Economic Winter Update

Few days ahead of the budget the reflation trade has been put into question and I have to consider whether the reflation trade is back.

Some people asking me why the 3^rd wave up would not start after the bank nifty completes an A-B-C correction.

When I moved from bearish to bullish in the month of September, the question was “Has economic winter ended or have I given up on the theory?” While I believe I have detailed this answer in my updates, it might require specific conclusions. An economic winter occurs when high debt causes the economy to slow down and it may be dealt with in many different ways. One of the effects of the winter is a complete slowdown in credit due to lack of belief among lenders and borrowers on the future of business and the potential for repayment. The winter ends after bad debts are meaningfully removed from the system or at least the sentimental impact is behind us. The top and bottom of the stock market will not exactly coincide with these events but we broadly know the themes that move them.

The policy makers a response can either come in the form of allowing bad debts to be written off through defaults or bankruptcy proceedings, or attempting to inflate the GDP through monetary policy in an attempt to reduce the debt to GDP ratio. The 2^nd set of measures is more likely in a situation where government debt tends to be high. That is the scenario in many other countries around the world, however it is not so in India.

Despite the talk about fiscal policy and fiscal deficit the national debt to GDP in India peaked at 92% in 2002 [83% in revised data] and has come down to nearly 65% and is now at 69% in 2019. The USA is close to crossing the 100% mark. Therefore in a world that talks of going back from monetary policy to fiscal policy to stimulate growth India should be in a better position to do so. Yes there are risks, but what comes without risk. The question is not what we should do but what we are likely to do. There is a building market consensus that it is time for policy markers to push the envelope with Keynesian policy to stimulate growth with direct intervention, and this chart shows that there is room to do so with active risk management of rates and currency.

It is almost a year ago at the fed step back from its quantitative tightening program by 1^st starting to lower interest rates again and put a timeline to and QT by the end of September 2019. Almost immediately from October the fed started buying bonds in the rapport market and to date has done more than it allowed to be reduced during QT. In the 3 months since the impact of this started to show up in what looked like a weakening dollar and rising commodity prices. The year 2019 was also favorable to gold and silver.

The more recent scenario however is that the dollar has not broken below the 96 shelf support and the starting to rise again. Breaking out of its downward trend of the last quarter has once again raised the odds of deflation first. These multiple bouts of shifting between inflation and deflation as the macro theme and allocating assets accordingly might not be fun, but is the financial reality.

The reason this is happening is that central banks are overreacting to every change in the narrative. The moment the economy slows and there is a slight deflationary impact visible they return to monetary policy and quantitative easing. On the other hand they back off from this when it appears that the economy has legs. At each point it leaves us guessing the extent to which reflation will play out or can it result in hyperinflation if we over inflate the money supply. On the other hand will markets fall on their own weight when central banks step back in their response?

As far as India is concerned, right now all eyes are on the budget and the expectation that we will step up government spending to counter the weakness in the broad economy. The markets near term response will depend on the extent and size of the measures and the time that it will take to implement them.

In the short-term like we have seen at the start of 2013 and 2016 the nifty may be near completing a 5 wave move up and can give us the deeper retracement before heading higher. Short term sentiment indicators are giving us a clue to the contrary. 

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