A status-quo budget from a pragmatic Finance Minister

Arun Jaitley is an outstanding lawyer, a shrewd political tactician and on occasion an outstanding orator. But, he is above all a pragmatist. In fact, you’d be forgiven for thinking this was merely a repeat of the interim budget presented a few months ago.

Perhaps that’s unfair, however. The method of delivery (an endless, exhaustive and frankly deathly boring list of every single government program) more than the content has created the impression of a listless budget. Let’s face it, Jaitley offered everyone a tax cut by raising the threshold and increasing deductions. That’s good for the middle class and could give savings a slight boost. He has tried to give infrastructure a kicker. And perhaps most importantly, if you dig deep enough you do find a few signs of potential reform. The petroleum subsidy number and a declaration that the government intends to dismantle the administered price mechanism for diesel are signs of serious reform. When the government finally decides on its gas pricing methodology – we will get the next necessary ingredient to encouraging investment in oil and gas exploration. Given that India now imports 80% of its oil and gas, reform here is deeply consequential.

However, parts of this budget are ill-conceived. Why, for instance would you get the government involved with a 10,000 crore fund for startups? Surely, there’s no market failure there and even if there were one, why get a tainted bureaucracy and political class involved with funding new businesses out of taxpayer money? I simply fail to understand the logic there.

Another place where Jaitley shows a degree of misplaced courage is in the introduction of REITs. But, again, how can investment vehicles in an opaque, corruption/cronyism infested sector succeed? Would you trust a stranger to accurately report prices in a sector where cash payments are the norm, and where proving wrongdoing is virtually impossible? Again, why you’d save your courage for a measure such as this, I do not know!

Then there’s the tweak to taxation of debt-based mutual funds that makes you wonder if the ministry understands the consequences of its own actions. How can encouraging the debt market go hand in hand with adversely revising tax benefits accruing to long term ownership? Why would you do so when part of the objective is to drive down interest rates over time? Frankly, this absurd measure looks like a case of the banker lobby influencing the finance ministry. Sure, fixed deposits get a boost – but we need transparency, liquidity and pricing for monetary policy transmission to be more meaningful. Further encouraging a banking system that takes short-term deposits at less than half the overnight rate is not only devoid of economic logic, it’s downright regressive.

And that’s where the true criticism of this Arun Jaitley budget lies. This is a stop-gap budget that refuses to weed out the ills of years of centre-left thinking. After an overwhelming mandate and years of regressive policy decisions, the minister has failed to use the political capital handed to him to drive through an agenda of serious reform. He is guilty of both sins of omission and sins of commission. Take the issue of STT, for example: for a mere 5000 crores of revenue (which is itself morally dubious because you’re often taxing losers, not just winners), you’re keeping a structure that actively discourages market liquidity, drives volumes offshore and fails on the basic test of justified taxation.

Even worse is the case of the dividend distribution tax. At its root, a dividend distribution tax is morally repugnant. It makes a mockery of the entire process of stock ownership. The tax essentially tells corporations not to pay out dividends and penalizes them if they dare to. So, those of us that want to own corporations are essentially told our corporations money isn’t ours, even after our corporations pay their taxes. If this system was permanent, it would be not different than a 15% STT. We live in hope; that one day, some finance minister will finally have the courage to dismantle taxes like this one. Indeed, we live in hope that one day, our finance minister will have the courage to shake up a system of vested interests and inverted incentives.

We live in hope that one day we might see a budget that seeks to get the government out of the business of big business. We live in hope that one day, we might see a government deliver serious labor reforms. We live in hope that one day, the answer to pricing decisions may be to develop an open market rather than to appoint a new commission. Indeed, we live in hope that one day political courage will triumph over mere pragmatism.

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Market Outlook: Notes from the emerging ‘crisis’

To this point, I’ve largely limited my thoughts on this blog to extremely big picture events; with the occasional, harmless bit of opinion on the events of the day. The record of picking up on major themes has been quite favorable: I pointed out back in 2011 that the crisis the world is fundamentally grappling with is a currency crisis. I’ve strayed well clear of the hyperinflationistas, through my writings on quantitative easing also back in 2011. I was quite bearish about the nature of solutions being offered by Europe in September  and again in October, 2011. I turned constructive on signs that internal revaluation was achieving some results in January, 2013.  I also pointed to the immense power of QE3 in September 2012, while going on to warn that an exit was unlikely to be smooth, in March 2013. Finally, I expressed repeated concern by India’s deep-rooted competitiveness problem in articles in January 2013 and then again, in June 2013. Apart from blowing my own trumpet, the reason I point out all of this is because I’m about to start to blow this reasonably healthy track record by getting into more micro market movements. I am afterall, a trader, not a philosopher, a theoretician or a journalist. So, the business of actual market moves is my business – not the business of offering ‘opinions’ with a fair likelihood of relative success. How you trade your view of the world is ultimately far more important than what your view of the world is. To quote the legend himself (George Soros), “It’s not whether you’re right or wrong that’s important, but how much money you make when you’re right and how much you lose when you’re wrong.”

So here goes the beginning of a journey of regular posts on my market parameters, where success rates drop, confused conjecture begins and clarity becomes a relatively scarce commodity. That’s the real world of trading. This is a risk management business; not merely an opinion and conjecture business. Strategic, secular views are extremely important here; but how you trade those views, and mix them with tactical calls is the secret sauce that there’s no one recipe, formula or method for. My aim here isn’t to advertise my actual trades, but simply to pen down thoughts on the dynamics driving current market action. Build broad parameters, and leave the value of this conjecture and its ‘actionability’ to the reader. With all of that out of the way, here goes. This one’s likely to be a lot longer than future posts, because of the nature of current conditions.

MARKET OUTLOOK

Emerging Markets

Emerging markets have turned center stage, both in the financial press and among policy discussions. The basic nature of the crisis is that much of the emerging world has fallen into the trap of slowing reform, widening deficits (in many cases, twin deficits) and the enabling condition for much of this has been hot money inflows; FIIs continued to pour money into emerging markets, even as the fundamentals in EMs were deteriorating. As the Fed announced its decision to taper; various carry trades seemed to reverse; and the resulting outflows created a self-perpetuating crisis. Weaker currencies led to a degree of panic for foreign investors, who saw the dollar value of any unhedged positions decline rapidly.

As is usually the case, markets have moved well ahead of EMs becoming central to the discourse; so, the issue at this point, relates to timing and how stretched markets already are, rather than simply the causes behind what has been a fairly predictable crisis.

A few notes in this regard: firstly, correlations are different across different time horizons. So, for example, over the last 6 months, the Indonesian Rupiah (brown), the Turkish Lira (orange), the Brazilian Real (green), the Indian Rupee (blue), the Thai Baht (pink) and 5-year US treasury yields (red) have been extremely correlated. But, as you stretch the time horizon on these relationships, correlations loosen. So for instance, contrast the 6-month chart below, with the 10-year chart that follows.

EM Currencies v US 5 Year yields over the last 6 months

 

EM currencies v US 5 year yields

EM currencies v US 5 year yields over the last 10 years

It’s difficult to say how long highly correlated movements across EM currencies will continue; but elevated correlations are in themselves an indicator of financial stress. At some stage; markets will again look to differentiate between countries and currencies where the problems are endemic, and others where currency adjustment itself leads to reasonable outcomes.

A couple of views on EMs that are worth a read:

1. Robin Wigglesworth of the Financial Times: “Too soon to buy unloved Emerging Markets

2. Nopparat Chaichalearmmongkol and Warangkana Chomchuen of the Wall Street Journal: “Thailand GDP Highlights Policy Dilemma

A longer-term structural view revolves around several competing considerations.

1. A data-centric view of country-wise trade elasticity. As imports become more expensive, and exports become cheaper; the classic view is that trade deficits should narrow. In some cases, for example, India, this hasn’t yet shown up in the data, to any significant degree. The leads and lags involved in this process, as well as externalities make it difficult to project trade elasticity. But it is true, that all things equal, weaker currencies should go some way towards fixing the underlying problem: a lack of competitiveness.

2. Not all countries in the midst of the current crisis are created equal. The trajectory of the current crisis is likely to be quite different from the 1997 Asian Financial Crisis because the countries involved have significant foreign exchange reserves. This is a short-term buffer.

3. Policy response. The signs so far aren’t great. The basic identity, (X – M) = (T – G) + (S – I) seems to have been thrown out of the window. The assumption that spending more to stimulate the economy, while simultaneously ensuring rates don’t rise is an approach that most of these countries have regurgitated, and that’s not encouraging. It undermines any progress that currency depreciation creates. Indeed, this sort of policy response is extremely dangerous.

4. Inflation dynamics: Rapid depreciations of the kind we’ve seen across EMs are quite likely to lead to renewed inflationary pressures, particularly in countries which depend on energy imports. This problem gains an additional, problematic dimension in countries which subsidize energy imports, since a weaker currency structurally creates a wider fiscal deficit in these countries.

5. Growth: last, but not the least: growth and indeed resultant confidence is often the best antidote to any economic crisis.

What this adds up to is a series of difficult policy choices and a high likelihood of policy accidents. Indeed, we’ve already seen at least one: where the RBI in India went in with hawkish measures to ‘reduce currency volatility’ but mixed it with a dovish tone on monetary policy which undermined the impact of these measures, leaving the market uncertain about the course of monetary policy and increasing the pressure on already stressed financial institutions. This is in fact, a key risk in the case of emerging markets, where policy incoherence and often, the lack of an educated political and civil society debate are facts of life.

Now, beyond these structural issues, we saw an important event on Friday, which may just set the tone for emerging market response over the near-term. Brazil announced a $60-billion intervention by the end of the year and the BRL responded by appreciating about 3.5% in Friday’s trade. Some may suggest that this is an extremely risky move, since it risks undermining central bank credibility itself; but I believe this intervention should enjoy a fair degree of success. This is primarily because the announcement is large enough for it to enjoy a degree of credibility and it came late enough for the market to be positioned with a large number of shorts. However, if US yields spike further, all bets are off.

That dynamic leads to the conclusions for short-term positioning. By short-term, I mean the next few days!

THE PARAMETERS:

India (NIFTY): While everyone has been looking at the USD/INR relationships and making projections on the NIFTY based on this; a relationship that has more closely tracked NIFTY movements has been the one to the Japanese yen. The following chart illustrates these relationships:

The Indian Rupee: Japanese Yen relationship has tracked NIFTY movements more closely than the dollar relationship.

The Indian Rupee: Japanese Yen relationship has tracked NIFTY movements more closely than the dollar relationship.

Historically, recoveries on the NIFTY tend to be led by banks. Indeed, the fact that the previous rise to 6100 went hand-in-hand with a fall in banking stocks was one of the primary reasons why I was skeptical about that move.

A rising BANK NIFTY: NIFTY ratio tends to be bullish for equities.

A rising BANK NIFTY: NIFTY ratio tends to be bullish for equities.

Much like the Rupee/Yen relationship; there’s little that suggests the brief rise in the Bank NIFTY: NIFTY ratio is sustainable. But, oversold banks, the NIFTY & the BANK NIFTY rising off oversold levels on the RSI; a degree of positive divergence and indeed, the large surge in volumes in the final stages of the decline towards 5250 on the NIFTY all suggest, the shorts within the system are currently somewhat vulnerable. I’m not a believer in predicting market moves; merely in trying to position yourself in a probabilistically useful manner.

Full disclosure: I tweeted on Thursday about having picked up NIFTY August, 5400 calls @ ~35 each. I continue to hold these and cannot reasonably project how long I will maintain these positions. While my base case is to hold these till contract expiry this Thursday, I am using a loose, trailing stop.

Broadly, while short-term traders look to be positioned poorly, I expect several doses of overhead supply if indeed this market heads higher. So, at this stage, the positioning is purely tactical. Given the extremely large negative trend over the course of the August futures contract; I’m looking for a bout of short-covering if the index futures trade above 5500 for any length of time. At this stage, I’d be looking to revisit my positional bias around 5600.

On the other hand, a failure to cross ~5500 would denote weakness and may lead me to develop fresh shorts, if the inter-market action supports a greater likelihood of weak EM equity action. This would include a stronger yen to the rupee; higher 5 & 10 year US yields and a degree of domestic bond market weakness.

Lastly, the metals and mining stocks continue to look quite interesting. I did close some metals longs; and am currently in wait and watch mode. A close above 3.40 on copper is likely to lead me to open fresh longs. This is an area I’m looking at, closely. The basic thesis here is that there has been a bout of commodity strength which has taken place under the radar. The CRB Index and others appear to suggest a long-term decline may have concluded. So the technicals suggest a degree of positioning into materials stocks may make some sense. However, this is a purely price based thesis that I don’t have a larger view on. I’d need to develop an underlying reason to expect continued dollar weakness before terating this as a serious, sustainable hypothesis.

United States; Dow, S&P 500 

Finally, my outlook on the Dow & S&P remains extremely cautious beyond the next couple of sessions. I hate to bring Japan into this once again, but this is another relationship I consider important and track closely:

A weakening yen and rising Japanese & American equities have gone hand-in-hand for the last year. This could be indicative of a carry trade.

Broadly, I don’t see too much conviction about moves above 100 on the USD/JPY or ~1700 on the S&P 500. There have been sustained signs of negative divergence on both the S&P and the USD/JPY pair and this looks and indeed ‘feels’ like a market undergoing some sort of an exhaustion process. I’d need to see a sustained move above 100 on the USD/JPY; to begin to re-consider this outlook.

Lastly, 2.80 on the 10-year looks like a pretty important level in the near-term. Trading below these levels for any considerable amount of time should be good for EM currencies. Also, keep an eye on other EM central banks following Brazil in announcing measures to use FX reserves in order to try and stabilize the currency.

That’s it for now. The main aim behind this section is to start to transfer some of my personal offline views and quite regular, but unstructured tweets to this blog. The main reason I’m doing this is to force myself to try and pen down views and to invite people to poke holes in them. This is not intended to outline specific trades. Managing risk is the skilful piece of the trading jigsaw. This is merely an attempt to create a degree of personal coherence in an ocean of randomness.

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Dollar index, S&P 500, MSCI Emerging Market Index: Intermarket analysis

Like any trader, I tend to spend a lot of time working through little thought experiments. Here’s one that I’ve been looking at, lately. The chart below outlines the relationship between the dollar index (black candles), the MSCI Emerging Market Index (Red line, in US dollar returns) and the S&P 500 index (blue line), going back to 1990.

S&P500 v DXY v MSCI EM

Inter-market relationship between the S&P 500, Dollar Index & the MSCI Emerging Market Index.

The reason I’ve gone back to 1990 with the chart is to display the shift in intermarket relationships. In essence, the early 1990s saw a powerful combination of a rally in US equities, compounded further by a rising dollar (relative to other currencies). While that was great for US stocks, it limited the appeal for Emerging Market equities which didn’t generate any real returns in US dollar terms (in part due to the East Asian currency crisis).

The bursting of the NASDAQ bubble, and 9/11 led to a sea change in US monetary policy. Strong dollar policies were largely abandoned; consumption was encouraged and the ensuing current account deficits went hand in hand with a cheaper dollar. This was a great environment for Emerging markets, which benefited both from rising demand for their goods, and (in many cases) rising currencies (relative to the dollar).

The graph below, which compares the US current account with the dollar index, is by no means a timing tool or indeed a complete explanation. A single factor model of current account surpluses/deficits does not explain currency movements. But, over long periods, the relationship plays out as you would expect.

Over long periods, greater current account deficits tend to drag the dollar down.

Over long periods, greater current account deficits tend to drag the dollar down.

This is the context within which, the dollar is vitally important to any asset allocation choice. Over short periods, intermarket relationships shift significantly (relative strength charts are a good way of studying shorter-term intermarket movements). But, over the long run, market moves and economic trends do interact. You could make the claim that markets (usually) discount data before it arrives, so the dollar index would be expected to lead, rather than lag current account data. But, this is a fluid process, and a historical narrative always sounds more compelling than making assertions about the future.

We can however make a few loose observations. A strong dollar plays a somewhat destructive role for emerging market equities. Till quite recently, the “risk trade” was fairly well defined. A strong dollar was a “risk off” trade – bad for all equities, good for bonds. More recently, the “risk on”, “risk off” paradigm has shown signs of shifting. We’ve seen the S&P rally alongside a stronger dollar, but Emerging Markets have under-performed. This could very well be transitory. There is nothing conclusive to suggest that we’re in a secular dollar bull market.

I’ll leave you with one of the charts that have grabbed my attention. This is simply a zoomed in version of the question mark area of the earlier chart comparing the S&P (in blue), the MSCI EM index (in Red) and the dollar index (candles). The structure of these relationships suggests that any significant signs of dollar weakness could make emerging markets very attractive. Signs of negative divergence on the RSI add a bit of zing to that potential trade. But, remember, divergence isn’t a substitute for price action. The point of analysis such as this, is to build a context to navigate multiple scenarios – not to lock yourself into any one view.

Signs of negative divergence on the dollar index make the MSCI Emerging Market index a temptation. But, depending on your strategy and approach, divergence itself usually isn't a sufficient signal.

Signs of negative divergence on the dollar index make the MSCI Emerging Market index a temptation. But, depending on your strategy and approach, divergence itself usually isn’t a sufficient signal.

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Dijsselbloem, Cyprus and Too Big To Fail

A couple of thoughts on this Dijsselbloem interview that’s been causing a lot of controversy. If you haven’t read it yet, here is a full transcript.

The Cyprus problem is at its root a violent depiction of the twin problems of too big to fail and governments with a funding problem. What Europe fails to recognize is the role of a sovereign in a fiat money system. Fiat money can’t survive under deflation. Credit won’t be extended in an environment of falling asset prices and credit is the root of all economic activity under government fiat. So, the role of the sovereign is first and foremost to fight deflationary pulses and then to ensure that the currency system itself maintains its integrity (i.e. a little inflation, but not too much). The fundamental difference between the functional system of credit in the US and the dysfunctional system in Europe is that the American policymakers appear to understand this.

In the European context, the root of the problem lies in an inability to recognize that in order for the sovereign to fulfill its primary responsibility, it must be able to issue currency. If it can’t, the deflationary pulse of a recession fast turns into a depression (a.k.a. Greece).

So, Djisselbloem is quite right in outlining a moral solution for banks. In fact, I couldn’t agree more when he says

If there is a risk in a bank, our first question should be: “Ok, what are you the bank going to do about that? What can you do to recapitalise yourself?” If the bank can’t do it, then we’ll talk to the shareholders and the bondholders. We’ll ask them to contribute in recapitalising the bank. And if necessary the uninsured deposit holders: “What can you do in order to save your own banks?”

In fact, in essence, Djisselbloem is outlining a process of bank resolution without the moral hazard created by sovereign bank bailouts (one of the more problematic aspects of US action over the last 20 years). But, here is where Djisselbloem blows it:

That is an approach that I think we should, now that we’re out of the heat of the crisis, consequently take.

European policymakers need to recognize that they’ve bought time through a series of dubious promises. They have not succeeded at restoring Europe to the status of being currency issuers. Eventually, we will get there – either under the banner of a Euro within a fiscal union, or through a return to individual currencies. But, the current purgatory that Europe insists on keeping itself in is little more than a road to perdition. In this environment, there are no moral solutions. Only sub-optimal choices that leave European policymakers open to criticism and resentment.

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Cyprus bailout: hitting where it hurts

A few quick thoughts on what has to be one of the more absurd policy decisions, even by European standards.

Here’s a basic summary of what Europe has done over the last two decades. First, they pooled together incompatible German, Greek, Spanish (and Cypriot) productivity to create a common currency, under the roof of the ECB. This we were told would create “stability”. What ensued was over a decade of southern Europe boosting its consumption and undermining its production under an artificially strong currency. Inflation was contained, there was widespread economic growth and the combination of low rates and an asset price boom fed this false consumption further.

Then came 2008. In the midst of a global banking crisis, the sanctity of deposits were themselves called into question. While it was assumed that European banks would act as one entity under the supervision of the ECB, they instead offered individual deposit guarantee schemes. Since it had now come to light that the banking system wasn’t a single, homogeneous system but instead a collection of widely disparate systems, risk had to be re-priced on a case by case basis.

A few national accounting scandals later, credit spreads essentially re-priced risk in order of productivity. So, nations in Northern Europe continued to enjoy low rates, but nations in the periphery were asked to pay higher rates for their borrowings. This in turn undermined the entire banking system, since bonds were largely treated as “risk-free” assets by financial institutions. Falling bond prices caused a massive crunch on liquidity, and in some cases stretched the boundaries of solvency. Since individual nations couldn’t issue fresh currency, a violent feedback loop between banks and sovereigns was unleashed. As yields rose, bank balance sheets got weaker which in turns increased the potential liability of the sovereign, which led to higher yields and weaker bank balance sheets.

At this stage, the banking system had seized up and Europe faced a fundamental choice between trying to preserve a union which shared neither a single identity, nor a common economic architecture or trying to create an orderly return to individual currencies. The choice was essentially between a transfer union or a return to individual currencies. The fact that individual countries were expected to supervise their banks, but didn’t have the authority to issue fresh currency made the system unviable.

We were told the powers that be had decided to move towards a fiscal union. We were told the ECB would do “whatever it takes” to preserve the Euro. We were told we’d have a single banking supervisor, Europe-wide deposit guarantees and a gradual move towards deeper economic integration. After years of crisis, markets were relieved. There was no need to even test the ECBs resolve, because jawboning had worked. Why would anyone bet against the central bank.

Northern Europe had succeeded. It imposed austerity on the south, in return for the promise of solvency. Then came Cyprus. A little nation with the same banking problem that inflicted Ireland. Suddenly, the rules of the game had changed. We didn’t just get a sovereign bailout with conditionality – we got a whole new method. Savers – large and small were swindled of their savings over a holiday weekend.

The ECB didn’t exactly do “whatever it takes” and the German’s thought primarily about German interests. Nobody seems to have weighed systemic risk. We’re now left with the realization that we have no fiscal union. We don’t have a coherent deposit insurance mechanism if your savings aren’t necessarily safe. We have no reason to believe that Europe is capable of delivering on any of its promises.

Now, the systemic saving grace is this: Cyprus is a small, largely insignificant nation in the broader context. The European banking system depends more on wholesale deposits than retail deposits. So, contagion isn’t guaranteed. But, if people in the South wake up to the sinister reality of how this system works, we do face systemic risk. If you can’t depend on your bank deposit in a fiat money system, faith in the currency system itself is undermined. This is a policy that flirts with deep systemic risk. All in an attempt to fund an additional 6 billion Euros. Whether we see spreads widen, depositors fleeing the south and broader systemic issues or not – this was not smart.

Some might say that in a capitalist system depositors should be at risk for their deposits, that the absence of penalizing nations with excesses would be the creation of moral hazard and so there’s no fundamental problem with the policy Europe is pursuing here. That would make sense if you treated all nations, all bondholders and all institutions at par. Much like that Lehman moment that was followed by saving AIG and others; European policy has revealed its unpredictability and incoherence. The systemic consequences are unlikely to be either as violent or as immediate; but the intellectual edifice of the single currency just took another hit. And so did savers: where it hurts the most.

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NIFTY & FII (Foreign Institutional Investor) Inflows

A quick post, before I get into the meat and substance of the nature of flows that most influence the Indian index. The graph below is a depiction of NIFTY levels, compared with cumulative FII (Foreign Institutional Investor) inflows (for equities). The degree to which this is a market structurally dependent on FII inflows is fairly self-evident.

NIFTY v FII Inflows

NIFTY levels v Cumulative FII Inflows

This isn’t a graph that should surprise anyone, but it is a neat depiction of an important reality: the NIFTY has been very dependent on FII money. So when you’re looking to understand market structure, a good place to start is to understand what drives FII money, and what we can say about it with reasonable conviction. An allied question is what we can say about other market participants. More on that, in a future post.

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