The World Economy : So Where Are We Today ?

Posted on October 10, 2015. Filed under: Uncategorized | Tags: , , , , , , , , , , , |

The QE along with the ultra low rates, as a loose monetary policy did what it had to do, during the crisis and also in the immediate aftermath, but the temporary measure also made the market somewhat irrational, and then came a time when markets got addicted to it, and kept on going higher regardless of the underlying fundamentals. And what we thought was a large Airbus 380 flying at 40,000 feet turned out to be an Airbus 318, so now, when our perception is changing, we find ourselves stuck, because, we know that an Airbus 318 is, simply not big enough to carry, and then keep the world economy flying at 40,000 feet, and also there is a realisation in some parts of the market that the Airbus 318 was never really flying at 40,000 feet. But the problem is, the central bankers, who kept the plane flying are now running out pages in the instruction manual.

So the central bankers in the developed world will need to find a way to get themselves unstuck. Low rates coupled with low inflation is not what most central banks in the developed world were expecting, and now they find themselves STUCK. In the QE era world, low interest rate environment isn’t necessarily all good and positive for the real economy, because the incentive to chase better returns leads to misallocation of capital. The asset price inflation that came about mainly from the misallocation of capital has more or less peaked, the fundamentals of the real economy were never that strong to drive the record level asset pricing. Easy money supply from QE was the main factor that created asset inflation.

Today, globally , the overall inflationary pressure in the real economy is somewhat subdued, and the central banks in the emerging economies are also lowering the rates. And this creates a very interesting problem for the central banks going forward especially in the UK and the US. The way, I see it is, the world economy is now starting to sail blind ( more or less ), and I must say, I’ve got my fingers crossed.

By waiting for an opportune time to raise rates, the central banks in the developed world have started the work of undoing all the previous good work that was done during the crisis, and in it’s immediate aftermath. Water in the ocean has to travel in a wave, and a still ocean is always a sign of something disruptive that’s probably on the way. So, we are getting stuck, by design, QE and the low rates as a part of the ultra loose monetary policy were supposed to be temporary measures, but for whatever reasons, it became the norm, and now, the markets have simply got addicted to the ” new temporary “.

The FED as well as the BOE will rightly say that there is no change in circumstances that demands a rate hike, in fact, the slowing world demands that the rates remains low for an extended period. And the markets are now starting to position themselves accordingly. But there is no guarantee that a low interest rate environment globally, will do the world any good, even when the developing world is also seeing a subdued inflationary environment. In my own view, the central banks can and should try to influence the flow of capital. It is what is required, and there is almost no real harm to the global economy if the FED was to raise rates by 25 bps, and by not doing that we run the risk of making what was supposed to be a temporary status quo, the ” new permanent “. If we continue with the existing ” status quo ” then there is a serious risk that markets will remain irrational and therefore volatile, and both will have damaging implications on the real economy. Take for example, the recent upswing in commodity prices , the price movement is not based on the assumptions that the fundamentals of the global economy is improving, or going to improve dramatically. In fact, it isn’t, and if we look at the recent growth projection of IMF, and also the overall inflation environment around the world, then it will be quite difficult to find a sound economic argument for the price movement upwards, but in my own view, I believe, the commodity market is moving up because of the realisation that rates will remain low. So the misallocation of capital as well as the distortion of market reality will therefore continue.

The benefits of QE as well as low rates was somewhat limited to the real economy, as a large part of the capital didn’t really flow into the real economy. And most data suggests that financial investors were in fact the main beneficiaries. The financial investors saw no real benefit, in terms of overall return of investing in the real economy , so a large part of the capital went into inflating the pricing of the financial assets for obvious reasons. Real economy isn’t designed to create high double digit returns in a very short period of time. So financial investors chasing quick and substantial return saw no incentive of committing capital to the large part of the real economy. But the hope was, especially from the central banks that at some point, the money will flow into the real economy. Having said that, QE and the low rates more or less served a their good purpose, but the central banks to a large extent failed in their attempt to channel the flow of capital where it could have been utilised to create growth in the real economy.

And if we are to rely on historical evidence, most available data suggests that when the financial markets starts growing bigger and faster, it is generally at the expense of hurting the real economy, and more often than not, it leads to a crisis.

The FED as well as BOE will need to change the ” status quo ” or in other words tweak the current market dynamics, a bit. You need a positive and a negative polarity to create the flow of current. The wind flows, when you have a high and a low pressure environment. And to keep a plane flying, you need to have a strong flow of air across both the wings. An economy like most planes requires two pilots, and so far, the central bankers have taken the lead in flying the plane, and they have done a good job especially in the absence of a strong leadership from various governments, but now, it’s time for the governments to play their role. So far the governments have failed to deliver on the important reforms that was badly needed. We have had sound bites coming out from various pockets of the governments as well as the political class in general, but the real lasting reforms aren’t quite visible yet. Blaming the financial markets and making the banks, a villain, is now an old story. The fact is, without the central banks taking the lead, the governments won’t really have an economy to talk about today. But there is a limit to what can be achieved through monetary policy alone, and I have always suspected that at some point, the central bankers will run out of tricks, and the limits of monetary policy tools will be tested and exposed. And it looks like that’s where we are today.

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The Changing GAME, and the Global economy

Posted on December 6, 2014. Filed under: Uncategorized | Tags: , , , , , , , , , , , , , , , , , , , , , , , |

The recent movements in the markets and its overall behaviour is starting to indicate that the game is changing and has already changed somewhat, and the market participants are having to adapt to these changes rather quickly. And here is an example, so when my GrandMa suggested that never mind the good old correlation theory, the markets overall behaviour today has changed so we could very well see the stock going higher while the crude oil could go as low as 70 or even lower,some folks in the market thought, it hasn’t happened before, and probably won’t now because crude and stock pricing have had historical correlation. And that’s a very understandable observation. But in the past month, the stocks have clearly been on an upward trajectory while the crude has continued to be on a downward trend. And by relying on the old economic theory as a reference, some may argue that one of these stories might be not be true, but I would disagree with that old economic assumption that one of these stories must be lying. Not at all, it’s just that people have evolved, and some of the old rules don’t work that well in the markets today. And here is an attempt to explain both the stories.

The stocks have been supported by a number of factors. For example, the European Central Bank ( ECB ) has just started its quantitative easing ( QE ) program, and the Bank of Japan ( BOJ ) as well as the Bank of England (BOE) are still maintaining the level of their QE program, also there are no real indication that the FED or any another central bank for that matter in the developed world  is going to start raising rates around Q1 of 2015, it’s simply too risky. And although at some point, the FED and BOE might have to raise rates in 2015 , the central banks in China and India will most likely be lowering their rates, and PBOC ( the Chinese Central bank ) has already started the process so clearly the game is being played differently around different parts of the world today.

And with regards to the downward trajectory of the current crude pricing, it  isn’t all a reflection of a seriously deteriorating global macro economic condition. In fact the recent policy easing in China as well as the Euro 315 billion investment & growth plan announced by the European Union along with the quantitative easing (QE) plan of the European Central Bank is all aimed at creating  growth so the under normal circumstances, the markets should push the crude prices up but the underlying reasons for a falling crude isn’t all based on global macro issues. There are number of other factors at play, and one of them is that the US marching on to becoming a net exporter of energy, and OPEC mainly lead by Saudis are trying their best to maintain their position in the game by making the shale gas business unsustainable. It’s hard to project, if OPEC and the Saudis will eventually succeed but the game has obviously changed, and the old rules don’t really apply.

The other interesting thing happening today is the positive momentum build up over India. And if India is able to find a way to unleash its potential then quite frankly, the global economy will be better for it. But the Indian economy has to deal with a series structural issues, and inflation being one of them.I believe, the current RBI governor needs to sit down with the government, and help device a plan to carry out wholesale structural reforms in the economy. Monetary policy has its limitations, just look across the world, the central bankers aren’t really able to get a good handle on inflation anymore because as stated before, the game has changed. And we need to look at the  bigger context when talking about inflation today.

For example, the financial assets in the U.S. as well as other developed markets got highly inflated, but without a real increase in disposable income, there is simply no capacity in the real economy to drive up inflation in the developed world. And specifically in context of India, India’s inflation is hard wired into how the country’s economy is structured, and unless the economy is unclogged, taming the inflation isn’t going to work. So practically, it’s almost impossible for India to export its inflation overseas, a process through which the developed world including of the U.S. was able to to export its inflation to an economy like China while continuing to grow and keep a relatively high living standard. The RBI governor has done an extremely good job so far, and I believe , he along with other central bankers know the limitations of monetary policy tools. Also Indian economy isn’t efficient enough structurally to quickly respond to policy changes, and this is thanks to the old ways of doing things. So an incremental reform agenda aimed at unclogging the engine has to be at the forefront. Inflation will tame down going forward with the structural reforms in the economy and also the existing lower fuel prices etc, but without carrying out a thorough structural reform, any slow down in inflation can’t be sustained.  I believe, the current governor of the RBI shouldn’t hesitate to use inflation as a leverage to keep the pressure on the finance minister to keep the reform agenda at forefront. And in Mr Rajan as the governor of India’s central bank, India has found a central banker who has a global reputation, also a central banker who isn’t shy of a debate. And this is why he gets respect in the market.

Overall, it looks like India is heading in the right direction. A country like India needed a strong government, and most importantly a strong leader. And on both these counts, the people of India have delivered, but India is a federal structure so if the states don’t participate in the growth and prosperity agenda of the federal government then it will be a struggle for the central leadership on their own to take the country forward. There is an overall positive sentiment around India today, and the country does have an immense potential. And the way, I would describe India’s potential is, if for example, the economic model followed by China has helped it create a Boeing 777 then India today has the chance to create Boeing a 777 X series plane, an upgraded version that will be largest and most efficient twine engine plane in the world, but for this to happen a lot has to go right for India.

Progress and reform has to be incremental, and also gradual. A steady take off requires the pilot to guide the plane making sure the climb is comfortable, and will not put the passengers as well as the plane at risk. And once the plane is flying at the desired altitude, a seasoned pilot as well as a passenger know that there will always be turbulence on the way. So the approach by the INDIAN  leadership shouldn’t be based around trying to blast off the country into outer space by carrying out one time wholesale Big Bang reforms. No progress or reform is permanent so the leadership and the policymakers should factor in a period of consolidation in the economy, and be always prepared to carry out the next set of reforms.

Also any well thought policy reform will fail to deliver the desired result, if the policy delivery mechanism isn’t fit for purpose. The current economic infrastructure of the economy is old and too  clogged up so the focus of the government should be to take immediate measures to unclog the system, and then the growth will start to trickle through. The road ahead won’t be a smooth ride but the focus should be on unclogging the system and changing the current administrative policy delivering mechanism set up in the country. Also, the rural India will need to be fully plugged into the overall progress agenda. This will create,and is already creating tremendous opportunities for entrepreneurs who are able to spot them. The strategy has to be tailored to make sure all parts of the economy is starting to perform efficiently, and won’t burden the ascend of the overall economy going forward.

Also most importantly a ” progress for all ” idea has to be sold to the entire nation, and by trying to make this into a national movement, the current PM of India is heading in the right direction. However, the people of the country will need to be willing participants by making their own contributions. So the leadership of the country should aim to pitch India as a potential B777 X, the latest and more powerful as well as more efficient version of the existing B777, and India can be that.

The government will need to discover an economic growth model that is sustainable over a long term period and also inclusive. Adopting and following an existing growth model will not work for a country like India, and this is why I always struggle to understand the idea proposed by some in the market that all emerging economies should follow the economic growth model of China as an example for their country without really understanding if that specific economic model is going to be sustainable for their respective economies.

China’s heavy reliance on investments to drive it’s GDP has created a massive over supply, and there are large amount of infrastructure assets that are simply sitting idle without creating any return for the tax payers so if we were to look in terms of return on investment basis then the picture is quite murky. In short they would fall under inefficient investments category, and we are talking about trillions of dollars worth of such investments here. And this is one of the reason why the leadership of China based companies are looking to invest overseas, and it makes good business sense because the companies in China do have tremendous experience in building substantial infrastructure assets.

So going forward, the state owned enterprise in China will look to invest overseas as there isn’t much to do at home, and in a way, this strategy works out well because the emerging economies that have massive infrastructure deficit might find that China based companies are more willing and flexible to help them develop and finance those projects than others. And as Europe and the U.S. gets more competitive, the foreign players currently operating in China will start to move their production facility closer to home, and it’s already happening as the cost of production is starting to get lower than that in China. The economic engine of China is going through a gear change, and the leadership will need to make sure the transition is well managed. And as the game continues to change, companies operating in the real economy will face different type of challenges but at the same time there will be many opportunities, and that’s just a natural process, the powerhouse of yesteryears will become irrelevant as the economy evolves.

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