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This time it's different...

It may not be. Given China-related recessionary concerns and the commodity crisis, the bomb may already be ticking

This time it's different...

Most market-men believe in the principle of reversion to the mean. What goes up must come down and all that. From that comes the other pattern: at the top of a market comes this consensus that 'it's different this time'. This is to sustain irrational valuations till the parcel has been passed onto the biggest fools... then bam! The bubble pops, and the (dead) rabbit falls into your lap.

As I said, this is mostly seen closer to a market top, while I am bringing this up closer to what looks like a market trough (if not a bottom). Sensible people are talking about a global recession next year (i.e., < 2 per cent global growth, with many economies slipping into the negative territory). While the US seems to be coasting along, China could pull the world into the recessionary territory. In small increments, most forecasts for global growth are shifting down to 3 per cent, and it will take just some small aftershocks from China to bring the world crashing down into its first recession after the global financial crisis of 2008.

Most traders would tend to believe that what goes down must come up, and almost all markets are at or below their long-term average valuations, whether in P/E or P/BV terms. Bottom-fishers would tend to believe that the market has bottomed, but they would do well to keep in mind that the commodity supercycle has troughed, but it may not come back.

Most of the damage is in the commodity sector, which has been decimated by the Chinese deflation- depression scenario. The global All Commodities Index is at a 40-year low, back where it started in 2003. Profitability in most (commodity) sectors is at historic lows, reaching the point that debt servicing is possible only if debt levels are kept moderate. Peak-of-the-cycle investments, including mergers and acquisitions, are not going to be repaid if they have been funded with debt; current profitability does not allow for that. So any investments made between 2006 and 2010 will see haircuts in debt repayment. Pre-boom investments will pull through mainly because half the debt repayments have already been made. In every case, if a company is pulling through, it is because of the 'past equity' embedded in older projects, which are still generating free cash flows, which are being used to subsidise debt repayments on new projects. A rational decision-maker would want to evaluate each project and see whether that particular project is meeting its cost of capital; but in the real world, each company will want to protect its 'baby' with whatever it has. So a Hindalco will use its Renukoot cashflows to subsidise the Novellis acquisition, rather than evaluate whether saving the baby will kill the mother. In medical ethics, it has now been clearly established that the life of the 'unborn child' is secondary to the life of the mother. But the same principle is not used to manage the business cycle.

This has been happening in companies, even sectors for time immemorial, but this time, it is happening at the level of countries, which is going to affect macro-economics. Most of the surplus capacity in the world is in China. In aluminium, China accounts for 56 per cent of the world production, while the world surplus is about 10-15 per cent. 'Surplus' is defined as that part of world capacity, which must close down to bring sectoral profits back to the point where they can service the cost of capital (which, needless to say, would include the servicing of debt). If that number is 10 per cent, it means some 20 per cent of Chinese capacity must close down. In a normal, fragmented, perfectly competitive, 'commoditised' sector, this would happen on its own, with bottom 20 per cent dropping out. But this is not going to happen because China's directed investment and its co-ordinated manoeuvring will ensure that its weakest players will ride out the bottom, while the weak players of other countries will close down.

So in aluminium, it is the American Alcan closing down its iconic 130-year-old smelter capacity. In steel, it is European/British steel plants and the Indian minnows that are closing down, while the peak-of-the-cycle Chinese investments will survive because China will subsidise the carrying cost of its plants. The natural Darwinian law of 'survival of the fittest' will be vitiated because too much of the capacity that needs to be mothballed lies in the hands of an 'irrational' player. This capacity overhang of the weak players who refuse to die will likely ensure that the recovery is weak, anaemic and short-lived.

The regular injections of liquidity, whether newly printed money (quantitative easing), or the recall of their savings parked abroad (forex-reserves selling), should ideally be used to promote consumption, which would be value-accretive. But it is likely to go into holding up zombie companies in the commodity sectors, which will be value-destructive. If too much of these (forex) reserves end up in malinvestments, it could push China into a depression and the world into a recession. China would be the next Japan, with its zombie steel and metals sectors, for example, while the world passes it by.

An increasingly irrelevant China is not just going to step back and watch. It will become a serious geo-political threat, which, if it precipitates a couple of serious wars, could create enough diversion and destruction... to the point that this time, there might not be a Planet Earth waiting for us at the end of it all.

So these two major points must be kept in mind, about the end of this commodity supercycle. One, it might not be played out completely at the microeconomic level, and two, the macroeconomic dimensions might spin out of control into the geo-political space, with disastrous consequences. For most of us, the first is of importance, while the second is of not much interest because we are all dead anyway.

Watching this play out will give us important insights into major tectonic movements in the currency markets. One, China's offer of a viable counterbalance to the dollar, in fact an alternate reserve currency, will be just another Ramlila show. After the fireworks, there will be nothing worth reporting except the fireworks themselves. And outsiders, like the Martians, will not understand the point of it all. I mean, why would a country fight so hard to become a reserve currency and simultaneously take action to devalue the currency, or see capital flight... Why would you want investments to come in and hold your dead ducks, while your currency loses reputation as a safe haven because of a prevailing culture of malinvestments?

I am saying all this on the presumption that China will go the Japan way, but that may not be true. Time and again in the past, China has shown greater vision and diligence than even the best democracy. If it is facing the music today, it is because of all centrally planned policies, and they have managed to push back the day of reckoning... but not forever. If history is any guide, China will come back faster and stronger in its new consumerist avatar than any of us would give them credit for. If in the process, it finds demand for its moribund excess capacity in various commodities, it would have belied the doomsayers yet again.

Eventually, it is just a debt problem. Debt destruction creates capital loss and destroys investor sentiment, which, in turn, affects the investment demand. If the resultant slack is picked up by an uptick in consumer demand, the world will not notice the change of tracks.

So finally, it will boil down again to leadership and human behaviour. Those who are watching for the right signals will see them coming and be able to jump out of the way, or ride the wave, as the case may be.

The author teaches, trades and writes at spandiya.blogspot.com.

This column appeared in the December 2015 Issue of Wealth Insight.