'Pay the bank to keep your money safe'!

Jun 7, 2014

In this issue:
» Is Europe headed towards deflation?
» Time to move to long term funds?
» Will foreign stocks now be attractive?
» Will real estate investment trusts be allowed?
» ...and more!

The whole idea of having to pay the bank for keeping your money safe may seem ridiculous! After all, as good savers, Indians have always been incentivized by the banking system to park more and more money in deposits. Since most Indian households do not have enough exposure beyond physical assets like gold and real estate, bank deposits are the most widely held financial asset. That apart, bank deposits in India have been quite lucrative as well. Barring the last 4 years when real interest rates for deposits have been in the negative.

But it turns out that central banks in the West are tactically using the concept of 'negative interest rate' to avert some chronic problems for their economies. Well, the central bank of the US and prior to that of Japan have stuck to near zero lending rates for a while now. However, the European Central Bank (ECB) has gone a step ahead and asked banks in Eurozone to pay it interest of 0.1% to park funds. The logic is to disincentivize banks from hoarding money and instead lend more aggressively. If the banks choose to pass on the negative interest rate to their depositors, the latter might consider riskier investments or spend more.

The ECB and its counterparts in the West believe that risky investments and growth in consumption will help GDP growth. Denmark, which also experimented with negative interest rates in 2012, has already proven that such an assumption is faulty. Yet, the ECB, which has so far resisted the temptation of printing money the US way, has gone ahead with the negative interest rate policy.

One can therefore conclude that the global economy may have to live with very low interest rates much longer than expected. With low interest rates becoming the 'new normal', economies that have high debt will benefit from higher inflation. This is because the value of their borrowings will keep getting lesser. However, this will be at the cost of 'prudent' economies like India when the tendency to save is more than that to borrow.

No doubt the RBI will try to insulate the liquidity scenario in India. Nevertheless, the three primary fallouts of the cheap money policies in the West will be asset bubbles, leveraged balance sheets and currency wars. Asset prices will continue to inflate on the back of cheap money coming in from West. Companies will find it easier to borrow, if not in domestic markets then abroad. And economies will indulge in currency wars to protect their turf.

Keeping these in mind, investors have to be very careful about the kind and price of assets they invest in. It is not just assets like real estate that tend to get inflated with foreign money. But buying companies with dodgy balance sheets at steep prices is also a strict no.

Which asset classes according to you, will investors prefer if global interest rates continue to remain very low? Let us know in the Equitymaster Club or share your comments below.

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 Chart of the day
The strange world we live in just got stranger. We are strictly talking economics here. Therefore, just as you were thinking that trillion dollar bond buying and near zero interest rates are perhaps the outer limits of the lunacy of western policy makers, well you haven't seen nothing yet. Pat came an announcement just recently that the European Central Bank has officially cut one of its key interest rates so low, its gone in the negative territory. Therefore if the rate is say 3% and you put your deposit in a bank, you'll get Rs 97 back at the end of one year for every Rs 100 that you invest.

Apparently, this is being done to inject life into an economy that as today's chart of the day shows is in the throes of a dangerously low inflation. It's natural for one to ask why not go the US way and indulge in quantitative easing? Well, it appears that this step is illegal as per the charter of the European Central Bank. And therefore it had to resort to this other method of negative interest rates. For us though, it's just the same wine in a new bottle. And it could have the same eventual effect, a dangerously high inflation. Yet another reason to hang on to that yellow metal gold we believe.

Eurozone inflation: Headed towards deflation?

While stock markets have been on a tear for quite some time now, bond markets too seem to buzzing with activity. While interest rates were unchanged in the latest monetary policy review, RBI's dovish policy tone sent Indian Government bonds to almost four month high levels.

As Indian macroeconomic indicators seem to be improving, speculations are high that RBI may go easy on rates. With hopes of easing interest rates and hence lower bond yields, one may come across suggestions to shift from short to medium term and long term funds. However, one must keep in mind that the central bank's focus is on controlling inflation and currency stability. High inflation in India is mainly on account of supply side constraints. The same cannot be removed overnight. Hence, betting on a reversal of interest rate cycle in the near future can be risky. Further, we would suggest that investors should avoid timing interest rates. Instead, it would serve them well to take investing decisions in line with the return requirements and risk appetite.

As the wave of liquidity around the world has increased, there has been growing interest in investing in foreign listed stocks. Given that the stock markets in the US appear over valued in relation to the economic fundamentals there, investors have been looking at other options. With more money in their hands, the risk appetites for better returns have also risen. For instance, there seems to be a lot of interest of late in Chinese and Russian stocks. And now India too is toying with the idea of letting Indians invest abroad. As per an article in the Business Standard, the RBI has hiked the Liberalised Remittance Scheme (LRS) limit to US$ 125,000 from the current US$ 75,000. But Indians should not get lured by the prospects of foreign stocks just because they seem to be the flavour among global investors. Just like they would do for stocks back home, Indian investors will need to do their homework in terms of understanding the businesses and valuations of these companies before they take the decision of investing in them.

Quite a few sectors have been in the doldrums for a while now. With interest rates high, and consumer sentiments not as desired, the real estate sector was one that has been impacted quite a bit. To add to the troubles of developers, liquidity became a problem given that the inventories were piling up and banks were not willing to lend. However, all this is expected to change soon as the much awaited real estate investment trusts or REITs are expected to be allowed in the upcoming budget. But from an investors' perspective, this will definitely be a good opportunity to increase exposure to the real estate segment. Being a large ticket item, property investing is not everyone's cup of tea. And given the strong desire for investing in real estate (especially over the past few years), it is expected that demand for REITs will remain very strong. As reported in Business Standard, REITs could possibly attract funds worth US$ 10 to 15 bn in the first year of operations itself! It is believed that regulators, developers and investors are waiting on the government's stance on the tax treatment of the same. Nevertheless, with the interest rates expected to start coming down in the medium term, the revival in the real estate is mostly on the cards. And as such, participating in the real estate story of India market through REITs would be a good option.

Barring Asia, global markets scaled new peaks in the week gone by. While Indian markets led the way in terms of gains, optimism was clearly visible across the US and Europe. The benchmark S&P 500 index in the US closed the week at an all time high, just shy of the 2,000 points mark. The US markets shrugged off the negative 1% GDP number for the Jan-March quarter as a one-off event caused by adverse weather conditions. The US markets also cheered the latest jobs report which showed that the economy had finally recovered all the jobs lost in the great recession of 2008-2009. However, it must be noted that it has taken a record 77 months for the US economy to recoup all the lost jobs.

In Europe, markets were enthused by the steps taken by the European Central Bank (ECB). In an unprecedented move, the ECB said this week that it would adopt a negative interest rate policy for bank deposits held by it. This means that the ECB will effectively charge banks an interest rate of 0.1% for parking their reserves with it. This has been done with a view to force European banks to lend and boost credit in the European economy which is currently struggling with deflation.

Performance during the week ended Jun 06th, 2014
Data Source: Yahoo Finance, Kitco

 Weekend investing mantra
"Know what you own, and know why you own it" - Peter Lynch

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Jun 7, 2014

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