The way forward

The US treasuries are a safe haven the way Pearl Harbor was a safe haven in 1941 - Niall Ferguson.

This quote aptly identifies the true nature of financial markets. People may believe that financial markets are efficient and/or rational. But neither one is true. To borrow from the words of Benjamin Graham, financial markets are like a mad man. Some day it will sell an asset at 1/10th of its value and the other day it will purchase the same asset at 10 times its intrinsic value. Sentiments can take a sudden turn in the markets. What seems to be a safe haven and a robust economy today can become a risky asset and a weak economy tomorrow.

To give you an example PIIGS countries suddenly became punching bag for global investor in this year. Everyone knew that they are running a huge current account deficit and have high debt to GDP ratio. Although one may argue that the Greek government has declared deficit to be11% and not 16%. But how does that matter. Greece was insolvent at 11% deficit as much as it is insolvent at 16% deficit. Financial markets don't react to a situation unless and until it reacts. This results into a parabolic rise or parabolic fall in the asset prices.  For example Greek debt which is trading at 5 % yield suddenly starts trading at 10% or 12% yield. And mind you this can happen and will happen to USA.

As Dr. Kenneth Rogoff says, "When you have a wave of bank crises, it is often followed by a wave of sovereign debt crises." Today in my blog I want to outline on why I believe that a currency crisis is inevitable and our road map to the series of future events leading us to the abyss. 

Before we go forward we need to understand that the current US/European economies are credit economies. Credit economy needs a constant flow of credit to sustain and grow. If the credit starts to contracts the economies will deflate. It’s an inevitable truth that credit cannot be inflated forever.

Credit also passes through a cycle of credit/debt inflation (i.e. increase in overall debt to GDP ratio) and credit/debt deflation (i.e. overall decrease in debt to GDP ratio). The last 30 years have been a period of credit inflation and now the deflation period is going to set in. As Mises says, “There is no means of avoiding the final collapse of a boom brought about by credit expansion. The alternative is only whether the crisis should come sooner as the result of a voluntary abandonment of further credit expansion or later as a final and total catastrophe of the currency involved.” 

As we all know that the benefits of credit/debt inflation/increases are tremendous for an economy. As credit percolates into a society the overall GDP growth rate rises as aggregate demand rises, employment increases and people are happy and confident of their economic future. For example India is currently in this phase of credit cycle. As you know that it was in late 1990 Indian banking system was liberalized and private sector was allowed to work this precipitated a flow of credit into Indian economy and the result is the splendid growth rate of average 8% we saw in this last decade. It means that we will also go into cycle where debt to GDP will grow very high (from 53% to more than 100%) in next two decade and we will also go through deflation cycle. But that is not the worry I have. The cause for the collapse of global economy is going to be US, Europe and China. Let me explain these risks in detail.

American Economy

As we all know that US is a credit dependent society. Consumer debt to GDP is more than 120%. As evident from M3 indicator consumers are deleveraging, which will result into reduced demand for goods and services which makes up 70% of US GDP. 

If the consumer demand has been robust in US despite of 17% unemployment rate it is due to the fact that 18% of the current disposable income in US is government transfer which can’t continue for long. I see no indication of employment going up or personal disposable income rising in US. In an environment of widespread unemployment and economic uncertainty the US consumer will use their saving to reduce their debt rather than increasing their consumption. 

The US government is betting on the resumption of US consumption demand to push GDP growth but, I see no circumstance where US GDP growth will resume and to my mind it’s near certainty that we will have a double dip recession next year. For more on this topic you can refer to my previous blog (http://stock-wizard.blogspot.com/2010/04/will-american-consumer-survive.html)

The double dip recession will produce deflationary scare which will result into lower prices of all assets including precious metals, industrial metals, energy, and equity. The only asset one should be invested during this time is US treasury and bonds from investment grade companies generating huge cash flows. The deflationary scare will be enough to force US government to go for second quantitative easing to increase the money supply by printing trillions of USD. I expect this will happen in next 6 -9 months.

The second QE will result into rise in price of all hard assets like commodities, energy, and Equity just like what happened in 2008 -2009. For readers who are unaware of the fact, The FED has 900 Billion of USD in money supply in 2008 which has been increased to 2.4 trillion dollars to rescue the economy during the current financial crisis. FED did not physically printed dollars but it created money by buying illiquid debt assets from banks and crediting their account with dollars. So even if one argues that FED has not really printed dollars it has electronically created dollars which are flowing into the system. 

Most of the newly printed money was used by banks to shore up their reserves in anticipation of future losses on their loan portfolio. It has also resulted into reducing new loans to consumer because of two reasons. The consumer himself has reduced demand for new loans as he is busy repaying his old debt. And number two the banks are not interested in giving new loans to risky consumers as they want to reduce their balance sheet risk. 

The remaining amount was channelized into buying hard assets like commodities and equities which resulted into doubling of the prices of industrial metals like copper, precious metals like gold, crude oil and equities. The same process will be repeated again. An approximate time line of events as per me would be

·         6 - 12 months: - Market tumbling down due to the double dip recession & scare of deflation (like early 2008 -2009)

·         9 - 16 months: - Government coming out with Quantitative easing Part II (September2008- late 2009)

·         12 -24 months: - Reflation trade resulting into increase in the price of all assets (March 2009 - April 2010)

But this time will be different. As we all know that the value of any commodity or currency is subject to its availability. If the supply is low the value of that currency or commodity is stable and rising. If the supply is increased manifold the value will erode. 

Up till now the USD had been successful in avoiding collapse inspite of huge increase in its supply. It’s because of two reasons. One is it is a global reserve currency and it acts as a store of value. This results into huge demand for USD. Second, US economy is the largest economy in the world. It’s also the most diverse and competitive economy. This supports the valuation of USD. 

But this does not mean that USD will never lose its value. Before USD, Britain was the global superpower and British pound was the reserve currency of the world. But that changed after World War II. The USD will be able to bear the strain and maintain its value till a certain extent. If the debt to GDP ratio keeps on rising there will be point in time when people will lose faith in USD and this can happen at the debt to GDP ratio of 100%, 150% or 200%

The fall in USD will be more abruptly than gradual. The USD is safe until it’s not safe anymore. As I have mentioned before in financial market the price moves are parabolic than gradual. Therefore the fall in USD will be more parabolic than gradual.

History has been a witness too many events where by the government have printed money in tones which has eroded the purchasing power of that currency. To quote an example lets refer to Hungarian Pengo crisis. The Hungarian government kept on printing more pengos in order to meet its expenses. The results as expected were disastrous. The value of 5 Pengo which was equivalent to 1 USD in 1927 went down to 4.6 trillion trillion pengo equivalent to one dollar. And all this happened in 1946.

Exchange rates (1 USD = ? pengő)

Date	Pengő[5][6]
1 January 1927	5.00
31 December 1937	5.40
31 Mar 1941	5.06
30 June 1944	33.51
31 August 1945	1320
31 October 1945	8200
30 November 1945	108000
31 December 1945	128000
31 January 1946	795000
31 March 1946	1750000
30 April 1946	59000000000 (5.9 × 1010)
31 May 1946	42000000000000000 (4.2 × 1016)
31 July 1946	460000000000000000000000000000 (4.6 × 1029)

To take another example let’s see how the value of German mark crashed in 1921 -1923 on a parabolic scale.

  

This is not to say that US dollar will meet the same fate. But I have presented the arguments in order to prove that rapid devaluation of a currency is not an unprecedented even. In fact it is one of the most effective methods of getting out of deflation. The US did it in 1935 when a price of gold was increased from 21 USD an ounce to 36 USD an ounce which represents a currency devaluation of 66%. 

If the US government will print more money sooner or later people will loses faith in the currency and it will be sharply devalued. Sharply devalued currency will increase the price of all commodities which will result into high or hyper inflation and growth will be near to zero because of high uncertainty. High uncertainty will result into 1) reduction in new business and absence of new hiring, 2) low spending by consumer. The result will be stagflation like we saw in the decades of 1970. Stagflation means zero growth with high or hyper inflation. 

This brings absolutely bad news for US equities and debt investment. Gold will be the investment of choice during such a scenario. If you remember Gold went up from 35 USD an ounce to 800 USD an ounce almost a parabolic rise from 1970 -1980. 

Although the current scenario is different from that of 1970 but I still expect gold to double by the end of this decade. It is one of the safest investments for the coming decade. If gold price falls below 900 USD an ounce due to the current deflationary scar it will give once in a life time opportunity to buyers for investing in gold. 

 

To summarize my points, I believe that US economy will pass through the following phases, 

Phase one will last for next  9 -12 months.

  PHASE:-1

Phase	Time duration	Investment to hold	Investment to avoid
Deflation Scare	0 - 6 Months	Short term US sovereign debt, Investment  grade high cash flow generating corporate bonds, USD	Equity, Commodities, Gold, Crude oil
Double dip recession/Deflation	6 -12 Months	Short term US sovereign debt, USD	Equity, Commodities, Gold, Crude oil, all other debt except sovereign debt

At the end of Phase one the government will have options of either adopting quantitative easing or go for deficit  reduction and choose to take a deflation hit. I believe that the government will go for quantitative easing.

  PHASE :-2

Phase	Time duration	Investment to hold	Investment to avoid
If Quantitative Easing II comes and Reflation Trade begins	12- 24 Months	Commodities, Precious metals, energy and Equity	US treasury
Inflation	24 - 36 months	Precious metals	everything else
Hyper inflation	36 -  60 months	Precious metals, Food grains	everything else

* Readers may note that the time duration I have mentioned is just for illustration. Actual time duration may vary as per the future economic environment.

If the government gets some saner and refuses to go for quantitative easing that we will find ourselves in the biggest deflation after 1929 and in such scenario one should only hold gold.

This sums up my case for US economy.

EUROPEAN ECONOMY

Europe is suffering from even worse problem than US. US still have the option of devaluing its currency to get out of deflationary spiral but EU being a part of monetary can’t even do that. The problems of Europe can be summarized as.

1. Very high home prices (In EU home prices have gone up 500% compared to 200% in US since 1970
2. Very high leverage in banking system (25 - 50 times leverage compared to 10 to 15 times in US)
3. High bank assets to GDP ( Asset to GDP ratio of European banks are 4 times larger than US banks)
4. High government debt to GDP (due to high fiscal deficit which will increase interest cost in future)
5. High private debt to GDP ratio (which results into debt deflation)   
6. Structural fiscal deficit to GDP (due to high welfare expenses and socialist economy)
7. High unemployment (High unemployment is a drag on economy)
8. Government controlled welfare state (which do allow market mechanism and efficiency)
9. Monetary union. (which do not allow for currency deflation)
10. Ageing population (will increase government expenditure and reduce productivity)

I will write a brief explanation on every point.

First, In EU home prices have risen to 500% from 1970 while in US they went up only by 200%. Since then the US home prices have corrected by 35% and this caused a loss of 2 trillion to US economy pushing the entire world into deflation. The housing price bubble in EU is yet to burst and when it will burst it will cause severe pain in the EU countries pushing them into recession.

Second, EU banks are two to three times more leveraged than US banking system. We have all seen the impact of highly leveraged institution like Lehman brothers going insolvent. When institutions are highly leveraged even a small increase in NPA will wipe out the entire capital base of banks and render it insolvent. EU banks are largely insolvent and it’s only a matter of time.  The crash of housing bubble or default of sovereign debt is the catalyst which will result into the crashing of banking system in Europe. (Repeat of September 2008 multiplied by 10 times)

Third, On the top of everything EU banks are huge compared to US banks when we look at their Asset to GDP ratio. To give you an example UBS have an assets size of 4 times the GDP of Switzerland. Now if UBS fails the Swiss government won’t be able to recapitalizes it unlike US government which was able to recapitalize city bank.  This is the case with most of the banks. Most of the government won’t be able to recapitalize its bank because of the banks size.

Fourth, US went into the crisis in 2008 with a debt to GDP of 40% and a currency which was serving as a global reserve currency. The average Debt to GDP ratio for most of the EU countries is above 65% and they do not have an advantage of a reserve currency. US government was able to take on more debt in order to simulate the economy. While the EU government has already declared that they won’t be able to take more debt and will go for fiscal austerity. Therefore when the banks fails there will no recapitalization and no fiscal stimulus.

Fifth, as demonstrated earlier high private debt to GDP ratio results into deleveraging when consumer starts to save instead of consuming. They prefer to pay off their existing debt instead of taking more debt to support consumption. This results into lower aggregate demand and lower GDP growth rate

Sixth, Structural fiscal deficit is very high is some European countries like Portugal, Ireland, Italy, Greece and Spain. The government is spending much more than its income which results into decreased government ability to stimulate economy by increasing the spending in case of an unfavorable event like housing crisis or banking crisis.

Seventh, Spain has 20% unemployment rate, Greece has 10%. Several other countries have high unemployment rate ranging from 5% to 15% this results into lack of aggregate demand, low consumption and lower growth rate.

Eighth, EU economies are more of government controlled welfare economies. They are more centralized and therefore have little room for market mechanism to work and this creates inefficiency. Once a state starts a welfare scheme it becomes very difficult to discontinue it. If these welfare schemes continue they will reduce the government ability to deal with fiscal deficit. And if they are discontinued we will see riots as what we are now seeing in Greece.

Ninth, we all know that European countries are a part of monetary union. They have no control over their monetary policy. They cannot control their money supply and therefore cannot devalue their currency in order to get out of deflationary spiral. Therefore they are left without an important tool to fight any future crisis.

Tenth, ageing population will reduce the future output of the economy. Older people will demand more health care and will contribute less to the taxes. Therefore will worsen the fiscal deficit and create more debt.

To summarize, I believe that European economies are doomed and they will fall apart in next decade. I don’t see any probability of the European economies getting out of the looming crisis by austerity measures taken by them. Austerity measures will actually precipitate the downfall. Although it will cause huge pain and a depression in the short term I believe that this is the step in the right direction. The only need is to stick to the austerity measures taken by them.

CHINESE ECONOMY

It is the most difficult task to write anything on Chinese economy. It’s the most opaque economy in the world. It’s also the largest planned economy. The problem with Chinese economy is that it do not provide with transparent source of data. Most of the data provided by government is not reliable. The most important objective of communist party of China is to keep itself in power and it can do anything to retain its hold on china. Manipulating data is the easiest of all.

I don’t believe that 200 people sitting in a room can make all the right decision for an economy like china. We have seen planned economy failing before and this time won’t be different. Instead of writing any lengthy article on china I am pasting two links written by eminent author. You can refer to these links for getting more clarity on china.

http://beyondboom.blogspot.com/2010/07/post-china-world-by-ruchir-sharma.html

The current investment to GDP ratio in China is above 50%.  The current construction portion of GDP is 45% this will come down to 30% or lower. My own belief is that China will have to reduce its reliance on exports and will have to become more domestic demand driven economy and the transition won’t be smooth. It will take at least one decade for consumption ratio to rise as a percentage of GDP. And during that decade it will face a period of subpar growth. 

I think China will grow by less than 7% in the next decade. The transition from being an export oriented economy to domestic consumption economy is going to be very painful for China. This will result into huge unemployment and lot of political struggle in the country. It may be possible to see a regime change in china and it may shift to a different political system. Although China exhibits the long term potential to be an economic superpower I think it will pass through the same phase as to what US did in 1929 -1945 before it became a superpower and ruled the world for next 70 years.

Summary:-

·         The US economy cannot grow on the back of consumption demand.

·         If they come out with QE–II then, we will see a massive devaluation of dollar & currency crisis.

·         If they don’t come out with QE-II then we will go into outright recession.

·         The European economy is in much worse shape and their banking institutions are largely insolvent.

·         The busting of House prices and sovereign debt crisis will prove to be the final nail in the coffin.

·         China will see a period of subpar growth.

·         Its transition from export oriented economy to consumption economy will not be smooth.

·         It may result into a power struggle and a regime change in China. This may also result into a large scale war with neighboring countries like India.

Implication for India:-

India is definitely a domestic demand driven economy. But still we 20% of our GDP is exports. Moreover we are dependent on foreign countries for capital inflows. If we will see all these problems cropping up in global economy the FII’s will panic and pull their money out of the Indian markets. This will repeat the cycle of 2008.

·         The stock markets will crash. They may reach 2008 bottom lows or lower.

·         This will give you once in a life time buying opportunity.

·         The GDP growth rate will fall to 5% -6% for next few years before bouncing back to double digits.

·         I believe that after the first five years of the next decade India will resume on the path of high growth rate.

·         If we are successful in avoiding a global large scale military conflict India will definitely emerge as a superpower by 2025.

Therefore one should exit the equity completely. It may happen that the market will rise by 5% before they finally succumb. But look at the risk reward ratio from here. The maximum upside in the markets is 5% - 10%. But the maximum downside is more than 50%. This implies a risk reward ratio of 1:5 or 1:10.

Second look at the probability of this happening. I believe that the probability of things turning my way is more than 80%. Therefore at this juncture the risk reward is compelling and it calls for an exit from equity investment.

Technical Look at Indian Market

Nifty Daily Chart

If you look at the above chart you can see that Nifty is moving within a channel since last 10 months. It has tested the support three times and resistance four times. This suggests that markets are either consolidating for an upward move or the intelligent players are distributing their holdings and preparing for a downward move.

I think the latter case is true as you can see that the advance decline ratio is constantly decreasing. This indicates that more stocks are sold than bought.

I think that the current up move which started in end of May is the last up move. The reason being the fact, that global markets have already started to their down move and are forming lower highs and lower lows. Only Indian markets are outperforming. Such out performance is not unusual also happened in 2008. For more details kindly refer to my blog (http://stock-wizard.blogspot.com/2010/07/invincibility-of-nifty.html)

The up move which has started recently has the maximum upside of 5650. The channel support exists at 4950 levels. If the market crash below 4950 than be sure that the larger down move has started which can take market to 4000 and below.

Some Random Thoughts

The days of welfare state and high standard of living are gone. The coming Tsunami will be game changer and once in hundred year’s kind of an event. It will not only affect the economical system but it will change our political system, beliefs, values and principles. 

Democracy is always temporary in nature it simply cannot exist as permanent form of government. Democracy will continue to exist up until the time that voters discover that they can vote themselves generous gifts from the public treasury. The majority always votes for the candidates who promise the most benefits from the public treasury, with the result that every democracy will finally collapse due to lose fiscal policy

I think that Europe has entered into the final phase of the collapse of democracy. The entire system in Europe and US needs a cleanup which is not possible with the present form of government which is ruled not by the elected representative of the people but by banking oligarchs and wealthy individuals. They manage to manipulate every policy decision of in their favor.

And whenever this transition happens it is fraught with risk of global war, natural calamity and widespread destitution.

Therefore I request my reader to be extremely careful as I see that the coming times are going to be disastrous in all sense.

Remember, a person who don’t have patience to wait when the markets are overvalued will have no money to buy when the markets are undervalued