Time to suck liquidity from the system

Stocks are pricing in a return to normality of earnings seen in the past few gung ho years barring mid 2008-09 (or abnormality : take your pick). And the hope is that China (4.95% of the world's GDP) and India (1.7% of the world's GDP) would lead this growth while the US (24% odd percent of the world's GDP) continues to suffer from unemployment woes and diminishing consumer spending (lower absolute spend and weaker spending power due to a falling US Dollar). High hopes in my opinion.

Every crisis has to end and eventually all markets bottom out rather than go to zero. So shall it be this time too.

However, whether there will be heady days of growth soon on the horizon, as early as late second half of 2009 according to some, is a matter of debate. Markets discount the future and a clear prognosis is not forthcoming at this juncture on the expected time frame for revival of growth.

I hope the author, Mr. Brussee, is wrong. In fact, I hope is dead wrong. For if he is right then the immediate future looks look bleak and the time beyond that looks bleaker still. Lending weight to the bleak scenario is the author's track record. He called it right in 2004 when in his previous book (The Second Great Depression) he correctly predicted not only the foreclosure crisis haunting us now but also the crisis engulfing Detroit that has left the American car makers gasping for survival.

In a way the book is refreshingly different as it is shorn of jargon. Mr. Brussee has spent his career implementing six stigma at GE plants in Hungary, China and USA. I guess he mixes his skills for numbers with a common sense approach of someone watching the markets from the sidelines, away from the day to day pressures of traders and market men and away from the daily tumult which can hide and blind the judgement of the best. The first few chapters establish the inevitability of the current crisis and establishes the propensity to live beyond one's income as the root cause.

Why are we so surprised that Satyam Computer (SAY) blew up?

Probably not because there were accounting shenanigans, not because Raju placed himself before shareholders, not the fact that auditors were probably hand in glove with the management and conveniently turning a blind eye to the fraud being perpetrated at the company, certainly not the fact that the so called independents were dwarfed by Raju, his charm, his wealth, his connections or were just plain incompetent and beholden to Raju for inducting them as independent directors in the first place. We are surprised by the sheer scale of the fraudulent activities which went on unchecked by reputed auditors and the numerous corporate governance awards which multiple organizations vied to bestow on Satyam. Well, it speaks volumes for these organizations but that is a matter for another debate.

I have a confession to make. Twice while reading the book Mobs, Messiahs, and Markets: Surviving the Public Spectacle in Finance and Politics, by William Bonner and Lila Rajiva, I felt a compelling need to refer to the first few pages and refresh my memory on when the book was published. For your information, it was published in the year 2007 (I believe in August) and well before the mega crisis and financial blowup of the second half 2008 unfolded. If not for anything else, then you have to read this book for its clairvoyance alone.

The authors have been bang on target painting what was then a potentially scary scenario which ended up becoming one of the biggest blowups in the financial history of the world as it unfolded. They deserve credit for having faith in their contrarian doomsday vision when everyone else was going all out buying mortgage originator companies and expanding prop desks funded by banks' leveraged books without any due regard for the inherent risks.

India will carry on resiliently as ever. It is a remarkable statement to make in the midst of another of India’s multiple 9/11s. With nearly 200 dead and counting and with hundred injured, everyone in India is filled with a silent rage. You have to be there to feel the disgust Indians feel at this senseless attack aimed at the nerve center of India’s commercial capital. I have lost count of the number of significant terrorist attacks India has suffered over the last few years and these attacks have been inflicted all over the country: Mumbai, Delhi, Hyderabad, Jaipur, Bangalore, Kashmir... and the list goes on.

India has hitherto managed to brush aside all attacks and Indians in a remarkably resilient and resolute manner have shrugged off the attacks on their safety and security and have carried on with their life albeit a bite more than shaken. The daily activity of an average Indian multiplied a billion plus times has managed to generate an average GDP growth rate in excess of 7% over these very years which have coincided with recurring deadly terrorist attacks.

The wealth destruction happening all over the world is on an unprecedented scale. The scale of the collapse of the markets is gigantic and almost all asset classes have moved south in tandem. There is no place to hide. As money searches for a safe haven, the US Dollar has been the biggest gainer. These gains are driven by the relative transparency of the US financial system and the flexibility in the American system to take drastic cost cutting measures through job layoffs and shutting down of unprofitable and unsustainable businesses. There is a flight to safety though the CDS pricing (Credit Default Swap) on US treasuries has been creeping up with investors seeking protection from a potential default by the US government itself.

Year to date, the best performing major equity markets in US dollar terms have been USA (Dow Jones down 38%), Switzerland (down 36%) and Chile (down 36%) while China (down 73%) and Russia (down 72%) have been amongst the worst performers. India, Austria, Greece, Hungary, Norway, Turkey, Indonesia and Venezuela are all down in excess of 60% year to date in US dollar terms. On a year on Year basis, metals are down over 44% since November last while Oil has closed at its 20 month low on its journey south. Gold which was thought of a safe haven in times of imploding markets and a cloudy future is down 9% over its closing previous November. Commodity index is down over 40% over November 07.

Imagine a market where you can trade your perception of someone else's credit worthiness. Imagine a market where you can encash an insurance policy on an asset gone bad without owning the underlying asset itself. Imagine a market which is larger than the capitalization of New York Stock Exchange and is yet not regulated. Welcome to the world of Credit Default Swaps (CDS).

The Instrument: The Credit Default Swap market is massive, estimated to be in excess of $50 trillion. CDSs are derivatives, i.e. financial contracts without the underpinnings of any actual assets. They are used to bet on the credit worthiness of a loan or debt instrument. The price of the swap moves in line with perception of the borrower's credit worthiness. A swap seller believes that the borrower's ability to repay the underlying loan will improve while a swap buyer seeks protection against the possibility of a loan or bond failing.

In a previous post, I discussed the fundamental underpinnings which would lead to a weakening dollar in the medium term. This is expected to happen, however, when stability returns to the markets - be they financial, foreign exchange or commodities. Moreover, for the dollar to start weakening, clarity on the fate of Euro zone economies is critical.

As it stands today, in the short run, the U.S. dollar is perceived to be the currency of choice. Interestingly, the dollar is strengthening at a time when it is clear that the fundamentals of the U.S. economy are deteriorating. The very pillars of financial strength and leadership in the areas of politics, high-end financial services, manufacturing and R&D, which gave the U.S. dollar its underlying strength and resilience, are shaky and no longer the sole hegemony of the U.S.