Do it yourself

Thursday, July 30, 2020

I am happy not owning Gold

Lately, I have received a lot of queries from readers about Gold. Everyone seems to have woken up to the idea of investing in yellow metal. Many readers have read a lot about the latest trends in the global financial markets, and appear to be in full concurrence with the idea of structural decline in the relevance of USD as global reserve currency; however the views about the rise of EUR or CNY as alternative reserve currencies do not seem to be sanguine. This uncertainty about the future of the global financial system is probably driving the interest of investors towards gold, which has traditionally been a popular reserve currency and preferred store of value during crisis period particularly.

Many readers have highlighted that it was perhaps a mistake on my part to cut allocation to gold in my portfolio. I would like to answer the queries and concerns of the readers herein below.

First of all, I would like to remind the inquisitors that it has been my consistent stand in past three decades of my investing life that in my view gold being mostly an unproductive asset, having little industrial use, does not qualify to be an "investment" grade product. Given its popularity and general acceptance in global financial system, it does qualify to be a decent alternative to the paper currency. It therefore does well with the rising inflationary expectations and negative real rate environment. I therefore use it more as a tactical shift from cash & bonds; and sometime as an opportunistic trade. I never use it as a permanent asset class in my asset allocation. (read more on this here Gold is glittering; but is it the endgame?) Incidentally, my wife and daughters are also not fond of gold; so there is no conflict on this issue at least!

In my investment strategy update for 2020 in December (see here), I had stated- "In view of the adverse risk reward ratio and growing divergence between bond and equity yields, I shall scale back my strategic equity allocation to 50% from 60% presently. The strategic asset allocation now stands at 50% Equity; 25% Gold and 25% Debt."

However, as the news of COVID-19 outbreak from China spread and global markets started to take note of the crisis in February I revised my asset allocation to sell the tactical allocation to gold and upgrade equities to overweight (see here). Incidentally, markets tanked in March affording me an opportunity to make the shift at favorable prices.

In April after the global economy went into a lockdown, I made a big call, increasing the equity allocation further (see "Time to Take Big Call") I maintained my equity overweight stance on asset allocation and increased equity allocation further to 70% from the previous 65%, cutting the debt allocation from 30% to 25%. The overweight stance on IT, Pharma and chemical (including agro chemical) was adequately emphasized.

I am pleased to note that the strategy has worked out well so far. Since the recent bottom of the market recorded on 24 March, IT sector has returned 61%; Pharma sector has returned 57%; Nifty is up 48%, S&P500 is up 41% and gold is higher by 29%. The chemical sector has also outperformed the benchmark Nifty and gold comfortably. Average IT sector mutual fund return has been 35% (absolute) in past 3 months.

I therefore do not see much point in this brouhaha over gold, and would prefer to continue with my strategy for some more time, till I see indications of an imminent and material correction in the equity prices.

Wednesday, July 29, 2020

SEBI need to learn the art of adding salt to the dish

The new margining norms proposed to be implemented from 1 August 2020, in respect of the equity market trades done on stock exchanges are a cause for worry for one simple reason, i.e., this highlights for the n^th time that the securities market regulation in India lacks a robust conceptual framework.

It is important to understand that regulation of securities market is like salt in a dish - any excess or less magnitude of regulation could make the dish unpalatable.

Any market participant would vouch for the fact that the regulators understanding of the risk management needs in the securities market is inadequate, as it relies more on adhoc methods rather than a strong conceptual framework. In the event of a crisis, comes out like a brave fire fighter and douses the fire with whatever tools it has. Unfortunately, there is little empirical evidence to highlight that SEBI has taken enough preventive measures to stop frequent occurrences of crisis in the market. We frequently witness the cases of blatant price manipulation, malpractices, and unethical conduct by corporates, intermediaries and large traders (called "operators" in the common market parlance). In past 28yrs of SEBI existence as statutory market regulator, there has been little diminution in the frequency or intensity of these instances.

The market participants will also vouch how much detrimental has been the SEBI's intervention in the matter of securities' classification for the purposes of categorization of mutual fund schemes. Ideally, the regulator should have flagged its concerns to the industry and self regulatory organization governing the industry, and let them evolve the optimum solution. Not relying upon the industry and imposing rules which made little sense caused tremendous pain to the industry and investors, and benefitted almost none.

One primary reason for this in my view is the lack of a robust conceptual framework for securities'' market regulation. For example, let us consider the instant case of revision in margining norms.

Minimizing the systemic risk is one of the paramount concerns of the securities' market regulation. Imposing prudent margining requirement for traders is one of most popular and effective method of managing the systemic risk. However, it defeats its purpose if margins become excessive or impractical. It is important to understand that margins are used to mitigate systemic risk of default on settlement obligation and not for the purposes like managing the trading volume etc.

There are two types of margins imposed in cash market, viz., (i) Value at Risk Margin (VaR) and (ii) Extreme Loss Margin (ELM). VaR is calculated based on historical volatility and trading pattern. This covers the normal expected adverse movement in the stock price in one day. ELM is used to cover exceptional volatility due to some extreme event. These margins should be adequate to cover 99.999% of cases of payment defaults.

When, an investor sells shares in the market, the default counterparty is the clearing corporation (e.g., NSCCL). Thus, the clearing corporation guarantees the settlement of all the trades executed on a recognized stock exchange. The moment trade is executed and securities are delivered to the clearing corporation as pre pay-in, the VaR for the seller defaulting on its obligation becomes Nil. Since the counterparty is clearing corporation, the risk of counter party default for the seller is also Nil. Not allowing seller to use the sale proceeds for buying other securities is certainly no prudent risk management. This in fact creates doubts about the infallibility of clearing corporation itself, which in turn makes the whole argument of trade guarantee and secure settlement system suspicious.

There are also chances that some of the traders may move to grey market (dabba market in common market parlance) for trading, thus exposing themselves to larger risk of default.

Tuesday, July 28, 2020

Consequences of runaway debt accumulation

Continuing from Friday (see Slipping back into deep abyss)

Two of the key questions that are begging answer from the central bankers infusing trillions of dollars in fresh liquidity in the global financial system and the governments borrowing incessantly to further their populist agenda, is what will be the impact of this debt burden on the potential economic growth? and How the perpetually slow growth will impact the demography, i.e., whether the world will follow the demographic trends of Japan and grow old? (see How will this tiger ride end?)

As per the World Bank report titled Global Waves of Debt - Causes and Consequences, "Amid record high global debt, low interest rates and subpar growth have led to an intense debate on whether the recent rapid increase in debt is reason for concern. Some argue that countries, especially those that issue reserve currencies, should take advantage of low interest rates to borrow more to finance priority expenditures. Others caution that high debt weighs on long-term growth, by increasing the risk of crises, limiting the scope for countercyclical fiscal stimulus, and dampening private investment."

The report further highlights that, "Although the focus of this debate has been mainly on advanced economies, similar issues are also faced by EMDEs. Many of these economies have also borrowed heavily and, in many cases, hard-won reductions in public debt ratios prior to the global financial crisis have largely been reversed over the past decade. The tradeoffs EMDEs face are actually even starker, in light of their histories of severe debt crises even at lower levels of debt than in advanced economies and their more pressing spending needs to achieve development goals and improve living standards."

The importance of public debt in growth economics can hardly be overemphasized. Government investment in physical and human capital provides an important foundation for stronger economic growth over the long term. It helps in attaining the ideal goal of full employment and optimum capacity utilization on sustainable terms.

It is important to note that despite substantial progress over the past two decades in many areas, several Sustainable Development Goals (SDGs) remain well out of reach. As per the World Bank estimates, to meet the SDGs, EMDEs have large investment needs: low- and middle-income countries face aggregate investment needs of $1.5–$2.7 trillion per year—equivalent to 4.5–8.2 percent of annual GDP— between 2015 and 2030 to meet infrastructure-related SDGs, depending on the effectiveness of this investment, accompanying policy reforms, and the degree of ambition in meeting the SDGs. Higher debt level for emerging and underdeveloped economies is necessary in most cases.

Besides, temporary debt accumulation can also play an important role in helping to minimize and reverse short-term economic downturns. During recessions, borrowing financed government spending or tax cuts can provide stimulus to support demand and activity.

However, it is important to do an intensive cost benefit analysis of every dollar in new debt. The cost of debt is not only the interest payable on such debt; but also the impact of the debt on the future growth potential and changes in socio-economic structures.

During the post-crisis period, the cost of government borrowing in terms of rate of interest has been historically low, for both advanced economies and EMDEs. Further, demographic shifts and slowing productivity growth are expected to contribute to a further secular decline in real interest rates in advanced economies, continuing a multi-year trend. However, if a sudden increase in global borrowing costs occurs; the sustainability of high debt in some countries will be tested. A failure in this test could bring disastrous consequences.

As per the World Bank, "Debt sustainability has deteriorated since the global financial crisis both in advanced economies and in EMDEs. In advanced economies, debt-reducing fiscal positions (i.e., positive sustainability gaps) in 2007 turned into debt-increasing fiscal positions (i.e., negative sustainability gaps) from 2008. Subsequently, sustainability gaps narrowed and, in 2017, returned to debt-reducing positions. In EMDEs, debt-reducing positions in 2007 turned into debt-increasing positions in 2015.

In commodity-exporting EMDEs, this deterioration partly reflected the sharp growth slowdown that came in the wake of the steep slide in commodity prices. Subsequent recoveries in commodity prices and economic activity helped improve debt sustainability in these economies and, by 2018, fiscal positions in commodity exporters had become debt reducing. In commodity-importing EMDEs, fiscal positions have remained weak as a result of fiscal stimulus implemented during the global financial crisis, chronic primary deficits, and, in some cases, anemic post-crisis growth, leading to debt-increasing fiscal positions in 2018.

High debt constrains governments’ ability to respond to downturns with countercyclical fiscal policy. This was the case during the global financial crisis: fiscal stimulus during 2008-09 was considerably smaller in countries with high government debt than in those with low debt. This is one of the reasons why weak fiscal positions tend to be associated with deeper and longer recessions, a situation that worsens if the private sector also falls into distress and its debt migrates to government balance sheets as the government attempts to rescue private enterprises. Reducing the effectiveness of fiscal policy. High government debt tends to render expansionary fiscal policy less effective. Specifically, high government debt can reduce the size of fiscal multipliers through two channels

With higher debt typically comes higher debt service. Spending on higher debt service needs to be financed through some combination of increased borrowing, increased taxes, and reduced government spending. Spending cuts may even include spending on critical government functions such as social safety nets or growth-enhancing public investment. Separately, high and rising government debt may raise long-term interest rates and yield spreads. High debt could also create uncertainty about macroeconomic and policy prospects, including risks that the government may need to resort to distortionary taxation to rein in debt and deficits (IMF 2018a; Kumar and Woo 2010). Higher interest rates and uncertainty would tend to crowd out productivity-enhancing private investment and weigh on output growth.

As per the available empirical evidence, a return to monetary policy normalization in advanced economies could raise borrowing costs (Ruch 2019). If there was a rapid increase in policy interest rates, as happened in the first global wave of debt accumulation, it could be accompanied by large currency depreciations in EMDEs that would sharply increase debt service burdens for foreign currency-denominated debt (Arteta et al. 2016). It would also be likely to trigger a turn in investor sentiment that would especially affect those EMDEs with large foreign participation in local bond markets, which in some economies now exceeds 30 percent of government bonds. Although the normalization of monetary policy in USA and EU is not visible on horizon, occurrence of this even could spell disaster for many emerging economies.

It is pertinent to note that during crisis it does not take much for the private debt to become public debt. Large private sector losses, including losses threatening bank solvency, and the materialization of contingent liabilities, including those of state-owned enterprises, can lead governments to provide substantial financial support. We have seen glimpses of this phenomenon in India in past 10 years.

During the current wave of debt, potential growth in EMDEs has also declined, because of slower productivity growth as well as demographic change. Productivity growth has declined as investment growth has slowed, gains from factor reallocation have faded (including the migration of labor from agriculture to manufacturing and services), and growth in global value chains has moderated. Slower investment growth has tempered capital accumulation. Demographic trends have become less favorable to growth, since the share of working age populations in EMDEs peaked around 2010. In case of India it is expected to peak in this decade. Burgeoning debt could therefore a major issue for these economies.

(Most of this write up is reproduced from the Word Bank Report titled Global Waves of Debt - Causes and Consequence. The copyrights are acknowledged.)

Friday, July 24, 2020

Slipping back into deep abyss

Continuing from Tuesday Repayment of Debt. Also see How will this tiger ride end?

The overall poverty level in the world has seen material decline over past three decades as highly populated countries like China, India, and Bangladesh pulled millions of people out of abysmal poverty conditions; even though, this period has also seen sharp rise in economic inequalities also.

The pace of poverty reduction has reduced since global financial crisis, as the flow of development aid from developed economies to the poor countries saw a marked decline; commodities dominated economies suffered due to persistent deflationary pressures; EM currencies weakened; and abundantly available credit at near zero interest rates helped the large global corporations and investors to increase their wealth disproportionately.

The global economic shut down induced by the outbreak of deadly COVID-19 virus is threatening to reverse the process of poverty alleviation. Millions of people who had been barely out of poverty conditions are facing the prospects of slipping back into the deep abyss. The fiscally constraint governments, anemic economic activity and feeble businesses would find it tough to support these people.

The key question to examine therefore is, If the global growth continues to remain low, how the poor and developing economies will bridge the development gap with developed countries and come out of poverty? And if this gap widens, what would it mean for the world order?

As per the World Bank, "Poverty projections suggest that the social and economic impacts of the crisis are likely to be quite significant. Estimates based on growth projections from the June 2020 Global Economic Prospects report show that, when compared with pre-crisis forecasts, COVID-19 could push 71 million people into extreme poverty in 2020 under the baseline scenario and 100 million under the downside scenario. As a result, the global extreme poverty rate would increase from 8.23% in 2019 to 8.82% under the baseline scenario or 9.18% under the downside scenario, representing the first increase in global extreme poverty since 1998, effectively wiping out progress made since 2017."

The report further emphasizes, "The number of people living under the international poverty lines for lower and upper middle-income countries – $3.20/day and $5.50/day in 2011 PPP, respectively – is also projected to increase significantly, signaling that social and economic impacts will be widely felt." Besides, "A large share of the new extreme poor will be concentrated in countries that are already struggling with high poverty rates and numbers of poor. Almost half of the projected new poor will be in South Asia, and more than a third in Sub-Saharan Africa."

As per another report of World Bank (Global Waves of Debt - Causes and Consequences), "...wave of debt began in 2010 and debt has reached $55 trillion in 2018, making it the largest, broadest and fastest growing of the four. While debt financing can help meet urgent development needs such as basic infrastructure, much of the current debt wave is taking riskier forms. Low-income countries are increasingly borrowing from creditors outside the traditional Paris Club lenders, notably from China. Some of these lenders impose non-disclosure clauses and collateral requirements that obscure the scale and nature of debt loads. There are concerns that governments are not as effective as they need to be in investing the loans in physical and human capital. In fact, in many developing countries, public investment has been falling even as debt burdens rise.

The debt build-up also warrants close analysis because of slower growth during the current wave. In comparison with conditions prior to the 2007-2009 crisis, emerging and developing economies have been growing more slowly even though debt has been growing faster. Slower growth has meant weaker development outcomes and slower poverty reduction."

"The latest debt surge in emerging and developing economies has been striking: in just eight years, total debt climbed to an all-time high of roughly 170 percent of GDP. That marks a 54-percentage point of GDP increase since 2010—the fastest gain since at least 1970. The bulk of this debt increase was incurred by China (equivalent to more than $20 trillion). The rest of the increase was broad based—involving government as well as private debt—and observable in virtually every region of the world.

The study shows that simultaneous buildups in public and private debt have historically been associated with financial crises that resulted in particularly xviii prolonged declines in per capita income and investment. Emerging and developing economies already are more vulnerable on a variety of fronts than they were ahead of the last crisis: 75 percent of them now have budget deficits, their foreign currencydenominated corporate debt is significantly higher, and their current account deficits are four times as large as they were in 2007. Under these circumstances, a sudden rise in risk premiums could precipitate a financial crisis, as has happened many times in the past.

Clearly, it’s time for course corrections."

...to continue on Tuesday

Weekend readings

From American to European Exceptionalism

Has Big Pharma Finally Stepped Up?

Gold – That Shiny, Problematic Object

Projected poverty impacts of COVID-19

कोशिश करने वालों की हार नहीं होती / सोहनलाल द्विवेदी

Thursday, July 23, 2020

Su karwa nu?

The decoupling of real economy and financial markets in past few months has certainly caught many market participants by surprise. There is no dearth of experts and masters of market who are claiming to have caught the March bottom and minted money. I have no doubts that they might have actually achieved what they claim. However, the publically available evidence suggests that most mutual funds have yielded negative return in YTD2021 and in past one year. The 5year return is worse than the average fixed deposit interest in this period.

The investors are thus caught in a quandary - whether they should use this bounce in the stock prices to redeem their investments or invest more money.

The problem in fact seems more acute with the investors who decided to play "safe than sorry" and redeemed their investments during March-April and are sitting on the fringes. Many of them are wondering whether it is a good time to invest back in equities; especially when the debt and money market returns have plunged sharply.

The questions I get these days vary - "su karwa nu?" (what to do?), "Kya lagta hai?" (how does it look?) "kuch karna hai kya?" (is there any investment/trading opportunity?), being the most common ones.

I do not believe in this entire FOMO (fear of missing out) theory of investment behavior. I believe that this is just a deceptive jargon to describe the unexplained part of the investor behavior.

In my view, it is perfectly normal and acceptable behavior for investors and traders if they do not find it desirable to venture into rough seas and prefer to wait in their cabin for the weather to clear out. It they are looking for assurance that the storm has passed and it's safe to sail now, this is a prudent behavior not fearsome.

My answer to the inquisitions of investors/traders who chose to retire to the safer confines of their respective cabins is as follows:

(a) The economic storm triggered by outbreak of COVID-19 virus is far from over. The economic consequences of the disruptions caused by global lockdown will continue to unfold over many years to come. I do not expect Indian economy to regain sustainable 6%+ growth trajectory (normalized for FY21 extraordinary fall) in next 3years.

(b) The asset prices, especially equities and precious metals, may continue to rise in short term, due to abundant liquidity; lower cost of funds & poor debt returns; lower capital requirements in routine businesses;

(c) There is no sign of bubble as yet in the market, as even the 3-5yrs returns are abysmal. The valuations appear stretched due to extraordinary fall in earnings. The negative real interest rates may afford higher valuations to sustain in the short term (12-15months).

(d) The market breadth has started to narrow again. In my view, this trend may accelerate in 2HFY21. I will not be surprised at all to see the benchmark indices scaling new highs in next 9-12 months, while the broader markets languish or correct materially from the current level. Too much diversified portfolios therefore may continue to underperform the benchmark indices.

My suggestion to the readers, who have asked these questions, is as follows:

Follow a rather simple investment style to achieve your investment goals. It is highly likely that most may find this path boringly long and apparently less rewarding, but in my view this is the only way sustainable returns could be obtained over a longer period of time.

I believe, taking contrarian views, anticipating short term performance (e.g., monthly sales, quarterly profits etc.) and reacting to that, or arbitrage on information/rumor of a corporate action are examples of circuitous roads or short cuts that usually lead us nowhere.

Taking straight road means investing in businesses that are likely to do well (sustainable revenue growth and profitability), generating strong cash flows; have sustainable gearing; timely adapt to the emerging technology and market trends, and most important have consistently enhanced shareholder value.

These businesses need necessarily not be in the “hot sectors” like commodities in early 1990’s, ITeS in late 1999s, or infrastructure and financials in 2004-07. These businesses may necessarily not be large enough to find place in benchmark indices.

I have discussed it many times in past. However, given that the market is in a prolonged period of high volatility and low returns, making investors jittery and indecisive, I deem it fit to reiterate. Of course there is nothing proprietary about these thoughts. Many people have often repeated it. Nonetheless, I feel, like religious rituals and chants, these also need to be practiced and chanted regularly.