Short View: Thank you Q2 2011 corporate results

Bears are confused…despite all the bad news around why Mr US Market is holding steady. US markets have recovered smartly from the lows seen in June 2011.

We are seeing a stalemate in the US debt ceiling issue though since 1940 there has been more than 100 changes in the debt ceiling limits…last time when it was done in early 2010 it was very smooth, most of us would not have even heard of it. Europe debt is getting out of control and there is a near consensus that Greece would default and its rating is just 2 notches above default…did I say default. The term default which was considered so sacred 1 month ago but now the markets are digesting it. There are so many news clips containing possibility of US default and probability of its credit ratings downgrade. Remember US has AAA ratings since 1914 and it has never defaulted on its loan ever. But despite these macro issues Mr Market is holding steady after a smart 5% rally.

Citing weak macro picture, the USD is declining against stronger currencies like JPY and CHF; and Gold is zooming to all time highs.

Bears are confused…finding reason for the steady market.

Since 2nd week of July we have seen a very good set of Q2 2011 corporate results emanating out of the US. Almost 75% of the companies have beaten their estimates. Very few prominent ones have disappointed which include the likes of Goldman Sachs, Caterpillar etc. This is almost 9th consecutive quarters of robust results. Many more are yet to come. We have host of energy companies which are yet to deliver their results which might led the market up for a while.

However things would start looking murkier again post the fading of result season and macro issues would again gain the ground to make bears happy. However there remains a distant possibility of US debt default but I would not undermine the probability of US credit downgrade citing political fight and non-consensus as reasons.

June Monthly Commentary

Global markets are significantly impacted by a broadening of the European sovereign debt crisis and the US debt ceiling impasse. As Italian and Spanish spreads widened, equity markets reflected these concerns as well. Global stocks and currencies are very volatile while gold prices climbed to a new record high, on fears the debt problems in Europe and the United States may spiral into a global crisis.

Stress tests for Eurozone banks released on last fortnight failed to stem the anxiety about a potential Greek sovereign debt default and its contagion effect. In the EBA stress tests, eight banks failed to meet the 5% Core Tier 1 ratio threshold. In the US, as the clock ticks towards the August 2, 2011 deadline for an increase in the statutory $14.3 trillion borrowing limit, investors are nervous about the stalemate in Washington. The lack of progress in negotiating a US fiscal package has already led two ratings agencies to warn of a credit rating downgrade in the event of a US default. However hope remains that the US may avert a default on the optimism that the Congress could reach a debt agreement before the deadline. However US's AAA rating is under a serious threat.

Economic data provide mixed patch for the global economic recovery. June employment data was very bad and way below the consensus however housing markets are seeing some life back. However we remain optimistic that the current soft patch will prove largely temporary and that the world’s largest economy will regain traction in the second half of 2011. Earnings of S&P 500 companies are coming in a very good shape and around 75% of the result so far has beaten the consensus earnings estimate.

The September 2008

September 2008 was a truly an eye popping month with so much events happened which one could not have imagined in his/ her generation!!!

• The Federal Housing Finance Agency (“FHFA”) placed the Government Sponsored Enterprises (“GSEs”) Fannie Mae and Freddie Mac, into conservatorship run by FHFA.
• Lehman Brothers filed for bankruptcy
• The U.S. Government provided AIG with an $85 billion loan (@around 11-12% pa) for 80% stake.
• Merrill Lynch was taken over by Bank of America
• Morgan Stanley and Goldman Sachs “transformed” over a weekend into bank holding companies.
• The Federal Deposit Insurance Corporation (“FDIC”) seized the assets of Washington Mutual, and sold off to JPMorgan Chase.
• The collapse of Washington Mutual is the largest bank failure in U.S. History.
• The FDIC also facilitated the acquisition of the banking operations of Wachovia Bank by Citigroup, however later on Wells Fargo announced its takeover
• HBOS was taken over by Lloyds, B&B in the UK was nationalized, Fortis has three sovereign governments now owning 49% each of the companies’ banks in those countries
• The US and UK regulators banned short selling on financial stocks.
• Other countries which instituted a ban on short selling (either a list of select names or all stocks) include Australia, Canada, France, Ireland, Italy, South Korea, Pakistan, Switzerland, Taiwan and the United Kingdom.
• Over a trillion dollars of liquidity was pumped into the global financial system
• On September 29th, Troubled Assets Relief Program (“TARP”) was voted down, and the US equity markets ended the day with a “mini-crash” like return of -8.79% (the largest one-day percentage drop in the S&P500 since 1987 crash).
• Both Implied and Realized Volatility across all asset classes spiked to 200-400% of historical averages. The realized 20-day volatility for the S&P500 was 59%, over 3.5x its long term average. This is the case for virtually all asset classes.
• Short term Treasury instruments served as the flight to quality, with yields on the US 3-month treasury bills at 0.91% from 1.72% at the beginning of the month.
• On the 17th of September, 3-month US treasury yields were zero and some trades took place at a negative yield – the last time that happened was in January 1940!
• Credit among counterparties froze, as LIBOR spreads went to unprecedented levels – all this despite a global coordinated effort among central banks to pump liquidity into the system.
• The US dollar strengthening by almost 4% against the EURO, but this monthly move masked very high intra-month volatility.
• Emerging Market currencies were for sale all month, with the Brazilian Real down over -14%. In particular, USD / Indian Rupee (- 7% for the month, -16% YTD) and USD / Korean Won (-10% for the month, -22% YTD)

US Out Europe in…Risk turns on Euro Area

Risk in the US financial system is known and more or less quantified between USD 1000-1500bn (though deviation is large in different estimates but that doesn’t matter in this context). With the bankruptcies and bailouts of financial biggies in the US, people are being increasingly risk averse. Every weekend one big fat trophy is on sale...and here goes Wachovia! Government is working on a once in a life time bailout measure, as they are now tired of providing billions and billions of liquidity in the money market with no respite.

So the cat is out of the hat in the US, now the focus shifts to the Euro Zone and the UK about their malicious balance sheet. Out of the total write offs of around USD 600bn till date, 40% has been written off by the European banks. Almost all write offs have been done on their direct or indirect US exposures and investments made with US assets as an underlying. But now with their local economies also in sight of slowdown or recession, they face larger risk of losses/ impairments on their domestic lending and investments (with underlying European assets).

We have seen few European examples cropping up wherein UK government took control of UKs’ largest mortgage lender Bradford and Bingley; Llyods took over HBOS, and Belgium-The Netherlands-Luxemburg governments bailed out Fortis where in they bought 49% stake in their respective country’s operations. Germany is bailing out its 2nd largest commercial property developer Hypo Real Estate in its Euro 34 bn loan. The disease is spreading every passing day. And the more credit market deteriorates, more bailout candidates would emerge.

Investors have already discounted this threat and Euro Zone currencies are taking a beating and Euro and GBP are down by around 10% since March 2008 against the USD. It shows that investors are now being more skeptical of Euro zone and the UK than the US.

India Economic and Financial Confidence Index-September 2008

Executive Summary

• Indian EFCI-Sep 08 reading of 2.22 (on scale of 5, wherein 1 shows most bearish sentiments). The reading is based on Population Mean.

• Responses are characterized by low dispersion and almost follow a symmetrical distribution; implying greater importance of Population Mean and that there isn’t any significant extreme response (thus no significant tail risk)

• Top concerns are Inflation, High Interest Rate, Slowing Economic Growth and Drying Other Income (from stocks, bonds, real estate etc)

• Among broad sub-groups, Economic Growth and Financial Insecurity are top 2 concerns (among 5 sub-groups surveyed)


Summarized Presentation of EFCI

Total Respondents: 135 (Comprised of Investors, Brokers, Financial Analysts, Economists, Corporate Executives including Senior Management, etc.)

Highlights of findings

EFCI for September 2008

• September 2008 EFCI Reading of 2.23 (on a scale of 1 to 5, wherein 1 shows most bearish sentiment and 5 most bullish) shows that respondents are pessimistic about the current Economic and Financial situation of India. A reading below 3 shows pessimism among respondents.

• The data has low dispersion measures like Standard Deviation, Coefficient of Variation, Skewness etc, thus shows greater significance of Population mean, and that responses are in a fairly tight range around the Mean.

• The response distribution almost follows a Symmetrical (near Normal) Distribution. Median of 2.20 is not much deviated from Mean (2.23). Skewness and Excess Kurtosis (i.e. Kurtosis minus 3) measure are of 0.04 and 0.05 respectively. 74% of the responses lie within 1 Standard Deviation from the Mean (as against 68% for Normal Distribution), 93% lie within 2 Standard Deviations (95% for Normal Distribution), and 100% lie within 3 Standard Deviations (99% for Normal Distribution).

• EFCI Reading of 3.5 (indicating marginal bullish sentiments) lies 2.9x Standard Deviations away from the Mean on a Standardize Normal Distribution (standardized by dividing the deviation from Mean by Standard Deviation). It signifies that bullish sentiments lie outside 99.8% confidence interval (in a one-tail test)


Individual Indicators Highlights

• Among the individual indicators, respondents are most pessimistic on the Current level of Inflation (Reading of 1.56) and 95% either Agree or Strongly Agree that Inflation is Worrisome and Alarming (Most of the responses: 52%, ie. Mode, are of Scale 1). Interestingly the response has the least Standard Deviation and fairly low Coefficient of Variation (SD/ Mean), thus there isn’t wide deviation in the response pattern

• Though respondents reasonably believe that Inflation will not rise further, however reading of 2.90 (3 is Can’t Say) shows that they are not very confident on their response.

• Among the individual indicators, respondents are most optimistic of their Next 12 months regular income with a reading of 2.94 (however still not out of bearish territory!). 60% respondents either Disagree or Cant Say that their next 12 months regular income is not secured However, high Standard Deviation shows larger deviation in the response pattern.


Sub Groups Indicator Highlights

• Among the sub-groups, respondents are most pessimistic on Economic Growth wherein the indicator shows reading of 1.92 with low dispersion measure as well.

• Inflation: High Inflation is grossly Worrisome, however response on whether Inflation Will Rise Further is fairly balanced. Also, so far Inflation has not largely affected the Discretionary Purchases.

• Economic Growth: Respondents are of the opinion that Economic Growth would Slowdown in the coming 1-2 quarters and that High Interest Rate would contribute to the said Slowdown. Real Estate & Construction work slowdown is also visible though on a modest scale.

• Financial Security: Higher interest rate is making Loan Repayment very Worrisome and Other Income (from Stocks, Bonds, Real Estate etc) are also drying up. Surprisingly response on next 12 month primary income (salary, professional income etc.) is balanced with higher Standard Deviation (which is understandable, as there are extreme cases of comfort and discomfort-depending on type of industry where respondents are working). However response on this particular question could be biased depending on the kind of target respondents (which in this case is primarily from financial services industry, which currently is not in a very strong shape). Around 40% of the respondents are not sure about 12 month visibility of their primary earning source.

• Different Asset Class Investment: Investors are not so bearish on Fresh Allocation in Equities and Real Estate at the current level. However, they are equally inclined towards investment in safer asset classes like Fixed Deposits and PPFs which in a way rivals Equities and Real Estate as they share the same pie of investment budget.

• Other Factors: Political interference in Business Matter is quite worrisome and that Corporate Income will slow down has drawn fairly consensus response. Respondents are not very sure about Should Sensex’s trade 1yr Forward PE Multiple of 15x in the current market situation.

Other remarks

• Top 5 concerns (among set of questions) are Inflation, Higher Interest rate and its affect on loan repayment, other income (stocks and bonds) slowing down, High interest rate leading to slowdown in economy and expectation that economic growth will slow down in next 1-2 quarters.

• There isn’t any sub-group or individual indicator having average (population) reading of 3 or more (bullish).

• Rise in inflation is of least concern (among the questions raised).




About EFCI

Economic and Financial Confidence Index is an attempt to quantitatively measure current economic and financial situation sentiment. The primary focus of the survey is on the macro picture and hence questions asked are broadly on a macro scale rather than focussing too much on micro segments. Broad areas covered in the survey are: Current Inflation, Likely Future Trend and its Impact; Economic Growth and its likely Future Trajectory; Financial Security and Income; Investment in various Asset Classes; and other factors like Political Interference in Business and Corporate Earnings etc.

While utmost care has been taken to include questions covering broad macro picture to arrive at a meaningful conclusion, any shortcoming will be taken care of in the future. Your feedback, comments, criticisms are invited at vikas.maheshwari@gmail.com

Impact of high inflation on the Middle Eastern economies

Impact of high inflation on the Middle Eastern economies

Middle East (more specifically GCC-Saudi Arabia, UAE, Qatar, Kuwait, Oman and Bahrain) economies are classical example of living in 2 extremes. Inflation in high teens or even 20s and interest rates of 4-5%. It has inflation of emerging market economies and interest rate of developed economies.

Why high inflation

Imported inflation:

Till mid this year, USD was on a steady decline against currencies (Euro, GBP, Yen, INR) of Middle East trading partners. This led to the so-called imported inflation as import cost increased in USD terms. Last year Central Bank of UAE said that 75% of total imports were in USD terms (but it was obvious that import costs were increasing as USD was declining against other trading partners’ currencies). There was a huge clamour for revaluation (appreciation) of local currencies against the USD, and more so after Kuwait removed its peg against USD to a basket of currencies last year. Locals and foreigners bet big on the revaluation and were buying Middle East currencies (AED, SAR etc) in the forward market. UAE’s AED 1 year forward was trading at AED 3.55 against USD (as against current peg ratio of AED 3.673) at around 3-4% premium, however with the USD appreciating sharply against all other currencies, the revaluation fizz is out of the market and these (speculative) investors are squaring off their position and hence there is a strain on the Interbank market.

High Money Supply (M2)

Another source of huge inflation is the money supply (M2) which is in excess of 30% Y-o-Y. Banking assets have grown by 35% for the past few years and personal loans have increased in excess of 40% during the past few years. Recent across the board salary increase of government employees (around 75%) will add fuel to the fire. During 2005 and 06, personal loans were taken to play in the stock market and market crashed after reaching an astronomical height, but in 2007 and YTD 08, people took personal loan to pay the down payment of 2.5% - 5% for their real estate purchase (which is more of a speculation rather than investment). It led to a huge jump in real estate prices and rent, as supply remains tight in Dubai and Abu Dhabi. Rental yield for residential properties hover at around 9-10%, which is quite high against a global standard of 3-4%. Rent forms around 23% of CPI Index (36% for the UAE). Rent currently contributes more than 60% to CPI Index.

Pegged currencies stifle independent monetary policy:

As the ME currencies are pegged against the USD (besides Kuwait’s even though USD plays a big role in its currency movement). Hence their monetary policies are largely imported from the US. Hence they cannot do anything on the interest rate which would be otherwise necessary to control inflation. Inflation is high, thanks to the high oil revenues…its USD 1bn a day. Petrodollars are ploughing back in the local economies (unlike before). Governments are trying hard to diversify economies away from oil, and are spending big time into real estate and infrastructure, industries, leisure, healthcare, tourism and hospitality etc.

Hence, lack of effective tool is also accentuating the problem.


Rental: Pain for some-gain for some

Rents are primarily paid by expats, as they cannot own properties across the city (they can hold freehold properties only in selected locations). Rent, which forms a substantial part of expense basket and thus of Consumer inflation for an expat, is a good source of income for the Locals here. Hence, inflation for an expat and for a local should be seen separately.

But Inflation is not same for all

For a typical middle income earning expat, I would not be surprised if inflation is in excess of 25%. Rent forms more than 50% of an expat’s expense which is increasing by 40-50% every year (2008 has been particularly bad especially in Abu Dhabi). Though rent caps prevail, but they are not implemented in a very transparent manner. Rent is no issue for a Local, hence major inflation contributor is absent for them as they have their own home in city. Hence they would be having inflation of only 4-5% (primarily from food). Weighted average inflation comes in between 12-15%. Different sources give different numbers here, though!

Hence we do not see much of monetary tightening here by the Central Banks, as inflation is leading to a less of savings and repatriation (as % of salary) and more of consumption expenditure by expats and the same money is coming back into the local economy and more so, to the UAE Locals. Thus money multiplier is leading to even higher M2. Kuwait has been pretty successful in tightening the money supply from 25% in Feb 08 to 16% in Aug 08 by various monetary policies.

Impact of high inflation

Negative Real Interest Rate:

With inflation hovering at 12-15%, and EIBOR of 2.5-3% (plus lending spread of 200-400bps), the real interest rate is deep inside the negative territory. It leaves no motivation for savings or investing in low yielding securities like Bonds or putting money in Bank Accounts. It depletes purchasing power of the same money as time passes. This negative real interest rate motivates investors to invest in high yielding assets like stocks and real estate. Investors are investing their savings and further taking mortgage loans (at around 7-7.5%) and personal loans (at around 8-9%) to speculate in the real estate market. There is a general feeling that real estate will hedge against inflation and real estate prices will adjust inflation hence you borrow at 7-9% and have capital return of atleast 12-15%, thus an arbitrage of 3-5% every year. Plus you have capital appreciation in real terms (in excess of inflation) and rental income, if any! It has led to sharp increase in real estate prices and rentals. Thus giving fillip to already high inflation and forming a vicious circle!!!

Wrong side of playing the negative real interest rate:

Investors are highly levered now, and with tightening real estate regulations (For some projects, atleast 15% of the capital cost has to be paid before selling the property; no off plan sale; no sale within 1 year of purchase etc) there could be some pain in the future. Hence inflation is giving genesis to another problem. Things look very rosy at the beginning, but even Freddie Mac and Fannie Mae can stumble in crisis. Even the unthinkable happens!

What is in it for foreign investors (primarily US investors)

Investors in the US can easily play with the high inflation in the GCC economies, as they do not have currency risk (assuming that UAE will not revalue the currency in the near future). Inflation in the US is at around 4%, hence they can borrow from the US and invest in local equities or real estate. It is expected that the net profit of local companies should atleast increase by the inflation rate (otherwise it would destroy the economic real value of the business). Assuming that local companies’ stocks are reasonably valued at current price (after recent sharp fall in the market, explained later*), the share price should atleast increase by the growth in net profit. Hence they can easily earn annualised return of 12-15% in terms of stock appreciation on a 18-24 months basis, plus 2-3% in dividends. Hedge fund guys…are you listening!!!


* Reasons why local equity market is falling down

• The recent selling in broader stock markets across the GCC (a natural hedge against oil price led inflation) and the UAE in particular coincides with the sharp correction in oil prices (down 29% in 8 weeks).
• Foreign based Hedge Funds are booking profits in GCC equities to cover up their July & August (of around 2.8% each month) losses on their broader portfolio.
• Many commodity driven emerging markets like Brazil and Russia had a very good first five months (Jan¬-May 2008) but have started falling since May 2008 after a halt in sharp commodity price rise. GCC followed the suit post oil price correction.
• My meetings with couple of foreign brokers gave us an understanding that foreign money managers are selling off GCC equities after their huge outperformance against global equities
• Recent reports by many brokers and analysts about softening Dubai Real Estate prices has also acted as a huge short term negative for real estate and thereby equity investors
• Many of the real estate buyers are not the end users and they intend to sell their property within 1¬2 years of the purchase, and any downward pressure on house prices would have a huge negative leveraged return. Investors’ sentiments would take a big hit.
• The investigations and legal clampdowns against top executives are putting a big question mark on the transparency on the corporate UAE. This lack of transparency is totally against the investment philosophy!
• UAE Central Bank is considered to be one of the most lax regulators in the GCC especially compared with Kuwait and Saudi Arabia. There are market talks that UAE Central Bank is considering tightening rules on the similar lines especially in personal and real estate lending


Squeezing profit margin and rising attrition:

Though not much evident right now, but higher inflation will lead to higher salary expenditure by local firms to retain their talent, else attrition will take place. In high inflationary scenario, attrition is the natural outcome as people pursue higher paying jobs to save their purchasing power.

So far, Local companies had a handsome operating margin because of a lower cost base. Imagine, what we can afford to spend during one weekend is the full monthly salary of a blue collar construction worker!!! But if inflation is not contained, the cost base will rise and thus the profitability of companies will get hurt.

Things might worsen and can even go out of government control:

Local economic regulation and governance are still in infancy. Regulators are not well equipped to tackle any kind of economic crisis. High inflation due to high rentals and higher money supply, is encouraging capitalist to come out with great plans worth billions of USD. For a population of 5mn, around USD 800bn worth of project is going on in the UAE, primarily in Dubai and now in Abu Dhabi too (per capita project of USD 160,000). 50-60% of the projects are being developed by government owned or sponsored companies.

If economy faces a supply glut, the developers will have 2 options. Either to sell at reduced or even distressed prices or to hold on inventories to check the falling prices. First one will lead to huge loss, while second one will test financial strength. Most of the Dubai govt companies are highly levered and their bonds are currently trading at a high yield of 6-8%. The Credit Default Swaps (to insure against any default) on government sponsored/ owned companies like DP World are hovering at around 235bps-which is considered to be quite high.

With financial strength of Dubai’s companies increasingly being questioned, either option will take a huge toll on the economy. The government has to be well equipped to foresee the scenarios and get prepared accordingly.


Reverse brain drain…in the extreme case:

If inflation remains high, it will take away the savings opportunity of an expat. If sustained, the trade off between higher savings and leaving own country would imbalance, and it would lead to a reverse brain drain and expat would start returning to their home country. Anyways, no one is happy to pay 25-40% of hard earned salary in form of rent (in this no tax country…rent is a tax here). Tax is normally charged from the public for the public. Rent here is charged from an expat for a local!

Indian equity market: Down and out- atleast for now!!!

I am not from the bear camp, but generally everyone is more cautious theoretically, than what he does practically. So here it goes…my cautious view on the market, though personally I am net long- quite contrary to my theoretical approach of thinking!!!

There was a report from a leading global investment bank that CY08E/ FY09E earnings growth for MSCI Asia ex Japan would increase by 4% YoY. The same was expected at around 12% at the beginning of 2008. They added they won’t be surprised if their estimate falls down to 0% growth later during the year. This is the kind of earning risk prevailing across the emerging markets in Asia.

India is also observing similar earnings downgrade threat. I believe the consensus expectation for FY09E is still of around 12-14%, though is down from 18% at the start of 2008. And I would not be surprised if the consensus growth number goes below 10% and then analysts start revising down their FY10 estimate too which currently stands at early 20s% (and increasing as FY09E numbers change and FY10 EPS remaining the same).

Better than expected Q1 FY09 numbers, the UPA No Confidence win in the Parliament, global stock rally (esp financials) in later July/ early August helped Sensex reach around 15500 by mid August. Decline in commodities and actual inflation numbers below expected for 2-3 weeks also helped the market. The credit market suddenly had a very good time, and CDS on Indian corporate debts reduced during July.

However globally Hedge Funds made substantial loss and Hedge Fund Index was down by 2.8% in July as they were long commodities and short financials-which panned out opposite during August. During August also, they are not doing good as they are short USD!!!

Commodities decline also helped the markets as India is net importer. Sensex of late has been showing a near perfect negative correlation with commodities, though during 2003-2006 both were trending north, but it requires a turmoil in the market which actually tests the correlation.

Sensex (White) and Goldman Sachs Commodity Index (Orange)

Source: Bloomberg

While other emerging commodities driven markets (Brazil, Russia) faltered during July.

Brazil Bovespa (White) and Goldman Sachs Commodity Index (Orange)

Source: Bloomberg

Russia RTS (White) and Goldman Sachs Commodity Index (Orange)

Source: Bloomberg

So, what lies ahead…is not so good picture…

Recession blues…and European banks’ worries
With more than 50% of global economy facing threat of recession or severe slowdown (likes of the US, Japan, Germany, UK, Spain etc), the global macro picture remains very bleak. The menace happened in the US, is waiting to happen in Europe. European banks, so far took hit on only their US centric investments, now that their home markets are under threat, another blow of domestic write down is on the anvil, so it might give another blow of negative sentiments to the investors.

Inflation worries
Coming to India, the 10 year Govt Bond Yield that retreated below 9% during early August, is again hovering at around 9.2% due to inflationary concern, as against Sensex current earning yield of around 7.2%. The inflation surged to 12.63% from around 11.8% during July.


Source: Bloomberg

Infact inflation now lies beyond 4x Standard Deviation from its 12 years mean of 5.05% and Std Dev of 1.8% (and 5 year mean of 5.6% and 1.8%). The observation till May end numbers had a normal distribution and all the observations lie within 2.5x Std Dev around the long term mean. However come June and we had a oil price hike led inflation spike, which surged past 11.5% and now at 12.63%. It threw the inflation numbers beyond 3.5x Std Dev. Till the inflation does not come within 2x SD (i.e. 8.5-9.0%)-within 95% confidence interval, market will remain jittery on the concern.

It will further increase the socio-economic divide. Poor people as it is did not participate in the India story so far, but they are being penalised as their only expense was towards non-discretionary expenses like food, depleting their savings potential, if at all they save.


Source: Bloomberg


Source: Bloomberg

Tight credit market and rising funding cost…
Rising inflation prompted RBI to increase interest rates and the reference prime lending rates (charged from most favored clients by banks) are at around 14%. Much deteriorated capital markets and increased interest rates are making funding very very tight. All exotic external funding sources are of no respite, as many of the previously issued FCCBs (convertible in equities) are deep out of the money, so now the global investor having risk appetite would demand much lower conversion price for further funding…which would lead to imminent dilution. ECBs are also not favoured currently as global lenders see deterioration in the Indian macro picture further spiked by downgrade rhetoric by credit ratings firms (infact Fitch has recently downgraded its ratings for India’s LT Currency Issuer Default Rating). Blue Chips like Tata Motors has recently shed out plan to issue convertible preferred shares and selling its assets and is issuing rights issue for the remainder instead.

Interbank rates are tightening in the Middle East, ME banks are also resorting to wholesale funding from global financial institutions. There is a lot of Tier II and Subordinate Debt issue happening in USD and Euro by ME banks. ME corporates are also raising funds from abroad. So, Indian corporates have to compete against their ME counterparts to get funding, and I believe on the sound macro footings, ME companies would win the battle if not the war.



And CDS again rising high…
Credit Default Swaps (CDS) on investment grade bonds issued by Indian corporates like Reliance Industries (230bps), Tata Motors (500bps), ICICI Bank (330bos), Reliance Communication (370bps) is again rising after falling from their March and Mid July highs. ICICI Bank followed by SBI and BOI has the highest CDS among the Asian banks’ investment grade bonds. It takes 3.3% (330bps) to insure ICICI Bank bonds against any default. So, if your cost of funding is let say 5% (lowest possible cost of funding), you need to pay 3.3% to insure yourself against any default. So 8.3% is you total cost. An investor would need atleast 2-3% net spread…hence you would demand 11-12% yield from their bond. Imagine, this is the cost of Senior Debt for ICICI Bank, and if they issue subordinated debt the cost would further rise as investors would demand even higher yield for the subordination.

CDS on Indian banks’ Investment Grade bonds

Source: Bloomberg

Trickling down effect of rising funding cost…
If this is the plight of big banks, imagine corporates who borrow from these banks. Let say a Construction Company A, who bids for a project for a margin of 3-5% over its cost of funds. Earlier, thanks to the benign capital market, their explicit weighted cost of funding were cheap (around 8-9%) as they used equity/ quasi equity routes (at huge conversion premium, so existing shareholders were also happy as dilution happened at higher price). Now equity capital market is fully dried up, Co A has to borrow locally. If ICICI banks’ marginal cost of fund is 11% it will keep a net spread of 2-2.5% and would lend to A at 13-14%. Hence the asking IRR climbs to atleast 17% to bid for any project A bids for. Earlier A was bidding at of IRR of 12-13%. Hence, either A has to bid at a very low IRR reducing its margin further or master project becomes extremely costly. And the cost trickles down to end user by way of higher toll/ utility charges.

Hence tightened market today for 2-3 quarters can have a long lasting impact on inflation. This is just one small example. Higher interest cost seeps into all forms of cost components, as for everything you do, you need money…to create money…

Global gloom…
Now with more than 50% of world economies flirting with recession (namely USA-25% of world’s GDP, Japan- 8%, Germany- 6%, UK- 5%, Spain- 3% etc.), and given so much of global financial sea-saw (Freddie-Fannie’s CDS at 350bps), writeoff scare on European banks and so much of earning risks for 2008 and 2009, Indian market Forward PE of 15x looks high. True currently Indian market PE is now at a premium of only 1% over Asian ex-Japan, as against an average premium of 10% during 2006 & 07, but that period was characterised by positive surprise in earnings numbers and lower interest rate/ inflation regime.

Things have turned upside-down as of now and expected to remain the same for next 1-2 quarters. Multiple measures of monetary tightening…multiple times…would start affecting the bottom line and balance sheet of Indian corporates expected from September quarter result, plus we can see some contraction in the capex plan or trimming of order book. And this time around we still have hidden earning risk…so even if markets remain at the same point, PE can actually increase.

Pundits say that credit crunch and slump will take half or whole of 2009 to get stabilise. And when any financial turmoil happens in developed market, correlation among global markets increases and the sentimental negative contagion spreads around the world. Middle East markets are largely negatively correlated with global markets, but during any sharp movement in S&P 500 Index, the ME markets react accordingly in the same direction.

Lagging foreign demand for Indian equities…
And in this global gloom, its very difficult to expect foreign investors to come back hugely, after USD 7bn YTD 08, and ticking, sell off. Domestic funds have been net buyer YTD but of no respite to the markets. Hence, thinking that Indian MFs will rescue the market will not help this time. We need foreigners…and now they need additional risk premium (remember rising bond yield will add risk free rate too!) and hence very cheap valuations. Middle East markets are trading at 11-17x CY08E earnings with ROE of around 23%. 1H 08 result has been stupendous. And this market is also attracting lot of global investors, primarily hedge funds. Now the biggest market Saudi Arabia is gradually opening for foreign investors. This region puts a threat to emerging Asia (incl India) in competition for foreign funds.



Conclusion
There could be an argument that now commodity prices are coming down, and thus is a good sign for inflation. Yes its good for short term, but if we see the reason for the decline…(and I believe it is more because of recession fear than a technical correction)…the story does not look favourable on a medium term basis. India is in Bear Market grip for the time being. Long run, everybody is dead that’s why we don’t bother to say…long term India is a Buy!!! 

The reason I compared Indian market with Middle East market, because both are considered emerging markets. One side you have poor emerging economy (PCI $1000), other side you have ultra rich emerging economy (PCI $25000). Though these markets are still considered as frontier markets, it’s a matter of time, couple of these markets (UAE and Kuwait to start with) would get added in MSCI Emerging Market Indices-hence they would come in more limelight for global big players and would compete with established emerging market like India for FII inflows.