Vijay Kumar Gaba

Despite the risks inherent in equity share ownership, the traumatic shocks of 1992, 2000, 2008 and 2020, equity remains a popular investment option among both individual and institutional investors. In fact, after the global financial crisis of 2008-09, the riskier equity (startups and pre revenue) has become even more popular with the investors who have been chasing yields on one hand and had access to cheap money on the other hand.

After the market crash due to outbreak of pandemic, the inflows into global equity funds have surged exponentially. The net flows in 2021 YTD alone exceed the net flows during previous two decades (2001-2020).

Anecdotal evidence suggests that one of the main reasons behind this unshakable popularity is the possibility of scoring “big”. It is this chance of multiplying the money in short term, which has attracted hordes of investors to the stock market.

Nonetheless, there is no dearth of people who are scared of the word ‘equity investing’.  Some of them have lost their entire savings in stock market, and the others, considering it another form of gambling, did never invest in shares.

Where do you stand in this picture?

·         Is it true that the investment option, which has statistically given highest returns in all economic conditions, did never work for you?  If yes, did you try to examine the reasons for this?

·         Even if you made fabulous gains in the stock market, could you attribute these to careful planning, or was it a fluke?

·         Do you consider investing in stocks an art and a science, or just a ‘roll of dice’?

 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

A random walk through the settlement statistic of NSE for past two decade and half decades provided some interesting insights into the market evolution over past two decades. It is interesting to note the things that have changed and the things that have not. Regardless, it is comforting to note that Indian markets are maturing well and the systemic risk appears to have subsided materially. The best part was to observe that our markets have become more democratic with deeper and wider participation.

(All data is sourced from www.nseindia.com)

Indian market maturing well

The latest bull market has shown that the Indian investors and traders are maturing very well. The tendency to recklessly over trade that was witnessed during dotcom bubble, and to some lesser extent during credit bubble of 2007-08, seems to have been reigned well now.

To give it some perspective, at the peak of the dotcom bubble, the average daily turnover of NSE was close to 0.8% of the total market capitalization in FY01. In FY08-FY09 it remained in the range of 0.3-0.4% of the total market cap. However, in the latest bull market, it peaked close to 0.3% in FY20-FY21.

In fact FY21 average daily turnover (ADT) as percentage of market cap has seen marginal decline over FY20, despite a 60% rise in the value of ADT.

Definitely, the changes in ownership pattern of Indian equity may have been at play in this. The institutional and promoter ownership is now much higher as compared to FY01. Nonetheless, there are clear signs of sensibility in day trading patterns, as depicted by the tremendous rise in the option volumes in past 10years. The traders now definitely prefer options more than the stocks, where they can better control their exposure in accordance with their risk tolerance.

A reliable evidence of the rationalization of speculative tendencies over past 20years is available in the form of lower interest in low value (penny) stocks.

In FY01, at peak of the dotcom bubble, in value terms only 8.4% of the traded value resulted into delivery of shares, while 91.6% value was intraday trading. Moreover, when we see the total number of shares traded resulting in delivery, it was 16.5%. This implies that traders were not only overtrading, they were trading more in low priced (penny) stocks.

The share of delivery in the value of trades increased to 27.6% in FY08, and this time the almost 25% of shares traded resulted in delivery; implying that the trading in penny stocks was much lower in FY08.

In FY21, the percentage of delivery has reduced materially to ~17% both in terms of value trade and number of shares traded; implying that traders continue to be cautious about penny stocks and focusing more on mid and large cap stocks for taking delivery.

Another evidence of market maturity comes from the share of smaller companies in the overall market activity.

In FY01, at the peak of dotcom bubble, numerous small, hitherto unknown and often unsustainable businesses were the top traded shares on the stock exchanges. In top 10 most active securities, 7 had market cap of 1% or less of the total market cap of NSE, with 4 having a market cap that was less than 0.1% of the total market cap.

In that year, on NSE the top 10 most active securities accounted for an insane 73% of the total traded value; whereas these securities accounted for just 13% of the total market cap. Himachal Futuristic (HFCL) with just 0.17% of the total market cap was the most active security accounting for over 15% of the total market turnover. Two other small cap companies Global Telesystem (0.11% of total market cap) and DSQ Software (0.05% of total market cap) accounted for 9% and 6.5% of total turnover respectively. To put this in perspective, the company with the largest market cap (Reliance Industries, 6.25% of total market cap) accounted for just 4% of the total turnover; and IT bellwether Infosys with 4.1% of total market cap, accounted for 8.1% of the total market turnover.

In FY08 also, 4 companies accounting for less than 1% of total market cap of NSE figured in the top 10 most active securities. The 6 top most active securities were Reliance group companies. But, the top 10 most active securities accounted for just 27% of the total turnover. Reliance Industries with 6.8% of total market cap contributed just 5% to the total turnover. IFCI was the only microcap stock in top 10 most active securities list.

Things improved significantly in FY20, when top 10 most active securities accounted for 20% of the market cap and 26% of the total turnover. Though this year also 4 companies with less than 1% of the total market cap figured in the list, the skew of share in total turnover was much smoother. Reliance Industries was again the top traded stock, but now accounting for just 3.6% of total turnover.

 

Systemic risks lower now

The stricter compliance norms, improved surveillance and disclosure practice and wisdom gained through hindsight have resulted in materially lower systemic risks in the markets.

Though the common man had started to participate in the stock markets from early 1990s as the economy was opened up, the development of Information Technology industry in late 1990s provided the real impetus. A large number of IT workers came from middle and lower middle strata of the society and had an opportunity to work in global companies. Young professionals from the smaller towns migrated to metropolis and foreign countries. ESOPs became popular and that laid foundation for a deeper and wider participation in the stock markets. The understanding about the financial investments however did not grew in tandem with the understanding of complex IT algorithms.

Besides, a large number of new entities, dealing in new economy businesses and services, came into existence. Many of these companies did not survive the test of solvency for long. Consequently, about one third of the companies listed on NSE in March 2000 had vanished by March 2004.

This was not repeated in 2008-09 and 2020 market crashes. The number of companies available for trading on NSE increased by 25% during the period from March 2007 to March 2010. During the period between March 2020 and March 2021 also the number of companies available for trading has increased by 1.5%.

Democratization of Indian markets

A key development in the stock market has been the democratization of the markets. Not long ago in the history of Indian stock market, the market participants were a small privileged group of people, mostly from established industrial families or senior corporate executives.

Common household investors had begun meaningful investment in listed equity in late 70’s at the time of forced dilution of foreign owned companies operating in India, under the provisions of a stricter Foreign Exchange Regulation Act (FERA). These companies now known as MNCs were then referred to as FERA companies in common market parlance.

Reliance in 80’s and PSU disinvestment and capital market reforms in early 90’s drew the 2^nd lot of household investors. IT boom of late 90’s drew the 3^rd and the largest set of new investors to the listed equity. However, the participants were mostly concentrated in the few larger cities of some industrialized states. The four top cities accounted for more than 80% of investment amount and investors.

Anecdotal evidence point to the fact that Covid19 enforced lockdown has drawn the latest set of investors to the equity markets. 2020 was the period when many businesses were either locked down or their workers were operating from home, whereas equity markets were functioning uninterrupted. This was one trading business that could be done from the comfort of homes and without any additional investment in infrastructure or facility building.

Since, traders and small business owner had no work to do; and bank deposit and bond returns were falling; many of them deployed their working capital in the equity trading. Many small and micro businesses which were declining since demonetization and GST implementation also shut down during this period, with their owner shifting their focus on financial investments.

Thanks to the significantly improved accessibility due to the financial inclusion efforts, technology and Fintech popularity, the participation in stock market is now much deeper and wider. People from across the country and wider spectrum of socio-economic background are participating in the equity investing.

One glimpse of this democratization process could be seen from the average trade size on the stock exchanges. In mid 1990s the average trade size on NSE was in excess of Rs1,00,000. This fell below Rs20,000 by FY12. In FY21 it has increased to above Rs 33,000, (higher than the past five year average of Rs26,000), but has again declined to around Rs29000 in past couple of months.

In a market with total market cap of Rs250trn, where the delivery percentage is just 17% of the total value and number of share traded on daily basis, an average trade size of Rs29000 is a stronger indication of democratization of market than the number of trading & depository accounts opened or mutual fund portfolios created.

 If we consider the sector wise performance since April 2020, there exists huge disparity between various sectors. While Metals and IT have remained massive outperformers; the consumer (FMCG & media) and PSU Banks have been lagging far behind. Auto, Services, Pharma, and Infrastructure have performed mostly in line with the benchmark Nifty.

Pharma and Infrastructure performance is little surprising as both the sectors had major catalysts in Covid19 and massive government spending on infra building to stimulate the sagging economy.

But what is most surprising is the lack of investors’ interest in PSU banks. Notwithstanding, numerous research upgrades of SBI; government beginning the process of disinvestment in couple of PSBs; improved profitability shown by all the PSBs in FY21; and a market heavyweight buying material stake into Canara Bank; and many private sector lenders faring much worse than their Public sector peers - PSU Banks have failed to impress the traders and investors alike. We may attribute this underperformance to a number of factors, e.g., huge losses suffered by investors who invested in these banks in past 4-5years; material equity dilution to bridge the capital inadequacy gap; uncertainty about how the Covid19 related stress will reflect in bank books etc.

Impact of Covid19 pandemic on consumers’ income and consumption behaviour might have impacted the sentiment towards the consumption sector. The displacement of a large number of workers due to pandemic may also have been a factor impacting the consumption. Notwithstanding the huge stimulus to support the household consumption, the consumption growth has been lower than the estimates. Of course expensive valuation due to outperformance of stocks in previous years may also be one of the factors.

The question now is – “Do we have enough catalysts present to cause a major sectoral rotation in the markets?”

Will a weaker USD, sharp outperformance, and expensive valuations result in traders and investors moderating their preference for IT sector?

Will supply augmentation due to easing logistic constraint, and demand tapering due to inexorbitant commodity prices, result in softening of commodity prices and therefore traders rotating out of metal stocks?

Will the well managed fiscal conditions, reasonable valuations, improved earnings and growth visibility and an earnest beginning to implement the National Asset Monetization Plan, spur interest in infrastructure sector?

We would know the answers to these questions in due course; nonetheless it is not a bad idea to be alert and keep a close watch

 Historic performance of a banker

In the summer of 2007, at the peak of sub-prime bubble, a top executive at a global bank presented to the Board that the bank has expanded its footprints to 11 new frontier markets and materially augmented the operations in the 13 emerging markets by enhancing the workforce by 19% in the past one year, a record in the 90year history of the bank. The board applauded the presentation and approved the 100% hike in the annual bonus for the top executive.

In the spring of 2009, the same manager made another enthusiastic presentation to the management. He said, “the management has been able to cut the cost by a whopping 28% to meet the challenges of global financial crisis. We have optimized our operations by exiting the non-profitable operations in 17 frontier market and 2 merging markets, and materially curtailing the operations in 9 emerging markets, to achieve 20% cut in the total workforce in the past one year; a record in the 92years history of the bank. The board applauded the gigantic effort of the management and approved a modest 35% increase in the bonus of the top executive.

Super Heroes and the Super power

The President of the United States, Joseph Robinette Biden Jr., defended the decision to withdraw forces from Afghanistan after 20 years of conflict. He described the decision as “the best and the right decision for America which ended an era of major military deployments to rebuild other countries.” In his address to the nation on Tuesday, Biden said, “there was no reason to continue in a war that was no longer in the service of the vital national interest of the American people.” He further assured is people by saying, “I give you my word: With all of my heart, I believe this is the right decision, a wise decision, and the best decision for America, he said.”

When the US decided to send the troops on ground in Afghanistan in the wake of the attack on World trade Center in New York (9 September 2011), the then president George Bush has commented, "The attack took place on American soil, but it was an attack on the heart and soul of the civilized world. And the world has come together to fight a new and different war, the first, and we hope the only one, of the 21st century. A war against all those who seek to export terror, and a war against those governments that support or shelter them."

After 20years, the US government has ended the war by handing over the power to the same people who it was supposedly fighting for 20years.

However, both the decision to invade and quit have been described as historic and in the best interest of the people of United States.

Art of managing the denominators

“This is massive! India records a GDP growth of 21.1% in Q1 o FY21-22”, exclaimed a leader of the ruling party.

One of the key economic advisors of the government emphasized that “the GDP data for the first quarter reaffirms the government's prediction of an imminent V-shaped recovery made last year.”

“It's a big economic comeback. Q1 GDP of 2021-22 grows by a phenomenal 20.1% as per provisional estimates”, a senior union cabinet minister exuded ebullience.

Similar sentiments were expressed by most office bearers and prominent supporters of the ruling party, advisors to the government and members of the union cabinet.

On the other hand, the members of opposition parties, their supporters and some outside experts were not too impressed with the apparently high growth number.

A prominent left party leader rejected the claims of the government by highlighting that “Compared to 2 years ago, India’s GDP shrinks -9.2%.”

A Congress spokesman clarified that “India's GDP for April to June 2021-22 (Rs32.38trn) is lower than India's GDP for April to June 2019-20 (Rs35.85trn) and very close to India's GDP for April to June 2017-18.”

A former senior economic advisor to the government who is presently a senior official with IMF, rejected the GDP as a shocking bad news. He commented, “It needs just a little arithmetic to see that India's Apr-Jun 2021 growth of 20.1% is shocking bad news. The 20.1% is in comparison to Apr-Jun 2020 when India's GDP had fallen by 24.4%. This means compared to GDP in Apr-Jun 2019 (i.e. 2 years ago) India has had a negative growth of -9.2%.”

The politicians these days have mastered the art of managing the denominator. They set a weak denominator to exaggerate your status and performance. Most governments have, for example, moved the denominator to “pre Covid” levels to make exaggerated claims of their status and performances. Not many people are bothering to note that “pre Covid” conditions were pretty bad in itself and reaching there by making a V shaped recovery may not be a great feat in itself. Though it certainly provides comfort that we did not deteriorate much due to covid.

Insofar as the common people are concerned, they would be better off ignoring these manipulated narratives and focusing on the per capita real growth in GDP and change in the Gini coefficient that measures the scale of economic inequality in the country.

The real GDP growth in percentage terms will have little meaning if the base or the denominator is very low (which is the case at present) or it is not adjusted for the population growth or the real household inflation. A 5% real GDP growth with 2% population growth would mean just 2.9% growth in per capita income. This is not likely to cause any material improvement in their lifestyle; especially when it is deflated by the headline inflation which may be very different that their actual household inflation. Also if the income inequality rises more with rise in GDP, it would mean that their income may not rise in tandem with the rise in average per capita income of the country.

 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)