Why Global Finance Got Into Trouble in the First Place

Have you ever wondered why global finance got into trouble in the first place. For decades, we mortals in India, were lectured on why our business models were unsustainable. We did not have the 'process' or 'systems' as a manager in GE Money put it to me in 2004 during the course of my field-work. Owners of Indian companies (referred to as 'partnerships') in contrast would constantly tell me that while their (the local partnership) model survived on the fact that they knew the inside out of their clients and had withstood economic cycles of nearly everykind, the national and international companies would not last long. They depended too much on a mechanical way of doing business. How could a finance company that set targets for loans every hope to get back their loans.

The picture below provides the best answer to the GE's problems. They decided that the best way to expand in India would be to push credit everywhere. 

Who knows, you would probably be willing to contemplate a loan when filling your petrol tank! This finance company in a petrol bunk is probably the best barometer to an unsustainable mechanical model that is often peddled as 'systems based process'. I am sure at that juncture, GE thought it was the type of  aggressiveness' that they needed from their 20-something employees. Hopefully, at least now, our management consultants understand that business success depends on understanding the local needs and conditions that exist in a particular region. The faster they understand to the limits of a 'systems based process' the more successful they will be in the business world.

Little wonder that GE decided to sell out in India. 

One would only wish that at least henceforth, they would understand the basic business logic of the fianance business that when you push credit to those who cannot hope to repay it, you are not doing a service and instead you are inviting trouble. That basic understanding would have served the world trillions of dollars.These trillions could probably have been better used if only our policy makers had decided that would come up with long-term solutions to the problems of the availability of finance.

Culture of Business: The Art of Exploring New Opportunities?

We keep hearing about the growing strengths of organised retailing in India and the multiple opportunities for the retail sector as about 98% of the present retail trade is in the hands of the unorganised sector. There are innumerable stories about how the organised retail sector is grabbing market share from the hitherto unorganised players through innovative marketing strategies. Innovation has been the hallmark of the Indian business culture for centuries. Innovation exists in the formal as well as the informal sector, though we rarely hear of the innovation in the informal business sectors as they tend to be much more localised in nature. 

The pictures below show that while the organised sector may be expanding its market share, innovative ideas for marketing abound in the informal sector. In Vijayawada, one unorganised player  decided that it makes good business sense to meet competition head-on and market his products by giving Reliance a literal run for its money and decided that he would take the battle right to the doorstep of the behemoth. After all , the can sell their products at a lower price in that single segment and they would  get great visibility - all at little cost.

This is surely one business segment that Reliance cannot compete. Reliance should best ask such entrepreneurs about the best marketing strategy.

Gold: Is it in a Bubble?

The interesting aspect of analysing the financial markets or for that matter the economy is that for every ten analysts (or economists) we invariably will have twenty different opinions. Spotting a bubble is always a very difficult thing, timing it right is a unique art that very few possess. Bubbles reinforce a brilliant observation by Keynes who wearily pointed out that ‘the markets can stay irrational for longer than you can stay solvent’.

The past couple of weeks have increased the number of people who are calling a bubble in Gold. Such has been the ‘noise’ that we have the mainstream media now taking a plunge. A recent spate of articles in The Wall Street Journal are very interesting. The writer quotes Warren Buffett who is stated to have observed sometime back “Gold gets dug out of the ground in Africa, or someplace, then we melt it down, dig another hole, bury it again and pay people to stand around guarding it. It has no utility. Anyone watching from Mars would be scratching their head"

Unfortunately, Warren Buffett does not live in the developing world and since he is a billionaire, he does not have to bother about accessing credit. Ask billions in the developing world, for them gold is money. Even a beggar can get raise money, if he can pledge gold in most of the developing world. I am sure the day is not far, when the Western world is probably going to be like that for the simple reason, that their own citizens will not trust their currency. Moreover, I really doubt an extremely savvy investor like Warren Buffett will actually tell Wall Street Journal about his personal holdings. The day Buffett defended Moody’s and Goldman, I think we should stop giving much credence to his objectivity.

A number of people may do well to try to remember what has been the best performing asset class in the past decade? Gold has returned 400%, and stocks (probably Buffett’s favourite asset class) have returned less than cash.

There are nonetheless, a number of important arguments that we may have to deal with as a number of other arguments deserve greater attention. The Wall Street Journal article itself raised two important points: (a) high levels of gold production accompanied by reduced demand for jewellery, and (b) the fact that gold cannot be used for anything except as a store of value. Both are valid arguments, but to a certain point. It has been pointed out that since 2002, total demand for gold for jewellery as well as other uses has declined to 22,500 tonnes from about 29,000 tonnes due to increased supply .

Invariably the above statistics about gold are quite important and should in normal times be a major cause for concern. Reports indicate that there has been reduced demand in traditional consumers like India. However, these are hardly normal times.

It has been pointed out that all the gold mined in the world in human history can fit into four Olympic sized swimming pools. A number of observers claim that it is bad news, but on the contrary, I believe that is good news, probably it may be reason why for centuries people have fought and died to possess it. More importantly, in a recent article, the Financial Times pointed out that the current composition of gold in a person’s portfolio averages about 0.05%, with “investment herd” concurring with the views of the Buffett like claimants. Infact most of the people in the West hardly own any gold, and those who have investible surplus there are in such a state of paranoia that even if they were to move about 5% of the their total cash holdings into gold, it would lead to the price shooting up. Despite all the claims, the Commodity markets are quite shallow when it comes to their ability to absorb huge amounts of cash. It has been pointed out that in 2009 about US$190 billion of new cash went into commodities and the result: most of them shot up by about 100% from their lows.

The Wall Street Journal articles cited above had a very interesting chart (given below). If history were to repeat then Gold will have a long way to go when compared to traditional bubbles.

 

I am personally bullish on gold in the long-term as I have been for the past few years. By long-term the time horizon is over a period of 3-5 years. That reasoning is based on two critical factors. One, is the Sovereign Debt Crisis, which is likely to morph into a currency crisis, sooner rather than later and, two the consequences of millions of people buying a few grams in the third world and in Western world by a few ounces.

The sovereign debt crisis is far from over, on the contrary the worst phase seems to be just about getting underway. It has been pointed out by David Rosenberg, that the global liabilities (private sector as well as public sector) stand at nearly US$220 trillions, about four times the global GDP. These excess need to be washed out. The nature of capitalism and the process of financialisation will mean that this debt will not totally disappear. I assume that the world needs to get rid of at least one-third of the outstanding (if not half) if there has to be a meaningful return to a bull market. This is not to mean that people and companies have no money. Those who have are not willing to spend it, those who need it are not able to get it. That is the inherent nature of the banking system. The age old description of a banker is apt for the present situation. A banker is one who lends you an umbrella when it is not raining and demands it back when it starts to rain.

It is likely to end when there are debt write offs (or defaults on an biblical proportions). However, before we get there, Gold is likely to rise further. But asset prices do not move in straight lines. The sovereign debt crisis will be no different. We are bound to have phases when the policy makers will invariably take up measures that would be provide some hope to investors and speculators. There will be periodic bouts of buying and selling frenzies in the asset markets.

More importantly, the economy is likely to go into a grinding downward move over the next few years – remember Japan. Every year we will witness people who will be excited about a possible recovery and there a slight improvement in the risk appetite. If history is a guide, these hopes will be dashed to the ground, leading to ever larger convulsions in the financial markets. There are a number of events that could trigger a major buying frenzy in gold, including a BP bankruptcy, geo-political tensions, etc. There are sufficient number of innumerable risks that the world faces at this point of time and this is not likely to change in the near future. If the Republicans come to power in the USA in 2012 then we are likely to see another war, this time with Iran. The list is literally endless. But, there is no need to be carried away by such things at the present juncture.

If there are two asset classes that investors are under-exposed then it is Bonds and Gold. Since investors are sceptical, and rightly so, that would leave them with only two alternatives – Gold and its poor cousin, Silver. Both these are likely to witness consistent gradual investment buying, especially in the Western Countries. As far as the Eastern Countries are concerned, it would be a fallacy to think that gold buying will reduce dramatically, considering its solid grounding in the soico-cultural ethos, especially in India. Moreover the collapse of the other investment favourite of Indian (buying land) it is likely that gold will retain its attraction. Millions of Indian get married every year and millions of kids are born every year. In each of those social occasions (even for the poorest of the poor) gifting gold (in whatever form) is a centuries old tradition, which will not only disappear but would instead regain the centre stage because of the rising prices.

Risks:
However, it is imperative to note that spotting a bubble is not only very difficult but is invariably accompanied by multiple risks. Gold is no different. The biggest risk is the gradually running out of the gold de-hedging by Gold Mining companies. It has been pointed out that gold mining companies break-even when they are able to sell at prices from US$400-600 (varies from company to company). It is likely that after a substantial run up in prices, companies are likely to want to protect at least some of their margins and hence, they are likely to re-start hedging their production, though this is only an assumption. The assumption is based on my thinking that as the cost of capital increases because the growing problems of the banking sector, companies would probably find it more profitable to hedge a part of their protection.

When to Invest in Gold?
I really wish I could time the market perfectly and knew the correct answer, because if I could do it consistently well, then I would be a billionaire many times over. But a look at the long-term charts are quite instructive. The long term chart (see the Kagi chart below from 1997 to present) seems to indicate a substantial correction because we find negative divergences building up. However, it is pertinent to note that the 200 day EMA stands at about 1100 and the 500 day EMA stands at 996.
 

 Thus as long as gold stays above those levels, technically gold is deemed to be in an uptrend – one of the few commodities that still continue to remain in an uptrend. Speculators are best advised to avoid gold if it moves below 1000 as it has the potential to fall to 800 (worst case scenario).

Charts Tell Another Tale

I find it quite fascinating to watch a number of these business channels in India. Nearly all of them are claiming that this is a good time to buy equities. So I thought that the easy answer would come from a look at the charts. Almost all the important Indices that I looked at are indicating a long-term downtrend. The interesting chart was the Shanghai Composite Index chart which is showing signs of a short-term upmove. But, dont jump the gun as yet. There are a lot of important economic news releases due to be released on 9th and 10th (tomorrow and the day-after). 

So there could be some profitable moves there. But if the index were to break the lows of the last one month then expect a major fall.The interesting part of the charts is that they are precariously balancing on the 500 day Exponential Moving Averages and they have broken the major trend lines. So watch for violent moves. The only thing that is certain in these uncertain times, is an exponential rise in volatility, which is a classic bear market symptom.

The Chart below of the CRB Commodity Index (Kagi Chart) is quite scary. It looks like the uptrend in the commodities is over. The index has already fallen below the 200 day exponential moving average and is about to fall below the 500 day exponential moving average (which stands at 440)

Dow Jones Transportation Average
This is yet another interesting chart, because I have been reading of a bit about the rise in trucking charges, which in some case is estimated at about 20% rise in the past few months. One has to keep in mind that such a rise is not because we have a major revival in economic activity but because a number of companies in the sector are closing down, not a very optimistic scenario for the long-term health of the economy. The chart below is once again quite bearish.

Shanghai Composite (Short-term)
This is very interesting. there is some positive divergence that may provide some interesting short-term speculative opportunities.

At the same time be very careful, there are not only a lot of news releases slated that could change the game. I am quite sure that they would indicate an economy that is rapidly slipping out of control because of overheating. Moreover there is a major trendline. If it breaks the trend line, then expect a major crash in that market and with that the commodity market.

Tailpiece:

The Journal of Commerce Smoothed Index is already indicating a recession in the USA so conserve cash.

Are we Heading for a Major Downmove in the Economy?

That is a difficult question to answer but I would believe that the present conditions indicate that such a major down move is very likely. 

At last we have the markets correcting (as the conventional wisdom would say), but since I tend to take up a more unconventional (and always a hated stance), I would think that we are at the throes of the start of a bear market. Undoubtedly, this is very early days in the start of the bear run, though I am willing to stick my neck out and call the start of a bear market. I think the world has seen the best of the economic growth story and now starts the “Age of Pain”, which could last about 3-5 in the west. It is important to note that the pain will not be equally spread out over the whole world. There will be pockets of growth (as there will be pockets of pain). Economy and the markets are always a Zero sum game. One winner needs at least one loser, though in the markets the proportion of winners and losers is disproportionate.

I had confidently asserted about a year back that the bounce would be temporary, and about six months back had clearly stated that the second half of the 2010 will be horrible – to put it politely. Therefore, I was considered to be a part of the lunatic fringe and was actually called a number of names (only a few directly and mostly behind my back). Now I stand vindicated. Sadly, it required the loss of nearly US$1.9 trillion of market cap, though I hope it would have been less scary. Interestingly, I am not exactly in a panic mode, since I have had the time to reflect on strategies that would enable anybody who listens to survive and actually take advantage.

Every Dawn compounds our problems:
The problem with the world’s economy is that the margin of safety that exists is almost nil. We need one incident even if it quite small, to boomerang all over the world causing great pain and billions of dollars of losses. Each of these losses may not seem too large at a cursory glance, but cumulatively they are slowly destroying even the best companies. When the best are going to see cash dissolve from their balance sheets, it is a matter of time before the smouldering mass of combustible material explodes. The most recent example is BP, where a loss that was erroneously estimated at a loss of 5000 barrels of oil a day now has the potential to cost damages that may exceed US$20 billion over the next 5-10 years. Undoubtedly, BP can overcome this problem, but not another few of such magnitude. What are the probabilities of such Black Swan events in the future? I believe quite high as we have had nearly 2 years of relentless cost cutting where companies are most likely to have cut off the muscle and bone rather than fat. Most of the companies are led by entrepreneurs who are more prone to either selective amnesia or hype (or fear) created by the media. A number of them still continue to believe that they can borrow their way to prosperity despite the fact that we are in an era of structural change where I am almost certain that the age of low interest rates have come to a close. The only way the low interest rate regime can be continuously perpetuated is by printing ever exponentially large amounts of money year after year for the next 10 years – an unlikely event. The next two years will see an increase in printing money but not beyond that.

Why I continue to bearish on the real economy:
It is pertinent to note that the present note, deals mostly with the logic behind my bear-case analysis on the real economy and not the financial markets. For the time being, it is important to overlook the financial markets as they are dominated by speculative capital flows, which are in turn an offshoot of easy liquidity conditions perpetuated by the Central Banks. The main reasons are enunciated in the following pages.

The Red Flags:
The problem areas in the world economy are well known and have not changed since the start of 2010. The problems are however, being accentuated by the inertia of the policy makers to undertaken drastic changes that are required. The problems at the present juncture include,
(a)    A likely recession in the West.
(b)    Deterioration in the US economy
(c)    Accelerating problems in European Sovereign Debt Issues
(d)    Slowing China
(e)    Insolvency of the banking systems of Europe
(f)    Pressure to cut deficits.
(g)    Gradual (future) deterioration of the financial sector over the next one year (this would include the banking, non-bank finance companies as well as the insurance companies).

In all likelihood we are about to witness a relapse of the western world into a recession. While it may be too early to claim that the whole west may relapse into a recession, I would bet that the USA and large parts of Europe are likely to relapse into a recession in the next one year. The news that has emanated from different parts of the world is clearly indicative of either economies that are topping or those that already have seen their peak performance. Interestingly, in an era of government cost cutting everybody seems to think that the best way to overcome the recession would be export their way out of troubles. One only is forced to wonder, who will be the consumer, since most of the world is highly indebted and those who are not indebted have no intention of taking on more debt.

US Economy: Recession, Highly likely
A recession is quite likely in USA unless it is aided by fortituous circumstances (that we don’t know as it) or unless there is a large statistical jugglery. The deterioration of the balance sheet of the US consumer continues abated as does the deterioration of the balance sheets of the US states, most of which have to cut their budgets by at 20% this year (over the previous) ones. The recent Household survey indicated that the total employment fell by about 35,000. The unemployment rate did come down, but that was largely because of statistical anomalies rather than real improvement in the economy. This was because the US labour force actually declined by 322,000. It has been pointed out that nearly half a million people have simply disappeared from the way US labour force statistics, because of the peculiar way in which the US calculates its unemployed. The four-week moving average (which is more reliable) continues to consistently show that the job losses continue to remain at 100,000 a week. This time we remain short of the old peak of employment, by an astounding 8.4m jobs. One in six Americans is either unemployed or underemployed. This is not a normal cycle when compared with a typical recession, which sees no more than 2m to 3m jobs lost. The average duration of unemployment rose to 34.4 weeks from 33 weeks in April. This is taking place when the number of hours worked has increased from 0.3% and wages declined.

Consumers continue to be in a bad shape and are becoming more and more despondent, so it is unlikely that they would spend go back to their old spending habits. The mood of US households is despondent. In May only 11.3 per cent believed they would see their income rise in the following six months, while 16.6 per cent thought they would see it decline. The May retail sales are quite indicative of the larger trend, when the year-on-year Chain store sales rose 2.5% (which was about 1.5% less than the consensus estimates). Moreover, last in last May the US was just witnessing the positive impact of the huge US government rescue packages. Interestingly, only about 54% of the retailers in the USA managed to beat their lowered sales targets, while those like Wal Mart clearly indicated that the economy was too soft for their comfort. Half of the US employers froze pay for at least a part of their workforce in the past year and about 13% actually cut salaries for their workforce.

One of the critical reasons why we are betting on a high probability of recession in the west are based on the movement of the bond markets, and the commodity markets – both of them are indicating turbulent times ahead. Manufacturing in the US may have already peaked or will peak in the next one month. Manufacturing new orders increased by about 1.2% over April, while the consensus was for an increase of about 1.8%. This is worrisome as it is clear that the recent growth was largely because of the rise in manufacturing may only have been inventory restocking, which may now be coming to an end.

Another important source of concern about the state of the world economy is the acceleration in the concern about the problems and issues related to sovereign debt. The last in the list of concerns is Hungary. There are growing fears that Belgium is doing precious little to solve its problem of indebtedness. This led to jump in interest rates on the 10-year bond from 3.15 to 3.50 percent (Belgium’s debt is now 99% of the GDP). The only likely solution that seems to exist (which nobody is interested in at the present) is a default by Greece and at least another one or two countries). The major panic is likely to occur as there is a persistent increase in the probability of a default rises. I believe that such a forecast would become more mainstay by the end of 2011 (that should be sufficient time for the Morons - twenty something traders to fully understand the internal dynamics of the state). The recent statement by the UK PM that they should expect huge cost cutting that would be ‘generational in nature’ should give rational investors what they could expect over the next few years. One option that the UK government is seriously considering is to cut its budget spending by 20% per year for the next three years, akin to what Canada did in 1994. This the PM claims is because the debt level of about 156 billion pounds is unsustainable. He is correct, but so are the cuts as they will bring unimaginable suffering to the people with the consequence being a recession. While Canada got away, I am not so sure about UK for the simple reason, that in 1994 consumer leverage was barely starting and the world was a different place then. Moreover, Canada did not carry such a large debt as UK. According to the British Prime Minister, Britain’s national debt stands at 770 billion Pounds and is expected to touch 1.4 trillion Pounds within five years – or 22,000 pounds for every man, woman and child in the country.

The government cutting in fiscal deficit along with the problems in the banking system will only create a perfect storm of another crisis. European banks have insufficient capital. SocGen has estimated that European banks have to raise US$357 billion of additional capital. This figure will only increase as more assets grow bad. The banks probably have a reasonably good idea as to which assets will go bad in the foreseeable future, and it is for that they are not lending. Interestingly the era of counter party risk is back on the table and banks are not even lending to other banks, let alone other borrowers. Overnight deposits with the ECB has increased by Euros351 billion, the highest since the establishment of the Euro, this was a jump from about Euro 300 billion the previous day. However, the financial buffer for most of the corporate sector (especially in the USA) is much better as a large number of them have borrowed sufficient amount of cash that would probably last for about a year, along with the cash flows that they generate in their business). It is for this reason that I believe that the problems will reach crisis proportions more slowly. As assets grow bad we are likely to witness the need for banks to come with more capital. The largest rally since 1930s led to the problem of the banks taking a backstage as most of the asset prices rose. This provided a false sense of security. This problem will come back to haunt the banks in the very near future.

Lower interest rates are simply not working, at least not with the consumer. Mortgage rates were actually down in May by about 15 basis points and the result: mortgage applications for new homes crash to a 13 year low. See the chart in the Charts section (Charts Tell Another Story).

There is simply too much complacency amongst business that China can provide the valuable cushion to the rest of the world. More importantly, the estimates about the corporate sector profitability is too high and it would have to be revised downwards very soon. This downward revision will invariably mean that the markets will have to grapple with another down draft. The problem with falling markets is that it would open a can of worms, which will probably increase the stranglehold. Credit shortages will lead to a rise in the cost of carrying out business, just at a time when companies have no pricing power and when their margins are being squeezed due to volatility in the currency and commodity markets. Where exactly is the pain threshold, is a fact that very few know and even if they know, very few would be willing to admit until it is too late.

Investors losing more will lead to more panics:
American equities have lost nearly US$1.9 trillion dollars of market capitalisation since April 23, 2010. A number of hedge funds have been burned because they bet on the rise of inflation and betting on a continuation of narrow credit spreads. The age-old dictum, those who forget history are condemned to repeat it still holds true even to this day. During the 1990s, investors were burned because they bet on a Japanese recovery. Now, shorting US Treasuries has led to huge losses, which will only come out in time. Hedge funds fell by 2.6% last month, the largest drop since November 2008. These losses may lead to a situation where funds and investors will have to sell profitable holdings in order to pay for their mark-to-market requirements or simply to provide more collateral for their trades. This could in turn set off losses in asset classes such as Gold and Silver, though one is not sure as to how severe the cash requirement or loss are as it would vary from fund to fund.

Gold:
The bull market in gold has more legs, but in the short term expect a pull back. I would not be surprised if a meaningful pull back starts sometime in the fourth quarter of 2010 rather than immediately. This bullishness is the result of a rather simple logic. Investors, the world over, are over invested in equities and under invested in bonds and Gold. Bonds are troubling because investors are stuck with a never-ending list of shoes that may be the next in line, hence the more prudent probably prefer gold to others. The world’s liabilities are nearly US$220 trillions (public and private sector) and the US has had to pump in US$2 trillions for a GDP growth of about US$200 billion. Thus, the law of diminishing returns for large money printing is quite advanced as far as the real economy is concerned. More importantly, only about 0.05% of the share of household networth is in gold. So all we need is about another 0.01% of new buying and gold can shoot up by another 50% since the markets are actually quite shallow. There are sufficiently scared millionaires in the world, who don’t know where to put their money. Ten Kilos of gold will easily be hidden in a bank locker.

Sting is in the tail
The latest Investors Intelligence poll for the past week showed the first rise in bullish sentiment since early May - up to 39.8% from 39.3%, while there are only 28.4% bears, down from 29.2% last week.