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D.Muthukrishnan (Muthu), Certified Financial Planner- Personal Financial Advisor

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It’s a complex crazy world

Posted by Muthu on August 7, 2011

At last U.S. has been downgraded by the rating agency S&P. A move which should have happened atleast 3 years ago.

U.S. treasury has disputed the S&P downgrade saying that there is a math error of $2 trillion.

To get some perspective, around $1.25 trillion is the GDP of India. Then you can imagine how big a $2 trillion number is.

But when you have debt running into trillions of dollars, a trillion here or there does not make any difference. Let them reconcile!

U.S. government may be angry with S&P.

But it looks like S&P has learnt its lessons. It was pulled up severely 3 years ago by congress, media and public for rating sub-prime backed securities as investment grade. Hundreds of billons of dollars worth securities were rated as good quality in lieu of fee worth tens of millions of dollars which brought few million people literally to the streets. 

So S&P has now decided that the best thing to do is to downgrade U.S.A itself. Moody’s and Fitch may soon follow suit.

If you think Americans would be the most worried lot because of this downgrade; probably you are mistaken.

China and Japan would be worrying the most. They are the one who are holding lot of  U.S. debts. These are the days when the creditors should worry than the debtors. 

If you wonder as to what made China and Japan to lend lot of money to U.S.; welcome to the complex crazy world.

U.S., which has less than 5% of the world’s population, consumes more than 25% of the world’s resources. So it’s a huge market. China wanted to grow itself by catering to the consumption requirement of Americans.

Americans do not mind anyone taking care of their addiction to consumption. So they were happy when China wanted to take that role. But U.S. does not believe in living within means. They have forgotten that value nearly 3 decades ago. So U.S. supplied dollar or dollar denominated bonds in lieu of all the materials consumed.

In exchange of real goods, China got back dollar or dollar denominated assets. All U.S. have to do to keep increasing the consumption was to keep printing dollars and issuing bonds. Dollar is the reserve currency of the world and U.S.treasury bonds are AAA rated. By mere printing, they have been able to get what they want. 

Now China has started issuing veiled threats that it is the responsibility of  U.S. to  protect China’s interest in dollar denominated assets.

I feel that U.S. cares a damn about protecting anyone’s interest other than its own. Unlike an average Chinese, an American does not bother about filing for bankruptcy when they cannot pay back the loans. 

When Chinese were working like bonded labours at low wages to supply to U.S., Americans were busy taking more loans on their already mortgaged homes to fund their vacations. 

The whole world was envying the American life style without realizing that they are the ones who are making it possible for Americans to be that way.

So there is no point in China threatening U.S. to pay back. What if  U.S. chose to default on their obligations? China will loose both their money and their major market.

China is very well aware of this risk and has been taking various measures for the last few years to correct this anomaly but is only partly successful so far. They became heavily dependent on exports and have created excess capacity.

Japan lent to U.S. not because they are aggressive as Chinese for growth, but just to keep their economy running. For the last 2 decades, Japanhas been in continuous decline for various reasons including its demographics.

The Japanese get nearly zero interest on their savings and their savings rate which was 32% decades ago is now merely 2%. Even that may not last long as the old people are withdrawing their accumulated savings  for survival.

In order to keep their economy going, they are working hard and producing to satisfy U.S. consumption and getting in return dollar and U.S.treasury bonds.

Looks like Japan’s woes may only increase.

From 1980’s, U.S. started spiraling up debts. They used to be a creditor to the world before (can you believe it now?) and after tasting the flow of easy money, they turned into a nation of borrowers.

For the last 3 decades of extravagance U.S. had, next 10 years is going to be the period of consuming less, saving more and paying off debts. In my opinion, both U.S. and its citizens cannot avoid this pain which they are trying to postpone. The quicker they accept the pain and work on it; they would be on the long road to recovery. Any attempt like  QE3 would postpone the problem shortly but make it more difficult to resolve.

The downgrade by S&P would make borrowing expensive and further strain the U.S. ability to service the interest and repay the debts.

No individual, family, corporation or country can keep spending beyond their income and keep rolling over their debt by incurring further debt. The party cannot go on forever; it has to stop somewhere.

What would happen to the world markets in the short run is unpredictable.

In the coming days, we may expect herd behaviour due to extreme panic. So volatility in all markets including Indian market cannot be ruled out.

Over next few quarters, since the consumption of  U.S. and Europe would go down, we may expect crude oil and other commodity prices to correct.

Over a period, dollar would get weakened against currencies of fundamentally strong economies. This means we can expect the rupee to get strengthened in the years to come. If you recollect, 2 years ago it touched around Rs.39 per dollar. Two decades ago, it was around Rs.11 per dollar. It is difficult to tell what would be the conversion rate; but the long term direction is clear.

Fall in oil and other commodity prices would help us in tackling inflation.

Interestingly, oil is now sold at much higher prices in India than it was in 2007. Currently crude trades around $85+ a barrel while it was trading around $140+ in 2007. Instead of rising interest rates and taming the growth, the government can reduce the oil prices to control inflation. The government would talk about the subsidy they are providing for every litre of oil. What they don’t tell is how much we’ve to pay more because of the excessive duties and taxes crude suffers in India. What is the fun in charging say Rs.30/- per litre more due to taxes and then subsiding us by Rs.5/-?

Our government would like to make issues complex. Reducing the oil prices by 10% would control the inflation better than all the monetary measures of RBI.

As I’ve been mentioning for a while, interest rates may start getting softened before next year end leading to rally in bond prices and giving better yield for debt based products like MIPs.

When the dust settles down after few months, capital would start flowing to area of superior return. Our economy is sound on absolute merit and very attractive on relative merit. There would be opportunities in the equity markets for making lump sum investments in the next few months due to attractive valuations. If you’ve money to commit for atleast 5 years, you may consider lump sum investments in addition to SIPs.

As far as gold is concerned, we’ve always been of opinion of keeping not more than 10% of one’s net worth in the same. Gold in the long run has been the preserver of purchasing power and not an enhancer.

The recent years run up in gold has got more to do with fear in the global markets. People who go long on gold in the times of fear are usually rewarded well.

But the problem with gold is arriving at its intrinsic value. It does not generate any cash flows, is not a productive asset and value is solely derived on how much the other person is willing to pay.

In 1970’s, double digit inflation across the world, Iranian crisis, heights of cold war, OPEC issues etc. kept on rising the price of the gold for a decade from $35 an ounce to $850 per ounce in January 1980. In fact there was such a frenzied buying for gold in the last few months before January 1980.

Then the gold prices started falling continuously for 19 years to reach $251 per ounce in 1999.

The gold has been rising for the last few years due to weakness of currencies and as people are looking for safe haven. Now there are predictions that a gram of gold would even touch Rs.5000/-.

People who want to capitalize on global fears and buy gold may do so keeping in mind that in the history of gold, it is very difficult to spot a bubble (as it has no intrinsic but only a perceived value) and we would be knowing it only in hindsight.

In earlier occasions, when gold prices fell we were not impacted because our currency got weaker against the dollar. That is the reason why when the gold prices fell between 1980 and 1999, the prices actually appreciated here due to rupee getting weakened against dollar.

In future, if and when the gold prices fall, as our currency is also likely to appreciate due to changed global dynamics, it may be a double whammy for us.

If you’re interested, you may read ‘The power of gold: The history of an obsession’ by Peter Bernstein.

To quote Warren Buffett “ Gold is a way of going long on fear, and it has been a pretty good way of going long on fear from time to time. But you really have to hope people become more afraid in a year or two than they are now. And if they become more afraid you make money, if they become less afraid you lose money; but the gold itself doesn’t produce anything.”

As far as IT & BPO sector is concerned, any cut in spending by U.S. and European companies would have a negative impact. There are also arguments that more outsourcing would happen to trim costs. Whatever be the case, weakening of the dollar would definitely warrant a relook at costs and business model in the years to come.

I know that I’m writing this piece lengthier than usual but doing so because wanted to cover some key aspects for you to face the volley of news about the financial market in coming days and weeks.

A client of us, who is an informed investor, texted me yesterday that he would borrow money even from his neighbour and their dog to invest lumpsum in Indian equities if markets fall due to global panic.

I’ve asked him whether his neighbour’s dog would be interested in lending me too.

Since I live in an apartment where dogs are not allowed; he has distinct advantage over me. All we have is poor street dogs outside our compound!

Blessed are those with rich neighbours and dogs.

Watching what U.S., Europe and institutional investors would do may look like a horror movie. Don’t panic, it is not good for your heart. 

This too shall pass.

One Response to “It’s a complex crazy world”

  1. prabeesh said

    Ok with all these factors into account ..it indirectly means the days of Outsourcing from US and Europe is over.Though not immediately but slowly they have to bring back the jobs they outsourced to other countries back to them in order to employ a lot with comparatively low wages(which they will be willing if it happens as u said).

    In that case what should people like me in the IT industry do. Knowing for sure it can run for more than a decade or two by depending on the US customers alone?
    Should we look out for second job or alternative arrangements in place?

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