August sure has been a tumultuous month, with the daily changes in the Dow Jones Industrial Average over one memorable week in early August (-635,+430,-520,-424 which amounts to daily movement of +/-4.5% in the largest and most liquid stock market in the world!) resembling more of a random walk than rational responses to changes in fundamentals. Volatile markets are likely to be with us for a while – as long as government policy uncertainty remains with us in the developed world. With this uncertain backdrop, I summarise below Jeremy Grantham’s latest quarterly which provides ( as usual) deep insights into the current state of markets and his outlook.
-“Can-kicking” to postponing the day of reckoning is an art form perfected by countries around the world – from Britain’s peace agreement with Hitler in 1938 to modern day examples of Japan’s lost decades , Europe over the last 10 years (by failing to rein in the growing uncompetitiveness of the peripheral countries) and finally to the US’s refusal to deal with the housing bubble earlier.
-His prediction in early 2009 of “seven lean years” for the US economy was somewhat optimistic - while some factors have shown modest improvement other key factors have failed to keep up with what were pessimistic expectations. GDP would have to grow by 4% a year for the next 3.5 years (unrealistic) to close the gap with the 2% projected trend line growth rate of the economy.
-The plus side of the “seven lean years” have been: the resilience of emerging economies, particularly China and India; the sizes of the Chinese trade surplus and US trade deficit have declined; the US savings rate has increased from 1% to 5%, and, corporate profits have risen.
-The negative side of the “seven lean years” is a long list: disillusionment with institutions and capitalism has increased, dampening animal spirits; resources prices are even higher than expected; fiscal deficits are higher ; housing prices are lower and could overshoot more on the downside; personal income growth has been very meagre with gains accruing to corporations and the very rich making the US one of the least egalitarian developed societies; while private debt is declining modestly through write-downs and pay-downs of debt, there is no new debt being created to boost consumption which remains anaemic; economic policy remains caught between half-hearted Keynesian stimulus and ill-timed “Austrian” cutbacks; if unchecked the “seven lean years” could rapidly result in a dramatic loss of the US’s leadership position, which has been a show piece to the world of entrepreneurial drive, effective government, social leadership and international justice and assistance.
-Corporate profits are at their highest levels, while wage growth is flat and 16-18%of workforce is either out of a job (9%) , discouraged to look for a job (4%) or working part-time (5%). Normally these conditions would have led to lower revenue growth, but the surge in government debt has allowed corporations to maintain top line growth while reducing costs and thereby increasing profits. This likely to change as government debt falls or its growth decelerates.
-In the current environment which is fraught with uncertainty , as he advised last quarter, its best to be cautious and remain cautious for the foreseeable future. Quality stocks have continued to outperform low quality stocks and points towards a classic late bull market rally.
-He continues to favour the following asset classes:
-Well-managed forestry and farmland.
-Natural resources, energy, metals and fertilizers over the next 10 years though near term they could be experience sharp declines.
-Quality stocks are priced to provide 4.5-5% real return.
-Emerging market stocks are also likely to provide 4-5% real return.
-Japanese stocks have the potential to provide double digit real returns for the next 7 years.
-Other global equity markets range from unattractive to very unattractive. With the S&P fair value being 950.
-Cash will provide the dry powder to take advantage of possibilities.
-Stop press: with the sharp market declines in early August, they became modest buyers for the first time since mid-2009 and own US high quality stocks, emerging markets, Japan, Italy and European growth stocks, with this portfolio likely to return about 6.5% real over the next 7 years.
-The main long-term risk continues to be that, after two massive bubbles and reflation programmes, the Fed may be out of ammunition if a serious global double-dip ensues.
-This would imply that instead of a sharp recovery in markets, they could become cheap and stay below long-term averages for a long while as has been the norm historically (pre-Greenspan). This would wash away a whole generation’s false expectations, high animal spirits and excessive risk taking. It would also mean high long-term returns from investing at cheap levels – i.e. long-term gain from short-term pain!
A brilliant piece which succinctly lays out the risks as well as the opportunities which the markets face today. A core equity funds portfolio in US quality stocks, global energy and natural resources, select emerging markets (China, India, Brazil, Russia), Japan, Korea, Singapore combined with a core bond funds portfolio (EM and select developed world govt& high grade credits denominated in local currencies, US private mortgages and credits) and a core portion in cash diversified across several currencies, and finally, gold, should be able to weather the storm ahead and provide decent returns over a 3 -5 year period. The key is to be disciplined in terms of not giving way to temptation to time the market, or be swayed by market movements, which inevitably is a recipe for buying high and selling low over time.
For those who doubt the positive impact of QE programmes on the markets and the economy i attached a graph which rather vividly demonstrates the relationship between the commencement and ending of the QE1&2 programmes and the waxing and waning of economic output. Yes, the effect is only temporary (and is not claimed to be otherwise) and can have unintended consequences (higher commodity prices) but it does work – as the economist Irving Fisher noted long ago in his classic study of deflations and depressions in the 19th and early 20th centuries. So if the economy continues to sputter along, or goes into another dip, we are likely to get another dose of QE (later this year?) and further fiscal stimulus (early next year?) as well which will limit the downside and provide potential for upside.
As sentiments continue to turn from bad to worse, the outflow of foreign institutional investments from Indian equity has gathered momentum and has hit a near three-year high for the month of August. The net outflow for the month of August reached Rs 11,222 crore — the highest since October 2008, post the Lehman collapse when the net outflow was at Rs 15,347 crore.
The net inflow for the calendar 2011 also turned flat and on Friday the net investment stood at (-) Rs 502 crore for the calendar 2011 as against Rs 133,264 crore in the calendar 2010.
The FII participation has a strong co-relation with the Indian equity market performance. With the outflow of FII money to the tune of Rs 11,222 crore in the month of August, the Sensex at the Bombay Stock Exchange in the same period has fallen by 12.9 percent.
On Friday alone the net FII outflow stood at Rs 1,494 crore and the Sensex fell by 1.8 percent.
Experts say that there is a feeling of general risk aversion in the market and they money coming back in the short-term is unlikely.
FII's have grown even more wary of the Indian markets since the Reserve Bank of India went for an unexpected 50 basis point hike in the repo rate in July.
Bottom line: nothing now, QE3 now expected to be delivered Sept. 20? or not…
BERNANKE SAYS FED HAS LIMITED ABILITY TO ENSURE LONG-RUN GROWTH
BERNANKE DOESN'T SIGNAL NEW STEPS FOR PROMOTING U.S. GROWTH
BERNANKE SAYS EXTRA DAY TO ALLOW `FULLER DISCUSSION' OF TOOLS
BERNANKE SAYS FED TO EXTEND SEPT. FOMC MEETING TO TWO DAYS
BERNANKE SAYS FED HAS `RANGE OF TOOLS' FOR STIMULATING GROWTH
BERNANKE SAYS `FINANCIAL STRESS' WILL BE A `DRAG' ON RECOVERY
Readers can listen to real time market commentary courtesy of RanSquawk at the following link
August 26, 2011
The Near- and Longer-Term Prospects for the U.S. Economy
Good morning. As always, thanks are due to the Federal Reserve Bank of Kansas City for organizing this conference. This year's topic, long-term economic growth, is indeed pertinent–as has so often been the case at this symposium in past years. In particular, the financial crisis and the subsequent slow recovery have caused some to question whether the United States, notwithstanding its long-term record of vigorous economic growth, might not now be facing a prolonged period of stagnation, regardless of its public policy choices. Might not the very slow pace of economic expansion of the past few years, not only in the United States but also in a number of other advanced economies, morph into something far more long-lasting?
I can certainly appreciate these concerns and am fully aware of the challenges that we face in restoring economic and financial conditions conducive to healthy growth, some of which I will comment on today. With respect to longer-run prospects, however, my own view is more optimistic. As I will discuss, although important problems certainly exist, the growth fundamentals of the United States do not appear to have been permanently altered by the shocks of the past four years. It may take some time, but we can reasonably expect to see a return to growth rates and employment levels consistent with those underlying fundamentals. In the interim, however, the challenges for U.S. economic policymakers are twofold: first, to help our economy further recover from the crisis and the ensuing recession, and second, to do so in a way that will allow the economy to realize its longer-term growth potential. Economic policies should be evaluated in light of both of those objectives.
This morning I will offer some thoughts on why the pace of recovery in the United States has, for the most part, proved disappointing thus far, and I will discuss the Federal Reserve's policy response. I will then turn briefly to the longer-term prospects of our economy and the need for our country's economic policies to be effective from both a shorter-term and longer-term perspective.
Near-Term Prospects for the Economy and Policy
In discussing the prospects for the economy and for policy in the near term, it bears recalling briefly how we got here. The financial crisis that gripped global markets in 2008 and 2009 was more severe than any since the Great Depression. Economic policymakers around the world saw the mounting risks of a global financial meltdown in the fall of 2008 and understood the extraordinarily dire economic consequences that such an event could have. As I have described in previous remarks at this forum, governments and central banks worked forcefully and in close coordination to avert the looming collapse. The actions to stabilize the financial system were accompanied, both in the United States and abroad, by substantial monetary and fiscal stimulus. But notwithstanding these strong and concerted efforts, severe damage to the global economy could not be avoided. The freezing of credit, the sharp drops in asset prices, dysfunction in financial markets, and the resulting blows to confidence sent global production and trade into free fall in late 2008 and early 2009.
We meet here today almost exactly three years since the beginning of the most intense phase of the financial crisis and a bit more than two years since the National Bureau of Economic Research's date for the start of the economic recovery. Where do we stand?
There have been some positive developments over the past few years, particularly when considered in the light of economic prospects as viewed at the depth of the crisis. Overall, the global economy has seen significant growth, led by the emerging-market economies. In the United States, a cyclical recovery, though a modest one by historical standards, is in its ninth quarter. In the financial sphere, the U.S. banking system is generally much healthier now, with banks holding substantially more capital. Credit availability from banks has improved, though it remains tight in categories–such as small business lending–in which the balance sheets of potential borrowers remain impaired. Companies with access to the public bond markets have had no difficulty obtaining credit on favorable terms. Importantly, structural reform is moving forward in the financial sector, with ambitious domestic and international efforts underway to enhance the capital and liquidity of banks, especially the most systemically important banks; to improve risk management and transparency; to strengthen market infrastructure; and to introduce a more systemic, or macroprudential, approach to financial regulation and supervision.
In the broader economy, manufacturing production in the United States has risen nearly 15 percent since its trough, driven substantially by growth in exports. Indeed, the U.S. trade deficit has been notably lower recently than it was before the crisis, reflecting in part the improved competitiveness of U.S. goods and services. Business investment in equipment and software has continued to expand, and productivity gains in some industries have been impressive, though new data have reduced estimates of overall productivity improvement in recent years. Households also have made some progress in repairing their balance sheets–saving more, borrowing less, and reducing their burdens of interest payments and debt. Commodity prices have come off their highs, which will reduce the cost pressures facing businesses and help increase household purchasing power.
Notwithstanding these more positive developments, however, it is clear that the recovery from the crisis has been much less robust than we had hoped. From the latest comprehensive revisions to the national accounts as well as the most recent estimates of growth in the first half of this year, we have learned that the recession was even deeper and the recovery even weaker than we had thought; indeed, aggregate output in the United States still has not returned to the level that it attained before the crisis. Importantly, economic growth has for the most part been at rates insufficient to achieve sustained reductions in unemployment, which has recently been fluctuating a bit above 9 percent. Temporary factors, including the effects of the run-up in commodity prices on consumer and business budgets and the effect of the Japanese disaster on global supply chains and production, were part of the reason for the weak performance of the economy in the first half of 2011; accordingly, growth in the second half looks likely to improve as their influence recedes. However, the incoming data suggest that other, more persistent factors also have been at work.
Why has the recovery from the crisis been so slow and erratic? Historically, recessions have typically sowed the seeds of their own recoveries as reduced spending on investment, housing, and consumer durables generates pent-up demand. As the business cycle bottoms out and confidence returns, this pent-up demand, often augmented by the effects of stimulative monetary and fiscal policies, is met through increased production and hiring. Increased production in turn boosts business revenues and household incomes and provides further impetus to business and household spending. Improving income prospects and balance sheets also make households and businesses more creditworthy, and financial institutions become more willing to lend. Normally, these developments create a virtuous circle of rising incomes and profits, more supportive financial and credit conditions, and lower uncertainty, allowing the process of recovery to develop momentum.
These restorative forces are at work today, and they will continue to promote recovery over time. Unfortunately, the recession, besides being extraordinarily severe as well as global in scope, was also unusual in being associated with both a very deep slump in the housing market and a historic financial crisis. These two features of the downturn, individually and in combination, have acted to slow the natural recovery process.
Notably, the housing sector has been a significant driver of recovery from most recessions in the United States since World War II, but this time–with an overhang of distressed and foreclosed properties, tight credit conditions for builders and potential homebuyers, and ongoing concerns by both potential borrowers and lenders about continued house price declines–the rate of new home construction has remained at less than one-third of its pre-crisis level. The low level of construction has implications not only for builders but for providers of a wide range of goods and services related to housing and homebuilding. Moreover, even as tight credit for some borrowers has been one of the factors restraining housing recovery, the weakness of the housing sector has in turn had adverse effects on financial markets and on the flow of credit. For example, the sharp declines in house prices in some areas have left many homeowners "underwater" on their mortgages, creating financial hardship for households and, through their effects on rates of mortgage delinquency and default, stress for financial institutions as well. Financial pressures on financial institutions and households have contributed, in turn, to greater caution in the extension of credit and to slower growth in consumer spending.
I have already noted the central role of the financial crisis of 2008 and 2009 in sparking the recession. As I also noted, a great deal has been done and is being done to address the causes and effects of the crisis, including a substantial program of financial reform, and conditions in the U.S. banking system and financial markets have improved significantly overall. Nevertheless, financial stress has been and continues to be a significant drag on the recovery, both here and abroad. Bouts of sharp volatility and risk aversion in markets have recently re-emerged in reaction to concerns about both European sovereign debts and developments related to the U.S. fiscal situation, including the recent downgrade of the U.S. long-term credit rating by one of the major rating agencies and the controversy concerning the raising of the U.S. federal debt ceiling. It is difficult to judge by how much these developments have affected economic activity thus far, but there seems little doubt that they have hurt household and business confidence and that they pose ongoing risks to growth. The Federal Reserve continues to monitor developments in financial markets and institutions closely and is in frequent contact with policymakers in Europe and elsewhere.
Monetary policy must be responsive to changes in the economy and, in particular, to the outlook for growth and inflation. As I mentioned earlier, the recent data have indicated that economic growth during the first half of this year was considerably slower than the Federal Open Market Committee had been expecting, and that temporary factors can account for only a portion of the economic weakness that we have observed. Consequently, although we expect a moderate recovery to continue and indeed to strengthen over time, the Committee has marked down its outlook for the likely pace of growth over coming quarters. With commodity prices and other import prices moderating and with longer-term inflation expectations remaining stable, we expect inflation to settle, over coming quarters, at levels at or below the rate of 2 percent, or a bit less, that most Committee participants view as being consistent with our dual mandate.
In light of its current outlook, the Committee recently decided to provide more specific forward guidance about its expectations for the future path of the federal funds rate. In particular, in the statement following our meeting earlier this month, we indicated that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through mid-2013. That is, in what the Committee judges to be the most likely scenarios for resource utilization and inflation in the medium term, the target for the federal funds rate would be held at its current low levels for at least two more years.
In addition to refining our forward guidance, the Federal Reserve has a range of tools that could be used to provide additional monetary stimulus. We discussed the relative merits and costs of such tools at our August meeting. We will continue to consider those and other pertinent issues, including of course economic and financial developments, at our meeting in September, which has been scheduled for two days (the 20th and the 21st) instead of one to allow a fuller discussion. The Committee will continue to assess the economic outlook in light of incoming information and is prepared to employ its tools as appropriate to promote a stronger economic recovery in a context of price stability.
Economic Policy and Longer-Term Growth in the United States
The financial crisis and its aftermath have posed severe challenges around the globe, particularly in the advanced industrial economies. Thus far I have reviewed some of those challenges, offered some diagnoses for the slow economic recovery in the United States, and briefly discussed the policy response by the Federal Reserve. However, this conference is focused on longer-run economic growth, and appropriately so, given the fundamental importance of long-term growth rates in the determination of living standards. In that spirit, let me turn now to a brief discussion of the longer-run prospects for the U.S. economy and the role of economic policy in shaping those prospects.
Notwithstanding the severe difficulties we currently face, I do not expect the long-run growth potential of the U.S. economy to be materially affected by the crisis and the recession if–and I stress if–our country takes the necessary steps to secure that outcome. Over the medium term, housing activity will stabilize and begin to grow again, if for no other reason than that ongoing population growth and household formation will ultimately demand it. Good, proactive housing policies could help speed that process. Financial markets and institutions have already made considerable progress toward normalization, and I anticipate that the financial sector will continue to adapt to ongoing reforms while still performing its vital intermediation functions. Households will continue to strengthen their balance sheets, a process that will be sped up considerably if the recovery accelerates but that will move forward in any case. Businesses will continue to invest in new capital, adopt new technologies, and build on the productivity gains of the past several years. I have confidence that our European colleagues fully appreciate what is at stake in the difficult issues they are now confronting and that, over time, they will take all necessary and appropriate steps to address those issues effectively and comprehensively.
This economic healing will take a while, and there may be setbacks along the way. Moreover, we will need to remain alert to risks to the recovery, including financial risks. However, with one possible exception on which I will elaborate in a moment, the healing process should not leave major scars. Notwithstanding the trauma of the crisis and the recession, the U.S. economy remains the largest in the world, with a highly diverse mix of industries and a degree of international competitiveness that, if anything, has improved in recent years. Our economy retains its traditional advantages of a strong market orientation, a robust entrepreneurial culture, and flexible capital and labor markets. And our country remains a technological leader, with many of the world's leading research universities and the highest spending on research and development of any nation.
Of course, the United States faces many growth challenges. Our population is aging, like those of many other advanced economies, and our society will have to adapt over time to an older workforce. Our K-12 educational system, despite considerable strengths, poorly serves a substantial portion of our population. The costs of health care in the United States are the highest in the world, without fully commensurate results in terms of health outcomes. But all of these long-term issues were well known before the crisis; efforts to address these problems have been ongoing, and these efforts will continue and, I hope, intensify.
The quality of economic policymaking in the United States will heavily influence the nation's longer-term prospects. To allow the economy to grow at its full potential, policymakers must work to promote macroeconomic and financial stability; adopt effective tax, trade, and regulatory policies; foster the development of a skilled workforce; encourage productive investment, both private and public; and provide appropriate support for research and development and for the adoption of new technologies.
The Federal Reserve has a role in promoting the longer-term performance of the economy. Most importantly, monetary policy that ensures that inflation remains low and stable over time contributes to long-run macroeconomic and financial stability. Low and stable inflation improves the functioning of markets, making them more effective at allocating resources; and it allows households and businesses to plan for the future without having to be unduly concerned with unpredictable movements in the general level of prices. The Federal Reserve also fosters macroeconomic and financial stability in its role as a financial regulator, a monitor of overall financial stability, and a liquidity provider of last resort.
Normally, monetary or fiscal policies aimed primarily at promoting a faster pace of economic recovery in the near term would not be expected to significantly affect the longer-term performance of the economy. However, current circumstances may be an exception to that standard view–the exception to which I alluded earlier. Our economy is suffering today from an extraordinarily high level of long-term unemployment, with nearly half of the unemployed having been out of work for more than six months. Under these unusual circumstances, policies that promote a stronger recovery in the near term may serve longer-term objectives as well. In the short term, putting people back to work reduces the hardships inflicted by difficult economic times and helps ensure that our economy is producing at its full potential rather than leaving productive resources fallow. In the longer term, minimizing the duration of unemployment supports a healthy economy by avoiding some of the erosion of skills and loss of attachment to the labor force that is often associated with long-term unemployment.
Notwithstanding this observation, which adds urgency to the need to achieve a cyclical recovery in employment, most of the economic policies that support robust economic growth in the long run are outside the province of the central bank. We have heard a great deal lately about federal fiscal policy in the United States, so I will close with some thoughts on that topic, focusing on the role of fiscal policy in promoting stability and growth.
To achieve economic and financial stability, U.S. fiscal policy must be placed on a sustainable path that ensures that debt relative to national income is at least stable or, preferably, declining over time. As I have emphasized on previous occasions, without significant policy changes, the finances of the federal government will inevitably spiral out of control, risking severe economic and financial damage.1 The increasing fiscal burden that will be associated with the aging of the population and the ongoing rise in the costs of health care make prompt and decisive action in this area all the more critical.
Although the issue of fiscal sustainability must urgently be addressed, fiscal policymakers should not, as a consequence, disregard the fragility of the current economic recovery. Fortunately, the two goals of achieving fiscal sustainability–which is the result of responsible policies set in place for the longer term–and avoiding the creation of fiscal headwinds for the current recovery are not incompatible. Acting now to put in place a credible plan for reducing future deficits over the longer term, while being attentive to the implications of fiscal choices for the recovery in the near term, can help serve both objectives.
Fiscal policymakers can also promote stronger economic performance through the design of tax policies and spending programs. To the fullest extent possible, our nation's tax and spending policies should increase incentives to work and to save, encourage investments in the skills of our workforce, stimulate private capital formation, promote research and development, and provide necessary public infrastructure. We cannot expect our economy to grow its way out of our fiscal imbalances, but a more productive economy will ease the tradeoffs that we face.
Finally, and perhaps most challenging, the country would be well served by a better process for making fiscal decisions. The negotiations that took place over the summer disrupted financial markets and probably the economy as well, and similar events in the future could, over time, seriously jeopardize the willingness of investors around the world to hold U.S. financial assets or to make direct investments in job-creating U.S. businesses. Although details would have to be negotiated, fiscal policymakers could consider developing a more effective process that sets clear and transparent budget goals, together with budget mechanisms to establish the credibility of those goals. Of course, formal budget goals and mechanisms do not replace the need for fiscal policymakers to make the difficult choices that are needed to put the country's fiscal house in order, which means that public understanding of and support for the goals of fiscal policy are crucial.
Economic policymakers face a range of difficult decisions, relating to both the short-run and long-run challenges we face. I have no doubt, however, that those challenges can be met, and that the fundamental strengths of our economy will ultimately reassert themselves. The Federal Reserve will certainly do all that it can to help restore high rates of growth and employment in a context of price stability.
Reserve Bank of India (RBI) governor Subbarao's decision to hike short term interest rates by 50 basis points on July 26th was a mistake. Monetary policy operates with a lag. Many of the earlier interest rate hikes are yet to filter through to economy.
The RBI is trying to fight inflation by raising rates and squeezing out demand. In the absence of fiscal policy action, the burden of inflation management falls on the RBI. The RBI is, however, fighting a lost battle. Interest rate increases are unlikely to be effective in controlling inflation and may in fact exacerbate the situation by choking investment and supply.
India is not one but multiple economies within one. The starkest difference is between two segments at opposite ends of the spectrum. One is the credit based urban India and the other is the mostly cash based rural India.
Urban India is choking, crying and gasping for help, but the RBI remains unrelenting in its crusade against inflation. The numbers have finally started catching up. Housing sales have plummeted and the real estate sector is in intensive care. Automobile sales have started declining. Power and infrastructure investment has come to a standstill. Loan delinquencies among small and medium businesses are rising at an alarming rate.
Rural India on the other hand is booming. Food prices have risen and remained high across three full crop cycles for the first time in decades. The rural employment guarantee scheme has ignited a fire under rural wages. The monsoon rains have been excellent and India is on track for a record agricultural harvest. Telecom connectivity has had a transformational effect on rural India. The demographic boom in rural India has created a positive consumption cycle that has been unprecedented. This explains why sales of motorcycles and tractors are booming while sales of passenger cars are declining.
For further validation of this trend, look at the ongoing anti-corruption movement being championed by social activist Anna Hazare. It is exclusively an urban Indian middle-class driven movement. Rural India is conspicuous by its complete absence and disinterest in the movement. Urban middle-class India is stuck and frustrated, while rural India has never had it better (albeit from a very low base). In times past, protests and agitations were primarily rural centric while urban inhabitants went about their lives.
Food is becoming expensive in Indian cities because a lot less is making it to them. A lot more food is being consumed in villages where it is being produced. For food availability to improve a lot of investment needs to take place in farming as well as in the distribution supply chain. High interest rates and policy inaction are not helping the cause.
How India measures inflation is completely flawed. India's headline wholesale price index is primarily a commodity index. In a zero interest rate world where all currencies are debasing, commodity price increases are an international phenomenon.
Indians are putting a record amount of their savings into fixed income instruments and bank deposits. They clearly don't see fixed income instruments giving them negative real yields. I don't believe that this phenomenon can be explained by money illusion alone. The fact of the matter is that we are in a world where relative prices shift suddenly and intensively. Most people recognize this and (rightly so) don't think of it as inflation or erosion in purchasing power. In India there is no homogenous consumption basket and everyone's effective rate of inflation is different.
I believe that, inflation, the way the Indian government measures it, will remain high and may even accelerate from here as debasement in the developed world kicks off in earnest. Raising interest rates to rein in this inflation will prove completely ineffective.
GDP growth in India in April-June will print below 8% and it is very likely that by the Oct-Dec quarter GDP growth will fall below 7%. The RBI needs to stop its interest rate increase cycle and start preparing for reducing interest rates lest it wreck the economy.
Banks, Utilities, Information Technology, Infra will see massive earnings downgrades in the coming quarters.
While the sharp correction in the market may suggest attractive valuations, we note that the pace of corporate earnings downgrades has intensified in the recent results season. We see downside risk to bottomup derived 15% earnings cagr over FY11-13 and even greater risk to the street estimates as we are 3-5% below consensus. We lower 12-m Sensex multiple to 13x to factor in the earnings downgrade risk.
We increase our Under-weight on banks, industrials
The sectors that look vulnerable to earnings are PSU banks (asset quality concerns), industrials (slower order flow), private utilities (lower utilisation rates and fuel availability)
We cut industrials to UWT by removing L&T from the model portfolio. The stock has held-up well despite the ordering slowdown and we see greater risks to its earnings / multiples. The slowdown in the investment cycle will impact banks' earnings through lower credit growth and uptick in NPLs. We increase our UWT on banks by taking off 2 points from Bank of Baroda
To maintain our UWT on IT, we have taken out e-Clerx. The stock has O-PF the markets by 20% since its inclusion in Jan-11.
We are taking out Adani Power as we see downside earnings risk on account of continued fuel shortages and Indonesia coal costs. Replacing with more defensive Power grid. We also bring in JSPL as the stock has corrected by c.20% over the last one month and downside appears limited.
Pace of earnings downgrades has intensified
We have lower FY12 and FY13 Sensex EPS estimates by 5.6% and 10.6% respectively since the beginning of CY11.
The pace of downgrades have increased during the recent result season with a downgrade of 3% and 5% respectively. This also indicates that the there would be more downside to our FY11-13 earnings cagr of 15%.
Downgrades so far have been driven by margin disappointments and revenues have held up well, which could be at risk going forward. We also saw interest cost led downgrades in 1QFY12 for the first time and full impact is yet to be seen.
We are 3-5% below consensus
Our new FY12 & FY13 Sensex EPS of 1,181 and 1,338 are 3% and 5% lower than the street (Bloomberg consensus) respectively.
On the negative side, our estimates are substantially below street on cement cos, telcos, Pantaloon, Suzlon Maruti, Tata motors and HCL Tech and believe that the consensus will likely see more earnings downgrades.
Lower 12-m Sensex multiple
Lower target multiple builds in the risks associated with more earnings downgrade.
Key downside risk remains faster slowdown of growth while the near-term upside risk would be potential loose monetary policy in the west.
We will continue to stay cautious on the markets till we see some evidence of investment demand picking-up.
Beginning Monday, Indian investors will be able to trade in derivatives contracts on the Dow Jones Industrial Average and the S&P 500 indices right here in the country, paying in rupee. The National Stock Exchange (NSE), the biggest stock exchange in India by turnover, will launch derivatives contracts on these two indices.
This is the first time that derivatives contracts on these two indices will be traded on any exchange outside of US, a statement from NSE said.
"Derivative contracts on these global indices will provide Indian investors easy access to the US markets in Indian market hours, without taking any currency risk," Ravi Narain, MD & CEO, NSE, said. While, NSE will launch futures contracts on both the Dow Jones and the S&P 500 indices, options contracts will be available only on the S&P 500 index. The Dow Jones index constitutes stocks of 30 of the largest listed US companies while the S&P 500 tracks 500 leading US stocks listed on NYSE and Nasdaq exchanges. Globally, these two indices are among the most tracked stock market benchmarks.
Kevin talks about algorithms and how it effects our entire world including the equity markets. There are 2,000 physicists on Wall Street now involved in quant/algo/black-box funds. 70% of trades are currently conducted by quants. It can go deadly wrong like the flash crash.
See the full video at
Warren Buffet is famously quoted as saying, "If you have been playing poker for half an hour and you still don't know who the patsy is, you're the patsy". Today, we got a glimpse of Buffett playing poker with Bank of America, and at least from my perspective, it seems clear who the patsy in this game is... it is either Bank of America's stockholders or the rest of us who attribute mystical properties (and uncommon ethics) to the Oracle from Omaha...
So, let's recap what happened. It has been a rough few months for Bank of America stock, prior to today. The stock price had halved between November and yesterday:
Macro factors (the Euro crisis and the S&P downgrade) did play a role in the price decline but the company had itself to blame as well. It reported a loss of $8.8 billion for the second quarter of 2011, reflecting payments to settle legal claims related to troubled mortgages.While the stock price decline suggested that the market was increasingly pessimistic about the company's future profitability, the company itself indicated that it was sufficiently capitalized to make it through these travails. Earlier this month, the company announced that it would lay off 3500 employees and cut costs, but evoked little positive response from the market.
Today, we woke up to the news story that Warren Buffett, white knight extraordinaire, had ridden to the rescue of Bank of America. http://on.wsj.com/nUOWBSHere were the terms of the deal:
- Buffett invests $ 5 billion in preferred stock, with a 6% cumulative dividend, redeemable by the company at a 5% premium on face value.
- If Bank of America is unable to pay the preferred dividend, not only do the dividends cumulate but they do so at 8% per annum and the bank is restricted from paying dividends or buying back stock, in the meantime.
- Buffett get options to buy 700 million shares in BofA at $7.14/share, exercisable any time over the next 10 years.
Let's see what Buffett gets out of the deal. Valuing the options with a strike price of $7.14, even using yesterday's low price of $6.40/share, an annualized standard deviation of 50% in the stock price (significantly lower than the 3-year historical standard deviation of 79% and the implied standard deviation in excess of 100% from the option market) and a ten-year maturity, I estimate a value of $4.30/option or an overall value of approximately $ 3 billion (700*4.30) for the options. (I know.. I know.. Buffett does not like using the Black-Scholes model for long term options...Perhaps, he sold Bank of America's managers on the idea of using the famous Buffett-Munger long term option value model to derive a value of zero for these options...) Netting the $ 3 billion value of the options out of the $ 5 billion investment in the preferred stock makes it a $ 2 billion investment, on which $ 300 million is being paid in dividends. That works out to an effective dividend yield of 15% on the investment. By exercising his veto power over dividends and stock buybacks, Buffett can ensure that he is always the first person to be paid after debt holders in the firm. To cap it off, Berkshire Hathaway will be able to exclude 70% of the dividends received from Bank of America in computing taxable income (this is the rule with inter-company dividends), when paying taxes next year. That is an incredibly sweet deal!
What did Bank of America get out of this deal? Let's look at what it did not get first:
1. It did not get Tier 1 capital (the most stringent measure of bank capital), which includes only common equity, and thus does not get any stronger on that dimension. 2. It gets no tax deductions, since preferred dividends are not tax deductible. So, the $ 300 million in dividends will have to be paid out of after-tax income.3. It risks losing flexibility on dividend policy and stock buybacks, as a consequence of the restrictions imposed on this deal. The only conceivable benefit I see accruing from this transaction to the company is that Buffett has provided some cover for the managers of Bank of America to make two arguments: that the bank is not in immediate financial trouble and that it is, in fact, a well managed bank. I, for one, am not willing to accept Buffett's investment (or his words) as proof of either, and the way the deal is structured is not consistent with any of the arguments I have been hearing all day (from those who think it is good for Bank of America stockholders).
• First, let us assume that the bank is not in financial trouble and that the market has run away with its fears over the last few months. But, why would a bank that is not on the verge of collapse agree to raising capital at an after-tax rate of 15% and give up power over its dividend and buyback policy? And given the extremely generous terms offered to Buffett on this deal, how can this action be viewed as an indicator of good management? • Playing devil's advocate, let's look at the other possibility, which is that the bank has been hiding its problems and is in far worse shape than the rest of us think. If so, perhaps the terms of the deal make sense to Buffett (high risk/high return), but the deal still does not make sense to Bank of America. If the bank is in that much trouble, it should be raising tier 1 capital, and adding $ 300 million in preferred dividends to its required payments each year makes no sense. And, if it is in fact the case that the bank is in a lot more trouble that we thought, how can Buffett in good conscience then claim that BofA is a "strong, well-led company"? Either the terms of deal are way too favorable to Mr. Buffett or he is not being forthright in his description of the company... In either case, this does not pass the smell test.
I know that there are some who are comparing Buffett's deal with Bank of America to his earlier deal with Goldman Sachs. But there is a key difference. The Goldman deal was entered into at the depths of the banking crisis, and in a period where liquidity had dried up, Buffett was providing capital. Even in that case, you could argue that Goldman Sachs paid a hefty price for taking money from Buffett to shore up their standing... Perhaps, this has become Buffett's competitive advantage. Rather than buy and hold under valued companies, which is what he used to do, he focuses on companies that have lost credibility and he sells them his credibility at a hefty price. I know that Buffett has accumulated a great deal of trust with investors over the decades, but even his stock will run dry at some point in time, especially if he keeps dissembling after each intervention about the company, its management and his own motives.
In summary, is this deal good for Buffett? Absolutely, and I don't begrudge him any money he makes on this deal or the fact that the tax law may work in his favor. Does the deal make sense to Bank of America's stockholders? I don't think so, notwithstanding some of the cheerleading you are hearing from some equity research analysts and the market's positive reaction. Is Bank of America a "strong, well-led" company? Only if you have a very perverse definition of strong and well-led...
Paper Products Limited (PPL / The Company) - Recommend BUY
At current levels of Rs.77.40 per share, Paper Products Limited seems like a good buy to me. According to my model (attached), the DCF valuation ranges between Rs.91 and Rs.100 depending upon assumptions we make primarily about (a) Working Capital - Inventory, DPO, DSO, (2) CAPEX in FY2014 and 2015.
Since PPL is a dividend paying company, one may consider using DDM - Gordon Growth too but I find it unfair to value the company using this method as the company does not pay out a large part of its earnings as dividends. Further, the retained part of earnings are not all used to make investments in order to support on going activities or expansion to support the growth in revenue and sales. The company regularly invests in financial instruments like Mutual Funds and other schemes as well. I believe the DDM/Gordon Growth model should apply to those companies which have a long history of dividend pay outs, and the amount of dividend would be that part of earnings which is not used or retained to make investments for expansion or continuing operations to support revenue stream. In this case, PPL's valuation is at approximately Rs.27 per share which in my opinion is far below the fair value.
The company's shares may seem overvalued compared to its domestic peers but what we need to consider is that PPL has very little debt in its capital while all the other domestic players are highly leveraged with Essel Propack's Debt-to-Equity being above 1. PPL's EBITDA is a mammoth 171 times Interest Expenses as compared to Indian peers' and AMCOR's at below 8 times the same. Clearly there is less risk associated with PPL than there is with its Indian and international competitors.
RISKS:
Input Costs Escalation: In FY2010, input costs rose sharply due to hike in price of raw materials. Although most of the other materials were volatile within a narrow band, PET Films prices rose by more than 150% due to global shortage of supply following shut-down of few major suppliers' units, delay in capacity additions and diversion of thin films to higher value added thick films for electronics industry. Other key raw materials that saw sharp rise in price were inks, adhesives and solvents.
Competition, Margins and Pricing power: In absence of long-term contracts with buyers, PPL seems to be on the disadvantageous side of the negotiation table. Adding to that, competition has been increasing with new players entering and capacity additions with existing ones. In such environment, escalation in raw materials prices and other inputs like fuel and energy costs may undermine margins and cash flows.
Inflation: PPL primarily serves the food processing industry. Due to recent inflation especially in food prices, PPL's customers have become price conscious and initiated cost cuts in their packaging expenses by compromising on packaging quality as well as by putting pressures on packaging suppliers' margins. Additionally they had resorted to reverse auctions, hard negotiations using consultants.
Regulatory risk / Plastic ban on Food Processing Industry
OPPORTUNITIES
India – Economy, infrastructure & Rise in organized retail: Having been partially insulated from global meltdown, India saw a robust GDP growth of near 8% and is expected to see the same in the coming year. Economic Times - "When larger wheels in a machine start rotating, the smaller ones automatically gain momentum. The same is true of the Indian packaging sector too. Strong growth in sectors like fast moving consumer goods, pharmaceuticals, liquor, cosmetics etc. has had a positive rub off on the packaging industry. Growth in consumer goods and organized retailing mainly drives demand for packaging." -
Growing in size of middle class population means shifting form traditional grocery shopping and buying habits at the corner grocery store to supermarkets and organized retail outlets. This adds potential to flexible packaging industry as packaging is and will be an important strategy of product placement on the shelves of such supermarkets and stores where customers walk around and try to judge the contents/product by their packaging and/or brand. It is the least we should remember that PPL's customers are some of the leading FMCG brands who occupy shelves at such supermarkets and stores. The FMCG brands are in general bullish on the scope India offers further through infrastructure development in rural areas and underdeveloped towns which means establishment and growth of organized retail in those areas in the coming decade.Government of India - Ministry of Food Processing's Vision 2015: Although we need to discuss the quantifiable benefits of this plan for PPL, at the first thought PPL should directly and indirectly benefit from this initiative subject to GOI's proper execution of this plan. Under this scheme the Ministry aims to (a) Become the Food Factory of the World, (b) Triple the growth of Food processing industries, (c) Increase the value addition from 20% to 35%, (d) Increase contribution to the world's agri-business from 1.5% to 3%. Further research on the Vision-2015 plan and discussions with the IR/Management of such companies would give us insights into the quantifiable benefits to PPL which may be in the face of Tax exemptions, subsidies, export incentives (kick-backs), minimum pricing power/protection, raw material quotas and rebates, etc.
STRATEGY AND OPERATIONS:
NASP (New Applications, Structures, Products and Processes): In the long run, moving more business to value added segments, Innovation and new products, exploring new markets are seen as critical to profitable growth. The company's endeavor to renew innovation program will continue to be the cornerstone of PPL's strategy. NASP initiatives which contributed to 27.2% of total 2010 sales would get added thrust in the current year and years to come. Organizational measures to further accelerate the NASP efforts are in place with the CEO directly overseeing the company's innovation programs and strategy. PPL has been expanding its supplier base for critical raw materials and introducing alternative materials for its products as part of the innovation drive.
Operations: The Company is making efforts to optimize existing capacity utilization and add units to plants that expect growth in their products. They have seen success in measures to cut operating costs and overhead expenses. To enhance capacity utilization, they initiated de-bottlenecking in supply chain and inventory controls. However, efficient management of Working Capital (Inventory, Receivables and Payables) is critical for favorable valuation in the light of rising materials prices. The DCF Model seems highly sensitive to these assumptions/inputs and further discussion with management regarding this would be vital to arriving at the valuation with more accuracy. Further, the valuation is also highly dependent on the company's ability to preserve or dictate sales margins (Cost + Input or Fixed Price) and Raw materials purchase price in the short and medium terms via contracts or expanding supplier base
Sometimes the general public can get confused in attempting to explain the complexities and the inefficiency of the banking sector when one simple chart brings the message home. A chart like that comes from the latest "Eye on the Market" from JPM's Michael Cembalest, who compares total bank deposits ($8.4 trillion), or bank liabilities, and total bank loan (about $2 trillion less) assets, or sources of cash flows that are supposed to fund bank liabilities and generate retained earnings, while the bank performs credit, maturity and risk transformation: a bank's three key functions. As the chart below shows, perhaps the primary reason why the economy is in its current deplorable state, is that instead of lending dollar for dollar to catch up with deposit growth, banks now rely on roughly $1.7 trillion in excess reserves with the Fed, an amount roughly equal to the difference between total deposits and loans, to plug the credibility gap. This also explains why according to Cembalest one of the expectations by the market from Jackson Hole is that IOER will be cut to 0% to promote bank lending, and thus the conversion of reserves into loans (something which the inflationistas out there will tell you is a big risk to a sudden surge in out of control inflation). So how does the Fed's direct intervention in bank balance sheets look like?
Full article at
http://www.zerohedge.com/news/charting-biggest-structural-problem-us-banks-and-what-market-expects-jackson-hole-version-n1
__,_._,___
To the Apple Board of Directors and the Apple Community:
I have always said if there ever came a day when I could no longer meet my duties and expectations as Apple's CEO, I would be the first to let you know. Unfortunately, that day has come.
I hereby resign as CEO of Apple. I would like to serve, if the Board sees fit, as Chairman of the Board, director and Apple employee.
As far as my successor goes, I strongly recommend that we execute our succession plan and name Tim Cook as CEO of Apple.
I believe Apple's brightest and most innovative days are ahead of it. And I look forward to watching and contributing to its success in a new role.
I have made some of the best friends of my life at Apple, and I thank you all for the many years of being able to work alongside you.
Steve
And the official Apple press release:
Apple's Board of Directors today announced that Steve Jobs has resigned as Chief Executive Officer, and the Board has named Tim Cook, previously Apple's Chief Operating Officer, as the company's new CEO. Jobs has been elected Chairman of the Board and Cook will join the Board, effective immediately.
"Steve's extraordinary vision and leadership saved Apple and guided it to its position as the world's most innovative and valuable technology company," said Art Levinson, Chairman of Genentech, on behalf of Apple's Board. "Steve has made countless contributions to Apple's success, and he has attracted and inspired Apple's immensely creative employees and world class executive team. In his new role as Chairman of the Board, Steve will continue to serve Apple with his unique insights, creativity and inspiration."
"The Board has complete confidence that Tim is the right person to be our next CEO," added Levinson. "Tim's 13 years of service to Apple have been marked by outstanding performance, and he has demonstrated remarkable talent and sound judgment in everything he does."
Jobs submitted his resignation to the Board today and strongly recommended that the Board implement its succession plan and name Tim Cook as CEO.
As COO, Cook was previously responsible for all of the company's worldwide sales and operations, including end-to-end management of Apple's supply chain, sales activities, and service and support in all markets and countries. He also headed Apple's Macintosh division and played a key role in the continued development of strategic reseller and supplier relationships, ensuring flexibility in response to an increasingly demanding marketplace.
Who says hedge funds are ambivalent about the current market? As of last week, they have not been
more bearish on the S&P since before Lehman. From SocGen: "Hedge funds have opened the biggest net short positions since early 2008, concentrated on the most liquid segment of the market, i.e. the S&P 500. Meanwhile, positioning on small caps hardly moved (slight increase in net shorts on the Russell 2000). Surprisingly, they actually stuck to their net long positions on Technology (Nasdaq)." As usual, the amusingly named "hedge" funds defy their purported nature (as in, to hedge), and merely pursue momentum, and should be more appropriately called "career risk" funds as the only variable is doing precisely what everyone else is doing: remember - to get a bonus at the end of the year, you don't have to outrun the market, you just have to outrun the biggest institutional fool out there. "Hedge funds have closed their net short positions on 10-year Treasuries and strongly diminished their net shorts on the long end (30Y), as recession fears have crunched expectations for higher bond yields, and endorsed by the Fed's announcement that it will keep rates low until at least 2013." Hedge fund infatuation with metals continues: "Hedge funds' enthusiasm for gold and platinum remains strong, as indicated by the high net long positions on these metals. Meanwhile, net long positions on base metals (copper) have been strongly reduced. Net long positions on crude oil remain relatively stable, less impressed by the perceived recession threats." Expect to see numerous short covering sprees until the end of the year, even as the market continues it secular decline back to fair value somewhere around 400.
Full article at
Following years of pandering to client demands, and assigning trillions of dollars in fixed income securities with whatever rating money bought (among other things, a factor to the credit bubble and its subsequent implosion) S&P finally tried to do the right thing and tell the truth. However in this case it picked if not the worst, then certainly the most hypocriticial credit in the world to expose – the US itself. Sure enough two weeks after the downgrade, someone made the phone call and the CEO Deven Sharma is no more. As for the kick square in the gonads: Sherma will be replaced with the COO of…you know it… the bank which demanded tens of billions in secret Fed bailout loans itself, Citibank, and whose existence is inextricably tied to America not seeing any more downgrades ever again.
As the FT reports, "The McGraw-Hill board made the decision to replace Mr Sharma at a meeting on Monday, where it also discussed an ongoing strategic review." Alas, this is nothing but a case study of modern corporate reality in America: if you are not with the status quo, you are against it, and you are promptly booted out of it: anyone who does not share the visions of one glorious future built on ponzi schemes, houses of cards, and games of three card monte, will be promptly suicided, either physically or professionally.
We expect that this flagrant example of how the powers that be will deal with any dissenters will instill the fear of god in anyone at either Moodys (or the French sycphants from Fitch) and nobody will ever again menton the words "US" and "downgrade" in the same sentence.
From the FT:
Deven Sharma is stepping down as president of Standard & Poor's only weeks after the rating agency issued an unprecedented downgrade of the credit of the US, according to people familiar with the matter.
Mr Sharma will remain as an adviser to S&P's owner, McGraw-Hill, for four months and leave the company at the end of the year, they said.
Mr Sharma will be replaced as S&P president by Douglas Peterson, chief operating officer of Citibank, the banking unit of Citigroup, they said.
As for the official story:
People close to the company said the search for Mr Sharma's replacement has been going on for six months, and was triggered by the split of its data, pricing and analytics business from its ratings business. The creation of that new group, McGraw-Hill Financial, reduced the scope of Mr Sharma's oversight, they said.
So let us get this straight: in America when you dare to tell the truth, your career is over, while if you are a corrupt, lying, incompetent tax evader you not only get to be Treasury Secretary but likely will be on for life as long as you do the one duty you are entrusted with: pander to the interests of the Too Big To Fail financial institutions
We should be speechless but at this point we are well beyond the point of even caring.
The only question left in this entire farce is how long before S&P issues the following upgrade of the US:
"Great service, AAA+++ rating, immediate payment, would do business again!!!"
