Friday, January 29, 2016

Why China is the elephant in the room

The sell-off in the first two weeks of this year have been attributable to two major themes:
1) The negative news coming out of China, [eg slowdown in PMI, GDP growth, Yuan depreciation, Capital outflows to be precise]
2) Second, oil breaking the once un-conceivable level of below $30 level

After briefly touching upon why lower oil prices (which is a input costs in production) are seen as negative, we try to examine the scale of problem that is "China"

First, lower oil prices are good when oil producers are making an economic profit and demand growth is positive. However, in this episode of oil price collapse, almost all producers are NOT making a sustainable economic profit and the needle on demand growth has not moved much. The reason for supply remaining unchanged or even increasing is that the once dominant OPEC is dysfunctional in its role of adjusting supply to price and the shale producers in N. America are forced to keep pumping oil irrespective of making economic profit or not, just in order to gather enough cash to service their huge debt pile. This way the whole sector is undergoing a sort of price war. As conventional economic wisdom dictates, price wars are ultimately won by the lowest costs producers. Nevertheless, the longer and lower oil prices go, they will undermine new production coming on stream proportionally and hence after the dust settles and many shale oil operators finally throw in the towel, market pricing power will return to OPEC.Expect shale operators to start biting the bullet this year and market pricing power to return to OPEC by 2017. This has been the very logic behind KSA unwillingness to cut production, they have the tenacity and political will to force utter capitulation on its competitors and enjoy LT benefits that come it higher real oil prices.

But for the while, lower oil prices are in unison with multi year lows for most other hard commodities, such as copper, steel, coal, aluminium, etc. the demand slowdown in these commodities is mainly attributable to ​slowing China as China constituted roughly 40% of the supply growth in these commodities over the past decade. China may already be on its way in deflating the property and excess manufacturing capacity bubble that was in the making for more than two decades. If China were politically determined to refrain from providing any federal bailout to failing 'zombie' corporates, the impact of slowdown in that country, due to rising bankruptcies and credit squeeze will be gigantic. A much slower growing China than what the world has been accustomed to for two decades will further lead to depression in commodity prices -esp, more pronounced when calculated in strengthening dollar. Deteriorating terms of trade for commodity exporters  means they will face tougher times with their own balance of payments and will in turn curtail demand in their domestic economies. In summary, lower commodity prices indicate slack in demand and that is, atleast in our opinion, why falling oil prices, inspite of being a factor of production, is viewed as a negative for the health of the global economy.
In this way, to some extent the rout in oil price is tightly intertwined with the economic prospects of China-atleast in the psychology of oil traders and hedge fund managers buying and selling oil derivatives worth hundreds of billions everyday. China is indeed the proverbial "Elephant in the room" for almost all commodity exporters, including GCC. 
Now lets us focus in understanding what really is going on in China.
Chinese rulers "The partymen" have historically had some kind of insane obsession with GDP growth numbers. Economic growth was made the top priority by none other than Mao Zedong himself and continued under his lieutenant Deng Xioping and those who followed after him. Interestingly, the Great Wall of China is the greatest epitome of Chinese mindset of forcing the masses into achievement of what rulers dub 'national pride'. Two thousand years back the Ming dynasty forced the peasants in the countryside to abandon everything and go and work in the hills. Almost a million died of cold, starvation and diseases and buried in the same wall that they built. in the mid 50s. Mao forced millions more peasants to forcefully work in small make shifts steel mills, producing more toxin than steel. The point here is to underscore a deep seated cultural need among Chinese rulers for achievement that looks physically overwhelming without any regard to the price paid. 

Something similar has happened with China urge to produce outsized GDP growth.In doing so, they may have paid a huge price: namely a massive misallocation of capital and a large percentage of the country's wealth tied up in economically impaired or outright worthless capital assets. These investments were financed mainly by keeping real interest rates artificially suppressed. Low real return to the Savers lead them to divert capital into real estate and lately into stock and corporate bong market as better protection for inflation and yields. It also gave rise to the now infamous 'shadow banking sector' where yields were roughly twice or thrice as high as in the formal banking sector. Although the return in the shadow banking sector reflected market demand/supply dynamics, the assets financed were still of dubious quality and increasingly funding of riskier and riskier assets which otherwise could not get funding from the conventional banking sector. The shadow banking sector become the de facto vehicle for funding the property and excess capacity bubble since the 2008 crisis. 

Since mid 2013 the shadow banking sectors access to capital has been incrementally restricted with rise in interbank repo rates with the blessings of the PBoC which is leading to a mini-liquidity crisis in that space. And, the assets on the other side of the banks balance sheets are worth increasingly less as the property bubble pricks and zombie corporates are unable to refinance or rollover their massive debt loads. This trend has been in play since mid 2013 but starting off a very low base was not getting reflected in the growth statistics aggregated at the national level. This triangular dynamic of evaporating liquidity, the inability of over-levered businesses to repay or refinance maturing debt and the reversal in property prices is now accelerating and having a material impact on demand and contributing to the economic malaise. Also, sharing the trophy is global slowdown in merchandise trade, where China is the biggest actor and appreciation of Chinese yuan over the past five year period vis-a-vis other competitor country currencies in inflation adjusted terms making economic viability of already sub-optimal manufacturing harder by the day. 

In a more simple terms, GDP growth is a function of growth in capital, labor and technology. Over the past 30 years, China economic success rode behind the back of large increase in the former two factors, achieved by artificially keeping their costs low by heavy political hand wringing. To start with China also had plenty to room to import low IP commodity type technology from the West (or from the East from Japan!). 

The former two factor of growth seem to have peaked with China's working age population expected to slightly contract from now onwards due to its single child policy in 80s and 90s and migration trend of the 2000s from countryside to cities having run its course. 

Capital formation also seems to have peaked in 2014 with capital investment to GDP ratio topping out at 49%. China has been a country with high level of household savings, but those savings which owners expect would be a source of future financial security have been wasted upon creating capital assets which have low economic earning capacity. A large percentage of household savings have been locked into over-valued assets and nothing much can be done when the bubble pricks and the elderly savers watch their wealth erode month-by-month. On the other hand, a lot of Chinese businesses have borrowed in foreign currency (read $) and a lot of FDI has got into the country, under the widely prevalent assumption that Chinese yuan is undervalued to pump exports and hence the LT trend for the yuan is for the currency appreciating vis-a-vis dollar. With wages rising, supply of labor peaking out, and easy access to credit getting difficult and demand slowing, that capital is desperate to exit. Also desperate to exit is the domestic capital which is afraid of president Xi's 'corruption campaign' and savers who want to avoid putting more money behind hugely overvalued property/stock investments. This capital flight-via Hong Kong and Macau-has been pointed out repeatedly by many noted China bears for as much as past three years. it is only now, that it has started to grab headlines in pink papers! 

To give you an idea of the scale of capital flight, Chinese investors are the largest single group in terms of US real estate investments by foreigners. Children of the elite class study in the US with the ultimate intention of settling in the country and parents moving family liquid assets to US. 

It will also be somewhat difficult for China to innovate and encourage new generation of businesses without personal liberty and deep and free capital markets to support these businesses. No facebook or Sequoia Venture fund here. That makes GDP growth through technology leadership also a challenge. Albeit, there is still a lot of scope for technology assimilation and productivity growth in China, but the political structure and incentives for it have to be more market driven.

In summary, China has exhausted atleast two of the three factors driving growth. The adjustment to the new reality will undoubtedly lead to some near term noise and the lack of transparency and scale of the adjustment means significant costs of cleaning for both China and its trading partners. 

What exactly are these costs?
The most immediate is to stem capital flight. Which is proving difficult. Once investors start to panic, it is usually very difficult to soothe them, especially if the governments words and actions seem inconsistent. Stemming capital outflow can be achieved by either:
resorting to capital account convertibility controls, or, 
outright currency devaluation, or, 
letting the currency float freely. 

Capital controls which although seeming to work on paper will lead to underground means to transfer wealth out of the country, but the costs of currency depreciation in the black market will fall entirely on the private investors and not on the PBoC. Nevertheless, capital moving out of the country will still tighten liquidity and exacerbate the slowdown. It may also damage China reputation and become a risk factor in attracting capital in the future.

The second option is to gradually depreciate the yuan while making under cover attempts to tighten capital controls in more informal way (muddle through option). It seems this is the path chosen by Chinese authorities for now. However, this choice does not guarantee the problem of capital flight will be solved. Lets assume, China devalues the currency over the course of the year by another 5-6% but capital flight remains undeterred as speculators and investors think the real level of depreciation vis-a-vis economic reality should be 10-15%. In that case, PBoC will still end up burning a lot of reserves to support the currency without really solving the underlying problem. Usually a controlled devaluation is actually a lost battle even before it gets started. 

So, what is stopping the Chinese to go for a one-off sharp depreciation to the same extent as the market forces believe to be the level reflecting reality? The problem will be one of perception and investor confidence. If the PBoC suddenly moves from a defensive posturing to aggressive one, the markets will think that the shit in store is much worse than what even they thought to be the case! More importantly, Chinese financial market and world markets will go into a tailspin on the "unexpected" magnitude of the official currency adjustment. The shock on Chinese economy in the immediate aftermath will be substantial as will be the transmission of the shock on the terms of trade of Chinese trading partners and competitors. Lastly, a PBoC engineered sharp devaluation will incite cries of currency management for export competitiveness from US and rest of Asia. This will be quite a episode just when the yuan was two months back finally included in the IMF SDR basket. 

The last option to let the yuan float freely is especially attractive as it will achieve the same objective that Chinese authorities want to achieve by the one-off gradual adjustment to the currency. And this will be achieved without burning reserves any further or take the blame of being culprit of deliberate currency management to support exports. As a bonus, the free flowing currency will most likely depreciate (but appreciate again as deflation sets in) and help Chinese exports from the back door. It will have negative repercussions on the domestic credit bubble and lower currency will make foreign denominated debt payments more pronounced. However, the economy is already slipping out of the control of the government and given the situation, the timing of exercising this option may not do any more harm than any other option in terms of economic contraction. In the worse case, it may only bring the harm forward instead of dealing with it for many years and cleaning the recklessness of pvt sector through burning public resources. 

All said and done, China has managed its currency for the past 30 years or so and stepping into a new world from a position of weakness is something government are always ill suited to do. In this way the public policy challenge for China and GCC is somewhat similar. Letting the currency to freely float is in your best interest, but can to pull the trigger now given that you haven't in 30 years?

A thought on the impact of Chinese trading partners in case of a sharp Chinese devaluations is also in order.

With imports becoming more costly and domestic demand decelerating, Chinese demand for imports will obviously fall further post the downward adjustment to the currency. Which will hurt commodity exporters like Australia, S. Africa, Brazil and the oil exporters of GCC. China is fortunately running a small current account surplus and has financial resources to run large fiscal deficit for a year or two to stimulate domestic demand. 

However, most EM commodity producers are not that fortunate, they are running twin deficit (current and fiscal) and hence will not be able to afford currency depreciation of the same magnitude as China (excl. GCC with pegged currencies). Weaker currency will be the last thing they need on the platter to repair their already battered current and fiscal deficits. To stem the sell-off in their own currencies they will be forced to tighten monetary policy and possibly fiscal spending just at the wrong time. Higher interest rates mean they will helplessly be staring at demand contraction in their respective countries. India is a case in point where monetary policy has remained relatively tight inspite of domestic demand weakness. Also, as Chinese terms of trade fall post the yuan devaluation, it will export deflation into China export markets, including US. The deflationary pressures will be a further downside risks to World financial and commodity markets. 

In conclusion, thinking about how China will manage the transition from super growth to more moderate growth and at the same time contain the fallout from the credit bubble, the options are all bad. There is no easy way out for China or for the rest of the World. This way or that, China will need to bite the bullet and this will be a major downside risk for World financial markets. Also the rising risk of China exporting its deflation to the rest of the World means asset prices in nominal terms might still be pricey in some quarters inspite of the sell off. This market scenario is neatly set up for a fat short trade, who will pull the trigger?

Siraj Presswala,
San Diego, 29/Jan/2016

Monday, October 13, 2014

"Seer sucker theory and my investment philosophy"

Monday, October 13th 2014

Every once in a while, the financial media gets enamored with catch phrases that subsequently become hop topics and most current risk factors for the market. After a while, but not before extracting its toll on asset prices, these flash in pan risk factors disappear from collective memory.As i write this note, the most recent one being last weeks IMFs warning about downside risk to Global economic growth forecast for CY'14. And its subsequent toll on world equity and commodity prices.

Now, I have been following IMF Global Economic Outlook reports for some time, and one thing that I can tell about these reports is: That they are usually a medium term extrapolation of what is current ground reality. Secondly, IMF is a specialist in listing all possible risk factors on the horizon and then caliberating the mood in its quarterly reports based on the importance it gives to some of these risk factors. That methodology makes IMF reports good source on analysis of the current environment but lends little credibility in correctly predicting future course of action. (Now, is that not true of all analyst, well including myself!). 

The real reason why market participants react to IMF warnings is mainly emotional, and can be explained with what behavioral economist like to call 'availability bias' and for some it is simply trying to pre-empt the rest by reacting (even blindly) to the reports' headline! As the inertia gathers momentum, the warnings actually turn out to be self-fulfilling prophecies. In that context, IMF would rather be serving the global community a service by not publishing any reports at all. But for that to happen, the ivy tower economist at IMF and such other institution have to accept that they may not have any durable edge versus the rest of the us in predicting future. And in most cases, the fact the future cannot be predicted. Current predictions are little more than approximation of the current collective emotional state of mind and status quo. With that belief, I set out to do some googling and came across and interesting paper "The seer-sucker theory -value of experts in forecasting" by J Scott Armstrong published in 1980. In a nutshell the paper concludes and I quote 1) No matter how much evidence exists that seers do not exist, suckers will pay for the existence of seers. 2) Expertise beyond a minimal threshold is of little value in predicting more accurately

I could immediately identify with the conclusions of that research paper. It also helped me outline a investment philosophy that I would eventually want to internalize and implement in taking investment decisions. That philosophy is
1) Future forecast are unreliable and/or of little practical value, except when these forecast (no matter how poor) can gather enough publicity to nudge public opinion in its direction (a clear example of the same being: controversy over climate change)
2) If future forecasting is of little relevance, on what premise/framework should investment decision be taken? In my view, if one believes in the above research findings, investment decisions should be based on 
a) current misallocation (eg. Japanese 10 yr JGBs yielding 0.6%) where the current situation is extreme to past history or reasonable expectation about future. Or where current data and projections implied in current price about the future are out of sync with one another (example the valuation of India listed cos. called Justdial)
b) When arguments justifying current valuations are largely based on complex future multi year forecasts 
c) Special situations which are not properly understood by market participants or entail significant emotional control that average market participant is unable to have 
d) investment decision that require only simple logical scenario modelling and conclusions which are readily intuitive and acceptable (eg; Warren Buffets reasoning of buying a farmland in '86 based on simple assumption about yield and crop prices)
3) Ability to accept disconfirming evidence and not get overly committed to our own prior beliefs (guarding against self-confirming bias)

Although the philosophy is well articulated above, the real challenge is to stick by it in thick and thin. Some of the above suggestions require significant psychological and emotional strength. And it is very challenging to remain true to the philosophy when managing external capital or working under an organizational setup where the investment philosophy is starkly different.

(all feedback welcome)

Siraj Presswala, CFA
San Diego, Monday, 13th Oct 2014. 

Thursday, September 25, 2014

The Gold price conundrum and coming bout of inflation. Oh really?

Thursday, Sep 25, 2014 (2:10 pm) San Diego

For atleast past two and half years, equities world over in general and US in specific have been influenced to a large extent by the Central Bank action and speculations regarding the course of the non-conventional monetary policy and its ultimate outcome. Pundits on both side of the aisle have had their own opinion in support or against FED actions. Though both (for and against) arguments are equally logical and potent, it is hard to take sides. Remember how Gold first outperformed (until end 2012) and then underperformed, in absolute terms, based on which side of arguments the general consensus approved of at a point in time.

When money printing seemed like a habit with no end (between 2011-2012), inflation mongers took refuge in Gold to preserve purchasing power. Gold bug argued that Central Banks if, intent on debasing paper money, will eventually succeed in doing so. In which case, money will loose its purchasing power vis-a-vis Gold. The evidence presented to corroborate the argument being, historical periods of high inflation triggered by loose monetary policy and Gold coming out as a winner in term of preserving real purchasing power during such episodes of inflation. When fear ruled supreme, Gold continued to do well and the hypothesis being vindicated.

When former FED chairman Ben Bernanke hinted sometime in Sep of 2013 of rolling up the game over a reasonable period , Gold started loosing momentum. In fact by end 2013, the mighty Goldman Sachs termed short Gold position as a 'Slam dunk'. The argument being extinguishment  of actions to debase currency, takes the punch bowl away from inflation mongers and hence invalidates the hypothesis in favor of investing in Gold. A secondary and smaller argument, being rising value of USD post the QE era also subverting price growth in USD denominated assets such as Gold.

Gold lost some of its sheen in 2013 having provided negative returns for the first time in any calendar year since 2002. So where did the inflation mongers go wrong? Did they not expect FED to stop some day? Did they not expect inflation in the short term remaining subdued due to the moribund employment and economy, plus the deflationary impact of govt and private sector deleveraging?

Answer to all of the above question requires no special intellectual faculties. Simple common sense and simple logical inferences would suffice. Lets start with the first of the two: It was reasonable to expect the FED to stop somewhere and at sometime. Even if no view is taken on how long they go before they stop. To make this point of thinking intuitive, let us for a moment assume, that the FED does not stop ad-infinitum. That would be the case only when the argument for QE remained valid (that being a hypothetical scenario where the economy would never return to a state of full employment). Resultantly, if the economy never gains the traction as desired by public policy, it would be hard to find a argument for inflation running amok in such as scenario. So we can infer here that if FED were never to stop than inflation or Gold would never hit the roof.

Now, it is possible that the inflation mongers did anticipate FED to stop at some future date but also anticipated the interim term to be so long and the magnitude of debasing so high that inflation in future would indeed be a high probability event. However, in that case, they implicitly are maintaining the position that: 1) Both, inflation will be persistently quite high for given period of time and Central Bankers will not be able to control high inflationary expectation by any policy tool.

If their view on any of the determining factor such as: 1) level of inflation 2) The period of sustained high and uncontrolled inflation 3) Policy tool ineffectiveness, is inconsistent with the original argument (that FED will some day stop and we will still have high and uncontrolled inflation in future) than the whole hypothesis is again under the scanner of critical cross examination . Lets go a step forward and assume that the view on the above determining factors is consistent with the hypothesis. In such situation, the analytical framework beneath the hood becomes quite complex. As complex assumptions have to be made about time horizon (persistence), level of inflation (magnitude), what constitutes high inflation compared to normal inflation in some future environment, Government fiscal and monetary policy response and Global trade and currency dynamics.

Although this all may sound little verbose, in my opinion, anyone who think that inflation is coming but also opines that QE will stop some day, is in effect consciously or unconsciously having a position on the above further assumptions. That level of prediction is far more complex than the starting notion of monetary debasing leading to future higher inflation and loss in purchasing power of paper money. The more factors involved, the more interrelationships to think about and the more stochastic the range of ultimate outcome becomes (increases error rate).

Coming to the second question of expecting short term inflation to remain low due to moribund economy and deleveraging, but however, expecting high long run inflation; brings us to an important juncture in our analysis. That being whether sharply appreciating Gold prices between 2009-2012 could withstand the continuous negative reinforcement in the short run of low realized inflation? What would happen to mass psychology in that event, would they stick to the original hypothesis even when proved wrong (even if only in short run)? Where goes the consensus, so goes the price. And this is what has been observed in case of Gold prices and investor interest in Gold between 2012 and 2013 end.  Even though the hypothesis of long run inflation without short run inflation were to remain true, it is not a necessary condition for Gold prices to keep creeping up. As one group of investors would reverse the trade mainly because they cannot have the patience of waiting for the long run. For most investors on the periphery, if there is no inflation today than there is not reason to remain invested in Gold.

In my opinion, this is exactly where lessons from history diverge from investor mentality and asset return today. Investors get into the bandwagon giving historical evidence of why the thesis should work, but forget that historical time horizon of couple of years in making is different than the daily, monthly or at best yearly time horizon that consensus price determining opinion has.  Another way to put it is even if a particular view in context of historical study is logical and might well come to pass, investors also need to have time horizon in line with that view. A shorter time horizon can lead to being wrong in the interim. And being wrong can put immense peer pressure on changing the course (self doubt).

This also brings me to yet another insight. Given the dynamics and complexities involved, in determining long term future and all together different set of dynamics and challenges (both practical and psychological) involved in sticking to an investment strategy consistent with those long run expectation. I believe taking investment position based on such line of thinking can be self defeating. I however caution that does not mean a bias towards short-termism or prejudice against long term investment outlook. What I mean is that it can be very difficult to make accurate long term assumptions (no matter how cogent the argument may sound).. More so when implicitly you are unconsciously making further assumptions and unknowingly increasing the error rate. At the same time committing large part of the portfolio that is benchmarked incorrectly (by you or the outside world) to such a position.

To return to our Gold conundrum, I think Gold price will increase when there is an actual evidence of high and persistent inflation and failing policy tools to control it (irrespective of the starting price of Gold). That is to say, that currently high realized inflation will lead to current positive return on Gold prices without much ado about prognosis few years back. Or if the consensus opinion again shift in favor of coming bout of inflation, even if only for a while.

It is hard to say what determines consistent success in the field: Whether it is ability to correctly draw long term trends and forecast (from the above I think it ain't); Whether it is ability to patiently stick to your conviction without getting distracted with short term outcome (it could, but it also poses the threat of self confirmation bias) or Whether it is about understanding and correctly anticipating consensus fears and concerns?

(all feedback welcome)

Friday, June 6, 2014

China and the value trap

The above chart shows how value added (or alternatively excess returns) is distributed across the Global electronics industries. Although, it reinforces what we already know about it for long, the chart allows for more deeper analysis. After looking at the below chart, it strikes to me that most of the world's most successful businesses have followed this operating model for atleast past two decades and some for even longer, examples include Coca Cola; VISA, Qualcomm, Apple, Cisco, Nike, even Colgate and P&G, 

Strikingly, firms in the hi-tech business that were active across the value chain (including manufacturing) are experiencing or have experienced problems in the past, examples: Hp, IBM, Intel, almost all Japanese electronic firms. One reason being, their investors primarily value them as hi tech companies rather than low tech manufacturing hubs which is sometimes untrue when low value add is more of the revenue mix than high value add. 

A modern company contradicting this trend and still steeply overvalued is Amazon which is diversifying from high value added activities (its potent online platform) into lower value added and more capital intensive ones (company owned warehousing and now logistics). It will be interesting to see whether Amazon proves to be an exception to the rule or will its market price react to this trend over time (now that is a short idea!). 

(Aside: This also reminds me of our original investment thesis in Aramex (high on brand, low on capital intensity), and why Aramex is truly under-appreciated.)

Infact, in Emerging countries there are many instances of listed entities moving from high to low value added. Usually, the devil lies with the initial success, as cash builds up, management in companies with poor corporate governance and shareholder monitoring, are motivated to reinvest the surplus and grow the size of the firm than to distribute the same to shareholders. Expanding downhill is more easier and certain than uphill which makes the decision look prudent for time being and safer for incumbent management. 

It also tells me something interesting about China and how probable it is for that country to make into the upper echelons of the income pyramid. China over the past three and half decades has grown mainly by becoming the workshop of the world -the activity which has least value addition across the chain. That success was made possible with fortuitous combination of 1) large initial supply of cheap factors of production Land, Labour and Capital. Being a authoritarian state, the government owned the land, made capital cheap by repressing market clearing interest rate (which also explains the real estate bubble in China). In an urgency to get unemployment and poverty down for hundreds of million of unskilled people after "The Party" came to power, what better than create low skill, low pay jobs by creating subsidies manufacturing base. Externally, this process coincided with the trend of rising Globalization and economic integration in 80s. 90s and 2000s. 

However, China has not been able to move upscale to more value added activities and it is likely that when the wind is out of the sails on the initial trigger factors (labour, land and capital), China will increasingly face the same risk that other middle income countries face -of stagnant incomes. Infact China's case it will be even difficult because liberty and freedom are prerequisites for providing the environment to innovate. Now, that tell us that whether "The Party" will have to go or Chinese aspirations will have to settle for less. 

The GCC economic growth in many ways is similar to that of China, given almost all GCC countries are authoritarian states of varying degrees. A large percentage of non-oil, non-consumer services GDP comes from low value add manufacturing in industries such as petrochemicals, aluminium, fertilizers, steel, etc. These sectors are globally competitive as long as they have access to cheap feedstock. Though the GCC is lauded for its economic stability and growth rates in excess of 5% and the bureaucracy extolling the growing role non-oil sector. The concerning point is that the non-oil sector is viable to a large extent only due to the indirect subsidies and surplus from the oil sector. That dependence on oil and how fast non-oil GDP can crumble when oil is removed from the equation, justify why long dated GCC assets (high duration bonds, equities and real estate) should correctly trade at a discount to other countries with similar growth but without the oil induced distortion. 

This line of thought also explains why Mr. Alabaar's (Chariman of Emaar) proclamation of Dubai real estate trading at a discount to London or Singapore should be taken only with a grain of salt. A large grain indeed!

Wednesday, April 16, 2014

The state of Indian Democracy

India heads for the biggest and greatest democracy show in Apr-May 2014 as the country of 1.2bn and registered voters of more than 800M goes to elect its new government in the center.

The election this year is very unusual and interesting from the past precedents. This years election is focused more on individual personalities that would potentially lead this country of old civilization and young population out of the longest period of moribund since early 1990s. At the center of this high pitch drama is Narendra Modi, the decade old recalcitrant Chief Minister of the western Indian state of Gujarat largely credited with engineering one of the fastest state level GDP growth.

Narendra Modi has also other feathers in his hat than just Economic development ( a preception that is selling like hot cakes in India as the country rellies from one of the slowest growth in more than a decade, rising inflation, unemployment, and never ending goverment goof ups driving scarce capital). Mr Modi is largely perceived as having covertly been a accomplice of the 2002 pogrom of the Muslims (13% of the population) under his watchful eyes in his state in 2002. A accusation that he has neither accepted and never rejected. A Supreme Court enquiry let him off the leash largely due to lack of substantial 'evidence' though the US Govt revoked his US visa and banned him from travelling to the US due to his alleged role in the genocide.

The whole campaign of the right leaning, nationalist Bhartirya Janata Party whoes PM candidate is Mr. Modi is foused on this superlative economic performance of Gujarat attributable to solely and squarely to the leadership, vision and dicision making skill of Mr. Modi. We will not go into cross examining the authenticity, and statistical analysis of that perception  here. Though sufficient to add in this context, that Gujarat has historically been a state with GDP growth higher than that of the aggregate India and Modi's autocratic and dictatorial style has earned Gujarat capital investments from national and international businesses at the expense of sidelining (sometime by force and other coercive methods) other interest-such as displacement of poor, land acquisiiton, environment, etc. A heavy handed approach indeed has its benefits, particularly in terms of raw economic growth as reflected in the 'China Model'. However India's political and economic setup is very different from that of China (Indian is the worlds largest democracy and China is the worlds largest communist). Albeit the only similarity between the two is entrenched political corruption, rent seeking and the nexus between the businessmen and politicians.

What is very puzzling and equally disappointing is that millions of Indias support Modi (including millions who knew nothing much about him and his achievements before his candidature for the top post) with the same fevour as they support their national Cricket team (India has almost no sport to talk about except Cricket). What they fail to realize is that they are choosing a leader to head a democratic country as vast and diverse as India, someone whoes values, past track record and very achievements are precisely an antithesis of democracy. All that sacrifice, based only on perception and expectation of being able to bring India on track of enviable economic growth. That is indeed a great sacrifice, as it reflects the mentality of average, mostly educated, Indian of today. He is ready to overlook (almost forgotten) the governments role in the pogrom that killed over 1000 of his fellow contrymen only a decade back, plus countless other miseries such as rapes, displacement, illegal appropriation of assets, and discrimination at work place, education institutes, and public offices of the minorities. He is ready to overlook the fact that: long term development, that is more meaningful and equitable, than just raw GDP data; it is necessary for the goverment to tackle issues that pose challenge to the 'capital investment' based model in its policy making, and respect the rights and concerns of other stakeholders than just the capitalist. Sidelining those concern and stakeholder, though can create jobs and growth in the short -run, it will eventually extract its price: by mainly rising social and ecnomic inequality, threat to internal national security and harmony and a unbalanced, unsustainable growth path that will engender anothet set of political issues to deal with down the line, as China has realized in the past 3-4 years.

Another trait of this elections campaign mania has been the ease with which the Indian voter (educated and otherwise) can be obfuscated with glizty marketing and branding ploys. Though there are millions of Indians to harp about Modi's economic miracle in Gujarat and his leadership (most of them confusing leaderhsip with autocracy) very few and I repeat indeed very few actually can articulate what those 'achievements' indeed are and still fewer have any idea of how they have been achieved. Not much doubting the depth of critical mindset of Indian voters, the BJP campaign machinery has gone the 'end of the world' in marketing Modi strength as the sole purpose of it being the rightful candidate to form the government at the center without devoting much time and energy in communicating What and How the Economic Growth implicty proffered to the voters in exchange of their votes will be achieved. Nor Mr. Modi has made any attempts to articulate what his vision for the country is, what issues does he intends to tacke and how? to re-ingite the India Shining story.

Although, I have to concede here that the last of the problems mentioned in the prior paragraph is across the Indian political landscape where candidates promises are more friction than facts. Very few, even those running for the highest posts, make any attempts to go into detail of their game plan for the country and how they intend to achieve it. Candidate never debate with one another on the same stage on issues vital for the country and how they intend to tackle it (maybe they too have no clue on that!). Mass rallies are similar in analogy to religious sermons where its sacreligious to ask questions and you have to use your emotions more than your head to believe that your candidate tells you. As much as 50% of the time is spend in only jibbing at and belittling the opponent on issues that are sensational rather than of national importance.

The Modi led BJP govt seems to be likely at the center after the May elections and that is what the polls suggest. It will be interesting to see what and how much Mr. Modi delivers when the rubber meets the road. I will endevour to update this article after the May election results outcome.

Sunday, June 23, 2013

Yen and how it may impact global asset classes

Originally written on 16th May 2013

BoJ’s ambitious plan to simulate domestic economy by sloshing the system with monetary easing (printing yen and exchange these yen to buy bonds and mortgages of all maturities) in order to stimulate domestic demand and inflation (2% inflation in 2 years by expanding the monetary base by 2 times) will have repercussion far beyond Japan

For one, printing money to artificially sequester real interest rates will at some point make investors in JGBs reluctant to either buy more JGBs or continue holding existing ones in the portfolio-consider the plight of an investor who has sacrificed consumption in the past to buy these bonds now find its claims at par with those who have brought the bonds by simply printing the money!-That scenario, if it comes to pass, will spell doomsday for Japan as the country currently has the highest Debt to GDP ratio (>200%) in the world (to put it in context, struggling Italy and Spain have debt to GDP ratio near about 100% but unfortunately cannot print their way out of the problem) and public debt is mainly financed through domestic savings.

After the bursting of the real estate and stock market bubble in early 1990s’ Japanese retail investors have mainly preferred to invest savings in bank deposits which in turn are channelized to buying JGBs. Loosing investor confidence may result in steep rise in yields –no matter how much more the government keeps printing money. On the other hand, retail investors were comfortable buying JGBs near zero return given that inflation was negative in Japan for a very long time and stagnant economy subdued outlook for other asset classes (such as domestic real estate and equities), that may now change with inflation outlook becoming positive and Nikkei at 5 year high giving investor more options than putting money in boring JGBs

The aggressive stimulus may have unexpected impact on Japan something with which the world has no prior experience in recent history, If I were to make a wild guess, I suspect the impact will be mainly on driving up steeply Yen yield curve (the trick is plain to see for JGB investors) and the associated problem Japan may face to funds its unbridled public debt –a scenario which will see yen depreciating much more

What would this mean for global asset classes
1.   First and foremost, selling one currency to buy another one eroding its value at a slower pace is not a solution, the ultimate hedge will remain hard assets such as real estate, commodities and metals
2.   Secondly, even though global economic growth may be sluggish, equities are placed relatively better than bonds fundamentally, as they are natural hedge against hyperinflation, as well as, share any upside that monetary stimulus is purportedly suppose to achieve. In that case, equity valuation multiple may remain higher than can been the case in recent past even without encouraging topline or bottomline growth
3.  Gold price correction in the recent past is puzzling when juxtaposed with the debasing of currency in Japan / US and maybe soon in EU due to competitive pressures. Gold has always and will remain a hedge against monetary debasing and threat of future inflation
4.    As lower yen conquers market share at Germany’s expense, EUs incentive to debase euro further which will meet the interest of both northern and southern members will rise, the question is if all three major currency blocs (EU, Japan and US) desire a lower exchange rate for itself,  the depreciation will be relative to which currency?
5.   An event / catalyst which can trigger market to reject buying QE prone currencies and nominal bonds denominated in those currencies will be a milestone event for world monetary policy. And possibility of countries once again reverting to fixed exchange rates or exchange rates tied to gold reserves cannot be ruled out in next decade or so. Although this may sound far-fetched now, such arrangements and reversion from free floating to fixed exchange rates and vice versa have happened multiple times over the past 200 years. With each episode of reversion from floating to fixed exchange rates being subsequent to sharp episodes of inflation usually after rising wartime public debt
6.   That view also explains why holding gold as long as printing presses at major central banks keep humming (and a few years after that to confirm status on ensuing inflation) is a good idea even though there may be opportunity costs involved here.

7.   Also for the first time in a generation, equities might actually be a safer assets than the risk-free asset called government bonds we grew up learning about 

Near term prospects for Bahrain goverment debt yields

Originally written on 20th May 2013

Bahrain faces a steep challenge relative to its other oil rich neighbors in the GCC over the medium terms in putting its fiscal health on a more sustainable path. In a nutshell concerns over Bahrain’s fiscal health have their provenance in two sources
1.  Generous state subsidies (including those on fuel, electricity, water, selected food items)
2. High dependence on Bahrain’s limited hydrocarbon production to support fiscal spending and generous subsidies

The political unrest which began in early 2011 and continues to this day-albeit having stabilized progressively-have put further pressure on state coffers to increase spending in order to both simulate a stagnant private sector, as well as, create employment on urgent basis. Secondly, subsidies tend to be sticky with steps to control / cutting back remaining highly unpopular with the constituencies, reform in that direction though urgently needed will be extremely challenging politically given the already stressed relationship between the government and a large majority of its countrymen.

Bahrain’s current break-even oil price at $115 is already above the market price and perhaps the highest among all oil exporters in the world.(breakeven price is the price of oil, keeping export volumes constant, would be required to fully fund budgeted state expenditure without resorting to borrowing or liquidation of past reserves). To me that would imply that the country will continue to run fiscal deficits persistently since my subjective judgment is for that expenditure on other hand will be extremely difficult to cut back and near term oil prices have probabilistically more downside risk rather than upside.

Given the small size of the economy and flagging private sector growth, a incrementally rising debt to GDP ratio will not be quite appeasing for both existing investors as well as prospective investors in Govt. of Bahrain paper. I consider the prospect for credit premium on Bahraini debt and CDS to increase over the next 2-3 year horizon from current levels than to decrease. Once the exigency to control ballooning government debt becomes a consensus opinion, a downward revision in Bahraini dinar-USD exchange rate (devaluation of the BHD) cannot be ruled out either.

On the positive side, Bahrain remain geo-politically important to contain Iran’s influence in the Arabian peninsula and has historically shared very strong relationship with regions big boy Saudi Arabia. A GCC bailout or soft financial assistance (as the current $10bn 10 assistance) is also a quite likely scenario in case of sudden distress. That would make investing in short term Bahrain government debt (after the yields have spiked in tune with new information) a attractive proposition in future if the country goes through a financial panic in coming years.

Key economic statistics of Bahrain

1.  GDP  2012 – 2.7% p.a.  (Historically, from 2000 until 2012, Bahrain GDP Annual Growth Rate averaged 4.61 Percent)

2.  Current account to GDP – 15.4%

3.  Government Debt to GDP – 31.6% (Historically, from 2000-2012, Bahrain Government Debt To GDP averaged 19.84 Percent)

4.  Yield on Bahrain (2020) government USD bond – 4.12% p.a. (USD 10yr T-Bond 1.95%)

5.  5 years CDS spread –c.2.05% p.a.