Troika + Syriza = Grexit ?

So you thought that Euro-Crisis had gone away. Well guess what, it is back baby, in bourses near you!!!

It has been something people have been predicting with the Troika (EC+ECB+IMF) designed austerity program that was imposed on the country where democracy originated. Those people tended to be economists of largely the Keynesian variety and many of them predicted that it will result in an extreme party coming into power rallying around people's misgivings with the brutal austerity measures. Well, it has happened and Syriza, a coalition of left wing parties, has come to power indeed. Its finance minister, Yanis Varoufakis, whom I have been following for some time on twitter is now on a road show advocating the restructuring of Greek debt with a possibility of linking it to GDP. What is now happening is a question of Who Blinks First and it seems both sides are unwilling to do so. So the odds for a Grexit (Greece Exit) have increased and the attitude that the union can survive the exit is also contributing to it.

How We Got Here

The narrative that has been built during the euro-crisis was that it a case of Creditor countries from Northern Europe (Germany primarily) getting screwed up by profligate peripheral countries like Greece, Spain and Portugal. The current mindset is that debt is sinful and it is debtors that got to pay when things go tits up. Michael Pettis examines how wrongheaded and dangerous it is to think of this case as one country against the other in his excellent blog: Syriza and the French indemnity of 1871-73 . It is a very long read indeed touching upon economic history and drawing parallels with the current situation. After the Franco-Prussian war in the 19th century in which Prussia emerged victorious, they extracted war reparations in the form of indemnity from France. Pettis looks at how it impacted both countries and finds that France didn't suffer much since it was a time of credit boom and the bonds that they issued were oversubscribed with a major portion by German investors. But for Prussia, recipient of the fiscal transfer, much of it was squandered which always tend to be the case when there is a sudden such windfall. This is so even after having the money routed through a centralized body like the government. Pettis compares this to what happened in euro-zone after the currency union citing the experience of Spain, an economy he is very familiar with. When you have a currency union of various countries with varying inflation rates like Euro-Zone is, then it is inevitable that the monetary policy won't work as desired for all the countries. The Germans started running a current account surplus after 2000 aided by keeping the wage growth of German workers in check and curtailing investments in their economy. The consumption was also very low compared to what it should be and in effect they had a lot of money sitting their waiting for higher yields. A major portion of this money went to peripheral economies like Greece and Spain and most of this were absorbed by the private sector and households. The interest rates in those countries were lower than what it should have been considering their inflation rates since they didn't have control over the monetary policy because of the union. Like Prussia with the French Indemnity that it received in 19th century, most of the money was squandered and in Spain's case it sustained a real estate bubble. It was inevitable and you can find the same thing happening in plenty of other instances from history when cheap credit was made available. It is not a case of one country's people having the propensity to behave in such a manner and if Germany was in a similar position, the same thing would have happened. And moreover in the case of peripheral countries-it was the private sector that built up this debt and it became sovereign debt when its banks were bailed out by the government. That is why it is so wrong to pit this as Germany on one side and Greece/Spain the other.

The Austerity Solution

When the euro-crisis began to rear its head a few years back, the Troika consisting of European Commission, ECB and the IMF started dictating terms to these countries. They worked largely in the interests of Germany, whose private investors had maximum claim over most of these sovereign debts. After some hair-cuts to the debt, which was not enough, troika designed austerity was imposed on the peripheral countries with tales of debtor's morality put into the forefront. They waxed lyrical about the Moral Hazard that would entail if the debtors were given too much leeway. What about the moral hazard for creditors? It takes two to tango and it is as much a fault of creditors as it is of debtors. Both sides have to suffer looses. As Pettis points out, it is always the people that will ultimately suffer since banks will be always bailed out. It is the German workforce that relatively suffered when Germany started running this surplus and it is Greece people that is suffering now due to austerity. You don't need to be a rocket scientist/economist to figure out that this is gonna end in tears. Suppose GDP of a country is 100 and its debt to GDP ratio is 100% now. If austerity is being imposed in a very depression like scenario, it is inevitable that the GDP will contract like it did in Greece. This is only going to help in its debt to spiral out of control. Forget about GDP contracting, even if the GDP is growing but at a rate less than the rate of growth in debt, then also Debt/GDP is going to worsen. People are suffering for no good reason and the backlash against austerity was inevitable and considering all this, it is a positive that Greece is still a democracy. Before the austerity and restructuring, Greek Debt/GDP was 170% and 157% immediately after the hair-cut. At the end of 2013 after austerity took its effect it again went back up to 175%

What Now?

As described in this FT article: All Grexit needs is a few more disastrous weeks like this, following are the ways Yanis can proceed:

1) Extension of existing program- This is not Syriza's mandate and even if Yanis Varousfakis accepts it after inventing more cuddly names and measures, the Greek parliament is not going to pass it.

2) He might ask ECB to release interest payments and profits from purchases of Greek debt during the crisis, He can also ask the troika to lift the ceiling of treasury bills that Greece can issue, which was imposed so that Athens cannot issue too much debt during the bailout. Troika might not accept this unless he agrees to their austerity program.

3) Find money elsewhere like from Russia and it is not gonna be easy politically.

4) Issue a parallel currency, which is more or less what Grexit is. 

Conclusion

The probability for a Greek Exit have increased with Syriza coming to power. Even Alan Greenspan has come out with a statement recently that a currency union without political union is not going to sustain and Eurozone is on the path towards a breakup. Many of the decision makers in Troika seems to think that the Union can withstand a Grexit, but I suspect it will be a Lehman moment for the markets. Then also the Fed underestimated the impact of letting Lehman go under and the same is going to happen if Greece makes an exit-it will be a clusterfuck. I have been looking for a trigger for the markets to collapse and this may very well be it, with the other possible triggers being China or a geo-political event like Ukraine war. 

Big Trouble In Little China

Michael Pettis' blog is a good source for understanding Global macros and its linkages and he is also considered as an expert on Chinese economy. This article is largely based on one of his article which describes how China developed so far and what it is supposed to do for making the final leap and become a developed economy. This is always the hardest phase for any growth story and many countries have failed in the past and got stuck in the middle income trap or worse.

He starts the article pointing out that many people have adopted a stand of there being a Beijing Consensus and the nearly four decades of Chinese growth is unprecedented in history. One can get a good understanding about the many growth miracle stories that didn't end well in the book 'Why Nations Fail' which in my opinion is a must read. It stresses on the importance of Institutions and incentives that are essential for a country to get into a virtuous cycle of development. Inclusive political and economic systems are needed for a country to get into this virtuous cycle. Without this a country might be able to sustain good economic growth for a seemingly large period only to ultimately collapse  (USSR, Brazil, Mexico etc).

Michael Pettis who is also a fan of 'Why Nations Fail', stresses on the importance of Social Capital. He attributes high levels of social capital as the cause for development and describes high level of capital stock as a symptom of wealth and not the cause. This is especially relevant in Chinese case with its high level of investments on infrastructure.

Pettis divides Chinese growth into four stages as follows:

 The First Liberalizing Period

This happened in the late 1970s and early 1980s and Deng Xiaoping played a major role in circumventing the elite resistance. The reforms were aimed at building social capital and it was made possible for a Chinese to produce and sell as individual and not just through the poorly managed and state controlled collectivist organizations. A limited number of farmers were allowed to keep whatever they produced above their quota which incentivized them to increase their productivity. Not surprisingly they were able to almost double their yield. The reforms increased the economic activity and generated tremendous wealth creation.

The Gershenkron Period

The economy ran into infrastructure and capacity constraints after the initial spurt in economic activity. This second phase addressed this issue by directing the domestic resources to fund an investment boom. China embarked on a program to resolve the problems identified by Alexander Gershenkron in 1950s and 60s as the things that constrain a backward economy: 1) Insufficient savings to fund the investments. This was resolved by constraining the domestic consumption and directing the savings towards investment. 2) Failure of private sector to engage in productive investments due to legal uncertainties and positive externalities which they themselves might not be able to take advantage of. It was natural for the state to step in identify where the investments should be directed to. This was welcomed by the elite/new elite and local governments since they will have much involvement in the activities of SoEs which directed this investment and growth and thus they became politically entrenched. Since the household income growth was constrained by keeping the currency from appreciating and not letting wages to increase by much, much of the wealth went to the top.

Investment Overshooting

In the previous period because of the low level of infrastructure from which China started, it was easier to identify where to direct investment to. Obviously the ICOR (Incremental Capital Output Ratio) began to increase over the years and the ability of investments to create real wealth reduced. Social Capital didn't keep pace with the physical capital because of the policy of investment led growth model favored the elites by giving them access to cheap land, capital and subsidies. So it largely remains an export driven economy which cannot primarily depend on its domestic consumption for growth yet. This was a problem leading up to the 2008 financial crisis and the fiscal stimulus after the crisis made it even worse since it unleashed another round of investment binge accompanied by debt. Many of these investments were badly directed (bullet trains anyone) and the real estate market in China is in the bubble category with its Ghost Cities and towns. China is in this phase right now and is trying to rebalance its economy from the investment driven growth phase to a consumption driven model.

The Second Liberalizing Period

China's current contribution of investments towards its GDP is around 50% and its ICOR has increased to above 6. This explains why its GDP has slowed down to around 7.5% right now. It is obvious that it has to increase the contribution of consumption which means that it has to do plenty of reforms. Many of these reforms should be aimed at undermining the elite rent capturing and will be met with great resistance. In the third plenum, many reforms were announced by President Xi Jinping and Premier Li Keqiang which aims at increasing the social capital. Those are; land reform, hukou reform, environmental regulations, interest rate liberalization, governance reforms, market pricing and elimination of subsidies and all them largely transfer wealth from state/elite to small and medium sized enterprises.  

Conclusion

Michael Pettis paints a hopeful picture of Chinese government taking the right steps. But the problem is that, as he points out, the GDP growth rate will have to fall very low close to around 4% and anything above that means it is through investment overshooting accompanied by unsustainable debt levels. What he doesn't stress much is the lack of political freedom in China and how the people have come into some sort of a compromise where they barter their freedom for growth. If the economy slows to around 4%, which will qualify as a hard landing, it will be accompanied by job losses and pain which can cause political unrests. We also don't  know whether the real estate bubble  when it pops will have as big an impact that it had in US after the sub-prime crisis. I don't think any crash in China will have a systematic impact on the World Financial System but it will definitely impact the commodity prices (already we are seeing) and the commodity super-cycle that accompanied Chinese growth story will be well and truly over. This will have its impacts on many of the resource rich nations like Australia, countries in Africa and Middle East. It will also affect Germany because of its capital goods export to China.

Case for India: In the medium to long term, a Chinese crash will certainly favor India because of our import dependence on many of the commodities. With the right policies we might be able to even attract manufacturing jobs. I don't know whether we will face a Lehman moment with respect to Chinese crash, but a further slowdown there is is not going to help the world growth numbers which is already getting downgraded. The difference in policies in different parts of the globe (tightening in US, loosening in EU and Japan) might smother the propensity for a big crash but one can never be sure because a return of the Euro Crisis will add to the chaos. The problems with EU, China and Japan are kind of systemic under their existing order and it is always good to keep in mind Murphy's law. In my opinion a Chinese crash is a matter of when and not if. Being bearish on China was a contrarian view two years ago but now it is very mainstream.

References

http://blog.mpettis.com/2014/06/the-four-stages-of-chinese-growth/ 

Are We In A Bull Market?

There have been plenty of noise from market participants that we are in a bull market or in the cusp of one. The feel good factor that the election result have given has propelled the markets to new highs but does it have legs? With the Fed not showing any signs of immediate tightening, ECB thinking of their own version of QE and continued easing in Japan with Abenomics, the liquidity situation looks to continue positively for India in the foreseeable future. The fall in crude prices along with other commodities is also very good for India. But are these factors enough for us to have a sustainable rally in share markets?

Three Phases of a Bull Market

Accumulation Phase

The first phase of a bull market is the start of the upward trend which usually comes at the end of the downward trend and is the hardest to spot. This is the time when the informed investors accumulate shares from the market at the heights of pessimism. It will be difficult to spot and there are high chances of you buying into falling knives. From a technical point of view it will be the period of consolidation and will be characterized by market not moving consecutively into lower lows and highs.

Public Participation Phase

This phase is marked by better earnings growth and strong economic data. With the good news more and more investors move back in sending the prices higher. This phase is the longest lasting but also with the largest price movement.

Excess Phase

This is the phase when every Tom, Dick and Harry start talking about the market. As more and more dumb people enter the markets driving the prices to stratospheric levels, smart people will scale back their positions.

It will also be characterized by plenty of IPOs from very dubious companies and people will be in denial about any signs of weakness in the economic numbers and macro indicators. Anchors of business news channels will be gleefully patting themselves in the back and people who warn them will treated like the boy who cried wolf. Terms like Dr. Doom will be coined and when the inevitable crash comes they will treat it with disbelief and some will also claim that they saw it coming.

So In Which Phase Are We?

Lets take a leap of faith and assume that we are in a bull market. We have already moved more than 30% from the lows of QE Taper speak. I have been spoiled by seeing the markets move about 400% during the 2004-2008 period and it is not fair to take that as the standard for a bull market with base effect also coming into play.

So in which phase are we? Ben Bernanke's QE taper talk coupled with the huge fiscal and current account deficits made rupee go into a free fall and markets also fell significantly. That event forced the government to get its house in order and RBI has been rightly stubborn in treating inflation as the big problem and ignored the clamor for rate cuts. We are starting to see some benefits from these actions with the global situation regarding commodity prices also helping.

I think we are in a mini bull market aided mostly by external liquidity and relatively favorable condition India is in with respect to other emerging economies who are either export driven or resource dependent. Things have not changed much at the ground level with the new government still reluctant to take the hard structural reforms that they could with the mandate that they have. I really don't think we will be able to solve the supply side problems without meaningful actions. The banks haven't still solved their NPA problems and the other side of the coin, the over leveraged firms from Infra, Power and Real Estate sectors, continue in their Zombie state of existence. Without solving these I don't think we can have a sustainable bull market because the underlying numbers won't improve much.

If this is a mini-bull market driven largely by external readjustment, then I think we are in the public participation phase. The mutual funds are seeing increasing flows as people move their money from physical goods like gold back into financial markets. I can't see much value out there and so I think we are very much in the latter part of the public participation phase. IPOs are kicking in and government is planning to divest its stake in some of the PSUs like Coal India. I don't think we are in the excess stage yet because there are still plenty of doubts out there. We need to see a higher level of craziness....People need to go full RETARD...

References:
http://www.investopedia.com/university/dowtheory/dowtheory3.asp 

Market Outlook-Sep 2014

So it turned out to be a healthy bout of profit booking with the FOMC meeting not sparking immediate fears of rate tightening. FIIs were net sellers on Tuesday and Wednesday with DIIs doing some buying. Initial report suggests that today's sharp upward movement was triggered by significant amount of FII buying with the uncertainty over US tightening over for now. Just goes about to show how much we are linked to International money flows.

I am kind of ambivalent to this development because I don't see any stocks available at bargain basement price to invest in freshly.  A deep correction would have helped in that regard. To take advantage  of such a deep correction one should be sitting on substantial amount of cash which I am not. It is about 6% of my total portfolio value which is just not enough. I am not anticipating a sustainable rally that remind us of the bull market prior to 2008 just yet. The reasons for which will be explained in another essay that I am planning to write pretty soon. So if I don't have any stocks to invest in and don't anticipate a sustainable rally (i.e >20% from the current levels), the natural course of action is to see how it plays out by sitting on the sidelines and build my cash level to at least 20% of my portfolio value. If the market continue its upward trend then some of the stocks that I hold  should reach their respective price triggers for profit booking.

Even though I am a value investor I have been trying to bring some technical elements into my strategy in an indirect fashion. One should always keep a target % of your portfolio value in cash/FD at all times. This will help you in taking opportunities when a sudden market crash occurs as well as acting as a natural re-balancing strategy. I haven't arrived at a target % just yet, but I think 15% would be enough for now. When you don't find much value in the market it will naturally increase and vice-versa.

Indian Markets, FIIs and Global Macros

It is no secret that Indian market is largely driven by FIIs (Foreign Institutional Investors). This is more pronounced after the 2008 Financial  crisis as domestic retail participation in Indian markets went into a free fall from which it has still not recovered. The secular bull run from 2004 to early 2008 attracted plenty of domestic money through mutual funds and other financial products like ULIPs as if it was the Californian Gold Rush. It also ended in a similar fashion as 'They couldn't handle the truth' that bloodbaths are also part of the market. They were promised something different and the blame for it should largely go to the financial illiteracy that is common among Indian people and the way in which it was exploited by people who were selling these financial products. As it stands no effort is being made to resolve the issue of financial illiteracy and the million dollar question is who is going to take responsibility for that. You cannot expect the unscrupulous people that sell these products, purely based on which products is going to earn them the maximum commission, to do it. Is it up to regulator who has made a clusterfuck in its dealings with the Mutual Fund Sector which resulted in people getting duped into putting their money on ULIPs which were marketed as investment products (It says fucking Insurance which should be a good enough clue). How money and economy works, Financial products, economic history etc are not something that is covered in the school syllabus (it should be) and the Indian investor is left to learn through their own experiences which ends up with them getting driven away from the financial markets when they get burnt. No wonder that they go back to invest in physical stuff like real estate and gold.

Influence of FIIs

Indian companies tend to have high promoter holding and I have read somewhere that when you take the entire index, the promoter holding comes close to 50%. That means the rest 50% is the free float shares available for domestic and  foreign investors. FIIs hold roughly half of these free float shares. So in short even though FIIs own only 25% of the market they drive the markets since they own 50% of the free float shares that could get traded in the bourses. So the Indian market is under the whims and fancy of the foreign investors which makes things very complicated for Indian investors. Even if you are a value investor looking for companies that are at bargain prices, you will face headwinds due to the mood of FIIs. Over the last ten years there have not been a boring period for the Indian share markets and value investors earn their keep by spotting opportunities even when the market is generally flat and boring. We don't tend to get that in India since the markets fluctuate widely but it should be seen as an opportunity because the whole theory behind value investing is the market irrationality which is beautifully summed up in Benjamin Franklin's 'Intelligent Investor' which cites the moody Mr. Market with whom we can deal. The trouble is that when you invest in a market like India even if you are a value investor you depend very much on market momentum to realize your returns which again comes with a further lag. So it is good to understand what drives this foreign money.

What Drives FII Money Flows?

Developed World Monetary Policy

Indian markets and Rupee exchange rate went into a free fall when Ben Bernanke did his QE (Quantitative Easing) taper talk last year. Yesterday also market suffered because of the fear about an 'ahead of  schedule' monetary tightening  by US Fed. The old adage that 'When US sneezes the whole world catches cold' rings very true. The post 2008 developed world monetary policy is characterized by loose monetary policy as they have been trying to kick start their economies with varying degrees of success. Both US and Japan have followed a policy of Quantitative Easing and Mario Draghi is also contemplating the same for ECB. For ECB it is kind of complicated because the process by which they determine the proportion at which they buy various Euro zone countries' bonds will invite criticism.

QE refers to the policy by central bank to buy up long term government bonds from the market using what is essentially for all intends and purposes out of thin air money (It is largely a balance sheet exercise between the central banks and normal banks which own these assets). Apart from government bonds, the central bank can also target to buy asset classes such as mortgage bonds like the Fed did in US. QE is supposed to help the recovery in the following ways: 

1) The demand from the central bank will drive down interest rates for these long term bonds and this in turn drives the rates down for other bonds like Corporate bonds. This will help companies to refinance their debts and prompt some to use the low interest rates to do capital investments which will boost up GDP. This is applicable for ordinary people also in terms of refinancing and boosting consumer demand.

2) The Central Bank buying up assets will transfer money to those who were originally holding these assets. This money might end up getting invested in riskier assets like equity markets propping up their prices. This in turn might lead to wealth effect and money trickling down to the real world economy through increased spending.

3) A portion of the money that is transferred gets out of the country searching for foreign assets and better rates which will have a depreciative effect on the domestic currency. This depreciation will boost the relative export competitiveness of the country that is undertaking the QE.

The third channel one is the money which ends up in Indian markets through FIIs. That is why their flow is dependent heavily on developed world monetary policy.

Relative Prospects of Indian Economy & Relative Valuation of Indian Markets

For the FIIs, they have a variety of countries that they can invest in and where the money goes depends very much on the relative prospects of these target economies and their relative valuations. They are also exposed very much to currency movements since their performance will be evaluated on USD returns. This very much increases the complexity in their decision making and since we are also exposed to their money flows, we are also exposed to this kind of complexity. We cannot think in isolation about the prospects of our economy and not give a damn about the World economy and the larger macro-economic trends. Many of the emerging economies are either following an export driven manufacturing model or are resource rich nations. We are not either of these and it makes us a good defensive play for foreign investors. Oil prices going down is good for us as long as the fall is not prompted by a big financial crisis.  

Individual Stocks in Indian Market

Once the FIIs decide an allocation for our market, it generally flows to the usual suspects which tend to be in the large cap and mid cap segments. They don't have many options in the market because the companies have  to be sufficiently big for it to make enough of an impact in their portfolio. Once the valuation of these companies get stretched money will trickle into the broader market and only then the value investor will get his/her reward. It will be very tempting to try to time the market but in my opinion it is an impossible task considering all the variables involved. 

Conclusion

Even though value investors are agnostic about market momentum, in Indian markets we are very much dependent on it when it comes to stock picking as well as profit booking. Wild fluctuations in Indian markets give value investors great opportunities but at the same time it will be nerve-wracking and many people will succumb to temptations. The momentum in market is driven to a large extent by the FIIs who are also a moody bunch with plenty of variables to consider in deciding where the money flow to. In my opinion it is futile to second guess all these factors and try to time the market. Have strength in your convictions and be patient to play things out in the market. You don't get plenty of markets where you can spot stocks that go ten times. The stock might languish below your buying price for 3-4 years and the ten times journey might get played out within the next six months.

Outlook on IT Sector-September 2014

Market fall yesterday was mainly due to the anticipation of Fed meet that is going on and there is fear that the FED would indicate the path for rate tightening. The depreciation of rupees with respect to USD may very well happen if the FED start the tightening and the market reaction maybe as drastic as when it happened after Ben Bernanke's QE Taper speech. If that happens then defensives like IT and pharma will perform relative well compared to other sectors. Fed tightening means US GDP and unemployment numbers are expected to be good which is also good for these sectors.

But if the tightening is smooth and market recovers without too much fuss then other sectors could be better bets especially if the govt unveils any meaningful plans for the future like policy on diesel subsidy. Many market players were predicting that we were in the second phase of bull market last week, but I can't see that happening until Banks clean up their mess first and the over-leveraged firms get their balance sheet restructured. Only then a bull market level rally could be sustained. So even if the market recovers I think defensives will be a good bet since they were the sectors that were doing good prior to this fall. 

So I think if you are not too bullish on the market, then IT sector would be a good pick without going into individual stock valuations. I personally don't invest in IT companies off late because you never get the large cap/midcap ones at bargain prices and the small cap ones tend to be very risky because of lack of diversification and complex nature of business that depend too much on a a very few clients and deals.