While equity markets do enjoy better attention of investors, it is the bond market that usually guides the direction of financial markets, including equity and currency markets.

The following recent signals from the bond market are worth noting:

US Junk Bond Yields fall below inflation

Investment demand for speculative-grade debt and high-yield bond exchange traded funds has been so high that yields on the riskiest U.S. companies are now below that of inflation. The rally in corporate debt rated below investment grade has also pushed yields down to record lows around 4.54%, compared to consumer prices that rose 5% in May year-over-year.

The head of equity research at Julius Bär, summarized the situation as “Inflation has risen to record-high levels in recent months, and the 10-year US bond yield has fallen to a fresh five-month low. What is the reason for the rally in US Treasuries? Obviously, investors believe that peak growth and peak expectations are already behind us. The US Federal Reserve’s (Fed) shift towards earlier-than-expected rate hikes has removed fears that inflation may run out of control, and falling purchasing managers’ indices from record-high levels support the case for decelerating economic growth. This is a normal mid-cyclical consolidation driven by base effects and most likely set to continue at least until Q1 2022.”

India: Credit risk category outperforming

In India also in past one year, the riskier corporate bonds have yielded best return as compared to the highly rated corporate and Sovereign bonds. The five year return on credit risk funds was less than half of highly rated corporate bonds and gilt.

These trends clearly indicate that bond market is not buying the theories of immediate full recovery to pre Covid level; sustainable higher growth, hyperinflation and imminent rise in borrowing cost.

 “The afternoon knows what the morning never suspected.”―Robert Frost

In past few years, cryptocurrencies (especially Bitcoin) have gained material importance in the global financial system. Though the character of Bitcoin (or cryptocurrencies for that matter) is still evolving and it is not certain if it will assume the character of a currency; end up just being a collectible asset like Art, wine, vintage vehicles, old coins, etc.; or just end like a bad dream. But as of now, the debate over its relevance, sustainability, desirability, etc., is intense and wide.

In my view, it is a debate that will continue for many more years and no one will remain unaffected by it. Almost everyone who transacts in money or is part of the global economic system will need to deal with at some point in time.

Majority of experts still skeptical

A large number of prominent personalities in the field of finance, technology and economics, like Warren Buffet, Jamie Dimon, Peter Schiff, Paul Krugman, Bill Gates, et.al., have publically criticized the popularity of Bitcoins. In their wisdom they have chosen the terms like “fraud”, “rat poison”, “scam” etc. to describe Bitcoin. In India, the legendary investor Rakesh Jhunjhunwala publically vowed never to own Bitcoin.

The following statements of the legendry investor Warren Buffet represent the sentiments of the people who are skeptical about the sustainability of cryptocurrencies as a viable currency or asset class”

"It's not a currency. It does not meet the test of a currency. I wouldn't be surprised if it's not around in 10 or 20 years. It is not a durable means of exchange, it's not a store of value. It's been a very speculative kind of Buck Rogers-type thing and people buy and sell them because they hope they go up or down just like they did with tulip bulbs a long time ago." (2014)

"In terms of cryptocurrencies generally, I can say almost with certainty that they will come to a bad ending. If I could buy a five-year put on every one of the cryptocurrencies, I'd be glad to do it, but I would never short a dime's worth." (2018)

It is “probably rat poison squared”. (2018)

“I think the whole damn development is disgusting and contrary to the interests of civilization. Of course, I hate the bitcoin success… I don’t welcome a currency that is so useful to kidnappers and extortionists”. (2020)

 "Cryptocurrencies basically have no value and they don't produce anything. They don't reproduce, they can't mail you a check, they can't do anything, and what you hope is that somebody else comes along and pays you more money for them later on, but then that person's got the problem. In terms of value: zero." (2020)

Later, however, JP Morgan, disregarding the earlier comments of CEO Jamie Dimon, “admitted its mistake” rejecting Bitcoin as a scam and has shown inclination to accept the cryptocurrency as an attractive asset.

Eric Peters, CIO of Hedge Fund One River Asset Management, proclaimed (about Bitcoin) that "There Is A Vague Sense That Something Powerful, Apolitical, Transnational, Is Emerging".

In the meantime, Rakesh Jhunjhunwala, the legendary Indian investors who is often referred as Warren Buffet of India, was heard saying in a TV interview, "I won't buy it for even $5. Only the sovereign has the right to create currency in the world. Tomorrow people will produce 5 lakh bitcoins, then which currency will go? Something which fluctuates 5-10% a day, can it be considered as currency?"

Regardless of the extremely negative expert commentary, Bitcoin has not been termed illegal in any of the major economies in the world; even though some countries like China have imposed severe restrictions on transacting in Bitcoins. El Salvador has become first country in the world to accept Bitcoin as the legal tender.

Despite being most volatile, Bitcoin has remained one of the best performing “assets” in past couple of years.

The historical context

The work on developing as crypto currency started in early 1980s. The idea was to create a medium of exchange that is independent of any central authority, is based on trust and is accepted by distributed consensus. The process was formally commercialized in 2009 with release of Bitcoin, the first decentralized cryptocurrency. May be uncertainty over future of fiat currencies post global financial crisis (which led to printing of unprecedented amount of new money) prompted adoption of an independent currency as medium of exchange. Since then, the cryptocurrencies based on block chain technology have been gaining popularity. Presently, besides Bitcoin, over 6000 variants of crypto currencies are in vogue globally. Many central bankers have also expressed in using digital technologies to supplement the paper currency.

The present value of all cryptocurrencies in circulation is over US$1.6trn; out of which bitcoin alone accounts for about US$750bn. This compares with US$5.8trn of monetary base (M0) of USA). The average daily trading value of bitcoins alone is over US$23bn. It is clear that Bitcoin is emerging as a serious challenger to Gold as an alternative currency or medium for exchange of value.

Two large global corporations Tesla (again!) and Amzon have expressed the intent to accept Bitcoin as valid payment for transactions. This has further intensified the debate and softened some of the critics.

The Indian context

In Indian context, the money market regulator (The Reserve Bank of India or RBI) has taken a guarded view of cryptocurrencies. It has refrained from terming it as illegal. However, some attempts have been made to discourage the use and ownership of cryptocurrencies. The Supreme Court of India has disagreed with some of these measures, and paved the way for legal ownership of cryptocurrencies. However, the regulatory and taxation regime is still evolving and may take some time to get established.

RBI vs Supreme Court

RBI issued a circular in 2018 directing all entities regulated by it (Banks and NBFCs) not to deal virtual currencies or provide services for facilitating any person or entity in dealing with or settling those; thus virtually banning use of crypto currencies in India. The Supreme Court quashed the said RBI circular in March 2020, on the appeal of the Internet and Mobile Association of India, representing various cryptocurrency exchanges. The SC accepted the argument of the appellant that in the absence of any specific law banning cryptocurrencies, dealing in these is a “legitimate” activity; hence RBI’s circular banning these is untenable.

In August 2020 various media reports suggested that a “note” had been forwarded to the concerned ministries for inter-ministerial consultation to promulgate a legislation banning the use of crypto currencies in India. Reportedly, the inter-ministerial committee headed by the former Finance and Department of Economic Affairs (DEA) secretary, Shri Subhash Chandra Garg (who has been in news recently for criticizing the government for backtracking on reforms) had drafted the Bill of the law to ban the cryptocurrencies. In the meantime, as per various media reports, since March 2020 SC order quashing the 2018 RBI circular, the local crypto exchanges have reported as much as 20x trading volume growth and a significant increase in the number of signups.

The aggressive marketing campaigns by these ventures however are focusing on promoting Bitcoin ownership for vanity purposes, palpably as a substitute for gold.

NITI Aayog initiative on Blockchain recognizing its importance

In January 2020, NITI Aayog (the think tank of the government of India on policy matters), had released part 1 of the discussion paper on “Blockchain: The India Strategy”. The well-researched and well-presented paper unambiguously stated that the government recognizes the opportunity, importance and need for blockchain based crypto currencies.

The paper recognized that “‘Blockchain’ has emerged to become a potentially transformative force in multiple aspects of government and private sector operations. Its potential has been recognized globally, with a variety of international organizations and technology companies highlighting the benefits of its application in reducing costs of operation and compliance, as well as in improving efficiencies.”

It is admitted that “Blockchain is a frontier technology that continues to evolve. In order to ensure that India remains ahead of the learning curve, it is important to understand the opportunities it presents, steps to leverage its full potential and such necessary steps that are required to help develop the requisite ecosystem.” And “Blockchain technology has the potential to revolutionize interactions between governments, businesses and citizens in a manner that was unfathomable just a decade ago.”

The paper candidly admits that “Blockchain is seen as a technology with the potential to transform almost all industries and economies. It is estimated that blockchain could generate USD3 trillion per year in business value by 2030.”

Obviously, the government of India recognizes the potential, opportunity, need and importance of cryptocurrencies. However, it wants to tread with extreme caution. The NITI Aayog’s discussion paper notes that —

“Blockchain has been positioned as a revolutionary new technology, the much needed ‘silver bullet’ that can address all business and governance processes. While the promise and potential of blockchain is undoubtedly transformative, what hasn’t helped this technology, that is still in nascence of its evolution, has been the massive hype and the irrational exuberance promulgated by a bevy of ‘Blockchain Evangelists’.”

“Any transformative technology, in its initial stages of development, as it moves out of research / development phase to first few applications to large scale deployment, faces several challenges. Part of the problem is that such technologies are initially intended to solve a specific set of problems. Bitcoin, which has led to the popularity of decentralized trust systems and has powered the blockchain revolution, was intended to develop a peer-to-peer electronic cash system which could solve for double spending problem without being dependent on trusted intermediaries viz. banks. As Bitcoin started gaining prominence, the potential of underlying blockchain technology started getting traction. However, some of the early design features that made Bitcoin popular, primarily limited supply and pseudonymity, have become potential challenges in wide scale implementation of blockchain.”

(The NITI Aayog discussion paper “Blockchain: The India Strategy” could be read here.)

Bitcoin ticks most boxes

Given the nascent stage of evolution of block chain technology and crypto currencies based on it, the cautious approach is understandable. However, the caution must be pragmatic and should not transgress to typical dogmatic paradigm.

In my view, the real debate is whether the world needs an independent reserve currency for cross border transactions; given that the unmindful printing of fiat currency by the respective large central banks in past two decades has perhaps diminished the credibility of the popular global currencies USD and EUR.

A broad evaluation of Bitcoin (or any other widely accepted cryptocurrency for that matter) highlights that Bitcoin may meet all prerequisites of a good currency – e.g., medium of exchange, store of value and unit of measurement. As evident from the following evaluation table, the advantages of Bitcoin, as an evolved independent digital currency, outscore gold on some parameters. It also outweighs any fiat currency that is not backed by real assets.

Gold vs Bitcoin

For many centuries, Gold was the most popular currency – store of value, medium of exchange and unit of measurement. However, with evolution of paper currencies and metric system, the usage of gold as a medium of exchange and unit of measurement declined significantly.

In past couple of centuries, Gold has served as reserve currency whenever the paper currencies have lost faith of people due to a variety of reason, particularly high inflation and fiscal profligacy. It has also been used as such during transition periods in global strategic power equilibrium. However since end of Breton Wood agreement in 1971, gold has not been used as reserve currency. Post fall of Berlin Wall in 1989 the strategic supremacy of USA, and consequently USD, has remained mostly unchallenged.

The demand of gold as store of value is a deeply complex matter. In past gold had been a preferred asset to store value both during economic (especially hyperinflation) as well as political (including geo-political) crises.

In 1970s the world faced serious stagflation as the demand generated by post WWII reconstruction activities faded and Iranian revolution created a worldwide energy crisis. Gold jumped 10x in real terms during the decade of 1970-1980), to give back most of the gains in the following two decades.

Again in the decade of 2000s, as the dotcom bubble hit the global economy, interest rates crashed leading to sub-prime crisis that culminated in a major global financial crisis. The gold jumped 5x in real terms during this decade (2001-2011).

Presently, the gold prices are only marginally higher than the highs recorded in 2011. Whereas Bitcoin has risen almost 1000% since 2011. Like gold in 2001-2011, Bitcoin has risen 5x since outbreak of Covid19 pandemic, whereas gold is higher by about 5% in this period. The question is whether unconsciously markets are replacing Gold with Bitcoin.

Is Bitcoin replacing Gold

When economics fails in providing solution to a problem of livelihood and sustainability, philosophy always provides the answer.It is a natural instinct of human being to look up to the skies for guidance when all our efforts fail. (Some even do so without making any effort at all!) Religion has therefore been an inextricable part of human life since beginning of the civilization.

Most ancient cultures, China, Egypt, Mesopotamia, Indus Valley etc. have believed in continuation of life after death. Gold being an indestructible (and therefore sacred) object had always been an important part of their religion, culture, traditions and beliefs. It naturally evolved as symbol of power and prestige over time. The church & temples, kings & feudal lords hoarded and displayed gold to asset their power and status.

In past one century, especially past three decades, the factors like popularity and spread of technology in common man's life; rising fascist and communist tendencies due to worsening socio-economic disparities; rise in electronic transactions (personal, social and commercial) thus lower risk (less travel, less physical transactions & deliveries); emergence of new articles of luxury to serve the vanity needs of the affluent; stronger and deeper social security programs; demise of monarchy and feudalism; popularity of spiritualism over rituals; dissipation of church & temples, etc., have all led to sustainable decline in traditional demand and pre-eminence of gold.

In the modern context, technologically challenging things, e.g., Bitcoins, certainly find greater favour with investors as compared to gold.

Conclusion

To conclude, I would say that the ultra-loose monetary policy prevalent in most developed countries shall have to end at some point in time in foreseeable future. This suppression of savers and poor cannot continue into perpetuity. However, ending this tiger ride may not be easy and would require some innovative measures.

For example, the following is one of the scenarios that is potentially possible—

·         US Government and Fed decide to correct the fiscal and monetary indulgences of past couple of decades, by material devaluation of USD and letting USD retire as global reserve currency; settle trade and currency dispute with China agreeing to restore the global trade balance.

·         Global commodities are no longer priced predominantly in USD. The share of neutral currencies (cryptocurrencies) increases substantially in global trade.

·         Consumption pattern change materially. The consumption of fossil fuels, steel, chemicals etc. declines structurally.

·         Digital transformation leads to material rise in productivity, further adding to deflationary pressures created by aging demography of the developed world; thus alleviating the fears of hyperinflation and need to resort to gold as reserve currency.

This may sound fanciful but is not totally unlikely.

There could be many similar or different solutions to end this tiger ride of quantitative easing, negative rates, and suppression of poor (people, economies and regions). Out rightly, rejecting the need and importance an independent currency at this stage could prove to be fatal.

The question, whether Bitcoin would be emerge as the independent global currency would best be answered by time. I would though not reject the probability. Nonetheless, Bitcoin (cryptocurrencies in general) has assumed the status of a popular alternate asset and there is no reason to despise it, just because its price in USD terms is highly volatile presently.

(A couple of years ago, one central minister got confused between Isaac Newton and Albert Einstein and erroneously attributed theory of gravity to Einstein. The Enforcement Directorate of Social Media (EDSM) immediately took cognizance of the mistake and forced the minister to correct his mistake. The minister in reference also happened to be a Chartered Accountant by professional qualification, like me. It is reasonable to believe that the minister, like me, does not understand the nuances of the theory of relativity and laws of motion, and got confused. Nonetheless, learning a lesson from that episode, I want to upfront clarify that my knowledge and understanding of the theory of relativity and laws of motion is zilch. Any references to relativity and gravity herein is just plain English and should be read as that only.)

My investment advisor often motivates me to invest in stocks having “valuation cheaper than the industry average or significant valuation discount to the industry leader”.

One of the most common investment advices I get from investment gurus is “invest in quality only”.

I have observed that the most common portfolio evaluation tool used by the market participants is “returns relative to the benchmark”. This benchmark could be an index, returns made by some famous large investor, returns made by a friend or family member, etc.

“Relativity” is thus an important driving force of the investment strategy.

“Mean reversion” or the gravitational pull & push of averages is one of the strongest premises in the financial analysis, especially in the context of investment timing and forecasting prices. The entire spectrum of technical studies of trends in prices (technical analysis); future valuation forecasts (long term average of valuations; standard deviation of valuation parameters etc.); and even earnings forecasts use the “gravitational pull towards mean” as a key control point in their operation.

I think there is a need to reimagine the application of the concepts of “Quality”, “Relativity”, and “Gravity” to the businesses of equity research, investment advisory and portfolio management.

Quality is good as a noun

"Good is a noun...Good as a noun rather than as an adjective is all the Metaphysics of Quality is about. Of course, the ultimate Quality isn't a noun or an adjective or anything else definable, but if you had to reduce the whole Metaphysics of Quality to a single sentence, that would be it."- Robert Pirsig in Lila: An Inquiry into Morals

Honestly, how many of us could tell “who is Kevin Mayer?” without taking the help of St. Google. A mention of Usain Bolt though may ring many bells. If I mention both names together, most may deduce that Kevin Mayer is also a sportsperson.

Kevin Mayer is the world champion of Decathlon, a discipline involving ten track and field competitions. On the other hand Usain Bold is champion of short distance running (100m and 200m). If someone asks me “who is better athlete Kevin or Usain?”, my answer would be “it depends from which vista point I am looking at them!”.

If I am primarily looking for momentary thrill, excitement and/or extreme competitiveness in sports, I would say Usain Bolt is better, because his performance sharply raises my adrenalin level, brings me to the edge of my seat, gives me Goosebumps for 10 to 20 seconds, and then I can go back to my regular work. I would also enjoy seeing someone winning with extremely thin margin (fraction of a second) and may derive some motivation to be highly competitive in my life.

However, if I am looking for an example of stamina, endurance, consistency, multi-dimensional talent & skills, I would prefer Kevin. His performance guides me to adopt a balanced approach in life; as it shows that you do not have to win all the games to be a winner in life. He could still be a winner by a large margin, even if he performs well in 6 out of 10 events of the decathlon.

Now apply this analogy to some popular comparisons in stock market, e.g., Hindustan Unilever & ITC and HDFC Bank and Kotak Bank!

The stock of a company does not necessarily become “quality” if it is “relatively cheaper”; or it has given “relatively better returns” over past few years.

I may prefer to invest in a company that has a sustainable business model; its stock has given 10% CAGR over past 20years, with low volatility, simply because I can plan my finances with this investment much better.

Someone else may find quality in a cyclical business that has just entered an upcycle. The stock of this company may have given 12% CAGR over past 20years , but with much higher volatility and unpredictable dividends.

The point I am trying to make here is that “quality” in relation to investments, like anything else in life, should not be considered in relative terms. The quality of a portfolio of investments should be absolute and in congruence with the underlying investment goals.

If my investment goal requires my equity portfolio to grow by 10% CAGR over next 20years, the quality for me would mean the portfolio of stocks which have high probability of growing 10% CAGR over next 20years. Performance of Nifty/Sensex; performance of competitors; performance of other sectors and markets; performance of alternative assets over this period should be mostly irrelevant to me.

Relativity may not always apply to stock analysis

There are many models to evaluate the fair value of a business, e.g., discounted cash flow method, earnings multiplier; revenue multiplier; replacement value; liquidation value etc. In practice it is seen that each business has some peculiarity and applying a standard text book valuation method may not be most appropriate way to find its fair value. Analysts accordingly modify the standard methods as per their understanding of the business.

Comparing the relative valuation of two businesses therefore may not be appropriate in most cases. Nonetheless it is common to evaluate businesses on relative valuation basis. The worst part is that analysts use different methods to find the fair value of a business, in accordance with the size, capital structure, off balance sheet items (eg., hidden assets or contingent liabilities) etc.; but often a common parameter is used to assess the relative valuation of two or more such businesses.

Imagine three pharma companies – one is a large diversified drug producer with presence in 40 countries; manufacturing branded generics and formulation; has a decent portfolio of specialty drugs and has a strong research capability for new molecules; second is a midsized CRAM service provider to foreign companies and third is a small domestic branded generic manufacturer with no export revenue. Would it be appropriate to compare these three businesses on the basis of PE Ratio; EV/EBIDTA; book value or dividend yield basis?

The businesses like depository services, stock brokerages, and asset management mostly collect the revenue upfront. The working capital requirement for these businesses may be negative or negligible. Comparing these businesses with NBFCs, which have a significantly different business model, risk profile and cash flows, may be highly inappropriate.

Notably, the global valuation guru Aswath Damodaran, calculated the fair value of the recently listed food delivery business Zomato to be Rs40.79 against the IPO price of Rs76 and listing price of Rs116. More than half the shares issued in IPO exchanged hands on the day of listing; implying that a large number of discerning investors were willing to pay 2.5x to 3x of fair value assessed by the guru. The quality and fair valuation obviously has different connotation for the guru and the market participants.

 Gravity does not work in many cases

The mean reversion or gravitation pull & push for stock prices and valuations has not worked in a large number of cases. In past one decade, the prices of stocks like Asian paint, Pidilite, Dabur, etc., have consistently defied the gravitational pull to mean. Similarly, there is of dearth of stocks that have defied gravitational push to mean despite much desire of the market participants. Most notable examples of such stocks include ADAG stocks, JP Group stocks, Suzlon (all part of Nifty in 2008-09). In some cases however, gravitation force has worked just fine, e.g., PSU Banks.

To conclude, in my view, individual investors must focus on “quality” of their portfolio in absolute terms not in relative proportion; set investment goals as per their social, personal and financial conditions; and evaluate performance of their portfolio in terms of congruence to their investment goals. This shall make their job much simpler.

 The yields curve in India has been moving higher for past few months, despite the efforts made by the Reserve bank of India to anchor the benchmark yields at lower levels. In past one year, the RBI has used most of the arrows in its quiver to manage the bond yields, apparently with the three targets in view – (a) to help the government fund its fiscal expansion at reasonable rate; (b) to keep the financial markets calm in the times of adversity; and (c) to keep the rate environment supportive of growth.

However, last week the RBI appears to have changed the trajectory of its policy by accepting higher coupon (6.10%) for the new benchmark security (6.10GS2031). This move is widely expected to result in India’s yield curve inching little higher, and perhaps flattening a bit.

The debt market traders have largely seen the latest move of RBI as the rise in its tolerance for higher yields. Though the governor has maintained that RBI is committed to keep the borrowing cost for the government under control, and focusing on the benchmark 10 year yields for yield directions alone may not be appropriate.

The minutes of the last meeting of Monetary Policy Committee of RBI clearly stated that “all members of the MPC unanimously voted to continue with the accommodative stance as long as necessary to revive and sustain growth on a durable basis and continue to mitigate the impact of COVID-19 on the economy, while ensuring that inflation remains within the target going forward”. The governor specifically stated that “At this juncture, providing a policy environment supportive of sustained economic recovery from the second shock of the pandemic is necessary.” It would be reasonable to infer that there is no certainty about the next move of the MPC on policy rates. If required it could be a cut also.

The global trends in bond yield have been providing mixed signals. Despite, the concerns expressed by the top central bankers about the rising inflationary pressures, the bond market have remained generally buoyant. People’s Bank of China has in fact went ahead and cut the key reserve ratio, committing to the growth disregarding the inflationary pressures.

In the year 2021, so far seven major central banks have effected change in their policy rate; out of which six (Brazil, Czech, Hungry, Mexico, Russia and Turkey) have hiked the rates and only one (Denmark) has cut the rates.

The US Federal Open Markets Committee (FOMC) has indicated that its next move could be a hike; though it not happen in next twelve months at least. The European Central Bank (ECB) signals are though mixed.

What does a tolerant RBI mean to markets?

In recent months, the inflation in India has mostly remained above the RBI’s tolerance range. The MPC committee has repeatedly reiterated that for now the growth remains a priority. Nonetheless the rising price pressures do find a strong mention in MPC commentary. Inflation has persisted above RBI’s base target of 4% for more than a year now. For FY21 as a whole, it has remained above the tolerance range of 4%+/- 2%.

The fiscal expansion in the wake of economic crises that emerged due to the pandemic is yet another cause of worry for the monetary managers. S&P Global has estimated that for FY22 the fiscal deficit of India may remain elevated at 11.7% of GDP. This is much beyond the limits envisaged under the Fiscal Responsibility and Budget Management Act (FRBMA). It is pertinent to note that for FY21, the general government fiscal deficit of Indian government amounted to 13.3% of GDP (S&P expects it to be 14.2%). Obviously, the fiscal pressures may also be weighing on the RBI mind.

In recent months there have been many occasions when the RBI auction of government securities has devolved on the primary dealers.

f

(a)   RBI is not getting enough demand for the benchmark 10yr securities at 6% or lower coupon.

(b)   RBI is finding itself behind the curve, since it effectively enhanced its tolerance to inflation, without making corresponding adjustment to the bond yields.

(c)    RBI is preparing the markets for the likely global monetary tightening. Even though the large global central bankers may not cut the policy rates in next twelve months, there are decent chances that they taper their bond buying program, leading to unwinding of some of the USD and EUR carry trade. A higher yield could be a good incentive for global investors to stay put in Indian gilts.

(d)   After accepting higher yield for benchmark 10yr securities, RBI may also desire a little flatter yield curve, which means rising yields at the middle of the curve. This may be desirable considering that the steeper yield curve may be acting as a disincentive to raise long term funds.

What could be the trade?

One of the obvious trades would be to increase the duration in debt portfolio to protect it from flattening of yield curve.

The other trade would be to invest in dynamic bond funds (debt counterpart of the Flexicap equity funds).

Insofar as the equity market is concerned, theoretically equity valuations ought to respond negatively to the rising yields. But in practice the correlation is not seen to have worked in many instances.

Theoretically, the higher bond yields should result in higher opportunity cost for owning equity. The probability of lower future return would make the trade relatively less profitable resulting in investors moving more allocation to the bonds. However, this may not work in the present circumstances due to a variety of factors. For example—

·         The yield curve is too steep presently to have any meaningful impact on the equity traders’ opportunity cost.

·         Even at the 5-6yr maturity, the real yields continue to be negative, whereas the equity returns are projected to be decent for next couple of years at least.

·         Higher benchmark yields are not likely to transmit to the lending rates in a hurry, given the poor credit demand and massive accumulation of reserve money with the banks.

·         The leverage in the equity markets is significantly lower as compared to previous rate cycles. Any large unwinding is therefore unlikely in the short term.

·         Despite the acceptance of higher benchmark yield, RBI remains committed to support the growth. Since the growth is not likely to reach the desired levels anytime soon, any meaningful tightening by RBI is highly unlikely, notwithstanding the pricing pressures.

The market has read this very well and refused to react negatively to higher yield. It is reasonable to expect that this status quo may prevail.

Is RBI running behind the curve?

The more pertinent question however is “whether RBI is running behind the curve and the economy will have to pay for this lag later in the day?”

In my view, the historical evidence indicates that most central banks usually like to remain behind the curve rather than jumping the gun. There are very few instances in the history of RBI when it has preempted the inflation and hiked beforehand. I will therefore not be unduly worried about RBI running little behind. Besides, RBI would not like to relive the experience of 2011 when the rates were hiked prematurely and the required a hasty retreat.

It is true that RBI will need lot of luck with inflation in next couple of years. The premise that “inflation is transitory” and pressures will ease as the global economy opens up more in next 6-9 months, must come true to make RBI’s task easier. Else, we shall be ready for an undeniable “Stagflationary” phase in the economy. Remember, the Indian economy is already facing a sort of stagflation, but it has been mostly denied.

What the Global trends say

Last weekend, Peoples Bank of China (PBOC) surprised the market by cutting the reserve requirement ratio (RRR) for all banks by 50 bps, releasing around 1 trillion yuan ($154 billion) in long-term liquidity. The analysts widely view the move as an attempt to sustain the post pandemic growth momentum which had shown some sign of fatigue in recent data.

As per the UBS EM strategist, "China was first in, first out (with COVID policy support) - it effectively started tightening (monetary policy) in Q3 last year - so now it is possible that the message is, if you are thinking about global significance, that the PBOC is showing that economies are still somewhat fragile and inflation is not likely to be too damaging over the medium term."

The Researach Analysts at Ashmore Group, London feels “The 50-bps cut in reserve requirement ratio came slightly earlier than most expected. China is likely to ease monetary policy via RRR cuts and OMO operations in order to allow for more local government bond issuance. This will support strategic infrastructure investment such as railways and 5G rollout. We expect fiscal policy to remain focused on specific sectors most affected by the pandemic like small companies. We also expect macro prudential tightening on the property market to remain in place.”

US yields are now at 2% or below across maturities and appear falling towards lows seen 6 months ago. Obviously the market does not believe that Fed would actually care to hike rates earlier than 2023. The market consensus also seems to be concurring with the Fed’s view that inflation is transitory and passé by end of 2021.

The Minutes of the recent FOMC meet suggest that while tapering of QE is on the table, but few Fed members are in a rush to actually do it. The statement read “The overall mindset was tilted towards patiently watching the progress of the economy and labor market, and providing ample adjustment time to the markets. Given the current condition of the labor market and the inflationary pressures, we reiterate our view that tapering could start early next year with the announcement coming in August-September 2021.”

Many analysts are sensing an economic signal from the plunging yields in US, with the simultaneous surge in the dollar. The evidence is rising that the reflation trade may be getting unwound.

There are some dissenting voices, like an analyst at Bridgewater Associates’, who believes that “Bond markets are sending a clear message that inflation is transitory but investors should prepare for the possibility that they're wrong”.

Bill Blain (morningPorridge.com) was even more candid. He writes, “The brutal reality is the Central Bankers, who are all honourable men and women, understand the levers they pull no longer function as they once did. Why? Well, these honourable men and women have broken the system as a consequence of their actions. Oops. Now they have no choice but to follow.. which means trouble ahead until the global financial system can be resolved.”

“Most of the market is fixated on what the S&P does this afternoon, what new high the NASDAQ will make this month, or where Amazon is going to top this quarter. They have the vision of a blind man when it comes to anything much beyond the end of their one-year time horizon. Even the bond market seems blind.”

In the meantime, fissures have emerged in the ECB’s unity over inflation target. As per media reports, “European Central Bank unity on its inflation target could dissolve into division as early as next week when policymakers meet to discuss changing its guidance on raising interest rates.”

“In its recent policy review, ECB has set 2% as the inflation target and will allow overshoot of this target as necessary. This marks a change in long established stance –since 2003, ECB has kept an inflation policy stance of “below, but close to 2%”. The recent surge in cases across Europe, if uncontrolled, could throw off Eurozone from recovery path and continuation of QE will be key.”

While discussing the present state of affairs in the markets, especially the valuations, two statistical parameters are used most often – (1) The price to earnings (PE) ratio of the benchmark (e.g., Nifty50) and (2) the market capitalization to GDP ratio (popularly known as Warren Buffet indicator).

Both these indicators may soon lose their relevance, particularly in the context of Indian markets.

In next couple of years a large number of new economy stocks may get listed. Many of the new economy stocks that listed earlier may get included in the benchmark indices. Obviously, the old economy stocks, especially PSU and cyclical commodity stocks will pave the way for these new economy stocks. The point here is that the new economy stocks are valued at multiple of revenue not profits.

For example, it is expected that in the next Nifty reshuffle Avenue Supermart (198x PE) or Info Edge (500x PE) may replace Indian Oil Corporation (5x PE). This will obviously inflate the composite valuation of Nifty in PE ratio terms. At some point in time Reliance Retail (100x PE), Reliance JIO (150x PE), Zomato (200x PE), PayTM (150x PE) Indiamart Intermesh (80x PE) etc shall find place in the benchmark index at the expense of Coal India (7x PE), BPCL (8x PE), NTPC (7x PE), Power Grid (9x PE). Assessment of market valuation through Nifty PE ratio would become totally meaningless at that point in time.

The Warren Buffet indicator has already become less relevant in the case of Indian markets, in my view. This indicator completely ignores the rise in private equity investments. In Indian context for example, the equity investment in self owned enterprise and home equity has risen sharply in past one decade, as compared to the decade prior to that. Besides, the size of unlisted private businesses has increased significantly. Factor in the estimated market value of Amazon India, Vodafone India, PayTM, FlipKart, Honda India, Hyundai India, LG India, Samsung India, Apple India, etc. and you will find this ratio running much higher than what the present statistic might suggest.

So the present argument that Indian market is “expensive but nowhere closer to bubble territory” based on historical PE ratio trends, may become totally redundant. The market participants might have to evolve new parameters for valuing the market that would be appropriate in the evolving scenario.

Till then, Nifty50 is trading above 1SD 12 month forward PE and GDP to market cap has crossed the threshold of 100%.

 Three decades ago, on 24th of July, 1991, when Pallath Joseph Kurien, Minister of State for Industry in Government of India, tabled the New Industrial Policy (NIP) in the Lok Sabha, not many would have realized how big was the moment in the socio-economic history of Independent India. After six years of preparation and facing political challenges, the new policy, which sought to end the Nehruvian Socialism in the country, finally saw the light of the day.

The process of economic reform was set in motion by Vishwanath Pratap Singh, the finance minister in the government of Rajiv Gandhi (1984-1987). It gained further impetus when Ajit Singh, the MIT educated, tech savvy industry minister of National Front’s government assumed the charge (1989-1990).

The original draft of NIP was prepared by Amar Nath Verma (then Industry Secretary) and Mohan Rakesh (then Chief Economic Advisor to Industry Minister Ajit Singh) in 1990. The proposal to radically reform the industrial policy of India were patronized first by Ajit Singh & Vishwanath Pratap Singh (1990), then by Yashwant Sinha & Chandrashekhar (1991) and finally by Manmohan Singh and Pamulaparthi Venkata Narasimha Rao (1991).

The NIP was followed by supporting reforms in the financial sector and fiscal policy. The committees set up in 1991 under the chairmanship of Raja Jesudoss Chelliah and Maidavolu Narasimham for Tax reforms and Financial Sector Reforms respectively. The recommendations made by these committees and several follow up committees like Narsimhan Commmittee 2.0, Shome Panel, Kelkar Task Force etc. have formed the basis of the economic and fiscal reforms in the country in past three decades.

Indubitably, we have travelled a long distance from 50% corporate tax rate to in 1990 to 25% in 2021. The journey in indirect taxation has been even more spectacular. From a multitude of classifications and tax slabs in 1980s, we have achieved minimum number of tax slabs and a single Goods and Services Tax (GST) in three decades.

Financial sector has also seen a metamorphosis in past three decades. Capital controls have been materially relaxed. A developed national trading & settlement system for financial instruments has been established. Foreign trade is materially deregulated. Financial inclusion has progressed materially with liberalization of banking, insurance and pension sectors. After initial hiccups, the Insolvency and Bankruptcy Code is now evolving fast.

The work of reforms though is still in progress and we have many more miles to cover. The reforms in two key sectors Agriculture and Industrial Labor have started by passing key legislations in 2020. The government has also outlined a clear policy on disinvestment of public sector enterprises. From the legacy process of reforms, The Direct Tax Code, The Indian Financial Code, Development of Retail Debt Market, Land Reforms, GST rates rationalization and coverage expansion, etc. are some of the areas where progress is still needed.

In recent years an entirely new economic development paradigm has emerged globally. Sustainability and Tech driven trade and commerce have emerged as the most dominant global socio-economic trends. India has the opportunity to adapt to these trends early by implementing a futuristic policy framework. The progress made so far appears patchy and reluctant. Comprehensive and constitutionally enforceable policies for sustainable development and digital commerce (including currencies) need to be evolved and implemented earnestly, at the earliest.

Backdrop of 1991 reforms

The reforms in 1991 were neither ushered voluntarily, nor enjoyed wider support. These were rather necessitated as the socio-economic milieu of the country had reached the brink of disaster. Four decades of pseudo-ness in post-independence policies had introduced numerous distortions in the society and economy.

The pseudo socialist model of development adopted post-independence in fact perpetuated the colonial feudal model. The private sector monopolies were protected through licensing controls & state patronage, and hugely inefficient public sector monopolies were created. Even implementation of Monopolies and Restrictive Trade Practices Act and Foreign Exchange Regulation Acts in 1972, were misused to perpetuate the dominance of already well-established industrial families.

The entire development paradigm was designed to focus on the weaknesses (risk capital and technology) of the country. The strengths of the country (food, art, culture, religion, languages, etc.) were undermined and allowed to dissipate easily. The effort of the government was on discouraging and regulating consumption, rather than increasing production and productivity. Industrial and scientific knowledge and technologies were mostly imported. The term “imported” became synonymous with quality and prestige and “local” became a derogatory reference. Even to date, many companies of old era proudly include “imported” or “foreign” technology in their promotion campaigns.

The backdrop of 1991 reforms was set by convergence of many social, political and economic factors.

Firstly, the country was witnessing unrest on many counts, most notably - Implementation of Mandal commission and Ram Mandir movement had become major socio-political issues.

The Congress leader Rajiv Gandhi had just been killed by Sri Lankan Tamil suicide bombers. Regional socialist parties had risen to capture power in the Congress strongholds UP and Bihar. Having permanently lost West Bengal and Tamil Nadu earlier, the Congress party’s popular support was shrinking to a few states in central and western India.

The collapse of USSR and Berlin wall meant realignment of global order. The non-aligned India, which was in fact closer to USSR, was left vulnerable on many counts, especially geopolitical support and crucial defense technologies.

In the post emergency era, the efforts of various governments to catapult India to higher growth rate through fiscal expansion had culminated in significant balance of payment crisis. The ten years of fiscal expansion did manage to break the vicious cycle of the Hindu rate of Growth (3-4%). Briefly a higher growth rate (7.6% average during 1988-1991) was also achieved; but it was not sustainable for obvious reasons. The gulf war and two years of severe droughts further aided to the economic woes.

The multitude of crisis pushed the policy makers to adopt a pro market approach. The Congress Supported minority government of Chandrashekhar sought IMF help and committed to a radical reform in fiscal policy and industrial policy. A roadmap was prepared for disinvestment of PSEs, fiscal reforms and implementation of NIP. However the government fell days before the finance minister Yashwant Sinha could present, what could have been the first dream budget of Independent India.

Impact of reforms

There is little argument over the fact that the economic and fiscal reforms initiated in 1991, India were inevitable. These reforms did help in bringing the Indian economy back from the brink of disaster; even though the adequacy and efficiency of reforms has remained a matter of intense debate ever since.

Three decades of reforms have resulted in many structural changes in Indian economy. The contribution of agriculture has reduced to about one sixth, while services now contribute more than half of the GDP. The structure of foreign trade has also changed in favor of manufactured goods and services. The balance of payment has remained robust. We have faced three global crises (2000, 2008, and 2020) without an iota of problem.

Financial markets have remained an example to the world. India has perhaps been the only major global financial market that neither shut down nor imposed any trade restrictions during 2000 and 2008 market crisis.

Positives

In my view, the 1991 reforms made three most important contributions to the Indian economy:

1.    The process of reform dismantled the pseudo socialist mindset of the policy makers; unleashing the private enterprise which had remained constricted since independence. Consequently, the minority socialist government of United Front in 1996-1998 presented the second dream budget. Another minority government supported by socialists (NDA 1998-2004) divested numerous government monopolies like coal, ports, mobile telecom, roads, power, airports, etc. without much trouble. The response to global sanctions post 19998 nuclear test was not lower spending, but larger capex on building local capacities. The UPA-1 government supported by communists made a nuclear deal with USA and UPA-2 allowed foreign capital in retail trade. The final epithet of older policy regime was written by NDA-2 with dismantling of planning commission; permitting off the shelve banking licensing; and move to privatize two PSU Banks (NDA-3).

2.    Shifting of policy focus on increasing production & productivity rather than constricting consumption. This allowed the Indian businesses and consumers to globalize; aspire more and achieve more. We could become part of global alliances and treaties without much resistance. We could set up large scale capacities in automobile, pharmaceutical, textile, space technology, civil aviation, ITeS, and housing etc. Private enterprise could attract significant capital from global investors.

3.    The horizons of the entrepreneurs expanded materially. The post reform generation of entrepreneurs was not infected by the traditional constraints. The new generation could think about globally competitive scale. They were not constrained by traditional characteristics like complacency, frugality, austerity, contentment etc. Targtes were now being frequently expressed in “Billion dollars” terms rather thn millions. Dreams not only became larger but also started to get realized. Consequently, the Indian MNCs started to grow in diverse areas like metals, automobile, ITeS, pharmaceuticals, hospitality etc.

Not so positive

However, statistically speaking, the reforms have not been adequate in putting India firmly on the path to become a middle income economy.

On relative basis, the peer economies like China, South Korea, Thailand etc. have done better than India. Our share in global trade has only marginally increased to ~3%, while China more than tripled it share in global trade to over 17%.

 Not making national education & youth policy an integral part of reforms has perhaps been a grave mistake. The growth in India has definitely failed in ensuring adequate employment generation. Despite significant reduction in agriculture’s share in national income, the percentage of population dependent on farm sector continues to remain in excess of 60%. We have miserably failed in exploiting the demographic dividend.

Though, the financial markets developed a global scale infrastructure, we have not been able to implement a robust system for early detection of frauds and scams. Consequently, the investors continue to lose significant amount of money due to frequent scams and frauds in banking system and financial markets.

Many recent steps taken by the government indicate that the policy makers are full cognizant of the inadequacies of Indian economy. The new education policy, schemes and incentives to promote local manufacturing and exports, farm sector reforms, etc. are important steps that shall help in overcoming these inadequacies in the decade of 2020s.