Vijay Kumar Gaba: Lehman Bros

Wednesday, February 28, 2024

Cognitive dissonance- 2

Continuing from yesterday’s post, let me share my thoughts on the issues raised therein.

If the condition of the economy is so bad, why are the equity markets booming?

In my view, there is nothing unusual or unprecedented in the current equity market behavior. We have witnessed markets scaling new highs during 1989-1994 (Sensex up 482%) when the global economy was struggling in the aftermath of the severe global economic slowdown; NATO forces attacking Iraq and a sharp rise in energy prices; India facing a severe balance of payment crisis, needing an IMF bailout; fall of National Front government in two and a half years and subsequently Chandrashekhar government within six months, and a minority government led by P. V Narasimha Rao at the helm in Delhi; first major financial market (Harshad Mehta) scam in India; belligerent BJP taking out Rath Yatra from Somnath to Ayodhya, Mosque demolition in Ayodhya and subsequent acts of terrorism that killed thousands; a slew of economic reforms causing the decimation of numerous MSME businesses. Commodities producers led the charge in this rally.

During 1999-2000, markets scaled new highs (Nifty up 42%) despite massive political uncertainties (3 general elections in 3 years); severe global economic sanctions post-1998 nuclear tests leading to sharp growth deceleration and capital outflows; LTCM default; sharp currency devaluation by Brazil, an Asian economic crisis; etc. The market rally was however very narrow, mostly led by IT services and the Internet.

The 2003-2007 market move was perhaps the most phenomenal (Nifty up 461%). Markets scaled new highs without any earnings growth. Corporate and lenders’ balance sheets worsened at an unprecedented pace – both in India and globally. The up move was much broader with consumers, financials, and capex all contributing in some measure.

The 2017-2024 market rally is remarkable in more than one sense (Nifty up 170% so far). First, it is perhaps the longest bull market in India. It survived the worst pandemic in over 100 years, rather easily. It has also survived, perhaps what could be termed the worst geopolitical crisis since the end of the Cold War. The leadership of the rally has rotated remarkably between a variety of sectors like consumers, financials, small and midcaps, capital goods, infra builders, realty, commodities, energy, healthcare, IT services, telecom & digital, etc.

My take on the current equity up move is:

1. Equity markets have always looked for opportunities in the crisis. The markets are looking much beyond whatever is happening today. Of course, there will be intermittent corrections and crashes, but Indian equities are geared for much longer bull markets this time, regardless of the global conditions. We have seen similar secular bull markets in the US, Europe, Japan, etc. in the post-WWII era.

2. The Indian equity market may be inching towards reality, i.e., rising income inequalities, stressed household finances, geopolitical uncertainties, and near-shoring and friend-shoring. The market is rewarding premium consumption, workforce rationalization (cost cutting), geopolitics (defense), local capex, manufacturing, and logistic infra, etc., and punishing staple consumption, savings, etc.

3. The market is not expecting any significant disruption due to civil unrest or political changes.

…to continue tomorrow

Tuesday, August 22, 2023

Layers of Nimbostratus fast covering the sun

Last week media headlines prominently mentioned that Michael Burry, the famous fund manager who earned his clients billions by positioning short on the US securities during the subprime crisis of 2007-08, has recently bought put options on S&P500 and Nasdaq100 worth totaling US$1.6bn in nominal value.

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.