It took a lot of effort to persuade Mr Jain to
give us a sneak peek into his repertoire every week through this exclusive
column. Here's the first one for you.
(Ritesh Jain, Chief Investment Officer of Tata Mutual Fund, is not seen in the media too often. But he is known to spend a lot of time accessing and rummaging through reports and studies on global macros and markets from some of the best names in the business. It took a lot of effort to persuade Mr Jain to give us a sneak peek into his repertoire every week through this exclusive column. The first instalment of this column, which we launch hereunder, gives you ample proof of what we are talking about. Dare we say, it is bound to become a part of your weekend planner! Enjoy it and feel free to share your views and start a debate on any of these issues. –Editor, ETMarkets.com)
By Ritesh Jain
Hey there! I have been reading some very interesting stuff of late. We published our latest edition of the monthly Charts That Matter series. Russell Napier’s latest edition of the solid ground fortnightly series gives a glimpse into German Chancellor Angela Merkel’s options vis-a-vis the sovereignty of the European Union. Then there is this latest from Bill Gross – drawing analogy from the board game monopoly. For those who have played monopoly in their childhood will surely relate to it. We also have the one-off mid-month absolute return letter.
Do share your thoughts. Happy weekend!!!
1.Russell Napier – Solid Ground Fortnightly We are going through a period of extraordinary volatility and uncertainty. When I read this report with the background of what is happening around us, it made huge sense. It is as if he is predicting the future!
German commitment to the European Union project cannot be taken for granted Russell starts with the question: “where is the helicopter?” and says that saving the economy from recession is key to saving the European political union project. At the crossroads is Germany, which undoubtedly stands to lose the most in case of a EU disintegration over time. Will Germany bet everything for the political union of Europe and let central banks across Europe extend outright financing of their governments? The decision cannot be delayed forever. Early clues as to which way the Chancellor might swing are to be found in Italian banks.
Russell has been warning that the introduction of the Bank Resolution and Recovery Directive (BRRD – effectively bailing out bank bold holders and deposit holders with public money) would undermine the stability of European banks and, if actually implemented, it would cause a run on banks across Europe. We are facing the prospect of BRBD implementation in Italy, a huge blunder, Russell asserts.
It appears likely, at this point of time, that she will back away from the implementation of BRRD. She openly voiced her displeasure of tweaking the laws of the EU to implement BRRD. This makes us believe that a German commitment to the EU cannot be taken for granted and Merkel may not possibly go all-in to save a disintegrating the EU project. Global investors are complacent about the German commitment mind you. So, Russell is talking about a crisis lurking around the corner – bank runs and those types.
If the rotors of the helicopter start whirring, equities will rise for months, maybe for years. Fiscal deficits will expand. Wage policies and spending pattern will undergo a big change. If you don’t hear the rotors of helicopter very soon, then what has begun is an economically painful but constitutionally necessary journey back to a common market and away from a political union. The United Kingdom would be at the centre of such a realignment of interests. While welcoming such a constitutional realignment, investors need to realise that the free movement of capital will be suspended in any such process. For years, Russell has warned that this is by far the most important change that investors will face in ‘the new normal’.
Meanwhile, still no sound of rotors!
2.For those of us who still play a board game known as monopoly this monthly update from Bill Gross will resonate well
Just a Game The larger economic landscape today is best typified by the monopoly game. In that game, capitalists travel around the board, buying up properties, paying rent, and importantly passing ‘Go’ and collecting $200 each and every time. And it’s the $200 of cash (which in the economic scheme of things represents new ‘credit’) that is responsible for the ongoing health of our finance-based economy. Without new credit, economic growth moves in reverse and individual player ‘bankruptcies’ become more probable. To some extent, the growth can continue but at a slower pace – the economy slows down due to a more levered position.
So in real world, hasn’t the Fed printed $4 trillion of new money and the same with the BoJ and ECD? Haven’t they effectively increased the $200 “pass go” amount by more than enough to keep the game going? Not really.
Because in today’s modern day economy, central banks have lots and lots of money available but only if the private system – the economy’s real bankers – decide to use it and expand “credit”. If banks don’t lend, either because of risk to them or an unwillingness of corporations and individuals to borrow money, then credit growth doesn’t increase.
Credit growth, which has averaged 9 per cent in the US a year since the beginning of this century, barely reaches 4 per cent annualised in most quarters now. A highly levered economic system is dependent on credit creation for its stability and longevity, and now it is growing sub-optimally. And when the private system (not the central bank) fails to generate sufficient credit growth, then real economic growth stalls and even goes in reverse. To elaborate just slightly, total credit now totals a staggering $62 trillion in contrast to money supply (M1/M2) totals which approximate $13 trillion at best.
The axiomatic formula of ("M V = PT"), which in plain English means money supply X the velocity of money = PT or gross domestic product. In other words, money supply or "credit" growth is not the only determinant of GDP, but the velocity of that money or credit is important too. Velocity of credit is enhanced by lower and lower interest rates. Thus, over the past 5-6 years post-Lehman, as the private system has created insufficient credit growth, the lower and lower interest rates have increased velocity and therefore increased GDP, although weakly. Now, however with yields at near zero and negative, the contribution of velocity to GDP growth is coming to an end and may even be creating negative growth.
Our credit-based financial system is sputtering, and risk assets are reflecting that reality. Until governments can spend money and replace the animal spirits lacking in the private sector, then the Monopoly board and meagre credit growth shrinks as a future deflationary weapon. But investors should not hope unrealistically for deficit spending any time soon. That means, at best, a ceiling on risky asset prices (stocks, high yield bonds, private equity, real estate) and at worst, minus signs at year's end that force investors to abandon hope for future returns compared to historic examples. Worry for now about the return "of" your money, not the return "on" it. Our monopoly-based economy requires credit creation and if it stays low, the future losers will grow in number.
3.The absolute return letter Slowly and surely, economists have started talking about helicopter money as opposed to QE, which has spectacularly failed to revive growth and inflation. What if QE is replaced with basic minimum wages for everyone (isn’t it wonderful?)! And if you think it can’t happen! Switzerland had a referendum last month to introduce basic minimum wages for every one of their citizen. It got defeated, but I think we will have Japan introducing this measure this year and their citizens do not vote on referendum. Voting in referendum is so European. Please read the summary below.
Change in inflation Inflation has dramatically fallen since the early 1980s. This can be attributed to following reasons:-
Collapse of wage-price spiral because of decreasing power of unions
Positive productivity shocks (e.g. the dot com revolution) which made it possible to produce more at lower prices
Global competition has intensified, which has caused pricing pressure, cost-push pricing, lower inflation expectation and reduction in animal spirits
Combination of all the above factors has had the effect of pushing the demand curve to the left and the supply curve to the right. Demand is no longer represented by D but by D1, and supply is now S1. The result? A declining inflation rate, which will ultimately lead to falling prices in absolute terms - i.e. outright deflation - if no action is taken.
Why QE hasn’t worked Central bankers all over the western world are aware of this problem and thought QE could fix it, but it hasn’t worked as intended. Central banks have two major assets on their balance sheets – cash (coins and notes in circulation) and free reserves. QE has boosted free reserves, but has had no impact at all on coins and notes in circulation, and it is only a rise in cash (i.e. helicopter money) that is inflationary; an increase in free reserves is not. Whereas many expected the rise in M2 caused by QE to be highly correlated with CPI, exactly the opposite has happened.
The ultimate consequence of declining inflation GDP, in fact, equals PxQ (price times quantity). So a declining ΔP will also lead to a declining ΔGDP. Hence the ultimate implication of an ever lower inflation rate is falling output. Another way of phrasing it is that, in a world where supply increases faster than demand, ΔGDP will decline and ultimately turn negative.
Why helicopter money might be the only answer The extraordinarily robust returns that we have all enjoyed in the last 30-35 years were a function of exceedingly good investment conditions: 1. Strong economic growth driven by a growing workforce. 2. Increased corporate profitability driven by rising productivity. 3. An exceptional drop in the cost of capital driven by the fall in interest rates. 4. An increase in equity valuations (PE ratios) driven by a combination of all of the above. Now, fast forward to today’s environment. 1. Workforce is beginning to shrink in many DM countries 2. Productivity is low everywhere – and unlikely to rise anytime soon as ageing has a negative effect on productivity and 3. Interest rates cannot fall much further In other words, only one of the four factors could drive equity returns higher meaningfully, and that would be a continued rise in equity valuations, and why should PE ratios rise if GDP growth is falling, if corporate profitability is under pressure, and the support from falling interest rates is (largely) behind us? Only answer is extraordinarily low interest rates and helicopter money, which will cause a part of the capital earmarked for credits (during normal circumstances) to flow into equity.
Bring in the helicopters What helicopter money is really all about is to ensure that the D-curve shifts out, and that it shifts out faster than the S-curve. Monetary authorities will have to print enough money to push the D-curve out to a point, where ΔP rises at a reasonable rate.
What is needed is a money-printing exercise controlled by the treasury department. Once people have money in hand, remarkably high percentage of them will spend the money relatively quickly, as well over 90 per cent of consumers lead a life style where virtually all household income is spent every month. This will cause an increase in animal spirits, which will lead to gradual increase in inflation and GDP.
Wealth-to-GDP As on March 31, 2016, total US household net worth stood at $88,087 billion and US GDP for 2015 was $18,558 billion. So, US wealth-to-GDP is now a whopping 4.75 times. In the long run, wealth-to-GDP is a relatively stable number and has averaged about 3.8 times in the US over the last 100 or so years. In the national accounts, national income is divided between capital and labour. In the long run, the split between labour and capital is nearly constant. Higher the share of national income that goes to capital, faster the net worth rises. Consequently, if we know that capital’s share of national income will have to come down in the years to come (and we do), we also know that net worth-to-GDP will have to fall. Slow economic growth in the years to come could quite possibly be the catalyst that make it all happen.
Besides, US wages have begun to rise again when measured as a percentage of GDP, following a 15-year slump, causing corporate profits to be squeezed. This will obviously impact the split between capital and labour in the national accounts, so perhaps the long awaited mean reversion has already begun?
A full reversion to the long term mean of 3.8 times would imply a drop in net worth of approx. $20 trillion (assuming a GDP of around current numbers). In that context note that total net worth in the US troughed at $56,214 billion in December 2008 at the bottom of the financial crisis – some $30 trillion below current net worth. What we don’t know is when this will happen and how fast it will happen.
4.Charts That Matter – July edition This bit is from the July edition of our monthly Charts That Matter. As with the earlier editions, I have tried to keep the charts interesting and diverse. A look at the lending pattern of Indian banks throws up a very diverse pattern between private and state-owned banks. While the state-owned banks are cutting down on lending to new projects citing thin capitalisation apart from weak demand, they seem to have no problems in deploying find capital towards retail lending.
There is no running away from the fact that Indian banks are among the most thinly capitalised in the world in terms of reported Tier-1 capital adequacy ratio. On the liquidity front, the Reserve Bank of India (RBI) has ensured more than adequate liquidity with the MIBOR at a five-year low heading into FCNR outflows. Some interesting statistics on how the Indian Railways continues to lose share of freight cargo to land transport and other medium and the key reason for this is congestion on rail network.
An interesting chart shows how savings on crude subsidy has not gone into capex, but into higher food subsidy bill. This time I have taken the liberty of including 12 charts. Just couldn’t decide which ones to remove.
5. And lastly, helicopter money’ is the solution One thing is common among whatever I have been reading – all of them are of the opinion that ‘helicopter money’ is the only solution when central bank policies have failed to revive growth and inflation. Monetary easing has not been able to liquefy the system. It’s about time that monetary and fiscal policies started to converge. I am talking about outright monetary financing of governments by central banks instead of going about printing money. Fiscal discipline will take a beating. Conventional central bank policies are clearly not working.
(Ritesh Jain is the CIO of Tata Asset Management. Views expressed in this weekly column are personal in nature and do not represent those of Tata AMC or ETMarkets.com. It should not be construed as an investment advice. Any action taken by the reader or recipient on the basis of the information contained herein is reader’s/recipient’s responsibility alone.)
