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A Strategy for Uncertain Times

Prominent fund managers tell you what the world economic situation means to Indian investors & how he should handle his money…

“Yeh Greece, Greece kya karte rahte hai? Usko ek baar fail kar dena chahiye. Itne din se ab hoga, tab hoga. Market mein kya kamayega?” (“What is this continuous headache with Greece? They should let it fail. Then we can get it over with once and for all.”) That is a comment from a frustrated Mumbai-based investor who has been waiting for a long while for markets to go up. Too simplistic? Yes. But the comment captures accurately the mood prevailing in the markets.
In our lead story, we bring you the lowdown on where the world economy and markets stand, and what all this mean for the Indian markets and for you, the investor. We also bring you strategic inputs from prominent fund managers regarding what you should do with your money. Read on to find out.

What’s happening? The US is suffering from the twin problems of anaemic economic growth and a burgeoning fiscal deficit. Much of this is the fallout of the financial crisis of 2008, which resulted in extensive job cuts, foreclosures, and an economy that simply won’t respond to any stimulus provided to revive it.
After the crisis of 2008, the government spent huge amounts on bailing out large financial institutions that were deemed too big to fail. It followed up with a fiscal stimulus plan aimed at jumpstarting economic growth. The Fed also did its bit by keeping interest rates low and launching two quantitative easing programmes. While these measures brought about a temporary revival, the quarterly GDP number for Q2 2011 showed that the economy is slowing again. Owing to its large fiscal deficit, the US government can’t afford to launch more stimulus programmes and the opposition won’t let it do so.
What could happen next? The US economy, is not witnessing your typical business cycle bust. Rather it is facing a “balance sheet recession” — one that results from huge amounts of debt accumulated over years. While the process of de-leveraging is on, it could take five to seven years for it to be completed.
When will things turn around? Consumer spending accounts for the biggest component of US GDP — 70 per cent. For the economy to revive consumer spending needs to go up. But with many households burdened with debts, unemployment at high levels and the job market in an anaemic state, a spurt in spending seems distant. The Obama jobs plan’s passage remains doubtful due to Republicans’ opposition. So forget about consumer spending reviving in the near term.
The US Federal Reserve too is running out of options. Recently it began Operation Twist (which entailed selling short-term bonds and buying long-term ones in order to lower the yields on the latter). Two quantitative easing programmes (QE1 and QE2) have come and gone without having much of a long-term impact. Even if the Fed launches QE3, it is doubtful whether it will be any more effective than its predecessors.
Watch out for the US elections in 2012. The Democrats and the Republicans have already started engaging in a show of grandstanding and one-upmanship. While the Democrats are gunning for tax increases on the wealthy, the Republicans are calling for cuts in government spending (which could impact jobs). Whatever the outcome, anaemic growth and high unemployment are not expected to improve anytime soon. Says Anup Maheshwari, executive VP and head of equities and corporate strategy, DSP BlackRock Investment Managers: “Nobody knows how the current crisis will be resolved, including the people in charge. We think markets are partly reflecting that.”

European crisis
What’s happening? What started as a sovereign debt problem has now snowballed into a crisis that threatens to splinter the European monetary union itself. Among the PIIGS (Portugal, Italy, Ireland, Greece and Spain) countries, Greece appears to be on the verge of a default.
Should a default occur, it will have wide ramifications. Several European banks hold huge quantities of sovereign bonds. A default would create large holes in their balance sheets. BNP Paribas holds 20 billion euros of Italian government bonds. The Belgian-French bank Dexia has 21 billion euros of sovereign bonds from these countries. Several banks could crash (a la Lehman). European banks also face the risk of downgrades: Moody’s recently downgraded French bank Société Générale. The bank has lost 50 per cent of its market capitalisation over the last one year.
Now, European leaders are coming round to the view point that Greece needs to undergo an orderly default. The risk herein is that a Greek default could lead to a contagion that would spread to larger nations such as Spain and Italy.
What could happen next? The European Central Bank (ECB) has bought bonds of some of the larger indebted nations to lower the yields on their bonds and prevent them from losing access to the debt market. It could buy more. There is talk of converting the European Financial Stability Facility (EFSF) — a special purpose vehicle meant to provide financial assistance to troubled countries — into a bank. Recently the EFSF’s fund limit was enhanced from 440 billion euros to 1 trillion euros.
Also under negotiation is a “debt haircut”. If this goes through, then lenders will get back only 50 per cent of the principal on the bonds they hold.
Moves are afoot to recapitalise banks that hold large quantities of sovereign debt from these ailing countries. Christine Lagarde, head of the International Monetary Fund (IMF), estimates European banks could require up to 200 billion ($267 billion) euros of additional capital. Other estimates put that number at close to 500 billion euros.
When could things turn around? A turnaround is nowhere in sight as the scope of the damages to be corrected is immense. First, there is the matter of Greece. Real problems could erupt not with the default of Greece but if Spain and Italy follow suit and if banks are not sufficiently recapitalised. Immediately though, the funds available with EFSF needed to be enlarged, and this has been done. But there is a lot of dissension among EU members regarding the best way forward.
The impact on markets will be felt for some time. According to Navneet Munot, chief investment officer, SBI Mutual Fund, “Stretched sovereign balance sheets and stress in the banking system will continue to hound the markets.”

China’s WOES
What’s happening? US, Europe and Japan together account for more than 40 per cent of its exports, tying China inextricably to the current global slowdown. Its GDP growth rate is expected to slow down to near 8 per cent this year. Moreover, the US is exerting pressure on China to let the renminbi appreciate.
Beijing faces a slew of domestic issues too. Inflation is biting. An infrastructure investment binge announced in 2008 to pull China out of the slowdown has now been estimated to have led to accumulated debts of RMB 10,717 billion ($1,681 billion). Low interest rates to minimise the burden of this spending saw retail investors rush out to higher yielding but unregulated financial institutions, trusts and loan sharks. These unregulated entities now supply more credit to the Chinese economy than regulated banks.
What could happen next? China will have to look towards domestic consumption led growth. Domestic consumption as a proportion of GDP stands at around 33 per cent — among the lowest for a major global economy (for India this figure stands at 60 per cent).
To jog its GDP growth rate, Beijing has a few options. It can issue government bonds (the recent sale in August this year of 20 billion yuan or $3.1 billion worth of bonds in Hong Kong was oversubscribed more than four times). Alternatively, it also has access to its humongous foreign exchange reserves of $3.2 billion.
could things turn around? That China will not allow the US to coerce it into appreciating its currency is clear as it would cause loss of its global competiveness. The shift towards a consumption-led economy will at best be gradual. Any sudden move to encourage domestic demand could fuel a cycle of borrowing, easy credit and higher inflation. The years of unbridled high growth may finally be catching up with Beijing.