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

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.

After culling through lot of data and research reports..its pretty clear that our markets are probably going to scale newer heights in the next 12-18 months or so..

‘Liquidity’ is the buzzword going around the markets..
Will the Fed cut rates again [on Oct 30, 2007] which would lead to more fund flows into emerging markets?

Meanwhile..some interesting theories have started floating around in the last 3 weeks:
1. Decoupling of Emerging Markets..
2. Low Correlation levels of India with other markets..
3. Is History repeating itself and will the next bubble be in emerging markets?
4. Will the central bankers get autonomy to take decisions without being influenced by the government?

On the home front the political fiasco has been merely postponed..
If one were to go by the latest news, there probably wouldn’t be a mid term polls after all..
this will further get ratified on 22nd October 2007 when the UPA meets once again..The stability factor could be decisive in bringing more fund flows into the country for the next 12-18 months..

The earnings season have kick started on a good note [In line results for Infosys and HDFC bank beating the street expectations] and it does look like there will be some decent number of positive surprises rather than negatives..

What is worrisome with ‘liquidity’ in the Indian context is.. the companies seem to be getting into unrelated diversifications[eg constructions cos getting into telecom, almost all large business houses getting into retail]..
One wishes its not the repeat of the 1990s..

What should you and I do as a long term investor in the next 12-18 months? Like I said before in the previous post [Sensex at 20K].. Re-balance/Churn selectively equity portfolios by booking significant profits at higher levels, buy Gold [ a very interesting piece followed by advice at the end of the article by the noted columnist Anantha Nageswaran]and buy/accumulate into businesses[at dips] that one belives strongly will deliver decent returns over a period of time.. One should also look at diversifying into international asset classes after due dilligence and research..now that the RBI has increased the investment cap to $ 200,000 per individual..
For first time investors in equity markets.. its better to participate in the equity markets through the systematic plan route in equity diversified/index/etf mutual funds..
For those who want to ride the momentum and make a killing on their short term portfolio allocation..may god bless!!

While we are contemplating on getting on to the bandwagon of the great chase ..I am reminded of Charles Mackay’s ” Men, it has been well said, think in herds ; it will be seen that they go mad in herds, while they only recover their senses slowly, and one by one!”

Indian markets are going to witness a never before fund flows from multiple segments..
In the last two days, FII inflows into the equity market stood at $608 million. Till date the FII inflows for this calendar year have already crossed $ 10 billion..
Raining wealth?!

Let me try and list out broadly the segments who could possibly contribute to the stratospheric highs of Sensex reaching 20k :
1. The existing ‘waiting on the side lines’ money from FIIs, Domestic Institutions and Retail/HNI segments.
2. The first time retail house hold investors who would enter the market through direct/Mutual Funds/ULIPS. The retail participation by house holds for FY 06-07 was a mere 6% of their savings into equity markets. This pie could significantly go up at the cost of the most dominant savings mode – Bank Fixed Deposits which is currently at 47%.
2. More and more hedge funds will enter the ‘arbitrage game play’ due to the return of the yen carry trade in a bigger manner [since BOJ went on the 'hold' mode with respect to interest rates]..
3. Newer Private Equity funds will find its way into the domestic markets..
4. The latest animal to the party, ‘Sovereign Wealth Funds’ would also try to wriggle its way into the market.
5. New Retail Investors from U.S. and other the developed world will join the bandwagon via India focused oversees Mutual Funds .
6. Last but not the least.. the NRIs pre-dominantly from the Middle East and other parts of the world will rush in as well..

In retrospect, at the start of the year 2007, I came across a very interesting column by a Neo Wave Technical Analyst who goes by the name Milind Karandikar whose column appeared on January 8, 2007 in the Business Standard’s ‘Smart Investor’ section.

According to Karandikar, “We are in the 5th wave as per the New Wave Theory.Wave 5 usually covers 100 % to 161.8% of the price action of Waves 1 and 3 combined. On a logarithmic scale this calculation sets a target of 20,000 plus for the Sensex. And that could happen in the year 2007 itself. Those who cannot over come the general feeling of nervousness would miss a life time investment opportunity, that the year 2007 presents. My advice to small investors is to over come this fear of heights and invest. They should take this opportunity; else the other wise men will take it away”.

Well.. there definitely seems to be a case for the build-up for the Sensex to hit 20,000 soon..

Hey..Should you and I join this party at all?
I am thinking..
Wait till I re-visit this subject[in the next few days] with more data and research and pen down my thoughts again ..
Meanwhile.. If you can’t wait to call your broker now, remember Jim Rogers latest quote ” Every time the Fed turns around to save its Wall Street friends it makes the situation worse. The dollar’s going to collapse, the bond market’s going to collapse, there will be a lot of problems in the U.S.”

What does it mean to you and me in India?
Well for starters..the Dow Jones has already rallied by 260 points to 13663.
Tomorrow the Asian markets and India will follow the rally..

While the Fed’s aggressive move of cutting 50 basis points in both fed funds rate and discount rate may stem the recession in the short term, what we need to watch is whether the American consumer is going to be wise enough this time or not..
It is interesting to note that equity markets across the world surge for a very short period and then decline considerably with interest rates climbing up again.

Meanwhile oil climbed above $ 82 per barrel!

All this leads us to Hyman Minsky’s ‘The Financial Instability Hypothesis’
At its core, the Minsky view was straightforward: When times are good, investors take on risk; the longer times stay good, the more risk they take on, until they’ve taken on too much. Eventually, they reach a point where the cash generated by their assets no longer is sufficient to pay off the mountains of debt they took on to acquire them. Losses on such speculative assets prompt lenders to call in their loans. “This is likely to lead to a collapse of asset values,” Mr. Minsky wrote.
When investors are forced to sell even their less-speculative positions to make good on their loans, markets spiral lower and create a severe demand for cash. At that point, the Minsky moment has arrived.
Another famous Bond Fund Manager Paul McCulley’s ‘Plankton theory meets Minsky’ is one of the widely read and appreciated report on the current financial crisis thats roiling the markets.

From an India perspective, we are fairly insulated thanks to our domestic demand and the pro-active RBI being ahead of the curve. The RBI’S focus of reducing inflation and inflationary expectations, bringing price stability and managing the rupee has been very well appreciated by most of the economists in the world. It went ahead with tightening credit through various measures when other central banks were groping in the dark, followed by stricter regulations in specific sectors like the banking sector[in terms of change in accounting system with respect to securitization activities], realty sector[curtailing ECB inflows to $20 million and higher risk weight for banks lending to realty sector] and allowing the rupee to appreciate have till date ensured that we are insular from many of the major global crisis in financial markets.
Thus be it the recent Sub Prime Crisis or Credit market bubble[the contagion though has not reached our shores, thanks to our corporates being lesser leveraged and the debt market in the country is literally non-existent] or Asian Crisis in 1997, we have been fairly insulated from the turmoil that affected other markets.
Further, unlike our wester counter parts our regulations do not allow mutual fund managers to invest junk bonds in money market funds. Neither does the Government’s Sovereign funds invests in risky investments or Private Equity Funds like some of those whose values have gone down significantly post the credit bubble.
India’s resilience has been well documented very recently by Jim Walker of CLSA in his report on Apocalypse Now! But India is a Safe Bet.

On this momentous day will leave you with two quotes that sum the current global crisis in financial markets:
Jeremy Grantham, Chairman of GMO LLC which manages $ 150 billion in assets, once ended one of his notes to clients in early 2006 with, “Guinea pigs of the world unite. We have nothing to lose but our shirts.”

“We are in the midst of a Minsky moment, bordering on a Minsky meltdown,” says Paul McCulley, an economist and fund manager at Pacific Investment Management Co., the world’s biggest Bond Fund Managers.

To sum up..what should you and I as an Investor do now in the next 6 months?
Book Significant Profits, buy Gold, stay in Cash , wait for correction and buy during the lows.

Anectodal evidence points to the fact that during 2005 and 2006 these funds trailed behind the sensex returns while the trend has reversed this year thanks largely to rupee appreciation to the tune of 8%..

While the debate on hedge funds investing through P -Notes rages, there is a new breed of funds that is all set to reach our shores – Yes ..the Soverign Wealth Funds or Government owned Reserve Funds.. Some of the well known investments of Soverign Wealth Funds are China’s investments in BlackStone Group LP – one of the largest private equity firms in the world , Qatar Royal Family’s Investment in J Sainsbury of U.K.

The total assets managed by all hedge funds put together is estimated to be in the region of $1.3trillion while the Soverign Wealth Funds currently manage in excess of $ 3 trillion!