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Bear in mind ‘unrest’
The past month may well mark the beginning of a turning phase, as public anger and popular resentment with the policy orientation of governments, especially in the developed world, starts to get expressed in an increasingly visible manner. The focal point for such trends is now Greece with the likes of Spain, Portugal, Italy and U.K, not too far behind. The genesis is in the high and still-rising levels of government debt – a risk that is now integral to the U.S, too. As stimulus spending and bailouts galore take away trillions, the burden was, is and will likely be on taxpayers. Unemployment looming large means tax hikes and spending cuts are not going to be received well. Governments face a massive dilemma in trying to balance factors that are almost impossible to juggle around, but those that will have to be dealt with at some stage. That time for Greece appears to have come, though it may still be able to postpone real pain, for a bit more, with a bailout from the European Union. The signs of unrest emerging as a key variable are, however, clear.This has implications for the likely direction of policy making and the choices are not appealing. Government debt (triggered by fiscal deficits) is a problem now, in both the developed world and several emerging economies, including India. Across the world, governments have resorted to jugglery over the years to mask reality: but it is easy to put what is on the record and off the record together to get a picture of the true state of affairs. The picture is not pretty by even the fanciest stretch of imagination. What is different in the developed world todaywith a few exceptions such as Japan, South Korea and Canada-is that the trillions spent or put up as cushion to save the big banks and an almost complete return to old ways by them in 2009 has left governments with little credibility. Tax hikes, spending cuts and actions to curb the influence of unions would have been easier and carried conviction, if the banking big wigs had been dealt with in an objective manner. In the U.S, the government and central bank are seen to been on the side of Wall Street and even Obama, with a message of `Change’ & `Yes, We Can’, has made no difference to this perception. This is true of quite a few other countries, including the U.K, as well. This lack of credibility and the divergence in approach to the big banks and to the man on the street is not going to help efforts to curb burgeoning government deficit and debt. That an eminent scientist such as Stephen Hawking has threatened to say goodbye to Cambridge after 50 years to protest the U.K government’s move to cut spending on science tells the tale. Stories abound of cuts in hospitals, army and universities (even though student fees continued to be hiked). Even as we seem to have a veneer of seeming stability in the financial system and fleeting signs of a recovery (aided by massive stimulus and comparison’s with low base after the tumble in Q3 & Q4 2008 and Q1 2009), we have a complete loop of tough choices.The sustainability of this recovery is also very dependent on stimulus and central bank support. Governments face rising debt, yet need to spend big time to sustain the present recovery (and it is much). Even if governments want to cushion against deflation and decide to spend further on stimulus, they can do it for at best another year or two.That, too, would be a stretch of present perilous state of government finances, and only mean more pain later. Just take a look at Japan for a realitybased feedback with experience of 20years plus, and counting. Japan today is the worst placed on the government debt front in the developed world after years of wrong choices to fight deflation. People have continued to suffer deflation; savings as a percentage of GDP have plummeted; low rates force more drawdown of capital by savers to take care of living expenses; and yet there is no way out.This state now beckons in other parts of the developed world, too, which have already suffered one lost decade. Tax hikes & spending cuts appear to be the only way out and public reactions could be of an unpredictable nature. Ironically if unrest becomes a big issue, political pressures will force governments to go slow on these measures and postpone the day of reckoning. This means government borrowings will rise even further and rates will have to go up eventually; the ratehikes story does not appear to be an outcome for this year or the next, barring token increases. This story, when it eventually pans out, will have implications for markets. Now if we add unrest and the prospect of rising rates eventually to rising debt burden, the present need for more stimulus as governments are unwilling to let reality set in and the problems faced by savers due to low rates, you get a heady cocktail. Compared to this quagmire, the government of India appears better placed, as of now, to deal with the problem of fiscal deficit and government borrowings. It does not suffer the present developed-world problems such as lost-credibility, lack of growth, financial institutions in weak shape, bailout wrath and overburdened consumers, to name a few. It has to, however, start dealing with the issue of government deficit. Combined fiscal deficit in the states and centre is in double-digit territory. First measures have been taken in the budget, but there is a long way to go. The three-year road map bristles with optimistic assumptions, but at least a beginning has been made. State finances are an even tougher story in the Indian context. We need to get the fiscal house in the centre and states in order before unrest becomes a possible risk in India, too. For now, unrest is a story to track in developed-world countries. T.P.Raman Managing Director Sundaram BNP Paribas Asset Management
Sundaram BNP Paribas Asset Management: Investment Sundaram BNP Paribas Asset Management Manager for Sundaram BNP Paribas Mutual Fund / Portfolio Management Services: Sundaram BNP Paribas Portfolio Managers
Chart of the Month
The Ring of Fire
This chart that caught our eye was published in PIMCO Investment Outlook for February 2010. Reading the chart: The burden of debt is starting to bite the advanced economies. This Ring of Fire provides a terrific snapshot of the risks that lurk. It shows how Greece is most likely a precursor of what is in store for a few other developed markets.
Current Annual Deficit
Public Sector Deficit (%GDP)
The vertical axis shows fisical deficit (public sector deficit as a percentage of GDP). Bear in mind that the horizontal axis only shows government debt or public sector debt as a percentage of each country’s GDP. Powerful as the chart is, the real picture will be when you add private sector debt, too. Private sector debt burdens are becoming public sector debt in this financial and economic crisis via bail-outs, takeover by the government and purchase of dubious assets by central banks across most of the developed world. On a complete debt (private + public) basis, you can safely assume that every country will move much further to the right in the Ring of Fire. Visualise how much more powerful and potent such a picture would look. The implications will obviously not be positive. – Editor of The Wise Investor
Sweden Germany Canada Netharlands France Spain Ireland USA UK Greece Italy Japan
-15.0 0 25 50 75 100 125 150 175
Outstanding Stock of Debt
Source: Reuters EcoWin, SEBX-asset Research
Public Sector Debt (%GDP)
Global Market Snapshot
Market Cap of Global Markets - A comparison in 2007 (close to peak), 2008 (close to bottom), 2009 (recovery) & the present Market Cap ( $ Billion) Region/Country World United States Canada Brazil Mexico Chile United Kingdom France Germany Switzerland Japan Honk Kong India Australia China + Others End Feb 2010 44608 13555 1638 1229 370 236 2796 1719 1238 1046 3553 2195 1260 1180 12593 2009 49722 13748 1609 1326 363 229 2975 1900 1371 1076 3488 2268 1294 1253 16823 2008 31901 10455 992 565 247 130 1981 1480 1075 848 3268 1312 640 652 8256 2007 60880 17660 1749 1273 398 208 4051 2736 2208 1217 4545 2655 1813 1415 18952 Share in World Marke Cap (%) End Feb 100.0 30.4 3.7 2.8 0.8 0.5 6.3 3.9 2.8 2.3 8.0 4.9 2.8 2.6 28.2 2009 100.0 27.7 3.2 2.7 0.7 0.5 6.0 3.8 2.8 2.2 7.0 4.6 2.6 2.5 33.8 2008 100.0 32.8 3.1 1.8 0.8 0.4 6.2 4.6 3.4 2.7 10.2 4.1 2.0 2.0 25.9 2007 100.0 29.0 2.9 2.1 0.7 0.3 6.7 4.5 3.6 2.0 7.5 4.4 3.0 2.3 31.1 2010 TYD -10.3 -1.4 1.8 -7.3 2.1 3.1 -6.0 -9.5 -9.7 -2.7 1.9 -3.2 -2.7 -5.8 -25.1 Returns (%) 2009 55.9 31.5 62.2 134.7 46.8 76.0 50.2 28.4 27.5 26.8 6.7 72.9 102.3 92.1 103.8 2008 -47.6 -40.8 -43.3 -55.6 -37.9 -37.5 -51.1 -45.9 -51.3 -30.3 -28.1 -50.6 -64.7 -53.9 -56.4 Distance from Peak (%) -26.7 -23.2 -6.3 — -7.0 13.5 -31.0 -37.2 -43.9 -14.1 -21.8 -17.3 -30.5 -16.6 -33.6
Data Source: Bloomberg;The last available figures for each year have been taken; Analysis: Sundaram BNP Paribas Asset Management End December 2007 figures have been reckoned as the peak as different countries reached the point on different dates.The approximate distance from peak has not been indicated for Brazil, which peaked only in mid 2008.
Sundaram BNP Paribas Asset Management 2 The Wise Investor March 2010
Budgets and beyond
and the disinvestment program. Should the government succeed in its effort to reduce its borrowing, it paves the way for a more sustainable growth environment in the country. The total tax collections at the centre and state level are now close to 20% of GDP, and hence there is a limited room to maneuver on the tax collection front. There is a case for tax levels to come down as India has among the higher tax levels with no social security program to protect the tax payer in the event of sickness, or unemployment. The bond markets have been nervous, and have not reacted to the budget as yet. This appears to indicate that the markets are not biting as yet, and it will take some more convincing, before it does so. Equity markets have been a little more optimistic, as there was a correction in global equity markets prior to that. The budget has now made it clear that the government’s role in building assets is diminishing and the incremental asset build up will now have to come from the private sector. India in the global context:There are more pressing issues facing the global financial markets these days. It starts with Greece and its large debt and fiscal deficit. Most experts are of the belief that the IMF will have to rescue Greece and administer strong medicine of reducing expenses and increasing taxes. A few countries in Europe continue to increase the retirement age in the hope that they can delay generous pension payments. With many countries having a high level of debt, the debt pay down will be difficult with intended and unintended consequences. What may those be? We think that taxes will increase in many countries, as also many subsidies cut either directly or indirectly resulting in lower savings and hence lower spending in many of these countries. This issue appears to be a global one as almost all countries raked up debt to insulate their economies from the global slowdown. The unwind of this excess will be slow and painful. It is in this context that we find the firmness in commodity prices surprising. Apart from China and India consuming more, almost all other countries are consuming less. There is also fresh capacity coming up across almost all commodities such as iron ore, oil and coal. Much of this was planned during the boom years in 2007 and 2008, and are now getting ready. Similarly, in oil, we find that there is enough to go around and yet oil prices are firming up. Some of this may be attributable to commodity exporting nations being financially well off and not in a distress to sell unlike in the past. And the other reason could be investments by banks and hedge funds into commodities. Some of this could go away, should the so-called “Volcker Rule” go through. When some of these proposals were discussed, there was a distinct nervousness in commodity markets.
3 The Wise Investor March 2010
Head-Equity Sundaram BNP Paribas Asset Management
The recent budget marks a new beginning by the Government to reduce its borrowings and reduce income taxes, and allow consumption to grow the economy, rather than the stimulus it had earlier offer during the peak of the financial crisis in the second half of 2008. Like rest of the world, India had three rounds of stimulus packages to ensure that the growth momentum is not stalled. Indeed the costs have been high, and we have come to a break point. The consolidated fiscal deficit for FY2010 is close to 10%, and needs to be reined in. The budget is no longer so munificent. • It has sought increase indirect taxes and reduces subsidies on petroleum products and fertilizers. • Import duty on oil has been imposed as also excise duties on all goods hiked. • All subsidies are to be paid out as cash rather than bonds, which were in a sense an off balance sheet item. From a mere Rs 50,000 crore deficit in 1991, the current deficit is now eight times that level at close to Rs 4,00,000 crore. This has in no small measure contributed to the inflationary regime present in the country. This alarming situation, along side the recent events in Greece, as well as a rating downgrade looming large, has prompted the Government to swallow the bitter pill and take measures to curtail the fiscal deficit and has been firm about it. Will they follow the course remains to be seen, as Governments are usually loathed to swallow debt reduction programs on a long term basis? A few of the assumptions have been ambitious such as revenues from 3G auctions
Sundaram BNP Paribas Asset Management
Gary Shilling's Top Trades
Gary Shilling has been one of the many who saw the economic crisis coming well in advance and he was ahead of most of others who saw it coming. Gary Shilling has become infamous in the last few years for predicting the credit crunch and the bear market. The bearish investor still believes deflation is the dominant force at work and that the credit crunch is in the process of unfolding. But he isn’t bearish about everything. His 6 buys: • Buy treasury bonds – the safe haven trade will return. • Buy income-producing securities – high quality dividend names will be a safe place to hide. • Buy consumer staples and foods – consumers won’t stop buying the necessities. • Buy ’small luxuries’ – consumers are trading down. • Buy the U. S. dollar – still the world’s safe haven currency. • Buy Eurodollar futures. Shilling is generally bearish about stocks and the global economy. His 11 sells: • Sell U.S. stocks in general – U.S. stocks are just too expensive. • Sell home-builder and selected related stocks – home prices will fall 10% in 2010 and the stocks will tank with it. • Sell big-ticket consumer discretionary equities- consumers aren’t buying luxury goods due to the trade down. • Sell banks & other financial institutions – the days of big bank profits and bailouts are over. • Sell consumer lenders’ stocks – consumers will continue to deleverage. • Sell many low- and old-tech capital-equipment producers. • If you plan to sell a home or investment house, do so yesterday. • Sell junk bonds. • Sell commercial real estate – the real estate bubble is a slow motion train wreck. • Sell most commodities – the dollar rally will crush commodities. • Sell developing country stocks and bonds – there will be no decoupling. Source: www.pragcap.com
Outlook: There is a significant chance, of the double dip taking place in sentiment if not in economic terms, as the favorable base fades away. We experienced a similar double dip in the period during 1997-2001. Reduction of fiscal deficits, go a long way in reducing demand also either directly or indirectly. A large portion of the demand in consumer durables during the past year came about due to the Sixth Pay Commission and higher farm incomes. Some of this income is cyclical, as crop prices soared to a record high on account of an overall shortage due to a poor monsoon. There are signs that the Rabi crop is better and food prices are abating. Farm incomes will also be impacted by higher input costs and wage costs. The most important aspect to watch would be China’s growth which is proving to be the perceived engine of growth for the world. China’s per capita consumption of many commodities, spare oil, are at historic highs. The US reached a peak per capita steel consumption of 750 kg before settling at 350 kg. China is currently at 600 kg and is expected to head higher. Will this continue and how long so? There are murmurs of excesses coming through, and should these be indeed true, then we could see some cool off in commodity prices. That could set off deflationary fears once again. Most Indian companies are going to see a challenging phase of managing margins, which are close to their peak levels, and will have increasing capacities and competition coming through. One of the reasons for higher inflation has been on account of lower capacity additions during the past five years, resulting in the current boom in all goods and services. So, we remain cautious on company profits in the short term. We think analysts have not factored lower margins adequately in their estimates. The higher range of short-term uncertainties point to a range bound market. Any sharp rally may find corrections as well. India is on a course-correction mode, and this is a structural positive, as it releases funds for the private sector to expand. The confidence level is also returning among investors, and the private sector, setting the stage for continued growth. The current velocity of money is low and liquidity adequate, hence growth can be accommodated without impacting interest rates. Also lower government borrowings will release much needed funds. There is usually a time lag between a lower fiscal deficit and it translating to actual borrowing costs, and this is yet to play out. Only then will the credit cycle pickup and result in a credit based growth coming through. The Indian investment has always looked fragile on account of its financial situation, yet investors should buy into the long-term story in India – lower interest rates due to lower government borrowings, a capacity starved market that could eventually lead to high margins and a very well balanced economy that shown remarkable resilience during the crisis. All of this could get a fillip, if the global investor also begins to see this in the same way as we are. There are signs of large investments by Japanese investors, as also other MNC’s setting up shop. This sets the foundation for growth to surprise all of us on the upside over the next few years.
Sundaram BNP Paribas Asset Management 4
The outside view
It is inevitable that at some point hopes of a normal cyclical recovery in America are going to be properly demolished. It is also, unfortunately, quite likely that the current decade is going to end up with even worse statistics than the decade that has just ended. A final point is the most obvious of all.This is that it is only a matter of time before the markets’ focus on fiscal deterioration in Euroland switches to the growing fiscal predicament in America. But in GREED & fear’s view the crisis will come first in Europe. In the meantime, the seeming inevitability of a systemic government debt crisis in the West remains the fundamental reason to remain long gold. Christopher Wood, Managing Director & Strategist of CLSA Asia-Pacific, an independent research outfit and author of the weekly report GREED & Fear. I found it remarkable that at a recent Barron’s roundtable discussion in New York where a number of prominent strategists and portfolio managers had gathered, India—the world’s second-most populous country, with more than a billion people and an economy that is growing at around 8% per annum—wasn’t mentioned once. I should stress that I am far from certain about current stock prices providing an ideal entry point; however, given the country’s size and economic potential, investors who either have no exposure to India’s economy and vibrant corporate sector or are massively underweight Indian stocks should gradually become more involved in this promising country. This is not to say that India is free of problems. Its rapid population growth will be challenging. India’s land mass is only a third that of China or the United States. India has just 4% of the world’s water resources and is likely to suffer in future from water scarcity. Dr. Marc Faber, renowned investor, strategist and author of several books as well as the monthly The Gloom Boom & Doom Report
The Wise Investor March 2010
commercial paper yields, which moved up by 125 bps and 68 bps respectively. The sharp movement in the shorter-end yields is due to the f the fiscal year end that is close on hand and the maturity of these instruments across March. It is also pricing in a reasonable amount of rate hike in the current year. There is also a regulatory aspect to this development, as the securities that mature after six months from April are less preferred by mutual funds now due to change in valuation norms. The effect of CRR rate hikes of 50 bps and 25 bps in two rounds has set in on the overall liquidity in the system. In addition, advance tax outflows in March, which is expected to be significant due to more robust growth than what appeared likely a few months ago, may create pressure on liquidity in the last fortnight of March. Yields are trending higher due to outlook on the longer end and due to unending supplies of Certificate of Deposits at the shorter end. The budget has triggered inflation fears in the markets due a few measures such as hike in customs duty and excise duty, fuel price hikes, indirect contribution to inflation of the fuel price hike, service tax on rail freight leading to higher transportation costs and more money in the hands of consumers, leading to increase in aggregate demand, to name a few. We expect the 10-year to hover at about 8% levels with markets giving support at this point. Markets will be looking forward to the borrowing calendar with nervousness, as it is expected to be front loaded. We believe The Reserve Bank of India RBI will be better off announcing OMO schedule along with the borrowing calendar, as was done in the previous year. In the absence of this development, yields can move up, even from these levels.
Head – Fixed Income Sundaram BNP Paribas Asset Management
In February, the 10-year and 5-year G-Sec benchmark yields moved up by 31 basis points (bps – a basis point is 0.01 %) and 44 bps respectively. The continued bearishness is due to the uncertainty on account of the fiscal deficit envisaged in the budget for 2010-11. The markets are wary of the system’s ability to absorb massive supplies from the central government in the absence of supporting activities such as Open Market Operations, MSS unwinding, surplus system liquidity, SLR rate hike, hike in the Hold-to-Maturity cap and lower credit off-take in the year ahead. The 3-month and the 12-month treasury bill yields also moved up by 33 bps. More significant is the movement in the 3-month and 12-month
Optimism dominates budget numbers on fiscal deficit The current year’s fiscal deficit estimates reveal that in spite of the absolute number going up by around Rs.14,000 crore, the fiscal deficit as a percentage of GDP has declined to 6.7% from 6.8 % projected at the time of the last budget.This is due to higher GDP numbers estimates. Similarly according to the Budget Estimates for FY 2011, gross tax receipts is expected to grow at 17.9 % in the year 2010-11 (4.6 % in 2009-10), total expenditure is expected to grow only at 8.5 % (15.6 % in 200910). It is twin optimism on increase in revenues and curtailment in expenditure. That explains the reduction in fiscal deficit numbers to Rs.3.81 lakh crore leading to rate of 5.5 % of the GDP. This also builds in an extraordinary income of Rs.66,000 crore out of disinvestment and proceeds out of 3G auction. Further, the oil and fertilizer subsidies are to be met in cash and within the budget framework. The expectation appears to be optimistic on all fronts, and hence disappointment in any will push up the fiscal deficit, government borrowing and interest rates higher A quick estimate of the fiscal deficit projected in the next three years reveal the following numbers. 2009-10 ESTIMATE 61,64,178 9.75 6.70 414041 2010-11 PROJECTION 69,27,273 12.38 5.50 381000 2011-12 PROJECTION 78,97,091 14.00 4.80 379060 2012-13 PROJECTION 90,02,684 14.00 4.10 369110
Nominal GDP in Rs lakh crore Nominal GDP growth Fiscal Deficit in % Fiscal Deficit in lakh crore
We have projected the Nominal GDP to be at 14% for the years 2011 to 2013. Any disappointment there can lead to higher fiscal deficit as a percentage of GDP.The reduction in deficit as a percentage of GDP is entirely dependent on the growing strength of the GDP and so much rides on the expected growth coming through. All these efforts still do not result in the fiscal deficit going lower than what it was ten years before 2012-13. A challenging task that is ahead to achieve these numbers and even after they are achieved to move to lower levels in a sustainable manner.
Sundaram BNP Paribas Asset Management 5 The Wise Investor March 2010
Emerging Markets Focus
We have past peak growth
The seasonal effect of the Chinese new year in January 2009 has clearly been a significant factor. Although there is little risk that inflation will get out of hand, prices will clearly be rising. China: Chinese authorities are keeping a very close eye on inflation expectations. Indeed, rising food prices are beginning to have repercussions on other economic variables. Some coastal provinces have raised their minimum wage from 10 to 15%, the government has announced a 10% increase in pensions and the labour shortage is putting upward pressure on wages. Chinese authorities are still highly concerned about developments on the monetary front. Despite the increase in the reserve ratio requirement and other measures to tighten credit, banks lent as much as they could in January in an effort to use up their credit quotas before the government changed its mind. Consumers and businesses are still flush with liquidity. Bank deposits are up 27.3% y/y, with deposits by firms surging 44.2%, while money supply growth is hardly slowing, despite the government’s intervention. Given this situation, we expect that the reserve ratio will be raised again, that credit controls will continue and that interest rates will be raised in the second half of the year. The 21% y/y export growth is not surprising in light of our indicators, which foresee solid growth for a few more months. Other leading indicators, such as imports of semi-finished products and the PMI for new export orders confirm this assumption. Imports will even grow at a faster rate and thus reduce the trade surplus even further, but without however neutralizing the positive contribution of net exports to GDP growth in 2010. The slight decrease in the official PMI (from 56.6 in January to 55.8) reflects the aggressive measures of government authorities to discourage property speculation and stabilise economic growth. Economic activity will remain robust over the coming months however, judging from the results of private surveys. This is the case for example of small and mediumsize Chinese firms, 75% of which have an optimistic outlook for the next six months and only 5% of which expect China’s economy to weaken. Chinese GDP grew 8.7% in 2009. Capital spending and final consumption made positive 8% and 4.6% contributions to growth respectively, while net exports subtracted 3.9%. Even if infrastructure investment is sharply reduced in 2010 (unlikely) this loss will be easily offset by the rebound in the trade surplus. We may therefore see 9.5% output growth in 2010 if private consumption is stable. Residential investment is still the most uncertain factor and a priority for the government, which must cool speculation in the luxury property market, where vacancy rates are high and prices are breath6
Head of Investment Management-New Markets BNP Paribas Investment Partners
Overview: The composite PMI for the emerging economies rose again in January, thus confirming that the manufacturing and service sectors are still growing and that there is some upward pressure on input prices. Judging from the ISM’s index on new orders, we are also likely to see a sharp rebound in exports over the coming months. After Turkey last month, the leading indicators of the major emerging economies (Brazil, China and India) have passed their turning point and other countries are very close to their own, suggesting that growth in these economies has peaked. Against this backdrop, the increasing flow of news of monetary policy normalisation has increased volatility in financial markets. We consider these measures to be simply adjustments of monetary policy, not the start of a tightening cycle, as growth in emerging economies is still below potential. The sovereign debt crisis in peripheral European countries should not affect the economic outlook of the emerging economies. Standard measures of credit risk, such as yield spreads and the cost of CDS on emerging debt, have shown little reaction to European problems. Of course, if the crisis of confidence continues it could affect Asian exports to Europe, which do represent 15% of the total. But there is little risk of this since the current pick-up in Asian trade is mainly intra-regional. Over the past few months we have adopted a relatively constructive position on Chinese inflation, which we expect to remain within 3% to 5%. Inflation in January was only 1.5% year-on-year and therefore much lower than expected and even less than the previous month. If food prices are stripped out inflation is even zero.
Sundaram BNP Paribas Asset Management
taking while ensuring that standard housing needs are met. Indeed, the government’s measures to prevent bubbles in the property market may have been too effective, since the volume of transactions has dropped sharply and prices are starting to fall. Sentiment has turned and potential buyers are postponing their purchases until visibility improves. This situation naturally has repercussions on residential construction. Brazil: A sound financial system and robust domestic demand have enabled Brazil to be one of the first countries to recover from the global economic crisis. Although Brazil’s economic momentum is still quite strong it is beginning to show signs of slowing. Industrial production, for example, declined for the second straight month in December, which reduced output growth from 20% in Q3 to 15% in Q4. Most of this decline may be explained by the sharp drop in durable goods production resulting from the fading effect of the government's measures to support consumption. We therefore see no particular cause for concern. Moreover, the manufacturing and mining sectors continue to post strong gains. Surveys of business confidence and activity also point to an improvement. The country's central bank now also seems more concerned about inflation, which has increased slightly to 4.3%. We therefore expect an initial increase in policy rates in the second quarter. Russia: Russia's economy ended 2009 on an upbeat note.The first estimate of GDP contraction is better than expected, at -7.9%.This surprisingly strong result seems mainly attributable to the sharp rebound in exports in the fourth quarter, as domestic demand remained weak. Nonetheless, recent data seems to be encouraging: retail sales are growing for the fourth straight month and consumer confidence is significantly stronger. With the price of crude oil now higher and the global economic environment more favourable, we expect both domestic and foreign demand to continue to expand over the first half of the year. This positive factor will be partially offset by the increase in the value of imports resulting from the rouble's likely appreciation. Another encouraging sign is the PMI's rise above 50 in January, with all index components stronger. This suggests that Russia's manufacturing sector should resume growth in the first quarter. The steady decline of inflation from 8.8% in November to 8% in January should also be noted since this reflects a still substantial output gap. Even if the economic situation is significantly stronger, we do not expect growth to return to its potential in 2010. We therefore anticipate further loosening of interest rates over the coming months.
The Wise Investor March 2010
Dealing with deficits & government debt burden
conclusion—U.S. fiscal policy must focus on reducing this debt build-up and its consequences. The fiscal projections for the United States are so stunning that, one way or another, reform will occur. Fiscal policy is on an unsustainable course. The U.S. government must make adjustments in its spending and tax programs. It is that simple. Three ways out, but only one good one: In managing our nation’s debt going forward, it strikes me that we have only three options: • First, the worst choice for our long-term stability, but perhaps the easiest option in the face of short-term political pressures: We can knock on the central bank’s door and request or demand that it “print” money to buy swelling government debt. • Second, perhaps more tolerable politically, although damaging to our economy: We can do nothing so long as domestic and foreign markets are willing to fund our borrowing needs at inevitably higher interest rates. • Third, the most difficult and probably the least palatable politically:We can act now to implement programs that reduce spending and increase revenues to a more sustainable level. I recognize that this last option involves hard choices and short-term pain. However, in my view it is the responsible path to sustainable economic growth with price stability The alternative options inevitably lead to financial crisis and greater long-run losses in national income and wealth. The goal of policy cannot be to “just get through” the current challenge, but rather to rebuild the foundation of a stable and prosperous economy, looking to our nation’s long-term future. It is in this context that I appreciate this opportunity to address what I see as our emerging fiscal challenges. Lessons from History: Throughout history, there are many examples of severe fiscal strains leading to major inflation. It seems inevitable that a government turns to its central bank to bridge budget shortfalls, with the result being too-rapid money creation and eventually, not immediately, high inflation. I The House-to Bread-Tale from Germany: German hyperinflation is one classic and oftencited example, and with good reason.When I was named president of the Federal Reserve Bank of Kansas City in 1991, my 85-year old neighbor gave me a 500,000 Mark German note. He had been in Germany during its hyperinflation and told me that in 1921, the note would have bought a house.
In 1923, it would not even buy a loaf of bread. He said, “I want you to have this note as a reminder. Your duty is to protect the value of the currency.” That note is framed and hanging in my office. Someone recently wrote I evoked “hyperinflation” for effect. Many say it could never happen here in the U.S. To them I ask, “Would anyone have believed three years ago that the Federal Reserve would have $1¼ trillion in mortgage back securities on its books today?” Not likely. II Spending Leading to Great Inflation of 1970s: If German hyperinflation seems an unrealistic example from the distant past, then let’s come forward in time. Many have noted that in the 1960s, the Federal Reserve’s willingness to accommodate fiscal demands and help finance spending on the Great Society and the Vietnam War contributed to a period of accelerating price increases. Although the Federal Reserve was a reluctant participant, it accepted the view that monetary policy should work in the same direction as the Congress and the administration’s goals and help finance at least part of their spending programs. Monetary policy accommodation during this period contributed to an increase in inflation from roughly 1½ percent in 1965 to almost 6 percent in 1970. It also helped set the stage for the Great Inflation of the 1970s as inflation expectations gradually became unanchored. The Current U.S. Fiscal Imbalance: Today, the United States is benefiting from policies that were established in the 1980s to end the Great Inflation. Confidence in the long-run stability of the U.S. economy and the Federal Reserve’s commitment to price stability have kept the demand for Treasuries relatively strong, allowing the government to borrow at low interest rates from its citizens and the rest of the world. It would be a mistake, however, to take this current ability for granted and to do nothing about the mounting debt. While the last 30 years have been relatively stable—at least until recently—our longerterm history is less reassuring. From World War II to the present, nominal federal debt held by the public has increased over 30 fold. And, supported by steady growth in the money supply, the price level has increased by a factor of 12. That’s a huge increase in the general price level, and it represents a significant reduction in the purchasing power of the dollar over time.These are matters that demand our attention as we make choices involving both fiscal and monetary policy.
The Wise Investor March 2010
Thomas M. Hoenig
President, Federal Reserve Bank of Kansas City
Concerns about the state of government finances – from Latvia to Argentina, Spain to Greece, U.K to Japan and the U.S as well - are mounting. So much has been spent on bailouts and stimulus with so little to show by way of sustainable and long-term benefits that government finances are badly out of shape. In this perspective, Thomas Hoenig – the sole credible voice in the U.S Fed system – shares his concern, the bad choices that are in the offing and the best & most desirable of the tough options. He also outlines the one good path to get out of the mess but highlights it means short-term pain and long-term gain. The policy today is, unfortunately, focussed on short-term gain, long-term pain. We present edited extracts from an excellent and comprehensive outline of the solution to the crisis in government finances. The speech is set in the U.S context, but bears relevance to India, too, as fiscal deficits (centre and states) are tilting at the doubledigit territory. The United States is moving into an era in which government finance is taking center stage. Fiscal measures taken to bring the economy out of recession, mounting longer-term liabilities for Social Security and Medicare, and other growing demands placed on federal government have invited a massive build-up of government debt now and over the next several years. Congressional Budget Office (CBO) projections have the federal debt reaching an unsustainable level of two to five times our total national income within the next 50 years, which leads us to an inescapable
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The immediate concern is the size of the deficit.The CBO projects the deficit was almost 12 per cent of GDP in fiscal year 2009 and will be almost 8 per cent in the current fiscal year-extraordinarily high levels by historical standards. In the entire history of the United States, the government has run deficits over 10 percent of GDP in only a few instances, and usually only during or immediately following a major war. As troubling as these deficits appear, even more disconcerting is the longer-term outlook for the federal debt caused by the accumulation of these deficits over time. A key part of the problem stems from rapid growth in entitlement spending, including spending on Social Security and, especially, Medicare. Over the next 30 years, the Government Accountability Office (GAO) estimates the present value of future expenditures on all social insurance programs exceeds future revenue by over $50 trillion. That is nearly four times the size of GDP and clearly unsustainable. Path One Forward-Monetize: One option for dealing with a fiscal imbalance is for the central bank to succumb to political pressure and monetize the debt. As deficits and debt levels within a country rise relative to national income, interest rates tend to rise as well. In this instance the central bank is often pressured to keep rates low and encouraged or required to assist the markets in facilitating the government's funding needs. If the central bank succumbs to this pressure, its balance sheet will expand, bank reserves will grow, and inevitably the money supply will increase. This process often appears benign at first, but if it goes on unchecked, the outcome is almost always higher levels of inflation and ultimately a loss of confidence in the value of the currency and the economy. Walter Bagehot’s famous dictum about banks holds equally true for governments—once their soundness is questioned, it is too late. At that moment, governments and their citizens are forced to make sizeable, painful fiscal adjustments. An example of both the political pressure that can be exerted on the central bank, as well as the inflationary consequences of debt monetization is currently playing out in Argentina. The president of Argentina recently forced out the Governor of the Central Bank because he would not transfer reserves held at the central bank to repay Argentinean debt. Inflation in Argentina is currently running near 8 percent and will almost certainly increase. Path Two Forward-Policy Stalemate: The second path forward is a stalemate between the fiscal and monetary authorities. • In such a stalemate, the fiscal imbalance grows while an independent central bank maintains its focus on long-run price stability. • Although the U.S. government is currently privileged to borrow at favorable rates, the fiscal outlook would inevitably undermine this privilege
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and its risk premium on debt would increase. • Also, as the government competes with private borrowers for funds, the potential exists for the fiscal imbalance to drive up the real cost of borrowing and capital to the private sector as well. • Eventually, this combination of large debt, and high cost of borrowing and capital weakens economic growth and undermines confidence in the economy’s long run potential. • Slowly, but inevitably, if the fiscal debt goes unaddressed, the currency weakens, as does access to global financial markets. • And the cycle worsens, leading ultimately to a financial and economic crisis. An interesting example in this respect is Canada in the first half of the 1990s. During this period, Canadian federal debt increased from about 55 percent of GDP to roughly 70 percent. At the same time, following a joint agreement between the government and the Bank of Canada, the Bank targeted a steady downward path for inflation from 3 per cent at the end of 1992 to 2 per cent at the end of 1995. With no monetary accommodation from the central bank, unsustainable government deficits and debt caused real interest rates in Canada to climb. While Canadian inflation was below that of the United States throughout this period, Canadians paid a substantial risk premium over U.S. rates to borrow. Moreover, the Canadian dollar came under persistent pressure. Overall economic performance suffered, with GDP growing very sluggishly in the recovery from the 1990-91 recession and unemployment climbing as high as 12 percent. Path Three Forward: Equitable Fiscal Discipline: The Canadian experience in the second half of the 1990s is suggestive of the third—and the only responsible— way to resolve our growing fiscal imbalance by addressing its source in an environment of price stability. In the United States, the Federal Reserve’s policies in the early 1980s provide a vivid example of the benefits that arise from the exercise of central bank independence. During this time, high interest rate policies designed to lower inflation were deeply unpopular both among elected leaders and the broad public. But the Federal Reserve was able to exercise its independence and pursue long-term goals, which systematically reduced inflation and changed the psychology of the nation regarding its expectation about inflation’s path. As a result, the United States has had nearly three decades of low inflation. All seem to agree this is the way we would prefer to go, but of course the devil is in the details. • At the outset, it requires an institutional framework committed to having an independent central bank. This discourages the fiscal authority from turning to its central bank and should it do so, strengthens the bank’s ability to say “no.”
• Knowing inflation is not an acceptable alternative to strong fiscal management, a government faced with rising debt levels must provide a credible long-term plan to re-establish fiscal balance. • The plan must be clear, have the force of law and its progress measurable so as to reassure markets and the public that the country has the will and ability to repay its debts in a stable currency. • To be broadly accepted, the plan must be seen as fair, in which there is a sense of shared sacrifice across all segments of the economy. • Without being specific, these requirements suggest an approach in which we are willing to disappoint a host of special interests. • It means, for example, controlling budget earmarks, trimming subsidies to numerous economic sectors and resolving our banking problems. • It means resolving our banking problems and the perception that Wall Street is favoured over Main Street, all of which would otherwise foster mistrust and cynicism among the public. • Leaving these issues unaddressed will undermine the essential popular support required for the tough decisions needed to bring our federal budget into balance. • Finally, there are no short-cuts.We currently must adjust from a misallocation of resources. There is no way to avoid some short-term pain in fixing the fundamentals in our economy. • Outlining a credible course for managing our debt will accelerate the restoration of confidence in our economy and contribute importantly to sustainable capital investment and job growth. Needed, significant and permanent fiscal reforms: Eventually, government budgets that are severely out of balance are inevitably reformed—either by force of the markets or, preferably, by choice. Unfortunately, nations often must experience a profound crisis to focus the government’s attention on taking corrective action. Usually it is at this point that governments re-establish fiscal discipline and renew their commitment to an independent central bank. Ironically, however, these generally are precisely the reforms that would have prevented a crisis in the first place. The only difference between countries that experience a fiscal crisis and those that don’t is the foresight to take corrective action before circumstance and markets harshly impose it upon them. In time, significant and permanent fiscal reforms must occur in the United States. I much prefer this be done well before anyone feels an irresistible impulse to knock on this central bank’s door. Only the third will resolve the imbalances without eventually causing inflation to accelerate or precipitating a financial and economic crisis. Source: Edited extracts from `Knocking on the Central Bank’s Door’ by Thomas Hoenig, President, Federal Reserve Bank of Kansas City, at the Peterson-Pew Commission on Budget Reform Policy Forum Washington, D.C. February 16, 2010 http://bit.ly/ajxnvu
The Wise Investor March 2010
Every year, legendary investor Warren Buffett (Chairman of Berkshire Hathaway) writes a detailed letter to shareholders explaining the operations of the company and providing views key aspects of the economy and financial markets. His letter for 2009 was published on February 28. 2010. We carry select quotes from the detailed communication that can be accessed at www.berskshirehathway.com.The letter is a recommended read and the quotes published here may be viewed only as a precursor to the real thing. (Topic of the quotes in italics has been provided by the Editor of this Publication to provide context).
Standard of performance measurement: From the start, Charlie Munger (Vice-Chairman of Berkshire Hathaway) and I have believed in having a rational and unbending standard for measuring what we have – or have not – accomplished.That keeps us from the temptation of seeing where the arrow of performance lands and then painting the bull’s eye around it. Our book value since the start of fiscal 1965 has grown at a rate of 20.3% compounded annually.
Worth more than book value yet we prefer it: In aggregate, our businesses are worth considerably more than the values at which they are carried on our books. In our allimportant insurance business, moreover, the difference is huge. Even so, Charlie and I believe that our book value – understated though it is – supplies the most useful tracking device for changes in intrinsic value.
What businesses we avoid: Charlie and I avoid businesses whose futures we can’t evaluate, no matter how exciting their products may be. In the past, it required no brilliance for people to foresee the fabulous growth that awaited such industries as autos (in 1910), aircraft (in 1930) and television sets (in 1950). But the future then also included competitive dynamics that would decimate almost all of the companies entering those industries. Even the survivors tended to come away bleeding. Just because Charlie and I can clearly see dramatic growth ahead for an industry does not mean we can judge what its profit margins and returns on capital will be as a host of competitors battle for supremacy. At Berkshire we will stick with businesses whose profit picture for decades to come seems reasonably predictable. Even then, we will make plenty of mistakes
Our defense better than offense: We have never had any five-year period beginning with 1965-69 and ending with 2005-09 – and there have been 41 of these – during which our gain in book value did not exceed the S&P’s gain. Though we have lagged the S&P in some years that were positive for the market, we have consistently done better than the S&P in the eleven years during which it delivered negative results. Our defense has been better than our offense, and that’s likely to continue.
Size shrinks performance advantage: The big minus is that our performance advantage has shrunk dramatically as our size has grown, an unpleasant trend that is certain to continue. To be sure, Berkshire has many outstanding businesses and a cadre of truly great managers. Charlie and I believe these factors will continue to produce better-than-average results over time. But huge sums forge their own anchor and our future advantage, if any, will be a small fraction of our historical edge.
Too-big-to-fail is not Berkshire: We will never become dependent on the kindness of strangers.Too-big-to-fail is not a fallback position at Berkshire. Instead, we will always arrange our affairs so that any requirements for cash we may conceivably have will be dwarfed by our own liquidity. Moreover, that liquidity will be constantly refreshed by a gusher of earnings from our many and diverse businesses.When the financial system went into cardiac arrest in September 2008, Berkshire was a supplier of liquidity and capital to the system, not a supplicant. At the very peak of the crisis, we poured $15.5 billion into a business world that could otherwise look only to the federal government for help. We pay a steep price to maintain our premier financial strength.The $20 billion-plus of cash equivalent assets that we customarily hold is earning a pittance at present. But we sleep well.
Source: www.berkshirehathaway.com Sundaram BNP Paribas Asset Management 9 The Wise Investor March 2010
Management style: We tend to let our many subsidiaries operate on their own, without our supervising and monitoring them to any degree. We would rather suffer the visible costs of a few bad decisions than incur the many invisible costs that come from decisions made too slowly – or not at all – because of a stifling bureaucracy. Charlie and I will limit ourselves to allocating capital, controlling enterprise risk, choosing managers and setting compensation.
State of U.S Housing market: Within a year or so residential housing problems should largely be behind us, the exceptions being only high-value houses and those in certain localities where overbuilding was particularly egregious. Prices will remain far below “bubble” levels. Indeed, many families that couldn’t afford to buy an appropriate home a few years ago now find it well within their means because the bubble burst.
Blinkered vision: I have been in dozens of board meetings in which acquisitions have been deliberated, often with the directors being instructed by high-priced investment bankers (are there any other kind?). Invariably, the bankers give the board a detailed assessment of the value of the company being purchased, with emphasis on why it is worth far more than its market price. In more than fifty years of board memberships, however, never have I heard the investment bankers (or management!) discuss the true value of what is being given.There is only one way to get a rational & balanced discussion. Directors should hire a second advisor to make the case against the proposed acquisition, with fee contingent on deal not going through.
Risk control is not delegated: The dangers that derivatives pose for both participants and society – dangers of which we’ve long warned, and that can be dynamite – arise when these contracts lead to leverage and/or counterparty risk that is extreme. It’s my job to keep Berkshire far away from such problems. Charlie and I believe that a CEO must not delegate risk control. It’s simply too important. If Berkshire ever gets in trouble, it will be my fault. It will not be because of mis-judgments made by a Risk Committee or Chief Risk Officer.
Responsibility of risk management: In my view a board of directors of a huge financial institution is derelict if it does not insist that its CEO bear full responsibility for risk control. If he’s incapable of handling that job, he should look for other employment. And if he fails at it – with the government thereupon required to step in with funds or guarantees – the financial consequences for him and his board should be severe. The CEOs and directors of the failed companies, however, have largely gone unscathed.
Tap dancing to work: At 86 and 79, Charlie and I remain lucky beyond our dreams. We were born in America; had terrific parents who saw that we got good educations; have enjoyed wonderful families and great health; and came equipped with a “business” gene that allows us to prosper in a manner hugely disproportionate to that experienced by many people who contribute as much or more to our society’s wellbeing. Moreover, we have long had jobs that we love, in which we are helped in countless ways by talented and cheerful associates. Indeed, over the years, our work has become ever more fascinating; no wonder we tap-dance to work. Nothing, however, is more fun for us than getting together with our shareholder-partners at Berkshire’s annual meeting An ideal period of investors: We’ve put a lot of money to work during the chaos of the last two years. It’s been an ideal period for investors: A climate of fear is their best friend. Those who invest only when commentators are upbeat end up paying a heavy price for meaningless reassurance. In the end, what counts in investing is what you pay for a business – through the purchase of a small piece of it in the stock market – and what that business earns in the succeeding decade or two.
Behavioural change is needed: Their (CEOs) fortunes may have been diminished by the disasters they oversaw, but they still live in grand style. It is the behavior of these CEOs and directors that needs to be changed: If their institutions and the country are harmed by their recklessness, they should pay a heavy price – one not reimbursable by the companies they’ve damaged nor by insurance. CEOs and, in many cases, directors have long benefited from oversized financial carrots; meaningful sticks now need to be part of their employment.
Save Ajit even if it means sacrificing Charlie and me: A hugely important event in Berkshire’s history occurred on a Saturday in 1985. Ajit Jain came into our office in Omaha – and I immediately knew we had found a superstar. (He had been discovered by Mike Goldberg, now elevated to St. Mike.) We immediately put Ajit in charge of National Indemnity’s small and struggling reinsurance operation. Over the years, he has built this business into a one-of-a-kind giant in the insurance world. Staffed today by only 30 people, Ajit’s operation has set records for transaction size in several areas of insurance. Ajit writes billion-dollar limits – and then keeps every dime of the risk instead of laying it off with other insurers.Throughout the world, he is known as the man to call when something both very large and unusual needs to be insured. If Charlie, I and Ajit are ever in a sinking boat – and you can only save one of us – swim to Ajit.
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The Wise Investor March 2010
Vision, a social stock market
months, the child gets all the micro-nutrients he or she needs and becomes a healthy, playful child. As a social business, Grameen-Danone follows the basic principle that it must be self-sustaining, and the owners must remain committed never to take any dividend beyond the return of the original amount they invested. The success of the company will be judged each year not by the amount of profit generated, but by the number of children getting out of malnutrition in that particular year. • We have a joint-venture social business with Veolia, a large French water company to bring safe drinking water in the villages of Bangladesh where arsenic contamination of water is a huge problem. Villagers are buying water from the company at an affordable price instead of drinking contaminated water. • BASF of Germany has signed a joint-venture agreement to produce chemically treated mosquitonets in Bangladesh as a social business. • Our joint-venture social business with Intel Corporation, Grameen-Intel, aims at using information and communication technology to help solve the problems of the rural poor. • Our joint-venture with Adidas aims at producing shoes for the lowest income people at an affordable price to make sure that no one, child or adult, goes without shoes. As these examples show, social business is not just a pleasant idea. It is a reality, one that is already beginning to make positive changes in people’s lives. Many more social businesses are on the way. One attractive area of social businesses will be in creating jobs in special locations or for particularly disadvantaged people. Designing each small social business is like developing a seed. Once the seed is developed, anybody can plant it wherever it is needed. Since each unit is self-sustaining, funding does not become a constraint. The owners of social businesses can direct the power of technology to solve our growing list of social and economic problems, and get quick results. Regarding the source of funds, one source can easily be the philanthropy money going for creating social businesses. This makes enormous sense. One problem of charity programmes is that they remain perpetually dependent on donations. They cannot stand on their own two feet. Charity money goes out to do good things, but that money never comes back. It is a one-way route. But if a charity programme can be converted into a social business that supports itself, it becomes a powerful undertaking. Now the money invested is recycled endlessly. A charity taka has one life, but a social business taka has endless life. That's the power of social business. Besides philanthropists, many other people will invest in social businesses just to share the joy of making a
Professor Muhammad Yunus
Professor Muhammad Yunus delivered the second Annual Hirendranath Mukerjee Memorial Parliamentary Lecture at the joint-meeting of the members of Lok Sabha and Rajya Sabha of India in Delhi on December 9, 2009. This is the second and concluding part of edited extracts from his lecture. A social business is a business where an investor aims to help others without taking any financial gain himself. At the same time, the social business generates enough income to cover its own costs. Any surplus is invested in expansion of the business or for increased benefits to society. The social business is a non-loss, non-dividend company dedicated entirely to achieving a social goal. Will anybody in the real world be interested in creating businesses with selfless objectives? Where would the money for social business come from? Judging by the real human beings I know, many people will be delighted to create businesses for selfless purposes. Some have already been created. Like any good idea, the concept of social business needs practical demonstration. So I have started creating social businesses in Bangladesh. Some of them are created in partnership with large multi-national companies. • The first such joint-venture with a multi-national company was created in 2005, in partnership with the French dairy company Danone. The GrameenDanone social business is aimed at reducing malnutrition among the children of Bangladesh. The Grameen-Danone company produces a delicious yogurt for children and sells it at a price affordable to the poor. This yogurt is fortified with all the micronutrients which are missing in the vitamins, iron, zinc, iodine, etc. If a child eats children’s ordinary diet two cups of yogurt a week over a period of eight to nine
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difference in other people's lives. People will give not only money but also their creativity, networking skills, technological prowess, life experience, and other resources to create social businesses that can change the world. Once our economic theory adjusts to the multidimensional reality of human nature, students will learn in their schools traditional money-making-and colleges that there are two kinds of businesses businesses and social businesses. As they grow up, they'll think about what kind of company they will invest in and what kind of company they will work for. And many young people who dream of a better world will think about what kind of social business they would like to create.Young people, when they are still in schools, may start designing social businesses, and even launch social businesses individually or collectively to express their creative talents in changing the world. We May Create Social Stock Markets: The good ideas will need to be funded. I am happy to say there are already initiatives in Europe and Japan to create Social Business Funds to provide equity and loan support to social businesses. In time, more sources of funding will be needed. Each level of government-international, national, state, and citycan create Social Business Funds to encourage citizens. Foundations can earmark a percentage of their funds to support social businesses. Businesses can use their social responsibility budgets to fund social businesses. We'll soon need to create a separate stock market for social businesses to make it easy for small investors to invest in social businesses. Only social businesses will be listed in this Social Stock Market. Investors will know right from the beginning that they'll never receive any dividends when they invest in social stock market. Their motivation will be to enjoy the pride and pleasure of helping to solve difficult social problems. Social business gives everybody the opportunity to participate in creating the kind of world that we all want to see. Thanks to the concept of social business, citizens don't have to leave all problems in the hands of the government and then spend their lives criticizing the government for failing to solve them. And let’s dream that by 2030 we'll have a range of creative and effective social businesses working throughout South Asia to solve all the remaining social problems. Does this dream sound impossible? If it does, it means it is likely to come true if we believe in and work for it. That’s what the history of the last fifty years teaches us. Source: http://www.muhammadyunus.org Note: By Invitation features articles solicited by The Wise Investor from experts. It may, on occasions, showcase excerpts of exceptional papers/speeches, which are available in the public domain or published with permission.
The Wise Investor March 2010
Mutual Funds Demystified
buckets which determine the data points on the yield curve ie 3 months, 6 months, 1 year, 2 years, 3 years, 5 years & 10 years, to name a few. So when we speak about inflation expectation for the future it is actually an expectation for each one of these data points. However no expert will be able to precisely forecast inflation for each time period given that there are so many variables which affect this. Hence there is generally possible to have an only estimate of the direction of inflation rates in the future. This is what explains how the three shapes of the yield curve are arrived at.
Suppose we find that, since the economy is in a boom phase, there are quite a few companies in a similar situation. Then we could face a situation where the lenders are inundated with a lot of similar borrowing requests. Essentially we might be facing a situation of scarcity of lenders willing to lend money for a 5-year timeframe. Then we can easily envisage a situation where the initial set of borrowers have exhausted the available lendable resources in the market at the rate implied by the yield curve ie 4%. Then what does a company which has just finalized its expansion programme do? It has no choice, but to offer a higher rate of interest to tempt a few lenders into diverting their surplus funds to him. This rate is determined by the negotiation process ie the level of desperation of the borrower. The rate has to be high enough to force the lender to back out of financing some other project or alternatively it should be high enough to change the mindset of a short-term or long-term lender and tempt him to lend for a medium term tenor. Let us assume that this transaction happens at a rate of 6 %. Obviously this becomes the new data point for the yield curve. Now we come to the important point – does this new data point imply that the rates for the 10-year period also goes up correspondingly to say 7% ? Not necessarily, because there may be no borrowers for 10-year money at 7%. In fact the lenders with an outlook of 10 years may be sometimes forced lend at even lower rates of say 4%, unless he is willing to shorten his investment horizon and jump into the 5-year bandwagon because of the higher interest rates. Thus we could envisage a situation such as the following : 1-year rate at 3%; 5-years rate at 6% and 10-years rate at 4%. Such a yield curve can only be explained as a humped yield curve. We have now introduced the idea that inflation expectation is not the only factor that differentiates short-term and long-term interest rates. This type of behavoiur is also referred to as the segmentation theory of interest rates. On this rather heavy note we will end today’s discussion.
The Wise Investor March 2010
Executive Director-Sales & Marketing Sundaram BNP Paribas Asset Management
In our last discussion, we had discussed how the yield curve (which basically describes the connection between short-term and long-term interest rates) should normally be upward sloping, implying that interest rates for longer tenors should be higher than those for shorter tenors. This fits perfectly with our intuitive understanding of interest as a price to be paid for foregoing the desire for immediate consumption and hence such upward-sloping yield curves are also referred to as normal yield curves. We had also explained how yield curves can be ‘other than normal’ in which long-term rates are lower than short-term rates. We had explained that this is because the market expects interest rates to decline in the future – mainly because inflation is expected to be lower (to refresh your memory - Nominal Interest Rate = Real Rate + Expected Inflation). We had also used a numerical example to explain how this occurs. Continuing this thread of discussion, we also could witness sometimes a flat yield curve. By now, you will easily answer this by saying that market expects inflation rates to be stable in the future!!! Excellent. Can there be there be shapes other than upward sloping, downward sloping and flat to the yield curve? To complicate your life further, let me answer:Yes. To understand this, we first need to know that there are a range of maturities in a continuum from short term to long term. Hence there are various time
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In reality, market participants are forced to decide on borrowing rates for each time-bucket based on the demand for and the supply of money.This is because a borrower generally has a requirement of money for a specific period only. Similarly a lender may be able to lend his surplus only for a specific time frame, after which he may need the money for his own needs. The actual rates of interest at which these lendingborrowing transactions take place are a result of the negotiation process between lender and borrower. These participants use the existing shape of the yield curve as a starting point for the negotiations. Where the borrower is the government, this takes place through an auction process. In the case of private transactions, the negotiations are conducted on a oneto-one basis.These actual rates then become the data points which form the new yield curve. It is the result of this negotiation process – otherwise referred to in economics as the demand-supply equilibrium that leads sometimes to a yield curve distortion- a shape that is not upward sloping, nor downward sloping or flat. To explain this we will again use a numerical example. Let us start with a normal’ yield curve (an upward sloping yield curve)- short-term (1 year) rates are 3%, medium term (5 years) rates are 4% and long-term (10 years) rates are 5%. Let us suppose that a company is putting up an expansion project which should be able to recover its capital investment in about 5 years. Naturally, the company would seek to finance the project with a 5year loan and with this in mind he approaches various lenders.
Micro Cap Sector Specific Small Cap Thematic Muti-Cap (Mid-& Small-Cap Bias)
Risk-Reward Spectrum High
Monthly Income Plan Equity Linked FMP Dynamic Bond Flexi Debt Gilt Funds Long & Medium-Term Bond Short-Term Debt Funds Capital Protection Orientation Plan Arbitrage Floating Rate Ultra Short-Term Treasury Funds Liquid Funds
Pure Mid-Cap Flexi-Cap Index Funds (Broad Market) Index ETFs (Broad Market) Multi-Cap (Large Cap Bias) Concentrated Large Cap Diversified Large Cap Nifty/Sensex Index Funds Nifty/Sensex ETF Funds
For Equity Linked Savings Schemes (Tax Planning Funds), their position in the risk-return spectrum has to be evaluated based on where the portfolio is consistently positioned in the categories indicated in the chart.The ordering is only indicative and is not intended as investment advice.
Sundaram BNP Paribas Asset Management 13 The Wise Investor March 2010
Financial sector cannot be an island or an illusion
periodically. • The exchange rate is largely market-determined and we intervene in the foreign exchange market in times of excessive volatility. • Our approach to financial sector regulation has been informed by the fact that our system is dominated by commercial banks. Thus, as early as mid-1990s, the Reserve Bank instituted the prudential framework governing banks, especially commercial banks, as a part of the overall structural reforms. As of April 2009, all our commercial banks are Basel II compliant. • The Reserve Bank has been proactive in adopting a counter-cyclical approach to financial regulations. Notably, in the years before the crisis, we increased the risk weights and provisioning norms on a selective basis.
Governor Reserve Bank of India
• The intent was to limit the exposure of the banking system to sensitive sectors of the economy posting high credit growth and thereby prevent mis-pricing of risk. • Again, in another counter cyclical measure, as part of crisis management, we reversed the earlier tightening and normalized the risk weights and provisioning norms to facilitate credit flow to these sectors. One little known aspect of capital flows, what could perhaps be called the law of capital flows, is that they never come in at the precise time or in the exact quantity you want them. • India’s banking system has remained remarkably well capitalized with capital to risk weighted asset ratio (CRAR) much above the minimum prescribed under Basel II. • The asset quality post-crisis also remained sound though there has been a slight deterioration in recent months. • In recognition of the fact that banks should build up provisioning and capital buffers in good times which can be used for absorbing losses in a downturn, recently, banks have been advised to ensure that the provisioning coverage ratio, i.e., the ratio of provisioning to gross NPA, is not less than 70 per cent. • In view of the heightened concerns with regard to financial stability during the recent years, the Reserve Bank is retooling itself to safeguard financial stability. • We have also set up a Financial Stability Unit which will make regular and systematic assessment of the stability of the Indian financial system. Crisis when financial sector growth outstrips real sector A study of financial crises shows that almost every crisis is preceded by, if I may use what is by now a cliché, ‘irrational exuberance’ of the financial sector with the growth of the financial sector outstripping the growth of the real sector engendering a belief, bordering on hubris, that real value can be created by sheer financial engineering.Take this crisis for example. In the world that existed before the crisis - a benign global environment of easy liquidity, stable growth and low inflation - profits kept coming, and everyone got lulled into a false sense of security in the firm belief that profits will keep rolling in forever. Herb Stein, an economist, pointed out the truism that, "if something cannot go on for ever, it will eventually stop." But no one paid attention. The magic of the financial sector gave it such a larger than life profile that we began to believe that for every real life problem, no matter how complex, there is a financial sector solution. Now, of course, we know better – for every real life problem, no matter how complex, there is a financial sector solution, which is wrong.
14 The Wise Investor March 2010
Several top officials of the Reserve Bank of India make speeches that offer vital insights into the thinking of the central bank, the state of the economy and policy approaches. These insights influence policy and markets. Starting this month, we pick views from several speeches by RBI officials and provide a concise summary on a range of key issues. The selection presented this month is from four speeches of Dr D Subbarao and views expressed by him in a conference call after the monetary policy announcement, the RBI’s first such initiative. Why India was affected by the global financial crisis? Almost every country in the world has been impacted, although to a different extent. India was no exception. Largely driven by the then intellectually fashionable decoupling theory, there was dismay in India that we were hit by the crisis.This dismay arose from two factors. • First, there was surprise that we were hit by a crisis with origins in the banking system even as our banks, and indeed our entire financial system, had minimal exposure to tainted assets. • Second, there was also concern that we were hit by global recession even though our export sector, at 15% of GDP, was relatively small. The answer to both these points is that India was hit by the crisis because we are more globally integrated than we tend to acknowledge.We were impacted through all channels - the financial channel, the real sector channel and the confidence channel. The impact of crisis on India was, however, relatively muted. India’s financial sector remained safe and sound, and our financial markets continued to function normally highlighting the stability enhancing features of our policy and regulatory framework. India’s approach to safeguarding financial stability On financial globalization, our stance has been gradualist. • We view capital account liberalisation as a process and not an event. The extent of opening is contingent upon progress in other sectors. • Our policy framework encourages equity flows, especially direct investment flows. Debt flows are subject to restrictions, and these are reviewed and fine-tuned
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Financial sector cannot grow in isolation Take the case of the United States. Over the last 50 years, the share of value added from manufacturing in GDP shrank by more than half from 25 per cent to 11 per cent while the share of financial sector more than doubled from 3.6 per cent to 7.5 per cent. The job share of the manufacturing sector declined by more than half from 29 per cent to 11 per cent while the job share of the financial sector increased by over a third from 3.5 per cent to 4.6 per cent.The same trend is reflected in profits too. Over the last 50 years, the share of manufacturing sector profits in total profits declined by more than half from 49 per cent to 21 per cent while the share of profits of the financial sector increased by more than half from 17 per cent to 27 per cent. Clearly, the excessive risk-taking behaviour of the financial sector raised the value-added of the sector beyond a sustainable level making the melt down, in retrospect, inevitable. Forgotten in the euphoria of financial alchemy is the basic tenet that the financial sector has no standing of its own; it derives its strength and resilience from the real economy. It is the real sector that should drive the financial sector, not the other way round. WPI, CPI, Growth & RBI’s struggles WPI inflation number is the best known and most widely used, but we have said several times the Reserve Bank looks at not just the WPI inflation but we look at the four CPI indices and we look at a host of other indicators. As some people in RBI keep telling me ours is a multiple indicator approach, which includes indicators beyond inflation. Now, you are right that services do not enter WPI, but they enter CPI and that is one of the reasons for the divergence between the CPI and WPI. The other reason for divergence is of course the higher weight for food items in CPI versus WPI. I have also been told that some commodities are better represented in WPI. For example, metals are there in WPI, they are not in CPI. So, we are aware of all this. In fact, over the last two years, since this divergence between CPI and WPI has widened we have been sensitive to tracking both the trends in WPI and CPI, studying the reasons for divergence and factoring in those inferences in our policy calculus. Our policy dilemma is that we need to tighten in order to manage inflation, but we also have to be very mindful of the fact that growth is yet to consolidate. So, we need to manage this over the next few months carefully, so that growth takes place in a manner sufficient. Yes, there is going to be government borrowing program, and it is not possible even for the government to scale down the fiscal deficit abruptly, but these are realities and challenges of our economy. As Reserve Bank, we do not have a magic wand and we are struggling with this. Dealing with capital flows Emerging market economies (EMEs) saw ‘sudden stop’ capital outflows during the crisis as a result of global deleveraging. Now the trend has reversed once again and many EMEs are seeing net inflows - a consequence of a global system awash with liquidity, the assurance of a low interest rate regime in advanced countries over an ‘extended period’ and the promise of growth in EMEs. One little known aspect of capital flows, what could perhaps be called the law of capital flows, is that they never come in at the precise time or in the exact quantity you want them. Managing these flows, especially if they are volatile, is going to test the effectiveness of central bank policies of semi-open EMEs. If central banks do not intervene in the foreign exchange market, they incur the cost of currency appreciation unrelated to fundamentals. If they intervene in the forex market to prevent appreciation, they will have additional systemic liquidity and potential inflationary pressures to contend with. If they sterilize the resultant liquidity, they will run the risk of pushing up interest rates which will hurt the growth prospects. Capital flows can also potentially impair financial stability.
Sundaram BNP Paribas Asset Management 15
How EMEs manage the impossible trinity - the impossibility of having an open capital account, a fixed exchange rate and independent monetary policy - is going to have an impact on their prospects for growth, price stability and financial stability. Role of central banks in preventing asset price bubbles A dominant issue in the wake of the crisis has been the role of central banks in preventing asset price bubbles. The monetary stance of studied indifference to asset price inflation stemmed from the famous Greenspan orthodoxy which can be summarized as follows. • Asset price bubbles are hard to identify on a real time basis. • The fundamental factors that drive asset prices are not directly observable. • A central bank should not therefore second guess the market. • Monetary policy is too blunt an instrument to counteract asset price booms. • Central banks can ‘clean up the mess’ after the bubble bursts. The surmise therefore was that the cost-benefit calculus of a more activist monetary stance of “leaning against the wind” was clearly negative. In other words, it is not the job of central bankers to remove the punch bowl no matter that the party is getting wild. The crisis has dented the credibility of the Greenspan orthodoxy. The emerging view post-crisis is that preventing an asset price build up should be within the remit of a central bank. Opinion is divided, however, on whether central banks should prevent asset bubbles through monetary policy action or through regulatory action. • On one side, there is a purist view that the case for monetary tightening to check speculative bubbles is questionable. • Opposed to this is the argument that a necessary condition for speculative excesses is abundant liquidity, and that controlling liquidity should be the first line of defence against ‘irrational exuberance’. • Some economists take a more granular position on this, and the argument goes as follows. It is important to differentiate between speculative excesses fuelled by bank lending and those that are not such as, for example, the IT bubble. • Central banks have a role in preventing “bank centred” bubbles, but the instrument for this is not monetary policy but regulatory intervention. No matter how this debate settles, if it will at all, what is beyond debate is that central banks’ efforts to check asset price bubbles demand not just analytical capability but mature judgement of the nature of the risk. Managing monetary policy in a globalizing environment The crisis has clearly demonstrated the challenges of macroeconomic management in a globalizing world. Even as governments and central banks acted with unusual show of policy force, they found that they were not able to get the situation under control because of the interconnectedness of the financial system. The question is, with the benefit of that hindsight, how are central banks going to manage the challenges from globalization to their macroeconomic policies. Experience shows that external developments interact with domestic macro variables in complex, uncertain and even capricious ways, and central banks need to deepen their understanding of these interactions. Is the challenge posed by globalization similar for all central banks? Obviously, the more open the economy, the greater the impact of globalization on domestic policies. Beyond that, it seems logical to conjecture that the broader the mandate of a central bank, the larger the influence of globalization on the effectiveness of its policies. There is a view that open economies can retain strong control over the medium and long term inflation trends even in the face of globalization.This is a debatable proposition, and at best true only in the case of pure inflation targeting central banks. Central banks with wider mandates need necessarily to factor in external developments into their domestic policy calculus. Globalization is not new; its risks and rewards are also not new. What is new, and what the crisis has revealed, is the ferocity with which the forces of globalization can strike and the diversity of channels through which they can transmit across borders. The challenge for central banks is to better understand the interplay of global factors and domestic variables, and factor that into their policy calculus. Source: www.rbi.org.in
The Wise Investor March 2010
Thoughts From The Frontline
It’s more than just Greece
That meant that Greek consumers could buy products and services that previously may have been out of their reach. Plus, with government debt at low rates, the Greek government could borrow more to finance deficit spending, without the threat of higher interest rates. And Greece began to increase its debt with abandon. Additionally, as it now turns out, Greece basically lied about its finances in order to gain admission to the union. It never complied with the fiscal discipline that was required for entrance. With the high exchange rate, however, came the consequence of higher labor costs relative to, above all, Germany. While reviewing some economic facts about Greece, I came across the factoid that Greek workers had the second highest level of actual hours worked. But even with that, Greece was running a trade deficit that is currently 12.7% of its GDP. And with the onset of the current recession, their fiscal deficit went from bad to worse. Their total debt is now €254 billion, and they need to finance another €64 billion this year, €30 billion of it in the next few months. Bottom line, without some help or a bailout, they simply will not be able to borrow that money. And since a lot of that money is for "rollover" debt, that means a potential for default if they cannot borrow it. European leaders said today that Greece will not be allowed to fail, hinting of a bailout. But there are a lot of "buts" and conditions. Between Dire and Disastrous: While German Chancellor Merkel has indicated a willingness to help, the German finance minister and other politicians are suggesting German cooperation will either not be forthcoming or only be there at a very high price; and the price is a severe round of "austerity measures," otherwise known as budget cuts. Greece is being told that it must cut its budget to an 8.7% deficit this year and down to 3% within three years. Let's put that into perspective. That is the equivalent of a $560-billion-dollar US budget cut this year and another such cut next year. And yet, that is what the Greek government is being asked to do as the price for a bailout. A few facts about Greece: Some 30% of its economy is underground, meaning it is not taxed. In a country of 10 million people, only 6 (!!!!) people filed tax returns showing in excess of €1
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Path dependence explains how the set of decisions one faces for any given circumstance is limited by the decisions one has made in the past, even though past circumstances may no longer be relevant. In essence, history matters. With regard to the future, the choices we make determine the paths we will take. As I have been writing for a long time, we have made a series of bad choices, often the easy choices, all over the developed world. We are now entering an era in which our choices are being limited by the nature of the markets. Not only are we in a path-dependent world, but the number of paths from which we may choose are becoming fewer with each passing year. Our economic future is more and more a product of the political choices we make, and those are increasingly difficult. We have no good choices. We are left with choosing the best of bad options. Some countries, like Greece, are now down to choices that are either dire or disastrous. There is no "easy" button. Let's look at how Greece came to its current rather dismal predicament. And we will look at why it may be even worse than many pundits think. First, we need to go back to the creation of the euro. Most of the Mediterranean countries that are now in trouble were allowed into the union with an exchange rate that overvalued their currencies relative to the northern countries, but especially to Germany.
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million in income. Yet over 50% of GDP is government spending, and Greece has one of the highest public employee levels as a percentage of population in Europe. And its unions are very powerful. Nearly all of them have gone on strike over this proposal. A National Suicide Pact: Now, here is where it actually gets worse. If Greece bites the bullet and makes the budget cuts, that means that nominal GDP will decline by (at least) 4-5% over the next 3 years. And tax revenues will also decline, even with tax increases, meaning that it will take even further cuts, over and above the ones contemplated to get to that magic 3% fiscal deficit to GDP that is required by the Maastricht Treaty. Anyone care to vote for depression? And add into the equation that borrowing another €100 billion (at a minimum) over the next few years, while in the midst of that recession, will only add to the already huge debt and interest costs. It all amounts to what my friend Marshall Auerback calls a "national suicide pact." We are in the fullness of time approaching the End Game. In country after country, the choices that have been made over the last decades will yield a Greek situation, where there are no good choices. And the longer the hard choices are put off, the more difficult they will become. Normally, a country in such a situation would allow its currency to devalue, which would make its relative labor costs go down. But Greece is in a currency union, and can't devalue. Or it would restructure its debt (think Brady bonds) to try and resolve the problem. • The dire predicament is the one where Greece cuts its budgets and more or less willingly enters into a rather long and deep recession/depression. • The disastrous predicament is where they do not make the cuts and are allowed to default. That means the government is plunged into a situation where it has to cut the entire deficit to what it can get in the form of taxes and fees, immediately. As in right now. And defaulting on the interest on the current bonds wouldn't be enough, although it would help. Why not just let Greece go under? Part of the argument has to do with moral hazard. If Germany bails out Greece, Ireland, which is
The Wise Investor March 2010
Thoughts From The Frontline
actually making such cuts to its budget, can legitimately ask, "Why not us?" And will Portugal be next? And Spain is too big for even Germany to bail out. At almost 20% unemployment, Spain has severe problems. Its banks are in bad shape, with large amounts of overvalued real estate on their books (sound familiar?) and a government fiscal deficit of almost 10%. While Spanish authorities say they can work this out, deficits will remain high. The fear is one of contagion. Some argue that Greece is only 2.7% of European GDP. But Bear Stearns held less than 2% of US banking assets, and look what happened. The recent credit crisis was over a few trillion in bad, mostly US, mortgage debts, with most of that at US banks. Greek debt is $350 billion, with about $270 billion of that spread among just three European countries and their banks. Make no mistake, a Greek default is another potential credit crisis in the making. As noted above, it is not just the write-down of Greek debt; it is the mark-to-market of other sovereign debt. That would bankrupt the bulk of the European banking system, which is why it is unlikely to be allowed to happen. Just as the Fed (under Volcker!) allowed US banks to mark up Latin American debt that had defaulted to its original loan value (and only slowly did they write it down; it took many years), I think the same thing will happen in Europe. Or the ECB will provide liquidity. Or there may be any of several other measures to keep things moving along. But real mark-to-market is unlikely. The entire EU is faced with no good choices. It is coming down to that moment of crisis predicted by Milton Friedman so many years ago. And there is no agreement on what to do. There is talk among some in Europe of a more centralized control of some countries that do not stay within guidelines, which means that Greece might be asked to give up some of its sovereign freedoms in exchange for bailout funds. French President Sarkozy emphatically stated that no member of the EU would be allowed to default. But he did not bring a checkbook to the press conference. Selling this to a variety of national parliaments will not be easy, when they have their own problems. And Merkel has problems on the home front. There are reports she is putting the brakes on a bailout, as she is getting pushback from her constituency.The Frankfurter Allgemeine Zeitung warned the chancellor that offering Greece any kind of bailout would be a betrayal of the trust of the Germans who so reluctantly traded in their marks for the euro. "If the no-bailout clause of the Maastricht Treaty is going to be abandoned, then the last anchor of a stable euro will be destroyed," warned the frontpage editorial in the conservative newspaper.
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"Chancellor Merkel has to be hard now so that the euro doesn't become soft." Ultimately, this is a political decision for the Greek people.They have roughly four options. • They can accept the austerity measures and sink into a depression for a few years. This would mean the total amount of debt would go up rather significantly, putting a very large crimp on future budgets. Debt is a constraint on growth. Debt-to-GDP is already over 100%. • The second option is that they can simply default and go into a depression for more than a few years. This would have the advantage of reducing the debt burden, depending on what terms the government settled on. Would bond holders get 50 cents on the euro? 25 cents? Stay tuned. But it would also most assuredly mean they would not be able to get new debt for some time to come, forcing, as noted above, severe cuts in government spending. From one perspective, it has the potential advantage of reducing government's share of the economy, which is a long-term good but a short-term nightmare. But it also keeps Greece in the euro zone, which does have advantages. However, it does little to deal with the labor-cost differential. • The third option is that they could vote to leave the European Union. While this is unthinkable to most Europeans, it is an option that may appeal to some Greeks. They could create their own currency and effectively devalue their debt. It would make their labor and exports cheaper.They would still be shut out of debt markets for some time. Any savings left in Greece would be devalued overnight.Those on pensions would find their buying power cut by a great deal. It is likely that inflation would become an issue. And it would be a full-employment act for legions of attorneys. Most people scoff at this notion, but money is flying out of Greek banks into non-Greek ones, and to my way of thinking that is a suggestion that some Greeks think secession might be a possibility. It is also causing severe stress at Greek banks. • The final option is to promise to make the budget cuts, get some form of guarantee on their bonds, and borrow enough to make it another year - but not actually cut as much as promised; just make some cuts and then promise more next year if you will just bail us out some more. That just kicks the problem down the road for another year or two, until European voters (mostly German) get tired of taking on Greek debt. The market is not going to let Greece continue to borrow without showing some serious efforts at cutting their deficit, and probably not even then
without some external guarantees. The history of Greek debt is not a good one. They have been in default 105 years out of the last 200. There are some optimists, however. Good friend and fishing buddy David Kotok thinks that this will all turn out OK. Writing this week, he said, "Taxes will rise. Public sector employment benefits and compensation will be pressured to compress, and the workers will resist but eventually compromise. By the way, that will also happen at the federal level in the United States and with the 50 sovereign state debtors that make up our country. Think of us as a US dollar zone, just as we think of them as a euro zone. They are new at it. We have had a century of practice and need only another few hundred years to get it right." My objection to that is, US states generally have a mandate to balance their budgets, so that the "debt-to-GDP" of a state is comparatively rather small. And a US citizen is ten times more likely to move from one state to another to find a job than a European will move to another country. As one person I read commented about unemployed Spanish workers in Madrid, "They won't even move to Barcelona!" It's More than Just Greece: The lesson here is that this is not just a Greek problem. Debt and out of control deficits are a problem all over the developed world.The Greeks are just the first. As Niall Ferguson wrote this week in the Financial Times, the contagion is headed to US shores unless we get our budget house in order. You cannot spend your way out of a fiscal crisis. The current path is simply unsustainable. At some point, we can become Greece. Yes, we have the advantage of having our debt denominated in dollars, but that is only an advantage up to a certain point. We are in the fullness of time approaching the End Game. In country after country, the choices that have been made over the last decades will yield a Greek situation, where there are no good choices. And the longer the hard choices are put off, the more difficult they will become. For some countries it could mean deflation. For others, it will look like inflation on steroids. Countries with sensible budgets and policies will thrive. For most of the last two decades, investors have ignored country risk in the developed world.That is no longer a safe option. John@FrontLineThoughts.com Copyright 2009 John Mauldin. All Rights Reserved John Mauldin, Best-Selling author and recognized financial expert, is also editor of the free Thoughts From the Frontline that goes to over 1 million readers each week. For more information on John or his FREE weekly economic letter go to: http://www.frontlinethoughts.com/learnmore
The Wise Investor March 2010
Economic Crisis Effects
Life in the time of Great Recession
The title is not original. It is a take off from Love in the Time of Cholera by Gabriel Garcia Marquez, Nobel Prize winning author from Columbia, who was also recently selected as the most influential writer of the past 25 years for this book. Pardon that indulgence on our part, but we felt this best captures what you are about to read. Even as equity markets led by Wall Street have charted a major bear-market rally on the back of liquidity since March 2009, the ground reality on Main Street is different. Read this ninth part of how the Great Recession is touching lives in many-a-different way.
Use of Temps No Longer Signals Permanent Hiring: It's not the signal it used to be. When employers hire temporary staff after a recession, it's long been seen as a sign they'll soon hire permanent workers. Not these days. Companies have hired more temps for four straight months. Yet they remain reluctant to make permanent hires because of doubts about the recovery's durability. Even companies that are boosting production seem inclined to get by with their existing workers, plus temporary staff if necessary. "I think temporary hiring is less useful a signal than it used to be," says John Silvia, chief economist at Wells Fargo. "Companies aren't testing the waters by turning to temporary firms.They just want part-time workers." More Generations Living Under Same Roof: The trend will deepen as families grappling with near double-digit unemployment share expenses, a study showed. Demand is escalating for multi-generational housing as buyers scale down during the deepest housing crisis since the Great Depression, according to a survey by Coldwell Banker Real Estate in Parsippany, New Jersey. Thirty-seven percent of the company's real estate agents polled in January said that in the past year, buyers were increasingly shopping for homes that fit more than one generation. Almost 70 percent of the agents said they expect economic conditions will drive still greater demand for this type of housing over the next year. "More buyers are pooling investments, considering bringing mom and dad into it," said Diann Patton, a Coldwell Banker real estate consumer specialist based in Grass Valley, California. Buyers were primarily driven by financial concerns when deciding to combine generations in a household, the survey found. Health concerns were the second most common reason and strong family bonds a distant third. This shift in homeownership comes as
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unemployment hovers just under 10 percent and many consumers are being dealt wage cuts. College graduates unable to get jobs are often returning to their parents' homes. Newer inmates & strained shelters, an alarming trend: Homelessness in rural and suburban America is straining shelters this winter as the economy founders and joblessness hovers near double digits — a "perfect storm of foreclosures, unemployment and a shortage of affordable housing," in one official's eyes. "We are seeing many families that never before sought government help," said Greg Blass, commissioner of Social Services in Suffolk County on eastern Long Island. "We see a spiral in food stamps, heating assistance applications; Medicaid is skyrocketing," Blass added. "It is truly reaching a stage of being alarming." The federal government is again counting the nation's homeless and, by many accounts, the suburban numbers continue to rise, especially for families, women, children, Latinos and men seeking help for the first time. Some have to be turned away. "Yes, there has definitely been an increased number of turnaways this year," said Jennifer Hill, executive director of the Alliance to End Homelessness in suburban Cook County, Illinois. Dumped! Brand names: Brand names are fighting to stay in stores. Don't be shocked if you can't find your favorite salad dressing or mouthwash on your next trip to Wal-Mart. Large retailers -- including Wal-Mart, world's biggest -- are wrestling with having too many types of brand-name products. At the same time, shoppers are buying less and looking for bargains. So unless a particular brand is a top seller in its category, it's getting knocked off the shelf -and sometimes getting replaced by a cheaper store brand. Bill Pecoriello, CEO of market research firm ConsumerEdge Research, expects Wal-Mart
and other sellers will trim several name-brands across categories in coming months, or negotiate deals to get better pricing. According to Pecoriello, those categories at greatest risk of losing brands are everyday-type purchases such as household products, toiletries and food staples. These are also categories in which retailers have aggressively pushed their own house brands. "If you consider the economics of this, if WalMart can build customer loyalty for its own brand, which is also cheaper-priced and cheaper to stock than name-brands, then it will," he said. Moves such as this are significant given Wal-Mart's heavyweight status in the retail industry. "Any change that Wal-Mart makes with its product assortment has enormous implications for the entire industry," said Ali Dibadj, senior analyst with Sanford C. Bernstein & Co. In good economic times, product variety is a must for retailers. But in down times, when shoppers aren't buying much, variety can be a burden. As a consumer, she asked, "Do I really need to decide between 15 different types of toothpaste when I go to a store?" Elderly placed under stress, as dentures, diapers are out: Poor people eligible for free Medicaid health care no longer would receive eyeglasses, dentures, hearing aids or as many adult diapers under the $109 million in social service spending reductions proposed by Gov. Jim Gibbons in Nevada. `We are down to the ugly list of options of where we can cut," Department of Health and Human Services Director Mike Willden told members of the Legislature's Interim Finance Committee. The state would save $829,304 by reducing the number of adult diapers that incontinent disabled and elderly people would receive.The reduction was mentioned repeatedly as the most horrendous example of a budget cut. Eligible people now receive 300 diapers per month; that would be cut to 186, which,
The Wise Investor March 2010
Economic Crisis Effects
according to the Health and Human Services agency, is in line with national standards. But Washoe Legal Services lobbyist Jon Sasser predicted that elderly people will be spending hours per day "with poop in their diapers." "It is abhorrent to be discussing this," Buckley said. "Are we really going to tell the elderly we are cutting them off dentures and hearing aids and diapers? I don't know how we can look the elderly in the eye." Rash of Retirements Pushes Social Security to Brink: Social Security's annual surplus nearly evaporated in 2009 for the first time in 25 years as the recession led hundreds of thousands of workers to retire or claim disability. The impact of the recession is likely to hit the giant retirement system even harder this year and next.The Congressional Budget Office had projected it would operate in the red in 2010 and 2011, but a deeper economic slump could make those losses larger than anticipated. "Things are a little bit worse than had been expected," says Stephen Goss, chief actuary for the Social Security Administration. "Clearly, we're going to be negative for a year or two." Social Security took in only $3 billion more in taxes last year than it paid out in benefits — a $60 billion decline from 2008, according to federal data. The slide in revenue occurred sooner than Social Security actuaries had expected, for three reasons: Hard Times Push More Women to Strip Clubs: She’s stunning, even in sweats. But Leilani Burkhead’s got her work cut out for her. It’s 9 p.m. on a weeknight, time to hit the stage at Atlanta’s Magic City strip club. She slips out of her sweats and half-jokingly mumbles something about getting geared up to work the room. It’s an about-face from a few years ago when money rained down on dancers at this and other Atlanta adultentertainment clubs like free-flowing Dom Perignon. Like the rest of the economy, adult dance clubs feel the pinch.The sluggish economy and closer police scrutiny have put about a dozen out of business in the past decade. And the regular patrons aren’t so regular anymore. But that hasn’t slowed the would-be dancers lining up to apply for the $350 permit to work in the city’s 19 clubs, Atlanta police say. Among the usual aspiring actresses and dancers, there are more college students, single mothers trailing toddlers, health and office professionals and even a few age-defying grandmothers — all looking for well-paid work in a city with unemployment above 10 percent. While there are no hard numbers, Atlanta police say they’ve seen a spike in applications for adult-entertainment permits in the past year or so due to the recession and the recent
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change in Georgia law that allows nude dancers to be as young as 18. Plight of Long-Term Unemployed: They still wait for recovery to arrive. Curtis McKenzie keeps hearing that the economy is getting better, most recently with news that unemployment fell to 9.7% in January. But he's still waiting for the recovery to reach his doorstep in Tulsa. McKenzie, 40, has been out of work since he was laid off from a $60,000-a-year job at a small technology company last March. "The only jobs I have been offered won't even allow me to cover bills," he says. "You build a lifestyle around the job you think you're going to have forever." McKenzie, his wife and two boys don't go out much anymore.They think twice about visiting friends to watch football, which would mean spending money on gasoline, beer and snacks. Millions of Americans are sharing McKenzie's pain: In January, a record 6.3 million people — 41.2% of the unemployed — had gone without jobs at least 27 weeks. The average unemployed American has been jobless more than 30 weeks, another grim record. "It's a deep recession," says Kevin Hassett, director of economic policy studies at the conservative American Enterprise Institute. "Everything's been unusually bad." The Economic Policy Institute figures there are 6.4 jobless people for every job opening. "It's a cruel game of musical chairs," says Lawrence Mishel, president of the liberal think tank. Man-cession is recession effect on both sexes: Both sexes are worse off than they were before the downturn, but men have suffered more. For the first time in recorded history, women outnumber men on the nation’s payrolls. This benchmark is bittersweet, as it comes largely at men’s expense. Because men have been losing their jobs faster than women, the downturn has at times been referred to as a “man-cession.” Women’s new majority in the nation’s workplaces comes decades after women first began trading in their aprons for pantsuits in droves, and it reinforces expectations that women will continue on the path to pay parity. “Important milestones remain to be achieved, but women’s surpassing 50 percent of employment is something that historians will note for years to come,” said Casey B. Mulligan, an economics professor at the University of Chicago who has been tracking the recession’s effects on both sexes. It was the recession that finally pushed women into the majority. As in previous recessions, male workers have borne the brunt of the job losses in the last two years. Since the recession began in December 2007, men have lost 7.4 million jobs on net, whereas women have lost
3.9 million jobs. The types of jobs held by men and women help explain the shift. Men are more likely to work in industries like manufacturing, which rise and fall with the economic cycle. Women are more likely to work in government, health care and education, among the safest categories in a downturn. Health care employment has been among the strongest of any type during the recession. The Human Recession: Unable to find jobs, kicked off welfare, women in Connecticut are forced to sell food assistance to buy basic necessities. Since she was 16, Eva Hernández has worked a string of low-wage jobs. She’s prepared chicken at KFC, run the register at Dunkin Donuts, packed and sealed boxes at a produce company, and held other similar jobs in Hartford, Connecticut, where she was born and raised. In March 2009, in the midst of the worst job crisis in at least a generation, Eva opened the last welfare check she will ever receive. She is one of a growing number of people in the United States who can’t find work in this recession but don’t qualify for government cash assistance, no matter how poor they are or how bad the economy gets. Without the help of welfare, Eva doesn’t have enough money left at the end of each month to feed her daughters full meals. It is the first time in her life, she said, that she hasn’t had enough money for food. Now, with no other source of income, Eva breaks the law, selling her food stamps to pay for the rent, phone bill, detergent and tampons. On the first day of each month, when her food stamps arrive, she walks to the convenience store up the street, buys food for her family with her food stamp card and uses it to pay off the debt she accumulated the previous month after she ran out of money. She then trades in the remaining balance for cash. About 6 million people receiving food stamps report they have no other income. Recession permeates kids at kitchen tables: Kids are being told about the Great Recession. Seven out of ten parents with children between the ages of 6 and 16 said their kids know we’ve been in a recession, according to a just released survey by American Express. “This number suggests that talks about the current economic environment are happening at kitchen tables across the country,” said a news release about the poll’s results. Hmmm. Seems like more proof to me that those highly paid Wall Street "experts," who are allegedly "in the know," don't know jack. Source: Reuters, Associated Press, CNN Money, USA Today, New York Times, Alternet, Mish Global Economic Analysis and Financial Armageddon.
The Wise Investor March 2010
BNP Paribas EcoWeek
Quick takes from across the world
Germany: Facing the crisis • Employment has been relatively unscathed given the reduction in GDP. However, slower growth has affected the labour market through a cut in the number of hours worked. • Lending conditions improved in the fourth quarter of 2009, but the worsening financial health of companies will hold back the recovery in investment. • The financial and economic crisis has dented the potential growth rate of the German economy. This is now around 0.75% per year between 2009 and 2011. South Korea: Banking withstood the crisis • In late 2008-early 2009, South Korean banks proved extremely vulnerable to the global liquidity credit crunch while the deep economic contraction at home let fear a major deterioration in their asset quality. • One year later, banks operate in a much better environment thanks to South Korea’s strong growth rebound and significant improvement in its external liquidity position. • The authorities have been very active in implementing a series of fined-tuned support measures, which have helped attenuate the impact of the global shock on the domestic economy and the banking system. • As a result, banks’ performance did not weaken in 2009 as much as initially feared. • Their solvency remained sound, local- and foreign-currency liquidity rapidly returned to adequate levels and asset quality deterioration was not overly severe. • The banking system still faces high credit risks stemming from persisting vulnerabilities in the SME and household sectors. However, overall, it seems on a good track to report an improving performance in the medium term. Greece: Explicit EU support • Europe has sent a clear message to the financial markets: everything will be done to preserve the financial stability of the euro zone. • Under current circumstances, that has legitimately been interpreted as amounting to explicit support for Greece, which has also been placed under strict surveillance. • The technical details of a possible support plan will be provided at a Eurogroup meeting at the beginning of next week. • The current crisis surrounding the debt of a number of euro zone countries has revealed once again the zone’s structural problems. These
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require economic reforms of course, but they also probably require institutional reforms. CEEC: Public finance under pressure • Due to the crisis, the situation of public finances in Central & Eastern European Countries (CEECs) has worsened in 2009. • The restoration of fiscal balances could be hampered by the lack of political visibility in the zone in 2010 and, on the longer term, by the problem of demographic ageing. • The situation of public finances is particularly tense in Hungary, with a level of public debt close to 80% of GDP and pressure on sovereign spreads. US: Public finances, a transatlantic concern • The release of the draft 2011 budget once again highlighted the drastic impact of the recession and of the measures adopted by Congress on public finances. The Obama administration projects a further increase in the federal government deficit in 2010, up to 10.5% of GDP. • Throughout the decade, the deficit-to-GDP ratio is expected to exceed 3.5%, a far higher level than recorded in the past and too high to prevent an increase in the federal government’s debt. In the years and decades ahead, in the absence of major reforms, the rapid increase in the cost of public healthcare and retirement programmes could prevent any clean up of public finances. • In a context of markedly deteriorating public finances, the main risk generally taken into consideration is the possibility of higher interest rates.Yet the rapid rise in debt and the associated risks must be kept in perspective, at least in the short term. • First, America’s current debt load is not exceptionally high compared to the debt of other developed countries. Moreover, the ease with which the US government has so far managed to finance its needs is reassuring. • Although it is surely too early to tighten budget policy, the government could nonetheless indicate the mechanisms it plans to use in the years ahead (debt targets, corrective measures) to reduce the uncertainty shrouding its fiscal plans and to reassure Indonesia: Another large emerging market • Like China and India in Asia, Indonesia avoided recession in 2009. Its GDP grew a sustained 4.5% after 6.1% in 2008 and should expand by 5.5% this year. • The 2008 global financial crisis left Indonesia’s rather sound economic fundamentals (public
finances, balance of payments, and banking system) largely unscathed. • Private consumption is the main growth engine, supported last year by accommodative economic policies, and contained inflation. • The country did not suffer from a significant rise in unemployment. • Rising standards of living, demography and urbanisation are accelerating the development of the large domestic market. However, to lift potential growth further, Indonesia needs to raise investment spending. • But the business climate remains poor, with deeprooted corruption and inefficient legal framework, though things are changing slowly in the wake of reforms lunched in 2004. ECB: No major changes • The ECB is likely to confirm its analysis of the state of the economy. • Inflationary pressures are very mild and are likely to remain low in both 2010 and 2011. Available survey data confirm the ongoing economic recovery, but there are incipient signs that growth is peaking.Activity could ease throughout the year. • Against this backdrop, the ECB will probably leave the refi rate unchanged, at least until the end of 2010. • Liquidity in the money market will remain well above needs at least until the end of June. If liquidity demand is still strong at the next 6month LTRO to be conducted in March, then excess liquidity is likely to persist through the end of the third quarter. Greece: Banks under threat of sovereign risk • Recent economic and financial developments suggest that the Greek banking system could have tough times ahead over the next few quarters, with slight decrease in outstanding loans, escalating cost of risk and a higher risk of refinancing, among other factor. • Greece's commercial banks seem, however, to be sufficiently robust to avoid losses and make it through this critical period, with solid solvency and liquidity ratios, low private debt, no property market bubble and strong potential for growth. • Greek banks are therefore likely to see a decline in earnings over the next few quarters, mainly due to an increase in the cost of risk. Notwithstanding any exceptional events, their solvency and longterm profitability do not seem to be in threat. Source: BNP Paribas EcoWeek, a publication of the BNP Paribas group www.bnpparibas.com
The Wise Investor March 2010
A five–step guide to contagion
Todd Harrison CEO Minyanville Why European debt matters to the United States Times are tough and those struggling to make ends meet have focused their efforts close to home. That's a natural instinct but it doesn't change the fact that problems on the other side of the world affect us all.To fully understand the depth and complexity of our current conundrum, we must appreciate how we got here. It is widely accepted that grieving arrives in five stages: denial, anger, bargaining, sadness, and acceptance. If we apply that psychological continuum to the financial market construct, it offers a valuable lens with which to view this evolving crisis. Denial: In April 2007, policymakers assured an unsuspecting public that housing and subprime mortgage concerns were "well contained." Minyanville took the other side of that trade and argued that the nascent contagion extended all the way around the world. (Read more in Well Contained?) In August 2007, as the Dow Jones Industrial Average traded near an all-time high, Canadian officials told investors it would "provide liquidity to support the stability of the Canadian financial system and the continued functioning of the financial markets" before systemic contagion ensued. (See also The Credit Card) In March 2008, Alan Schwartz, CEO of Bear Stearns appeared on CNBC to assuage concerns that his firm was facing a liquidity crisis. "Some people could speculate that Bear Stearns might have some problems since we're a significant player in the mortgage business," he said, "None of those speculations are true." On January 28 of this year, Greek Prime Minister George Papandreou offered that Greece was being victimized by rumors in the financial markets and denied seeking aid from European partners to finance the country's budget deficit, according to Bloomberg. As we know, European issues are
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now staking claim as the next phase of the financial crisis. Anger: Two of my Ten Themes for 2010 are relevant to this discussion. The first is the "tricky trifecta," or the migration from societal acrimony to social unrest to geopolitical conflict. Populist uprising, the rejection of wealth, and an emerging class war are symptomatic of this dynamic, as is the unfortunate fact economic hardship traditionally serves as a precursor to war. The other theme is the notion of "European Disunion," as I wrote in early January: The European Union is committed to the regional and economic integration of 27 member states, with sixteen countries sharing a common currency. That was a fine idea when it was first founded but the economic fallout of the financial crisis will put loyalties to the test. Look for the Union to adopt more stringent guidelines in the coming year, including but not limited to distancing itself from the weaker links such as Greece and Ireland. Sovereign defaults, as a whole, should jockey for mind-share.This could conceivably spark a rally in the US Dollar, which could have ominous implications for the crowded carry trade. European discontent continues to simmer with labor strikes and social strife as efforts are made to map an amenable plan before €20 billion ($28 billion) in Greek debt comes due in April and May.While that amount is far smaller than what financial firms faced in September 2008, the dynamic is eerily reminiscent. (Read also Pirate's Booty) Bargaining: By the time it was evident subprime mortgage woes weren't contained, the damage already occurred. Our government reactively responded to the crisis by consuming the cancer in an attempt to stave off a car crash. (See also Shock & Awe) As the European Union and International Monetary Fund wrestle with how to address the sovereign mess, our financial fate can be drilled down to one very simple question: Will we see contagion, as we did with Fannie Mae, Freddie Mac, AIG, Bear Stearns and
Lehman Brothers, or will the current congestion be contained in the context of an evolving globalization? The bulls will offer that corrections must feel sinister if they're to be truly effective.They're right, of course, but I will remind you of a salient point made by Professor Peter Atwater on Minyanville. If sovereign lifeguards saved corporations when the financial crisis first hit, who is left to save the lifeguards? Over the last few weeks, we've seen significant widening in overseas credit spreads, including Hong Kong, Switzerland, Indonesia, Malaysia, Portugal, and New Zealand. As markets are fluid and policy takes time, the lag must be factored into the fragile equation, particularly as the European Union is structurally interlinked. Sadness: We can talk about how the capital market construct forever changed, how our constitutional rights have been challenged or how the lifestyles of the rich conflict with the struggle to exist. While those dynamics remain in play, they miss an entirely more relevant point for purposes of this discussion. (See The Declaration of Interdependence) Social mood and risk appetites shape financial markets. One of the greatest misperceptions of all time was that The Crash caused The Great Depression when The Great Depression actually caused The Crash. It's been a full year since Minyanville fingered Eastern Europe as a modern day incarnation of a sub-prime borrower. The question is therefore begged, what if Greece is Fannie Mae, Portugal is Freddie Mac, Spain is AIG, Argentina is Wachovia Bank, and Ireland is Lehman Brothers? (Also read Eastern Europe, Subprime Borrower) Contagion, by definition, arrives in phases and we must remember that Greece is a symptom of the problem, not the problem itself. Regardless of what IMF or Euro Zone "cross border solution" we see, it'll simply buy time, much like the bearded nationalization of Fannie and Freddie pushed risk out on the time continuum.
The Wise Investor March 2010
Given the trending direction of social mood and the discounting mechanism that is the market, the perception that defines our financial reality must remain front and center in the mainstream mindset. Acceptance: In September 2008, we offered that the government invented fingers to plug the multitude of holes that sprang open in the financial dike.That imagery would again apply if there were viable fingers attached to a healthy and able arm. While many dismiss the notion that Greece or Portugal "matter" in the global financial construct, I'll explain why they might. Concerns in the Euro zone could manifest through a "flight to quality" in the US Dollar, as it has to the tune of 8% in the dollar index (DXY) since the December low. Those hoping for a stronger greenback should be careful for what they wish, much like the "lower crude will be equity positive" crowd learned in 2008. In an "asset class deflation vs. dollar devaluation" environment, a weak currency is a necessary precursor to -- but no guarantor of -- higher asset class prices. (See Hyperinflation vs. Deflation) The hedge fund community currently has the carry trade on in size. If the greenback continues to strengthen, the specter of an unwind increases in kind. Should that occur, asset class positions financed with borrowed dollars would come for sale across the board. The point of recognition will eventually arrive that our debt issues are cumulative; when that happens, the contagion will no longer be contained. In the meantime, as we edge from here to there, be on the lookout for the unintended consequences of European austerity initiatives, including but not limited to social unrest and the abatement of risk appetites. Takeover is: risk management over reward chasing as we together find our way. Author Background: Todd Harrison is the founder and CEO of Minyanville (www.minyanville.com), a community of analysts and traders. Minyanville offers running commentary by dozens of analysts on what's happening in the markets real time. There is something for everyone, even a place to help teach your kids about money and finance. (Edited version of description by John Mauldin in his Outside The Box newsletter). Source: John Mauldin’s Outside The Box JohnMauldin@InvestorsInsight.com
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Eleven lessons from Iceland
Thorvaldur Gylfason What can be done to reduce the likelihood of a repeat performance – in Iceland and elsewhere? Here are eleven main lessons from the Iceland story, lessons that are likely to be relevant in other, less extreme cases as well. # 1 We need effective legal protection against predatory lending just as we have long had laws against quack doctors. The problem is asymmetric information. Doctors and bankers typically know more about complicated medical procedures and complex financial instruments than their patients and clients. # 2 We should not allow rating agencies to be paid by the banks they have been set up to assess. The present arrangement creates an obvious and fundamental conflict of interest and needs to be revised. Likewise, banks should not be allowed to hire employees of regulatory agencies, thereby signalling that by looking the other way, remaining regulators may also expect to receive lucrative job offers from banks. # 3 We need more effective regulation of banks and other financial institutions; presently, this is work in progress in Europe and the US. # 4 We need to read the warning signals. We need to know how to count the cranes to appreciate the danger of a construction and real estate bubble (Aliber’s rule). We need to make sure that we do not allow gross foreign reserves held by the central bank to fall below the short-term foreign liabilities of the banking system (the GiudottiGreenspan rule). We need to be on guard against the scourge of persistent overvaluation sustained by capital inflows because, sooner or later, an overvalued currency will fall. Also, income distribution matters. A rapid increase in inequality – as in Iceland 1993-2007 and in the US in the 1920s as well as more recently – should alert financial regulators to danger ahead. # 5 We should not allow commercial banks to outgrow the government and central bank’s ability to stand behind them as lender – or borrower – of last resort. # 6 Central banks should not accept rapid credit growth subject to keeping inflation low – as did the Federal Reserve under Alan Greenspan and the Central Bank of Iceland.They must distinguish between “good” (wellbased, sustainable) growth and “bad” (asset-bubble-plus-debt-financed) growth. # 7 Commercial banks should not be authorised to operate branches abroad rather than subsidiaries if this entails the exposure of domestic deposit insurance schemes to foreign obligations. This is what happened in Iceland. Without warning, Iceland’s taxpayers suddenly found themselves held responsible for the moneys kept in the IceSave accounts of Landsbanki by 400,000 British and Dutch depositors. # 8 We need strong firewalls separating politics from banking because politics and banking are not a good mix.This is why their belated privatisation was necessary. Corrupt privatisation does not condemn privatisation, it condemns corruption. # 9 When things go wrong, there is a need to hold those responsible accountable by law, or at least try to uncover the truth and thus foster reconciliation and rebuild trust.There is a case for viewing finance the same way as civil aviation: there needs to be a credible mechanism in place to secure full disclosure after every crash. If history is not correctly recorded without prevarication, it is likely to repeat itself. # 10 When banks collapse and assets are wiped out, the government has a responsibility to protect jobs and incomes, sometimes by a massive monetary or fiscal stimulus. # 11 Let us not throw out the baby with the bathwater. But private banks clearly need proper regulation because of their ability to inflict severe damage on innocent bystanders.
Author Background: Thorvaldur Gylfason is Professor of Economics at the University of Iceland and Research Fellow at CEPR (Centre for Economic Policy Research) in London and CESifo (Center for Economic Studies) at the University of Munich Hyperlink to this article: http://www.voxeu.org/index.php?q=node/4612 Source: www.voxeu.com (VoxEU.org is a policy portal set up by the Centre for Economic Policy Research (www.CEPR.org) in conjunction with a consortium of national sites)
22 The Wise Investor March 2010
Why should I pay back?
Conversation With My 14 Year Old Son: I do not have a son, nor daughters. However, I did receive an email from "Clyde" who does: Clyde Writes ...Good day Mish. I had an interesting moment with my 14 year old son the other day. I had gone to the US Debt Clock website and was taking a minute to just watch the numbers roll up and down in the various amounts. The site breaks down the debt into a per person amounts. It is quite depressing. My 14 year old son walked by and I had him take a look at it all, explaining that someday my son, all this will be yours. His first words were "Why the hell should I have to pay that back?" I found that comment interesting in that he does have a point. It's not like the money that has been borrowed in the past has been used to create world class infrastructure or world class anything. The vast majority of all the money borrowed by the government decade after decade has been just thrown down every conceivable rat-hole. Imagine if his entire generation comes to the same conclusion someday. Best, Clyde Hello Clyde: You have a very bright son. His generation should not have to pay that debt back. Indeed, his generation cannot possibly pay that debt back even if they wanted to. Given enough time, his generation will be in charge and decide enough is enough and default on that debt. I expect a crisis long before that.The result will be anything but inflation. What cannot be paid back won't be paid back. What obligations cannot be paid won't be paid. That process is deflation, not inflation. Changing attitudes are proof enough. We are in the grips of deflation now, led by pension promises that simply will not be met while millions look for jobs that do not exist. Blog: Mish Global Economic Analysis http://bit.ly/ca5l98 10 Reasons to Fade the Recovery: This is NOT a business cycle: this is a one-time reversal of twenty years of inflation of the household balance sheet. An aging population needs a 10% savings rate (at least) to meet minimum funding requirements for the biggest retirement wave in US history (comparable to Japan’s retirement wave during the “lost decade” of the 1990s).With 17% effective unemployment, many Americans are dis-saving, after a $6 trillion shock to home equity. 10) There is no recovery at all in Europe.
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European growth ground to a halt during the fourth quarter and German business confidence unexpectedly fell in February. 9) China won’t collapse, but government efforts to stop overheating by raising reserve requirements make clear that the world’s second-largest economy can’t be the locomotive for world growth. 8) Greece and its prospective rescuers in the European Community are at loggerheads over conditions for EC help. 7) State fiscal crises continue to worsen. On top of this year’s $200 billion deficit, states face a trillion-dollar shortfall in pension funds. 6) Commercial real estate is nowhere near bottom, with some sectors (example: hotels) at delinquency rates of nearly 10%. 5) Regional banks continue to drop like flies, with 702 banks holding assets of $403 billion on the danger list. 4) Bank credit continues to shrink. Total bank credit is still falling at a 5% annual rate, an unprecedented decline: 3) What bank credit is available is funding the US Treasury deficit in the mother of all crowding-out, replacing commercial loans on banks’ balance sheets: 2) Industrial production has bounced of the bottom, but manufacturing is only 15% of US employment. 1) Employment won’t come back. Today’s consumer confidence number is one more nail in the coffin of exaggerated hopes for a cyclical recovery. Blog: Inner Workings http://bit.ly/d6WQUV A Question of Cultural Failure: I’ve said this before in different ways, but I will say it once more, “Governments are smaller than markets; markets are smaller than cultures.” The reasoning is simple: • Governments can only control a fraction of what an economy or culture does. Governments that are overbearing on an economy or culture may gain greater proportional control, but the size of the pie will shrink. More of the economy or culture goes into hiding, away from the prying eyes of the government. • Markets only express a fraction of what mankind does. They cover the tradeable aspects of what we do, but typically do not give us our deeper goals or desires for ourselves, and the culture as a whole. When I look at the biggest economic problems facing the world today, many of them stem from deeper cultural problems.
* Greece got into the Eurozone via subterfuge; they lied about the true status of their indebtedness, and Wall Street (with its counterparts in European investment banking) helped them do it. So did a number of the other nations in the EU that are presently under stress. Now, the core members of the Eurozone wanted the Euro to grow as a currency-they were committed to an ever-wider and -deeper union. The dream of a united Europe made them willfully blind to the low probability that the nations which were fiscal basket cases had genuinely changed. The core should have been skeptical, and now they are paying the price, though not paying any money, yet. The core nations that could pay or guarantee to help Greece are playing a tight game. They act as an internal European IMF, insisting on reductions in the Greek budget deficit. Greece does its part by saying it hasn’t asked for aid, which is unlikely. At the same time, reductions in the Greek budget deficit bring the competing political factions inside Greece out in force. Protests! Strikes! There are few arguing for what is best for Greece overall, and many arguing for a larger piece of what is a shrinking pie. In a situation like this, it might be better for outsiders to let Greece fail, but they won’t do that. Why? The banks in the core nations can’t afford a default by Greece if by contagion it leads to defaults in Portugal, Spain, Italy, and Ireland. A failure of the banking system does not conduce well to maintaining power for elites. • Dubai is a place where anything can get done. Anything indeed, but who pays the bills? Dubai is a place of big ideas and little responsibility. It is a moral flaw to bite off more than you can chew, particularly if you do so on behalf of others. • Many US States and Municipalities are in a world of hurt, because they compromised their long-term financial position to solve short-run budget crises. That is the nature of the crises that we face today. • The same is true of the current US government — they fight for short term political advantage, rather than the long term good of the nation. Who will favor the longterm and sacrifice for the greater good? A simple summary statement here is “Greed is not good.” Societies that are willing to sacrifice self interests have a much better probability of succeeding than societies that pursue self interest. Blog:The Aleph Blog http://bit.ly/by8ThS
The Wise Investor March 2010
The Book of Choice
This Time Is Different
triggered by a credit crisis. If you wish to understand the implications of a recession triggered by a credit crisis, the first port of call should be `This Time is Different: Eight Centuries of Financial Folly’ by Carmen M Reinhart & Kenneth Rogoff. Based on extensive research of credit crisis across the world and across time, the authors offer the detailed view of the consequences. Deep in analysis, rich in charts and insightful in commentary, This Time Is Different is a musthave reference for all time and a must read now. In the panel on the right, we present edited excepts from Growth In A Time of Debt, a draft paper published by the authors of the book in January 2010, which takes forward their thought process. Here we present, select extracts from the book: • Perhaps more than anything else, failure to recognize the precariousness and fickleness of confidenceespecially in cases in which large short-term debts need to be rolled over continuously-is the key factor that gives rise to the this-time-is-different syndrome. • Highly indebted governments, banks, or corporations can seem to be merrily rolling along for an extended period, when bang!-confidence collapses, lenders disappear, and a crisis hits. • What one does see, again and again, in the history of financial crises is that when an accident is waiting to happen, it eventually does. • When the international agency charged with being the global watchdog (IMF) declares that there are no risks, there is no surer sign that this time is different. • When debt-fueled asset price explosions seem too good to be true, they probably are. But the exact timing can be very difficult to guess, and a crisis that seems imminent can sometimes take years to ignite. • Outsized financial market returns were in fact greatly exaggerated by capital inflows, just as would be the case in emerging markets. • Capital inflows pushed up borrowing and asset prices while reducing spreads on all sorts of risky assets • What could in retrospect be recognized as huge regulatory mistakes, including the deregulation of the sub prime mortgage market and the 2004 decision of the Securities and Exchange Commission to allow investment banks to triple their leverage ratios (that is, the ratio measuring the amount of risk to capital), appeared benign at the time. • The outsized U.S. borrowing from abroad that occurred prior to the crisis (manifested in a sequence of gaping current account and trade balance deficits) was hardly the only warning signal. In fact, the U.S. economy, at the epicentre of the crisis, showed many other signs of being on the brink of a deep financial crisis. • Measures such as asset price inflation, most notably in the real estate sector, rising household leverage, and the slowing output - standard leading indicators of financial crises - all revealed worrisome symptoms. • Indeed, from a purely quantitative perspective, the runup to the U.S. financial crisis showed all the signs of an accident waiting to happen. • The United States was hardly alone in showing classic warning signs of a financial crisis, with Great Britain, Spain, and Ireland, among other countries, experiencing many of the same symptoms. • The most significant hurdle in establishing an effective and credible early warning system, however, is not the design of a systematic framework that is capable of producing relatively reliable signals of distress from the various indicators in a timely manner. • The greatest barrier to success is the well-entrenched tendency of policy makers and market participants to treat the signals as irrelevant archaic residuals of an outdated framework, assuming that old rules of valuation no longer apply. • If the past we have studied in this book is any guide, these signals will be dismissed more often that not. • Policy makers must recognize that banking crises tend to be protracted affairs. Some crisis episodes (such as those of Japan in 1992 and Spain in 1977) were stretched out even longer by the authorities by a lengthy period of denial. Book: This Time is Different: Eight Centuries of Financial Folly by Carmen M Reinhart & Kenneth Rogoff; Hardcover: 496 pages Publisher: Princeton University Press; ( First Edition September 11, 2009) ISBN-10: 0691142165 ISBN13: 978-0691142166 Price: latest quote is $ 20.47 at www.amazon.com (delivery charges will have to be paid) and Rs 1437 at www.flipkart.com (a discount of 15% and free delivery in India). Comment and pick of extracts by S.Vaidya Nathan
The Wise Investor March 2010
Every time there is a financial and/or economic crisis, the first tendency is look for patterns in the past. For such crisis, precedence is rich and hence the rush to seek comfort in the past. Even if you take the ongoing financial and economic crisis, realms have been written by sell-side strategists comparing it to the Post World War II recessions. Then we have the bloggers (a community in which many saw the crisis coming) comparing it to the Great Depression and rubbishing the Post World War II comparisons. There are differences between a recession that is part of the normal business cycle and a recession that is triggered by a credit crisis. The implications for the economy and markets are significantly different, based on the type of recession at hand. And what we have today is a recession
Growth In A Time of Debt The sharp run-up in public sector debt will likely prove one of the most enduring legacies of the 2007-2009 financial crises in the United States and elsewhere. We examine the experience of forty four countries spanning up to two centuries of data on central government debt, inflation and growth. Our main finding is that across both advanced countries and emerging markets, high debt/GDP levels (90 percent and above) are associated with notably lower growth outcomes. In addition, for emerging markets, there appears to be a more stringent threshold for total external debt/GDP (60 percent), that is also associated with adverse outcomes for growth. Seldom do countries simply “grow” their way out of deep debt burdens. We note that even aside from high and rising levels of public debt, many advanced countries, particularly in Europe, are presently saddled with extraordinarily high levels of total external debt, debt issued abroad by both the government and private entities. In the case Europe, the advanced country average exceeds 200 percent external debt to GDP. Although we do not have the long-dated time series needed to calculate advanced country external debt thresholds as we do for emerging markets, current high external debt burdens would also seem to be an important vulnerability to monitor. Sundaram BNP Paribas Asset Management 24
Taking note of
No, Not The India Budget
What caught the eye over the past month is the Economic Survey, and we, also, do not wish to inflict a few more words on the budget on readers. The focus on the Economic Survey is not choosing for the sake of doing so, but a recognition of a high-quality document that has been put by the Government of India led by Dr Manmohan Singh. His imprint as well as that of the New Economic Advisor is reflected through the Survey. The Economic Survey has, over the years, been perceived as a routine document that precedes the budget. There has been an improvement in depth and breadth over the years. The Economic Survey presented on February 25, 2010 was, however, a best-in-class document for content, quality of information, quality of presentation, the level of detail on economic matters, the depth in outlining the direction of policy, rich in telling charts and as usual, a deep statistical information. The degree to which, inclusion, has become an integral part of the economic agenda is evident from the fact that the Chapter on Microfoundations of Inclusive Growth was accorded the pride of place in the document as Chapter 2 after a summary of the state of affairs in the first chapter. Interestingly, a priced edition of The Economic Survey is to be released by the Oxford University Press, India. This is a first and there is bound to a robust market for the book, given the rising importance of India in the calculus of global investors and economists. Even as a marketing document for India as a destination, the quality of this survey should pack a punch. The survey also is a treasure trove of information on India, even for those who are not looking for hard-nosed economic facts. You can find the survey at http://indiabudget.nic.in/es2009-10/esmain.htm. Book mark this site and also download the document for ready reference. This small part from Chapter 2 provides a clue on the underlying quality of the document. • Hard-nosed Government documents usually make no mention of the role of social norms and culture in promoting development and economic efficiency. • There is, however, now a growing body of literature that demonstrates
Sundaram BNP Paribas Asset Management 25
how certain social norms and cultural practices are vital ingredients for economic efficiency and growth. • Groups and societies that are known to be honest and trustworthy tend to do better than societies that do not have this reputation. • There have been broad cross-country studies and also laboratory experiments with the “trust game” that illustrate this. • More generally, what is being argued is that a nation’s success depends of course on its resources, human capital and economic policies, for instance fiscal and monetary policies, but also on the cultural and social norms that permeate society. • We go through life striking hundreds and thousands of minor contracts and deals. You give a person money one day and the understanding is that that person will repair your plumbing the next day or it can be the other way around (the person repairs your plumbing today and expects you to pay him the following day); you supply garments to a store and the store then pays you for it; someone gives you a hair-cut and, after that, you pay her. It is difficult to have such minor contracts enforced by a third party or some formal legal/bureaucratic machinery. • If we try to do it that way, as we have on occasion in India, the result will be a cumbersome bureaucracy that is anyway unable to deliver. • Societies that are endowed with personal integrity and trustworthiness have the natural advantage that no third party is required to enforce contracts. • For outsiders the mere knowledge that a particular society is trustworthy is reason to do more business and trade with it. And this from Chapter 5 on Financial Intermediation & Markets: The recent experience from the global financial crisis, has however, shown that, despite the variety of instruments and the sophistication of the markets, they may not remain immune to crisis, if the investors/institutions do not pay adequate attention to the fundamentals or if the pricing of risk and the ratings for these instruments are not transparent, and if the regulatory oversight is poor. An efficient and healthy financial market, should therefore avoid the shortcomings as gleaned from the experience of the global financial markets in the last couple of years.
The Wise Investor March 2010
Jeremy Grantham is the Co-Founder and Chief Investment Strategist of GMO. He has been among the most prescient in evaluation economic trends for long years now. His quarterly newsletters are always a must read. We present edited extracts from his letter titled `What A Decade’ published in late January 2010. We would recommend you make reading his quarterly letters a habit and you could do so by registering at www.gmo.com.
One minute Paul Volcker, the only financial administrator not called Brooksley Born who has shown any real backbone in the last 30 years, is so out in the cold that his toes must have frozen off, and the next – hey, Presto! – his ideas are put forward lock, stock, and barrel and Geithner and Summers are left scrambling to take some credit for the plan and pretend they hadn’t been dissing Volcker up until eight seconds ago for what they thought were his antique and unnecessary ideas that were far too harsh on our poor banking system. Wow! Well, these new ideas are all good stuff as far as I’m concerned, and entirely justified. Going into this next decade, we start with the U.S. overpriced, so do not be conned into believing that every bad decade is followed by a good one. It happened historically because when bull markets peak at only 21 times, a bad decade’s return will always make them cheap.This does not necessarily apply to a decade that started at 35 times! A decade’s poor performance can still leave you expensive (as this one has) when it starts so overpriced. My view of the economy’s future is boringly unchanged: “Seven Lean Years.” I still believe that after the initial kick of the stimulus, we will move into a multi-year headwind as we sort out our extreme imbalances.This is likely to give us below-average GDP growth over seven years and more than our share of below-average profit margins and P/E ratios; it would feel more like the bumpy, but not so disastrous 1970s than the economically lucky 1990s and early 2000s. All investors should brace for the chance that speculation will continue for longer than would have seemed remotely possible six months ago. I thought last April that the market (S&P 500) would scoot up to 1000 to 1100 on a typical relief rally. Now it seems likely to go through 1200 and possibly higher.The market, however, is worth only 850 or so; thus, any advance from here will make it once again seriously overpriced The real trap here, and a very old one at that, is to be seduced into buying equities because cash is so painful. Equity markets almost always peak when rates are low, so moving in desperation away from low rates into substantially overpriced equities always ends badly.
If the equity markets are indeed driven higher in the next six months, which, unlike my view of last summer, now looks to be at least 50/50, we will very slowly withdraw equities: eight times bitten, once shy, so to speak, for in these situations we typically beat a much too rapid retreat. The Fed’s balance sheet is unrecognizably bad, and the government debt literally looks as if we have had a replay of World War II.The consumer, meanwhile, is approximately as badly leveraged as ever, which is to say the worst in history. Given this, we would be well advised to avoid a third go around in the bubble forming and breaking business. But I realize the Fed is unwittingly willing to risk a third speculative phase, which is supremely dangerous. Let us say that by 1965 – the middle of one of the best decades in U.S history – we had perfectly adequate financial services. We’re debating the razzmatazz of the last 10 to 15 years. Finance was 3% of GDP in 1965; now it is 7.5%. This is an extra 4.5% load that the real economy carries. The financial system is overfeeding on and slowing down the real economy. It is like running with a large, heavy, and growing bloodsucker on your back. It slows you down. For 100 years the GDP Battleship grew at 3.5%. (Even the Great Depression did not change that trend.) But after 1965 the GDP growth rate ex-finance fell to 3.2% a year. After 1982 it fell to 3.1%, and after 2000 to 2.5%, with all of these measurements to the end of 2007 before the current crisis. From society’s point of view, this additional 4.5% burden works like looting or an earthquake. Both increase short-term GDP through replacement effect, but chew up capital. We have never in our lifetime seen a financial and economic bust such as the one we just had. We have never had two great asset bubbles break in the same decade. We have never wiped out so much wealth in all asset classes as we have this time: $20 trillion at its worst point, on our reckoning.We have never experienced such rapid deterioration in the government’s budget and in the balance sheet of the Fed, nor witnessed such moral hazard, with bailouts flying around like this.What hope do we really have in making accurate predictions of how the world will recover from all of this, and in what ways it will be changed? Very little
Source: www.gmo.com Sundaram BNP Paribas Asset Management 26 The Wise Investor March 2010
Broad–Based Sector Profile Emerges in Ten Years
How the sector profile of Indian markets has changed over the past 10 years (share of total market cap on the NSE) GICS Sectors Consumer Discretionary Consumer Staples Energy Financials (Banks & Financial Services) Financials (Real Estate) Health Care Industrials Information Technology Materials Telecommunication Services Utilities Dec-00 Dec-01 Dec-02 Dec-03 Dec-04 Dec-05 Dec-06 Dec-07 Dec-08 Dec-09 % % % % % % % % % % 6.6 16.7 13.9 7.7 0.4 7.0 5.5 28.0 9.2 3.0 2.1 5.3 18.4 16.9 9.1 0.1 8.3 5.5 20.6 9.2 3.4 3.0 5.3 12.7 23.4 12.2 0.1 7.0 6.4 18.0 9.6 2.5 2.9 6.8 8.1 25.6 13.6 0.1 7.0 8.2 11.1 12.1 3.1 4.5 6.6 6.2 19.4 13.8 0.1 7.0 8.0 14.9 12.0 3.9 8.1 7.8 7.0 18.0 14.1 0.2 5.3 11.9 14.5 10.4 3.9 7.0 7.4 5.7 14.1 13.2 2.0 4.5 13.3 14.5 12.2 7.2 5.8 5.9 4.0 15.1 14.8 6.0 2.9 14.8 7.5 13.3 6.8 8.9 5.2 6.6 16.5 15.6 2.6 4.3 11.0 7.2 11.6 7.9 11.4 6.9 5.1 15.3 14.6 2.4 4.0 12.3 9.7 16.1 3.6 9.9 Average % 6.4 9.1 17.8 12.9 1.4 5.7 9.7 14.6 11.6 4.6 6.4
At least a five-percentage point swing in each sector during the past 10 years indicates massive structural shifts in economy & markets GICS Sectors Consumer Discretionary Consumer Staples Energy Financials (Banks & Financial Services) Financials (Real Estate) Health Care Industrials Information Technology Materials Telecommunication Services Utilities
Data Source: Bloomberg; Analysis: In-house Sundaram BNP Paribas Asset Management 27
Dec 2009 %
10-Year High %
Distance from Change in key phases High Low Average 2004-2007 2008 2009 Percentage Points Percentage Points
6.9 5.1 15.3 14.6 2.4 4.0 12.3 9.7 16.1 3.6 9.9
6.4 9.1 17.8 12.9 1.4 5.7 9.7 14.6 11.6 4.6 6.4
7.8 18.4 25.6 15.6 6.0 8.3 14.8 28.0 16.1 7.9 11.4
5.2 4.0 13.9 7.7 0.1 2.9 5.5 7.2 9.2 2.5 2.1
2.5 14.4 11.7 8.0 5.9 5.4 9.3 20.8 6.8 5.4 9.3
-0.8 -13.3 -10.2 -1.0 -3.6 -4.3 -2.5 -18.3 0.0 -4.3 -1.5
1.7 1.1 1.5 6.9 2.3 1.0 6.8 2.5 6.8 1.1 7.8
0.5 -3.9 -2.5 1.7 1.0 -1.8 2.6 -4.9 4.5 -0.9 3.6
-0.8 -2.1 -4.3 1.0 5.9 -4.1 6.8 -7.4 1.3 2.9 0.7
-0.7 2.5 1.4 0.9 -3.3 1.4 -3.8 -0.3 -1.7 1.1 2.5
1.7 -1.4 -1.2 -1.0 -0.3 -0.4 1.3 2.5 4.5 -4.3 -1.5
Analysis: Satish Mahadevan
The Wise Investor March 2010
Performance Tracker Global
Index Year-To-Date Return S&P 500 Dow Jones Nasdaq Composite Nikkei 225 Dax FTSE 100 S&P GSCI Index Spot MSCI World MSCI Europe MSCI Asia ex-Japan Crude Gold -1.0 -1.0 -1.4 -4.0 -6.0 -1.1 -1.4 -3.0 -3.3 -5.8 -0.7 1.2 One Month Three Months Six Months One Year Three Years Five Years Rank 23 22 18 25 17 19 11 21 24 10 8 2 Rank Return Rank Return 3 4 7 14 21 5 6 12 13 18 2 1 2.9 2.6 4.2 -0.7 -0.2 3.2 6.4 1.2 -0.4 0.4 8.8 2.8 8 10 5 20 17 7 2 14 19 16 1 9 0.8 -0.2 4.4 8.4 -0.5 3.2 1.0 -1.4 2.6 -1.7 -1.6 -5.2 Rank Return Rank Return Rank Return 10 12 3 1 14 5 8 18 6 20 19 23 8.2 8.7 11.4 -3.5 2.4 9.1 14.0 4.4 4.0 8.9 11.5 17.0 15 14 10 25 24 12 7 21 22 13 9 3 50.3 46.2 62.4 33.8 45.7 39.8 53.9 50.9 41.2 79.9 70.7 18.1 19 20 15 24 21 23 17 18 22 9 12 25 -21.5 -15.8 -7.4 -42.5 -16.6 -13.2 15.4 -24.0 -32.9 2.3 26.4 66.5 20 17 8 22 23 10 4 1 Rank Return 21 19 14 -8.2 -4.1 9.1 -13.8 28.7 7.8 45.4 -3.7 -8.9 47.8 52.9 155.1
Emerging Markets (MSCI Indices)
BRIC Brazil Russia India China Korea Taiwan Singapore Honk Kong Indonesia Mexico South Africa Turkey
-5.9 -7.1 -3.0 -4.1 -6.6 -5.9 -9.9 -5.3 -2.9 -1.7 -2.3 -5.8 -7.9
19 23 11 15 22 20 25 16 10 8 9 17 24
1.7 4.4 -5.2 1.3 2.2 -1.1 -3.7 0.9 3.8 -3.7 4.2 -0.4 -9.4
12 3 24 13 11 21 23 15 6 22 4 18 25
-4.5 -5.9 0.2 -0.8 -6.2 1.9 -2.2 0.9 -0.9 3.7 -0.4 -1.1 8.0
22 24 11 15 25 7 21 9 16 4 13 17 2
14.2 20.0 23.2 14.4 6.5 7.9 9.7 6.5 7.8 15.0 11.8 5.2 3.4
6 2 1 5 18 16 11 19 17 4 8 20 23
92.6 102.7 121.9 119.3 67.0 104.3 68.7 71.8 57.6 159.9 97.6 77.3 93.7
8 5 2 3 14 4 13 11 16 1 6 10 7
16.3 56.1 -33.7 22.9 23.5 -7.5 -13.8 -12.9 -2.1 51.0 -7.0 -1.0 8.4
7 2 24 6 5 15 18 16 12 3 13 11 9
116.6 181.7 40.3 129.9 128.4 34.8 -0.2 31.4 29.7 148.8 71.3 42.0 50.7
6 1 13 4 5 14 20 15 16 3 7 12 9
Top Performer Worstt Performer
Nikkei 225 China
Russia Nikkei 225
Gold Nikkei 225
Brazil Nikkei 225
Analysis: A Preetha
Source: Bloomberg; P/E: Price-to-Earnings ratio; P/B: Price-to-Book ratio; 12-M: 12 Months; Returns is in percentage and in U.S. Dollar terms for each period and not on an annualised basis. Sundaram BNP Paribas Asset Management 28
The Wise Investor March 2010
Performance Tracker India
Index Trailing 12m P/E Cap-Curve Indices BSE Sensitive Index (Sensex) S & P CNX Nifty Nifty Junior Nifty 100 CNX Mid-Cap BSE Mid-Cap BSE Small-Cap BSE 100 BSE 200 BSE 500 S & P CNX 500 24.6 24.4 20.4 23.7 16.9 17.6 15.1 24.5 23.1 22.5 20.9 -5.9 -5.4 -2.7 -4.9 -3.6 -4.8 -3.5 -5.1 -5.0 -4.7 -4.7 20 18 5 15 9 14 7 17 16 13 12 0.4 0.8 1.1 0.9 -0.5 -1.7 -2.0 0.6 0.3 0.1 -0.7 12 10 8 9 15 17 18 11 13 14 16 -2.9 -2.2 1.7 -1.6 0.3 -0.3 7.2 -1.8 -1.6 -1.0 -0.4 20 19 6 15 10 11 3 17 16 14 12 4.9 5.6 18.2 7.4 17.2 8.8 15.3 6.5 7.3 7.8 7.5 18 17 6 14 8 11 9 16 15 12 13 84.8 78.1 153.7 87.6 125.7 131.9 159.7 93.9 98.3 101.7 95.4 19 20 5 17 11 7 3 15 13 12 14 27.0 31.4 50.2 34.2 46.9 16.1 20.3 34.2 34.1 32.0 32.8 18 144.7 17 134.0 7 130.2 13 — 9 12 15 — 11 19 17 10 13 14 16 Year-To-Date Return One Month Three Months Six Months One Year Three Years Five Years Rank Rank Return Rank Return Rank Return Rank Return Rank Return Rank Return
9 140.5 20 104.8 19 116.3 12 142.5 14 130.7 16 130.7 15 125.9
Sector Indices BSE Auto BSE Banks BSE Capital Goods BSE Consumer Durables BSE FMCG BSE Healthcare BSE IT BSE Metal BSE Oil & Gas BSE Public Sector BSE Power BSE Realty 50.5 15.2 32.7 19.3 30.1 54.7 22.7 — 18.0 17.7 29.8 17.5 -3.6 -2.0 -4.5 5.7 -4.6 -2.1 -0.2 -5.7 -8.4 -3.3 -7.1 -16.1 8 3 10 1 11 4 2 19 22 6 21 23 3.1 1.8 2.7 5.3 -2.3 3.1 3.9 2.8 -3.4 -2.7 -3.3 -7.5 3 7 6 1 19 4 2 5 22 20 21 23 2.2 -2.1 1.2 14.7 -7.3 3.1 8.8 0.7 -6.7 0.8 -0.6 -11.6 5 18 7 1 22 4 2 9 21 8 13 23 22.0 17.8 2.5 21.4 4.3 25.9 24.0 32.5 -1.8 9.9 -1.0 -26.7 4 7 20 5 19 2 3 1 22 10 21 23 167.3 131.8 128.5 159.4 30.3 89.2 146.8 249.6 58.2 84.8 69.1 129.0 2 8 10 4 23 16 6 1 22 18 21 9 40.3 53.4 52.5 14.0 49.1 40.4 6.2 92.7 52.4 61.3 51.3 — 11 158.0 3 151.0 4 299.6 21 165.7 8 149.9 10 22 88.6 91.7 5 6 1 4 7 21 20 8 2 18 3 —
1 147.4 5 202.5 2 106.8 6 176.4 — —
BSE Metal BSE Realty
BSE Metal BSE FMCG
BSE Metal BSE IT
BSE Capital Goods BSE Healthcare
Consumer Durables Consumer Durables Consumer Durables Worst Performer BSE Realty BSE Realty BSE Realty
Source: Bloomberg; P/E: Price-to-Earnings ratio; P/B: Price-to-Book ratio; 12-M: 12 Months; Returns is in percentage for each period and not on an annualised basis. Sundaram BNP Paribas Asset Management 29
Analysis: A Preetha
The Wise Investor March 2010
Equity Chart Book
1200 1600 1400
MSCI Emerging Markets
1200 1000 800
1000 800 600 400
Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-00 Jan-01 Jan-02 Jan-03 Jan-09 Jan-10
Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-00 Jan-08 Jan-07 Jan-09 Jan-10
800 700 600 500 400 300 200 100 0
Jan-05 Jan-06 Jan-07 Jan-09 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-08 Jan-10
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09
The horizontal in each graph indicates the average level of the respective index since January 2000 Sundaram BNP Paribas Asset Management 30
The Wise Investor March 2010
Commodities Chart Book
170 150 130
110 90 70 50
800 600 400
Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-09 Jan-10
Jan-00 Jan-02 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jan-01 Jan-03 Jan-09 Jan-10
Baltic Freight Index
21700 18700 15700 12700
3000 5000 4500 4000 3500
LME Metals Index
6700 3700 700
Jan-00 Jan-01 Jan-02 Jan-03 Jan-07 Jan-08 Jan-04 Jan-05 Jan-06 Jan-09 Jan-10
2000 1500 1000
Apr-01 Apr-02 Apr-04 Apr-05 Apr-07 Apr-00 Apr-03 Apr-06 Apr-08 Apr-09
S & P Goldman Sachs Commodity Index
CRB Non-Energy Index
800 700 600 500 400 300 200 100
Jan-07 Jul-07 Jul-08 Jan-00 Jul-00 Jan-01 Jul-01 Jan-02 Jul-02 Jan-03 Jul-03 Jan-04 Jul-04 Jan-05 Jul-05 Jan-06 Jul-06 Jan-08 Jan-09 Jul-09 Jan-10
500 400 300 200 100
Jan-09 Jan-00 Jan-01 Jan-02 Jan-03 Jan-04 Jan-05 Jan-06 Jan-07 Jan-08 Jul-04 Jul-05 Jul-06 Jul-07 Jul-00 Jul-01 Jul-02 Jul-03 Jul-08
The horizontal in each graph indicates the average level of the respective commodity index since January 2000 Sundaram BNP Paribas Asset Management 31
The Wise Investor March 2010
In a lighter vein
In a lighter vein features incidents from 1930s to reflect the atmosphere of the times – the only period that was, as of now, worse than now. • "First Chorine - Did you tell anybody of your secret marriage? Second Ditto - No, I'm waiting for my husband to sober up - I want him to be the first to know." • A Chicago actress entered a lawyer's office and asked what the fee would be for a divorce. "Five hundred dollars" was the reply. "Nothing doing," retorted the lady. "I can have him shot for ten." • "'How d'yer like yer new boss, Mame?' asked one stenographer of another on the elevator. 'Oh, he ain't so bad, only he's kind of bigoted.' 'What yer mean, bigoted?' 'He seems to think that words can only be spelled in his way.' • Very rich lady's will: "And to my nephew Percy, for his kindness in calling every week to feed my darling goldfish, I leave my darling goldfish." • Judge - But how could you marry a known burglar? Witness - Well, he was so quiet around the house. Source: http://newsfrom1930.blogspot.com/ Being a daily summary based on reading of The Wall Street Journal from the corresponding day in 1930.
1 Who is the head of the Bank of International Settlements? 2 13 Bankers is a book authored by….. 3 Which fund house launched India’s first dedicated small-cap fund?
Compiled by S. Vaidya Nathan Design and layout by Spark Creations: +91 044 45510041
4 Who was most recently appointed Deputy Governor of the Reserve Bank of India? (The RBI cannot have more than four Deputy Governors). 5 What is the significance of the Herengracht canal in the history of financial markets?
P R I Z E
Answers must be mailed to firstname.lastname@example.org The first 25 responses with correct answers to all questions will receive a prize. Please mention your mailing address in your e-mail. Employees of Sundaram BNP Paribas Asset Management, its Sponsors and Associates & Group Companies of the Sponsors shall not be entitled to prizes even if they participate and mail correct answers.
Answers for February 2010 Quiz
1 Name the foreign investor who picked up a small stake in Reliance Mutual Fund, a couple of years ago? Eton Park Capital Management 2 The currency of this Latin American country was devalued by its government steeply last month. Which currency and country are we referring to? Bolivar & Venezuela 3 Who is the author of Too Big To Fail? (We had in November 2009 asked for the author of Too Big To Save) Andrew Ross Sorkin 4 What is the maximum fee + expenses that a fixed-income fund can charge according to SEBI regulation? 2.25% 5 Which fund house was the first in India to launch an exchange-traded fund to track gold? Also which was the first fund launched to track gold-mining stocks? Benchmark. DSP BlackRock World Gold Fund was the first fund launched to track gold-mining stocks?
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The Wise Investor March 2010
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