A persistently sick Europe will hurt global growth

Apr 24, 2012

In this issue:
» Hedge funds continue to face flak
» Auction of coal blocks finally sees light
» TRAI ups the fee for upcoming 2G auctions
» Why PE funds have not been doing well
» ...and more!

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Have the developed countries started showing signs of recovery? The outlook for a while at least looked brighter. For instance, according to the Economist, Japan is expected to grow by around 2% in 2012 after a terrible 2011. The IMF's World Economic Outlook has revised expected global growth in 2012 to 3.5% from 3.3% in January. In September last year, the IMF opined there was a 10% chance of global growth dipping below 2% in 2012. Now it believes the chance is just 1%.

But this optimism is most likely to be short lived. There are a few factors that could spoil the party. First are commodity prices. Many years of high food and metals prices have given a fillip to production. But oil remains an exception as supply fails to catch up with rising demand. Thus, any nasty surprises notably in the form of steep oil price hikes could topple global growth.

The worsening crisis in Europe also remains a cause for concern. The European Central Bank (ECB) had provided over US$ 1.3 trillion in three-year liquidity to banks. Austerity measures have also been stressed upon. The hopes from this have faded as European countries still struggle to stay afloat. The recent deteriorating scenario in Spain has only made matters worse. GDP in the country has contracted for two successive quarters pushing the country back into recession after showing some recovery before that. Political uncertainty has taken centrestage in France and the Netherlands as disagreements have arisen between parties on budget cuts. All this does not paint a bright picture.

So far the global economy had been just about managing despite the crisis in Europe. But if the recession deepens or if the Eurozone breaks up, both of which seem very likely possibilities, then the turmoil would only rise further. This in turn is bound to have an impact on the US, Japan and the Asian economies. Thus, unless Europe comes out with some meaningful solutions besides austerity measures, global growth would be in peril in the coming months or even years.

Do you think that the crisis in Europe could worsen further going forward? Share your comments with us or post your views on our Facebook page / Google+ page.

 Chart of the day
The global financial crisis has certainly taken its toll on Europe, US and Japan. But European countries appear to have borne the maximum brunt. Today's chart of the day shows the GDP per person that has been lost since the crisis broke out in 2008. This is by comparing the actual figures in Q4 2011 with what the trend would have been had the crisis not taken place. Ireland has suffered the worst in this regard, while Germany the least.

Data Source: The Economist

Warren Buffett once explained the phenomenon of conflict of interest in a way that only he can. Never ask a barber if you need a haircut, he is believed to have said. Similarly, if you go to a hedge fund for investment advice, it will recommend nothing less than investing your hard earned money into the fund. But has this been of any use in the past? Certainly not if the global daily Financial Times is to be believed. The fact remains that 2011 was the ninth consecutive year when a simple 60:40 stock and bond portfolio outperformed the average hedge fund.

Thus, despite their hefty fees and sophisticated analytics, an average fund was unable to beat a simple plain vanilla portfolio. Hedge funds however are quick to counter this with their own study. They argue that their own 17 year study shows that hedge funds have significantly outperformed traditional asset classes. This could well be true or it could also be a result of using favourable time horizon to one's advantage. Over the long term though, odds are heavily stacked against hedge funds. We cannot see how an investment approach where fund managers skim off significant percentage points as fees and a short term orientation towards profits can beat a long term investment approach with a very low performance fee. For us, its common sense over complex world of hedge funds any day.

Thanks to the CAG reports, our cash strapped government is finally seeing some light. That coal is a scarce resource was always known. But its scarcity became more profound when the largest coal mining company (Coal India) failed to meet mining targets year after year. The government on its part favoured some private sector enterprises by offering free mining blocks. This too did not help supplies as the blocks remained unused. Road blocks such as delays in getting environmental clearances and acquiring land also delayed mining projects. In the bargain, the government lost billions that it could have earned by auctioning the blocks.

Finally, some sense seems to have prevailed amongst our policy makers. The government has plans to auction as many as 54 coal blocks this year with a total estimated reserve of 18.2 bn tons. India is the world's third-largest producer of coal, after the China and the US. Hence, it is a pity that despite this, we have become increasingly reliant on imports from countries such as Indonesia because of slumping domestic production. This year, demand is expected to outstrip production by about 100 m tons. Hopefully, companies having to acquire coal blocks through the auction will be more proactive in mining the output as well.

Policy flip flops have already hurt the sentiments in the telecom sector. To add to it, the government has decided to continue its step child policy. It has to come up with proposals that suit its own coffers rather than the health of the overall sector. The Telecom Regulatory Authority of India (TRAI) has proposed to set the minimum fee for the upcoming 2G auction at sky high levels. This means that if a company were to get a pan India license in the 1,800 MHz (Mega-Hertz) zone, then it would have to shell out a minimum of Rs 180 bn. For spectrum in the 800 and 900 MHz zones, it would pay a minimum of Rs 72 bn. These prices are nearly 13 times the price at which 2G spectrums were given in 2008. To add to this, the incumbents would need to pay through their noses for 're-farming' of the spectrum. They would have to pay around Rs 950 bn for the spectrum they already hold. Naturally, the operators are not happy with these ridiculous prices. The consumers too should not be happy with TRAI's proposals either. If the companies dish out this high amount, it is but natural that they would look at increasing their revenues to compensate the increased costs. This means that telecom tariffs would go up. So, the TRAI's proposals would lead to burning a hole in the pocket for both the consumers as well as the operators. All for helping the government in meeting its fiscal target.

Rewind 5 to 7 years back when everything was hunky dory in the world of finance. At that time, the Indian stock markets were marching ahead in full optimism. That was also the time when private equity (PE) as an asset class gained a lot of ground. Typically, PE funds in Asia take equity stakes in unlisted companies. When later the companies go public, they tend to gain handsome returns. In other words, it's a high-risk high-return game. Unfortunately, so far, PE funds in India haven't been able to taste the kind of success they set out for. Why? As you know, Indian stock markets have slowed down over the last few years. The IPO markets are running dry. At the same time, many owners are reluctant to issue public shares.

But there is a more fundamental reason for the failure of PE funds. During the heydays of 2005 and 2007, they were carried away by greed. They made investments at expensive valuations. Even when they had to opportunity to sell off when the markets were soaring, they did not, hoping for even better valuations. This is a very important lesson for retail investors. Greed has the power to make even highly qualified professionals behave in irrational ways. It is best to stick to the fundamentals of value investing and not get carried away by market swings.

Capital is like a precious commodity in limited supply. It needs to be conserved and used efficiently For the banking industry capital is all the more important. Manufacturing companies have plants, machinery, etc. to their name. These real assets can be sold in times of distress. However banks do not own any significant tangible assets. Since bank's assets and liabilities are just 'paper transactions', these entities need to maintain certain levels of liquid cash and equity capital as a buffer.

The global Basel III norms are likely to put pressure on bank's earnings, according to Reserve Bank of India's (RBI) deputy governor, Anand Sinha. These norms require the equity capital of a bank to be greater than 5.5% of risk-weighted assets. Most banks currently have a buffer over this level. But, as their assets grow in size, they would require more capital against the same. Banks would now need to focus on increasing productivity in order to protect their return on net worth.

In the meanwhile, the Indian stock markets were trading well above the dotted line. At the time of writing, the BSE Sensex was up by 112 points (0.7%). Among sectoral indices, IT stocks displayed maximum strength and were up by almost 5%. Capital goods, healthcare and autos were on the losing side. Asian stock markets were a mixed bag while Europe opened on a positive note.

 Today's Investing mantra
"Diversification may preserve wealth, but concentration builds wealth." - Warren Buffett

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    3 Responses to "A persistently sick Europe will hurt global growth"

    Amit Kumar

    Apr 26, 2012

    It has to happen in the long run when undiversified economies like greece and spain had to encounter such global shocks where they could not even change the monetary policies in their favour and only resort to their fiscal policies and austerity measures. Even somewhere else the father of modern euro currency "Rober A Mundell" was aware of this fact and quoted that in such a situation country has only one resort keep the taxes low and interest rate high whose quantum phenomena was even not very clear to many capitalist economists of his time.

    Like (4)

    Ajay Kaul

    Apr 24, 2012

    European manufacturing Industry particularly the Clean Tech Industry needs a revival and to revisit its Asia Strategy where Growth momentum is still high and sustainable due to its Demographic advantage.

    Like (6)


    Apr 24, 2012

    Very likely that it will hurt.Eurozone problems are not going away anywhere so soon as it is culmination of free entitlements given away over many years by politicians who have no economic moorings.Somebody somewhere have to pay for the grandpa's free lunches.It is in every bodies interest to prop up such sick economies hoping for a better day in the process global growth will have to take a hit in the medium term.Countries who can get away with financial profligacy will be the least affected.

    Like (2)
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