Jun 14, 2012

'Grexit' next week? Probably Not.

The most common debate doing rounds in the financial circles this week is whether or not Greece will be a part of the Eurozone a month from today? The prevailing view amongst macroeconomic observers is that Greece would exit the Eurozone eventually; the debate centres around whether the exit will be orderly or disorderly. The present conditions will not precipitate a Grexit. A Grexit cannot be orderly for Greece. It can be orderly for the EU, and indeed might be instigated by the EU, if a mechanism to stabilize the financial system can be agreed upon. Greece will initiate a move towards exiting the Eurozone only in circumstances resembling a revolution effecting a regime change. The present policy will be to award limited concessions to Greece. The focus will be on preventing the locking out of Spain and Italy from the bond markets. These are the most imminent risks to the future of the Eurozone.

The outcome of the Greek elections on June 17 is expected to be critical to the fate of Greece. The New Democracy is the market favourite as they intend to honour the existing bailout agreement while requesting for concessions in the existing terms. An extremely uncertain situation will emerge if the Syriza party wins the majority - they are openly critical of the existing bailout agreement and potentially intend to challenge, not request, the EU to ameliorate the terms of the bailout. The possibility also exists that the elections might be inconclusive like last time which would also leave market participants quite anxious. Whatever be the outcome of the Greek elections, there is very low support in Greece for abandoning the Euro or leaving the EU. 

The Greeks stand to lose a great deal from leaving the Euro. Their banking system will almost certainly collapse unless the exit is confidentially and immaculately planned with capital controls and withdrawal restrictions on existing Euro denominated bank deposits. Recent events makes it abundantly clear that the politicians in Greece, and elsewhere, are incapable of such planning. Further, a departure from the Euro will leave existing Greeks poorer by the 20% to 50% devaluation implied by the introduction of a new Drachma. This tantamounts to expropriation of wealth by the Greek state from the people of Greece - an unnecessary step unless the level of crisis escalates significantly. 

Further, an exit will cause the exclusion of Greece from international trade, tourism and international capital flows. The institution that normally step in to help a country after such a crisis, the IMF, is already fully engaged in Greece. Any exit from the Eurozone cannot be orderly for Greece; it will almost certainly lead to a strong negative economic shock.

The EU maintains that they will not negotiate or relax the terms of the bailout agreed to by Greece in the past. However, this seems like political posturing as EU has not denied the next bailout tranche though it is evident that Greece has not met completely its target for economic reforms and restructuring. The Greek bargaining position is further strengthened by the generous terms of the recent Spanish bailout. 

The EU will continue to indulge the Greeks and their demands as they have been unable to agree on a mechanism to prevent contagion from a Greek exit. An uncontrolled ‘Grexit’ would lock out Spain, and possibly Italy, from financial markets leaving the core countries, led by Germany, to foot the bill. This is precisely the situation that Merkel wants to avoid at all costs. However, once Germany is able to agree to a mechanism ensuring financial stability for ‘core’ and large economies like Italty and Spain, the PIIGS may be left to fend for themselves and a zero-tolerance policy may be adopted towards awarding further concessions. 

News flow from the Eurozone will continue to remain exciting with Greece being slowly overshadowed by Spain and Italy. There will be no exits from the Eurozone leading up to the summit at the end of June. The summit will probably fail in its objective of developing a mechanism for insuring the stability of the financial system in Europe. Instead of a concrete plan like the TARP in the US, the summit will conclude with promises of a commitment towards a resolution. In the meanwhile, the ECB will continue to provide liquidity to the banking system in Europe to keep it on life support. Credit markets will continue to remain frozen and GDP growth numbers will be negative for the Eurozone. We will continue to see phases of risk ‘on’ and ‘off’ in the markets depending on news flow from Europe.

The current policy of postponing the problem and spreading the losses over time might work. However, it is a dangerous policy with high chances of a sudden implosion. Bank runs have the tendency to work in jump functions - sentiment changes from a quiet mistrust leading to a sudden failure of a large number of institutions. Europe has not yet demonstrated the ability to competently deal with such exigencies. Deteriorating economic conditions, continued political unrest, an unstable government, high rates of youth unemployment are signs that often precede revolutions. Some of these can already be seen in Greece. 

The current mercantilist structure with Germany exporting goods to a periphery of less efficient economies is unsustainable without German support for the peripheral economies to the tune of 2 to 3 trillion euros either via joint-euro bonds, ECB monetization of debt, or other joint contingent liability mechanisms. Economic history has several examples where mercantilist exporters finance their exports by lending money to the importing nation. Germany need only look east towards China who is the largest holder of US debt today. Without this understanding in the German political establishment, political disagreements between the ‘core’ and the ‘periphery’ will eventually lead to the disintegration of the Eurozone and the potential shutting out of Germany from several European markets. In either case, the economic outlook for the Eurozone is negative and has potentially severe consequences for Asia.

Mar 14, 2012

Crystal Ball Gazing: adrenaline rush; remain Long

I've been meaning to write an elaborate post on the budget, monetary policy, politics, etc, for the last 10 days but just haven't had the time. Quickly summarizing what I am thinking in no particular order -

  • Union Budget will be reformist. 
    • Power sector will receive attention - SEB finances and coal policy rationalization
    • Fuel prices will be hiked to manage finances... and this can add to reforms
    • FDI in retail will most probably not be put forward - politically unpalatable. Mamta and Akhilesh will never agree
    • Infra and roads will receive thrust 
    • Education and health will get focus especially in tier II and tier III cities
    • Fiscal deficit will not be cut - there is no benefit to the Government right now. Think of the electorate and the Government as growth junkies.. Fiscal deficit is probably going to be the concern for the next Government when they put the economy in 'rehab'
  • Monetary policy
    • Inflation - noises to the effect that inflation is cooling off but risks remain on account of potential rise in energy prices
    • Growth concerns will be voices in the policy statement
    • Monetary easing almost certain 
      • 40% chance - rate cut of 25bps 
      • 30% chance - rate cut of 25bps plus some relaxation in SLR
      • 20% chance - rate cut of 50bps
      • 10% chance - no easing but dovish noises
  • Politics
    • SP will form an alliance with the Congress at the Centre. Direct support, outside support, whatever, doesn't matter. Mulayam will probably get a Union Cabinet post.
    • Mamta and Congress will patch up a wee bit more. The Congress will accommodate her more, leave Bengal to its miserable state and stay away from FDI in retail which will not go down well with electorates in both UP and Bengal so it will be hard to get political support for this.
    • The Congress will try to push through popular reforms like roads, infra, etc which will get the growth momentum rolling. It will stay away from FDI.

Jan 9, 2012

Subbarao hints at easier policy. Why did markets not rally?

The RBI Governor, D Subbaroa, hinted at an easier monetary policy (see ET article on 6th Jan). The rate cycle turning will be positive for the economy and markets. Why did the markets not rally then? I think stagnancy in the markets is related to uncertainty about the date of rate cuts compounded by the risks posed by the earnings season.

The state of public finances is not exactly where the government wants, or the market expected. The government has overshot its fiscal targets and agencies like NHAI are making large bond offerings with more paper expected down the line. The prevailing sentiment is that the markets will not be able to absorb so much lending at lower rates and that the RBI, as the de facto debt management office of the government, will try to auction G-sec first and cut rates later. Essentially, this implies that rate cuts will not happen on the Jan 24 meeting but at some date after that.

To add to uncertainty related to the date of a rate cut, there are quite a few corporate earnings which will be announced in the two weeks leading up to the monetary policy meeting on the Jan 24. There is a fair degree of unease in the markets about corporate profits, bank asset quality, order book growth in infrastructure, regulation and scam in telecom, etc.

If you buy the markets today, and there are negative shocks to earnings between now and the policy, you don't really make any money. If the policy is good, you simply recover the intermediate loss. If they do not ease, well, then you lose some more. The compounded probability makes buying the market an unattractive proposition for risk averse traders.

Chances of a negative surprises for the dominant part of the NIFTY are low. The sectors with the highest weights in the NIFTY - financials (26%), energy and related (15%), pharmaceuticals (4%), software (14%), infra related (more than 5%) - have a small chance of further negative surprises with expectations already being very low, though IT can be complicated with the impact of the rupee still not known clearly. I think that there are low chances that the rate cuts will be deferred beyond the Jan 24 meeting - there is too much at risk for the government and the economy to be stupid about monetary policy any further.

This is a time to go long without leverage on quality large cap stocks which are oversold. Public sector financials and infrastructure stocks like Larsen and BHEL look good. Select midcaps like Biocon look very attractive as well.