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‘Current market rally’s not a sustained recovery’

This article was posted on Sep 18, 2009 and is filed under Market Outlook

By invite: Manish Chokhani:- The current hype over ‘green shoots’ and the prevailing investor complacency due to abundance of liquidity tend to disguise a darker economic reality. The world economy and markets are merely rebounding after falling off a cliff; a bounce, therefore, should not be construed as a sustained recovery. A period of extended difficulty and volatility lies ahead as consumers, banks and governments deleverage their balance sheets.

Before I’m misunderstood as a prophet of doom, let me clarify that my natural instinct is to be optimistic. Indeed, last Diwali, at the height of the economic gloom, we at Enam published a “Flashback from Diwali 2009,” predicting a 74% rise in the BSE index from the lows of November 2008. At that time, it seemed like too bold a call. Today, with the benefit of hindsight, it seems to have been too timid! Indeed, markets have risen higher and faster than we anticipated.

This was ‘Stage 1’ of the recovery. Following the collapse of Lehman Brothers and the seizure of credit markets, governments and central banks unleashed an unprecedented amount of fiscal and monetary firepower to prevent deflation and demand destruction. Their ‘brahmastra’ response prevented an economic meltdown and restored confidence. It had the desired effect of reliquefying trade channels and reflating asset values, thereby allowing businesses to start inventory restocking and banks to repair their balance sheets.

However, at some stage in early 2009, the astute ‘Mr Market’ sensed a new reality. The economic malaise was so deep that no country, including China, was willing to go against the status quo and assume the mantle of economic leadership. The world economy could not find an engine of growth to replace the US consumer. Hence, each country effectively allowed the US dollar to retain its supremacy, even as the Fed ran the currency printing presses as never before and the US fiscal deficits went into uncharted territory.

The reluctance of every major country to allow appreciation of its currency against the greenback allowed the creation of a new wall of liquidity and a massive wealth transfer to the US. (Note that Indian currency reserves have increased by about $50 billion since January 2008 even as, ironically, the rupee has depreciated from 40 to 48 in the same period).

This charade where everyone colluded in pretending that things are back to status quo and money remains cheap and freely available has led to a speculative frenzy centred on staple commodities (up 50%) and emerging markets (up 100%), the two areas where demand is expected to hold up, thanks to demographics and saving trends.

In the real world, despite ample liquidity, businesses find little reason to invest in new capital stock, as enough capacity exists to meet the one-time demand surge that’s being coaxed out of consumers by government handouts and stimulus packages. Indeed, the global demand outlook for the next few years is clearly anaemic as Western consumers save more. We may indeed get a brief round of ‘profit prop’, achieved through cost-cutting and restocking. But sustained earnings growth seems a long way off, thanks to a lacklustre operating leverage. At the same time, banks are shying away from releveraging their balance sheets. The green shoots have a few harsh winters ahead!

As ‘Stage 1’ of the recovery nears its end, the forces of economic recovery, government and central bank intervention and speculation are set to collide.

Welcome to ‘Stage 2’. In the coming months, the US Federal Reserve and other central banks in the West are on course to cease their ‘quantitative easing’ operations in order to prevent bond markets from panicking. In other words, they will soon stop buying what they are printing themselves and the current delusion of cheap liquidity will end. Real investors will have to be found for all new government treasury issuances. No less an authority than Warren Buffett has commented that these ‘Greenback emissions’ cannot be funded even to the extent of 50% if all the increased US savings and Chinese trade surpluses are invested in US treasuries! Whatever scenario one paints, Western liquidity is set to get tighter and asset prices must get relatively cheaper to attract investors. This means a combination of a cheaper dollar (or US asset prices) and higher interest rates in the months ahead.

Global liquidity is, therefore, seeking destinations such as India, taking into account its relatively attractive long-term outlook. However, as real investment demand remains muted, an asset price bubble in the property and the stock market in the immediate short term is a real possibility. We have already seen signs of this. With just $8 billion of FII inflows so far this year, selective stock and land prices are already approaching previous highs. Imagine the scenario if $4 billion of QIPs and IPO issuances had not partially met this demand!

Policy action holds the key to whether we can absorb enough liquidity to improve our fundamentals or whether we will passively go through another boom-bust phase. Faced with a record fiscal deficit and continued investor interest in India, the government has a golden chance to monetise large amounts of PSU assets, shares, land, 3G spectrum and NELP VIII exploration rights to create a virtuous environment of non-inflationary growth, with a strong currency and low interest rates. While this may arrest the upward march of stock market prices in the short term, it is the scenario most consistent with improving our long-term fundamentals and creating a sustainable bull market.

This window of opportunity is limited for us in India. In the next few months, global bond and currency markets face an inflexion point as quantitative easing ceases. Record borrowing requirements must be met even as trade surpluses, consumption and profit growth weaken. Interest rates are set to harden and currencies are likely to turn volatile. At the same time, expect the speculative frenzy in commodities to climax as it faces a headwind due to unsustainable prices (e.g., in steel), lack of storage capacity (e.g., in oil) and higher carrying costs (interest rates).

As we head toward the climax, we in India may soon have to contend with the risk of inflation and a fat subsidy bill, thanks to a rise in prices of globally-traded commodities (oil, food grain, pulses, sugar, copper, etc.), combined with the pressure on prices emanating from the erosion of local buffer stocks because of the drought. In 2010, we could potentially face a repeat of the 2008 ‘high-inflation-weak rupee’ scenario that will force interest rates higher and GDP growth lower. While we cannot control international commodity prices or our rain gods, we need to move pre-emptively and use the current benign scenario to our advantage.

The Chinese are preparing themselves for ‘Stage 2’. They’re diversifying their asset basket by buying up resources and have attempted to pre-empt inflationary pressures by stocking up on commodities ahead of a speculative climax. Indeed, they are already in the process of trying to prick their steel production and property/stock market bubble.

You, dear investor, must not get carried away into taking on more risk unless you are a savvy technical trader. My advice would be to construct a portfolio comprising companies that are well-capitalised, innovative, entrepreneurial and reasonably priced! Sectors to favour are domestic consumption; energy/utilities; insurance, and cost-competitive scale players in resources. Above all, I urge you to stay alert. The game is about to change.

(The author is a promoter-director of Enam Securities)

source: Economictimes

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