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.