In the last few weeks, Greece has taken the center stage in the financial markets. Within the next two months, Greece has to pay back the maturing bonds [to investors across the world] and finance its budget deficit. The country needs to borrow around $ 40 billion from the international markets. With 10 year Greek Government bond interest rates of  around 7% [more than 3% to 4% higher than 10 year U.S. Treasury Bonds and German Government Bonds], this has led to fresh worries over a potential default by the Greek Government. What has added to the problem over the last two days is a rapid withdrawal of deposits from Greek banks by its citizens. Unless Greece agrees to the terms set forth in the rescue package put together by the European Union and IMF [ to reduce government spending and increase taxes], it is difficult to get the support of this consortium to raise the $ 40 billion to stave off the crisis. As you can see from the graph, Greece’s debt is over 111% of GDP. We believe the situation in Greece is getting grimmer day by day and could be a trigger for a crisis in other European nations – Portugal, Italy and Spain.

The China Bubble

The fiscal stimulus initiated by China last year through bank lending to the tune of $ 1.2 trillion has led to potentially unstable conditions in their economy. According to well known investor James Chanos – with 60% of the country’s GDP relying on construction, ‘China is on a treadmill to hell’. Marc Faber a long time optimist on China and well known economist Kenneth Rogoff have also spoken of a China Bubble recently. With the Chinese government trying to enable a slow down in real estate speculation via a recent tax on sale of homes owned less than 5 years, one cannot rule out a rapid decline in prices which would have a negative impact on the economic growth.

Any one or combination of the two global factors identified above could trigger a mild to deep correction in the financial markets and slow down the world economy. Due to the strong financial linkages with the U.S. and the rest of the world, India will not be spared.

Srinivasa Sharan contributed to this article.

Graph Source : DNA

Ironically, the financial crisis in 2008 coupled with the rapid growth of  China and India, the trade is now shifting its balance to ‘South producing for South’.

In a recent article written by Manas Chakravarty , which is based on the latest World Bank paper on the changing balance of trade, he focuses on the raising consumerism in Asia. With de-leveraging playing out across consumers, private sector and sooner or later from Governments across developed economies, consumption would raise in key southern markets like China and India. According to the World Bank paper , Asian consumers would replace the North American and  European consumers [ who currently consume 26% and 38% respectively] by contributing 59% of world consumption by 2030. See the chart in the link for more details.

It is interesting to note that the structure of these markets would be very different from the markets in the North. Being low income economies, the south will consume more food as their incomes raise. To be a producer for south, these southern countries would need to invest more in infrastructure, manufacturing  and hence the demand for commodities – be it agricultural or industrial along with energy will continue to increase.

The other change to watch out for is the price sensitive nature of the emerging economies that would lead to product standardization, which at times may lead to lower quality standards.

The large Asian economies like India do have the potential to become a new hub for consumption what with its domestic consumption, raising income levels and a favorable demographic dividend.

1. The U.S. will continue to do ‘quantitative easing’ to ease the credit crunch..Unfortunately, it has not yielded meaningful results till date. According to Meredith Whitney,the Small and Medium Enterprsises in U.S. [ which contribute to over one-third of the GDP] till date have been increasingly denied access to credit.The SMEs are the prime engines of innovation and employment revivals[represents 50% of the nation's workforce]. Lack of credit leads to lay offs and closure of businesses.

2. The U.S. Government’s intent to stimulate the economy through more consumption[ like cash for clunkers program, etc] would not work, since the consumers are paying off their debt and saving more.  The notion that  over 70% of GDP contribution would still come  through consumption seems to be history.

3. Dollar[due to zero interest rate policy] has now replaced the yen as the ‘carry trade’ for investors, fuelling asset bubbles across emerging markets.

4. Recent data put out by IMF indicates that Fiscal Stimulus doesn’t work in reviving the economy, when the fiscal deficit is beyond 60% of GDP. The U.S. has already reached that level.

5. When all mechanisms to revive the economy fails, drastic depreciation of the currency would be the only option for U.S. to revive its economy. This would temporarily bring down the soaring un-employment rates and push consumer prices upwards[deflation to inflation].

Recent Report published by David Rosenberg on The case for commodities captures the above premise very well and also suggests how investors now should re-align their portfolios.

It clearly raises a strong case for commodities. As history shows, during high inflation its the commodities and precious metals which not only acts a hedge to our portfolios but performs better.

What does all this mean to the Indian Investor?  Our country and other nations across the world has very high correlation to U.S. and hence what happens there does impact us. For eg. 16% of world GDP consumption is still driven by U.S. investors.

To sum up, it would be prudent to  trim equity portfolios , add commodities & precious metals [with a 20-25% exposure] and  increase fixed income allocation  in your portfolio.

After all, Portfolio Diversification and Dynamic Asset Allocation is the way to preserving and managing our wealth in these uncertain times.

Lehman Brothers collapses..Credit markets freeze.. Equity markets crash.. Commodities Markets go on a tail spin..

Central Banks start getting their act together in a coordinated effort to revive the credit market..

Circa May 2009

Quantitative Easing led by the Fed  and followed by other Central Banks have brought down the interest rates to near zero..

All major asset classes and commodities have risen dramatically since March 09..

While the U.S. Government, by using the extreme measure of monetary policy of ‘quantitative easing’  is hoping that the credit flows would lead to economic recovery, in the medium term it is setting itself up to ‘hyperinflation’ due to the dollar that would start losing its value.

In this context it is interesting to note that the famous author of ‘Black Swan’ , Mr Nassim Nicholas Taleb and his collaborator who manages and runs a hedge fund have launched a new fund betting on ‘hyperinflation’.

There is a great probability that we would see higher inflation in India too..

The financial linkages have become stronger across the world in the last 4 years..

How should we re-align our  portfolios to prepare us for this new scenario that would hit us in the next 2-3 years..

Watch out for the next post which would focus exclusively on this theme..