Vijay Kumar Gaba: Care for the big elephant sitting right to ya

Thought for the day

"The duty of rhetoric is to deal with such matters as we deliberate upon without arts or systems to guide us, in the hearing of persons who cannot take in at a glance a complicated argument or follow a long chain of reasoning."

- Aristotle (Greek, 384-322BC)

Word for the day

Defenestrate (v)

To throw (a person or thing) out of a window.

(Source: Dictionary.com)

Malice towards none

Why all celebrity friends of Salman Khan chose to visit him unshaven and disheveled.

Care for the big elephant sitting right to ya

The sharp corrections in equity prices accompanied with material rise in implied volatility, as seen in past few trading sessions, is definitely disconcerting for all market participants, especially short term traders.

It is easier, under the circumstances, for equity traders to get overwhelmed and focused on daily price movements. Thus increasing the chances of missing the big elephant present in the room and committing avoidable mistakes many fold.

I strongly agree with the view that the happening in stock market, domestic and global, developed and emerging, is only a side show. The primary event is taking place in the bond markets.

The global markets might have derived some comfort from the latest statement of the US Federal Reserve (Fed) in which reference to timeline for raising policy rates was omitted altogether. But the fact remains that most investors and analysts are apprehensive about imminent end to zero and sub-zero yield regime. Bond investors, after years of rising prices and big returns, are bracing for the return of 'normalcy' in debt market.

The sudden and sharp rise in commodity prices, despite continuing poor economic data across the world, and rise in US bond yields indicate that the long bond and short commodity trade has begun to unwind.

The process is slow and not unidirectional as the opinion on direction of global rates is not yet unanimous.

The more prominent view is that the US rates are inevitably headed higher. Hence, going forward the US yields and USD carry trade unwinding will accelerate, and the long bond unwinding shall gain more momentum. Given the exorbitant level of leverage in the bond markets, the unwinding will obviously be torrential and extremely painful once some clarity on timeline of the "Lift" emerges. Legendary Warren Buffet and Bill Gross subscribe to this view.

The other view, certainly not a small minority, is that US economic conditions are far from suitable for a "Lift" as yet. The bond bull markets, in their view, has many more miles to go before it ends.

Good years ahead for Indian equities

The rise in global rates and bond yield may be a terrible news for global financial markets in the near term.

A whole generation of dealers, traders and investors has now been raised on low rates. The strategies and tactics these people have so far used are completed untested for a bear market in bonds.

In an environment where half of world's outstanding bonds trade at zero or negative yield, equity analysts and traders in their twenties and early thirties are used to discounting future cash flows of companies at zero or even negative rates. Their valuation models and investment strategies may perhaps not account for 4-6-8% discounting rates.

In simpler terms, at near zero discounting rate you need low earnings growth to be bullish about a company's stock and could accord higher P/E. However, if you have to discount the future cash flows by higher discounting factor, the required earnings growth for the same P/E multiple would be much higher.

This could be good news for Indian equities in medium term.

The rising cost of capital in global market may have three impact on Indian economy and markets.

(a) The cost of capital may rise for Indian companies. But this could be offset by higher availability as the savings rates go up in developed world with rise in yields.

(b) The INR may weaken against USD, GBP and EUR as the higher rates push up these currencies.

(c) Indian equities may look cheaper in relative terms, as higher discounting factors and lower earnings growth (due to stronger currencies and lower demand due to higher rates), push up valuation of equities in the developed world.

This translates into the following in investment strategy terms:

1. The companies which are inadequately capitalized or whose business model is highly capital intensive but which have poor balance sheet/credit rating would face trouble due to rising cost of capital. These businesses should be mostly avoided.

2. Exporters who are competitive on product and technology front shall gain further strength and remain preferred investments.

3. The companies with strong balance sheets and higher RoEs would remain the most preferred investments. The relatively higher valuations may become more reasonable in medium term (3-5yrs).

Contempt of popular mandate

As expected, the finance minister seems to have virtually given in to the pressure of FPIs over issue of MAT demands for previous periods. The matter has been referred to an expert committee; which in Indian parlance is nothing but an euphemism for avoiding a stand on any controversial issue. In recent times we have seen this tactics used successfully to bury GAAR.

The moot point is what did prompt the government to kick the can in the instant case. Was it the fear of collapse in financial markets due to some mindless selling by the "concerned" FPIs? or the government is truly doubtful about the legal validity of the tax demand raised on FPIs from outside DTAA jurisdictions.

In case the former is true - it is unfortunate. The markets which cannot sustain couple of billion dollars worth of selling by investors who have pumped in US$9bn in just past four months, need some serious restructuring.

However, if the latter is true, it is much more serious matter. It raises questions over the credibility of the promises made by the government both inside and outside the Parliament.

The conduct of various political parties in the Parliament has already cast dark clouds over the entire legislative process. Given the minority status of NDA in Rajya Sabha and adversarial attitude of opposition parties over most government agenda, there is little certainty over any legislative business.

As I write this today, the critical economic legislations like GST Bill face uncertainty due to partisan brinkmanship. The prospects of laws relating to land acquisition, real estate sector regulation, and black money regulation also look poor.

While it is difficult to determine who is at fault (government or opposition) for this legislative logjam - the economy and poor shall suffer, and so would markets.

Politically speaking, both the Congress and BJP appear losing in this internecine battle and the regional parties are gaining at their expense. To me it is a contempt of the popular mandate.

Three decades of falling rates may be coming to an end

Warren Buffett is famous for his long-term bets on companies that he thinks are cheap.

Conversely, he's not known for short positions.

But in an interview with CNBC's Becky Quick, Buffett revealed one asset class he would short.

"If I had an easy way, and a non-risk way, of shorting a whole lot of 20- or 30-year bonds, I'd do it," he said.

These long term bonds have effectively been a bull market for three decades as falling rates translated to higher bond prices.

Regarding interest rates, Buffett noted that if rates were to increase to more normal levels, stock prices would look expensive.

While he said he would short long-term bonds if he could, he also said that he couldn't.

"But that not my game, and it can't be done in the kind of quantity that would make sense for us. But I think that bonds are very overvalued. I'll put it that way."

Trivia

Speaking in typical desi lingo, Mr. N. R. Narayana Murthy now has high connection in British government.

Traditionally, such people are bracketed in a special category within our society, so that we could exploit their high connections for furtherance of our petty vested interests.

Remember Shahrukh Khan and Irrfan Khan starrer "Billu".