The Price of Uncertainty

“People with MBAs”, it used to be said, “know the price of everything, but the value of nothing.”

As an investor, price is the starting point of any decision. Value (though of a different kind from the moral content of the MBA put-down), too is critical: it is when you find a gap between current prices and the fair value of an asset that you make an investment decision. When you have a major disturbance in financial markets, huge price adjustments are required for a new equilibrium to be reached. Unfortunately, these price adjustments throw up many losers, and can lead to massive after-shocks. In order to contain the damage, governments around the world moved rapidly in 2008 to buffer asset prices. There was a certain pragmatic value to this buffering; at the same time, it is delaying recovery.

By their actions following 2008, governments have populated the financial world with fake prices. In our own economy, we don’t know where buyers and sellers would set bond-yields, as the RBI has bought a record volume of bonds from the market, artificially inflating bond prices, and depressing their yields. We don’t know how the market is pricing the rupee vs. the dollar, as the RBI has been selling dollars. We don’t know how demand and supply would price diesel, because the government sets the price. And we don’t have an accurate picture of bank balance sheets, because of the shifting guidelines with regard to Non- Performing Assets.

Last week, Ben Bernanke, Chair of the the US Federal Reserve trumped Indian financial managers, by fixing the world’s single most important price for the next 3 years, namely the interest rate at which his institution will make funds available to US banks. In effect, Ben Bernanke is banker to the world’s banks. He has now committed to a Zero Rate Interest Rate Policy (ZIRP), for the next 3 years, effectively saying that he will flood the world with cash through the end of 2014.

The immediate impact of the extended ZIRP was on gold prices, which soared almost 5% in the wake of his policy statement. That apart, it makes me wonder about the nature of what I would call a ‘Fake Certainty.’ Imagine a scenario in which inflation re-entered the US economy. Since the Fed is committed to holding the annual rate of US price increases to around 2%, higher price rises would force the bank’s hand into lowering interest rates. In that case, the Certainty of ZIRP would have to be abandoned, and I would be justified in calling it fake.

Could this happen? I think so. Consider the following scenario in Europe: the peripheral countries, like Greece and Portugal, realise that their austerity program is not working, and that a German-led Europe is not going to extend them unlimited financial aid; as a result, they take the time-honoured path of deeply indebted nations, which is to devalue their currency. In this case, this means exiting the Euro. If this were to happen (quite apart from the losses to banks, etc.), a Euro without the peripheral nations would suddenly be a very attractive currency, and would get bid up hugely. Commodity prices would rise, and the dollar would come under attack. This would make it very difficult for producers to hold prices in the US, and for the government to borrow funds at its current all-time lows. The certainty the Fed is trying to inject into the system would be out the window. Banks would be hurt, bond-holders would get hurt, and the US government's own deficit would swell.

The underlying point here is that the more artificial price fixes you have in a system, the more prone it is to a brittle collapse. Market players know this, which is why, for example, trading volumes on the New York Stock Exchange are lower than they have been in over a decade.

The present cheery recovery is built on this assembly of rigged prices, fake certainty and poor conviction. Reminds me of Bob Dylan – “something is happening, but you don’t know what it is…”

Didi and the Hausfrau

Mamata Banerjee, Chief Minister of West Bengal, seems to have put paid to our government's plans to allow foreign direct investment (FDI) in the retail business. The Finance Minister, Pranab Mukherjee, has been evasive in replying to media questions about his government's intentions, but it doesn't appear that the UPA  has the mojo to take on both its partners as well as the opposition.

I saw the FDI announcement as untimely, given the fact that a dysfunctional, unruly parliament was in session. Under the circumstances, it could only be seen as a last-ditch effort to inject some positivity into the rupee, especially given that the RBI had pronounced it would not attempt to shore up our currency. Now that the FDI prop has gone, the RBI has stepped out and said it will defend the rupee. This may not work, especially with crude oil prices seeming more and more firm every day.

In Europe, Angela Merkel has the Eurocrat-socialist consensus in her thrall. The overspending, overpaid mob want to pile all the failures of bloated European government debt onto her plate, and get her to sign blank cheques and bank guarantees to pay for their sins. In response, Merkel's saying, "I'll pay the piper, if I can call the tune". This is not what they want - they want her to pay the piper now, and then 'help' her write the tune later. It's not going to happen - she has a parliament to run, and an electorate to respond to, and they have made their sentiments well known - no supporting lazy Southerners.

Whatever comes out of the European summit this week, its not going to be a Big Bazooka rescue for Europe.  World markets, which were riding on this hope, are going to be sorely disappointed.

But well before that, in the next couple of hours, we are going to see a sell-off in the rupee. The RBI may try to jump into the fray, but that would be ill-advised.

The Fed's steroid shot

Yesterday, the US Fed announced measures to inject liquidity into the European banking system, which has been desperately short of dollars over the last couple of months. Equity markets rallied, and the dollar dropped, prompting energetic buying of gold.

As Mohammed el Erian said, risk markets love liquidity injections. Makes me think of those who mainline heroin, and of quacks who give patients steroid injections when they don't have the ability or willingness to tackle the underlying malaise.

In this case, the underlying chronic ailment is the massive debt under which European governments are labouring, and the escalating price at which they have to finance this debt. Investors across the world are increasingly reluctant to buy European government securities, underlined by these numbers from a Reuter's report: "Globally, the bonds allocation to the euro zone fell to 26.9 percent from 27.4 percent. But this masked a much greater U.S. and UK retreat. U.S. investors moved to 17.6 percent from 19.1 percent and British counterparts sliced their exposure to just 8.9 percent from a previous 11.9 percent." *

Making more cash available to the European system is not going to make this debt any more attractive; cheap dollars will help banks temporarily square off their books, but a Eurozone in recession doesn't suggest that the struggling European governments will be able to service their debt without a massive readjustment.

Here, for example, is speculation about an upcoming Spanish bond auction: http://www.reuters.com/article/2011/12/01/spain-bonds-idUSL5E7MU6KV20111201

The Fed's move smacks of desperation, and I wonder how many hours of trading the buoyancy will hold out.
For India, it had the immediate effect of kicking New York crude above 100 dollars; when our commodity markets closed last night, crude oil December futures were above Rs. 5200 per barrel, the highest they've been this year; if the rupee remains depressed, our Finance Minister will have to go back to the Parliament, asking for a supplement to the supplementary budget to finance the losses of the Oil Marketing Companies. This, of course, will not be a great signal for Foreign Exchange markets, which will bid the rupee down further.. etc.

Meanwhile, with our GDP growth rate slipping to 6.9% (and I suspect we have a ways to climb down yet), the India growth story is acquiring a somewhat tatty look. I suspect a de-rating of our PE multiples is around the corner, as soon as the euphoria of the Fed steroid shot wears out.

* http://www.reuters.com/article/2011/11/30/us-fund-assets-idUSTRE7AT1CK20111130

Markets in the week to come

What will this week hold for Indian equities, after the new lows of last week?

News from Europe will have a major impact; as yet, these are still rumours, but it seems that the IMF is preparing a fund to bail out Italy, via the ECB. This would seem unfair if it didn't include Spain; in turn that should require funding for a total of 14 countries where bond yields have spiked. Till the rumours find a concrete expression in reality, one way or the other, expect some risk-positive behaviour, meaning higher prices for equities.

This would also mean higher prices for gold, as greater monetisation takes place in the Euro zone. If this leads to higher crude oil prices, the fate of the Indian rupee remains questionable, and it may not find much support.

From the U.S., strong retail sales on Friday, the beginning of the holiday shopping season, will also prompt higher equity prices, which would reinforce crude and gold.

In India, our Finance Minister's demand for more funding of government expenditure is going to put the cat among the pigeons, and pressure bond prices. While the Reserve Bank of India (RBI) has been playing along, by buying bonds from the market, it knows this will pump extra cash into the system, with the consequent impact on prices.

News from abroad, in other words, may help lift Indian equities, but the more important influences will be domestic. The best bet this week, in my view, will be gold.

Umesh Pandey was murdered by bad policy

A toll-booth attendant was murdered in Gurgaon, near Delhi, on the night of September 22nd.

The apparent murderer, Vijayveer Yadav was an unemployed youth from the village of Kho, near Manesar. According to the Times of India, "cops said Yadav flew into a rage when the victim - toll booth attendant Umesh Kant Pandey - asked for the original registration certificate (RC) of the Bolero (vehicle) for letting him pass without paying toll, as was the practice for local vehicles. Yadav had just a photocopy of his driving licence".

The list of those exempt from paying toll on such highways is quite substantial, and includes the usual suspects - Chief Ministers and Ministers, Governors and judges, government officials on duty; all those who are paid from our taxes. Strangely, Robert Vadra is not specified as being exempt, as he is in the case of security checks at our airports!

Looking at the list as I drive to Uttarakhand or Jaipur, I have often idly wondered whether government officials on such drives are ever off-duty. I was not, however, aware of the exemption for those living in neighbouring villages; perhaps this was some kind of "enlightened" gesture for the toll road operator to generate local support for the project.

Clearly, the move back-fired. OK, morbid pun. But exemptions are usually bad ideas. They lead to contention about who qualifies and who doesn't; create incentives to forge documents and misrepresent antecedents, and vitiate the creation of an environment where all are equal before the law.

Two particularly egregious examples of  'special treatment' come to mind - the reservations of college seats for students belonging to certain castes, which led to the Mandal riots, and some particularly gruesome protest deaths; and the subsidy for kerosene, which has led to widespread adulteration of diesel, and the murder of at least two individuals brave enough to investigate the fradulent practices that most of us accept.

"Special treatment" is a manifestation of weak administration, which seeks the path of least resistance and most votes. Short-term measures create trouble in the long run, of which the death of Umesh Pandey is an extreme and heart-rending manifestation.

Suing US banks is counter-productive

Two major developments in the US made me sit up over the weekend:

- the first was the terrible employment report for August, which showed that new job creation in the US is at a stand-still.

- the second is that the Fed is going to sue virtually every major US bank for selling mortgage and mortgage-related securities to the housing agencies Fannie Mae and Freddie Mac. These institutions are now custodians of the US Fed, by virtue of the massive infusion of capital that the Fed provided.

The first bit of news has obvious implications for the US economy: lower employment can set off a downward spiral of lower demand, and hence even lower employment. This cycle will adjust only when there enough of a recession in the US for producers to force prices down so as to become competitive in world markets, and begin increasingly producing for export. This will, however, tend to be accompanied by  lower domestic prices, too, which is counter to the US government's desire to prevent deflation, which could cause nasty consequences for the huge debt overhang. 

Aside from the conflict between the self-adjusting cycle of prices and demand on the one side, and the government's concerns regarding debt on the other, there is another problem, namely that economic uncertainty all over the globe is pushing many investors into the dollar, which is leading to dollar appreciation, rather than the other way around, preventing US economic adjustment through this route. We have seen this before - in 2008. It will reverse, sharply, and not without further turmoil on financial markets; only then will this price-demand adjustment take place to the benefit of the US economy. It is going to be a long, volatile journey.

The second bit of news has much deeper ramifications. By deciding to sue banks on behalf of the housing agencies, the Fed is essentially suggesting that Fannie Mae and Freddie Mac were innocent victims of conniving banks. This is the worst kind of political posturing. The fact is that these were government sponsored agencies supposed to specialise in housing finance; they were leaders in creating mortgages and pioneers in creating derivatives for mortgage re--finance. To now suggest they were exploited by the big bad wolves of Wall Street selling them instruments they could not independently assess is dissimulation of the worst kind.

The timing of the proposed legal action is uncanny - it comes at a time when the Fed is at a loss on monetary stimulus, and virtually everyone has given up on the jobs front. Oh, and the US presidential elections are barely a year away. When this administration came into power, it bailed out Wall Street, peddling the move as an instrumentality to rescue Main Street. The first rescue was spectacular; bank profits bounced back, as did multi-million dollar bonuses. This created political discomfort, which deepened when the second part of the rescue act failed to materialise. Obama's ratings are dropping, and something needs to be done. Step 1 - step away from the banks.

Suing the banks will achieve nothing except some optics; however, it will deepen the uncertainty regarding economic policy and regulation in the US. One economic commentator calls such uncertainty 'regime change'. It think this is rather an extreme term; however, it does convey the level of complexity large financial corporations have to deal with. Amping up this uncertainty is not good for investment and growth, and drives a wedge of distrust between government and business. Good though this may seem for popularity ratings, it can only be bad for what matters, which is jobs on the ground.

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Obama admin seeks to recover political capital from banks

Obama's biggest political mistake was to bail out the banks shortly afer he took over as US President. At the time, he was (ill-) advised that this would help the economy recover, that "bailing out Wall Street"  was critical for the recovery of Main Street. Three years down the line,
- Main Street has not recovered
- unemployment is high, and the labour participation rate dropping.
- the economy is stagnating.
Most importantly, 
- elections are around the corner.


Something, clearly, has to be done. It seems unlikely that Obama will be able to do anything substantive to push the economy over the 12 months he has left to demonstrate any progress. Time for some optics, then, to show he is not on the side of Wall Street. Hence the move to sue US Banks for the quality of mortgage-backed paper they sold to Fannie Mae and Freddie Mac, now essentially custodians of the US tax-payer.


Little matter that these two housing agencies were supposed to have been expert at evaluating mortgages; were set up expressly with the purpose of expanding the market for housing loans. Hardly babes in the woods! See the second para (below) extracted from the Financial Time's blog, ftalphaville.


Commencing this vendetta against the banks is ironic for an administration that put them in ICU when they could have been allowed to die. Worse, it creates an adversarial relationship between the government and the banks, and sets up the apprehension that other arbitrary moves could be around the corner. This will inject more instability into a financial system that is already tottering. This will end badly. Very badly


From ftalphaville:

"Since Fannie and Freddie are in government conservatorship and Royal Bank of Scotland, another target of the action, is majority-owned by the UK government, the lawsuits have produced the unusual situation of Washington suing London over crisis-era losses on $30.4bn of securities.

Banks reacted angrily to the move."

Passing the Bucks:

BofA said Fannie and Freddie “claimed to understand the risks inherent in investing in subprime securities” and yet were “now seeking to hold other market participants responsible for their losses”. Deutsche Bank said the institutions were “the epitome of a sophisticated investor” and the bank would “vigorously defend against the action”.