Vivek Kaul
Ben Bernanke, the Chairman of the Federal Reserve of United States, the American central bank, announced on June 19, that the Federal Reserve would go slow on money printing in the days to come.
Speaking to the media he said “If the incoming data are broadly consistent with this forecast, the Committee(in reference to the Federal Open Market Committee) currently anticipates that it would be appropriate to moderate the monthly pace of purchases later this year…And if the subsequent data remain broadly aligned with our current expectations for the economy, we would continue to reduce the pace of purchases in measured steps through the first half of next year, ending purchases around mid-year.”
The Federal Reserve has been printing $85 billion every month and using that money to buy American government bonds and mortgage backed securities. By buying bonds, the Fed has managed to pump the newly printed dollars into the financial system.
The idea was that there would be no shortage of money going around, and as a result interest rates will continue to be low. At low interest rates banks would lend and people would borrow and spend, and that would help in getting economic growth going again.
The trouble is that quantitative easing, as the Federal Reserve’s money printing programme, came to be known as, has turned out to be terribly addictive. And anything that is addictive cannot be so easily withdrawn without negative repercussions.
As Stephen D King writes in When the Money Runs Out “Bringing quantitative easing to an end is hardly straightforward. Imagine, for example, that a central bank decides quantitative easing has become dangerously addictive and indicates to investors not only that programme will be put on hold…but it will come to a decisive end. The likely result is a rise in government bond yields…If, however, the economy is still weak, the rise in bond yields will surely be regarded as a threat to economic recovery.”
This is exactly how things played out before and after Bernanke’s June 19 announcement. With Federal Reserve announcing that it will go slow on money printing in the days to come, investors started selling out on American government bonds.
Interest rates and bond prices are inversely correlated i.e. an increase in interest rates leads to lower bond prices. And given that interest rates are expected to rise with the Federal Reserve going slow on money printing, the bond prices will fall. Hence, investors wanting to protect themselves against losses sold out of these bonds.
When investors sell out on bonds, their prices fall. At the same time the interest that is paid on these bonds by the government continues to remain the same, thus pushing up overall returns for anybody who buys these bonds and stays invested in them till they mature. The returns or yields on the 10 year American treasury bond reached a high of 2.6% on June 25, 2013. A month earlier on May 24, 2013, this return had stood at 2.01%.
An increase in return on government bonds pushes up interest rates on all other loans. This is because lending to the government is deemed to the safest, and hence the return on other loans has to be greater than that. This means a higher interest.
The average interest rate on a 30 year home loan in the United States jumped to 4.46% as on June 27, 2013. It had stood at 3.93% a week earlier.
Higher interest rates can stall the economic recovery process. It’s taken more than four years of money printing by the Federal Reserve to get the American economy up and running again, and a slower growth is something that the Federal Reserve can ill-afford at this point of time. In fact on June 26, 2013, the commerce department of United States, revised the economic growth during the period January-March 2013, to 1.8% from the earlier 2.4%.
These developments led to the Federal Reserve immediately getting into the damage control mode. William C Dudley, president of the Federal Reserve Bank of New York, the most powerful bank among the twelve banks that constitute the Federal Reserve system in United States, said in a speech on June 27, 2013 “Some commentators have interpreted the recent shift in the market-implied path of short-term interest rates as indicating that market participants now expect the first increases in the federal funds rate target to come much earlier than previously thought. Setting aside whether this is the correct interpretation of recent price moves, let me emphasize that such an expectation would be quite out of sync with both FOMC(federal open market committee) statements and the expectations of most FOMC participants.”
What this means in simple English is that the Federal Reserve of United States led by Ben Bernanke, has no immediate plans of going slow on money printing. There will continue to be enough money in the financial system and hence interest rates will continue to be low.
After Dudley’s statement, the return on the 10 year American treasury bond, which acts as a benchmark for interest rates in the United States, fell from 2.6% on June 26, 2013, to around 2.52% as on July 3, 2013. The market did not take remarks made by Dudley (as well as several other Federal Reserve officials) seriously enough. Hence the return on 10 year American treasury bond continues to remain high, leading to higher interest rates on all other kind of loans.
It also implies that the market will not allow the Federal Reserve to go slow on money printing. As King writes “It (i.e. money printing by central banks), is also, unfortunately, highly addictive. If the economy should fail to strengthen, the central bank will be under pressure to deliver more quantitative easing.”
V. Anantha Nageswaran put it aptly in a recent column in the Mint. As he wrote “Financial markets will force the Federal Reserve to delay any attempt to restore monetary conditions to a more normal setting. Further, as and when such attempts get under way, they will be half-hearted and asymmetric as we have seen in the recent past. Since the Federal Reserve has tied the mast of the economic recovery to a recovery in asset prices, any decline in asset prices will unnerve it. Hence, the eventual outcome will be an inflationary bust due to the prevalence of an excessively accommodative monetary policy for an inordinately long period.”
If interest rates do not continue to be low then the recovery in real estate prices, which has been a major reason behind the American economic growth coming back, will be stalled. To ensure that real estate prices continue to go up, the Federal Reserve will have to continue printing money. And this in turn will eventually lead to an inflationary bust.
In fact, Jim Rickards, author of Currency Wars, feels that the Federal Reserve will increase money printing in the days to come. As he recently told www.cnbc.com “They’re not going to taper later this year. They’ll actually going to increase asset purchases because deflation is winning the tug of war between deflation and inflation. Deflation is the Fed’s worst nightmare.” Deflation is the opposite of inflation and refers to a situation where prices are falling.
When prices fall people postpone purchases in the hope of getting a better deal in the future. This has a huge impact on economic growth.
Hence it is more than likely that the Federal Reserve of United States will continue to print money in order to buy bonds to ensure that interest rates continue to remain low. If interest rates go up, the economic growth will be in a jeopardy. As King puts it “The government will then blame the central bank for undermining the nation’s economic health and the central bank’s independence will be under threat. Far better, then, simply to continue with quantitative easing (as money printing is technically referred to as).”
This means that a strong case for staying invested in gold still remains. Rickards expects the price to touch $7000 per ounce (1 troy ounce equals 31.1 grams).
(The article originally appeared on www.firstpost.com)
(Vivek Kaul is a writer. He tweets @kaul_vivek)
Investing
Japan to India: Busting the biggest myth of investing in real estate
Vivek Kaul
Japan saw the mother of all real estate bubbles in the 1980s. Banks were falling over one another to give out loans and home and land prices reached astonishingly high levels. As Paul Krugman points out in The Return of Depression Economics “Land, never cheap in crowded Japan, had become incredibly expensive: according to a widely cited factoid, the land underneath the square mile of Tokyo’s Imperial Palace was worth more than the entire state of California.”
As prices kept going up, the Japanese started to believe that the real estate boom will carry on endlessly. In fact such was the confidence in the boom that Japanese banks and financial institutions started to offer 100 year home loans and people lapped it up.
As Stephen D. King, the chief economist at HSBC, writes in his new book When the Money Runs Out “ By the end of the 1980s, it was not unusual to find Japanese home buyers taking out 100 year mortgages (or home loans), happy, it seems, to pass the burden on to their children and even their grand children. Creditors, meanwhile, naturally assumed the next generation would repay even if, in some cases, the offspring were no more a twinkle in their parents’ eyes. Why worry? After all, land prices, it seemed, only went up.”
Things started to change in late 1989, once the Bank of Japan, the Japanese central bank, started to raise interest rates to deflate the bubble. Land prices started to come down and there has been very little recovery till date, more than two decades later. “Since the 1989 peak…land prices have fallen by 60 per cent,” writes King.
Every bull market has a theory behind it. Real estate bull markets whenever and wherever they happen, are typically built around one theory or myth. Economist Robert Shiller explains this myth in The Subprime Solution – How Today’s Financial Crisis Happened and What to Do about It. Huge increases in real estate prices are built around “the myth that, because of population growth and economic growth, and with limited land resources available, the price of real estate must inevitably trend strongly upward through time,” writes Shiller
And the belief in this myth gives people the confidence that real estate prices will continue to go up forever. In Japan this led to people taking on 100 year home loans, confident that there children and grandchildren will continue to repay the EMI because they would benefit in the form of significantly higher home prices.
A similar sort of confidence was seen during the American real estate bubble of the 2000s. In a survey of home buyers carried out in Los Angeles in 2005, the prevailing belief was that prices will keep growing at the rate of 22% every year over the next 10 years. This meant that a house which cost a million dollars in 2005 would cost around $7.3million by 2015. Such was the belief in the bubble.
India is no different on this count. A recent survey carried out by industry lobby Assocham found that “over 85 per cent of urban working class prefer to invest in real estate saying it is likely to fetch them guaranteed and higher returns.”
This is clearly an impact of real estate prices having gone up over the last decade at a very fast rate. The confidence that real estate will continue to give high guaranteed returns comes with the belief in the myth that because population is going up, and there is only so much of land going around, real estate prices will continue to go up.
But this logic doesn’t really hold. When it comes to density of population, India is ranked 33rd among all the countries in the world with an average of 382 people per square kilometre. Japan is ranked 38th with 337 people living per square kilometre. So as far as scarcity of land is concerned, India and Japan are more or less similarly placed. And if real estate prices could fall in Japan, even with the so called scarcity of land, they can in India as well.
Economist Ajay Shah in a recent piece in The Economic Times did some good number crunching to bust what he called the large population-shortage of land argument. As he wrote “A little arithmetic shows this is not the case. If you place 1.2 billion people in four-person homes of 1000 square feet each, and two workers of the family into office/factory space of 400 square feet, this requires roughly 1% of India’s land area assuming an FSI(floor space index) of 1. There is absolutely no shortage of land to house the great Indian population.”
The interesting thing is that large population-shortage of land is a story that real estate investors need to tell themselves. Even speculators need a story to justify why they are buying what they are buying.
Real estate prices have now reached astonishingly high levels. As a recent report brought out real estate consultancy firm Knight Frank points out, 29% of the homes under construction in Mumbai are priced over Rs 1 crore. In Delhi the number is at 11%. Such higher prices has led to a drop in home purchases and increasing inventory. “The inventory level has almost doubled in the last three years. In the National Capital Region, the inventory level reached 31 months at the end of March 2013 against 15 months at the end of March 2010, while in the Mumbai Metropolitan Region the inventory level has jumped from 17 months to 40 months. In Hyderabad, it reached 49 months in March 2013 as compared to 23 months in March 2010, according to data by real estate research firm Liases Foras. Inventory denotes the number of months required to clear the stock at the existing absorption rate. An efficient market maintains an inventory of eight to ten months,” a news report in the Business Standard points out.
The point is all bubble market stories work till a certain point of time. But when prices get too high common sense starts to gradually come back. In a stock market bubble when the common sense comes back the correction is instant and fast, because the market is very liquid. The same is not true about real estate, because one cannot sell a home as fast as one can sell stocks.
Real estate companies in India haven’t started cutting prices in a direct manner as yet. But there are loads of schemes and discounts on offer for anyone who is still willing to buy. As the Business Standard news report quoted earlier points out “As many as 500 projects across India are offering some scheme or the other, in a bid to push sales in an otherwise slow market. According to Magicbricks.com, an online property portal, Mumbai has the maximum number of projects with schemes/discounts at around 88, followed by Delhi with 56 and Chennai and Pune with 33 each. Kolkata has 30 such offers, while Hyderabad has 18 and Bangalore has 16. On a pan India level, Magicbricks has about 274 projects with discounts offer.”
Of course the big question is when will the real price cuts start? They will have to happen, sooner rather than later.
The article originally appeared on www.firstpost.com on July 2, 2013
(Vivek Kaul is a writer. He tweets @kaul_vivek)
The case against equity investing: In the long run we are all dead
Vivek Kaul
Stocks are for the long run is a phrase you would have heard often. But that’s not what William H Gross seems to believe anymore. “The cult of equity is dying. Like a once bright green aspen turning to subtle shades of yellow then red in the Colorado fall, investors’ impressions of “stocks for the long run” or any run have mellowed as well,” he wrote in his monthly investment outlook for August 2012.
Gross is the Managing Director of Pacific Investment Management Company (Pimco) and manages Pimco’s Total Return Fund. The Total Return Fund currently has assets under management of $263billion and is the biggest mutual fund in the world.
“An investor can periodically compare the return of stocks for the past 10, 20 and 30 years, and find that long-term Treasury bonds have been the higher returning and obviously “safer” investment than a diversified portfolio of equities,” wrote Gross. So what this clearly tells us is that the higher risk of investing in stocks is not always rewarded with excess return and sometimes it might just make sense to invest in dull and boring bonds which guarantee a given rate of return.
But that’s just one part of the evidence. In the really really long term stocks have done very well. As Gross points out “The long-term history of inflation adjusted returns from stocks shows a persistent but recently fading 6.6% real return (known as the Siegel constant) since 1912.” Hence $1 invested in 1912 would have turned to $500(inflation adjusted) hundred years later i.e. now in 2012. No wonder the Americans took onto investing in stocks like nobody else did. The prime reason for this was the premise that returns from equity beat that from bonds over the long run. Shankar Sharma, joint managing director and vice chairman of First Global explained this phenomenon to me in a recent interview I did for the Daily News and Analysis (DNA) in this way: “Rightly or wrongly, they (the Americans and the much of the Western world) have been given a lifestyle which was not sustainable, as we now know. But for the period it sustained it kind of bred a certain amount of risk taking because life was very secure. The economy was doing well. You had two cars in the garage. You had two cute little kids in the lawn. Good community life. Lot of eating places. You were bred to believe that life is going to be good so hence hey, take some risk with your capital. People were forced to invest in equities under the pretext that equities will beat bonds… They did for a while. Nevertheless, if you go back thirty years to 1982, when the last bull market in stocks started in the United States and look at returns since then, bonds have beaten equities. But who does all this Math?” (You can read the complete interview here)
What has changed now is the ability of Americans to take risk by investing in equity. “Americans are naturally more gullible to hype. But now western investors and individuals are now going to think like us. Last ten years have been bad for them and the next ten years look even worse. Their appetite for risk has further diminished because their picket fences, their houses all got mortgaged. Now they know that it was not an American dream, it was an American nightmare. So I cannot make a case for a broad bull market emerging anytime soon,” said Sharma.
And this seems phenomenon seems to be clearly evident in the numbers that are coming out. As the USA Today reported in mid May: “Stocks remain out of fashion…Retail investors have yanked more than $260 billion out of mutual funds that invest in US stocks since the end of 2008, says the Investment Company Institute, a fund trade group. In contrast, they have funneled more than $800 billion into funds that invest in less-volatile bonds. Investors’ chronic mistrust of stocks is reigniting fears that an entire generation is unlikely to stash large chunks of cash in the increasingly unpredictable market as they did in the past. “Investors have suffered a traumatic shock that has caused severe psychological damage and made them more risk-averse,” says Carmine Grigoli, chief investment strategist at Mizuho Securities USA.”
The phrase to mark here is “risk-averse”. As Sharma puts it “Investing in equity is a mindset. That when I am secure, I have got good visibility of my future, be it employment or business or taxes, when all those things are set, then I say okay, now I can take some risk in life.”
The question that concerns us in India is how will this change in mindset impact India? Before I come to that question let me deviate a little and discuss the concept of naturally occurring ponzi schemes.
A ponzi scheme essentially is a fraudulent investment scheme in which money being brought in by new investors is used to pay off the old investors. The people running the scheme typically promise very high returns to tempt prospective investors to invest money in the scheme. But this money is not invested anywhere to generate returns. The “promise” of high returns ensures that newer investors keep coming in. They money they bring in is used to pay off the older investors. The scheme keeps running till the money being brought in by the new investors is lesser than the money that needs to be paid off to the older ones. This is the point when the scheme collapses. Typically the people who run such schemes disappear with the money, before the scheme collapses.
In his book, Irrational Exuberance, Robert Schiller introduces the concept of Naturally Occurring Ponzi Schemes, which happen without the contrivance of a fraudulent manager. Such a scheme works on a price to price feedback theory. When prices go up creating successes for some investors, this may attract public attention, promote word of mouth enthusiasm and heighten expectations for further price increases. (Adapted from Shiller 2003). The stock market is the best example. Stories about stock markets going up spread very fast. Investors, in an optimistic mood, might want to buy stock and take the stock price further up. This leads to more investors entering the market, fuelling an even greater price rise and the cycle gets repeated over and over. As Shiller mentions, “When prices go up a number of times, investors are rewarded by price movements in these markets, just as they are in Ponzi Schemes.”
The point being that the real returns in the stock market are made when prospective investors are in the Ponzi scheme mode and are willing to invest. A major reason for the bull run in the stock market in India between 2003 and 2007 was the fact that foreign investors brought in a lot of money, thus driving up stock prices and generating returns for those who had already invested. But things have changed over the last five years.
Between April 2007 and July 2012, the foreign investors invested Rs 3,538,108.46 crore in Indian stocks. That clearly is a lot of money. But they also sold Rs 3,537,016.97 crore worth of Indian stocks. This means that the net investment of foreign investors in Indian stocks in the last five years and three months has been a miniscule Rs 1091.49crore.
During the same period the domestic institutional investors made investments worth Rs 1,571,084.73 crore. They sold stocks worth Rs 1,462,118.66 crore. Hence their net investment in stocks was Rs 108,938.27 crore. (Source: www.moneycontrol.com)
It is this net investment by Indian institutional investors which ensured that the BSE Sensex, India’s premier stock market index, has delivered an absolute return of 30% since April 2007. This means an average return of 5.1% per year. I need not tell you that you would have been better off doing a fixed deposit where the returns were more or less guaranteed. If you had taken on some risk by investing in a mutual fund scheme like Birla Sun Life MIP-II Savings 5 G, you would have managed to get a return of 10.35% per year, more than double that of the stock marekt. The scheme invests 95% of the money collected in debt and the remaining in stocks.
The point I am trying to make is that for the stock market in India to give good returns it is important that foreign investors bring money into India and stay invested in Indian stocks. With their attitudes towards investing in stocks changing whether they will continue to invest in India, remains to be seen.
The other way out is that Indian investors start investing more money in the stock market both directly and indirectly. I don’t see that happening due to two reasons. A lot of Indian investors over the last few years invested money in the Indian stock market indirectly through unit linked insurance plans(Ulips) sold (or rather mis-sold) by insurance companies.
They are now coming to the realization that they have been taken to the cleaners. Money invested five to seven years back is just about breaking even and they would have been much better off by simply letting their money lie idle in a savings bank account.
This is primarily because Ulips used the premium paid by investors to pay very high commissions to insurance agents and did not invest the full premium. So these investors who were taken for a royal ride are not going to come back to the stock market anytime soon.
While systematic investment plans( SIPs) offered by mutual funds have done a lot better than Ulips but the returns are nowhere in the region that would compensate for the increased risk of investing in stocks.
The other reason is a more fundamental reason that was explained to me by Shankar Sharma. “Emerging market investors are more risk averse than the developed world investors. We see too much of risk in our day to day lives and so we want security when it comes to our financial investing… But look across emerging markets, look at Brazil’s history, look at Russia’s history, look at India’s history, look at China’s history, do you think citizens of any of these countries can say I have had a great time for years now? That life has been nice and peaceful? I have a good house with a good job with two kids playing in the lawn with a picket fence? Sorry boss, this has never happened…. Indians have figured out that equities are a fashionable thing meant for the Nariman Points of the world.”
Given these reasons it is difficult to make a case for equities as a long term investment in India as well, though things may not turn to be as bad as they might turn out to be in America and other parts of the Western world.
In the end let me quote an economist who the world always goes back to, when they run out of everything else. As John Maynard Keynes once famously said “In the long run we are all dead”.
(The article originally appeared on www.firstpost.com on August 6,2012. http://www.firstpost.com/investing/the-case-against-equity-in-the-long-run-we-are-all-dead-406223.html)
(Disclosure: Despite the slightly negative take here, the writer continues to makes regular investments in the Indian stock market through systematic investment plans, though the amount of investments have come down over the last six months)
(Vivek Kaul is a writer and can be reached at [email protected])