers in the wild. Project Tiger, a last ditch attempt to save the remaining severely endangered population began at the behest of then Prime Minister Indira Gandhi. In 2010, the tiger population has been reported at 1400 left in the wild; an optimistic number in my view. The way that Project Tiger has been administered (with 75 million dollars per annum as a budget) is indicative of a greater systemic governance problem that is characteristic of the way things operate in India, the way things are prioritized. The website for Project Tiger seems to be perennially 'under construction'.

To ask what is wrong with a country that cannot get itself to save the animal that has come to symbolize it (along with the elephant, which is not doing too well either!), and yet beats its chest in the power and glory of being one of the emerging superpowers of the new world order, requires deep introspection. One does not need to read Arundhati Roy's expositions against the Indian State to get a sense of the numbers at play, and for some reason, maybe alluding to tigers may make the sense of failure more painful than thinking of the 60 million kids that are malnourished. After a while big numbers such as that are incomprehensible and abstract! 

The Sensex closed on a very healthy 20,000+ this week boosted by the risk appetite shown by foreign investors and the Coal India IPO. The market in India seems to be riding a wave of irrational exuberance.

The only time a truly malicious bubble forms, is when it cannot be seen by everybody. The asset bubble was definitely visible in the States, but only to a chosen few. Applying the same logic to gold prices; everybody knows that gold is overvalued and so I declare that it is not a bubble. There will be a correction in gold prices, but thats about it. According to the FT; "Indian and Indonesian stock markets are trading at earnings ratios of over 40 times, based on ten-year average earnings".  The fact that nobody on Dalal Street seems to give a hoot, signifies a bubble. A bubble that is not just a one of exuberance, but one that has drawn a select population of the country into strict isolation from the fundamentally distorted realities that are present in it. Furthermore, and perhaps more importantly in the spirit of this blog, it keeps people from seeing that the going is good only till so long as investor confidence in the US is on shaky grounds (refer to currency wars article). 

Word has come out from the Fed that the most likely form of QE2 is going to be the purchase of 100 billion dollars worth of assets every month starting November, until the there are improvements in the employment situation. In my opinion, if this happens, it will be a smart move, and one which will give a slow and manageable boost to equities which have already rallied and priced in large asset purchases to a big extent since September. It will also lead to increased investor confidence, and the steady outflow of capital from countries like India and Indonesia. Rest assured that the Sensex will revisit some of those apocalyptic 2008 numbers. The Javan and Sumatran tigers have been extinct for some time now and the Asian Financial Crisis has probably left a deep enough imprint in the Indonesian psyche. Unfortunately for India, there is nothing that seems to  signal impending gloom clearly enough to even encourage concerned dinner table discussions.

Here's my two pence: start with the tiger.

The Week of October 11th: The Great Divide

Adam Smith published the book that started economics 'An Inquiry Into the Nature and Causes of the Wealth of Nations' in 1776, which by any measure, was a fair while back. Why is it then, that human beings, who have gone to the moon in 1969, have still not come to a broad consensus about how to run economies in trouble? The answer perhaps lies in a place that is not extremely comfortable for an economist to look into; the gut!

The gut tells us that beyond all the hubris of bell curves and complicated  mathematical expectation based modelling, the subject matter rests upon one big fault: the need for specific assumptions. There is no way that one theory of unemployment and search frictions which won Pissaredes and co. the Nobel prize for Economics this year, can capture the interactions in the labour market in every country accurately. There is no way that the growth models of Solow and Ramsey can be used as a generalized input output models for every country in the world. We as human beings, have the innate tendency to prefer extremes in theories; whether about religion, philosophy or science. The middle path seems almost invisible to the naked eye, and hence we have the great divide.

The events of the past week have served to increase and solidify the differences in approaches to tackle this monster of a global recession. The Eurozone is hell bent for austerity; a word that provides warmth and comfort to every German citizen unlucky enough to live through the great hyperinflation era in the 1920s. The British, fired up with the exuberance of a coalition government, and some time off from Gordon Brown, have also accepted that life is not going to be easy for a few years, and it is a sacrifice worth making. The increased VAT will hit the consumers in February, and even University professors from  Oxford etc are going to take a 1.6 billion pound hit on their payrolls.  On Thursday this week, BOE MPC members De Anne Julius and Rachel Lomax said explicitly that a further stimulus programme would be a wrong move. Eurozone inflation reports also came out this week, and the numbers held with analyst predictions at a lowly 0.2% y/y. 

The Americans, stand on the other side of the fence, and believe that further stimulus is imperative to recovery. This week, Ben Bernanke gave a speech at the Boston Fed, stating very clearly, that in all likelihood we are going to see at least another 500 billion dollars if not a trillion, injected into the American economy in November. As I argued last week, the markets had already priced in a further stimulus, as the Dow and S&P 500 hovered around the previous week levels. If Bernanke had said anything indicative of an indecision about further stimuli, markets would have taken a big tumble accelerated by the release of poor economic data yesterday. The University of Michigan Consumer Confidence index, which is an important indicator for the markets, fell to 67.9 against analyst expectations of 68.9. However, the retail sales numbers were good, rising 0.6 percent. Retail sales make up about 70% of purchases by consumers in the American Economy. However, inflation numbers remain low and this is a good excuse for the Fed to justify further stimulus even on the back of a worse than expected trade balance number clocking in at -46.3 billion m/m. 

The Americans, have a ponzi scheme running with the dollar. Their total debt to GDP ratio (60% or thereabouts) is still not at a place that would cause concern to people like Paul Krugman, who have been actively campaigning for stimuli since the crisis began. And it is definitely true that without the injections of artificial demand in the economy, the unemployment numbers would be comfortably in double digits. The question that does not have any definite answers though is this: If the Fed believes that more stimulus is needed and its been two years since the recovery process was initiated, how long will the markets be fooled into believing that they should go up and not down on the back of further stimulus as its an indication of a more chronic problem in the economy than was initially thought? The answer probably is that at some point in time, they will stop believing that more and more intervention is good for them. However when that time arrives is not certain in any way. When the endemic nature of the problem surfaces, the deficit hawks might have the last laugh. It is not wise to  count out the nature and impact of self fulfilling prophecies, but having said that, it is not wise to bet against the American economy either. As long as people around the world believe in the American Economy's total supremacy, and productivity increases like the ones we have seen over the last two years continue to happen, the tide would continue to work in America's favour. After all, no country with a sovereign currency has had a default problem like Greece and Ireland, so another 10 years of trade deficits would not be completely unacceptable from an economist's perspective. Furthermore, with American consumers saving higher amounts of money than ever (the recession has indeed managed to scare the indomitable American consumer), there does not seem to be much of an option presented to the Fed.

The great debate about stimulus vs austerity is not a debate after all. And there is no panacea for the state of the developed world right now. The trick is to know when to stop with the stimulus and when to ease off the austerity; the trick is to know your people. For Example, German consumers can endure a lot more fiscal prudence than the American consumer; and with these two countries being at the polar opposite ends of this debate, it seems only reasonable that they act according to what is feasible rather than what is ideal. 

Currency Wars!

The problem with terming what is happening in the exchange markets as "currency wars" is that its not in line with how the markets are working. There are several reasons for this. 

If one was to believe in the (in)famous Efficient Market Hypothesis, markets have already factored in all the information coming their way in the form of predominantly low interest rates in the G3 economies and their clear intentions to stay at those levels (The ECB and BoE have not changed their stance for many months now). Even if one was not a staunch adherent of this theory, what is happening now, can be termed as the obvious byproduct of monetary and fiscal policy followed by the G3, especially the US, rather than terming it as a veritable war of currencies. This is exactly what Joseph Stiglitz had to say in a recent interview following the IMF meetings this weekend. Keeping interest rates low has inadvertently lead to this low intensity diplomatic standoff. In any case, the term seems to be an exaggerated media headline.

USA faces a tremendously huge trade deficit right now, reminiscent of the later parts of the Reagan era. The easiest way for a country with its own currency to fight back to be competitive in its exports is to devalue the currency. The US is doing exactly that but is getting caught up in a battle for competitiveness of its exports with the developing world, especially with the artificially low CNY.  However, it is pretty self evident that China is going to appreciate its currency slowly, taking its own time, and perhaps they are justified in doing so until there is some new (anti) Bretton Woods kind of agreement within the G20 community (possibly this might be discussed in the upcoming conference in Seoul?). What gives a nation the right to be protectionist can hardly be dictated by the whims of another, since in that game everyone is a hypocrite!

Meanwhile, developing countries such as India and Brazil will continue to reap the benefits of inflowing capital, invested by developed world to avail of higher interest rates. At the same time, they must be prepared for the unknown, and be aware of the risks of a flight to quality by investors by imposing better capital control measures. Living in a fools paradise is only going to ensure the infallibility of the Greenback and the status quo to continue for a long time to come.

The week of October 4th

Barack Obama must be having a hard time sleeping this weekend. The Economist fittingly featured an article last week titled "The loneliness of Barack Obama". With all his key aides leaving to kickstart/restart their own pursuit of happiness, Obama must truly be alone. With his popularity ratings of 41%, which is in any case an all time low for the first term of any president, he now will soon have to seriously consider signing up for some further quantitative easing adding to ire of the public in America.

The big numbers came out on Friday; the non farm payrolls. While the unemployment percentage held at 9.6%, all the other figures disappointed as the non farm payrolls dropped by 95,000 in September. Although a number of (76,000!) temporary workers for the 2010 census are also included in this figure, thereby not leading to any great alarm in the markets.The numbers only confirmed the downward trend in the recovery process for the US, and this has further lead to a consolidation of the ongoing rally in the Euro/Dollar and GBP/Dollar markets and crude oil. With the dollar taking a severe beating from all sides, it has been recording lows against the Yen and the Aussie Dollar as well, albeit for slightly different reasons than the aforementioned spreads. 

There are clear indications that further quantitative easing is coming and with the market mantra this week being "dont fight the Fed!", the S&P 500 and the Dow have both consolidated at a confident and comfortable 1165 and 11000 respectively. This counterintuitive rally has been due to expectations of the dollar further weakening in the face of QE2 leading to a party for US equities. 

The ECB and BOE have maintained their rates in their latest announcements on Wednesday. The BOE has clearly indicated that they would prefer a broad scale asset purchase programme to infuse liquidity into the economy, instead of concentrating on further lowering the rates. The zero lower bound is a clear and present danger to the Europeans and they are more than aware of the limitations it presents (albeit the Japanese think otherwise, with their recent lowering of rates to 0%-0.1%). 

Meanwhile, the new feud in the developed world now termed the "currency wars" rage on, and promise to make the coming weeks an interesting proxy battle. Dominique Strauss-Kahn of the IMF has accepted the role of enforcer in this all out battle against currency appreciation, and it remains to be seem whether he will be victor or victim to this collective madness that is clearly going to be an impediment to a faster global recovery.