Vivek Kaul
Richard Nixon, who was the President of the United States between January 1969 and August 1974, appointed Arthur C Burns as the Chairman of the Federal Reserve of United States (the American central bank) on January 30,1970. “I respect his (i.e. Burns) independence. However, I hope that independently he will conclude that my views are the ones that should be followed,” Nixon said on the occasion.
Burns did not disappoint Nixon and when it was election time in 1972. Since the start of 1972, Burns ran an easy money policy and pumped more money into the financial system by simply printing it. The American money supply went by 10.6% in 1972.
The idea was that with the increased money in the financial system, interest rates would be low, and this would encourage consumers and businesses to borrow more. Consumers and businesses borrowing and spending more would lead to the economy doing well. And this would ensure the re-election of Nixon who was seeking a second term in 1972. That was the idea. And it worked. Nixon won the second term with some help from Burns.
As investment newsletter writer Gary Dorsch wrote in a column earlier this year “Incumbent presidents are always hard to beat. The powers of the presidency go a long way….Nixon pressured Arthur Burns, then the Fed chairman, to expand the money supply with the aim of reducing unemployment, and boosting the economy in order to insure Nixon’s re-election…Nixon imposed wage and price controls to constrain inflation, and won the election in a landslide.” (you can read the complete column here)
History is expected to repeat itself
Something similar has been expected from the current Federal Reserve Chairman Ben Bernanke. It has been widely expected that Bernanke will unleash the third round of money printing to revive the moribund American economy. Bernanke has already carried out two rounds of money printing before this to revive the American economy. This policy has been technically referred to as quantitative easing (QE), with the two earlier rounds of it being referred to as QE I and QE II.
The original idea was that with more money in the economy, banks will lend, and consumers and businesses will borrow and this in turn would revive the economy. But the American consumer had already borrowed too much in the run up to the financial crisis, which started in September 2008, when the investment bank Lehman Brothers went bust. The consumer credit outstanding peaked in 2008 and stood at $2.6trillion. The American consumer had already borrowed too much to buy homes and a lot of other stuff, and he was in no mood to borrow more.
The wealth effect
The other thing that happened because of the easy money policy of the American government was that it allowed the big institutional investors to borrow at very low interest rates and invest that money in the stock market. This pushed stock prices up leading to more investors coming into the market.
As Maggie Mahar puts it in Bull! : A History of the Boom, 1982-1999: What drove the Breakneck Market–and What Every Investor Needs to Know About Financial Cycles: “In the normal course of things, higher prices dampen desire. When lamb becomes too dear, consumers eat chicken; when the price of gasoline soars, people take fewer vacations. Conversely, lower prices usually whet our interest: colour TVs, VCRs, and cell phones became more popular as they became more affordable. But when a stock market soars, investors do not behave like consumers. They are consumed by stocks. Equities seem to appeal to the perversity of human desire. The more costly the prize, the greater the allure.”
As more money enters the stock market, stock prices go up. This leads to what economists call the “wealth effect”. The stock market investors feel richer because of the stock prices going up. And because they feel richer they tend to spend some of their accumulated wealth on buying goods and services. As more money is spent, businesses do well and so in turn does the economy.
As Gary Dorsch writes “Historical observation reveals that the direction of the stock market has a notable influence over consumer confidence and spending levels. In particular, the top-20% of wealthiest Americans account for 40% of the spending in the US-economy, so the Fed hopes that by inflating the value of the stock market, wealthier Americans would decide to spend more. It’s the Fed’s version of “trickle down” economics, otherwise known as the “wealth effect.”
Why Bernanke won’t launch QE III soon
Given these reasons it was widely expected that Ben Bernanke would start another round of money printing or QE III this year to help Obama’s reelection campaign. Bernanke has been resorting to what Dorsch calls “open mouth operations” i.e. dropping hints that QE III is on its way. In August he had said that the Federal Reserve “will provide additional policy accommodation as needed to promote a stronger economic recovery.” This was basically a complicated way of saying that if required the Federal Reserve wouldn’t back down from printing more money and pumping it into the economy.
But even though Bernanke has been hinting about QE III for a while he hasn’t gone around doing anything concrete about it. The reason for this is the fact that Mitt Romney, the Republican candidate against the incumbent President Barack Obama has gone to town criticizing the Fed’s past QE policies. He has also warned the Federal Reserve to stay neutral before the November 6 elections, says Dorsch. As Romney told Fox News on August 23 “I don’t think QE-2 was terribly effective. I think a QE-3 and other Fed stimulus is not going to help this economy…I think that is the wrong way to go. I think it also seeds the kind of potential for inflation down the road that would be harmful to the value of the dollar and harmful to the stability of our nation’s needs.”
Romney even indicated that he would prefer someone other than Bernanke as the Chairman of the Federal Reserve. “I would want to select someone new and someone who shared my economic views…I want someone to provide monetary stability that leads to a strong dollar and confidence that America is not going to go down the road that other nations have gone down, to their peril.” With more and more dollars being printed, the future of the dollar as an international currency is looking more and more bleak.
Romney’s running mate Paul Ryan also echoed his views when he said “Sound money… We want to pursue a sound-money strategy so that we can get back the King Dollar.”
Given this it is highly unlikely that Ben Bernanke will unleash QE III before November 6, the date of the Presidential elections. And whether he does it after that depends on who wins.
Of Obama and Salman Khan
As far as pollsters are concerned Obama seems to have the upper hand as of now. But at the same time the average American is not happy with the overall state of the American economy. “According to pollsters, two thirds of Americans think the US-economy is still stuck in the Great Recession, and is headed in the wrong direction. Only 31% say it is moving in the right direction – the lowest number since December 2011. The dire outlook is explained by a recent analysis by the US Census Bureau and Sentier Research LLC, indicating that US-household incomes actually declined more in the 3-year expansion that started in June 2009 than during the longest recession since the Great Depression,” writes Dorsch.
But despite this Americans don’t hold Obama responsible for the mess they are in. As Dorsch points out “Although, Americans are increasingly pessimistic about the future, many voters don’t seem to be holding it against Democrat Obama. Instead, the embattled president is getting some slack because he inherited a very tough situation. In fact, Obama’s strongest base supporters are among also suffering the highest jobless rates and highest poverty rates in the country.”
Obama’s support is similar to the support film actor Salman Khan receives in India. As Manoj
Manoj Desai, owner of G7 theatres in Mumbai, recently told The Indian Express “Even when the fans are disappointed with his film, they never blame him. You will often hear them say, bhai se galat karwaya iss picture main. (They made Bhai do the wrong things in this movie)”
What’s in it for us?
Indian stock market investors should thus be hoping that Barack Obama wins the November 6 elections. That is likely to lead to another round of quantitative easing. As had happened in previous cases a portion of that matter will be borrowed by big Wall Street firms and make its way into stock markets round the world including India.
(The article originally appeared on www.firstpost.com on September 5,2012. http://www.firstpost.com/world/obama-salman-khan-qe-3-why-we-have-to-wait-for-6-nov-444474.html)
(Vivek Kaul is a Mumbai based writer and can be reached at [email protected])
Gary Dorsch
The pain in Spain will get us too; so forget market rallies
Vivek Kaul
If you are the kind who reads the pink papers religiously, you would have come to conclusion by now that good times are back again for the stock market investors in India, now that the finance minister has deferred the implementation of GAAR to next year. But before you open that champagne bottle and say cheers, here are some reasons why the stock market will remain flat or fall in the days to come.
Pain in Spain:
The gross domestic product (GDP) of Spain grew at the rate of 8% every year from 1999 to 2008. This primarily happened because Spain went all out and promoted the Mediterranean lifestyle. As Jonathan Carman points out in a presentation titled The Pain in Spain “Millions flocked to its sun-drenched shores, buying houses along the way. As the demand for houses increased, construction became the industry. Housing prices exploded, tripling in just over a decade.”
So far so good. The trouble was Spain ended up building way too many homes than it could sell. Even though Spain forms only 12% of the GDP of the European Union (EU) it has built nearly 30% of all the homes in the EU since 2000. As John Mauldin and Jonathan Tepper point out in Endgame – The End of the Debt Supercycle and How It Changes Everything “Spain had the mother of all housing bubbles. To put things in perspective, Spain now has as many unsold homes as the United States, even though the United States is six times bigger”.
All this building was financed through the bank lending. Loans to developers and construction companies amounted to nearly $700billion or nearly 50% of the Spain’s current GDP of nearly $1.4trillion. With homes lying unsold developers are in no position to repay. And Spain’s biggest three banks have assets worth $2.7trillion or that is double Spain’s GDP.
What makes the situation more precarious is the fact that the housing prices are still falling. Carman expects prices still need to fall by 35% from their current levels if they are to reach normal levels. This will mean more home loan defaults and more trouble for Spain. The Spanish stock market is already taking this into account and IBEX-35, the premier stock market index of the country is down a little more than 10% in the last one month. Banking stocks have fallen much more.
While countries like Greece may be in more trouble, they are not economically big enough to cause a lot of trouble worldwide. But if Spanish banks go bust, there will be a lot of trouble in the days to come. Spain has now emerged the basket case of Europe, but other countries in the European Union are not doing well either and this means trouble for China.
China’s After Party:
If things are not well in Europe, it has an impact on China because Europe is China’s biggest trading partner. The Chinese exports to Europe in March were down 3.1% in comparison to last year. Chinese exports had ranged between $475billion and $518billion in the last three quarters of 2011. In the first three months of this year the number has fallen to $430million. Falling exports are not the best news for China.
There are other things which aren’t looking good either. As Ruchir Sharma writes in Breakout Nations – In Pursuit of the Next Economic Miracles “In the last decade the main driver of China’s boom was a surge in the investment share of the GDP from 35% to almost 50%, a level that is unprecedented in any major nation…The investment effort focused on building the roads, bridges, and ports needed to turn China into the world’s largest exporter, doubling its global export market share to 10% in the last decade.”
This spending spree which was responsible for its fast growth is now slowing down. New road construction is down from 5000miles in 2007 to 2500 miles. Railway spending is down by 10%.
The other major factor likely to pull down growth is wage inflation i.e. salaries are rising at a very fast rate. In 2011, the average wage was rising at a rate of 15%, in a scenario where the consumer price inflation was around 5%. As Sharma points out “In fact hourly wages are now rising twice as fast productivity, or hourly output per worker, which is forcing companies to raise prices just to cover the cost of higher wages.” This has led to manufacturers moving to cheaper destinations like Bangladesh and Indonesia.
Given these reasons it is highly unlikely that China will continue to grow at the rates that it has been. Since 1998, China’s economic growth has averaged around 10% and it has never fallen below 8%. As Sharma points out “China’s looming shadow is about to retreat to realistic dimensions.” Sharma expects Chinese growth to slowdown by 3-4% percentage points in comparison to its current growth rate over the next decade.
A Chinese slowdown will mean disaster for nations which have been thriving by exporting commodities to China. In 1998, when China was a $1trillion economy, to grow by 10% meant it had to expand its economy by $100billion. This could have been done by consuming 10% of the world’s industrial commodities, raw materials like oil, steel and copper. In 2011, China is a $6trillion economy. If this economy needs to grow by 10% or $600billion, more than 30% of the world’s commodity production would be needed. With growth slowing down, China’s commodity requirements will come down as well. As Sharma puts it “It’s my conviction that China – commodity connection will fall apart soon”.
China’s stock markets remain largely closed to international investors. But the Hang Seng index listed in Hong Kong has a lot of Chinese companies. This index has gone up 0.9% over the last one month.
The Kangaroo Won’t Jump:
In fact the Aussies are already feeling the heat with a slowdown in Chinese exports. Australian exports to China in 2011 stood at A$72billion (Australian dollar), up 24% from 2010, or around 26% of total exports. An ever expanding China bought coal, iron ore and natural gas from Australia, driving up Aussie exports. But exports for the month of February fell to A$24.4 billion, the lowest in an year. Coal exports were down by 21% to A$3.4billion. The S&P ASX/200 one of the premier stock market indices in Australia, has been flat for the last one month.
Brazil – God’s Own Country:
The rise of China has led to huge demand for Brazilian commodities. As Gary Dorsch an investment newsletter writer points out in a recent column “Brazil has been enjoying an economic boom based on soaring prices for its natural resources including crude oil, agricultural products, such as soybeans, corn, and cattle, and metals such as iron ore and bauxite-aluminum.”
The rise of Brazil was captured very well by Glenn Stevens, governor of the Reserve Bank of Australia. Stevens pointed out that in 2006, money received from shipload of iron ore could buy 2,200 flat screen TVs. In 2011, the same shipload could buy 22,000 flat screen TVs.
Since the start of the financial crisis a lot of money printed by Western governments to revive their economies has flowed into Brazil. This has driven up the value of the real, the currency of Brazil, and made Brazil one of the most expensive countries in the world. As Sharma points out “Restaurants in Sao Paulo are more expensive than those in Paris. Hotel rooms cost more in Rio than French Riviera”.
An expensive currency has meant that imports rising faster than exports. This situation is expected to get worse as China’s slowdown and the demand for Brazilian commodities falls. In fact the impact is already being felt. As Dorsch points out “Brazil’s economy stalled out in the past two quarters, showing near zero growth in Q’3 of 2011 and Q’4 of 2012. Factory output in February was -3.9% lower than a year ago.” The premier stock market index Bovespa is down 4.5% over the last one month.
On a totally different note the most popular television serial in Brazil is a soap opera called “A Passage to India” shot in Agra and Jodhpur and which has Brazilian actors playing Indian roles and as Sharma puts it, they could “pass easily for North Indians”.
India- Done and Dusted:
The economic problems of India deserve a separate article. But let me list a few. In the year 2007-2008 (i.e. between April 1, 2007 and March 31,2008) the fiscal deficit of the government of India stood at Rs 1,26,912 crore. Fiscal deficit is the difference between what the government earns and what it spends. For the year 2011-2012 (i.e. between April 1, 2011 and March 31, 2012) the fiscal deficit is expected to be Rs 5,21,980 crore.
Hence the fiscal deficit has increased by a whopping 312% between 2007 and 2012. During the same period the income earned by the government has gone up by only 36% to Rs 7,96,740 crore. The targeted fiscal deficit for 2012-2013 is Rs 5,13,590 crore. This is likely to go up given the fact that the rupee is depreciating against the dollar and thus our oil bill is likely to go up, pushing up our fiscal deficit. This would mean that higher interest rates will continue to prevail.
The stock market obviously realizes this and hence has fallen by 1.8% over the last one month, yesterday’s brief rally notwithstanding.
Over the last few years stock prices all across the world have moved in a synchronized fashion because the international investors like to move in a herd. Whenever there has been trouble in the United States or Europe it has led to emerging markets all across the world falling. Now we are in a situation where the emerging markets themselves are in a lot of trouble. So it is a no brainer to say there will be no rally in the stock market in the near future. Unless of course a certain Mr Ben Bernanke decides to open up the money tap again and go in for Quantitative Easing Round Three or to put it in simple English, print some more dollars. If that happens, then investors can get ready to have some fun.
(This article was originally published on May 8, 2012 at http://www.firstpost.com/economy/the-pain-in-spain-will-get-us-too-so-forget-market-rallies-302278.html. Vivek Kaul is a writer and can be reached at [email protected])