Policy Sedatives: Overwhelming Effects and Unintended Side Effects

Before the Financial Crisis in 2008, it was frequently claimed that the developed economies had permanently ended the cyclicality of prior eras. In fact – a name – the “Great Moderation” – was invented by Economists to describe the stable period from 1984-2008 when the variability of real GDP growth and inflation fell markedly. Recessions did occur during these years, but they represented short and fairly shallow punctuations between extended periods of moderate expansion. In 2004, Bernanke credited “better monetary policy” for the great moderation – meaning, of course, better monetary policy under Volcker, Greenspan and him.

That was before the Great Recession of 2008-09, by far the deepest since the 1930s. The financial crash made the term “Great Moderation” seem hubristic, if not absurd, and for a while it was banished from the lexicon. But now it seems to be back, albeit in a slightly different form.

Post the GFC, global Central Banks have not shied away from adopting a “whatever it takes” policy to support the global economy and avert another crisis. The fact that there is close to US$10tn of negative yielding debt globally bears testimony to this. It also appears that global Central Banks have succeeded in their new mission. After all the US economy is just two months away from surpassing the record 120-month 1991-2001 expansion while US equities have already hit their longest bull run in history.  So have Central Banks finally tasted blood in eliminating the obstreperous business cycle?

While it is difficult to say that business cycles have been eliminated, but it does look like they have been tamed. To put it simply, while unconventional policy response by Central Banks in recent years have avoided recessions, it has led to increased occurrence of mini-cycles. These mini-cycles are shorter in duration but occur more frequently and lead to weaker recoveries.

Below we elaborate some of the characteristics of these mini-cycles:

• The mini-cycles are entirely driven by the performance of the two largest economies in the world – US and China which together account for ~50% of global growth. The US economy is important because of its role as a supplier of dollar liquidity (via its current account) while the Chinese economy is important because of its impact on Asian supply chains
• The mini-cycles comprise shorter periods of boom due to the structural problem of debt and demographics as well as shorter periods of bust (slowdown) since policy-makers have now become very agile in their policy response
• The mini-cycles are a result of the conflict faced by Central Banks in managing short-term growth expectations vs. the longer-term destabilizing forces of excessive leverage
• Although, each mini-cycle elicits a strong policy response by the Central Banks but the subsequent recovery invariably turns out to be weaker than the previous one

Perhaps the best way to explain these mini cycles is to compare the economic environments in late 2015 and late 2018. In late 2015, the global economy was staring at the cusp of recession led by a plunge in oil prices and China induced global manufacturing weakness. As volatility roiled equity markets, policy makers quickly stepped in via the purported “Shanghai Accord”. This was the apparent quid pro quo that emerged from the G20 summit in February 2016 in which the Fed agreed to be patient in raising rates while China launched a major stimulus program. What followed for the next two years were a synchronized global growth recovery and a fierce rally in equity markets.

Fast forward to late 2018 and the environment looks eerily similar to what transpired in late 2015. A curb on leverage at the start of 2018 caused the Chinese economy to slow considerably. As Chinese growth faltered, so did several economies dependent on global trade. With risk assets in a state of turmoil, policy makers once again stepped in with Fed swiftly moving to dampen expectations of further rate hikes and China embarking on policy easing.  In fact, it now appears that these mini-cycles are closely linked to China’s credit cycle with some lag (Chart 1).

   Chart 1: Bloomberg China Credit Impulse (% of GDP)

Source: Bloomberg

While Central Banks through their unconventional policies have managed to depress large variability/volatility in macro data, they have been unable to tackle the issue of prolonged low nominal growth. The remarkable absence of inflation even after unprecedented monetary easing and tight labour markets is particularly startling. Technological advancement is now often used as an explanation for mysteriously low inflation. However, low inflation itself could be responsible for subduing the business cycle due to its dampening effect on incomes. To counter this, the proponents of MMT (Modern Monetary Theory) are now prescribing an unorthodox combination of fiscal expansion supported by Central Bank money printing. Despite criticism from many eminent voices, this new school of thought has been successful in garnering attention, as few within the Fed have now started talking about targeting nominal GDP growth as a policy objective.

However, be it QE or MMT, the fact of the matter is that volatility cannot be suppressed forever. With policy makers now pushed to the wall to either adopt unusual policies or risk deep contraction in asset prices, mean reversion of volatility appears to be the most probable outcome going forward.

In the last few years, like the global economy, the Indian economy has also been experiencing mini-cycles characterized by low growth and low inflation (Chart 2). Apart from global factors, domestic issues like absence of financial slack (declining household savings rate) and health of balance sheet of various stakeholders have led to this subdued environment. While on a relative basis, the Indian economy is the fastest growing economy in the world, the problem is low growth for long (real as well as nominal) coupled with declining investment rate can lead to marked decline in potential growth.

Chart 2: The Indian Economy has been experiencing low growth low inflation in the last 5 years

Source: CMIE Economic Outlook

However, unlike global Central Banks who have tried to fight all headwinds via a “whatever it takes” policy, the RBI seems to have fallen short. While the RBI has been infusing liquidity into the system via OMO’s and forex swaps, the injection has been more reactive rather pro-active (even in the wake of the current NBFC crisis). Their single-minded focus on inflation targeting has meant that the economy has been grappling with oppressively high real interest rates which in turn has been deterring private investments and lowering the economy’s potential output.

Recently, the RBI has expressed its concern over fiscal slippage. In the medium-term, yes that has to be resolved because crowding out is a genuine issue when financial savings are low. However, growth considerations need to take precedence over other things at the point of time. Rather than being dogged down by the fear of inflation (which is non-existent), the RBI needs to err on the side of excessive easing. Moreover, to be more effective, RBI liquidity injection has to be directed towards troubled segments like MSME's, rural economy and NBFC's.

While the ingredients for a sustainable growth cycle may be missing in India, without significant Central bank easing, there is a risk that India’s growth may structurally shift downwards.With India’s medium term growth outlook plagued with uncertainty, the Indian economy/markets in line with the rest of the world cannot escape volatility ahead.

Riding the Liquidity Tiger

"Last thing I remember, I was running for the door, 

  I had to find the passage back to the place I was before, 

 'Relax' said the night man,

  We are programmed to receive

  You can check out anytime you like,

  But you can never leave"  

                                                                                                     The Eagles - Hotel California

Against the expectations of another solid year after a stellar 2017, last year turned out to be fairly miserable for investors with every asset class significantly under-performing cash. In our regular year end survey in 2017, we found that consensus was expecting mid teen returns from EM equities in 2018 with not a single strategist calling for a negative return year for EMs. In contrast, MSCI EM ended the year down 17%, while the strongest of the markets like the US also suffered its first double digit losses this decade. The pain in risk assets was felt despite US GDP growth hitting 4%, global EPS rising to fresh highs (15% yoy growth), US corporates alone buying back ~1trn of equity and unemployment falling to multi-decade lows in US and Europe.

While there are various explanations to the sudden risk off (including possibility of a US recession in 2019), the most plausible explanation could be that the World is currently experiencing a liquidity squeeze. Post the Global Financial Crisis, we were in a slow deflationary recovery, prone to aftershocks (Eurozone periphery, China) which forced Central Banks to print money in vast quantities. It all started with the US Fed, but as the contagion spread to other economies, they also pursued  large scale monetary easing. The result was 713 rate cuts, US$12trn of asset purchases and global bond yields falling into negative territory.  In fact, 2017 alone saw a whopping US$2trn of asset purchases by the ECB and BoJ (the highest ever). Not surprisingly, it was this flow that conquered all risk assets, resulting in a stellar rally in global equities with preposterously low volatility in 2017. 

However, 2018 marked an important turning point with the script changing from quantitative easing (QE) to quantitative tightening/tapering (QT). It is the US Fed which started withdrawing stimulus from last year, while both the ECB and BOJ continued with their asset purchases, but at a much slower pace. Consequently, total assets of major Central Banks peaked at $15trn in Mar-18 and has now fallen to $14.2trn at the end 2018 (chart 1). With liquidity getting scarce at the margin, assets that performed exceedingly well when liquidity was abundant (stocks, bonds, EMs) are now struggling, while assets that performed miserably under QE (cash, US$) are now outperforming. Moreover, volatility across risk assets has shot up significantly.

Chart 1: Total Assets of Major Central Banks

Source: Ed Yardeni Research

There are other factors which have amplified the recent equity market correction:

Debt funded share buybacks: Loose monetary and fiscal policy have led to unprecedented buybacks. Massive share buybacks not only have boosted EPS but have also led to reduced equity market float. Over the past decade, S&P 500 companies bought back ~$5 trillion shares. Less number of shares for trading means less liquidity. Less liquid markets amplify the market gyrations.

Side effect of the dominance of passive investors: Typically, active investors buy when stocks are undervalued and sell when overvalued. This active role has been critical, and the basis of mean reversion led cyclical investing.  Relative to active investing, passive investing is more about momentum. However, as more and more markets are under the grip of passive investors the buying (liquidity) support which active managers tend to provide is now missing. This in turn has exacerbated the downward spiral in equities (especially in the US where the speed of the fall since October has taken everybody with surprise).

These technical issues are also in some ways offshoots of grand monetary experiment that various Central Banks have done at varied time periods since the Global Financial Crisis. However, what is now clear is that:

Peak Central Bank Liquidity = Lowest volatility (what we saw in 2017)

Liquidity withdrawal by Central Banks = Heightened volatility (what we are witnessing now)

While most Central Banks around the world have started to withdraw their liquidity support, there is one Central Bank which has expedited liquidity infusion since 4QCY2018. That Central Bank is the RBI. So far in FY19, the RBI has conducted purchases of government bonds to the tune of Rs.1.9trn via Open Market Operations (OMOs). Further, the RBI has stated that it will infuse another Rs.500bn worth of liquidity per month from January to March-19. Also, it mentioned that the “OMO amount stated above is indicative and RBI retains the flexibility to change it, depending on the evolving liquidity and market conditions” – basically implying a strong commitment to infuse durable liquidity.

Important to note that liquidity of such large magnitude has never been provided by the RBI ever before in its history. The last time RBI had infused liquidity of somewhat similar quantum was back in FY13 when it did OMO purchase worth Rs.1.5trn.

In our last article, we had argued that the recent decline in household savings in India meant that capital availability (liquidity) in the economy is likely to become a structural challenge. This year, the situation got amplified by the sharp rise in oil prices during middle of the year as well as the government crowding out the private sector. With respect to government finances, the need to support the farm/rural economy (in the form of loan waivers, higher MSP and direct cash transfer) is now acting as a permanent drain on the fiscal side. Lower than expected GST collections in the election year means that the Govt. is now looking for new and innovative ways to fund its spending program – and yet is likely to fall short!

As we know, the oil led brief BoP shock caused a sharp decline in forex reserves which in turn led to the decline in base money. Therefore, the RBI anyways had little choice but to generate sufficient reserve money in order to sustain growth. However, it was the ILFS default and the consequent shadow banking crisis that acted as a catalyst for the RBI to really step up its liquidity operations. While the RBI has been guilty of committing several policy mistakes in the last couple of years (and we have been critical of it), it is currently doing a commendable job of supplying durable liquidity at a time when the economy really needs it. The financial slack in the system is fairly limited as evident from the highest ever banks' credit to deposit ratio (chart 2). Also, the gap between call money rate and the repo rate along with corporate credit spreads continues to remain quite elevated despite the recent sharp correction in oil prices. This suggests that without the RBI’s liquidity support, economic growth will most likely suffer.

Chart 2: Record High Bank Credit to Deposit Ratio

Source: CMIE Economic Outlook

To conclude, the last few months have made one thing very clear. We are in an era where markets are overly  dependent on Central Bank support. The design of the QE framework was that it will work mainly through the financial (asset prices) economy rather than real (capacity creation) economy. Therefore, when there is even whiff of withdrawal of quantitative stimulus the markets are reacting very negatively. The message from the markets is that the World is in QE trap and the foundations of the decade old expansion (post GFC) is on extremely shaky ground.  Balance sheet normalization has been and will be a major challenge for all the policymakers. Markets would force the policymakers more than ever to continue to pursue loose monetary policy. Case in point is this Friday, when in response to weak Chinese economic data, the PBoC announced a RRR cut and even the Fed Chair Powell (despite a bumper labour market data) conveyed that the “Patient” Fed will be flexible with all of its monetary policy tools, including the all important balance sheet. In a nutshell, whether it is the RBI, Fed, PBoC, ECB or BoJ, the burden of heavy lifting squarely rests on their shoulders. They are riding a liquidity tiger and no matter how hard they try, there is no jumping of it!

The Great Indian Consumption Conundrum

It is a well-known fact that in the last five years, the Indian economy has slowed down considerably. GDP growth between FY13-FY18 has averaged 7% (under the new series) which pales in comparison to the 9% average growth (under the old series) registered during FY04-FY11. Also well-known is that the slowdown has been brought about by a marked decline in domestic capex activity as well as stagnant exports. After gaining market share by over 1.5% during the last decade, India’s total exports as a % of global trade has plateaued at 2% for the last many years (Chart 1). However, more noteworthy, is the unusually large decline in capex activity which the economy has experienced in recent years. Thus, while Gross Fixed Capital Formation (GFCF) grew at roughly 2x the rate of GDP growth between FY04-FY11, its growth has now fallen much below GDP growth in the last few years.

                                          Chart 1: India’s share in world trade has stagnated

With two major engines of the economy moving in slow-motion, needless to say, private consumption has been the sole driver of economic activity in the current decade. In fact, what is striking, is that the share of private consumption in GDP has declined in every single decade, since independence, except the current (Chart 2). There is no doubt that consumption has provided the much-needed lifeline to the economy at a time when other engines have failed to fire. Generally, in an economic recovery, first consumption picks-up which in turn leads to better capacity utilizations and consequently leads to pick-up in capex activity. Therefore, consumption led growth is not bad per se. However, in India’s case, while consumption has undoubtedly supported growth, it has also resulted in the emergence of certain structural imbalances. These structural imbalances if not addressed can have serious implications for the long-term growth potential of the economy and can turn the “Great Indian Consumption Story” from a boon to bane.  

Chart 2: Rising Private Consumption (% of GDP)

These imbalances have manifested itself in mainly two forms:

• Consuming more of what is not domestically produced: India’s consumption profile seems to be increasingly misaligned with its production profile. A testimony to this is the continuous  rise in India’s non-oil non-gold trade deficit in the last few years (Chart 3). It has always been convenient to blame oil and gold imports for India’s external vulnerabilities. However, beyond the oil curse, what is being ignored is the steady deterioration in the composition of India’s import basket.  In fact, electronic goods appear to have become the new gold with electronic imports more than doubling since the start of 2010. While a weak commodity cycle has masked India’s external vulnerabilities in the last few years, underlying trade balance has continued to worsen. As the support of benign commodity prices wane, the economy could become increasingly susceptible to an external shock.
• Declining household savings rate: In most emerging economies, out of the three stakeholders, savings by the household sector tends to the be the largest and the least volatile component of the overall savings rate. While corporate and government savings fluctuate with the business cycle, household savings are generally determined by more structural factors like demographics. In India, household savings rate has been on a rising trend ever since data is available (from 1950s onwards). It is only since 2010 that this trend appears to have broken with household savings rate declining continuously (Chart 4). A possible explanation is that in the absence of any significant income growth in the last 5 years, households have increasingly started to substitute savings with consumption. Moreover, higher consumption can be supported not only by withdrawal of savings but also higher debt. This too appears to be happening with household debt in India rising recently (albeit from very low levels). 

 Chart 3: India's worsening non-oil non-gold trade balance

Chart 4: Declining Household Savings (% of GDP)

What are the implications of the above?

For the last many years, discussions of India’s growth have centred on one simple question: how soon will the economy revert to 8-10 percent growth? The question is at times posed as if such a reversion is a fait accompli, a phenomenon just waiting to occur. Perhaps it is even just around the corner, given all the structural reforms the government has implemented in recent years.

However, history suggests that no economy has been able to achieve consistently high economic growth without accompanied by rising savings rate. The economic success of many East Asian economies is a case in point. Experience of these economies show that during the phase of good demographics, household savings rose sharply. This in turn led to higher investments and propelled these economies into a higher growth trajectory (Chart 5). On the other hand, in many LATAM economies (Brazil, Argentina, etc.) despite favourable demographics, household savings rate remained stagnant with households substituting savings with consumption. Not surprisingly, this led to creation of several macro imbalances (high interest rates, high inflation, high CAD) with the economies falling into what is known as a “low-income trap”.  

                  Chart 5: In China, savings & investments grew during phase of good demographics

                                             Chart 6: This did not happen in case of Brazil

India is at the cusp of realizing its own demographic dividend. It therefore becomes imperative to exploit this phase of good demographics optimally to prevent the economy from going the "LATAM way". However, household led current account imbalances which result from declining household savings rate are difficult to tame. Also, it is not ideal to solve it by stifling the consumption engine through contractionary policies. This is because such policies (be it fiscal or tighter monetary conditions) tend to have a greater adverse impact on capex activity rather than making any significant dent on consumption trend. Instead what is required is a supply side response, i.e aligning the country's production profile with its consumption profile. “Make in India” cannot remain a mere slogan. “Make in India by Indians for Indians" is the urgent need of the hour. For this, a collective effort by all stakeholders including the RBI and the Government is needed. A clear vision and execution strategy to achieve the right growth mix cannot be compromised for any other objective. 

Who Moved My Interest Rates?

Any investor who has spent reasonable time in financial markets would tend to agree that the narrative can change very quickly as far as asset prices are concerned. Roughly a year back, the world was grappling with the idea of negative interest rates. In fact, in early 2017, close to US$10 trillion worth of global bonds had negative yields. This was unprecedented and led to widespread concerns of deflationary pressures in the global economy. Fast forward to 2018 and the concern has now shifted from NIRP/ZIRP to the recent sharp rise in bond yields. There has been an across the board sell-off in DM bond yields with the US 10-year treasury yield increasing by roughly 80bps since last September.

This brings us to the question – what macro outlook are US treasuries currently pricing in?

In order to explain the behaviour of longer-term rates, it is useful to decompose the yield on a long-term bond into three components: expected inflation, expectations about the future path of real short-term interest rates, and a term premium.  If we look at recent inflationary expectations (using US 10-year breakeven rate as a proxy), we observe that while they have risen, they continue to remain well-anchored around the Fed 2% inflation mandate (Chart 1). In other words, US ten year yields are currently discounting a relatively benign profile for CPI inflation. Thus, inflation expectations cannot be a good explanatory variable for the recent sharp move in US treasuries.

Chart 1: US Bond Yields have risen far more than inflationary expectations

One of the major reasons why bond yields have spiked recently is that markets have finally begun to price a more aggressive Fed. In fact, the market implied Fed policy rate hikes is now closest to the FOMC’s median dot plot than it has ever been since the start of the tightening cycle. The Fed futures rate is now pricing in 3 rate hikes this year as opposed to one hike being priced in at the beginning of the year. Consequently, this adjustment in expectations has led to the recent sell-off in bond markets. Although difficult to measure, there seems to have been a rise in term premium as well. All these years, large scale quantitative easing programs by major Central Banks created an artificial demand for bonds and helped to keep term premiums extremely low (in fact term premiums moved to negative territory). This trend finally seems to be changing. The interplay between a heavier prospective supply of bonds by the US Treasury and the absence of Fed purchases now seems to be finally weighing on long term bond yields.

Going forward, US bonds face two significant headwinds. Firstly, the ongoing trade war can lead to a significant rise in inflation risk premium than what is currently been priced in by the bond markets. In the last two decades, world trade has played a very important role in bringing down inflation globally through free movement of goods as well as labour. Any reversal of the same could create significant inflationary pressures. Secondly, there could be a serious mismatch between the demand and supply of US treasuries going forward which could raise term premiums further.

In the past few years, the US Treasury has needed to (on net) raise about three percent of U.S. GDP from the market to fund the budget deficit. A portion of the deficit has been funded with short-term debt, so funding deficits of that size have required roughly 2% of GDP per year in (net) issuance of Treasury bonds and notes. However, with the Trump tax plan, the fiscal deficit is rising toward 5.5% of GDP, which implies that the Treasury will need to sell about 4 percent of GDP of bonds (on net) a year—not the roughly 2 percent of GDP it now sells. On the other hand, the Fed will be cutting back its Treasury portfolio at an annualised pace of $90 billion a quarter, or a bit under 2% of GDP, once the roll-off is fully phased in. The market consequently will likely need to absorb over 5 percent of GDP of longer-dated Treasury issuance—a real step up from the current level.

It is very usual that equities perform well when bond yields rise – it is a clear sign of growth. However, two things need to be kept in mind about the current cycle. Firstly, ultra-low interest rates have propelled global equity valuations close to record high levels. Some mean reversion is likely as interest rates rise. Secondly, thanks to ultra-low interest rates, U.S. firms have spent roughly $4 trillion on share buybacks since 2009, making corporations the biggest single source of demand for U.S. shares. Buybacks have “accounted for +40% of the total earnings-per-share growth since 2009, and an astounding +72% of the earnings growth since 2012”! This trend is also likely to be impacted as the cost of debt rises further.   

Coming to India, the Indian bond market has been in the midst of a massive turmoil of its own in the last few months. From a low of 6.4%, the Indian 10-year G-sec has seen a jump of more than 120bps in a span of just 4 months! It is important to note that Indian G-secs have seen a sharp sell-off at a time when yields in other EMs have been extremely contained (Table 1). Thus, it is clear that local rather than global factors have been responsible for the recent carnage in the domestic fixed income market. 

Table 1: Sharp Under-Performance of India 10-Yr G-Sec vs. EM Peers

So what has brought about this movement? As is the global case, inflation does not seem to be the culprit in our case too. While the inflation prints since Nov-18 has inched higher, it still remains comfortably within the RBI mandate. Moreover, both RBI and consensus forecasts for the next 1 year remains relatively benign. Also, what is rather interesting to note the current gap between the repo rate and the 10-year G-sec is unusually large (more than 150bps). In fact, it is the highest ever barring the period of the Great Financial Crisis (Chart 2). On the face of it, this implies that markets are pricing an extremely aggressive RBI hiking cycle (atleast 75bps of rate hikes this year). However, neither RBI's current inflation forecast nor its current stance warrant pricing of such aggressive hikes. In other words, bond markets seem to be perturbed not by RBI but by some other factor.

Chart 2: The Gap between the 10-Year G-Sec and Repo Rate is unusually large

This "other" factor appears to be demand and supply. On the supply side, fiscal slippage in FY18 as well as concerns over the FY19 deficit target (on the back of optimistic GST projections) seems to have made markets rather uncomfortable. On the demand side, as the demonetisation induced surplus liquidity situation has quickly evaporated and as credit growth has picked up (rising credit-deposit ratio), the demand for G-Secs by commercial banks has progressively come down (Chart 3). The demand angle has been further exacerbated by PSU banks not willing to buy G-secs due to complete erosion of their treasury income which were the biggest contributors to their calendar 2017 profits. In fact, volumes in the bond market seem to have collapsed quite a bit. Bond trading volumes averaged Rs.290bn a day in the first two months of this year vs. Rs.435bn in the same period last year. 

Chart 3: Rising CD ratio resulting in reduced demand for G-Secs

As we know, the Indian economy is in the early stages of a cyclical recovery after being impacted by two major disruptions – demonetisation and GST. Given that the recovery is quite nascent, rising cost of capital does not bode well for the sustainability of the economic acceleration. Moreover, cost of capital has risen even before RBI has embarked on its rate hike cycle which suggest that domestic liquidity conditions remain very tight. In such a scenario, it becomes important for the RBI to refrain from further adding to the financial tightness. It is quite likely that liquidity situation improves momentarily in 1QFY19. This could be accompanied by some cyclical pickup in inflation aggravated by base effect. However, RBI should overlook these developments and maintain status quo. Also, when liquidity starts to turn unfavourable in the latter months, the RBI should proactively supply durable liquidity (via OMOs). A delayed response could lead to further hardening of rates. Growth has suffered too much for too long. Protecting the ongoing nascent growth recovery is now the urgent need of the hour for policymakers! 

A Decade is a Rather Long Time!

8^th January 2008 was a watershed moment in the history of Indian financial markets. It was on this day that the Nifty made its major top after rallying by a monstrous 500% since the start of 2002. Similarly, the S&P 500 rallied 95% between Jan-02 to Dec-07 and then fell by a whopping 60% in the ensuing months. We are now in the 10^th anniversary of the worst ever financial crisis which the world experienced since the Great Depression of the 1930's. The scars of the crisis are still etched vividly in the minds of the investing community. In fact, it has significantly altered the way policymakers and investors think about the economy, recognising the important role that financial frictions play on the functioning of the business cycle.  

Fast forward 10 years and most global markets are now making new highs. In fact, the S&P 500 is up a massive 72% from its previous 2007 peak while the NIFTY has also registered similar gains during the same period.  This brings us to the question - what have been the similarities and dissimilarities of the current bull-run vs. the previous? Are two bull markets always the same?

The common thread between the last market peak and the current highs appears to be stretched valuations. Global market cap to GDP reached ~100% at the end of 2007 before declining sharply as the financial crisis hit. Global market cap once again stands at ~100% of GDP (Chart 1) and most markets are currently trading at the top decile of their respective long-term one-year forward P/E history. 

                                   Chart 1: World Market Cap (% of GDP) back to  2007 levels

However, this is where the similarity seems to end. A defining feature of the last bull-run was synchronisation. This synchronisation occurred at two levels:

• Global Business Cycle Synchronisation: The opening up of world trade and China’s accession to WTO at the end of 2001 created a virtuous cycle which helped improve productivity levels across all major economies. The result was that the business cycle of most economies got aligned with potential growth increasing together in the first half of the previous decade and getting bridged together in the latter half of the decade. The biggest reflection of this came in the form of convergence of monetary policies with all major central banks cutting and raising rates in tandem

• Business and Market Cycle Synchronisation: As the global economy grew at a robust pace thanks to trade openness and productivity gains, it translated into revenue and earnings growth worldwide. This in turn propelled global markets higher. Notwithstanding the excesses that got built into the financial markets towards the fag end of the bull-run, a large chunk of the market returns in the previous decade were backed by strong economic fundamentals.

While synchronisation was a major characteristic of the last bull market, divergence seems to be the name of the game of the current rally. Firstly, business cycles appear to have become misaligned – US looks like a late cycle economy, Euro area appears to be a mid-cycle economy while most Emerging markets are in the early to middle stage of an economic recovery.  This divergence is once again well reflected in the conduct of monetary policy – while Fed is well into the hiking cycle, the ECB and BoJ continue to ease.

Not only have business cycle diverged, but financial markets too appear to have become disconnected from the business cycle. Never ever in the history of financial markets have this kind of disparity been seen between the financial economy and the real economy. While 2017 has only been the first year of a broad-based global profit recovery – most equity markets have already hit new highs. Thanks to the liquidity super-nova courtesy the major central banks, equity markets appear to have borrowed too much from the future.

A few other discrepancies between the last and the current bull-run include performance of asset heavy vs. asset light models. The last cycle was all about capex while the current cycle has been all about consumption. It is therefore not surprising that the market cap of FAANG+BAT now exceed the entire market cap of Germany! Similarly, trade openness was a big theme of the last cycle while protectionism has gained significant ground in the current cycle. Above all, the political landscape has undergone a massive change all across the World. After all, ten years ago who could have imagined that an eccentric TV show host would go on to become the President of the United States of America or British political leaders would be negotiating for an exit out of the Euro zone.  

Surprisingly, nowhere have the divergences been as acute as they have been in India. For instance, most of the macro data points currently suggest that the Indian economy is in the early stages of a cyclical recovery – capex to GDP, profit to GDP, credit to GDP and inflation are at cyclical lows. Yet most of the indices are sitting at new highs with frothy valuations that are generally observed towards the fag end of the business cycle.

This sharp divergence between the real economy and the financial economy means that we are likely entering a phase where the tussle between bottoming fundamentals and sky-high valuations would certainly lead to higher volatility. Indeed, the absence of volatility in the markets specifically in the last few quarters is also unprecedented.

What is even starker is how dramatically the composition of the market has changed between the last bull-run and the current. This is highlighted in the table below:

                                           Table 1: Sectoral Composition of BSE 500 Index

The above table clearly shows the large adjustments which the market has undergone in the last ten years. The share of the so-called “old economy, capex driven, asset heavy” sectors have shrunk massively, while consumption driven stocks (consumer NBFCs, consumer discretionary, consumer staples, etc) have gained at their expense. This is not surprising. The 2002-2008 business cycle in India was led by capex while consumption share in GDP declined precipitously. On the other hand, the current cycle is the first in last many decades, where the share of consumption in GDP has actually increased.

Market changes are constant but very difficult to predict. At one hand, no one would have envisaged the kind of changes that has happened over the last decade. However, the fact of the matter is that these changes if caught at the right time, give tremendous opportunity for alpha creation. For instance, the Nifty is up 75% in the last 10 years, where as many sectors and companies which aligned themselves to the macro changes have risen by multiple times.

We acknowledge that predicting how the aggregates would shape up is a daunting task. But it’s also true that macro/sector/theme rotations are permanent features. No two bull markets are ever the same. The winners of the last bull-run may very well turn out to be losers of the next. The above particularly holds true for the Indian economy. India by virtue of being at a nascent stage of its development cycle keeps undergoing rapid transformation from time to time. For instance, formalisation, financial inclusion, supply-side reforms and digitisation are some of the changes that the economy is currently witnessing. These changes will ensure that our market composition keep changing rapidly. This in turns provides a tremendous opportunity for active asset managers to beat benchmarks. What's critical is to find "where is the sweet spot"? Getting the rotation right and early is the key!

Policy Challenges in the World of Faltering Phillips Curve

Global equity markets have done remarkably well over the last few months aided by ultra loose monetary conditions, low interest rates and more recently good macros and earnings growth. However, valuations are elevated and therefore investors are worried about potential risks ranging from political uncertainty to policy mistakes.  One of the biggest concerns is that it will probably not be long before worldwide money creation starts being reduced. G4 central bank balance sheets currently stand at a staggering US$14 trillion. This has more than doubled from 2009 and compares with US$100 trillion in investable global bond and equity outstanding. 

The big question that arises is whether the economic conditions that had led to this massive balance sheet expansion in the first place have turned favourable enough to justify a withdrawal of QE.  While there is no denying that growth currently is at its strongest level it has ever been in this cycle, what seems to be still missing in action is inflation (Chart 1). Thus, despite eight years of the “Grand Monetary Policy Experiment”, G-20 inflation remains at is lowest levels since the Great Financial Crisis.

                                       Chart 1: Global Inflation continues to remain absent

                                     Source: OECD

Global excess capacities, debt and deleveraging as well as the sharp decline in oil prices are some of the well discussed reasons for the current low inflation environment. However, a less talked about factor is the complete absence of wage inflation despite a tightening labour market. The Phillips curve, named after the 20^th-century economist A.W. Phillips conjectures an inverse relationship between the unemployment rate and inflation, that is, a tighter labour market (lower unemployment) should be consistent with higher inflation (or wage inflation). In general, this relationship has withstood the test of time.

However, since the Great Financial Crisis, we have seen the US unemployment rate from drop from nearly 10% at its peak to just 4.4% today, yet core PCE inflation has failed to break above 2.0% - the Fed’s price stability goal. This is true not only for the US but other developed economies as well. The consistent downside miss amid continuously dropping unemployment rate and tightening labour market has now led many investors to question the validity of the Phillips curve concept.

So why does the relationship appear to be breaking down? Our best guess is that technological disruption is thwarting the war on deflation, that is, technological disruption is proving to be deflationary. For instance, in 2015, a spot-welder working in the US automotive industry was paid about US$25 per hour. A spot-welding robot can now do the same job for US$8 per hour (all in), and the difference is only likely to get bigger in the years to come (Source: BofAML).

In other words, the acceleration of robots and AI (the number of global robots is forecast to rise from 1 million in 2010 to 2.5 million in 2020) seems to be exerting downward pressure on wage expectations. A basic principle of economics is that when you face more competition, you are less inclined to put your price, or as a worker, your wage, up. Perhaps as a consequence of this extra competition from robots, many workers in advanced economies now feel less inclined to take a risk by seeking larger wage increases.

If the above is indeed true then it poses some serious challenge for central banks. It means that the Phillips Curve is now much flatter than it once was and thus inflation is now likely to be much harder to generate. This probably explains the utter failure of QE to help central banks achieve their inflation mandate. However, while QE has failed to generate what we call consumer price inflation, it has definitely led to inflation of a different kind. The liquidity bazooka provided by the central banks in recent years has resulted in an environment where prices of financial assets are high across the board – almost nothing can be bought below its perceived intrinsic value while risk aversion (volatility) is at lowest levels on record.And it is precisely this asset price inflation along with the threat it poses to long-term financial stability which is pushing central banks towards unwinding their “Great Monetary Policy Experiment” rather than any threat of real life inflation.

Coming to the India, the Indian economy too has been facing a similar situation where inflation has consistently surprised to the downside in the last couple of years. Thanks to a combination of global and domestic factors, inflation has come down sharply from a peak of 10% in 2012 to close to 2% today (much below RBI’s target of 4%). In fact, it now appears that the economy is undergoing a structural shift in the inflationary process towards low inflation.

It is important to note that being a current account deficit economy, India has always been a net importer of price trends from the rest of the world. Thus, if global inflation is on a structural downtrend thanks to the long lasting decline in oil prices and a flattening Phillips curve, then India no longer needs to worry about imported inflation. More importantly, domestic factors are also pointing to a paradigm shift towards lower inflation. Supply side pressures are far lesser now than it was in the past (e.g. power, coal, telecom, etc) while recent reforms (including GST, demonetisation) are on balance deflationary in nature.

However, despite these favourable developments, both the Government and the RBI have adopted a policy consolidation approach. It is perhaps the trauma of the past inflationary episodes and the serious dent it had caused on their credibility that is forcing policy makers to adopt such an approach. Clearly, by adopting an inflation target framework, their main objective is to reduce medium term inflation and inflationary expectations. However, if both local and global factors are firmly in favour of structurally lower inflation then purely for the sake of preserving credibility, policy makers may inadvertently do more harm by being too adamant in sticking to their ambitious inflation targeting framework.

Looking beyond the narrow discussion of near term policy response, a flattening Phillip’s curve globally represents a major challenge for the Indian economy. This is because labour is the only factor of production which India possesses in abundance and that factor of production is now losing pricing power. In fact, the rent on labour that India receives from the rest of the world (as a proportion of GDP) has already begun to fall (Chart 2). Going forward, if incremental growth will require lesser and lesser labour, then it becomes imperative for India to adopt the right policies and pursue higher growth with a single-minded focus. The entire “India story” is predicated on its demographic dividend and if that under delivers, then it will not only have economic repercussions but serious social and political implications as well.

                              Chart 2: India's rent on labour from overseas has started to decline

                                Source: CMIE Economic Outlook

Bridging the Income Gap: A Delicate Balancing Act

The world currently seems to be experiencing a “Piketty moment”. Thomas Piketty’s magnum opus, the controversial, surprise bestseller, “Capital in the Twenty-First Century” perhaps very adequately captures the events which have unfolded in 2016. In his book, Piketty derives a simple theory of capital and inequality. According to him, wealth grows faster than economic output if r>g (where “r” is the rate of return to wealth and “g” is the economic growth rate). Other things being equal, faster economic growth will diminish the importance of wealth in a society, whereas slower growth will significantly increase it. However, there are no natural forces pushing against the steady concentration of wealth. Only a burst of rapid growth (from technological progress or rising population) or government intervention can be counted on to keep economies from returning to the “partrimonial capitalism” that worried Karl Max. Piketty closes the book by recommending that governments step in now, by adopting a global tax to wealth, to prevent soaring inequality which could result in economic or political instability down the road. 

While Piketty’s thesis and recommendations are debatable, there is no denying that income inequality is leading to political upheaval across the world. The unprecedented rise of Donald Trump as well as the British vote to leave the Eurozone bears testimony to the fact. Post the Global Financial Crisis, anemic global growth combined with the extreme expansionary stance of central banks has had the effect of increasing wealth disparity by benefiting foremost the wealthy. This is well reflected in the sharp divergence in performance of financial assets (Wall Street) vs. wage growth (Main Street) in recent years. It comes as a no surprise then that electorates all over the world are now demanding a new “War on Inequality” by policy makers, requiring less taxpayer’s money being spent on bonds and more money on people via fiscal stimulus to boost wage growth. If 2016 is anything to go by, then 2017 could prove to be even more interesting given the election heavy political calendar globally.

          Chart 1: US wealth inequality - Top 0.1% hold the same amount of wealth as the bottom 90%

                                       Source: Deutsche Bank Research

No discussion on income inequality can be complete without a mention of India. This is because as per a recently released Credit Suisse report, India is the second-most unequal country in the world with the top 1% owning 58.4% of the economy’s wealth. The gap is not only large but rising. A long dated history of corruption and crony capitalism has been one of the biggest factors contributing to the rising gap between the rich and poor. This ever increasing gap has finally started to impact the political landscape of the economy through the emergence of anti-establishment politics. This probably also explains the historic rise of Modi – a "chaiwala" who promised greater transparency, breaking of oligarchic structures and “ache din for all”.

 Chart 2: Inequality is rising rapidly in India

                                        Source: International Monetary Fund (IMF)

With almost three years in power, Modi’s policies can be distinctly divided into two parts. The first part focused on the upliftment of the poor through productivity enhancing techniques – Jan Dhan Accounts, Direct Benefit Transfer, Skill India, Mudra Bank, etc. These schemes had the dual effect of curbing leakages in the system (thereby preventing the corrupt from getting richer) as well as providing adequate resources to the poor for a better life. It is important to note that none of these measures had any element of populism via direct dole out to the poor. Instead, it focused on a more sustainable upliftment of the underprivileged without hurting the “private sector”.

The second part of Modi’s tenure on the other hand seems to be in stark contrast to his first. It now seems that Prime Minister is determined to position himself as the “Indian Robinhood” – i.e. taking away from the rich and giving to the poor. A clear example of this is the recent demonetisation exercise. What the exercise aims to do is generate a “negative wealth effect” where the richer section of the society is left feeling poorer and then use the bounty to redistribute to the less privileged. In fact, last year’s Economic Survey had a special section called “Piketty in India: Growing Concentration of Incomes at the Top”. One of the suggestions it gave to reduce the income disparity included: reducing bounties for the rich and taxing the well-off regardless of the source of income. In a recent speech, Mr. Modi proclaimed “those who profit from financial markets (rich) must make a fair contribution to nation-building through taxes. For various reasons, the contribution of tax from those who make money on the markets has been low. I call upon you to think about the contribution of market participants to the exchequer”.

 

All the above indicate a very clear change in stance – helping the poor even if it inadvertently hurts the “private sector”.

 

There is no denying that a more equitable distribution of wealth is desirable and the need of the hour. However, the method to achieve this seems to be a complex issue. Neither Trump’s rhetoric against globalization/immigration appears to be the right solution nor Modi’s growth impacting demonetisation program. The key thing to remember is that higher inequality goes along with lower economic growth, especially in Emerging Economies. Therefore, the right matrix perhaps is to have a more conducive and compliant growth environment rather than one where the private sector feels threatened. The upcoming Central government budget is most likely to have a social upliftment agenda. However, to increase the size of the overall cake, the government has to acknowledge and act in favour of investments and job enhancing policies. Thus, infrastructure spending and tax rationalization has to meaningfully surprise positively to achieve sustainable growth driven income equality. Good intent alone is not enough, balanced policies are needed.