What no one is telling you about the financial crisis

Oct 16, 2013

In this issue:
» TCS hits an all-time high on strong second quarter results!
» CBI names Kumar Mangalam Birla in coal block scam
» Dr Doom doesn't find any asset class safe
» Singapore has a real estate lesson for India
» ...and more!

If you have been following the developments in the global economy, this question may have come to your mind: Why is there such a deep disconnect between economic realities and asset prices?

The world is still reeling under the after-effects of the 2008 financial crisis. The crisis was so severe and widespread that the fundamentals of the global economy have been adversely hampered.

Major central bankers have been pumping loads of cheap money to keep their economies afloat. But this is a very dangerous game. They're piling up colossal amounts of debt.

The US government is facing a debt ceiling crisis. If the debt ceiling is not raised above the US$ 16.7 trillion cap, then US Treasury will not have enough cash to pay its bills tomorrow onwards.

Emerging economies too have succumbed to the malaise in the global economy. Take India for instance. Our economy is in a terrible shape. Growth is fast slowing down. And on the other hand, inflation and government deficits remain uncomfortably high. We are almost witnessing stagflation (very low economic growth and high inflation).

There are several impending dangers lurking in the global economy. The cheap liquidity is brewing asset bubbles across the globe. Stock prices and property prices are at unsustainable levels.

So when will this bubble burst? Or rather, why are markets not reacting to these impending risks? An article in the Financial Times provides a very sagacious insight.

To understand the dissonance between economic fundamentals and asset prices we need to first understand the nature of markets. Financial markets constantly respond to the tireless inflow of news. It almost gives the illusion that markets are constantly factoring all the relevant economic changes. In fact, this even inspired some economists to propose the Efficient Market Hypothesis.

But markets have had a poor track record of factoring in the risks of rare but highly impactful events. So let's say the seeds of a major crisis could be out there. But the markets would not react for long periods. And then suddenly markets would take a steep, unexpected plunge. So instead of factoring in the increasing risks in a smooth manner, the reactions of the market are often sporadic.

Take the example of the Eurozone sovereign crisis. For a pretty long period, the markets behaved as if there was no risk of sovereign default. But when they finally did react to the risks in 2011, they ended up over-reacting.

Why such strange behaviour? Were the markets unaware of the impending crisis? Why does the so-called smart money appear to behave in a dumb manner?

Here is the reason... Firstly, it is cumbersome for big institutional investors to change large portfolios promptly. Secondly, buying hedges for an extended period can be expensive. This would not just increase their costs but also erode their short term performance in comparison to their peers. Since fund managers are more concerned about their short term performance, prudence is not something that they show a great affinity for. So they wait till the evidence of a major crisis is very apparent. But by then, many other investors are also reacting to the crisis. And this often results in asset prices going into a free fall.

So if you see a major global crisis sometime again, don't be too surprised.

Do you think we will see a major global crisis in the next one year? Let us know your comments or post them on our Facebook page / Google+ page

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 Chart of the day
Information technology major Tata Consultancy Services (TCS) reported strong growth in its second quarter earnings (2QFY14). This has boosted the company's stock price to an all-time high. With market capitalisation of about US$ 70 bn, TCS bears the tag of the company with the highest market capitalisation in the Indian stock markets. Mukesh Ambani-led Reliance Industries Ltd (RIL) is a distant second with a market capitalisation of about US$ 45 bn. Today's chart of the day compares the market capitalisation of TCS with some major global companies. Its market capitalisation is now almost close to Wall Street giant Goldman Sachs and renowned German brand BMW. It is worth noting that the Tata Group market capitalisation now stands at US$ 110 bn, with TCS alone accounting for about 64% share.

How does TCS stand compared to major global firms?
Data source: The Times of India

With widespread corruption scandals emanating every day, corporate governance has assumed greater importance. But when promoters of highly rated companies are found greasing palms to further their corporate interest, it gets all the more difficult to assess management quality. Take the case of Kumar Mangalam Birla for instance. The CBI has formally named him in the FIR of the coal block allocation scam. It is believed that Mr Birla connived with the then coal secretary to ensure that his company was allowed to mine from a block that was reserved for a PSU.

Now, Mr Birla is a widely renowned businessman who generally plays the game neat. Thus, CBI's FIR against him has come as a shock to many. Quite a few businessmen have also voiced their opinion supporting his business practices. However, the decision by CBI to name him might be on some merit. A crime investigation body will not name a top honcho in a FIR without any concrete evidence. However, considering that CBI is not reputedly autonomous, one cannot rule out a foul play here. Now, whatever the truth, the fact is that Aditya Birla Group's corporate image has taken a beating. And this may not bode well with its investors.

It's been a while since we heard from Dr Doom Marc Faber. So, here's the latest on how his mind perceives the economic and political world around us. Unfortunately, it's not painting that good a picture. He opined to Bloomberg TV that there are no safe havens in the world anymore. Bank deposits are not safe. Money in Government bonds is not safe because of the paltry returns. And equities in the US are also not safe because of the high valuations. Consequently, the best that one can hope is have a diversified portfolio and pray that not all assets go down at the same time as per him.

He can't be more correct as per us. The Government intervention in the financial markets, especially in the developed world, is unprecedented in its scope and size. And when this happens, no free market rules apply. Everything moves in accordance with what the Governments and central banks do. Consequently, diversification with a good deal of leaning towards gold is the best bet to deal with such an uncertainty we reckon.

Most of the countries in Asia are battling high property prices. Governments have been putting measures in place to try and cool off this 'bubble' but none have been successful so far. For all these governments, including that of India, there are lessons to be learnt from the island nation of Singapore. The government's measures have finally helped it at least control the increase in housing prices. Housing sales finally declined by 52% YoY in September 2013. Price increase was just 0.4% as well. So what is it that the country did to achieve this?

Singapore took strict measures and took them when property prices had started to rise way back in 2008. Measures include capping mortgage loans, restricting the amount of loan that can be taken. And most importantly keeping interest rates pegged to the global economy. In the current scenario, where global interest rates are expected to rise, the last factor has been a big deterrent to prospective loan takers.

The thing is that if governments are truly interested in controlling property prices, then they have to take strict measures even if they are considered to be draconian at the time. Even more importantly, measures have to be taken on time and have to evolve over time. Just passing one rule/reform and expecting its benefits to last forever, is not a solution. Perhaps countries like India could take a cue from Singapore on how to rollout reform measures to control price bubbles.

Tomorrow could be a day of reckoning in the history of financial markets. While most of us are oblivious to it, there is reason enough why we shouldn't! The final outcome of a prolonged debt negotiation in the US is expected tomorrow. One that will decide the fate of US Treasuries. Now this de-facto safe haven asset class is considered at par with gold by many investors. Even when a solid company like Apple issues debt to pay its bills, Apple is considered relatively more risky than the debt of the United States. And thanks to its AAA rating, the US has managed to become the largest debtor on the planet.

As per Money News, the US owes roughly US$ 12 trillion to public investors. Even China and Japan are famously known to hoard US Treasuries. Therefore a debt default by the US, if any, could have serious implication for global investors. Most importantly, if the demand for US Treasuries falls dramatically, the cost of global borrowing rates could see a steep rise. Time to keep fingers crossed.

How would a default by US affect your portfolio in India? We know it is questions like these that concern you these days. And your trusted source for views and opinions, The 5 Minute WrapUp, too has unfortunately not helped by staying silent on such questions. We understand that, in addition to broad views on global stock markets, you might also be looking forward to our views on few unexpected movement in stocks. And that is why we are taking steps to make The 5 Minute WrapUp more relevant to you. Watch this space for more details in the coming weeks.

Indian markets were closed today on account of Eid. While other Asian markets closed a mixed bag, markets in Europe have opened flat to positive.

 Today's investing mantra
"It's better to hang out with people better than you. Pick out associates whose behavior is better than yours and you'll drift in that direction." - Warren Buffett

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5 Responses to "What no one is telling you about the financial crisis"

g. das

Oct 20, 2013

The U S shutdown has shown that the US Govt. is bankrupt. It is running on borrowed time. The question is at what time US will actually default. Certainly they are going to default because for decades they are running the biggest ponzy game . Its effects will be a great depression ( much bigger than housing credit collapse in US in 2008 ) all over the world including India.


Chandrakant Deo

Oct 17, 2013

Equitymaster, you have correctly said that how can there be such a disconnect between economic realities and assets prices.

There are some events when we feel what actually is happening to world economy, for instance last month US fed didn't taper and market cheered the news.
I mean to say there is problem and there is no or lesser growth in case of industries and US economy and for that the fed has to buy bonds, and if they don't then what? Again there will be no growth. That means either it is tapering or raising the debt ceiling US is postponing the bursting of the bubble from today to tomorrow.

Now you may experience another strange behaviour of markets today if they raised the debt ceiling.
What's there to cheer Today I don't have money to pay and I am raising the limit to higher levels is a sign of expanding the size of crisis and not a measure to tackle the crisis.

Thank you.


H K Prakash

Oct 16, 2013

In spite of everything, Indian industry is NOT doing all that badly. Sure earnings are off, exports are slightly up (since USD/R is up), margins are squeezed BUT our companies are not down and out. How do I know ? A. I have earned totally more than Rs 1 lakh dividend this year from many companies (ie not just a few out of my total holdings), B. A few have showed respectable earnings but decided NOT to declare a dividend to conserve earnings.
If our Pseculiar Leaders have some guts, cut down unnecessary imports (coal, gold, silver, Chinese junk, Italian pasta), pare down cumbersome restrictions, encourages exports (particularly easy to export items like rice, sugar, wheat etc which we have in plenty) and force the PSU Banks to lend more to worthwhile borrowers, we might be pleasantly shocked by 2014/5 FY corporate earnings!



Oct 16, 2013

Mr.Kumarmangalam Birla may have an haloed image,but the takeaways and his dealings at shareholders meets of his Company Hindalco,etc(the only point of contact for shareholders)is not very comfortable for the silent,discerning shareholder,who has watched his interaction with other shareholders.
He does not like shareholders asking searching (but genuine questions) and dismisses them on grounds of paucity of time at meetings. This has sent alarm bells ringing.
Maybe now he will be given sufficient time to explain.
Everything does not appear above-board.Time will tell.

Like (2)

svs prasada rao

Oct 16, 2013

dear sir , excellent presentation on global facts .it is said truth is bitter some times . i wish that all readers
will be benifited thro your article .
prasada rao

Like (1)
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