Vijay Kumar Gaba

In the US, the financial system was on the verge of collapse. Several banks, insurers, and other financial institutions were reporting massive write-downs on their subprime Collateralized Borrowing and Lending Obligations (CBLO). The cost of protecting debt (Credit Default Swaps) was rising sharply. The US administration and Federal Reserve were mostly in denial, at least in their public posturing; even though the Fed had started to cut the benchmark fund rates from September 2007.

Signs of a sovereign debt crisis had started emerging in peripheral Europe. In countries like Portugal, Iceland, Greece, and Spain (popularly called PIGS) treasury default swaps had spiked to indicate imminent default.

The financial markets in the developed world had started correcting sharply. Both equity and bond prices had fallen. The emerging markets were however doing relatively better. The investment strategists at the large global banks were coining terms like BRIC (Brazil, Russia, India, China) and Frontier Markets (including Pakistan, Bangladesh, Bahrain, etc.) to distract investors from the crisis in the developed markets and peripheral Europe. Many of these markets like India and Pakistan had become the best-performing global markets in the October 2007-January 2008 period. Bangladesh and Sri Lanka had also done extremely well.

Despite the financial system in the developed markets collapsing and talks of bail-out gaining currency, a section of the market started forecasting hyperinflation, matched only by the inflation preceding the great depression in the 1930s. The resource-rich Latin America was becoming the hot investment theme. Numerous Latin America and Natural Resource funds were launched to collect billions of dollars in fresh investment worldwide.

This was the time when a renowned commodity guru, Jim Roger forecasted an unprecedented commodity super-cycle. I had an opportunity to meet him in person in the spring of 2008 when he was speaking at the prelaunch event of the Natural Resource Fund by an Indian fund house in Mumbai. In a brief 15-minute interaction, I found his knowledge of economics, global finance, and strategic affairs quite ordinary. He appeared to be a smart trader who would sense opportunity in commodities markets and rotate his positions swiftly.

Nevertheless, all the assumptions of global experts and gurus were demolished in the next 12 months. BRIC and Frontier markets performed the worst. Commodity markets went into a long (almost a decade) bearish phase. Investors who relied on these experts lost money, despite the financial stability returning to most troubled countries. Smarter investors who ignored these experts and invested in Greek and Italian bonds at 60c to a dollar raked in the mullah.

I find that the global markets are in the same position as they were in 2007-2008. Experts in their wisdom are making a variety of forecasts.

For example, numerous experts are forecasting the trajectory of Fed rates in 2024 and 2025; even though there is no empirical evidence of any correlation between Fed decisions and experts’ forecasts.

One renowned global strategist has reportedly forecasted a 25% correction in Indian equities if the incumbent regime loses power in the 2024 general elections. Disregarding the fact that there is no empirical evidence of any correlation between political regime and stock market performance in India.

Similarly, there are forecasts of Bitcoin topping US$1,00,000/per coin; gold outperforming financial assets; and Japanese equities doing better than Europe and the US.

There is an intense debate over the US economy skirting (no recession), slithering (soft landing) or collapsing (hard landing) into a recession. The debate on the end game for mountains of debt developed markets have accumulated over the past 15 years, more particularly in the past three years is also intense.

For a tiny investor like me, the situation is very tough. After reading zillions of pages of research, I discovered almost no one (analysts, economists, strategists, government officials, central bankers, et. al.) has any clue about how the situation is evolving. Everyone seems to be arguing from their biases and experiences; and praying to god that their prophesies come true so that they can tell the world “I told ya so”.

The Fed chairman is no exception to this. As you would hear from him tonight, he has literally no control over prices, growth, geopolitical situation, and markets. Regardless, there is an entire industry that will try to establish a correlation between what the Fed says and what happens in the market thereafter.

I have therefore decided to read research reports only for some useful data points and indications towards future trends. I shall avoid the forecasts, conclusions and recommendations, till I find strong evidence of clarity emerging.

The campaign against the incumbent government was so effective that it swayed the big industrialists and SMEs which directly benefited from the government’s developmental efforts; the poor who benefited tremendously from the transformative social initiatives; and the middle classes who were protected from any potential collateral damage from the global financial crisis and events in its aftermath, against the government.

In their disappointment with the then incumbent government, few consider allowing the government any concession for-

(i)      The global financial crisis (GFC) of 2008-09 threatened to push the global economy into the worst condition since the great depression of the 1930s. The Indian economy still managed to grow over 7% during the five-year (FY10-FY14) period post-GFC, notwithstanding the challenging global conditions.

(ii)     A high base effect. The Indian economy had its best phase during 2004-2011; growing over 8% CAGR. Despite such a high base effect and global slowdown, the Indian economy was still growing by over 7% in 2014.

(iii)   The several major policy decisions taken by the UPA government, having a transformative impact on India’s socio-economic milieu. For example—

·         Employment Guarantee (MNREGA) through enactment of Mahatma Gandhi National Rural Employment Guarantee Act, 2005.

·         Food Security for 81 crore poor people through National Food Security Act, (NFSA) 2013

·         Right to Education for all children between the age of 6-14 through The Right of Children to Free and Compulsory Education Act, 2009. (It is pertinent to note that through the 86^th amendment to the Constitution of India in 2002, Article 21A was inserted in the Indian constitution to make Education a fundamental Right.).

·         Right to Information through enactment of the Right to Information Act 2005.

·         Financial Inclusion- provision of banking facilities to all 73,000 habitations having a population of over 2,000 by FY12, using appropriate technologies.

·         Unique Identity for all citizens (Aadhar) through the implementation of Aadhaar and Other Laws (Amendment) Act 2009. Unique Identification Authority of India (UIDAI), has been officially acknowledged as a legislative authority, since July 12, 2016, in accordance with the Aadhaar Act 2016.

·         Digitization of payments through incorporation of National Payments Corporation of India (NPCI) was incorporated in 2008 as an umbrella organization for operating retail payments and settlement systems in India. NPCI facilitates transformative payment solutions like UPI, Bharat Bill Pay, FasTag, and Direct Benefit Transfers (DBT).

·         FDI in retail trade.

·         Civil Nuclear Deal with the US allowing India entry into elite clubs as a key strategic partner.

·         Right to Fair Compensation and Transparency in Land Acquisition, Rehabilitation and Resettlement Act, 2013 to facilitate faster execution of infrastructure projects and minimize litigation in the acquisition of land.

·         Deregulation of transportation fuel prices and eliminating kerosene subsidies that had adversely impacted the fiscal balance of the central government for decades.

·         Including reforms in tax sharing formula between states and center in scope of 14^th Finance Commission (set up in 2013 and recommendation accepted in February 2015) to improve state and center relationships and allow states more autonomy.

·         UPA government also proposed a uniform Goods and Service Tax (GST) in 2007 and a Direct Tax Code later. However, these could not be implemented due to different views of the opposition ruled states.

Instead, some unsubstantiated allegations of mega corruption dominated the narrative and overwhelmed the voters’ sentiment.

It is pertinent to note that some hypothetical charges of corruption in the allocation of 2G spectrum and coal mines raised in CAG reports were blown out of proportion and eventually led to the cancellation of 122 telecom licenses in 2012 and 204 coal blocks in 2014 by the Supreme Court. Notably, in 2017 a special CBI court acquitted everyone accused in the 2G spectrum case stating that the prosecution had failed to prove any charge against any of the accused, made in its well-choreographed charge sheet. Nonetheless, the cancellation of licenses and coal blocks led to the bankruptcies of some entities, causing massive losses to their lenders.

In my view, therefore, it is particularly important to evaluate the performance of the incumbent government in relation to “policymaking”; because good policies have the potential to catapult the economy into a higher growth orbit. Execution of policies and programs indubitably helps in sustaining the momentum, but innovative policies are key to growth acceleration and socio-economic transformation.

...to continue tomorrow

Obviously, the headlines left many traders worried about the markets, particularly, their long positions. The S&P500 index corrected over 2% last week and has now lost over 3.60% in the past month. Besides, the US, markets like Hong Kong (-6%), South Korea (-4.5%), the UK (-5.2%), and Japan (-2.6%) have also corrected in the past month. Indian markets have done relatively better, losing about 2.2% in the past month.

In my view, it’s not Michael Burry’s positioning that is the reason for the market fall; it is the concerns over the stability of the financial system and markets that may have prompted Burry to take a short position.

Pertinent to revisit 2007

Before we take note of the current situation, revisiting the sequence of market events in 2007 may be worthwhile.

By April 2007, over 50 mortgage lenders in the US, which mostly specialized in subprime lending had declared bankruptcy, the largest amongst these being New Century Financial, and over 100 such lenders had already closed their operations. Taking note of the events in the US, all global stock markets had corrected around 10% during June-July 2007 when the media headlines began to be dominated by the subprime crisis unfolding in the US and Europe.

However, to everyone’s surprise (and shock to many who had by then built up massive short positions in the financial markets) the markets rose sharply with Chinese stocks gaining over 40% in just three months and US stocks gaining over 10% during the same period. Most markets made a peak in October 2007 with the top banks like Bear Sterns, Merrill Lynch, and Morgan Stanley showing stress and raising additional capital from Asian sovereign funds; and started their final descent.

The Indian equities however continue to rise till the first week of January, gaining over 50% from the July 2007 low. The Great India Story, There Is No Alternative (TINA) to India, etc. were famously part of the global fund managers’ narrative at that time.

Plane loads of foreign investors with bags full of money were landing daily in Mumbai and Bengaluru. However, the dream run of Indian equities did not last much longer. The correction started on the 8^th of January 2008, and by October 2008, Indian equities had lost about 60% from their January 2008 highs, becoming one of the worst-performing markets in the world.

Notably, the Indian economy had grown 9.3% in FY08, on a high base of 9.5% in FY06 and 9.6% in FY07. In the subsequent three years (FY09 to FY11) the Indian economy recorded an average real growth rate of over 8%. The benchmark bond yields corrected from a high of 9.3% in January 2008 to a low of 5.3% in December 2008; only to rise again to 8.9% in the next twenty-one months.

Ominous dark clouds (Nimbostratus) covering the Sun

The events of 2023 bear some resemblance to 2007. After years of low rates, and supportive money & fiscal policies, the economies have heated. Asset prices have risen sharply showing clear signs of unsustainability and irrationality. Consumer inflation is running high despite accelerated tightening. Debt defaults and bankruptcies have started to happen. Bond yields are rising to multiyear highs. Central bankers continue to remain hawkish; indicating further tightening. Conspicuous signs of an impending economic slowdown are everywhere. The US Government bonds have been downgraded and the major US banks are also under close scrutiny for a possible downgrade. The growth engines of world China and India are not able to accelerate growth.

US economy facing strong headwinds

For the past year at least, the US economy is facing strong headwinds.

·         As the Covid stimulus has started to unwind, the growth has dwindled.

·         The household debt burden is at a record high with diminishing debt servicing capability.

·         Household savings are depleting at an accelerated pace.

·         The interest burden of the US treasury has almost doubled from pre Covid level to appx US dollar one trillion.

·         Fiscal deficit funding faces hurdles as the global demand for the US treasury is declining. Reportedly, the US treasury portfolio of China alone is down by over US$500bn from peak of 2013.

·         Bond yields are at a multi-decade high, inflicting massive MTM losses on bond portfolios of insurance companies, pension funds and banks etc. The leveraged bond portfolios are bleeding badly, raising the specter of a major financial sector crisis.

The growth engine of the world is stuttering

China has been a major driver of global growth in the past couple of decades. In particular, after the global financial crisis, China and India have been the major contributors to global growth, contributing over 15% of total global growth.

The Chinese economy has been struggling to sustain its high rate of growth and consistently reporting lower growth. The growth rates of retail sales, property sales, industrial production, employment, investment, etc., and overall GDP have declined in recent months. In fact, China’s People’s Bank of China, is perhaps the only major central bank that has not increased interest rates even once in the past decade. Several experts have raised questions about the sustainability of the Chinese model of growth in the recent past. Some have even pronounced the end of the Chinese era of economic high growth led by investment in manufacturing and property.

In fact, it is not only China. The fabled BRICs that were seen as a major support to the global economy is struggling. Russia is engaged in a prolonged war. Brazil and South Africa have hardly grown in the past decade. India has been maintaining a decent growth rate, but not adequate to make a significant difference to the global economy. Besides, it is not likely that India’s growth will accelerate in any meaningful measure in FY24-FY25 also.

The next 6 months are critical for global markets

Given the current level of fragility and uncertainty, in my view, the next six months are very critical for the global markets. At present, few would rule out a credit event like the collapse of Lehman Bros, or a sovereign debt crisis like Greece in the near future.

The financial markets will definitely take a significant hit in such an eventuality; even if the central banks resort to indulgent monetary loosening immediately to stem the crisis. 

I am not sure about how many amongst the audience actually concurred with his view, but the first thought that came to my mind was “how would this old man look without a shirt!”

In a recent visit to the financial capital Mumbai, I also had the opportunity to meet some senior market participants (bankers and investors). None of them sounded enthusiastic about the markets. The consensus appears to be strongly favoring a slow grind over the next 6-9months.

Incidentally, the reference point for most of the senior participants is 2008 market crash, in the wake of the global financial crisis (GFC). The fear is that rising cost of funds and fast drying liquidity could trigger some major defaults that could trigger a global contagion like what happened post Lehman collapse in 2008.

Obviously, the senior bankers and fund managers have much wider vision and knowledge base to form their opinion; and therefore are certainly in a better place to foresee what direction the markets are taking. Nonetheless, I am not inclined to agree with their assessment. I strongly, believe that a repeat of 2008 like condition is unlikely, for the following simple reasons:

1.    Contrary to popular perception, the abundant liquidity infused in the global financial system post the GFC, has not resulted in excess return on assets. In the past 15yrs - European Equities (Stoxx600) has returned a mere 0.7% CAGR; Chinese equities have yielded negative return; Japanese equities continue to be lower than their 1990 level; Brazilian equities have yielded about 3.5% CAGR despite very high inflation; US and Indian equities have yielded less than 7% CAGR.

In comparison, during 2005-2007 – the Chinese equities had surged at 131% CAGR; European equities prices gained at 25% CAGR; US equity prices gained at 14% CAGR and Indian equity prices gained 58% CAGR.

Gold, aluminum, copper, crude oil prices (in USD terms) are at 2011 levels, while silver and steel prices are much lower as compared to 2011 levels.

Apparently, there is no bigger bubble to burst this time. There were localized bubble in sectors like US Tech, India internet; Taiwan semiconductor; China real estate etc. which have been punctured in past 9 months and the gas is releasing mostly in an orderly fashion, so far. It is also important to note that unlike numerous infra builders commanding crazy valuation in 2007-2008 (e.g., JPA, Suzlon, GVK, GMR, Lanco, Reliance Infra, KSK et. al.), and totally dominating market activity, the share of crazily valued new age businesses in the overall market is much less this time.

Another bubble was inflated in cryptocurrencies, which has already burst.

2.    The subprime crisis came to light in July 2007 when Bear Sterns announced the implosion of two of its hedge funds due to credit defaults. The market fell 20-25% and rose again to record higher highs in the next 6months. The governments and central bankers were mostly complacent in this period. They kept sitting on fringes waiting for the crisis to blow out in due course.

The global financial markets started to freeze due to threats of sovereign default crisis and sudden surge in energy prices. But it still took months for the governments and central banks to come out with a concrete plan for handling the crisis. The collapse of Countrywide Financials, Fannie Mae and Freddie Mae and Lehman Brothers (September 2008) actually catalyzed the globally coordinated response to the crisis. The markets made a strong bottom in the next six months (March 2009) and have not looked back since then.

While it took more than a year (July 2007 to September 2008) to devise a rescue and revival plan during GFC, the template is now available readily. The template has been tested extensively during the 2020 pandemic induced global lockdown. Despite a worldwide lockdown, no market froze and the panic fall in the markets was corrected in 3-4 months.

Besides, the global markets have handled Brexit; defaults by countries like Argentina, Sri Lanka etc.; China Evergrande crisis; collapse of some large funds and decimation of some cryptocurrencies (and tokens) etc. rather well in the past one decade.

Hence, it is safe to assume that the chances of a global market freeze like 2008 are significantly less.

3.    During the 2003-2007 market rally, the subprime credit was a primary supporting factor. This time it is materially different. This time subprime debt is mostly a tertiary factor. The debt is mostly sitting in the books of the financiers who have funded the investors in private equity funds. These private equity funds have invested in the equity of all these fancy startups. An implosion in the astronomical valuations of these startups would be the ultimate lenders with a significant time lag. Thus the grind could be slower and protracted this time.

4.    The regulatory changes since GFC have materially strengthened the global financial system. The risk management systems and processes are much superior now as compared to pre GFC period. Besides, the global agreements on information sharing systems have reduced the probability of unexpected global contagion.

5.    Leverage in Indian markets is significantly lower as compared to 2008. In 2008, over 55% NSE derivative volume was single stock futures and less than 10% was in Index options. Now 98% of derivative volumes are in Index options and less than 0.5% volume is single stock futures. Besides, cash margins are much higher. Hence, the chances of markets falling 10-15% in a day are much less.

I therefore believe that the probability of markets falling like 2008 due to inflation, slower growth, debt defaults, any other well-known factor or a combination of all these is insignificant. Of course, the markets can crash 30-40% due to some extraordinary ordinary, which is totally unexpected and cannot be foreseen.

In my view, as I said three months ago (see here), we are more likely to witness a “boring” market rather than a “bear” market in India. The indices may get confined in a narrow range and market breadth also narrow down materially. The market activity that got spread out to 1200-1300 stocks in the past couple of years may constrict to 200-250 stocks.

It will be a test of patience as well as endurance of the investors. Not doing much in the next few months would be the best course of action, in my view.