Now What?

With so many people crystal-gazing, it becomes a little difficult to say something original. Most of the debates centre around the Recession Vs Depression theme, which is the main reason that this time it might really turn out to be ‘different’.

Most investors who are looking to play the current market conditions are like the people who pull at rubber bands. Mostly the rubber bands spring back with boring regularity. The more predictable this pattern, the more likely it is to be broken. Commentators are discussing various aspects of how it could be different this time. Let us examine how the current situation is abnormal, and its ramifications.

Inflation Vs Deflation: In most recessions, inflation redistributes pricing power, taking it (pricing power) away from sectors that have overinvested and where supply outstrips demand. Simultaneously, sectors where this has not happened do better. Market Cap moves from the former to the latter. Since excess Market Cap actually created the overinvestment, the stock market goes through a deep trough as the real economy adjusts. For those who can anticipate these cycles, there are good returns to be made. Readers might remember how, through 2006-07, I carried on a monologue about the excessive valuations accorded to the real estate, infra and power sectors.

In deflationary situations, companies lose pricing power almost uniformly. Asset price deflation in the recessionary part of the cycle, flows into the product markets, impacting the real economy. If this goes long enough and deep enough, it leaves such a lot of poverty and bankruptcy around, that it affects demand, thus completing the (self-perpetuating) vicious cycle.

Analysts have started to project zero inflation in FY 2010 even for India, otherwise one of the least affected of the major economies. That should give you some idea of the scale of the deflationary threat in the rest of the world. With global auto companies reporting upto 50 per cent drop in sales, unsold inventories will throttle any pricing power that these companies have.

Deflation is debilitating to the economy, because it makes some very strange economic behaviour, seem very sensible. For example, if you defer consumption, you will be better off. Thus you will play into the paradox of thrift. Keeping cash will become more profitable than keeping any asset, except perhaps gold.

The Inversion of Liquidity Preference: The meaning of ‘Interest’ is the amount of money a borrower pays to a saver, in return for giving up his ‘liquidity preference’, i.e., ignoring risk-reward, there is a certain interest rate (a.k.a. risk-free rate) that is paid for just the transfer of liquidity from the saver to the borrower.

In a late stage deflationary economy like Japan (1999), you can have ‘liquidity preference’ so deeply ingrained into economic behaviour that interest rates can turn negative, like they did in Japan for a while. This can reduce the velocity of money to near zero. In such an economy, you can have unprecedented levels of liquidity sloshing around, with no economic traction.

The Irrelevance of Monetary Policy: Monetary Policy tries to manoeuvre the stock of Money so as to manage the direction and quantum of economic growth (measured as GDP). Under normal conditions, the stock of money impacts the velocity of money, through interest rates. When (under deflation) this relationship breaks down, Monetary Policy loses relevance.

Till the 20th century, governments were on the Gold Standard and could not increase the supply of gold, with rare exceptions like Spain in the mid-1700s. With the exception of the Industrial Revolution and the bubble periods (South Sea Bubble and Tulip Mania, etc), European economies stayed deflationary. It was only after the creation of paper money that inflation was discovered as an economic tool.

Inflation targeting came much later, and the terror of deflation only came after 1929 and Japan 1989 onwards. Today, it is axiomatic that Monetary Policy breaks down under deflationary conditions, leaving Central Banks helpless in managing inflationary/ deflationary expectations.

Cash Is King, Better Left Under The Mattress: It means that incremental flows into asset markets can go down to zero, once a consensus builds up that ‘cash is king’. This can lead to monumental drops in stock indices. The US (1929), at one point was down 90 per cent and Japan (1989) was down 82 per cent from their respective peaks. Today, Russia is already down 70 per cent, India has come back from 60 per cent down and the forecast for the US is a trough of 70 per cent, peak-to-trough. Sensible analysts are now able to say such numbers loudly.

The actual percentage numbers are not important. The prevailing (deflationary) mindset is important, and right now, it is still limited to asset markets. If this seeps into the product economy, you will have an India projecting 7 per cent GDP growth with zero inflation, which means that corporate profit growth is now at 7 per cent or less (Market P-E will come down to 5). The economics establishment may have shied away from forecasting lower GDP (growth) numbers, but don’t be surprised if this turns out to be an understatement.

When Does Reflation Start: For some, never. For others, it is far too late. Happiness and optimism will be with those who stop thinking in nominal terms (i.e., in Rs. Lacs or whatever) and convert their thinking to the currency of real assets. For example, if I am able to maintain my salary levels this year, and house prices are down 35 per cent in Gurgaon, I can buy 50 per cent more house with my salary, which gives me a 50 per cent pay hike if I calculate my salary in (real) terms of Gurgaon housing. That should give me a feel-good; a couple of years of this and I might be able to muster up the courage to start spending and investing into real assets, which will reflate one day, maybe in time to give my children some security.

Yes, it takes between half-to-one generation to get over this irrationality called ‘nominal thinking’. While one half of a leveraged population struggles with the debt they must pay off in a deflationary environment like Japan, the others are nursing dreams of achieving their nominal heights, like Sensex 21K. This paralyses their consumption & investment flows into inactivity, further perpetuating the deflationary spiral. Like in case of Japan, it can take upto a generation for asset markets to retrieve such nominal levels.

That’s Enough: I can go on like this, but I am depressing myself. Let me devote the rest of this article to convincing you why things won’t be so bad in India. For all the ranting I was doing about real estate in 2007, mortgage debt is still about 6 per cent of GDP. The maximum size of the ‘credit crisis’ in India is therefore limited to <1% of GDP, my personal opinion is that it will actually be inconsequential. No RBI/government funded injections of capital will be needed, just a couple of banks nursing their wounds for some years’.

Forex markets will squeeze Indian liquidity for a while, but our household savings rate of 32 per cent should take care of that in about 2 years. We should turn Current Account surplus from FY 2011 latest, even at the cost of a couple of percentage points in GDP growth. That is my worst case for the current set of problems.

At worst, we go down to 4-6 per cent GDP growth, turn insular again (but we should be used to that; it wasn’t so bad in the 80’s after all; that is when I last fell in love…). Thank God I stayed put in my Santro, and yes, thank God I have my job….still! Most of India will not notice. The unemployed will stay that way, the poor will hopefully blame destiny rather than the government. Nobody will accuse me of bringing down the markets any more. I am told hemlines will go up, but I don't know why…I just want to look forward in hope….!!!