Stock markets continue to trade at cheap valuations and with India being the biggest beneficiary of commodity price correction
The past few days have been full of so many events both local and global. It is important to take a perspective of the same to arrive at some sort of view on the direction going forward.
The first few data points were from the domestic side where we saw the Index of Industrial Production underperforming expectations again as the lack of policy initiative, combined with extremely high interest rates crippling corporate capex as well as consumer demand. The following few days saw the Inflation data coming out that was higher than expectations, driven largely by supply side food inflation as well as the impact of the rupee depreciation of 25 per cent over the last one year. Contrary to what the RBI commentary would like us to believe ex of the impact of the rupee fall the actual inflation would not be more than 3-3.5 per cent.
Nearly 45-50 per cent of the WPI basket is driven by import parity pricing where a large number of global commodities are down 10-40 per cent in dollar terms over the last one year but are up in rupee terms just due to the rupee fall.
In any case the entire structural inflation argument (ex of food) will be exposed over the next couple of months as the entire impact of the severe global commodity price fall gets completely translated into the domestic economy. One also needs to remember that indirect taxes were increased by 2 per cent in the current year’s budget which directly flow through into prices to the extent of 1-1.25 per cent and is a one off factor that has increased reported inflation.
In the euro zone:
The euro zone drama continued in right earnest right through the last few days. The biggest event of the year i.e. the Greek elections, thankfully went off in a manner where the Lehman moment was avoided (or postponed?) for Euro zone. An adverse outcome could have resulted in a kneejerk sell off. The issues in Spain came to fore with the government out there asking for a banking sector bailout that was promptly forthcoming.
Growth figures continued to disappoint and all data points point to a bleak economic scenario in the Euro zone. In the midst of all of this what is clear in the troubled countries and also those not in trouble in Europe that the only way out over the long run is to carry out structural economic reforms. There is need of disinvestment, labour reforms and most importantly a reduction of the welfare state.
The expenditure on social security, unemployment benefits & all other things those are free to most people in the Western world, unlike countries like India where there is little or no social security need to be reduced drastically in order to bring about fiscal discipline. The era of free lunches is over and the earlier it is realized the better it will be. Labor reforms will also be key in countries like Spain and Italy. Extreme fear drove 10 year German Bonds to as low as 1.15 per cent and Spanish yields above 7 per cent.
Unfortunately for countries like Spain and Italy, despite huge ECB liquidity operations the rising sovereign bond yields combined with fiscal austerity is resulting in both a monetary and fiscal squeeze which is further deteriorating the growth outlook. The banking sector bailout of Spain could be more positive than being currently thought of if it is also accompanied by making the economy more flexible.
Recapitalisation of banks is always better than funding the sovereign as it is possible to leverage the capital (as also a capital squeeze leads to deleveraging) and banks can be held more accountable for the money they are given vis a vis sovereign governments. In any case the problem at this stage is not of liquidity but of solvency.
Euro zone is now also talking of a growth agenda. Let’s see how they conjure up growth which looks very difficult at this stage.
Economic news flow out of the US continued to be mixed with some figures showing a growth revival and others showing the contrary. The most important event was the Fed meet over the last couple of days which bought out interesting thoughts from Bernanke. It is very clear that the the Fed Reserve is very uncertain and unwilling to expand its already bloated balance sheet further. They have said that they are unsure of the long term impact of unconventional measures which they have undertaken and their ability to reduce the size of the balance sheet in a non disruptive manner at a future date. The interest rate risk on the Fed balance sheet has become huge.
They have extended operation twist by around $260 billion till the end of the year. However with this move, by the end of the year they would have exhausted their entire holding of 1-3 year securities. The maturity of the holdings would have gone up so much that a spike in inflation at some later date could result in them staring at large mark to market losses. Moreover with so much money printed its longer term impact on inflation is also unknown. I believe that internally the FED recognizes the role of its money printing operations on boosting commodity speculation and the adverse impact that has on consumer sentiment.
Although reported CPI might be low, the fact is that high gasoline, food, consumer good etc prices impacts sentiments and consumer behavior. With 70% of the US economy being driven by consumption it is important that both the actual inflation as well as perceived inflation is low. The good thing about the US economy at this stage is that the financial system has stabilised well and there is no solvency issue. However low savings rate & low income growth combined with high unemployment will result in subpar growth for the foreseeable future.
Rest of the world:
Other events were the G20 summit which was frankly a waste of time as everyone committed to boosting growth without knowing how to do it. The only positive was the increase firewall for IMF to the extent of another $460 billion which is quite significant. Data coming out of China reflects a continued slowing of the economy albeit at a pace of slight moderation. The ability of China to drive a 15 per cent export growth in the month of May despite the global scenario was quite surprising.
China has started moving towards easing monetary conditions, although the government out there is moving cautiously on the fiscal front. It seems that the Chinese are willing for some slower growth in the near term so as to avoid a hard landing at some future date. However this will lead to a further correction in commodities where commodity bulls/speculators were holding on the unsustainable long positions expecting a quick Chinese revival. Most commodities are expected to be in surplus over the next one year, which should keep prices subdued.
With the drastic fall in commodity prices the downside risks for the Indian economy have reduced substantially. Crude prices have fallen over 30 per cent over the past three months. This has a direct and immediate impact on India’s growth prospects. Last year higher crude prices sucked out $ 40 billion from the Indian economy, which had two negative impacts.
First, domestic liquidity reduced to that extent, thus creating liquidity scarcity at a time of RBI tightening. Secondly, it impacted the Current Account as well as Fiscal deficit adversely. Brent at $90 and Opec basket at $87 if sustained could lead to a reversal of the last year’s negative contribution. This will reduce domestic inflation, government deficit as well as impact the rupee positively over a period of time. For the first time in the last several years supply exceeds demand in the oil market globally. The reduction in other commodity prices like that of Thermal coal from $120 to $ 80, palm oil by over 20 per cent lately, global fertiliser prices etc will also have a positive impact on the domestic economy as India is a net importer in most commodities. Although the rupee fall has negated some of these benefits in the near term it still benefits the current account positively.
The rupee fall will eventually boost the terms of trade and result in a pick up in exports as Indian manufacturers become more competitive, however the problem as I highlighted the last time is that of export credit and its cost. Although the RBI has moved on the availability of credit the costs are still prohibitive. Hopefully this will get addressed as liquidity improves.
RBI made a very intriguing observation in its monetary policy which runs totally contrary to economic logic when they said that reducing interest rates at this stage will not boost growth. This is a totally fallacious argument as in a scenario where solvency is not an issues, banks are well capitalised and the economy is capital starved reducing the cost of capital will have a direct impact on boosting growth.
Their sudden liking for CPI as against WPI for formulating monetary policy stance also reflects a clear lack of consistency. However the fact of the matter is that the drastic fall in global commodities will result in a sharp fall in domestic inflation over the next three months which will have nothing to do with RBI’s monetary policy.
Nothing new to report on government decision making which continues to be stalled. First it was supposed to be in hibernation till the end of the budget session, and then it was the presidential elections and next will be the start of the monsoon session. The only positive is that the expectations from the government are zero or negative at this stage. They know that they need to boost the investment cycle, let’s see how they move on it.
The move to impose duties on the import of power equipment is a much needed one. With domestic capacity being adequate and there being a competitive disadvantage by giving foreign equipment duty benefits the domestic industry has been impacted adversely. Moreover there are clear cases of substandard equipment being sold and then a lack of accountability. Chinese equipment manufacturers are not only getting subsidized by their own government but by the Indian government too. This needs to be changed at the earliest. The impact of the move on power tariffs will be so low that it can be ignored for all practical purposes.
The CCI order against cement companies should not be correlated with the general anti growth policies of the government. The evidence in my view seemed to be quite overwhelming and the kind of profitability that cement companies were reporting at a time of huge capacity addition, economic slowdown and low capacity utilizations indicated some sort of collusion and anti consumer behavior. Let’s see if the order holds in appeal. This is a positive development from a longer term standpoint and a clear warning against cartelisation.
Stock markets continue to trade at cheap valuations and with India being the biggest beneficiary of commodity price correction the downside risks have reduced further. The only risk at this stage is a continuation of the risk off trade for some more time that can possibly keep prices subdued. Positive policy action from the government at this stage could lead to a huge outperformance coming through from India due to its low external linkages. The outlook overall is much better from the last time I wrote as a number of possible events that could have lead to a significant adverse reaction are behind us.
The fall in commodities will reduce gross margin pressures for companies and impact profitability positively. Exporters will benefit due to a highly competitive rupee at this stage and the rupee fall also creates huge import barriers and a protection to domestic industry.
Near-term concerns of economic growth remain. This requires an investment cycle revival which should unfold over the next few quarters. However that does not mean that the markets will wait for that to happen before moving up.