‘V’ is the word for 2009

‘V’ is the word for 2009 so far. I don’t know many market participants who saw the current market rally to be so furious and so fast. Neither did I expect. At best many traders called for a 50% rally over a period of few quarters. Now with most of stock Indices hovering around their 200 DMA in western markets and all Asian indices much higher from their 200 DMA question still looms whether we have entered a bull market or not. In my previous updates on S&P CNX Nifty 50, i.e. the Indian stock index, I had mentioned that prices suggest a bottom when we crossed above the all crucial level of 3200. Asian market too looks like they have formed a strong base. The trouble is the western stock markets. There is no clear indication from these indices whether this is a bear market rally or beginning of a new bull market.

The US stock markets have risen sharply over the last two months. The S&P 500 has rallied to a new high for 2009 which is 39.6% above the March 9th low. There are sector which have rallied in excess of 50% like materials and financials. There are some important changes in different markets that have occurred in the current calendar year. The US yield curve has steepened significantly and commodity prices have staged a strong rally along with an incessant fall in USD. The rising bond yields in a deflationary expectation scenario gave an early signal that stock prices will rebound sharply over a period of time. Equity markets always lag the bond markets and this was true this time also. There are two distinct signals that come from rising bond yields. First is the clear expectation of market participants that the economy is going to recover and growth will lead to inflation. Bond yields would also rise if there is an expectation of inflation without growth. This is a rare phenomenon and can occur only in case of misallocation of capital. This may happen if there is demand for goods and services due to excess liquidity instead of rise in base aggregate demand. Now the current scenario has seen continued unemployment in the US, EU and other western markets. There is continued weakness in retail sales and housing markets in whole of the western world. With stocks rising steadily, the real economy has not thrown out numbers which should appear after such a market recovery. This means that the monetization of debt has lead to a dramatic rise in expectation of a high inflation environment just after a severe deflationary threat. If we see the trajectory of inflation for the last one decade, there has been a dramatic shift from high inflation expectation – just at the turn of the century, then a deflationary threat due to tech bubble, then a high inflationary scenario due to the oil shock and back to deflationary expectation because of the financial melt down. The rapid change in inflationary expectation has been due to the severe monetary policy measured taken by central banks all over the world. The central bank either cut rates too low too soon or remained stubborn over a period of poor growth environment with high interest rates.

With bond yield steadily rising in the western world there is another phenomenon that explains the rise in bond yields. The buyers of western agency and government debt, especially the Asian countries are now worried about the long term stability of most of the western currencies and economies. This is leading them to purchases short term debt and either selling or not buying the long term debt especially in the US. This is leading to a steeping yield curve and a seeming expectation of a rise in inflation expectation. However this theory suffers from a serious threat from commodity prices. Most of inflation sensitive commodities like oil and copper have risen sharply. Gold has lagged this rally but is still near its all time high. The commodity indices have rallied sharply and steadily with support from agricultural commodities which are not directly linked with inflation and are generally cyclical and seasonal. The USD has been another factor which has supported this rally in energy, metals and some agricultural markets. The markets are devaluing the USD and there is a seeming revaluation of commodity prices. It’s been seen time and again the social moods drive the economy rather than the other way round. The bear market of 2008 has left most of the participants fearful of a fall in stock markets. Even a slight correction triggers bad investor confidence and poor financial reporting. So it’s prudent to keep and eye on how the USD moves once equity markets correct. Ultimately investors and governments along with their central banks have always returned to USD in times of crises and it becomes the safe haven when there is a real panic in the market. The argument that USD is doomed in the long term have held but in times of crises investors fear for their funds to be in a place which is ‘too big to fail’ or with some real value like gold.

Rising bond yield combined with huge monetization of debt and an every increasing money supply is creating inflationary expectation. More than any where else the Asian markets with excessively low inflation, high money supply and growing economies are being targeted by all the excess liquidity in the markets. This massive money supply which is not being lent to consumers in the western markets is now travelling to emerging markets and to any other asset class which has some real value or growth expectation. Stock prices in Asia have exploded without any correction as foreign investors flock to these markets. This was augmented with a huge short covering that triggered the bottom in most emerging market equity indices.

Current intermarket relationships suggest that rising bond yields are indeed pointing to inflationary expectation. If bonds stage a rally from the current level, which looks like it would happen sooner than later, it is just a matter of time before the downtrend begins again as high inflation scenario is here to stay for the next few years.

For the next few weeks to quarters focus should be given to movements in the USD, Euro and JPY along with the strength in gold. If equity markets see strong falls on rising volumes and gold rises with ever increasing investment demand, it would be good to have your funds in commodities which have value. Asian and emerging market might be the bubble of the new millennium built of the highest money supply that was ever created.

Exporting hunger, importing inflation

Free economies aim at setting up markets which can adjust the demand supply mismatch and reach an equilibrium price state. But policy markers all over the world are trying to look beyond this aspect and redo the controlled model which was bared of any merits with the fall of the great eastern block. India which is among the largest democracies is the world is not far behind.

India, Vietnam, Argentina, Indonesia, Brazil, and Egypt have banned exports of various essential commodities such as wheat and rice. With commodity price rising skywards there is little support from this factor. Export ban lead to exporting hunger instead of food. Looking at the domestic scenario the countries exercising the food export ban has two motives -
a. To curb the incessant price rise and
b. To try and protect short term supply shocks

However curbing exports would not lead to lower prices of these commodities in the long term. For keeping a check on the long term price stability it is necessary to prop up production. Indian population has grown four times since 1950 and the food grain production has not grown even to that extent. India has a yield per hectare of just 2 tonnes per hectare for rice, wheat and coarse cereals taken together.

Indian poverty line (urban and rural combined according to the latest government and planning commission figures) stands and Rs. 538.10. It translates to Rs. 18 per day. The total production of rice and wheat combined is less that 14kg per capita per annum. Combined price of 250 gms of wheat and 100 gms of rice of poorest quality at market price stands at Rs.3 when uncooked. Still 22% of the Indian population is still under this poverty line. It is still debatable whether the Rs. 18 per day is above poverty line.

There is enough data that can be looked into and feeling awful of the state of the socio economic fabric of the country. Growth in agricultural production, largely achieved through increased yields since the mid 1960s, has dropped from roughly 3 per cent in the 1980s to 1.75 per cent in the first six years of the 1990s, and has continued to decline. On the demand side the calorie consumption in the rural areas and urban areas have dropped some what but the total undernourishment has risen. 40% of urban India eats less than 90% of minimum calorie needs and nearly 50% of rural India eats less than 90% of basic calorie need of 2200 calorie. Rural areas demand higher calories needs to the tune of 2400 calorie but this is fast diminishing.

The problem India is facing and which will become a major hindrance to the growth is the food scarcity. Unless the production is increased readily there is little that can be done to prevent food riots. Food crisis and riots have dominated most of the developing and under developed nations. Have a look at this graph -


pic taken from: www.cambridgenow.ca

Price controls fail miserably in the long term and any agency trying to control prices artificially would eventually fail to do so. Since the world markets are now seeing considerable pressure from the nations which import nearly all their food needs, the right step is to open up the trade barriers and let the market decide the prices. In the short term this might be radical step but it would lead to stabilization of prices as more supply comes in for higher prices. The resource rich economies of the world are trying to impose restriction on international trade of these commodities. If these restriction were to be taken off, there would a large amount of wheat, rice corn, soybean in the markets at elevated levels. This would lead to expected fall in the prices of these commodities. In the short run it will create inflation in the regional economies, however in the longer term this would lead to lower prices. The resource economies such as Australia, China, India, Brazil etc which are rich production of certain commodities will get a boost on the revenue which can be used for development and higher production. However some of the resource economies are themselves insufficient to feed its people which is due to poor investment in agricultural sector in the last few decades. This poses as the single biggest risk to the world economy. However long term love is still love, and short term pain can lead to a long lasting solution. Resource economies need to invest heavily into agriculture to gain benefit of the rising demand which will create the self correcting mechanism and price equilibrium or bring the 'invisible hand' into play.

Since inflation posses the biggest risk presently and to this hypothesis as well, there can be a serious clamp down on the demand for goods by reducing the broader money supply. This would lead to lower demand and less of excesses in certain sectors such as housing and automobiles. However this is not entirely true for domestic economy that is the Indian economy. Indian economy faces greater threat from supply side constraints. The better idea domestically would be to first provide subsidy to agricultural sector by providing better seeds and irrigation facilities. Loan waivers would not solve the problems. A comprehensive system of presenting a stimulus by introducing a voucher system is a much better way of providing relief to the farmers. A standard voucher of certain denomination can be given to farmers. Farmers can present these vouchers to money lenders and eliminate indebtedness. It would be required to first enroll the money lenders in different parts of the country into a single institution. This would eliminate some irregularities that may emerge. most of the India farmers take loans from wealthy money lenders and not from banks. Some pay interest as high as 5% per month and depend on a single crop with Over 60% of India’s net sown area is at the mercy of the monsoon.

Energy is another important factor which is raising the inflation bar and making it difficult for India to jump it. Currently India needs 160,000 megawatts in energy immediately to sustain economic growth. The important step in this direction is to slowly and steadily increase fuel prices over time to avoid future price shocks. This would lead to rationing on its own and conservation will become a norm. Introduction of public transportation would be an added advantage. Crude oil imports in India is rising fast, latest data shows a rise of 8.4% in June over the same period last year. With government raising the tax subsidy to unprecedented levels it is keeping the pressure on the tax payers by compensating high energy consuming entities at the expense of all taxpayers. India's trade deficit widened to 10.8 billion dollars in May 2008 as exports growth slowed down and a 50.8 per cent increase in oil import during the month pushed the overall import bill.The surging oil import bill also turned India's current account balance into deficit of 1.04 billion dollars in the fourth quarter of 2007-08 against a surplus of 4.25 billion dollars a year ago.With this, India's current account deficit rose by 77 per cent to touch 17.4 billion dollars, constituting 1.5 per cent of GDP last fiscal against 9.8 billion dollars or 1.1 per cent of GDP in 2006-07.

If we expose the consumer to real prices of energy there is bound to be major economic changes with potential conflicts. Since smooth transitions are difficult we should make a choice in doing so. Atleast government should continue to raise the prices of fuel by a percent every quarter.

I think solutions lies in taking some drastic measures by the government and the central bank. The need for better economic policy and liberal monetary policy was never so urgent as it is today.

Sahil Kapoor