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Is Federal Reserve Getting Ready for an ‘Easy Money’ Confrontation with Donald Trump?

3D chrome Dollar symbol

We were at the Taj Mahal Hotel in Mumbai, attending the Equitymaster conference over the last two days. Overlooking the dark waters of the Arabian Sea and the Gateway of India, as we ate, talked and heard, we also sat back and thought about how the end of the easy money era would play out.

As we heard Marc Faber and Ajit Dayal lay out their ideas, we got more ideas. And we came to an old conclusion, all over again: forecasting, especially about the future, is a difficult business. But then someone’s got to take a shot at it. Everyone in the investing world cannot be cautiously optimistic. We have clearly have had enough of that term.

So how is this end of the era of easy money, likely to play out? The Federal Reserve of the United States, the American central bank, has started shrinking its massive balance sheet from October 2017 onwards. Between October 3, 2017 and January 29, 2018, the Federal Reserve has shrunk its balance sheet by around $40 billion, we can see that from the Fed documents. But there is still a long way to go, given that the size of the Federal Reserve’s balance sheet is still more than $4.4 trillion.

In the aftermath of the financial crisis that started in September 2008, once the Lehman Brothers, the fourth largest investment bank on Wall Street went bust, and many other financial institutions in the Western world almost went down with it, the Federal Reserve decided to print a lot of money. But just printing money wasn’t enough, this money, had to be pumped into the financial system as well.

This printed money (or rather created digitally) was pumped into the financial system by buying American treasury bonds and mortgage backed securities. American treasury bonds are bonds issued by the American government in order to finance its fiscal deficit, or the difference between what it earns and what it spends.

Mortgage backed securities are essentially securitised financial securities which are derived from mortgages (i.e. home loans). As of September 1, 2008, the Federal Reserve had assets worth $905 billion. As it got around to buying treasury bonds and mortgaged backed securities, it expanded its balance sheet very quickly. The size of Federal Reserve’s balance sheet peaked at $4.51 trillion, towards the end of December 2016.

The idea was that all this money floating around in the financial system would drive interest rates low and keep them there. This happened. Over and above this, the hope was that the companies would use low interest rates as an opportunity to borrow, invest and expand. This would create jobs and employment, would lead to spending and create faster economic growth.

The companies didn’t quite behave the way they were expected to. Yes, they did borrow. But they borrowed to buyback their shares and reduce the number of outstanding shares, and hence, pushed up their earnings per share.

These buybacks essentially benefitted the rich Americans who owned shares. The benefits were two-fold. First, they had an opportunity to sell their shares back to the companies buying them. And second, as the stock market rallied because of improved earnings and all the money floating around, those who owned shares benefitted.
But this wasn’t really what the Federal Reserve had hoped. The consumers were also supposed to borrow and spend at low interest rates. But that didn’t quite play out the way the Federal Reserve had hoped.

What happened instead was that large financial institutions borrowed money at very low interest rates and invested them in stock and bond markets all over the world, including India. These trades are referred to as the dollar carry trade. This led to stock markets rallying all over the world, irrespective of the fact whether the earnings of the companies were improving or not.

The Federal Reserve has decided to gradually start withdrawing all the money that it has put into the global financial system. Between October and December 2017, it planned to sell treasury bonds and mortgage backed securities worth $10 billion. Between January and March 2018, this will go up to $20 billion a month. Between April and June 2018, this will go up to $30 billion a month. Between July and September 2018, the Federal Reserve plans to sell bonds worth $40 billion a month. After that the amount will rise to $50 billion a month.[i]

How does the actual evidence look like? As mentioned earlier in the piece, the Federal Reserve had managed to shrink its balance sheet by $40 billion between October 3, 2017 and January 29, 2018. From the looks of it, the Federal Reserve seems to be doing what it said it would do. Nevertheless, these are early days.

In 2018, the Federal Reserve is expected to shrink its balance sheet by $420 billion and 2019 onwards, the balance sheet is expected to shrink by $600 billion a year. With the Federal Reserve taking money out of the financial system, there will be lesser money going around, this is likely to push up interest rates. In fact, the yield (i.e. return) on the 10-year treasury bond has crossed 2.85%. This yield acts as a benchmark for other kinds of lending, simply because lending to the American government is deemed to be the safest form of lending. With interest rates expected to go up, the carry trades are expected to become unviable. This will lead money being withdrawn from stock and bond markets all over the world.

In fact, regular readers would know that we have already discussed a large part of what has been written up until now. But now comes the completely crazy part. The United States government is expected to borrow $955 billion, during the course of this year, to meet its expenses. It is further expected to borrow a trillion dollars, in each of the next two years. Basically, the American government needs to borrow close to $3 trillion between 2018 and 2020.

During the same period, the Federal Reserve is working towards withdrawing more than $1.6 trillion ($420 billion in 2018 + $600 billion in 2019 + $600 billion in 2020) from the financial system. In this scenario, when the Federal Reserve is withdrawing money from the financial system and the government needs to borrow a huge amount of money, it is but logical that the interest rates in the United States are going to go up.

This will impact the carry trades. Hence, stock markets and bond markets will have a tough time all over the world. Of course, all this comes with the assumption that the Federal Reserve will continue doing what it is. The question is will it continue to withdraw the printed money it has pumped into the financial system?

Now this is where things get really interesting. The American society as a large is a highly indebted one. The total household debt of the Americans as of September 30, 2017, stood at $12.96 trillion. The debt has been going up for 13 consecutive quarters now. This debt includes, home loans, auto loans, student loans, credit cards outstanding, etc.
Hence, rising interest rates will hurt the average American as the EMIs will go up. It will also hurt the American government which is in the process of borrowing more, in the years to come. Governments, because they borrow as much as they do, as a thumb rule, like low interest rates.

In this scenario, if the Federal Reserve continues withdrawing the printed money, it is more than likely to run into a confrontation with the American president Donald Trump. Trump has only recently chosen Jerome Powell as the Chairman of the Federal Reserve, after Janet Yellen. One school of thought seems to suggest that Powell, given that he has been appointed by Trump, is likely to bat for Trump and go easy on withdrawing money from the financial system, and allowing interest rates to go up. But it is not just up to him. The American monetary policy is decided by the Federal Monetary Policy Committee (FOMC), which has Powell and 12 other members.

In fact, even if that Powell does not bat for Trump, the FOMC might still vote to go slow on allowing interest rates to rise. Ultimately, the Federal Reserve has to ensure that the American economy continues to remain on a stable footing. If rising interest rates end up hurting the American economy, the FOMC will have to react accordingly. No Federal Reserve decisions are written in stone and can always be changed.

The question is how quickly is this likely to happen? Now that is a very difficult question to answer. But my best guess (and I use the word very very carefully here) is that during the second half of the year, the Federal Reserve might have to reverse its policy of taking out all the money that it has put into the global financial institution.

Up until then, a lot of damage will be done to the stock and bond markets around the world. The funny thing is that though the Federal Reserve is now pulling out money to let interest rates rise, the European Central Bank continues to buy bonds issued by its member governments and the 10-year government bond yields of European countries, is significantly lower than that of United States.

What does this mean in an Indian context? Unless, the American Federal Reserve reverses its current policy, the Indian stocks are going to have a tough time. That is a given. What happens next, if and when Federal Reserve changes track? Will another easy money start? On that your guess is as good as ours.
Let’s watch and wait!
[i] https://www.federalreserve.gov/newsevents/pressreleases/monetary20170614a.htm

The column originally appeared on Equitymaster on February 12, 2018.

The Old-New Investment Lessons from the Recent Stock Market Crash

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It took the BSE Sensex, India’s premier stock market index, a period of nine months (from late April 2017 to late January 2018), to go from 30,000 points to higher than 36,000 points. This meant a return of more than 20% in a period of just nine months.

In an era when fixed deposits give a post-tax return of 5% per year, a return of 20% in less than a year, has to be fantastic. Of course, there are many listed stocks which have given more than 20 % returns, during the same period.

Between January 29 and February 6, 2018, the BSE Sensex has fallen by around 5.8% and wiped out one-third of the gain between April 2017 and January 2018. A week’s fall has wiped off one-third of the gain over a period of nine months.

When the stock market falls, a new set of investors learn, the same set of lessons all over again. What does this mean?

The price to earnings ratio of the BSE Sensex crossed 26 in late January 2018. This basically means that an investor was willing to pay Rs 26 for every one rupee of earning for the stocks that make up the Sensex.

Between April 2017 and January 2018, the price to earnings ratio of the Sensex had moved from 22.6 to 26.4. This meant that while the price of the stocks kept going up, the profit of the companies they represent, did not move at the same speed. Ultimately, the price of a stock is a reflection of the profit that a company is expected to make.

The price to earnings ratio of NSE Nifty touched 27 in late January 2018. The midcap stocks were going at a price to earnings ratio of 50. And the small caps had touched a price to earnings ratio of 120.

Such price to earnings ratios, or what the stock market likes to call valuation, were last seen in 2000 and 2008. With the benefit of hindsight, we now know that at both these points of time, the stock market was in a bubbly territory.

In fact, all the occasions when the price to earnings ratio of the stock market was greater than in the recent past, were either between January and March 2000, when the dotcom bubble and the Ketan Parekh stock market scam were at their peak, or between December 2007 and January 2008, when the stock market peaked, before the financial crisis which finally led to many Wall Street financial institutions going more or less bust, broke out.

Nevertheless, the stock market experts told us that this time is different because there was no bubble in the United States of the kind we saw in 2000 or that the financial crisis that broke out in 2008, was a thing of the past. Hence, there was no real reason for the stock market to fall. (Of course, to these experts, the lack of earnings growth did not matter).

The trouble is that when the markets are in bubbly territory, there typically is no reason for them to fall, until some reason comes along. The first reason came in the form of the finance minister Arun Jaitley, introducing a long-term capital gains tax of 10% on stocks and equity mutual funds. This tax will have to be paid on capital gains of more than Rs 1 lakh, starting from April 1, 2018.

Investors took some time to digest this, and the stock market fell by 2.3%, a day after the budget. If this wasn’t enough, the yield on the 10-year treasury bond of the American government came back into the focus.

This yield jumped by around 40 basis points to 2.85%, in a month’s time. This yield sets the benchmark interest rates for a lot of other borrowing that takes place. In the aftermath of the financial crisis that broke out in September 2008, the central banks of the Western world, led by the Federal Reserve of the United States, printed a lot of money to drive down interest rates.

This was done in the hope of people borrowing and spending money and the economies recovering. That did not happen to the extent it was expected. What happened instead was that large financial institutions borrowed money at low rates and invested them in stock markets all across the world. This phenomenon came to be known as the dollar carry trade.

All this money flowing in drove up stock prices. The problem is that as the 10-year treasury bond yield approaches 3 %, dollar carry trade will become unviable in many cases. Given this, many carry trade investors are now selling out of stock markets, including that of India.

The larger point here is that nobody exactly knows when the stock market will reverse. The way the market has behaved over the last few days, has proved that all over again.

The sellers are not selling out because the valuations are too high (they were too high even a month or two back). They are selling out because of an entirely different reason all together; investors are selling out because they are seeing other investors selling out. The herd mentality that guides investors to buy stocks when everyone else is, also forces them to sell when everyone else is.

Also, the stock market, when it falls can fall very quickly. The last generation of stock market investors learnt this when the BSE Sensex fell by close to 60 % between January 9, 2008 and October 27, 2008.

Is it time for this generation of stock market investors to learn the same lesson all over again? On that your guess is as good as mine.

Stay tuned!

The column originally appeared on Firstpost on Feb 6, 2018.

The Republic at 69 and the next seven decades

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India has been independent for more than 70 years and a republic for 68 years. Between 1950, the year, the country became a republic and 1991, the year, the government initiated economic reforms, the economic size of the country became five times.

By 2014, the economic size of the country was 4.2 times of what it was in 1991. I am forced to stop this comparison at 2014 because India adopted a new GDP series in January 2015 and the GDP data in that series is available only from 2011-2012 onwards.
The differentiating point between pre and post 1991 eras, is that the economic growth has been faster post 1991. There is no denying that this economic growth has had huge benefits.

At the same time, it has created its own set of problems as well. In 1990, as per the World Inequality Report 2018, the top 10 % of India’s population earned around 34 % of the national income. By 2016, this had jumped to 55 %. This rise in inequality has happened because the upper echelons of the society have benefitted more from the economic reforms of 1991.

As can be seen from Figure 1, India along with Brazil, have the highest concentration of wealth in the world, after the Middle East. In purchasing power terms, the per capita income of Brazil is 2.3 times that of India.

Figure 1:
inequality
Source: World Inequality Report 2018.

Inequality is not the only reason to worry about on the economic front. For years, the story of India’s demographic dividend has been sold to the world. Demographic dividend is a period of few decades in the lifecycle of a nation where it’s workforce increases at a faster pace than its overall population. As these individuals enter the workforce, find jobs, earn and spend money, the economy grows at a faster pace and pulls out many people out of poverty.

At least that is how things are supposed to work in theory. Around a million Indians are joining the workforce every month. This is expected to continue for the next decade and a half. The trouble is that there aren’t enough jobs going around. A recent estimate made by the Centre for Monitoring Indian Economy suggests that in 2017, two million jobs were created for 11.5 millions Indians who joined the labour force during the year.

There are other data points also which suggest a lack of jobs. The investment to gross domestic product ratio has been falling for a while now. The capacity utilisation rate of manufacturing firms has stagnated between 70 and 72%. If existing capacities are not being used, there is no reason for firms to expand and create jobs.

Labour intensive export sectors like apparels, gems and jewellery, leather, agriculture etc., have remained flat, over the last few years. Real estate and construction, two sectors which have tremendous potential to create jobs which cater to India’s cheap and largely unskilled labour, are down in the dumps.

For many, agriculture is no longer economically feasible. A discussion paper recently published by NITI Aayog suggests that agriculture contributes 39% of rural economic output, while employing 64 % of the workforce. For agriculture to be economically feasible nearly 8.4 crore individuals need to be moved out of it. This unfeasibility of agriculture has also resulted in landowning castes across the country, wanting reservation in government jobs.

The education scenario continues to be depressing. Children are going to school but aren’t really learning. The latest Annual Status of Education Report (ASER) states: “For the past twelve years, ASER findings have consistently pointed… that many children in elementary school need urgent support for acquiring foundational skills like reading and basic arithmetic.” Given this, even when firms have jobs, they cannot find people with the necessary skillset.

The trouble is that skilling is not happening at the scale that it needs to. The different ministries in the government had accepted a target of training 99,35,470 individuals in 2016-2017. Of this, only 19,58,723 or around less than one-fifth had been trained up to December 2016. It isn’t fair to blame the government for this, given the huge scale required. This needs a total overhauling of our education system with a huge focus on vocational studies.

Further, the Indian firms start small and continue to remain small. Labour laws remain the major culprit on this front. The state of Jammu and Kashmir has 260 labour laws. Other estimates suggest that India has around 200 labour laws in total. A very serious effort is needed at the government’s level to improve, the ease of doing business.

All in all, the scenario that prevails for India’s demographic dividend, is very bleak. And it is this demographic dividend which is expected to take us forward for the next seven decades.

The column originally appeared in the Daily News and Analysis, on January 26, 2018.

It’s Surprising That More People Aren’t’ Moving to Urban India

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Filmstar and member of parliament, Hema Malini, blamed the recent Kamala Mills fire tragedy, on India’s population and migrants. She was quoted in a Zee News report as saying: “The population is so high. When Mumbai ends, another city should begin. But the city keeps extending. Uncontrollable… The administration has allowed every migrant to live in the city. However, looking at the wide population in the city, the authorities should have brought in some restrictions here to control the population.”

Of course, migration and population, had nothing to do with the Kamala Mills fire. It had everything to do with the collapse of governance that Mumbai (or for that matter most Indian cities) has seen over the years.

Having said that migration is a huge issue that many Indian cities are facing. In fact, as a recent discussion paper titled Changing Structure of Rural Economy of India Implications for Employment and Growth, authored by Ramesh Chand, SK Srivastava and Jaspal Singh, and published by the NITI Aayog, points out: “As per the 2011 Census, 68.8 per cent of country‟s population and 72.4 per cent of workforce resided in rural areas. However, steady transition to urbanization over the years is leading to the decline in the rural share in population, workforce and GDP of the country. Between 2001 and 2011, India‟s urban population increased by 31.8 per cent as compared to 12.18 per cent increase in the rural population. Over fifty per cent of the increase in urban population during this period was attributed to the rural-urban migration and re-classification of rural settlements into urban.”

The question is why is this happening. The answer is fairly straightforward. Agriculture, as a profession, is not as remunerative as it used to be. The average size of the land farmed by an Indian farmer has fallen over the decades and in 2010-2011, the last time the agriculture census was carried out, stood at 1.16 hectares. In 1970-1971 it had stood at 2.82 hectares. This has happened as land has been divided across generations. This fall in farm size has made farming in many parts of the country, an unviable activity, leading to the size of agriculture as a part of the economy becoming smaller and smaller, without a similar fall in the number of people who continue to be dependent on it.

In fact, the situation could have only got worse since 2010-2011, as farm sizes would have shrunk further. Further, there are states like Kerala and Bihar, where the farm sizes are smaller than the average 1.16 hectares across India.

The NITI Aayog discussion paper points out that in 2011-2012, agriculture contributed 39.2 per cent of the rural economic output, while employing 64.1 per cent of the rural workforce. In 2004-2005, agriculture had contributed 38.9 per cent of rural economic output, while employing 72.6 per cent of the rural workforce.

What this basically means is that between 2004 and 2012, many rural workers essentially moved away from agriculture to other areas. Many would have migrated to cities for better opportunities as well.

What it also shows is that way too many people continue to remain dependent on agriculture. The sector has what economists refer to as huge disguised unemployment. If we look at the national level, agriculture contributes around 12 per cent of the gross domestic product (a measure of economic output), while employing 47 per cent of the workforce.

This clearly means that those working in agriculture are worse off than those not working in agriculture. In fact, the NITI Aayog discussion paper points out that the average urban worker made around 8.3 times the money an average agricultural worker does. The average urban worker makes 3.7 times the money an average cultivator does.
Given this, huge difference in income, it is not surprising that people want to migrate from villages to cities. Another data point that adds to this trend is the fact that only around half of the rural workforce looking for a job all through the year, is able to find one. In urban India, this is more than 80 per cent.

Given this, many people need to be moved from agriculture into other activities. The NITI Aayog discussion paper points out: “To match employment share with output share of agriculture another 84 million agricultural workers are required to quit agriculture and join more productive non-farm sectors. This amounts to about 70 per cent increase in the non-farm jobs in rural areas.”

What all these factors come together to tell us is that it is surprising that more people not moving to urban areas from rural areas, given the huge difference of income between rural and urban workers and the fact that there is a huge disguised unemployment in agriculture. Given the limitation of data (with the Census only being carried out once every 10 years), we will come to know the real situation only once the next census is carried out in 2021. But seeing how things are currently, it is safe to say that more people will move from rural to urban areas, than was the case in the past.

The column originally appeared in Daily News and Analysis on January 7, 2018.

But What About Bitcoins?

In the last one month, many people have asked me a simple question: “But what about bitcoins?”

Between 2013 and now, the price of a single bitcoin has gone from close to zero to more than $19,000. In fact, in 2017, the price of a bitcoin has gone from less than $1,000 to more than $19,000.

This astonishing price rise has been noticed by people. But before we go any further, let’s understand what is a bitcoin? It’s a digital currency that does not use banks or any third party as a medium. It is governed by a string of cryptographical codes that are not easy to break, as they are believed to be of military grade.

The law of demand basically states that demand for something tends to pick up when the prices are low. But this basic law in economics does not tend to apply to various forms of investments. This includes, stocks, real estate etc. A large bunch of people start entering the stock market only once it has rallied significantly. The same is true about real estate.
Along similar lines, the bitcoin has caught the attention of people at large, only after having risen significantly in price. This is a point well worth remembering.

In late 2008, when the investment bank Lehman Brothers went bust, the Western world plunged into a serious recession. In order to come out of this, the Western central banks led by the Federal Reserve of the United States, the American central bank, decided to print a huge amount of money and pump it into the financial system.

The idea was to increase the supply of money and make it less costly, that is, drive down interest rates. At lower interest rates, people and corporations were more likely to borrow and spend money, and this in turn would help businesses and the overall economy.

At the same time, this power to create unlimited amount of money out of thin air created a fear that if central banks continued with this strategy, sometime in the future paper money would lose the ‘perceived value’ it had.

There was a fear that with such a huge amount of money being printed, it would unleash consumer price inflation, and money would lose value. While, that hasn’t happened, all the money has led to huge asset price inflation, stock markets and real estate markets have risen across the world, as a large chunk of the printed money has found its way into these markets.

Bitcoin was a response to this phenomenon given that unlike paper money it cannot be created out of thin air. The number of bitcoins is finite and it cannot go beyond a limit of 21 million. Hence, people initially bought into it. But, over the last year or two, at least, the people entering it are largely speculators looking to make a quick buck and that has driven up the price as fast as it has.

The trouble is the history of money essentially shows that, even though, all new forms of money are created by the private sector, they are ultimately taken over by the government. The government basically has three powers: 1) The right to “legal” violence. 2) The right to tax. 3) The right to create money out of thin air by printing it.

And this right to create money out of thin air comes from the basic fact that the people accept government money as money, in the economic transactions that they carry out. In the years to come, if economic transactions, that is the buying and selling of things, move towards bitcoins, the governments all over the world are not going to like it.

No government likes any competition against the pieces of paper that it deems to be money. And given this, the governments all over the world will want to crackdown on bitcoins sooner rather than later. What the believers in bitcoins like to say to this is that the virtual currency has been built with this eventuality in mind. How this plays out, only time will tell.

The column originally appeared in the Bangalore Mirror on December 21, 2017.