»5 Minute Wrap Up by Equitymaster

On This Day - 12 AUGUST 2011
This global crisis is not just a 'Great Recession'

In this issue:
» Will France also lose its AAA credit rating?
» Warren Buffet is on a buying spree...
» RBI dumps hopes of ending interest rate hikes
» Exports zoom in July but bumpy road ahead
» ...and more!
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 Chart of the day
The first week of August, 2011 saw the world financial markets tumbling like a house of cards, the trigger being the US debt downgrade by credit ratings agency Standard & Poor's. Today's chart of the day shows that stock markets across the globe witnessed heavy panic selling between 1st and the 8th of August, 2011. The biggest losers were the markets of Brazil and the USA, both losing 16.9% and 13% respectively. However, stock markets in India and China were relatively resilient and declined by 8.1% and 6.6% respectively.

Source: Yahoo Finance

But, the roller coaster ride hasn't ended yet. The global economic landscape seems shrouded with extreme fear and uncertainty. Though the Indian economy is not significantly impacted by the global economic turmoil, it cannot totally escape the mess. Thus, investors would be better off if they have a grasp of the big picture.

So let us get some basic understanding of what's really happening out there. Many economists have called the current economic condition of the developed world as the "Great Recession". However, that is a grave mistake. A recession implies a temporary cyclical economic downturn. By adding the adjective 'great' before 'recession', it only means that the downturn would be severe. Now, you may ask why the name matters so much. Kenneth Rogoff, co-author of the book This Time is Different presents a very apt analogy. Say, for instance, you have pneumonia but you only think it's a very severe cold. In that case, you go on a completely wrong medication which instead of curing your disease further aggravates your woes. In a nutshell, this is exactly what happened with the developed world. They misjudged the real problem. Governments and central banks used the wrong medicines. They tried to treat a debt-problem with more debt. No wonder the health of the economy became bad to worse.

The term "Great Recession" totally missed the real culprit of the current global financial crisis- "Overleverage"! The developed economies went through a massive credit expansionary phase that created an extreme imbalance between lenders and borrowers. With the economies slowing and the debt-burden mounting, borrowers are having a hard time returning the money. The recent downgrade of the US debt was not the climax and in fact, only the starting point. There is much more severe turmoil yet to come. The imbalances will find their way out through a series of defaults, financial repression measures and not to mention, inflation. The world economy is likely to experience an extended period of contraction and deleveraging.

There is an important lesson for investors in this macroeconomic story. Be it a company or an economy, the same rules apply for both. Though leverage can be a catalyst for growth, the same can spell doom if not handled well. As such, we strongly believe that while evaluating stocks for investment investors should be wary of heavily indebted companies.

According to you, how important is it to weigh a company's debt burden while investing in stocks? Share your comments with us or post your views on our Facebook page.

Just as we said earlier, the US downgrade was only a starting point. Now there maybe another developed economy that faces similar fears. This time it is France's turn to panic. The country's debt has increased to a whopping 82% of its GDP (Gross Domestic Product). As per rating guidelines, this is way too high for the 'safe 'AAA' rating. At the same time, the country's economic growth has slowed down to a snail's pace. As a result, there were fresh fears that the Big 3 rating agencies may downgrade French debt. But as per a leading daily, the Big 3 - Moody's, Fitch and S&P, have assured the French President that in their opinion France's rating is stable. This makes the case of rating a country's debt curious and it is just getting curiouser. Apparently, the agencies bend and change the rules as they please. They would downgrade Country A for having too much debt. And at the same time give a stable rating to another which has the same level of debt. We wonder why then investors rely so much on these ratings that they are willing to sell every stock they own when there is news of downgrades.

Not for nothing is he one of the most successful investors in the world. Perhaps the most successful! For the majority of us, this time does look like different. But it is all the same for a certain Mr Warren Buffett. For him, no matter how dark it becomes, a new dawn will always emerge. It hardly comes as a surprise then that when stocks are falling like nine pins in the US, Mr Buffett is standing by, looking to scoop them up with both hands. "The lower the things go, the more I buy. We are in the business of buying", he is believed to have said. This is not all. He is also seizing the opportunity of raising capital in light of the ultra cheap rates prevailing in the US. Clearly, this man appears like he has been hard wired to keep compounding money at phenomenal rates. We may not agree with his views on the economy, but it would be foolhardy to bet against his stock picking abilities given the evidence at hand. It is best to ape legends like him rather than try and prove him wrong.

When central bankers in a globalised economy are poles apart in their policy making stance, the times get tougher. On one hand our very own RBI has resolved to keep interest rates firm even if that means sacrificing growth rates. On the other hand, the US Fed wants to keep pumping cheap money for the next 2 years at the cost of over leverage. In such a scenario, the Indian consumers and investors will have to live with their woes for some time at least. Commodity and food prices will remain far from correction unless the excess liquidity in global markets is sucked out. Also, investment returns in domestic markets will remain volatile as long as cheap capital inflows continue to chase high returns. Thus, the Indian consumers and investors must brace their consumption budgets and investment portfolios for such shocks in the medium term. Having said that reversion to the mean is a given. And whenever that happens in the longer run, the conservative lot (Indians) will stand to benefit.

When QE2 ended, the US Fed was adamant that it would not resort to more quantitative easing. But there is an increasing possibility that the US central bank will end up eating its words. For starters, the Fed took the unprecedented step of promising it would keep interest rates near zero for a set period of time- at least until 2013 - and said it was exploring other options to support a flagging recovery. Now what would QE 3 involve? While it is still unclear, one thing that the Fed may consider is another round of asset buying akin to what the QE2 involved simply because it will be on familiar ground. The other option on the table is to let a bit of inflation creep up into the economy especially if the economic scenario continues to deteriorate. We are of the view that none of these will really work and the failure of the previous quantitative easing programs, more than amply highlight the fact. For the US economy to grow the government needs to create jobs while at the same time cutting down its debt considerably. More asset buying and inflation targeting will only create a fresh set of problems that will come to haunt the US economy in the future.

Exports grew by a whopping 82% year-on-year (YoY) in July 2011 but caution is sounded going forward. Imports were up by 51.5% YoY during the same period. Exports in July saw such a huge jump on account of new segment of engineering products which is showing healthy growth numbers. Also, bullion and petroleum exports helped the country post exports of US$ 29.3 bn last month. However, such a growth is not sustainable. Looking at the economic situation in the two major export markets of the US and Europe, things are set to change. Recent downgrading of the sovereign rating of the US along with the ongoing debt crisis in the European countries will impact the exports adversely. Also, the other economies like Thailand, Vietnam and Malaysia may see some slowdown as they too deal in US dollars. As per the Prime Minister's Economic advisory Council (PMEAC), merchandise trade deficit is projected to be US$ 154 bn which would be 7.7% of the 2011-12 GDP (Gross Domestic Product) up from US$ 130.5 bn in 2010-11 (7.59% of GDP). The trade deficit level reached US$ 42.7 bn during the first 4 months of the current fiscal.

Indian stock markets have been trading weak today. At the time of writing, the benchmark BSE Sensex was down by 22 points .The sectoral indices were trading mixed with IT companies leading the pack of losers and consumer durables trading strong. The Asian stock markets too are trading mixed with Taiwan and South Korea leading the losers and Singapore and Hong Kong trading in the green. All European markets opened in the green.

 Today's investing mantra
"Once we realize that imperfect understanding is the human condition there is no shame in being wrong, only in failing to correct our mistakes." - George Soros

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