SANDIP SABHARWAL
Stocks,shares, finance, money, profit and the economy

As the budget speech started and Part I of the speech wound down I actually thought that it was Mr Chidambaram speaking and not Mr Jaitley. However Part 2 did wave me up from the slumber and increased the rating of the budget substantially.

THE GOOD

First of all the thing that pleased me the most. The rule for establishing where the permanent residence of a Fund lies will no longer be dependent on where the Fund Manager sits. This absurd rule had forced many Fund Managers managing investments into India to sit in Singapore, Hong Kong, Dubai, London etc. Now if the Fund Manager is in India it will not establish permanent residence and the taxation of Foreign Funds. This makes the life of Fund Managers like me who never wanted to move out of India easy and creates more opportunities. Now there is no longer any need to sit at high cost destinations away from on ground research to invest into India.

Also in line with changes to improve funds flow into India were the proposals to treat taxation of Real Estate Investment Trusts (REITS) at par with equity and allow pass through status. The other major change was with reference to taxation of Alternative Investment Funds (AIFs) where again there will be pass-through and moreover foreign funds can now invest into AIFs which will improve funds flow into these funds and provide greater opportunities for Foreign Investors investing into India.

The other positive announcement was the strong action of the government on Black Money where holding black money abroad and holding Benami properties in India now will become a criminal offence imprisonable with sentences upto 10 years. The government has shown its sincere intention to control black money generation and this will eventually lead to greater flows into Equities, Bank Deposits and Insurance.

Tax breaks on savings have also been increased with a further limit of Rs 50000 being allowed into the New Pension Scheme as a tax exempt investment.

The postponement of GAAR by two years and its implementation from 1st of April 2017 and will also be applicable prospectively on investments made after that date. This improves lot of tax ambiguity. There are also moves to reduce taxation on royalty payouts by domestic arms of MNCs.

The GDP growth next year is projected to be in the range of 8-8.5% which looks realistic as per the new series.  The proposed legislation on reducing red tape for setting up new establishments by formulating regulations to follow and not take approvals from various authorities is a big positive.

Combining FDI and FII into one single category of FPI is also positive as it reduces monitoring requirements, an artificial distinction between good and bad foreign money and simplification.

I do not want to get into each and every step but just focus on main points.

THE BAD

 

The negative impact of the budget is in terms of the increase in Excise duties as well as the substantial 2% increase in service tax which will be highly inflationary. On top of that there has been hardly any move on addressing structural issues which impact inflation especially food inflation. I am afraid that this will make food inflation raise its ugly head sometime in the near future. When the finance minister said that problem of inflation has been addressed structurally it is simply not true. You just got lucky due to the commodity price collapse. Brent crude prices have already moved up from $ 46 to $ 63 now and might see levels of $ 70 during the month of March driven by reduced OPEC output, disruption in Libya production as well as short covering.

There have been no major steps taken to improve the balance sheet of PSU Banks.  The contribution towards PSU Bank recap at Rs 7940 Cr is a joke. Given their balance sheets they need at least Rs 30000-50000 Cr this year.

The disinvestment target is too steep at Rs 69500 Cr when the achievement for this year is just Rs 26000 Cr, although the move to undertake strategic sale of loss making PSU’s is positive.

Although a long term direction has been given on reducing the Corporate Tax rate in the current year it has actually gone up. This is ridiculous given the slowdown in the economy. We need lower taxes now not at a time when the economy is roaring.

There is also no clarity on final GST rates which could create some volatility for the economy as 1st April 2016 approaches.

Overall there have been lot of announcements however no substantive steps to improve the growth of the economy in the near term.  At a time when we are undergoing growth slowdown this is a negative.

IN CONCLUSION

In conclusion I would say that the budget is directional good but does little to provide near term economic stimulus or momentum. The probability that in light of poor corporate performance and a likely bottoming of inflationary downswing that the markets will move substantially higher from the current levels is extremely low. The markets need to consolidate and possibly give up some gains over the next few weeks and months.  Can markets rise from here? Sure they can on momentum but will find it difficult to sustain. The attention will now shift from making the Ordinances into law via the parliament.

As I conclude the article new is coming in that Petrol and Diesel prices have gone up by Rs 3 per litre. The best of deflation is behind us; don’t bet on lower rates in the near term to drive the markets.

The action from here on will be stock specific where there is still potential of generating huge alpha.

BUDGET AND THE MARKETS, REALLY?

The annual season of pre-budget expectations and discussions around how this budget is going to be trend setting for the Indian Markets and the Indian Economy have been buzzing for the last few weeks now. After having watched Budgets being presented as I have been working in the field of investments for the last  20 years now there are two things that I can conclusively say-

  1. The impact of the Budget speech on the markets is vastly exaggerated.
  2. The trends in the markets are long term in nature and the Budget is an annual event. Normally events in a trend never have the ability to change the trend

That said, a vast majority of traders, Rating Agencies, brokerages etc give a lot of importance to the event. We can say that the annual Budget exercise could have been very important when we were living in a closed environment and India was a closed economy. Now that the economy is open and most of the products can be freely imported and exported and there is very little to do on the indirect tax front the Budget should be treated as just one factor among many. Just to take a recent example, the first budget speech of the current Finance Minister in July last year was considered to be a letdown with not too many takeaways. However did it impact the long term direction of the markets? It did not. Infact in the last 20 years the markets have fallen 11 times in the month following the Budget and risen 9 times.  

So does this indicate that the Budgets were good only 9 times in the last 20 years or were bad 11 times?  Moreover 6 times out of the 11 times it was negative the markets gave a significant positive return for the full year.

Now what should we conclude from this data. I believe that the Budget in India has become an annual exercise where the government of the day puts out its agenda and thinking for the economy. There are a lot of things said in the Budget speech which are supposed to be followed up and done by various ministries who work independent of the Finance Ministry. Implementation of the things spelt out by the government, the growth rate of the economy, inflation, interest rates, and global factors i.e. all the standard factors have a much bigger impact on the performance of the markets than the Budget.

There should ideally be no change in investment strategy because of the Budget. The trends in the economic growth cycle as well as stock market moves are long term in nature. Negatively perceived events create correction in Bull Markets and positively perceived ones corrective up moves in Bear Markets. Ultimately markets are slaves of earnings and if economic growth is strong and earnings beat expectations markets tend to do well.  These days there is another major factor that affects the performance of stock markets globally and that is the Quantitative Easing programmes of various central banks. With economy growth anaemic globally most of this money is flowing into bonds and equities and this event has become more important than any other for the performance of global equities in the near term.

Near term market outlook seems more dependent on Global factors related to the movement in Oil prices, the crisis in Greece and Russia as well as the expected pace of tightening by the US FED. My view at the beginning of the year was that the first half of the year 2015 is tricky for the markets and we should see a better performance in the second half. I still believe that we need to be cautious till April/May by which time we should have clarity on lot of things.

In conclusion trade or invest based on the Budget at your peril. It is unlikely to impact long term stock market returns in any way. 

It has been an interesting visit by US President Obama. To be frank my expectations about the outcome were not very clear however a lot seem to have been achieved which could lead to much greater investment into India and defence cooperation. Setting up of a hotline between the Indian PM and US President as well as the NSA’s is huge. Intelligence sharing is likely to help India prevent terrorist attacks and a clear signal on no tolerance towards terrorism is likely to eventual reduction in cross border terrorism. Operationalization of the Civil Nuclear Deal is positive and we need to see how fast investments can move on this.  The other important feature of Narendra Modi’s speech in the Joint Statement was a reiteration of the entire Swachh Bharat scheme where it does not only mean cleanliness in general but also the cleaning up of the environment. This could open up huge opportunities in the alternative energy; clean energy as well as a clearer move away from fossil fuels by India at a much early stage of development than other countries. The flipside is of-course in increased monetary cost of progress. Support for India’s position as a permanent member of the UNSC is also very significant.

Overall the working together of the two biggest democracies is likely to be a big positive for India for its security and development over the long run. When Narendra Modi started his focus on overseas diplomacy there was a critique of his focussing too much on External Affairs. However as it turns out both the external and domestic issues are being managed well. The longer term economic prospects and as a follow through stock market outlook is improving.

GREECE- Greece matters move in the short run as the leftists come to power. As a right wing thinker I should ideally not agree with what the Syriza party is talking of.

However the reality is that Greece has no option but to restructure its external debt and let go of the extremely painful and forcefully imposed austerity programme. The country’s economy has contracted 25% over the last 5 years, youth unemployment is 60% and debt at Euro 320 billion is 175% of GDP. There is no way out but a restructuring of the debt obligations. In all probability the creditors need to take a 40-50% haircut in order to get the debt back to sustainable levels.

Spending cuts and soaring unemployment have seen around 3.1 million people, or a third of the population, lose their social security and health insurance, leaving the country on the brink of humanitarian crisis. Almost third of Greece’s population now lives below the poverty line, while 18% are unable to afford basic food needs.

If a company in the US was in such a stake it would go into bankruptcy protection. However countries do not go down. They survive as it is a real economy and it involves real people. The creditors who lent Greece so much money should have known that they are taking a risk. There is no way that forced austerity at a time when unemployment is so high and the economy is contracting can sustain.  A 175% Sovereign Debt at the borrowing rates that Greece has is no way sustainable. The Eurozone will need to accept a haircut to move forward. If Greece moves out of Eurozone then it will be an outright default with no money likely to come back anytime soon. At this moment Greece has little to lose. As it is people are miserable and they might get more so in the near term by asking for a restructuring. However going with the IMF and Troika narrative will lead to pain for years.

Under the circumstances, in the near term Draghi’s money printing might prevent a major selloff. However as Syriza makes its intentions clearer after coming to power we should see volatility coming in.  This space will need to be watched carefully along with renewed violence in Ukraine where things again seem to be going out of control. 

Despite there being a huge number of both public and private sector banks in India the entire banking industry works as a big oligopoly. The interest rate transmission mechanism is very poor and transparency even more so despite several efforts by the RBI to improve the same. This is extremely high in the case of Retail Floating Rates given by banks where the transmission is 150% on the way up and 50% on the way down. For example statistics reveal that post 2008 crisis when RBI reduced rates by 525 basis points besides cutting CRR several times the average lending rate reduction by Indian banks was just 128 basis points.

I will explain via a personal example. I have a housing loan from HSBC. This loan started off at an interest rate of 7.25% in the year 2005. At that time the repo rate was 6.25%. Subsequently as the repo rate moved up to 9% the interest I was paying moved upto as high as 13%. I did not protest against this as this is a feature of floating rate loans. However when the repo rate was subsequently cut by the RBI to 5% in the year 2009 the reduction in rates was barely 1%. When I wrote to the bank chairperson the rate was reduced to 9.25% from 11.5%. They were as it is offering this rate to new customers but not to the old ones. A lot of people will not understand how this happens. It is by increasing or decreasing the discount they had on the Retail Lending Rate which was different for different customers. For example when I took the loan the RLR would have been 10.5%, so I was at a 3.25% discount to that. In the tightening cycle of RBI they increased the RLR to 16.5% so my loan got repriced to 13.25%. However when the RBI cut rates they did not reduce the RLR as much but offered higher discounts to new customers. and ripped off the older ones.

Subsequently RBI increased rates again and in this cycle my housing loan rate moved up disproportionately again and then the entire cycle of writing to the Bank Chairperson had to be repeated. Even after that My loan is priced at 11.5% today whereas ideally it should be less than 11%.

Public sector banks, due to their high Non Performing loans are not able to participate in monetary easing as they have to make continuous provisions for bad loans.The relatively professionally run Private Sector Banks are able to use this to maintain high Net Interest Margins and are not pushed to reduce rates by PSU banks which is something that should happen in ideal circumstances.

Monetary transmission is something that RBI needs to work on strongly. Rated corporate’s are easily able to take advantage of the lower rates by issuing bonds or Commercial Papers for working capital financing. Banks do not ostensibly reduce rates even for them but subscribe to these CPs and hence circumvent the entire Base Rate process of the RBI. It is the retail borrower who has to suffer. Floating rates need to be implemented in letter and spirit. However we still have a long way to go before this happens.

After being extremely bullish right through the phase prior to the start of 2014 and more specifically after Raghuram Rajan took over as RBI Governor I turned cautious on the markets in September/October when the markets were around 8000 levels. Infact I still remember being in a TV interview the day markets hit a peak of 8175 and to me that seemed to be a decent peak to give an 8-10% correction. The reasons were both domestic and global as global risks seemed to be growing and the pickup in the domestic economy was slower than expected. However markets continued to rally after giving two minor corrections and have reached a new all time high today. As such it’s important to look back and reconcile the view to what’s happening on the ground and what could happen going forward.

Narendra Modi’s image- I had written in April last year to ride the pre NaMo wave inorder to participate in the post NaMo wave. This came true as the new government came with a huge majority. The positivity created by the PM combined with the strong reputation of the RBI Governor seems to have placed India in a preferred position as far as foreign investors go. It seems most investors are willing to look past a few months to ride the India wave. The impact has also been strong domestically where domestic investors have poured in huge money into Equity Mutual Funds where the total inflows have crossed Rs 30,000 Crores.  The success of the BJP in subsequent state elections has also added to the positivity. It has also become clear over time that the government is focussed on getting the economy going as most issues impacted due to the parliamentary logjam have been cleared through ordinances. It might be debatable whether this is the right way to go, however investors have taken it positively.  Although recovery and action has been slow to start of investors seem to be playing for the long haul. I am also personally sure of the delivery from the government.

Crash of commodities, especially Crude- At the time when I gave the initial cautious view Brent Oil was trading at $ 95 per barrel. We have seen prices rapidly crash to $ 50. This obviously gives a huge impetus to India both in terms of contributing to a lower Trade Deficit as well as putting nearly $ 50 billion into the pocket of Indian Consumers which is a huge stimulus for consumption. However the crude price fall also has negative consequences for Oil Producing countries and a crisis in Russia or the Middle East could have global ripples. The bonds outstanding of US Shale producers are also to the magnitude of $ 550 billion where we could see some defaults. Normally such a crash in commodities would see its ripple effect across other Asset classes. However the Quantitative Easing programmes of various central banks have distorted the normal response. India is obviously one of the biggest beneficiaries of the crude crash. However it impact on global fund flows will be seen going forward. The negative impact for India could be in the form of lower remittances as well as lower investment by Oil nation Sovereign Wealth Funds.

US Dollar Rally- We have normally seen that a US Dollar rally creates a liquidity squeeze in Emerging Markets. The rally of the USD did create a selloff in a vast majority of Emerging Market currencies as well as their equity markets however India did not participate. This was a rare event in an era of interlinked global markets and funds flow. Additional stimulus by the Bank of Japan and expected QE by the ECB seems to have reduced the liquidity scare this time. While we saw many markets like Brazil, Russia and even South Korea move to years lows the Indian Markets held on. Given the likely policy divergence between the USA and other countries the probability is high that we will see a further rally in the US Dollar this year. This should reduce overall flows into Emerging Markets and is something we need to watch.

Sharp fall in inflation – The Consumer Price Inflation as well as the WPI fell rapidly over the last two months as a result of the crash in global commodities as well as the base affect of last year’s spike in food prices. As a result the RBI has started cutting rates earlier than expected. Now since the RBI Governor has always said that when the policy stance changes it will be directional we can expect a 100 basis point fall in policy rates this year. This should support economic growth in the later part of the year and was always expected. It is also likely that inflation will now remain subdued for a good part of this year unless we have a food price spike during the summer months. Rabi planting has been much lower than last year and could impact food prices at that time.

Risks remain- Risks related to global events, Central Bank policy failures as well as some sort of Sovereign crisis due to the commodity price crash remain. Concerns related to Chinese wealth management products as well as high Debt to GDP ratio also remain. The impact of cross currency moves on Indian exports at a time when the INR is becoming increasingly overvalued will also have an impact at some stage. There have been huge flows into Indian Debt last year and over the last few weeks. Unlike FDI this can also move out very fast.

Markets at the current levels now trade at near 20X current year earnings. At the beginning of the year the expectations were for a 15% earnings growth this year. The actual delivery has been much lower. The assumptions for next year are also in the region of 18-20% which looks to be a tall task as of now.

CONCLUSION

In conclusion I would say that the long term picture still remains very bright and with the interest rate cycle actually turning this will be the year where the stock specific approach will work very well. On the other hand it is also true that for the short run both the Indian markets as well as global markets seem to be priced for perfection with no scope of disappointment. We have now had a 17 month up move in India without a single negative 5% month which is a record of sorts. Normally a rise in markets is followed by earning upgrades whereas we have actually seen downgrades this time. The results season in the US has also started off with disappointments. A major selloff in the US will impact other markets.

Despite record stimulus by Central Banks the economic growth globally still continues to be anaemic. The risk of a decent selloff sometime over the next few months remains.

On the other hand opportunities related to improvement in domestic macro economics, lower interest rates as well as in companies operating in areas where the Government proposes to focus on remains. We have seen markets rally 5% plus in January itself YTD which is almost half of the 10-12% I thought they would do this year. Let’s hope I am wrong and this turns out to be a much better year. I would hold my horses for now.

 

We have, in general heard of a large number of successful investors who have made lot of money by investing right over long periods of time. However we rarely hear of very successful traders. Some of the successful ones have done very well but that has been out of discipline and taking positions that they can afford to take.

Historically I have not been a very good trader myself as I have focussed on long term investing and have found it easier to pick out long term winners. However over the last few years I have also been trading and out of my empirical experience the key features to be successful in trading are the follows.

  1. Every trader needs to put a limit or value on the amount of trading that he or she will do per call. Now trading being very different from investing requires that emotions or long term view of a stock or commodity not being attached to a trading position. Since that is the perspective with which one starts operating I normally recommend that every trading position should be take with an equal value. What this essentially means is that you are totally taking out any biases from your trading position. For example for the long run one might be more positive on ICICI Bank rather than Reliance Industries. As such in the investment book one should buy more of ICICI and less of Reliance. However when one is trading on the two the positions should be equal.
  2. Now once a position has been taken Trading requires one to be disciplined on the STOP LOSS most of all. The reasons for this are that Trading essentially is impact by several short term factors which Long Term Investing can ignore. An example of this was seen last week when RBI unexpectedly cut interest rates. This created a huge rally in interest rate sensitive stocks. Now as a Trader if this event led to your stop loss getting triggered then please honour that stop loss. The other factor here is that even a very successful Trader will atmost have 70-75% of right calls. Now if there are disciplined stop loss levels which are adhered to then in a majority of cases you are making money and overall will make money. Stop Loss levels in trading normally should be a fraction of the Profit Booking levels.  As such if a trading position is taken at Rs 100 and the profit booking level is 120 then the Stop Loss has to be 95 and not 80. The logic here is simple; in trading you will go wrong several times due to unexpected events. These could be domestic, international, macro or micro. Under the circumstances it’s important that you exit the losing positions fast and ride the profit.
  3. So then how to operate on the profit side. Even on profits discipline is required. The reasons for this are simple. In the stock markets the more the price moves up the more confident are market participants on the direction of the move. Here again a trader needs to keep emotions away. Take the profits when they come. In some circumstances where you really do not want to do that and want to try to ride the move further it’s important to have a trailing stop loss. For example if a stock was bought at Rs 100 with a target of Rs 120 and the price moves above Rs 120 very fast and reaches Rs 125 then the trader needs to keep a trailing stop loss at Rs 120. Now if the stock rises further then it is great. However if the move falters that original profit level of Rs 120 is protected.
  4. Do not try to recover the losses by taking excessive risks; Now there will be lot of circumstances where a few trading calls would have gone wrong one after the other. This can happen in both trending markets (where calls are taken against the trend) and whipsawing markets (where the trend keeps on changing). In these circumstances when a trader has made losses one after the other the tendency is to take bigger positions, higher risk to immediately recover the losses. However this is the worst thing to do. It’s best to step back in such a situation, let things settle down and come back to trading with discipline.
  5. Profits made out of trading ideally should not be used to increase the quantum of trading positions but ideally to deploy the profits in longer term investments which will grow over time. I have seen several traders who have done well in short periods of time, increased their trading and as a result not only lost out the profits but also gone into losses. If your networth increases over a period of time the quantum of trading can be increased but with the same discipline which was there earlier.

I will now conclude this piece by adding that most of the people who ask questions from me or come for advice tend to veer towards doing more trading. Under the circumstances it’s difficult for me to build up discipline in everyone. As such the above mentioned rules could be helpful. Ideally the money deployed towards trading should be a smaller part versus that deployed in long term investing where, with the right picks it’s difficult to go wrong. For the trader the following saying is most relevant

When facts change, I change my mind . What do you do sir?J M Keynes

As we come to the end of an amazing year for India to forecast what lies ahead this year is more difficult than it was for the year 2014. The longer term picture is very much intact as I had put in my presentation a few weeks back. However the year 2015 is somewhat difficult to call. Overall markets have behaved as per my expectations over the last three years. At the beginning of 2014 I had forecast a NIFTY LEVEL OF 7654 for the end of December 2014. We have actually ended nearly 600 points higher. However it is pertinent to note that there was no forecast which was above 7200 at that time. Lot of forecasters who were predicting markets to be 5400 by the end of 2014 subsequently revised it to 8000. This is nothing but a mockery of forecasting.

As we enter the year 2015 there are a few things that I can see

-India is a consensus favourite Market with most Emerging Market Funds as well as other investors heavily overweight on India

-The NIFTY FORECAST for the end of 2015 of most people seems to be in the range of 9800-10200 reflecting high optimism

-Inflows in many cases, especially into Equity ETF’s globally are approaching euphoric proportions

-Most risks are getting ignored which include a structural slowdown in global growth, the fallout of currency wars, possibility of renewed crisis of some sort in the Eurozone. Greece & Spain could be flashpoints. Sovereign bond markets are sanguine given ECB backstop.

-Other risks to Funds Flow are a liquidity squeeze due to continued US Dollar strength as well as reduced funds flow due falling crude prices which will impact flows both from Oil rich Sovereign Funds as well as remittances from the Gulf

-The possibility of unprecedented stimulus in Europe as well as increased stimulus in China not having the desired impact due to structural issues. China could emerge as the biggest Global Risk sometime in the future with its huge corporate liabilities that exceed $ 14 Trillion as well as unhedged foreign borrowings that exceed $ 1 Trillion. Any big fall in the Yuan could create significant issues.

-A slower than expected recovery in the Indian economy both due to domestic structural issues and slower export growth. Pressure on CAD as domestic recovery takes place even as the Global Economy falters will also need to be seen.

-The fall in crude prices is an unprecedented stimulus for the Indian Economy. It adds a stimulus of nearly $ 40-$ 50 billion if the low prices sustain. Low commodity prices combined with supply side measures can lead to a period of sustained low inflation for India.

Overall as I see things from the sidelines today one thing is very clear to me, optimism is high and the attention to risks is low. Normally markets will never behave in line with consensus forecasts. They will either far exceed them in returns or be much below. I am still in the process of forming a view on what should 2015 overall look like. But it will not be as good as 2014 is very clear to me. We have gone right through 2014 without any major correction. Infact it has now been 16 months since a 10% correction in the markets.

I believe that 2015 will be a market of two parts. The first 4-5 months will give extremely subdued returns with the possibility of a biggish selloff at some time. The markets will subsequently pick up as the US FED finally starts raising rates and the market take that in their stride. In all probability the Budget will disappoint investors as per what we have seen of the steps from the Finance Ministry till date. However eventually we will see lower interest rates as well as economic recovery. Some government ministries are manned by extremely competent people especially Railways, Defense etc. We should start seeing some traction in these sectors eventually. Lower base of the previous year will also lead to higher growth numbers as we move through 2015. I will write more around the mid of January.

2015 is a year of cautious optimism. Lets hope that the positives play out and the negatives are absorbed. My broad guess would be for market returns in the high single digits or low double digits. However stock specific opportunities will abound and that’s where money will be made.

Best wishes for 2014. I will leave you with a couple of thoughts to carry forward for the year.

“Your success in investing will depend in part on your character and

Guts, and in part on your ability to realize at the height of the ebullience

and the depth of despair alike that this too shall pass.”

- John Bogle

 

“The stock market is filled with individuals who know the price of

Everything, but the value of nothing.”

- Phillip Fisher

ECONOMIC ACCELERATION & DECELERATION IMPACT IS LONG TERM

As chickens are coming home to roost in the Junk Bond Markets in the US the threat of a contagion impact across asset classes is now increasing. The fall in crude oil prices was welcomed as a positive development as till now it has created a massive $ 2 Trillion of savings for the global economy by putting extra money in the pockets of consumers. However as I had mentioned earlier a fall is very good but a crash will always have some negative side effects. We see those side affects play out now in the Junk Bond Market in the USA.

Out of a total of $ 1.3 trillion of Junk bonds raised over the last few years nearly $ 550 billion has been by oil exploration and related service providers to the US Shale gas investment cycle. This cycle has created a huge impetus to parts of the US economy and helped the US reduce dependence on imported oil significantly. However the crash in price of US Crude to levels of $ 58 which is lower than the average breakeven level of Shale Oil of $65 has the potential of triggering off a crisis. Some level of sell off has started again and the ripples of that are being felt across the entire asset value chain.

On one hand we have the “Junk Bond” markets and on the other hand we have the market of Bonds that are priced AAA when they possibly should be valued Junk. When the US Federal Reserve started its cycles of Quantitative Easing it was actually successful in bringing long term rates down while bringing short term rates around the policy rates. On the gross basis the US FED is sitting on significant mark to market profits at this stage. How it will behave in the future is a matter of debate. However the bigger risk comes from the Euro Zone where countries like Italy and Spain (Lets not talk Portugal, Greece etc) today borrow at interest rates which are lower than the rate at which AAA borrowers can borrow. This is despite no structural improvements in their economies and recessionary economies. The ECB is moving on its new asset buy program at a time when the prices of those assets are already distorted much beyond fundamental. No one was willing to lend to these countries at 7% plus two years back and now they are borrowing at 2% for 10 year money.  The probability of the ECB ending up with huge losses on its Balance Sheet is extremely high as it accelerates its new Asset Buy program. Financial Markets now used to continuous doses of drugs are unable to fathom the risk that lies ahead.

Credit Market risks do not only flow from the US and European Markets. There is this case of borrowings of Oil Export Revenue dependant economies where the probability of default in some cases in increasing. Last week the probability of default of Venezuela went upto as high as 93%.

The Sovereign Wealth Funds of large Oil exporting countries have also been huge providers of capital across the world. As Oil prices collapse, export revenues reduce and the Budgets move into Deficit most of these countries at this stage could stare at actually removing liquidity from Global Equity and Bond assets from a scenario where their flows continuously increased over the last 10 years.

The risk of implosion of Chinese Wealth Management products that are extremely opaque has been talked off over the last 2-3 years. However defaults in China have been muted and have not been of any systematic risk till date. However these things come to fore much more as Economic Activity slows which results in an increase in Non Performing Assets. It is now a reality that Chinese Growth is going to slow. The impact this has on Chinese Local Government Debt as well as other opaque wealth products will need to be seen going forward.

IN CONCLUSION

In conclusion we have seen that Equity Markets have reached all time highs across markets in the month of November. We have seen a selloff in Emerging Market currencies start a few months back. A vast majority of EM currencies are now at multi year lows. The Equity Markets of some of the commodity dependant EM’s have also sold off significantly. With an improving US growth outlook and probability of rate increases going forward we could see a further strength in the US Dollar and sell off in EM currencies. This has happened at a time when growth has been faltering everywhere but the US. On top of this we now have issues that have come up in the Credit Markets which have the potential to create huge volatility and potentially a global market selloff.

While long term potential remains high in India the short term risks are high and growing. It should play out over the next few weeks. 

In the first part of the article I had illustrated the issues facing the Indian Economy. Now I come to solutions that are critical both for the short run as well as the long run.

Growth and only growth is the fix to India’s Fiscal Deficit problem in the long run. Now besides creating an enabling environment for private sector investments there are a few things that the government can do to revive growth in the near term.

-Focus on Urban Infrastructure projects-Urban infrastructure projects are easier to execute, especially projects like metros, overhead road and rail networks, water and waste water projects etc. An initial focus on these could contribute strongly to investment revival.

For example metro projects in 20 cities would involve a layout of Rs 200000 Crores. These projects do not face problems related to land acquisition

The DMIC involves an investment of $90 billion over the course of the project. It has been in the making for nearly 6 years now and lot of the plans and land acquisitions in a number of states are also through. Taking up project awards on the various parcels of this project will be extremely beneficial as it will create a huge amount of investments as well as job creation.

 

-Railway and Road projects-The boom in the last cycle started from the NHAI projects. Road projects are hugely positive for the economy as they generate large employment, & require lot of inputs & machinery. The economy around the project sites also gets a boost with increased demand for a number of products. The slowdown in this sector is easier to reverse as collection of user charges has not been an issue with roads till date.Easier exit norms post completion of project combined with proper evaluation of bids can attract lot of PE money. A combination of EPC & PPP with relaxation of Environmental norms will lead to a rapid revival of investments. An award of 8000-9000 kms of projects per annum will lead to an investment cycle of Rs 100,000 per annum.

Railways have been the most neglected sector of the Indian Economy. Huge investments can take place and start at a rapid pace by means of up gradation of stations, trains as well as on new tracks. This might require a greater support for the government in the short run. However the multiplier impact of this on the economy will be huge.

—  Agriculture supply chains- In good times supply constraints have not been worked on especially in the case of agricultural produce where it is an estimate of many that nearly 33% of the perishable produce gets destroyed. This is valued at Rs 200000 Crores. There is need to set up food processing units, modern cold storages as well as transportation networks. The total storage capacity in the country currently is just 300 lakh tonnes. Estimates indicate a requirement of another 370 lakh tonnes requiring an investment of Rs 120000 Cr by 2016-17.     It is unlikely that the wary private sector will come in without government support or tax benefits in this segment.  Government needs to move fast on this as this is one key facet of supply side reforms for bringing down inflation in the long term. This will set the tone for Round 2 of Rural Growth & Prosperity which started off with the inefficient NREGA scheme

-Relaxed environmental norms in the short run- Forest and Environment clearances take the maximum time need to move with a deadline. Most countries that have developed till a particular point of time have had relaxed environmental norms. However we seem to be moving towards one of the most stringent norms even at low development level of the economy. Another five years of somewhat relaxed environmental norms is not going to kill the country. This time frame can be used to streamline processes and guideline.  This needs to be accompanied by time bound project clearances.

I have illustrated some steps that should be the first steps to revive the economy. Consumption demand will take time to kick in. Awarding projects and implementing their execution is key. In the near term government needs to spend in Viability Gap Funding, Equity Funding or Funding private sector projects by the means of long term soft loans. Once the revival starts it can be self sustaining for a long time.

WHAT AILS THE INDIAN ECONOMY (PART 1) 

The Indian Economy has gone through one of the toughest periods since the beginning of the Millennium over the last three years. With the ushering in of the new government there has been a rejuvenation of hope which is reflected in Consumer and Corporate confidence. However this has not translated into actual economic activity till date. This is somewhat strange in the context of the fact that normally strong consumer confidence does translate into higher consumption spending. However this has not happened till now. Investment activity also continues to be on the slow lane as the NDA government grapples with trying to fix the system for smoother execution of projects.  Let’s look at some aspects of the economy now

Poor Consumption – Consumption held on quite well even during the time when the economy was in absolute doldrums. However despite a strong recovery in consumer sentiment there has been no pick up in consumption. A large number of companies actually believe that consumption of their products is worse than last year. So what explains this? In my view there are 3 major factors

-High inflation of the past- Indian’s have had to go through a phase of unprecedented inflation over the last 3-4 years. Even though we can be happy at seeing a figure of 5.52% for the CPI as the latest print the fact of the matter is that CPI has gone up in absolute terms by nearly 40% since the beginning of 2011. Most people have had to reduce savings and cut corners in order to keep up with their lifestyles. The inflation has been worse for the Lower and Middle class owning to the fact that Food Inflation in the same time period has been greater than the overall CPI by 5-10%. This has also happened at a time when economic activity has been slow and as such the increase in incomes has been muted across the board. In such a situation it is very difficult for people to suddenly start spending more even though they might be feeling better. On the one hand their overall savings have reduced which need to be built up and on the other hand a better sentiment has not yet translated into better incomes for people at large. Inflation on the services side of the economy has also been very high. As such lower inflation in the near term will go more into saving than spending.

-Falling rural incomes- The rural consumption story has been strong over the last few years as the multiple impact of MNERGA and huge increase in Minimum Support Prices for various agricultural products led to strong rural incomes. Incomes were also supported by high prices of various agricultural cash crops like Sugarcane, Rubber etc. As such, although rural inflation was also high it was counterbalance by high rural incomes. However this does not hold any longer. Spending under various rural employment schemes has been curtailed now. Moreover agricultural commodity prices have come down substantially from the highs of 2013 and on top of that MSP increases have been muted this year. Agricultural production is also down due to the erratic monsoons. Under the circumstances rural consumption is coming under pressure.

-Inflationary expectations are still high- Normally after a period of very high inflation there is a general belief that inflation will remain high for a prolonged period of time. The same is the case in the inverse.  As such, although prices might be coming down the expectations in the minds of people still continue to be high and this makes them save more than spend.  Although people do see a brighter future they would rather wait for it to come rather than spend in its expectation.

Poor Investment Cycle- In a recent survey of corporate it was revealed that nearly 54% of companies are still operating at a capacity utilization that is below 75%. More than 20% operate below 50%. Only a single digit of companies is operating near a figure that exceeds 90%. Now this creates a situation where even after the economy starts showing some traction and growth picks up there is unlikely to be a huge Corporate Investment boom in the near term. Any large corporate capital expenditure cycle will take at least 2 years to kick in.  In this situation the key is to see what will lead to an industrial revival.

-Misplaced focus on Fiscal Deficit- As the demand revival kicks in we will start seeing better figures on the IIP, however this will be in the absence of any huge corporate capital expenditure. 6-12 months from now the companies will start planning expansions and the real impact of this pending will be seen 1-18 months down the line. Under the circumstances the government needs to step in to revive demand. However the Finance Ministry in continuation of the UPA tradition is focussed on an artificial fix of the Fiscal Deficit. A reduction in Fiscal Deficit by reducing economic growth is a vicious cycle which is difficult to come out of. The Finance Ministry needs to stop pleasing rating agencies and foreign brokerage economists and get back to getting the economy on track. They also need to come out with realistic estimates of numbers. For example figures that came out this week show an amazing divergence between reality and what has been projected just three months back. Indirect tax increase for the first seven months has been just 5.6% against a projected 25.8% leaving a huge gap of Rs 50,000 Cr in government finances. If crude oil prices had not fallen the Fiscal Deficit would have easily crossed 5% this year.

Growth and only growth is the fix to India’s Fiscal Deficit problem in the long run.