Vijay Kumar Gaba

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

“The crisis of today is the joke of tomorrow” — H. G. Wells (English Author, 1866-1946)

As of this morning, a number of regional economies appear struggling with some sort of crisis. The factors causing these crises are varied; and in many cases even trivial. Collectively, these regional crises appear to be clouding the global economic recovery; and threatening a protracted phase of stagflation (negative or very poor real growth).

In particular, the sharp rise in global energy prices is a matter of serious concern for all. The prices of natural gas and coal are now at decade high. Crude oil prices are also at 5yr high and forecasted to move further in view of expected harsh winter. Consequently, the electricity prices and transportation (shipping and freight) costs have also risen sharply. The sharp inflation in energy prices is becoming a global crisis and being seen as a major threat to the global economy recovery.

From a plain reading of the events across the globe, inter alia, the following factors appear to be catalysing some sort of crisis, impacting the global economic recovery from the Covid-19 pandemic.

1.    Supply chain disruptions caused by labour displacement due to the pandemic; underinvestment in capacity building in past one year; uneven recovery across sectors and geographies; etc.

2.    High tide of pandemic stimulus ebbing.

3.    Erratic weather patterns across the world adversely impacting the crops.

4.    Hard geopolitical and trade related positioning between groups led by China and the USA.

5.    Precipitous shift in the business models towards ESG and digital, leading to significant change in demand and supply patterns for carbon and decarbonized products; material shift towards renewable energy and electric mobility, etc.

6.    Rising fragility of global financial system, with burgeoning debt both at the sovereign as well as household levels.

7.    Hardening nationalist positioning constricting free movement of labour and capital (e.g., Brexit).

The following are some of the instances that reflect the changing business conditions, demand supply patterns and the crises emanating from these.

US – Business consolidation and uncertainties hurting the supply chain

"Sorry. No French Fries with any order. We have no potatoes", a board at the Burger King in Florida read this week.

The shortage of trucks and driver is choking the supply chain across US. As per the industry sources, “Truck drivers that would transport cargo on flatbed trucks are being recruited away by Walmart and Amazon to exclusively pull box trailers or shipping containers. Large items like steel piles and premade concrete pieces either can't fit or can't be loaded into containers or box trailers. Vendors tell me demand is as high as 40:1, meaning for every available flatbed truck there are up to 40 waiting customers. The roads around the NYC metro area are as clogged with truck traffic as ever, but we're facing longer waits and higher prices to haul non-containerized cargo.”

One of the largest shipping ports in USA (San Pedro, LA) reported that some 60 container cargo ships idling at the entrance of the port complex last week. With an increase of 30.3% in cargo volume as compared to the same period in 2020, the congestion at ports is showing no signs of easing.

As per WSJ reports - The armada of cargo ships is due to surging volumes and unpredictability in global supply chains caused by the Covid-19 pandemic, and exacerbated by shippers pulling holiday-season imports forward to avoid delays later. The congestion at ports is one of a number of global bottlenecks as ports juggle strong consumer demand and shortages of workers and equipment caused by pandemic-related health and safety measures. These challenges have been  leading to significant delays and additional logistics costs.

UK gasoline crisis – Brexit may have a role to play

As the country heads into what could be a harsh winter, the US energy prices are soaring. In past nine months, the prices of natural gas in UK have risen over 250%. Though multiple factors could be attributed to the precipitous rise in energy prices and consequent second round inflation, logistic issues are cited as one of the principle reasons.

The complexity of the situation forced Paul Scully, the U.K.'s minister for small businesses to comment, “We know this is going to be a challenge and that's why we don't underestimate the situation that we all find ourselves in.”

The government officials and the prime minister himself have maintained that there is no shortage of the fuel in the country. It is the shortage of the drivers that is causing supply chain disruptions for fuel and food. The government is even contemplating to call the army to help bridging the supply chain gaps.

While there is no official word on labour shortages, it is estimated that labour supply may have got choked due to Brexit; travel restrictions due to Covid19; and less number of labour participating due to Covid19. The chief economist of KPMG speaking to media estimated that labour shortages may take 6 more months to fully resolve.

Andrew Goodwin, chief U.K. economist at Oxford Economics, told CNBC – “Households have got this big stockpile of savings to spend, but that will be starting to ebb away a bit simply because the bad news we're having on things like inflation. I suspect, we're going to end up in a situation where the reality is a little bit disappointing to what we were expecting say three months ago. And that's simply because of these issues with supply shortages, both in terms of sort of constraining output and also just eating into consumers' purchasing power."

Though the US economy is expected to reach pre Covid level by 3Q2021, demand pull is not something that is being cited frequently as one of the primary reasons for inflation spike. It is mostly the supply chain disruption.

Another popular view is that “It’s outrageous to suggest the current UK energy situation is the result of a rapid transition away from fossil fuels. It is primarily a gas crisis, fuelled by the nation’s slow transition to lower carbon sources. The origins of the crisis are complex, and date back many years.”

“Gas prices in Europe are at record highs, but the European Union’s internal energy market – of which the UK is no longer part – allows member states to trade with each other in a way that balances prices out.

This means EU countries can’t always take full advantage of very low energy prices, but at the same time means they’re protected from very high prices.

The UK, as an independent country outside the internal EU market, can take better advantage of low energy prices. But at times like these, when energy prices are very high, it left highly exposed to price shocks.” (Prof Aimee Ambrose, Sheffield Hallam University)

China’s decarbonization plan – Beijing Winter Olympics in play?

In the last week of September, the production line of a solder company in Kunshan was silent. In previous years, the factory was busy, stocking up for the National Day holiday. However, due to strict local power restrictions, they have temporarily had to suspended production. “All companies are going to stop production,” one manager explained, “When the policy first came out, it was thought that it wouldn’t affect processing companies. But since September 27, it requires all companies to stop production.”

Steel, non-ferrous metals, chemicals, textiles, and other energy-consuming industries are all affected. Unlike the previous round of flexible measures, which aimed to reduce energy consumption by 10%-30%, the current power control policy is more stringent. Now, local authorities are implementing an “open 2, stop 5” measure; companies will only be allowed to operate for two days a week. Most will have to reduce their production by 90% or shut down completely.

China aims to keep power consumption under control with carbon neutrality targets in mind. In August, the central government issued the “Barometer of 2021 Half-Year Regional Energy Consumption Intensity & Total Amount” – also known as the energy consumption “double control” plan. Under this plan, provinces must manage “total energy consumption” as well as “energy use intensity” while meeting their five-year targets.  (International Tin Association)

Some observers suspect that this plan is primarily aimed at ensuring blue skies during winter Olympics in Beijing; while other believe that it is part of the long term plan to decarbonize the Chinese economy.

The impact of “double action plan” is that Global consumers are already facing shortages of smartphones and other goods ahead of Christmas. The Global Times reported that “Multiple semiconductor suppliers for Tesla, Apple and Intel including ESON, Unimicron and ASE groups, which have manufactured plants in the Chinese mainland, recently announced they will suspend their factories’ operations to follow local electricity use policies.”

Brazil agriculture – snow and drought cause havoc

Brazil faced an unusual cold weather with froth killing the crop, followed by one of the severest drought in many decades. Brazil is also one of the worst affected countries due to Covid-19 pandemic in terms of the fatalities.

The New York Times reported, “Crops have shriveled up under searing heat. Immense water reservoirs, which generate the bulk of Brazil’s electricity, are growing alarmingly shallow. And the world’s largest waterfall system, Iguaçu Falls, has been reduced from a torrent to a trickle.”

Several states in the country are facing the worst drought in at least 90 years. The crisis has led to higher electricity prices, the threat of water rationing and a disruption of crop growing cycles. Agriculture, an economic engine of the nation — which relies heavily on hydropower — is now at risk.

Experts said the arid landscape, which coincided with a rise in illegal deforestation over the past months in the Amazon rainforest, could lead to a devastating fire season. Enforcement of environmental regulations is weak in the rainforest, and fire season traditionally begins in July.”

Before the worst drought in a century, Brazilians were surprised by unusual snow fall in July. At least 40 cities in the Rio Grande do Sul reported thick ice, while 33 others witnessed heavy snowfall reaching up to a meter high in some places, according to several reports. For most of the Brazilian population it was their first snow experience. The snow materially damaged sugar, citrus, and coffee farms.

“We’re left with a perfect storm,” said Liana Anderson, a biologist who studies fire management at Brazil’s National Center for Monitoring and Early Warning of Natural Disasters. “The scenario we’re in will make it very hard to keep fires under control.”

Brazil, is the world’s biggest exporter of coffee, sugar and orange juice. Poor Brazilian crop means that the global coffee and sugar prices have shot up sharply.

Conclusion

These are only some of the instances of regional crisis that are having global impact. The prices of food and energy are rising across countries. The productions lines are working at sub optimal capacities due to input shortages. The policy makers are hoping that these crises are all transitory and would ease in next few months (mostly on their own) as the pandemic related curbs are eased and bottlenecks are removed. However, in the interim severe damage could be caused to many small and medium sized business and households.

Presently, the global markets are looking jittery as the magnitude of the crises and their impact is not assessable. Besides, there is no visibility of a cohesive global plan to manage these crises, as was the case with Global Financial Crisis in 2008-09; even though these apparently regional crises have definite global repercussions. Next few months are very critical in my view. Lack of a united response could push the global economy deeper into a Stagflationary mess that can push the economic recovery process 3-4years down the lane.

 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)