Things are lately having us dubious on how can markets display a great degree of optimism in the time of dismay. It also has many of us skeptic on sustainability of rally in equities, gold.
This pandemic has brought some interesting events like markets being flooded with streaming new liquidity, sharp fall in GDP, contradictory rising equity markets, historic low yields, falling dollar value and ever rising gold prices. We witnessed the first global covid crash in equities in month of March-April 2020, which by now have almost recovered, on hopes of fiscal stimulus and liquidity.
This is rarest catastrophe being experienced by current generation, there is uncertainty looming out there - on the recovery path of global economy, how mankind will respond to rising cases in second wave, when will vaccine be introduced, how markets will behave to these events !
About Monetary standards – Historic & Modern
19th century had Gold Standard followed by the central banks. Under this monetary system, nation’s currency was directly linked with gold reserves it had. The currency value was backed with gold since the supply of money must not increase without increasing the gold reserves. This controlled the supply of money limited up to gold reserves, thus protecting an economy against risk of hyper-inflation. Later in mid 1900s, this standard was abandoned by many countries, including US who gave it up in 1933 (note: Post Depression period) and in 1971 effectively delinked the US dollar and Gold.
What replaced the gold standard and have now is Fiat money - nothing but a government issued currency, not backed by any physical commodity like gold or silver (but for government itself). Hence, currencies like US Dollar, Pound Sterling, Euro or Indian Rupee are fiat or paper currencies. Value of these currencies is derived from its demand-supply conditions, strength of the economy, government stability. (It is important to note that – intrinsic value of any security is derived from its utility/embedded assets or backed securities).
Fiat money gives greater control to the central banks on issuance of new currency, in simpler terms to print new money as and when required by central banks.
Interest Rates – key tool to manage money supply
Interest Rate management is a key tool to manage the money supply and drive economic activity. Reducing interest rates, lowers cost of borrowing and drives growth. Interest rates are on an increasing trend when economy booms, reaches the peak as economy slows down. As it enters into recessionary period, interest rates are on decreasing trend.
Long term Interest rates also indicate the Demographic Dividend of an economy. Demographic dividend impacts economy’s productivity and decides the future growth prospects. Economies with lower interest rates over a longer period has falling demographic dividend, e.g. Japan. Interest rates are changed in tandem with the growth state of the economy. Lower demographic dividend leads to lower productivity, which lead central banks to decrease interest rates to improve economic activity
Lately, US and Europe have touched zero interest rates
When recession sinks in deep and lowering the interest rates even up to zero does not help raising the struggling economy, central banks are left with no other option but to inject fresh liquidity through Quantitative Easing (QE) program. QE is nothing but the modern word for printing new money.
Quantitative Easing
QE basically involves purchase of financial securities by the central bank from the market i.e. member banks. These securities mainly involve Treasuries, Mortgage based securities. The newly printed (nowadays its digital in form of credit in the account of member banks) money adds on the liability side of the balance sheet (like share capital of a company) and securities bought on the asset side. The massive buying by central banks pushes up securities prices creating liquidity in respective markets, thus lowering yields and consequent streaming supply of new money in the market pulls down the interest rates.
US Fed Balance sheet has ballooned 7 times in last 12 years since 2008. This increase is a result of QE implemented in 4 rounds throughout 2008-2014, to lift the struggling economy from Great Financial Crisis. These measures were driven towards boosting the US economy back to track, by driving demand & consumption and to achieve desired inflation target.
Falling US Dollar, Rising Gold
The law of demand–supply applies to every commodity, money, currency. Gold is traditionally considered one of most valued commodities, especially during crisis. It serves as crisis hedge due to its less/nearly negative correlated with equities.
Central banks, global investors resort to gold as perfect hedge against equities. This buying spree has led gold to break many resistances.
Besides, US Dollar has been traditionally believed as another hedge against crisis.
But, lately situation seem to have changed. Whenever US has faced the downturn, US dollar has fallen and gold has surged.
Now, with the growing fears of weaker US economy, increased supply of currency through money printing mechanisms, US Dollar is losing value. At this time, gold is the only reliable hedge.
Chart for recent period shows a sharp fall in dollar coupled with increase in gold prices. Higher volume in past few days when it crossed resistance during day.
Historically, last time gold price touched peak was in 2011-2012 when European Central Bank adopted the QE program to deal with the Sovereign Debt Crisis in Europe, caused by inability of Greece to meet its public debt obligations, which brought it to the brink of default. Since then ECB assets have also enlarged by 3-4 times post 2008.
Expansion of ECB assets due to QE also involves rise in Gold assets
Debt Risk
Fed Balance sheet is expected to balloon to USD 10 trillion dollar this year. Many other economies will follow. This raises concerns since central banks may lose control over it as the asset purchase programme keeps expanding. Unwinding of balance sheet would mean reverse stimulus, where it would sell assets in the market, leading to higher interest rates, constrained liquidity, higher yields and fall in economic activity, ultimately having a hard hit on economy. Considering, the effects of reverse stimulus, it is not remotely likely that this shall be carried out anywhere in couple of upcoming years.
We have also seen that as money supply and risk in safe haven economies increase, their currencies are lose sheen. Japan is a classic example of it. Despite of being a developed economy, the currency is highly depreciated (1 USD = 106 JPY). Japan has decades of unconventional monetary policy, having QE for more than 15 years, coupled with highest GDP to Debt ratio. Despite high credit spreads and rising risk of defaults, bond issuance in US is increasing.
Gross Debt to GDP is highest among the developed economies. Top 5 are Japan, Italy, Singapore, US, France
The Debt to GDP ratio is on a Rise for developed, EMs and low income developing nations
Crater formed may take time to fill..
There is immense uncertainty and mixed opinions on recovery of global economy. Annualised US GDP for 2Q 2020 is -32.9%. Fall in consumption accounts for major portion of slump. The savings rate in US has spiked in recent months as consumers are cautious about future income. Many nations are still struggling to fight the pandemic spread. Lockdown measures have contracted the economy. Second wave of cases may cause larger disruption since already the economies are facing a tough time. Although many studies expect a V-shaped recovery, it appears to be over-optimistic.
Increased unemployment, suppressed income shall impact the consumption patterns in coming time. Subsequent defaults and bankruptcies would lead to rise in unemployment. The impact of pandemic is wide and can be deeper as never seen before. Crater is a bowl-shaped depression produced by the impact of a meteorite, volcanic activity, or an explosion. Similarly, this crater or the gap formed by pandemic may take time to fill and get back to track.
Is Gold only option?
We have already discussed that Gold is the perfect hedge for crisis. The global investors, central banks resort to accumulating this best hedge i.e. Gold. With potential risk in economies, falling value of safe haven currencies, highly valued equities, Gold appears to one best option available. This view has led the buying spree and increase in the gold prices.
Gold trend line on 14-07-2020, indicating potential for increase beyond 1900$ /oz…
Gold Trend line on 31-07-2020 crossing Resistance with Spike in Volumes…
With limited gold reserves on this planet, increasing new money creates more demand, law of demand-supply suggest further rise in Gold prices. It may take some time for Gold to cross the psychological level of $2000, but it does appear positive.
Markets driven by liquidity and not fundamentals,
Leading US equity markets to an optimistic extreme during the pandemic time. But for selective technology stocks, the equities are giving a poor show. It is hard to believe but current move by markets suggest that Liquidity is the Showman, not fundamentals!
India - at risk of Inflation with falling interest rates
Upcoming monetary policy is expected to notch down the interest rate further.
Only akin stimulus we have had is the decrease in the interest rates. Lowering of interest rates leads to traditional issue of higher inflation. At this juncture, we are already facing a risk of higher inflation rise, with lower interest rates. This leaves Real interest rate diminishing (Two factors - real interest rates and inflation factor in the Nominal Interest Rate).
In ideal scenario, increase in inflation increases the nation’s risk premium, which should be factored in the discounting of earnings and cash flows (both have impact of inflation) to arrive at the discounting rate, which brings down the valuation of assets.
Bank moratorium gives benefit of deferred payment of liability, but with the cost of compounding interest for the outstanding period. Challenge for banks involved here would be to recover the dues with higher interest. Extension of moratorium period shall also have a bearing on the bank stocks.
Post 2008, GDP fall addressed with lowered Interest rates, Inflation is seen shooting!
Nifty P/E at lifetime highs!
Nifty P/E touched an ever high of 30 (decade mean of 21) times due to - falling EPS coupled with rising stocks.
DII/FII investments in cash segment reduced, in contrast to relative rise in speculative positions..
Nifty rise in past 3 months appear to be accounted for higher retail participation since institutional investors have muted investments. On other hand, their speculative participation has increased. This does not count for sustainable rally. This looks to me more like - Party till the Music lasts!
Longer the Pandemic, Bigger Jolt on GDP…
Daily cases in India are increasing, peak is yet to reach. This limits the scope for easing lockdown. Globally, second wave of cases is on a rise too. This indicates that we are far away from a normal situation (even if vaccine gets introduced, it would take a long period to get 1.3 billion Indians vaccinated).
Ripples may be felt for a longer time due to the gap created in cash flows and earnings. Potential for defaults and bankruptcies have also increased. Cyclical Sectors, commodity based, banking sector may see impact for longer time. In today times, we are left with very limited options to earn minimum returns - with bonds at record low yields, interest rates at new bottom, over-valued equities. As time passes by, cascading impact of pandemic will unfold, till then the best way to manage money is hedging or low risk investments (if you can time the markets well, you can take short positions.) Mantra should be - Minimise risk, Minimum positive returns.
Note: Market data till 31-07-2020
Thank You!
-Ushma Zunzavadiya
(It was a pleasure writing down and your views shall add more to it. If you liked the note, kindly feel free to share further.)
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