We went into the last week with expectation of heightened volatility in financial assets and currency markets and we got it. What we got would make Mr Soros very pleased as his theory of reflexivity played out to perfection in the traded markets. George Soros postulated in his version of Reflexivity Theory, markets are principally driven by expectations. Once the basis of those expectations is altered, the market corrects.
The European Central Bank did a lot but it did not do enough to please the lofty expectations of Mr Market and the result was a convulsion in the FX, interest rates equity and corporate bonds. Yields jumped, dollar was dumped, risk flunked and equities dunked. Midst of this mini panic, the Indian rupee almost went past the 67 handle against the US dollar. RBI, as usual, was the savior, and it stood like a Santa Claus and showered the land with dollar bills from its billions of dollars of war chest. Thanks to RBI, our local unit got a graceful close of 66.75 against the greenback.
Economic docket was full with market moving data scheduled from all major geographies. Euro zone surveys of industries, PMI was better than expected. Over the past 12 months, trend of economic data from Euro zone has improved. Germany and Spain has seen the most of the improvement, but other countries have seen their economic data hold up.
We have seen business confidence improve and core inflation tick higher. Infact this was one of the reason that made us call for a no hike in QE from ECB in the just concluded December meeting. We believe, two factors may have played a major role in an improved performance of the Euro zone economy. One was the epic drop in bond yields across the Euro zone nations and massive depreciation of the Euro.
The above diagrams is a snapshot from our recent report “world economy, central bank stimulus and divergent monetary policies”. It helps to explain how Euro zone has benefitted, especially the core countries like Germany at the expense other export oriented nations. Keep in mind that a current account surplus denoted a nation is a net producer of goods and services and a current account deficit denotes that the same country is a net consumer. Since 2008, Germany has seen its surplus grow. Additionally, since 2009-10, other Euro zone nations like Italy, Greece, Spain, Ireland and Portugal have flipped from a massive current account deficit nations (consumers) to current account surpluses (producers). How a shift in current account balances over a short period of time affects a nation’s economy depends on how that economy is structured, is it a net producer or a net consumer.
For an economy which is a net consumer, like the PIIGS nation of the Euro zone, if they see their current account balances flip like they have done, between 5-16% change towards surplus, it is an indication of a massive deceleration of economic activity. It portrays the economic pain which is inflicted on the consumers in those economies. Therefore, it corroborates the deep economic adjustment which these countries had to bear due to the GFC and the euro zone crises. Similarly, for China, which is a production engine of the world, the second-largest economy, growing from a share of world GDP of 4% in 2000 to 14% now, running a current account surplus of near 10% during the 2007-08 period, has had to feel the economic pain that was brought about by a near 8% drop in that surplus over the past 7 years. So how interesting are the global economic cross currents, where a larger surplus in one part of the world means distress but the same thing can mean more prosperity in the other parts of the world.
Interestingly during these last 7/8 years, a country like Germany, another major global producer, saw it take maximum benefit out of a negative interest rates and very weak currency. In fact, we have to sympathetic to China, who being loosely tied to the US Dollar had seen its currency appreciate significantly against its peers, including the Euro. China could not have asked for a worse scenario. On one hand, major consumers like US, other developed nations and even some of the Asian nations were reducing their appetite for consumption (evident from the sharp drop in current account deficit in these nations) and on the other the divergent monetary policies were driving the US Dollar higher against every other currency except the Yuan. China is caught with a massive idle production capacity backed by debt and an uncompetitive currency. The way out is a combination of depreciation of Yuan and closure of excess capacity. However, remember closure of excess capacity is painful as it leads to debt default, unemployment and even social discord.
India in midst of all these has had a mixed fortune. For India, the current account has flipped from near 5% deficit to now around 1%. Such a massive swing in current account in 3 years, like the PIIGs, has taken a toll on the economy, which has now slowed to a decadal low in the nominal terms.
Many have scratched their heads to make sense of the real GDP numbers. A 7.4% growth number is hard to square with any other data from the economy. We are still dumbstruck how CSO is able to continue with this data when a sixth grader can look through it. Anyways, it is the nominal data on GDP which has semblance and continuity with factors on ground. Remember our wages, corporate profits and government revenue are all in nominal terms and hence they are a function of the nominal GDP. It is the economist who has the luxury of living in both the worlds, real as well as nominal. However, a common man cannot comprehend easily the concept of real growth, i.e., nominal growth adjusted for inflation. In an inflationary world people, businesses and government can get away with dubious capital structures, because inflation (price effect) can keep leverage ratios lower and revenue higher. It is to be noted that your debt repayment obligation remains fixed in nominal terms, so even when inflation or higher prices is pushing revenues higher, countering a flat line in the volume of business, the debt obligation ratios keeps falling (repayment liability % of revenue drops). Similarly, fiscal deficit as well as debt/GDP ratios can become depressed by higher inflation. But such bag of tricks no longer works when we move into a low inflationary or worse a deflationary world. Then financial shenanigans are exposed and over leverage can fast become toxic. Governments of the day find it difficult to grow revenues to meet revenue obligations and debt/GDP and even fiscal deficit/GDP can rise. If they sacrifice expenditure then either of two will occur, a slowdown in growth and/or loss of electoral popularity. It is a tough balancing act in a low inflationary/deflationary world with economic growth.
Before we conclude let us touch upon the interest rate expectations. After a better than expected headline jobs growth over the month of November, 211K vs 200K expected, US central bank is widely expected to raise interest rates by 25 bps in its mid-December monetary policy. However, at the same time US Fed may sound quite dovish about the pace of future hikes. Therefore going into the Fed policy, an EM currency like Rupee can remain under pressure against the US Dollar. However, we do not expect run-away depreciation as the central bank remains vigilant, ready to intervene. We therefore can see a range of 66.20/40 and 67.40/50 over the rest of the month. The lower end of the range can be tested if we see a passage of the GST legislation in the winter session of Parliament.