Vijay Kumar Gaba

I vividly remember it was the winter of 2007. The global markets were in a state of total disarray. The subprime crisis was unfolding in the developed world.

Continuing from yesterday (see here).

I am convinced that the current global monetary and fiscal conditions will have an enduring impact on the global financial system, trade, businesses, and markets. We may feel comfortable with the resilient performance of the Indian economy and markets in the past couple of years, but it would not harm if we factor in the global conditions and trends in our investment strategy. In particular, household investors with relatively smaller portfolios need to exercise due precautions to protect their portfolios from a negative shock.

I have negligible knowledge of global economics, financial systems, and markets. I therefore usually approach these larger issues with common sense and my elementary understanding of the basic concepts of economics. History, of course, always provides some useful support.

I usually study the historical behavior of economies and markets to anticipate the likely actions and reactions of the current set of market participants and policymakers. It is my strong belief that the reaction of investors and fund managers in their 30s or early 40s, who have never experienced borrowing costs in high single or double-digit; policymakers who have not governed through prolonged periods of war, human misery, uncertainty, lack of information, and are not particularly committed to ethics, ideologies, and standards seen during crisis during would react the same way as their predecessors acted/reacted during 1920-1940; 1950-1960, 1970-1980, and even 1990s.

I may be wrong here, but I believe that the policymakers today are governed by the principle of SoS (Save our Souls first). Their natural tendency is to protract the inevitable decision (kick the can) as long as possible rather than make hard decisions that provide sustainable solutions. Similarly, the market participants are also influenced by their inexperience. To me, this implies that the global policymakers and market participants are not adequately prepared to face a material event (credit, geopolitical, natural); and may panic easily and excessively if such an event were to occur. We have seen glimpses of such panic during the outbreak of the Covid-19 pandemic in the year 2020.

Considering that the present global economic, financial, and geopolitical conditions are much more fragile as compared to the summer of 2020, the contagion will spread much faster, wider, and deeper. Therefore, hiding under the shelter of the assumption that India shall mostly remain immune to the impending global crisis may not be a good idea for smaller investors for the simple fact that their capital is much more precious (much higher marginal utility) as compared to the larger or institutional investors.

With this background, I may now share my views about the five points I mentioned yesterday:

1.    Whether the Fed is done with hiking: In my view, this question is not important as of now. A 25bps hike in the next meeting would not make much of a difference, as the previous hikes are still permeating through the financial system. The lending rates may continue to rise even if the Fed does not hike any further.

2.    Will the rates stay higher for longer: In my view, yes. I believe higher rates are arguably the most effective method to bring down the indebtedness of the US government. The federal bond prices have already fallen by 25-40% in the past year, from their recent highs. A 2% rise in yields would shave off another 20 to 30% in bond values. In the meantime, the Fed is creating leverage (through QT) to buy back bonds at half the face value. Large corporations with tons of cash parked in treasuries, hedge funds with leverage positions in treasuries, and the US trade partners with a surplus (China, etc.) would bear much of the losses. Pension funds etc. which hold most securities till maturity may not suffer much. Savers may enjoy higher rates offered by the fresh issuances. Since most new issuances would be at a much higher coupon rate, these may automatically enforce fiscal discipline over the next 2-3 years.

In the interim, however, we may see severe pain in the financial markets as the excesses of the past two decades are obliterated.

3.    Hard landing or soft landing: In my view, it would most likely be a growth recession – a prolonged phase of low or no real growth, as the US economy adjusts to a normalized monetary and fiscal policy mechanism and the USD is freed of onerous responsibility of being the only global reserve currency.

4.    Impact of higher rates on USD: In my view, the normalized interest rates would eventually result in a much less volatile and stronger USD.

5.    Impact of a softer US economy on the global economy: A softer US economy now would be bad news for the global economy and therefore markets. However, over the medium term, a fiscally disciplined US economy (with higher domestic saving rates, positive current account balance, and refurbished infrastructure) could provide strong support to the global economy, especially the emerging economies, much in the same way it did in the 1950s and 1990s.

How do I build this in my investment strategy…will share as I figure it out.

Post the latest meeting of the US Federal Open Market Committee (FOMC), the market narrative is primarily focused on the following five points –

(i)      Whether the Fed is done hiking rates or it may hike once more in 2023.

A larger section of market participants believes that the Fed may hike another 25bps by the end of 2023 and then pause for 6-9 months before cutting the rates from 4Q2024. Another section is however of the view that the economic conditions are too tight to tolerate another hike. This section believes that the hiking cycle of the Fed may well be over and we may see rate cuts from 2Q2024 itself.

(ii)     Whether the treasury yields and other lending rates in the US economy will stay “higher for longer”, as forecast by the US Fed, or we shall see a faster decline, as the economic conditions deteriorate.

The higher rates have already started to reflect a slowdown in the US housing market. The rate of bankruptcy filings has also reportedly reached the 2008 levels. We have already witnessed one round of trouble in the regional banks, which was contained by the Fed support; but the fragility of smaller banks and pension funds remains pronounced.

(iii)   Would the US economy witness a gradual bottoming out (soft landing) or will it contract quickly into recession (hard landing) as the higher rates permeate through the economy?

The US Fed has reduced its balance sheet by over US$940bn since April 2022, while the US public debt has increased by ~10% to US$33trn in this period. A recession may prompt the Fed to unleash another round of quantitative easing (QE) through balance sheet expansion; whereas a controlled slowdown may permit it to further contract its balance sheet (QT).

(iv)    How would the “higher for longer” rates impact the US dollar?

In recent quarters, we have witnessed a tendency to reduce the USD treasury holdings amongst some of the major holders of the US treasury, e.g., China, Japan, and Saudi Arab. Besides, the percentage of USD invoicing in global trade has also come down. Some central bankers have increased their holding of gold, and cryptocurrencies have also gained larger acceptance. The question therefore is whether we are likely to witness a prolonged phase of USD weakness.

(v)     How would a softer US economy or a US recession impact the overall global economy?

The growth rate in the Chinese economy has been slowing down for the past many quarters despite frequent attempts to stimulate growth. Despite showing promise, the Japanese economy has not been able to accelerate its growth. Most major European economies are struggling to avoid recession. Some emerging economies, like India and Indonesia etc., have shown resilience; but a slower US economy could potentially have a more severe impact on the overall global economy, as compared to the global financial crisis period (2009-2010) when growth in emerging economies like China and India sustained at much higher rates.

I am too small an insect to comment on these larger global issues. Nonetheless, I retain the right to assess the impact of outcomes on my tiny portfolio of investments. I shall be happy to share my naïve thoughts on these issues that I will take into consideration in the next couple of years…more on this tomorrow.

From various recurring events that generate significant anticipation and anxiety amongst market participants, the speech of the US Federal Reserve chairman at Jackson Hole annual symposium is the most popular one. This year the speech is scheduled to be delivered on 26^th August. Since, the markets are again filled with anticipation and anxiety. I find it pertinent to highlight a few things about the event and its likely consequences.

Jackson Hole is Davos in Wyoming

Later this week the Fed Chairman Jerome Powell is scheduled to make a speech in a symposium held in Jackson Hole valley (Wyoming, USA). This annual symposium, sponsored by the Federal Reserve of Kansas City, has been held since 1978; and in Jackson Hole since 1981. The symposium is usually held in the month of August, just ahead of the pre scheduled US Federal Reserve Open Market Committee (FOMC) meeting in September.

Many prominent central bankers, finance ministers, reputable academicians and market participants take part in this symposium to discuss the currently important issues facing the global economy. In the distant past, some reputable economists, like James Tobin (Tobin Rule) and John Taylor (Taylor Rule), have presented their path breaking papers at the symposium.

It is customary for the US Fed representative (Usually the Chairman or a senior official) to present their thoughts on the topic selected for that year’s symposium. The topic for the 2022 symposium is “Reassessing Constraints on the Economy and Policy”.

There have been a couple of instances (Paul Walker 1982 and Greenspan 1989) where the US Fed representatives dropped some hints about the imminent policy changes in the ensuing FOMC meetings. But those hints were incidental and not by design. Otherwise, there has been no instance where the thoughts of the US Fed representatives have actually digressed from the given topic for the symposium. Nonetheless, various experts have been regularly conducting a post-mortem of their speeches to find mentions of the words and terms which they can use to market their own views in the garb of the Fed’s hints.

In fact in the past two decades, no path breaking paper has been presented at the symposium and Fed chairman speeches have been noted for all the wrong reasons; most notable being the Bernanke dismissal of sub-prime crisis (2007); and Greenspan’s advocacy for expansionary policies (2005), which was heavily criticised by Raghuram Rajan in 2005 and rest of the world in 2008.

It would therefore be not completely wrong to say that the Jackson Hole event is now mostly irrelevant for the financial markets. A harsher criticism would be to state that Jackson Hole is on the path to become the American version of annual outing of worlds’ elite held by an NGO (World Economic Forum) in Europe’s Davos.

For records, at the last year Jackson Hole symposium, the Fed Chairman did not say or hint anything that had not been said at previous FOMC meetings, Congressional testimonies and various public speeches. The focus was on the topic of the symposium (“Macroeconomic Policy in an Uneven Economy”) rather than the monetary policy of the US Federal Reserve. In fact, to highlight the role of monetary policy in the current macroeconomic environment, Chairman Powell had mentioned that “The period from 1950 through the early 1980s provides two important lessons for managing the risks and uncertainties we face today. The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation. Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times.” (Speech of Fed Chairman Powell at 2021 Jackson Hole Symposium)

Do not rush to fill your buckets

In case an investor is feeling a rush to act in anticipation of what the Chairman Powell might (or might not) say at Jackson Hole this Friday, I would like to narrate the following to him/her:

If a geologist tells you, “the Himalayan Glaciers are melting fast and there will be no water in the Ganges in the year 2050”; what would be your instant reaction? Will you—

·         Rush to store water in buckets?

·         Begin to explore places which are not dependent on the Himalayan Rivers for their water needs, for relocation in next few years?

·         Commit yourself to the environment conservation by adopting 3R (Reduce, Reuse and Recycle) as part of your life so that the green house emission is reduced, global warming is reversed and the geologists are proven wrong?

·         Dismiss the information provided by the Geologist as fait accompli and get on with your routine life?

I may say with confidence that various people will react differently to this information, but none will rush to store water in buckets, and a very large majority will dismiss the information as fait accompli.

I believe that the finance and economics experts prophesying various policy changes are no different than the Geologist forecasting the end of the Himalayan glaciers; and the investors’ collective reaction to their prophecies is also no different. A large majority of investors dismiss the experts’ views and perhaps no one takes material investment decisions based on these prophecies. Nonetheless, these prophecies do create an environment of great anticipation with usual jitteriness and eagerness in the near term. One mistake most of the investor make in this environment of jitteriness and eagerness to do something, is to not ask themselves—

(a)   What is the situation that is being sought to change?

(b)   How the change would impact the businesses underlying their portfolio of investments?

(c)    How the action they are contemplating to take will protect them from the perceived adverse impact of the change in the status quo?

For example, if Quantitative Tightening (QT) is prompting you to take an action on your portfolio – look at the following US Money Supply chart (M2) chart and decide how long will it take for the US Money Supply to reach pre QE1 level.

The weather in India these days is as diverse as the country itself. There are severe floods (usually not seen in pre monsoon period) in North East; cyclonic storms in East and South East, torrential rains in South; drought in North and scorching heat in North and West. Power supplies are challenges; wheat has ripened early; sugar cane is drier; seasonal vegetable crops have been damaged.

While the equity markets have generally welcomed the Union Budget for FY23, the bond market seems to be majorly disappointed. It may be pertinent to note that the government bond yields had started rising in December 2021 itself, even though the April-October 2021 deficit numbers were very encouraging; and the RBI had categorically assured that the policy stance will continue to be “growth supportive” irrespective of the rising price pressures.

YTD 2022, the benchmark 10yr yield has seen a sharp surge, rising over 55bps. With this the benchmark yields are higher by 100bps from 2020 lows. The higher yields have however not transmitted to the lending rates.

Perfect storm in the bond street

A perfect storm seems to be developing in the Indian bond market.

·         The net government market borrowings are most likely to stay elevated in the midterm as fiscal consolidation is expected to take longer than previously estimated.

·         The inflation is persistently hitting the upper bound of the RBI tolerance range. The Monetary Policy Committee (MPC) of the RBI is widely expected to yield to the pressure of staying close to the curve and begin hiking the rates.

·         The US Fed has already announced the pathway to normalize the near zero interest rates. Besides, the US fed has also announced termination of Covid related quantitative easing (QE) program by March 2022. This could impact the global demand for emerging market bonds

·         The domestic household savings are continuing to slow down, forcing the government to reduce its reliance on small savings funds for deficit financing.

·         The banks are anticipating acceleration in credit growth, shrinking the pool available for bond buying.

·         The RBI has already started unwinding the excess liquidity infused in the system to complement the government’s Covid relief measures.

The ambitious capital expenditure plan of the government would need to be evaluated against a rising rate environment; especially when it largely hinges on the private sector participation in capacity building.

Historically, bond yields had a good negative correlation with the equity returns. The correlation has been much stronger in case of broader markets. It would be interesting to see how things unfold in the coming months.

In its latest meeting the US Federal Reserve Open Market Committee (FOMC) reiterated its position stated in the last meeting. The Committee maintained status quo on the Fed rate (Repo Rate) and its asset (bond) buying program (US$120bn/month). The limit for single counterparty under reverse repo has been raised to US$160bn from the present US$80bn, allowing the banks to park more money with the Federal Reserve.

The Committee reiterated its stance of last meeting, stating that “If progress continues broadly as expected, the Committee judges that a moderation in the pace of asset purchases may soon be warranted”; implying that the FOMC decision on QE continues to be data driven, and the present reading of data guides a gradual unwinding of the monetary stimulus introduced to mitigate the impact of Covid-19 pandemic.

“While no decisions were made, participants generally viewed that so long as the recovery remains on track, a gradual tapering process that concludes around the middle of next year is likely to be appropriate”, the Fed Chairman said in a post meeting conference.

The Chairman also informed that the Committee feels that the Fed is closer to passing the test of “substantial further progress” on employment and inflation. Accordingly, more members now see the first rate hike happening in 2022. It is pertinent to note that in June, when FOMC members last released their economic projections, a slight majority of members had projected rate increase into 2023.

The markets have obviously read what it wanted to in the Fed statement. The bullish response to the Fed statement implies that market is giving more credence to the “slower growth” forecast than the “higher inflation” expectation. The market move post Fed statement implies that the confidence in “November Taper” is much lower given the slowing growth and uncertainties in Chinese markets. Even if the tapering begins in November, the pace may slower than anticipated. Also, the data for the “lift” (rate hike) may not adequate as of now and much more evidence may be required before a concrete lift decision could be taken.

Despite the headline inflation running much higher than the fed target of 2%, FOMC did not appear concerned about price situation. The Chairman repeatedly stressed in his interaction with the press that “he expects price pressures to subside as supply chain factors, goods shortages and unusually high levels of demand return to pre-pandemic levels’; thus reiterating his “transitory” stance on inflation.

Many analysts have related the Fed decision to postpone the question of Tapering to the November meeting, to the debt ceiling fracas in US. “The Fed never makes major changes to policy when there are major unresolved issues in Washington,” said Danielle DiMartino Booth, chief executive of Quill Intelligence. “Between the debt ceiling, budget resolution and potential for a government shutdown, there are plenty of political reasons for the Fed to not change policy.”

In my view, Fed would refrain from taking any decision till the (i) concerns over Covid-19 variants subside materially; (ii) political fracas in US ends amicably; (iii) dust created by Evergrande settles down and (iv) “transitory” nature of inflation is denied. November Taper, if at all happens, would be slow (may be US$10bn/month) and protracted. The rate hike decision is still in the realm of speculation.

 The latest macro data indicates that the Indian economy may be standing at an inflection point. It may have survived a major accident in the form of Covid19 pandemic; luckily scraping through with couple of broken bones and some bruises. The economy is recuperating well and is perhaps ready for discharge from the hospital. Of course, for next few quarters the economy may still need to use the crutches of government spending, before it could walk on its own.

The amount of bill for the recovery from pandemic would mostly be known in next six months. We would also know how the cost of pandemic would be shared between various stakeholders, i.e., government, citizens and businesses.

Post pandemic, the challenges before the government are multifold; and so are the opportunities. A successful resolution of these challenges could trigger a virtuous cycle of growth and catapult the economy to the higher orbit. A failure may not be an option, as it could cause a disaster of unfathomable proportion.

The popular words of Jigar Moradabadi may be used to describe the proposition before the Government of India “ये इश्क़ नहीं आसाँ इतना ही समझ लीजे, इक आग का दरिया है और डूब के जाना है”.

1. Broken bones need to be strengthened

The foremost priority of the government should be to strengthen the broken bones (MSME Sector and Unorganized Labor). In fact, these two bones were weakening since demonetization in November 2016. Implementation of GST from July 2017 stressed these further. The pandemic was yet another major blow to these two segments.

Many MSMEs may have lost market share to the larger organized players. The changing consumer behavior in favor of digital platforms also seems to have impacted them. Broken supply chains and tighter credit norms also presented challenges before them.

According to a survey by community platform LocalCircles, “about 59 per cent of the startups and micro, small and medium enterprises (MSMEs) in India are expected to scale down, shut down or sell themselves this year due to the impact of the second wave of Covid-19 pandemic.”

Unorganized labor faced large scale displacement due to the pandemic. Many have since returned to their previous places of work; but the challenges remain. Not all of them have got work due to a variety of reasons. The urban unemployment level remains elevated despite economy opening up materially.

CMIE highlighted that the composition of this fall in employment in August reveals the challenges India faces in providing jobs. The loss was essentially in farm jobs. Non-farm jobs increased to absorb a very large proportion of the jobs shed in the farm sector to leave a net deficit of 1.9 million jobs. However, the non-farm jobs that expanded were mostly not the kind that could be considered good quality jobs.

2. Driver to accelerate growth need to be applied urgently

The drivers for the acceleration of the growth to swiftly recoup the deficit of two years need to be identified and applied. The government has shown intent to turn this crisis into an opportunity by pushing through some key reforms, especially in farm and manufacturing sectors. For example-

·         The government consolidated 44 labour laws into four codes under the Wage Code Bill, Industrial Relations Code 2020, Occupational Safety, Health & Working Conditions Code 2020 and Social Security Code 2020.

·         The three farm laws -- the Farmers' Produce Trade and Commerce (Promotion and Facilitation) Act, the Farmers (Empowerment and Protection) Agreement on Price Assurance and the Farm Services Act and the Essential Commodities (Amendment) Act – have been implemented to allow farmers to sell their farm produce at a price of their own choosing and even outside their respective states, thereby leading to better rural incomes.

·         The production-linked incentive (PLI) scheme rolled out for many sectors, covering a wide gamut of products and technologies, to encourage the domestic manufacturing sector, promote exports and make the country an integral part of the global supply chain.

·         FDI limits increased in key sectors like defense production, insurance, telecom etc.

·         Significant amendments made in Minerals and Mining laws to end monopoly of Coal India.

3. We need to go way beyond mere ‘V’ shape recovery

Merely achieving a full ‘V’ recovery to the pre pandemic level of economic activity will be inadequate, since pre pandemic the economy was slowing for many years and was completely unable to generate adequate jobs for the burgeoning youth population. The government will need to apply multiple accelerators for the sustainable growth to reach to the target of 8% plus.

4. …while preventing a regression to ‘K’ shape

Fourth, the pandemic has widened the divide in the society, as the recovery so far has been rather ‘K’ shaped. Income and wealth inequalities have widened. Disparities in access to digital infrastructure have amplified the divide in social sectors like healthcare and education. The gap between organized and unorganized sectors has enlarged materially. To maintain harmony and peace in the society, these gulfs would need to be managed.

As per a study done by the Azim Premji University scholars, “one year of Covid-19 pandemic has pushed 230 million people into poverty with a 15 per cent increase in poverty rate in rural India and a 20 per cent surge in urban India."

CMIE data showed that “the unemployment rate has gone up as high as 12 per cent in May 2021, 10 million jobs have been lost just on account of the second wave and 97 per cent of the households in the country have experienced declines in incomes”.

As per the study published by Azim Premji Foundation, almost 60% children cannot access online learning opportunities. Reasons for this varied from absence of a smartphone, multiple siblings sharing a smartphone, difficulty in using the Apps for online learning, etc. The issue of access is further exacerbated for children with disabilities. Among teachers of children with disabilities in their regular classes, more than 90% found them unable to participate in online classes.

Of course there is no credible precedent to show that these gulfs could be narrowed materially through state efforts alone. Nonetheless, by building strong bridges (Opportunities and Access) between the two sides which allow the underprivileged to freely and smoothly cross over to the other side, a positive momentum could definitely be created.

5. Need to prepare for short term disruptions that QE unwind might cause

The ultra-loose monetary policies were adopted by the central banks across the world to mitigate the damage caused by the pandemic. These would need to be reversed at some point in time.

 6. Northern borders need to be guarded even more closely

While the world continues to recuperate from the pandemic the geopolitical standoff in Asia is worsening with Afghanistan becoming a symbolic battlefield between US and China (supported by Russia). The worries for India on Northern and North Eastern borders have risen materially with China & Pakistan supported Taliban taking control of Afghanistan, and complete exit of US forces from the region.

7. Erratic Monsoon may spoil the Diwali party

The erratic monsoon and continued supply chain issues mean that the prices of essential commodities (most notably Onion) could rise materially in the forthcoming festival season. As the process of elections in key states of UP & Punjab (and three others) will start around Diwali, keeping food prices under control would be a challenge for the government.

Augmenting supply may not be adequate

The direct measures that the government could take to support the economic recovery are broadly divided in two categories, i.e., (i) the measures to increase the production of goods and services or the supply side measures; and (ii) the measures to support the higher consumption for goods and services or the demand side measures.

The supply side measures usually include direct investment in building enabling infrastructure and augmenting production capacities; or providing incentives to the private sector for investing in capacity building. Some popular supply side measures include building and/or augmenting physical infrastructure and providing investment linked monetary and fiscal incentives, easing production and sales curbs on regulated commodities, relaxing restrictions on import of foreign goods and capital, augmenting money supply and easing credit norms for businesses, etc.

The demand side measures usually include providing monetary and fiscal concessions and incentives to consumers to stimulate demand and increase the utilization of existing capacities. Some popular demand side measures are interest subvention, direct cash benefits, rebate in taxes and levies, subsidizing the retail prices, and relaxing credit norms for consumers, etc.

It is felt that the government strategy to deal with the crisis so far has focused more on supply side measures. The measures to augment demand have been few and inadequate.

The supply side measures that included significant increase in the outlay for infrastructure building, PLI schemes for building capacities to substitute imports and promote exports, aggressive targets for achieving the committed emission norms, credit guarantees, accommodative monetary policy stance etc. These measures are beginning to show some results in terms increased construction activities and higher exports.

The demand side measures included direct cash distribution to farmers and laborers, encashment of LTC, interest subvention on affordable housing, some duty cuts, etc. These measures were materially offset by steep hike in fuel prices, food inflation, wage cuts, higher cost of education and lower rate on savings, etc. Consequently, the household debt has seen sharp rise, private consumption continues to slow down, and unemployment level stays elevated.

Government reluctant to spend

As per CMIE, “GDP data revealed that besides the second wave of Covid-19 deficient government spending constrained India’s economic recovery in the June 2021 quarter from the slump of fiscal 2020-21. Government final consumption expenditure (GFCF) fell year-on-year by 4.8 per cent in real terms during the quarter.

The government expenditure here includes public spending by both, the central and the state government. As per the data released by the Controller Auditor General (GAG), 20 state governments reported a 17.2 per cent increase their expenditure in the June 2021 quarter. But, the central government, on the other hand, kept its expenditure constant at the year-ago level. In real terms, this implies a 4.9 per cent fall in central government expenditure.”

 UBI could be one solution

As highlighted by the World Resource Institute, “About 90% of India’s workforce is informally employed, which includes gig economy workers. This population is extremely vulnerable to economic shocks and needs greater access to formal credit and social safety nets such as insurance and pension schemes.

Beyond employment guarantees, a universal basic income – broader than current schemes that are conditional upon occupation and land ownership – can help provide vital resources for subsistence, or for investing in education and health.”

Household debt needs to be contained

 If a geologist tells you, “the Himalayan Glaciers are melting fast and there will be no water in the Ganges in year 2050”; what would be your instant reaction? Will you—

·         Rush to store water in buckets?

·         Begin to explore places which are not dependent on the Himalayan Rivers for their water needs, for relocation in next few years?

·         Commit yourself to the environment conservation by adopting 3R (Reduce, Reuse and Recycle) as part of your life so that the green house emission is reduced, global warming is reversed and the geologists are proven wrong?

·         Dismiss the information provided by the Geologist as fait accompli and get on with your routine life?

I may say with confidence that various people will react differently to this information, but none will rush to store water in buckets, and a very large majority will dismiss the information as fait accompli.

I believe that the finance and economics experts portending about various policy changes are no different than the Geologist forecasting end of the Himalayan glaciers; and the market’s reaction to their prophecies is also no different. A large majority of investors dismiss the experts’ views and perhaps no one takes material investment decisions based on these prophecies.

Nonetheless, these prophecies do create an environment of great anticipation with usual jitteriness and eagerness in the near term. One mistake that most of the common investor make in this environment of jitteriness and eagerness to do something, is to not ask themselves—

(a)   What is the situation that is being sought to change?

(b)   How the change would impact the businesses underlying their portfolio of investments?

(c)    How the action they are contemplating to take will protect them from the perceived adverse impact of the change in the status quo?

For example, take the case of experts’ prophecies regarding gradual termination (tapering) of the latest assets buying program of the US Federal Reserve (the Fed). For past few months, almost every finance and economics expert has spoken and/or written about the imminent decision of the Fed to taper its assets buying program and its likely impact on the markets. The markets have been witnessing intermittent bouts of volatility whenever any official of the Fed or a reputable expert speaks/writes about this change.

Jackson Hole is Davos in Wyoming

Last week the Fed Chairman Jerome Powell was scheduled to make a speech in a symposium held in Jackson Hole valley (Wyoming, USA). This annual symposium, sponsored by Federal Reserve of Kansas City, is being held since 1978; and in Jackson Hole since 1981. The symposium is usually held in the month of August, just ahead of the pre scheduled US Federal Reserve Open Market Committee (FOMC) meeting in September.

Many prominent central bankers, finance ministers, reputable academicians and market participants take part in this symposium to discuss the currently important issues facing the global economy. In distant past, some reputable economists, like James Tobin (Tobin Rule) and John Taylor (Taylor Rule), have presented their path breaking papers at the symposium.

It is customary for the US Fed representative (Usually the Chairman or a senior official) to present their thoughts on the topic selected for that year’s symposium. The topic for 2021 symposium was “Macroeconomic Policy in an Uneven Economy”.

There has been couple of instances (Paul Walker 1982 and Greenspan 1989) where the US Fed representatives dropped some hints about the imminent policy changes in the ensuing FOMC meetings. But those hints were incidental and not by design. Otherwise, there has been no instance where the thoughts of the US Fed representatives have actually digressed from the given topic for the symposium. Nonetheless, various experts have been regularly conducting a post-mortem of their speech to find mentions of the words and terms which they can use to market their views in the garb of the Fed’s hints.

In fact in past two decades, no path breaking paper has been presented at the symposium and Fed chairman speeches have been noted for all the wrong reasons; most notable being the Bernanke dismissal of sub-prime crisis (2007); and Greenspan’s advocacy for expansionary policies (2005), which was heavily criticised by Raghuram Rajan in 2005 and rest of the world in 2008.

It would therefore be not completely wrong to say that Jackson Hole event is now mostly irrelevant for the financial markets. A harsher criticism would be to state that Jackson Hole is on the path to become American version of annual event held by an NGO (World Economic Forum) in Europe’s Davos.

For records, at this year Jackson Hole symposium, the Fed Chairman did not say or hint anything that had not been said at previous FOMC meetings, Congressional testimonies and various public speeches. The focus was on the topic of the symposium rather than the monetary policy of US Federal Reserve. Mr. Powell just reiterated, “The Committee (FOMC) remains steadfast in our oft-expressed commitment to support the economy for as long as is needed to achieve a full recovery. The changes we made last year to our Statement on Longer-Run Goals and Monetary Policy Strategy are well suited to address today's challenges.”

If you were also bothered about the taper signaling at Jackson Hole, the Fed Chairman actually hinted that they have taken lessons from the past instances of Fed trying to stay ahead of the curve and hurting the markets. Mr. Powell said, “The period from 1950 through the early 1980s provides two important lessons for managing the risks and uncertainties we face today. The early days of stabilization policy in the 1950s taught monetary policymakers not to attempt to offset what are likely to be temporary fluctuations in inflation.¹⁵ Indeed, responding may do more harm than good, particularly in an era where policy rates are much closer to the effective lower bound even in good times.”

So where do you see the scope of any action by the mighty US Federal Reserve, that would even marginally harm the investors’ interests!

Dealing with Taper Tantrums

Now coming to the Taper tantrums, it is important to understand the implications of the Fed’s assets buying program; simply because the impact of the tapering will entirely depend on these.

Fed’s Large Scale Asset Purchase Program (QE)

The Fed started a Large Scale Asset Purchase Program on 25^th November 2008 (QE1) to “manage the supply of bank reserves to maintain conditions consistent with the federal funds target rate set by the FOMC”. The idea was to provide enough liquidity support to stabilize the financial system and stimulate faster growth. The program was executed by increasing money supply (Quantitative Easing or QE) through purchase $175 billion in agency debt, $1.25 trillion in agency MBS, and $300 billion in longer-term Treasury securities. It was also decided to reinvestment the principal amount received on maturity of the securities purchased under the program.

The Second Round of the Program was started on 3^rd November 2010 (QE2) to purchase $600 billion in longer-term Treasury securities.

The Third Round of the program (QE3) was started on 13^th September 2012 and included a total purchase of $790 billion in Treasury securities and $823 billion in agency MBS during September 2012 and October 2014.

Overall, close to US$4trn were added to bank reserves during 2008-2014 under the three rounds of Asset Purchase Program by the US Federal Reserve. Besides, these purchases, the Fed also implemented Operation Twist under which it managed to extend maturity of over US$660bn US government securities.

On 16^th December 2015, the FOMC noted that the conditions set for normalization of monetary policy have been achieved, and process of normalization of target rate could now begin. The actual normalization process started in October 2017 when the Fed “decreased the reinvestments of principal payments from the Federal Reserve’s securities holdings”.

The tapering of first three rounds of QE did not entail any Sale of securities by the Federal Reserve. It just implied that the Federal Reserve will not reinvest the amount received in maturity of the securities purchased under the program. The maturities may happen over a period of up to 25yrs.

Consequently, the assets on the Fed’s balance sheet decreased from the peak of US$4.5trn in winter of 2014 to US$3.8trn in the summer of 2019.

To support the economy in the wake of lockdown imposed to mitigate the impact of Covid-19 pandemic, the fed started the latest round of its Asset Purchase Program (QE4), as the Fed cut back its target rate back lower. QE4 has resulted in the Fed’s balance sheet ballooning to over US$8trn, a rise of over 100% in less than 2yrs time.

Presently, the fed is buying US$120bn worth of securities every month from market.

Five things to note from this—

(a)   The US Federal Reserve’s asset purchase program aims to achieve the FOMC’s target rate, implying that the assets are purchased by Fed to keep rates lower by supplying adequate liquidity to banks.

(b)   Tapering does not mean immediate sale of securities held by the Fed. It just means not buying more and/or refraining from reinvesting the maturities as and when these occur.

(c)    If US$120bn/monthly purchases are decreased by US$20/month, it would still mean that Fed will still be adding US$300bn more to its balance sheet in next 6months.

(d)   Fed balance sheet had started to increase in November 2019, even before the pandemic forced worldwide lockdown. If the circumstances need, the Fed shall again restore its QE program, like in 2020.

(e)    US Fed is not the only Central Banker in world which is running a QE program. European Central bank (ECB), Bank of England (BoE), and Bank of Japan (BoJ) are also running major QE programs.

QE is win-win for the Fed and US economy

The cost of funds for the Fed is zero. So when Fed buys interest bearing securities from the market and infuses more liquidity in the system, five things happen –

(i)    Fed is able to earn substantial income on the securities so purchased;

(ii)   The interest rates in the economy are pegged lower, thus helping the government to finance its fiscal deficit at lower cost;

(iii)  Fed repatriates its income surplus to the Federal government by way of dividends, which also helps reducing the fiscal deficit;

(iv)   The additional liquidity supplied by the Fed helps to stabilize the financial system and supports the economic growth; and

(v)    QE keeps the USD from strengthening and thus helps the trade account of US.

It is thus a win-win arrangement for the Fed and US economy. There is no reason to believe that QE will be completely terminated without significant improvement in the US economy or an even more attractive alternative to QE emerging.

QE is not same as Fiscal easing

Quantitative Easing (QE) must be understood different from the fiscal easing. In case of fiscal easing the government borrows money from the market and hands out immediate benefits to the people and businesses in the form of tax cuts, subsidies, incentives and cash payouts; whereas in case of quantitative easing, the central bank provides reserves to the commercial bankers so that they can meet the increased credit demand, without pressurizing the lending rates. The decision to lend or not to lend, and decide the actual lending rate remains with the banks.

QE and Bank Credit are poorly correlated

From 2008 to 2014 almost every penny of QE was getting accumulated in banks’ excess reserves (liquidity with banks that can be given as loan). It was only in 2016 (after taper tantrum started) that banks started to grow their loan books by running down on reserves. The excess reserves have again increased sharply in 2021 to an all-time high of over US$4trn.

The argument that the tapering will suck out liquidity from the system therefore does not appear to be fully supported. It is true that the mortgage rates had risen from 3.5% in 2016 to ~5% in early 2019. However, correlating this fully with the tapering may not be justifiable. This period saw sharp rise in economic growth, asset prices and therefore credit demand. Besides, the rates had started falling from mid-2019 when growth started faltering, much before the pandemic and QE4 started. 

QE and Indian investors

Insofar as India is concerned, there is little evidence to highlight any strong correlation between QE and foreign flows, market performance and economic growth.

In past 20 months the US Fed has done over US$4trn in QE. However, the Indian secondary markets have received a paltry US$9.7bn in net FPI inflows. The net FPI inflows since 2010 have been less than US$35bn against QE amount of US$8.3trn. Five out of past 12 years have witnessed negative FPI inflows. Nifty returns have shown very poor correlation to net FPI flows in a particular year; even though on day to day basis, a stronger correlation might exist.

Besides, India’s external position is much stronger as compared to 2013-16 taper tantrum period. The present situation of the current accont balance, short term foreign currency debt and forex cover is substantially better than the 2013-2016 position.

What to do? – Do not fill your buckets for now!

The question now is “what a common Indian investor do when the Fed actually announces a tapering by the end of 2021, as widely expected, or refrains from doing so?”

In my view, the answer is “Nothing”.

The common investors must note that QE of 10yrs may not have played any direct role in construction and performance of their respective investment portfolios. They must also keep faith in the collective wisdom gained by of the central bankers of the world since the global financial crisis; and believe that they would not do nothing to harm the still fragile global economy, weak in the knees markets and governments with explicit socialist agendas.

Therefore, it would be prudent to not take any investment action merely because of quantum of QE done or not done by the Fed. (No water storage in buckets)

An action on the investment portfolio would be needed only if any pertinent change is witnessed in the prospects of the underlying businesses. (Look for businesses that are likely to grow regardless of central banks’ actions)

As a prudent policy they should maintain a balance between Safety, Liquidity and Returns (SLR) factors in their respective portfolios. (Own businesses that will survive the volatility; hold sufficient liquidity for the transition phase; invest in businesses that promise sustainable higher return)