Coming Tsunami aka Capital Flight

Coming Tsunami aka Capital Flight

Clock is ticking and all eyes are glued to 17^th September 2015 when the clock would strike 12.00. It’s time for Cinderella to return home. Will she or will she not? That’s a million dollar question. If she doesn’t then market will take a sigh of relief, of course only for few days as the clock for October 29^th meeting will starting ticker sooner than sigh of relief lasts. Yes! You got it right. We are talking about FED meeting and whether our own Cinderella, FED Chairwoman Ms. Janet Yellen would stop dancing and raise the interest rates. I don’t know whether its Sep/Oct/Dec that she would quit the party but whenever she does I know for sure it will lead to a Tsunami – a tsunami in global financial markets – most closer to US Debt market and Emerging Market currencies.

Oil at $40! And it means a lot Good to the world!

The last time I wrote the piece I had titled this paragraph, ‘Óil at $60! And what does it mean to the World and India’. Today as I write this article WTI crude is already at USD40 and Brent Crude Oil is USD46. I had mentioned then about the direct casualty being countries feeding on black gold and the risk of blowout at banks/funds with disproportionate exposure to Oil; but on a whole the improved strength of global financial system and economy will help us tide through these challenges. Thankfully, no major setbacks anywhere in the world have been felt so far. In fact, even Russian Ruble at is back to highs – as on 19^th Aug USD/RUB stands at 67 compared to high of 69.

So, what Oil at USD40 means to the world is - a resounding YES to slowing Chinese economy, a resounding YES to non-sustenance of cartel amongst gulf countries as individual interests take precedence to overall interest of the Group and last but not the least, a resounding Yes to reversal of Oil trade, which was driven on the back of Chinese dragon. So these have now become known fact but important thing to realize here is that Oil at USD60 didn’t mean disaster to the world nor would it be at USD40 per barrel.

Yes! There would be pressure on Oil/renewable Capex and construction boom in the middle-east but the world as a whole would move ahead without much of turmoil. However, till this process of Oil correction gets over, world-over corporate earnings would continue to suffer due to inventory losses and postponement of purchases in order to avoid high-cost inventory.

Last time I had mentioned that we don’t where would Oil settle but one thing is sure it won’t be $100 any time soon.  Similarly this time, we can safely call that bottom isn’t far away be it $35-40….certainly won’t keep falling to $20. What this means is the World is closer to the times, it actually start deriving real benefits of lower crude prices - in the form of stable lower prices to consumers, stronger demand and higher profits for Corporates and stable fiscal situation for Governments.    

So far so good!

But the real problem of deflation which I sighted then is just getting stronger. And Yes! Oil is acting just as the name suggests – adding fuel to this fire! 

Broader Deflation has intensified but wait…have you noticed the Core Inflation?

*Core Inflation excludes Food and Energy **as of Sep’14 (+Sep’14 was the latest data in the last piece – Looking through the Dust Storm)

Across the world inflation continues to fall at a rapid pace as is evident from the data in table above – in US inflation has slowed down to 0.1% from 0.3% in Sep’14. In Europe it’s down to 0.2%, China the level is flat at 1.6% while in Japan all efforts to drive inflation have gone waste with CPI down to 0.4%. So, the data fairly and squarely corroborates the general perception about the deflationary world. But something which has not been talked about and something which is critical for both common public and policymaker is core CPI. While broader indicator of inflation - CPI is down across the countries if we take out food and energy deflation then the core inflation i.e. core CPI has gone up almost across every part of the world. This makes the whole deflation/inflation problem very complex and interesting. How policymakers would react to this phenomenon would hold the key for ensuing Tsunami.

Why do Central Banks weigh Core Inflation more than any other indicator?

As we all know the single largest objective of Central Banks is to ensure ‘Price Stability’ in the system. We saw in the previous note that this price stability is quantified and defined by most of the Central Banks in the world as ‘two percent inflation’.

The next question to tackle is which inflation? Policy makers evaluate changes in inflation by monitoring several different price indexes. A price index measures changes in the price of a group of goods and services. In US Fed looks at Personal Consumption Expenditure (PCE) produced by Department of Commerce; consumer, hourly wage rates & producer price indexes issued by Department of Labor. In India, RBI looks at WPI and CPI and policies used to be governed by movement in WPI until recently when they shifted to CPI as their primary tool to assess inflation and based their monetary policy upon. Though such varied indexes and compositions thereof are looked at for understanding inflation and predicting its future direction, a Central Bank weighs high Core Inflation to determine its policy action, mainly because that’s what it can influence and that’s what it can predict with reasonable certainty and hence lends higher credibility to policy actions. Given the importance of core inflation Fed also has made it a part of Board Staff Economic Projection released with every FOMC meeting. Thus, combining the two views i.e. a) rising and closer to 2% core inflation b) Oil soon forming base for next year inflation, I believe FED would not be  worried about deflation hereon and we could see Fed raising the rates sooner than later.

No reason to not raise the Fed Fund rate…rather fear of loss of Confidence demands so!

As can be seen from the analysis presented in the table below, the deflation risk which was the Goalpost for US Fed is no more a concern today. With stable economy growth, tight labor market and hourly wage rate rising at 2%, the only cause of concern is appreciating USD which is hurting both corporate profitability and competitiveness of the country. But we believe there is not much Fed can do here. 

In world elusive for growth every country is trying to protect their turf with a more competitive currency i.e. devaluing their currency - the recent devaluation of Yuan by Chinese government for 3 straight days is a scary testimony of the same. The only currency which can stand on the other side is USD. If US also got into defending their turf then the downward spiral will have no bottom to reach. Again, with the reserve currency of the world that’s where all the money lies and flies. 

Fed perfectly understands this and hence we don’t think the USD will assume goalpost for the time being. 

Another thing which we sighted last time for continuation of low interest rate policy of Fed is the competing interest rates and that hasn’t changed. That means Fed should logically continue to hold on its zero interest rate policy.  

The danger of continuing with a very loose monetary policy, however, cannot be ignored. The cheap money is flowing entirely into high risk non-productive activities which could endanger financial stability, yielding socially undesirable effect of low returns for elderly people on their savings and completely undermining expected returns for Pension and Insurance funds. If these excesses grow to proportions which market believe unmanageable by Fed then we could stare at crisis of confidence leading to fall in USD and wealth destruction across the world. We won’t know when we would reach that point and better we stop earlier than reach that point. In my belief, Fed would therefore act sooner than later and raise the rates! 

Change in Fed interest rate policy will lead to Tsunami of capital outflows 

Fed has waited much longer than most of the market participants anticipated and this time hike could be smaller and slower than it has ever been in past. Last time in 2004-06, Fed took 24 months raising rates almost every month from 1% to 5% in 0.25%-0.5% quantum. However today the impact of 25bps could be much larger on much lower base plus global economic uncertainty and divergent central bank policies could be a deterrent.

Nonetheless, whenever it starts we know what to expect. There has been large asset shortages created in market thanks to QE.  Excluding QE the market depth has been poor and off-late liquidity has become extremely thin. This we believe is the perfect set up for ensuing Tsunami in US debt market as and when policy lift-off happens.

The other big casualty would be Emerging markets – both equities and currencies. This is vicious circle one feeding other and as capital flies back from these markets we could see a sharp fall in emerging markets currencies and equities. Stay away from these asset classes. However, the World will still stay flooded with money and after the initial turmoil across the markets this money will find its way back in stronger/higher yielding asset classes – read US Equities and EM debt. History suggests equity markets have delivered 10-15% returns in a year following US Fed started reversing interest rate cuts. So do use this correction to load you guns again but till that time keep your powder dry and prepare to survive Tsunmai.  

One last piece of advice: the way to survive Tsunami is not to build Noah’s Ark but just to stay away from places of Tsunami!