Should you be worried about geopolitical risks? - The 5 Minute WrapUp by Equitymaster
Investing in India - 5 Minute WrapUp by Equitymaster

Should you be worried about geopolitical risks? 

A  A  A
In this issue:
» Derivatives trading in India on the rise
» Junk bonds are finding favour
» Debt in China has zoomed
» Is there an upside to the HDFC-HDFC Bank merger?
» ...and more!

We are living in an increasingly uncertain world. The crisis in Iraq and Syria, the Ukraine-Russia war and the Israel-Palestine conflict means that the risk of geopolitical tensions has increased. The downing of a Malaysian Airlines civilian plane over Ukraine has only raised the stakes higher.

Are these developments something that investors need to worry about? The global stock markets certainly do not seem to think so. Most of the global indices in 2014 so far have posted gains. There are probably several reasons for this. One is the belief that despite all these conflicts, diplomacy will prevail which means that these risks will not spread to other geographies. The other reason probably is that not many think that these tensions will impact the GDP growth of their respective economies too much.

But the most important factor driving the stock markets is obviously the easy money policy being followed by central bankers of the developed world. With so much liquidity in the markets, most of the asset classes are rising with the danger of bubbles forming in some of them. However, none of the developed economies have displayed any meaningful signs of a recovery. So, in an era of escalating conflicts and weak global growth, if global stock markets are rising, it only shows the extent of distortion that the central bankers have created.

We think it would be foolhardy to completely ignore geopolitical risks. For one, in a global economy which is becoming more and more interconnected, prolonged conflicts of any kind are bound to have some sort of an impact on GDP growth. Oil is a classic case in point as prices typically rise on geopolitical risks; thus, persistently high oil prices can wreak havoc on GDP growth. Even though the extent and the timing of these risks will always remain uncertain, some impact from them will have to be priced in.

Given that the Indian economy is also increasingly integrated with the global economy, it is no longer completely insulated from what is happening overseas. And so the risk from geopolitical tensions hangs over the Indian economy as well. Having said that, India's GDP does have the potential to grow provided the current Modi government delivers on its promise of implementing reforms. The current buoyancy in the markets also seems a product of companies reporting better results for the June 2014 quarter. And once the infrastructure story starts picking pace, there is no reason why corporate earnings should not grow either.

Thus, for Indian investors, investing in equities still has the potential to increase wealth provided money is put into strong quality stocks. Not just that, given that we have always been advocating the principles of asset allocation, we believe that investors should also have some part of their portfolio allocated towards gold. In this way, equities are helping you participate in the India growth story. And gold to some extent is insulating your portfolio from the rising geopolitical risks and cheap money policies in recent times.

Do you think that rising geopolitical tensions will have an impact on your investment portfolio? Let us know in the Equitymaster Club or share your comments below.

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01:36  Chart of the day
Equity markets in India have evolved over the last decade. Not only have they become vibrant and more transparent, investor participation has also increased. As a matter of fact, the combined trading volumes on both BSE and NSE have increased by 50% in the last 10-12 years. Also, NSE's achievement to be ranked amongst the top two exchanges in the world within such a short span of time is noteworthy.

However, keeping the evolution part aside, a further breakdown of trading volumes reveal why development of India's micro structure is nothing short of being scary. Fathom this. About 96% of the expansion in volumes which we mentioned earlier is driven by retail investors who speculate heavily in derivatives. Indeed, as today's chart of the day shows, the derivatives to shares trading value in India is disproportionately high. Now derivatives at best should be used as an effective hedging tool. But are being used to speculate to make quick gains in India. And that too by naive retail investors. You would be surprised to know that more sophisticated investors constitute just 13-17% of the overall derivative trades that conclude on exchanges!

Derivatives being risky in nature, speculating in them have resulted in huge losses for investors in the past. Agreed, systemic risks for such instruments are high which were deemed to be a weapon of mass destruction by the Oracle of Omaha. However, they also present an opportunity to earn 45% in one month if you have the right trading strategy in place. And this is where retail investors should effectively focus if they have a taste for higher risk.

Derivatives trading in India is quite high

We have mentioned time and again that the current Fed policy of keeping interest rates low is not helping the economy at all. As a matter of fact it is once again creating asset bubbles that will eventually burst with devastating consequences. Recently, the popular magazine Businessweek has drawn the world's attention to one such bubble. And it answers to the name of junk bonds. Sample this. It took 12 years for the value of bonds in the high yield index to touch US$ 1 trillion. It however took just four years to add another US$ 1 trillion to its value! And why are people piling on to these extremely high risk, high yield bonds? Simply because they are not earning enough returns in safer asset classes on account of the Government's policy of keeping interest rates low. They are thus being forced to take great risks and invest in bonds that have a much greater probability of default should the conditions worsen. However, investors are so confident of the good times continuing that default is the last thing on their minds. In fact an expert has been heard saying that he has rarely seen a market so unworried about defaults. Now, that's certainly not a good sign we believe.

We have reiterated time and again that debt is not always a bad thing. It can be a great means for accelerated economic growth. But like all things, anything in excess can be dangerous. Debt too can turn out to be a double-edged sword if not used with restraint. We have seen how excess leverage has not just killed many corporates but has even brought countries down on their knees.

China's phenomenal growth would have been impossible without debt. But it seems that the dragon economy's growth model of debt-driven investments has run its course. The economy is now sitting on a mountain of debt coupled with slowing growth prospects. Consider this fact for instance... At the end of 2008, China's total debt as a percentage of GDP was 147%. But as per a new estimate from Standard Chartered Bank reported in The Financial Times, China's total debt at the end of June 2014 stands at an overwhelming 251% of GDP.

But the size of the debt burden is not the only worry. A bigger worry is the rate at which it has escalated in recent years. If history is anything to go by, such rapid increase in debt levels is usually followed by financial crisis. These are indeed worrying signs. A financial crisis in China would wreck havoc not only in China but the entire global economy.

Investors in the telecom sector have a reason to cheer. The telecom regulator TRAI has recommended norms for sharing of telecom spectrum between two operators. All spectrum bands have been freed up for sharing. This move will certainly help telcos reduce operating costs. It will also lead to lower tariffs if the benefit is passed on to the consumer. After years of policy logjam, it is heartening that some progress is now being seen. However, it may not be a time for celebration just yet. The new norms are just suggestions as of now. They still have to be notified. What's more, the norms have come with caveats. The TRAI has put a 25% cap on the amount of spectrum that a company can share. Also, companies will be allowed to share spectrum that they hold in the same band. Thus a company cannot share its 2G spectrum with another telco's 3G spectrum. Despite these restrictions, we believe this is a positive move by the regulator. It will ease operating costs for telcos as well as improve the quality of service. We hope this is a sign of things to come. Easing of more regulations can certainly bring 'Acche Din' to the sector and to its investors.

Size does not make an entity great. However, despite the 'too big to fail banks' displaying their fragility in 2008, the obsession with big banks has not died down! At least not in India! Investors continue to salivate at the prospect of banks in India getting bigger to compete with their Chinese and American counterparts. Take the case of merger between HDFC Ltd and HDFC Bank for instance. The reason why investors are keen to speculate on the merger is because it could create the largest private bank in the country. One that will surpass the current biggest ICICI Bank in balance sheet size. Moreover, the merged entity would be India's most valuable bank. As per rough estimates, their combined market valuation could top Rs 3.5 trillion, leaving both State Bank of India's (Rs 1.9 trillion) and ICICI Bank's (Rs 1.7 trillion) market caps far behind. But in this investors are assuming that the combined entity will fetch the premium valuations that both the HDFC entities get currently.

Now, the two entities do have an unparalleled track record in consistency of financial performance. However, when one analyses the incremental cost benefit that could flow to it from the new infra lending norms, there is not much upside in the near term. HDFC is already one of the very few housing financiers which enjoys AAA rating and thus raises funds cheap. For it to take the benefit of new norms it will have to concentrate on infra lending besides mortgages. Doing so may lead HDFC to compromise on its area of specialization. As we said earlier, we do not think, the merger, if any, will have immediate upside for either of the entities. Hence investors should not take investment decisions in any of the stocks, based on the speculations about the merger.

In the meanwhile, the Indian stock markets continued to trade strong. At the time of writing, the BSE-Sensex was trading higher by 210 points (+0.8%). Majority of the sectoral indices were trading in the green led by oil and gas and IT. However, capital goods and power stocks were facing selling pressure. Barring Indonesia, all Asian indices were trading strong led by Hong Kong and China. European markets have also opened on a firm footing.

04:56  Today's investing mantra
"Asset-heavy businesses generally earn low rates of return - rates that often barely provide enough capital to fund the inflationary needs of the existing business, with nothing left over for real growth, for distribution to owners, or for acquisition of new businesses" - Warren Buffett
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1 Responses to "Should you be worried about geopolitical risks?"

Jul 24, 2014

The World is truly globalized and no country can remain decoupled from the global economy.
Growth or a decline in China affects India ,Asian economies and the world at large.
Recession in Europe and the US affects the world economy.Middle east and the flow of oil is crucial to the global economy.

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