Out of the Woods and Into the Sea

A lot has happened in market behaviour, and economic events that there appears no need to try and connect the dots. In fact when the markets appear so good and bullish then everything else must not be as important. The worst must be over and discounted. What can go wrong now? In fact having been around this long I must agree that for everything that is going down there is always something that is going up. And it is only apt that I answer the question that comes to me repeatedly again and again and especially twice, in 2013 and now 2017. Is the Kondratieff [Kf] winter over?

Now first I must say that theories about cycles and market behaviour have been abused by global newsletters and advisers to a degree that the cycles are often considered as doomsday forecasting methods or conspiracy. However that is not the case. Economic cycles forecast both expansionary and contraction in cycles. Their application is not in calling market tops but allowing for the right Asset allocation. I too have learnt this with some mistakes. The role of these theories however gains more prominence during contractions because of the pain involved and everyone wants to avoid the pain.

So in 2009 identifying that India was entering an Economic winter, meant that we would have to deal with our debt problems and the right thing to do was simply avoid debt laden corporations. That would have made a huge difference in the performance of anyone's portfolio. That was the most important part of the role of knowing the cycle. It did not forecast a crash but a need for change. So in 2013 when the market took off to a new high I was asked for the first time if the winter was over. And now in 2017 the question must arise again. The answer lies in the troubles of our banking sector.

Would the NPAs in the banks be addressed by a bailout, write down, haircuts? Will the bad bank cause losses to the corporations involved or prolong their pain. The banks will in any case need fresh funds or a capital restructuring of some kind. Similarly will companies drowning in debt survive be bailed out? Will their respective businesses survive given that they must be capital intensive businesses to start with. And without new capital doing new business would not be possible. So for banks the problem first is getting new capital to lend into the economy. Then they have to find borrowers that are deserving, surviving businesses or new entrepreneurs. Businesses need to find viable projects to invest in to add new capacity. All of this does not come without headwinds.

So the process of restructuring whenever it is done involves some short term pain. Any deleveraging exercise can have a deflationary rub off on the economy. And subsequent to that you need fresh spending that is a stimulus and expansionary. The action of spending and stimulus risks inflation but the deleveraging is meant to balance the two. Without going through this process to expect Macroeconomics to turn around would not be correct. So while Rajan did the Job of getting the NPA skeleton out of the closet. It is still walking around like a Zombie. This is why the 2013 rally did not end the Indian winter in an economic sense. 2016 saw the issue come out but the issues remain unresolved in 2017.

I may add that while many thought the Demonitisation exercise was meant to help the Public sector banks. I wonder if that was the agenda. Maybe it was to bring down interest rates to allow for the survival of the bad loans longer. Nothing more. It served many other purposes of governance and corruption well and more maybe done in those respects. However it would have been known to those in power that a quarter down the line all the Cash will go back into the system and things will be back to square. This is already happening as Cash withdrawals continue at a record pace daily. So if the banking problem has to be addressed it is going to need another Crisis.

We are the World

So when we discuss Economic cycles I am not sure most get it where we are compared to the rest of the world. In my opinion we are one cycle behind the developed world mostly represented by the US. Let me put it in context at the risk of being a little technical. If you have read my Kondratieff winter article then you understand the four seasons that an economy goes though. So 1970-1980 was an Economic summer for the US. A summer involves an overheated economy which shows up in high rates of inflation and interest rates.

India has always been late in the world and so we joined the Globalisation force in the 1990s, and by 1992 started our economic summer. 1994-2001 saw peak inflation and interest rates for this period of economic contraction as is witnessed in a Kf summer. So while the US started its Autumn bull market in 1982 and it went on to 2000. India started its own Autumn bull market in 2001. Did it end in 2009 or will it end in 2017? In an economic sense it ended in 2009 with the economic cycle but not yet in the stock market. But the point is that we are behind the curve with the world on the cycle. So by 2008 the US faced its debt problems face to face and managed it with bailout and QE stimulus. That revived the economy over the coming years. India has still to face up to this. The deflationary rub off of the deleveraging however continued into 2015 with the commodity crash of the period. Now the stimulus in the developed markets is starting to have the expansionary impact that it should have of Inflation rearing its head.

Inflation around the developed world has turned around alarmingly. It should not come as a surprise as the turn comes with a lag to the commodity cycle. The Eurozone inflation is back up not just because of the devaluation of the Euro/Yen but also the QE stimulus of funding the banks.

Similarly the impact of the QE in the US is starting to show up only now. But remember that price deflation came first. US CPI at 2.7% and Core CPI at 2.2% has been rising vertically for a while now. Now we may want to believe that the trends above are temporary and will not last. But that would be based on the belief that the US economy is weak and slow. But that is just what the media has been feeding us along with the conspiracy theorists. Like the belief that the dollar is strong and will keep rising because interest rates are rising. The dollar had a 9 year bull market from 2008-2017 which involved only one interest rate hike in the last year of the move. People will believe anything they are told by the Media I guess. But the media is not alone to blame, many prominent analysts are also singing the same tune. So here is a picture of US Capital Expenditure plans published recently by hedeye.com sourced from blolomberg. What do you see? Now from where did everyone start panning so much Capex and more important what will be the impact on the economy and mostly inflation?

The return on price inflation as measured in rising commodity prices at least can often be linked to the dollar and so starting 2016 I took the view that the dollar is topping out. It read 100 in 2016 and did go above it to 103 in 2017 for a while but it could not stay there. What people missed is what happened in between. The basket of EM and other currency pairs including the Yen had already rallied a lot against the dollar driving it down. So the Euro or Pound were just like the last men standing. The Euro and Pound however make up the most of the most watched Dollar index. Similarly the new high in the dollar this year was not accompanied by new lows in Commodity prices anymore. They made higher bottoms. These inter market divergences are glaring and should not have been missed by any Technician. Occurring in the final phases of the rising trend of the dollar they were important contrarian indicators of the coming change in trend. The dollar should have stared what could end up being another 7 year bear market based on historical cycles. The bear market in the dollar will then bring with it the inflationary head wind that has been missing in the face of massive global stimulus. How much Inflation will we actually get? Can we risk Hyperinflation? These are more difficult questions to answer so just be prepared for the trend.

The immediate impact of this is on commodities and the lagged impact is then on inflation. In a world that boasts of survival on the highest levels of debt in the history of mankind high levels of Inflation is the last thing that anyone wants to deal with. Now quietly maybe that is what everyone wants, inflate away the debt by causing Nominal GDP to go up, but central banks cannot admit that. Thus interest rates are likely to be behind the curve and keep Real interest rates negative for a long time to come. All this said. what does it mean for India? The Inflationary storm that is about to hit the global markets is going to rub off on us as well and we should witness rising prices down the line. A strong rupee can try to wear off the effect of higher prices to a degree but not beyond that. The real headwind for us though will be that we will finally get the crisis we need to deal with our debt problems. If the coming Inflation pushes up interest rates again it would be tough corner to work in. Deleveraging and its deflationary effects for India might be, in a way, the ideal thing to use to fight off the global inflationary storm to a degree. Alternately we will just do what the rest are doing and allow the coming Inflation to inflate Nominal GDP in our favour. It is hard to predict precisely the course of action the government will take in the coming storm. But to put it in one line what might be the largest Macro trend of the coming years, it will be 'The Falling Dollar" 
 

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