Big Bang Theory

In my most recent ‘Forex Analytics’ webinar I spoke about two possible regime changes that are taking place right now. The 1^st major change is likely to be a move away from the deflationary regime towards an inflationary regime. I titled this 'The reflation trade 2.0' because the 1^st attempt to make the shift was made in 2017 when the dollar index topped out to decline for the entire calendar year.

That was followed by a 2 year advance in the dollar that made a protracted attempt at the beginning of 2020 to take out the top made in 2017, but failed to do so and has left us behind with the possible double top in the dollar index.

While most people might wait long enough before they shift their positioning based on the above setup, Elliott wave analysis allows you to have the confidence to do so at a point when the risk reward is exponential, meaning that you are close enough to the turning point that may become the important stop loss for your view to go wrong. The ability to assess the probability of an opinion is not possible with any other fractal science. Knowing it early gives you a clear risk reward to deal with.

If you start looking for data to confirm then you might end up looking at backward looking information for example the chart below of WPI inflation that was published after the most recent data and shows a drop in wholesale prices growth to the lowest level in years. But this decline did not start in 2020 after the COVID-19 pandemic. Deflationary forces have been pushing down inflation since 2012 you look at longer dated chart.

This second chart shows the history of inflationary cycles in India. There are many spikes to 15% and higher that later cooled off. But we went below 5% after 2 decades in the late 1990s. The most recent episode saw inflation peak in 2010 and since then deflationary forces are at hold. The chart below is into the year end of 2019, so it misses the recent drop seen above. Now back at near zero inflation has a chance to start another move higher especially aided by fiscal and monetary stimulus.

in my mind the 1^st signal of this regime change came with oil prices dropping to single digits achieving many long-term forecasts for sub $ 20 that had been made over the years. Subsequently not only has the Fed stepped into buying oil bonds, but central banks around the world have resumed asset purchases that are being accompanied by some form of fiscal intervention as well. That oil prices have gone back from single digits to $ 40 recently may have gone unnoticed as the media went silent/numb on the rebound, after going hyper when we dropped to negative in the futures market. This quarterly chart shows the massive candle that we are forming on the rebound. 

Starting last year itself the RBI stepped up bond buying by conducting LTROs in a direct attempt at bringing down long-term interest rates to ensure transmission. The initial size of the program was small but expanded many fold after the Covid crisis. This is unlikely to stop.

The direct result of these operations can be seen in declining bond yields, that are now below the trendline from the 2002 lows, setting us up for interest rates that may end up being the lowest that we have seen in Indian history. This is now a trend and not a knee-jerk reaction as the central bank may continue to push yields lower, and over time expect borrowing rates not just for the corporate sector but consumer related purchases as well to come down significantly. Over the next year or two I would not be surprised if borrowing rates come down to lower single digits something we have probably not seen in decades.

For investors this has a very significant bearing on their investment behavior. On the one hand saving accounts become even more unattractive and deposits lag behind the inflation rate. As inflation slowly makes a comeback equity valuations that appeared expensive all of a sudden start looking cheap. Valuation models after all a function of interest rates [or the risk free rate] and once you bring down rates everything changes. Some might argue that the end result would be a bubble, but bubbles are processes and they first need to be built before they can pop. The opportunity is in between

The years 2010 to 2018 involved the recognition of India’s economic winter in the form of excessive debt in the corporate sector and its resulting impact on non-performing assets in the banking system. Most of these problems are now in the open and being addressed by the central bank. Many corporate groups and banks and financial institutions have already reached near failure over the last 7-9 years. In its most recent address the RBI has stated that it will not allow any more of the banks/financials in India to fail.

We all know about the debt problem or the problem of overcapacity in some sectors and are doubtful about the solutions. However economic winter cycles always end with 1 of the 2 outcomes. Either a default by all over stretched sectors or and the debt leads to a series of banking and corporate failures and a contraction in the economy on the back of these events before growth can be revived, or, those in power decide along the way to attempt to inflate their problem of Debt/GDP by expanding the denominator in nominal terms. In short the nominal GDP can be increased by slowly increasing prices at an acceptable rate, to bring down the debt to GDP ratio.

It is very important to understand which one is being undertaken by the government or central bank in power to be able to comprehend the end result and its impact on investment assets. Too many people relate a deflationary cycle with the 1929 US stock market crash that involved the Dow Jones Industrials index falling by 90%. What they forget is that one of the reasons for this deep decline was the then President’s decision to allow businesses and banks to fail if they had made mistakes. This was among the primary reasons why the collapse exaggerated itself on the downside.

This is also the reason why central banks are more proactive this time round to avoid a similar scenario. However the other alternate path is to inflate. The is an option. In other words the outcome at the end of a deflation is not just something that has to happen one way, but a function of what the policy path is to reset the debt. By default or inflation. So we are not in a position to decide this. We have to pay attention to the policy makers and then take the lead. This then will show up in the many indicators discussed here from the dollar to inflation to interest rates. The path to inflation is the path it appears, at least at the moment, that most of the world has taken to. Provide as much liquidity in the financial system as required to ensure that there is no financial collapse because of systemic issues. To allow failed businesses to either restructure or be downsized and refinanced into a new entity. US started down that road in 2008, India now faced with its own crisis is going down the same path now. Lower rates and avoid financial failure. Then wait for the lower rates to reignite consumption as the cost of borrowing new money goes down making it viable even at higher prices of goods [read inflation of prices] accompanied by wage increases [another form of inflation in wages]. 

While the US has been trying to inflate its economy since 2009, it is new for India because we are only going through this process now. After more than a two year crash in mid-and small cap stocks and the broad market, and a sell off in large caps in the post pandemic period, India joins the rest of the world in an attempt to reflate the economy without a debt collapse. In many parts of the world where monetary policy is no more having an effect on the economy direct government spending is now be undertaken. India is currently at the stage of using more of monetary policy before it can adopt more fiscal profligacy. So a lot of the inflation India may face maybe imported. This part is important to understand. Monetary policy only supports expansion of debt and consumption but that does not always result in rising prices. Fiscal spending is more direct and its impact on demand and prices could be very different. India however is still behind the curve in the long wave cycle than other parts of the world. We are doing what they have already a decade ago.

All the above put together is having changes in many major trends that have been in force over the last decade. Here are a couple of charts showing historical cycles of some patterns. The 1^st between value and growth investing. It displays a prolonged period of growth outperforming value a trend that might be overdue for change.

The 2^nd chart shows another trend where developed markets were outperforming emerging markets. Part of the reason may have been the pressure that came from a rising dollar. The US recovery since 2009 was accompanied by a rising dollar that lead to many crisis in bond markets of Brazil and Russia, and a hyperinflation in Venezuela, and trouble in Turkey. The list may be longer, but an easing of pressure on the dollar could change this trend once again in favor of emerging market equities.

The advent of floating-rate currencies has been one of the greatest financial engineering feats of our time. It has allowed the world to manage interstate balances and debts in a way like never before. In the past the government would have had to devalue its currency openly creating a currency panic. However this single change decades ago change the game completely. Today multiple central banks devalue their currencies simultaneously or in sequence one after the other with no net effect on either. This does not mean that there have not been any casualties along the way, but at large we have been able to create a much larger credit environment. The chart below shows the exponential growth of total credit both government and corporate over time. The risk to emerging market debt that is at large now denominated in dollars comes from rising dollar. Between 2008-2020 EM debt expanded by over 10$ trillion [estimates]. A falling dollar environment where a large part of the dollars are supplied by the US Fed reduces the pressure on these financial markets.

If the above trends create an even bigger bubble, we will have to deal with it tomorrow. But we are not at the end but a possible new beginning of a global bubble to be created by cheap money and easy credit in Emerging markets. Ems may attempt to Mimic the extravagance of the west. The regime shift from a strong dollar to a weak dollar maybe one of the biggest culprits of this trend. One of the secondary effects of all of the above might be another regime shift that markets have not thought about. Liquidity may flow from DMs to EMs financing another round of expansion at lower rates of interest as long as inflation does not become a problem.

Last but not least we may witness a move from a low Volatility regime to a high volatility regime. After years of the US weeks remaining below 17 on average, we may now have to get used to above 17. A similar period of high volatility can actually be seen between 1997 and 2003. In other words the tech bubble of the late 1990s actually took place in a high volatility regime and it did not change till the next bull market took hold. Few discuss this today given that low volatility has become the norm with many strategies built around it. If higher volatility becomes the norm then expect the coming bubble to the rapid and fast both on the way up and on the way down.

At the end of such a long discussion people always want a timeline for these events. In my experience time is not a science but a guesstimate of possible future outcomes. The 7 year cycle for the dollar from 2017 may end in 2024 and can provide a rough timeline for these outcomes. What you can expect though is that this game goes on till inflation runs hot enough for one markets to pay attention. At that point interest rates will have to adjust to that reality and might break the bond market bubble. Interest rates particularly in EMs would be important. Interest rates in DMs are already flirting with negative rates. EMs are starting a move from high yield to low yield at the end of a deflationary crash in oil and commodity prices. Low interest rates and liquidity are the fuel for EMs as of now as long as the dollar is falling. If any of these factors change course so will I.

All this is still part of how the Economic Winter ends. So being bullish or bearish has nothing to do with the Economic winter. The winter is about debt. But the impact on markets can change from time to time based on policy action toward that debt and we need to pay attention. Given this explanation there is nothing irrational about what the markets are doing right now. Still, for those of you who still think it is irrational, while markets can be irrational longer than anyone can be solvent, timing is everything, irrespective.

Rohit Srivastava

The Truth About the Markets