There is incredible amount of uncertainty. Any sustained recovery in risky assets looks unlikely in H1 2009. My preference remains for outlook neutral trades or investments that would benefit from incipient signs of a recovery but present minimal downside should such a scenario not materialize.
1. Long U.S. Credit: U.S. credit markets seem to be discounting economic cataclysm. Lehman’s U.S. Corporate Bond Index yields 7.66% (as of December 26, 2008; Source: WSJ) and the Baa sub-segment commands a YTM of 9.56% (versus 30-year and 10-year treasuries yielding just 2.60% and 2.14%, respectively). In comparison, Moody’s 30-year industrial spread measured 688bp in July 1932. The U.S. HY space seems priced for defaults exceeding the 3-year average rate observed during the great depression. The U.S. leveraged loan sector presents another compelling opportunity. Monetary policy remains focused on unfreezing credit markets and bringing interest rates down. In the event authorities fail, downside seems limited given already dire pricing. (long LQD and HYG)
2. Long U.S. Dollar: The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well. The INR will likely weaken above the 50 level over the next 6-months. Please refer to my previous piece for details: INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER. (long UUP)
3. Long 10-year U.S. TIPS versus treasuries: 10-year breakevens imply virtually no inflation. The market’s price escalation outlook seems at variance with the current level of 10-year real yields. If rates decline further, inflation protected securities should keep pace with nominals. More likely, there will be a vicious sell-off in nominal bonds at some stage. (long TIP vs. TLH)
4. Long Indian bonds (both Government and corporate): The Reserve Bank of India will ease again. The reverse repo rate will be cut by at least 100bp over the next 1-year. The market does not seem to be discounting that outcome yet. Please refer to my previous piece for details: LONG BOND TRADE NOT DONE YET: EXPECT LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN.
Sunday, December 28, 2008
Sunday, December 21, 2008
INDIAN RUPEE: THE END OR MERELY A BEND? RISK REWARD NOT GREAT FOR INDIAN RUPEE LONGS; NOT EVEN WHEN EQUITIES RECOVER
THE END OR MERELY A BEND
The Indian rupee tanked 27% in the year to November 20, 2008 to reach an all time low of 50.12 versus the U.S. dollar. Over the last 30-days, the INR recovered about 6% to close at 47.05 on December 19. A key question is whether 2008 marks the end of the appreciation cycle that began in 2002.
In my view, the lofty INR levels seen in early 2008 will likely not be reached again over the next 5-years. The base case for the first half of 2009 is a retest of the 50 level. Beyond that, longer-term exchange rate expectations should remain geared to further weakness.
THE RESERVE BANK MANAGES THE CURRENCY IN THE CONTEXT OF A BROAD-BASED REAL EFFECTIVE EXCHANGE RATE; INDIAN RUPEE APPEARS FAIRLY VALUED
The RBI’s 36-country real effective exchange rate (1993-94 =100) fluctuated in a band of +/-5% over the last 16-years. In September 2008, the INR appeared undervalued by about 3.4%. In the period from September to December 19, the broad dollar index gained 6.5%, while the Indian rupee lost only 3.3%. The INR seems fairly valued right now and the future would crucially hinge on the direction of the U.S. dollar.
REVIVAL OF CAPITAL INFLOWS INTO EQUITY MARKETS WILL NOT TURN THE TIDE; THE RUPEE IS NOT AN INDIA STORY
The reversal of the INR’s fortunes coincided with portfolio capital outflows from equities. While the exchange rate continues to display high correlation with stocks, a sustained equity revival would not be accompanied by renewed rupee strength, in my view.
Instead, the outlook hinges on accurately forecasting the U.S. dollar. In 2008, the INR merely reflected the negative correlation between the U.S. dollar and risky asset performance. The dollar benefited from the status of treasuries as the ultimate risk free asset. Net private purchases of treasuries measured $253 billion in the 12 months to October 2008 versus $198 billion in 2007 and $126 billion in 2006. Additionally, with inter-bank dollar liquidity strained, it remained difficult to borrow and sell dollars. A natural conclusion seems to be that once the financial system stabilizes, the dollar slide will resume.
There is merit to this argument, but other developments underway suggest that a sustained recovery in risky assets will only mute the rise of the dollar, but not reverse the ascendancy.
THE U.S. CURRENT ACCOUNT DEFICIT IS CORRECTING; NEGATIVE WEALTH EFFECT CURBS CONSUMER SPENDING
After adjusting for crude oil imports, the U.S. trade deficit corrected by $85 billion during January-October 2008 compared to the same period last year. This trend will likely continue as declining housing and equity wealth force U.S. households to save. Restrained credit should also work to limit spending expansion.
NEAR-TERM DOLLAR VIEW SEEMS ECONOMY NEUTRAL
The Fed cut rates to 0%-0.25% (basically zero) last week. The U.S. authorities remain the most aggressive in providing policy stimulus. The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well.
THE BASE CASE: A U.S. LED GLOBAL RECOVERY COUPLED WITH DOLLAR STRENGTH
Global growth leadership outside the United States seems difficult to visualize. This point figures particularly pertinent in the face of the current account adjustment underway in the U.S. The last similar phase of U.S. current account adjustment stretched from 1987 to 1991. Rapidly growing Germany and Japan saved the day then. Such a state of affairs looks remote today.
Germany, Japan and China remain export-led. Other large current account deficit countries such as the U.K., Ireland and Spain suffer from their own housing busts. The best case for the global economy would be that extraordinary policy actions in the U.S. make the current account contraction more protracted. This would give the world more breathing room, enabling a feeble economic resurgence.
In this scenario, rate differentials will incrementally shift in the favor of the U.S. and that coupled with the dipping trade deficit will propel the dollar higher.
INFLATION TAIL OUTCOME MORE LIKELY THAN DEFLATION
What if monetary policy remains ineffective? With the financial system clogged, there is a positive probability that substantial base liquidity does not percolate into the system. In this low likelihood scenario, policy makers in the U.S. would prefer inflation to deflation. In a debt laden economy, there is really no choice. The Fed will continue undertaking unconventional policy actions to stoke inflationary expectations. Large monetized budget deficits would be the natural course to pursue. It is hard to imagine how other democratic governments will defend tight policy in the face of large scale job losses. The winners will be gold and hard assets in this scenario.
RISK REWARD NOT GREAT FOR USD/INR SHORTS
If the broad dollar index remains unchanged for the next 5-years, the INR will depreciate in line with inflation differentials – about 3% per year. More likely, generalized greenback strength will cause losses more than 3% per year.
In light of the above, for strategic short USD/INR trades; it seems more like the end of the road.
The Indian rupee tanked 27% in the year to November 20, 2008 to reach an all time low of 50.12 versus the U.S. dollar. Over the last 30-days, the INR recovered about 6% to close at 47.05 on December 19. A key question is whether 2008 marks the end of the appreciation cycle that began in 2002.
In my view, the lofty INR levels seen in early 2008 will likely not be reached again over the next 5-years. The base case for the first half of 2009 is a retest of the 50 level. Beyond that, longer-term exchange rate expectations should remain geared to further weakness.
THE RESERVE BANK MANAGES THE CURRENCY IN THE CONTEXT OF A BROAD-BASED REAL EFFECTIVE EXCHANGE RATE; INDIAN RUPEE APPEARS FAIRLY VALUED
The RBI’s 36-country real effective exchange rate (1993-94 =100) fluctuated in a band of +/-5% over the last 16-years. In September 2008, the INR appeared undervalued by about 3.4%. In the period from September to December 19, the broad dollar index gained 6.5%, while the Indian rupee lost only 3.3%. The INR seems fairly valued right now and the future would crucially hinge on the direction of the U.S. dollar.
REVIVAL OF CAPITAL INFLOWS INTO EQUITY MARKETS WILL NOT TURN THE TIDE; THE RUPEE IS NOT AN INDIA STORY
The reversal of the INR’s fortunes coincided with portfolio capital outflows from equities. While the exchange rate continues to display high correlation with stocks, a sustained equity revival would not be accompanied by renewed rupee strength, in my view.
Instead, the outlook hinges on accurately forecasting the U.S. dollar. In 2008, the INR merely reflected the negative correlation between the U.S. dollar and risky asset performance. The dollar benefited from the status of treasuries as the ultimate risk free asset. Net private purchases of treasuries measured $253 billion in the 12 months to October 2008 versus $198 billion in 2007 and $126 billion in 2006. Additionally, with inter-bank dollar liquidity strained, it remained difficult to borrow and sell dollars. A natural conclusion seems to be that once the financial system stabilizes, the dollar slide will resume.
There is merit to this argument, but other developments underway suggest that a sustained recovery in risky assets will only mute the rise of the dollar, but not reverse the ascendancy.
THE U.S. CURRENT ACCOUNT DEFICIT IS CORRECTING; NEGATIVE WEALTH EFFECT CURBS CONSUMER SPENDING
After adjusting for crude oil imports, the U.S. trade deficit corrected by $85 billion during January-October 2008 compared to the same period last year. This trend will likely continue as declining housing and equity wealth force U.S. households to save. Restrained credit should also work to limit spending expansion.
NEAR-TERM DOLLAR VIEW SEEMS ECONOMY NEUTRAL
The Fed cut rates to 0%-0.25% (basically zero) last week. The U.S. authorities remain the most aggressive in providing policy stimulus. The outcome for the dollar seems economic outlook neutral; at least in the near-term. If aggregate demand responds to the measures taken so far, rates will rise relative to the rest of the world and the currency will climb. On the other hand, if spending remains moribund, then there will be another leg down in the global economy and the ECB and BOE will be forced into near ZIRP. Relative yield dynamic will favor the U.S. in this scenario as well.
THE BASE CASE: A U.S. LED GLOBAL RECOVERY COUPLED WITH DOLLAR STRENGTH
Global growth leadership outside the United States seems difficult to visualize. This point figures particularly pertinent in the face of the current account adjustment underway in the U.S. The last similar phase of U.S. current account adjustment stretched from 1987 to 1991. Rapidly growing Germany and Japan saved the day then. Such a state of affairs looks remote today.
Germany, Japan and China remain export-led. Other large current account deficit countries such as the U.K., Ireland and Spain suffer from their own housing busts. The best case for the global economy would be that extraordinary policy actions in the U.S. make the current account contraction more protracted. This would give the world more breathing room, enabling a feeble economic resurgence.
In this scenario, rate differentials will incrementally shift in the favor of the U.S. and that coupled with the dipping trade deficit will propel the dollar higher.
INFLATION TAIL OUTCOME MORE LIKELY THAN DEFLATION
What if monetary policy remains ineffective? With the financial system clogged, there is a positive probability that substantial base liquidity does not percolate into the system. In this low likelihood scenario, policy makers in the U.S. would prefer inflation to deflation. In a debt laden economy, there is really no choice. The Fed will continue undertaking unconventional policy actions to stoke inflationary expectations. Large monetized budget deficits would be the natural course to pursue. It is hard to imagine how other democratic governments will defend tight policy in the face of large scale job losses. The winners will be gold and hard assets in this scenario.
RISK REWARD NOT GREAT FOR USD/INR SHORTS
If the broad dollar index remains unchanged for the next 5-years, the INR will depreciate in line with inflation differentials – about 3% per year. More likely, generalized greenback strength will cause losses more than 3% per year.
In light of the above, for strategic short USD/INR trades; it seems more like the end of the road.
Sunday, December 14, 2008
LONG BOND TRADE NOT DONE YET: EXPECT YIELD LOWS SET IN THE PREVIOUS CYCLE TO BE BROKEN
MASSIVE DECLINE IN YIELDS BOTH IN CASH AND DERIVATIVE SEGMENTS
The 10-year Government security yield fell to 6.16% on December 12, 2008 from a high of 9.47% established in July 2008. 5-year OIS rates declined 548bp to 4.88% from the peak set in June 2008. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index descended to 8.95% from the crest on November 11, 2008. The growth-inflation picture for 2009 suggests that the long bond trade will continue to deliver returns in the foreseeable future.
EXPECT BELOW POTENTIAL INDIAN GROWTH IN 2009 AND 2010
U.S., Europe, and Japan remain in a recession. Sharply slowing export data (-2.2% in November 2008) from China point to lower growth in times ahead. Consensus expects a tepid global recovery in the second half of 2009 at the earliest.
Indian industrial production numbers for October 2008 registered a 0.4% y/y decline. While the Indian economy is relatively closed with exports/GDP of just around 20%, the secondary sector depends on global demand to a large extent. Manufacturing expansion in 2009 will be challenged by underperformance of external spending. And services will not be immune due to inter-sectoral linkages (Sustainability of Services-Led Growth: An Input Output Analysis of the Indian Economy; 2003 RBI Occasional Papers). Capex will be the next casualty as capacity utilization falls. Bottom-line, 8% real GDP growth will not be seen for at least the next couple of years. Expect readings in the vicinity of 5% instead.
INFLATION TO AVERAGE SUB-5% IN 2009 AND 2010
Although headline WPI and various measures of CPI appear elevated, the outlook figures positive in view of weak world expansion prospects and the substantial decline in commodity prices. International factors drove bulk of the local price escalation over the last 4-years, with the largest contribution coming from fuel and metals. The Baltic Dry Index fell off the cliff in 2008, as did the CRB index. Resurgence looks unlikely in the foreseeable future.
BELOW POTENTIAL GROWTH AND SUBDUED INFLATION = AGGRESSIVE MONETARY EASING
How much of a difference six months can make! Global central banks quickly changed gears from fighting inflation to supporting aggregate demand. The Fed will cut to 0.5% in the coming week. The effective Fed Funds rate remains firmly below target due to quantitative easing. The ECB and BOE will maintain their aggressive easing bias. Monetary authorities will probably over ease to prevent deflationary expectations from taking hold and to counter de-levering induced bloated risk-spreads.
The RBI also acted with alacrity to reduce borrowing costs. Expect more of the same. The Reserve Bank will likely cut the reverse repo rate by at least 100bp over the next 6-months.
PERSISTENT EXCESS LIQUIDITY TO BE THE NORM
The quantum channel of monetary policy retains importance in India. The RBI will keep the economy flushed with money. Additionally, assuming an incremental capital output ratio of 4, a 5%-6% real expansion will require funding of the order of 20%-25% of GDP. The domestic savings rate of plus 30%, clearly in excess of the economy’s absorptive capacity; will adjust lower in a dis-inflationary fashion. The process will manifest in the banking system in form of high time deposit growth and slowing non-food credit ascension. The result – enduring excess deployable funds. The call rate will hug the reverse repo as a result. The end-game would be an increasing investment to deposit multiple. The combination of low yields, excess liquidity and a positive rate outlook would trigger a chase for yield leading to lower term and credit spreads.
YIELDS WILL CONTINUE TO SLIDE
In the scenario outlined above, sub-4% 5-year OIS rate is a clear possibility. Yet going forward, most of the rally will manifest in the cash segment. The previous low for the 10-year Government security yield (4.94% in 2003) will most likely be broken.
MOST OF THE OPPORTUNITY LIES IN CORPORATE BONDS
The maximum upside trade would be going long a diversified basket (with issuer due diligence) of AAA corporate bonds. Nominal spreads over treasuries on FIMMDA Bloomberg 10-year AAA corporate bond index descended to 279bp from 416bp on November 6, 2008. The average yield over term-matched local treasuries since December 5, 2001 measures 105bp. Clearly, there is still a lot of room for price appreciation in high quality corporate paper.
To summarize, despite a significant decrement in yields already; the economic outlook suggests still more downside. The risk reward appears better for cash bonds versus swaps. Within the cash segment, high quality corporate bonds would reward fixed income portfolios most in the times ahead.
The 10-year Government security yield fell to 6.16% on December 12, 2008 from a high of 9.47% established in July 2008. 5-year OIS rates declined 548bp to 4.88% from the peak set in June 2008. The yield-to-maturity on the FIMMDA Bloomberg 10-year AAA corporate bond index descended to 8.95% from the crest on November 11, 2008. The growth-inflation picture for 2009 suggests that the long bond trade will continue to deliver returns in the foreseeable future.
EXPECT BELOW POTENTIAL INDIAN GROWTH IN 2009 AND 2010
U.S., Europe, and Japan remain in a recession. Sharply slowing export data (-2.2% in November 2008) from China point to lower growth in times ahead. Consensus expects a tepid global recovery in the second half of 2009 at the earliest.
Indian industrial production numbers for October 2008 registered a 0.4% y/y decline. While the Indian economy is relatively closed with exports/GDP of just around 20%, the secondary sector depends on global demand to a large extent. Manufacturing expansion in 2009 will be challenged by underperformance of external spending. And services will not be immune due to inter-sectoral linkages (Sustainability of Services-Led Growth: An Input Output Analysis of the Indian Economy; 2003 RBI Occasional Papers). Capex will be the next casualty as capacity utilization falls. Bottom-line, 8% real GDP growth will not be seen for at least the next couple of years. Expect readings in the vicinity of 5% instead.
INFLATION TO AVERAGE SUB-5% IN 2009 AND 2010
Although headline WPI and various measures of CPI appear elevated, the outlook figures positive in view of weak world expansion prospects and the substantial decline in commodity prices. International factors drove bulk of the local price escalation over the last 4-years, with the largest contribution coming from fuel and metals. The Baltic Dry Index fell off the cliff in 2008, as did the CRB index. Resurgence looks unlikely in the foreseeable future.
BELOW POTENTIAL GROWTH AND SUBDUED INFLATION = AGGRESSIVE MONETARY EASING
How much of a difference six months can make! Global central banks quickly changed gears from fighting inflation to supporting aggregate demand. The Fed will cut to 0.5% in the coming week. The effective Fed Funds rate remains firmly below target due to quantitative easing. The ECB and BOE will maintain their aggressive easing bias. Monetary authorities will probably over ease to prevent deflationary expectations from taking hold and to counter de-levering induced bloated risk-spreads.
The RBI also acted with alacrity to reduce borrowing costs. Expect more of the same. The Reserve Bank will likely cut the reverse repo rate by at least 100bp over the next 6-months.
PERSISTENT EXCESS LIQUIDITY TO BE THE NORM
The quantum channel of monetary policy retains importance in India. The RBI will keep the economy flushed with money. Additionally, assuming an incremental capital output ratio of 4, a 5%-6% real expansion will require funding of the order of 20%-25% of GDP. The domestic savings rate of plus 30%, clearly in excess of the economy’s absorptive capacity; will adjust lower in a dis-inflationary fashion. The process will manifest in the banking system in form of high time deposit growth and slowing non-food credit ascension. The result – enduring excess deployable funds. The call rate will hug the reverse repo as a result. The end-game would be an increasing investment to deposit multiple. The combination of low yields, excess liquidity and a positive rate outlook would trigger a chase for yield leading to lower term and credit spreads.
YIELDS WILL CONTINUE TO SLIDE
In the scenario outlined above, sub-4% 5-year OIS rate is a clear possibility. Yet going forward, most of the rally will manifest in the cash segment. The previous low for the 10-year Government security yield (4.94% in 2003) will most likely be broken.
MOST OF THE OPPORTUNITY LIES IN CORPORATE BONDS
The maximum upside trade would be going long a diversified basket (with issuer due diligence) of AAA corporate bonds. Nominal spreads over treasuries on FIMMDA Bloomberg 10-year AAA corporate bond index descended to 279bp from 416bp on November 6, 2008. The average yield over term-matched local treasuries since December 5, 2001 measures 105bp. Clearly, there is still a lot of room for price appreciation in high quality corporate paper.
To summarize, despite a significant decrement in yields already; the economic outlook suggests still more downside. The risk reward appears better for cash bonds versus swaps. Within the cash segment, high quality corporate bonds would reward fixed income portfolios most in the times ahead.
Sunday, December 7, 2008
SENSEX PRICED TO DELIVER ATTRACTIVE MEDIUM-TERM RETURNS
THE LARGEST CORRECTION SINCE 1980
The Sensex declined 59.3% in real terms in the year to December 6, 2008. If the current levels sustain until year-end, this will go down as by far the steepest descent since 1980. The worst performance for the index pre-2008 was a 27.6% real decline in 1995. The index’s yearly inflation adjusted appreciation averaged 12.9% since 1980 (with a volatility of 32.7%). In 2008 so far, the market undershot the yearly average by more than 2-sigma. The key question is whether valuations already reflect the significant economic slowdown that lies ahead. The answer is important to gauge the prospects for aggregate market returns over the next few years.
VALUING THE MARKET BASED ON PRICE TO TRAILING NOMINAL GDP
A reasonable estimate of equity returns over longer periods depends on sustainable earnings and risk appetite as reflected in the multiple the market attaches to those aggregate net profits.
At cyclical turnings points, using current earnings (or even bottoms up aggregated forward earnings) for valuation remains fraught with problems. Studies document that analysts recognize the cyclical reality too late. Thus, based on yearly trailing or forward P/E ratios, the market may continue to look overvalued in the face of an upturn or undervalued even when a macro-downturn seems imminent.
A better valuation method would be to use some form of normalized earnings. Alternatively, price to trailing one-year nominal GDP could also serve the purpose. Sales tend to be less variable compared to profits. Thus, nominal GDP – economy wide sales - can be an important benchmark when judging sustainable earnings potential.
THE MARKET SEEMS UNDERVALUED
Based on the data since 1980, the average for this multiple measured 0.22 versus 0.17 as of close on December 6 (based on IMF’s estimate of GDP for 2008). The mean since 1991 figured 0.27 versus just 0.15 for the 10-years ending in 1990. The lowest value for the parameter – 0.11 – was registered at the end of 1980 and 1984.
There can be several good arguments as to why the decade of 1980s was not representative of the current reality. If we simplistically assume that investors assess future growth prospects based on a reasonable moving average of the variable in question, then expansion expectations would have been markedly lower in early 1980s. Real GDP growth in 1970s averaged just 3.0%. And not that 1970s had been a decade of abnormally depressed activity. The Indian economy took-off in the second half of the 1980s. There was no precedent of sustained 6.0% plus growth till then. Additionally, the volatility of real GDP growth declined steadily over the last three decades as the contribution of largely rain-fed agricultural sector fell.
It is tempting to argue that the current reality suggests an entirely different set of possibilities. A caveat though – 28-years of data is just not enough. Almost 200-years of data for the U.S. economy present a picture of remarkable stability of real returns of about 7% per annum. The United States went through numerous structural changes during the last 2-centuries, but 7% proved to be iron clad over long periods. That is not to say that returns did not diverge from this number. However,movements away from equilibrium were corrected by subsequent performance dynamic.
VALUATION AT INCEPTION MATTERS FOR RETURNS
Initial inspection suggests a negative correspondence between starting valuation and subsequent 5-year average returns. The sub-par returns in the second half of the 1990s seem to be a function of the stratospheric price to nominal GDP ratios in 1993 and 1994.
A graph with a few turning points does not lend statistical validity. A simple regression of Sensex’s yearly real returns with 1-year lagged price to nominal GDP as the dependent variable presents a robust relationship.
Real Returns = 53% - 145% * Price to Nominal GDP (-1)
Valuation explains 15% of 1-year forward returns. The coefficient for the price to nominal GDP ratio is negative and statistically significant at the 5% level.
THE GOOD THING ABOUT THE CARNAGE OF 2008: ENTRY POINT FOR MEDIUM-TERM INVESTORS
Often markets cheapen over extended periods by continued earnings growth and range-bound price action. Sub-par price appreciation even in the face of improved economic prospects during 1994-1997 reflects this phenomenon. Real GDP growth averaged 7.0% over 3-years, but stocks failed to deliver.
The sharp decrement in the current year worked to correct the extreme overvaluation (0.45 as of 2007-end) in one shot. The market now looks attractively priced for investors with a medium-term horizon.
The above analysis does not imply that a bottom has been made. The great depression tail-event does not seem to be priced in yet. Additionally, the lowest valuation seen over the last 18-years (2002-end) would imply a Sensex level of about 7500. Going back to the 1980s would suggest still more downside.
Yet, a global recession is now a reality and the already significant equity downdraft globally most likely accounts for it. Cash credit markets in the U.S. continue to price in economic cataclysm. Given the substantial and most importantly, timely policy stimulus in the U.S. and elsewhere, credit pricing will likely converge to equities in the times ahead. Looking back from 2013 investors will probably recount equity returns that will beat fixed income by a decent margin.
The Sensex declined 59.3% in real terms in the year to December 6, 2008. If the current levels sustain until year-end, this will go down as by far the steepest descent since 1980. The worst performance for the index pre-2008 was a 27.6% real decline in 1995. The index’s yearly inflation adjusted appreciation averaged 12.9% since 1980 (with a volatility of 32.7%). In 2008 so far, the market undershot the yearly average by more than 2-sigma. The key question is whether valuations already reflect the significant economic slowdown that lies ahead. The answer is important to gauge the prospects for aggregate market returns over the next few years.
VALUING THE MARKET BASED ON PRICE TO TRAILING NOMINAL GDP
A reasonable estimate of equity returns over longer periods depends on sustainable earnings and risk appetite as reflected in the multiple the market attaches to those aggregate net profits.
At cyclical turnings points, using current earnings (or even bottoms up aggregated forward earnings) for valuation remains fraught with problems. Studies document that analysts recognize the cyclical reality too late. Thus, based on yearly trailing or forward P/E ratios, the market may continue to look overvalued in the face of an upturn or undervalued even when a macro-downturn seems imminent.
A better valuation method would be to use some form of normalized earnings. Alternatively, price to trailing one-year nominal GDP could also serve the purpose. Sales tend to be less variable compared to profits. Thus, nominal GDP – economy wide sales - can be an important benchmark when judging sustainable earnings potential.
THE MARKET SEEMS UNDERVALUED
Based on the data since 1980, the average for this multiple measured 0.22 versus 0.17 as of close on December 6 (based on IMF’s estimate of GDP for 2008). The mean since 1991 figured 0.27 versus just 0.15 for the 10-years ending in 1990. The lowest value for the parameter – 0.11 – was registered at the end of 1980 and 1984.
There can be several good arguments as to why the decade of 1980s was not representative of the current reality. If we simplistically assume that investors assess future growth prospects based on a reasonable moving average of the variable in question, then expansion expectations would have been markedly lower in early 1980s. Real GDP growth in 1970s averaged just 3.0%. And not that 1970s had been a decade of abnormally depressed activity. The Indian economy took-off in the second half of the 1980s. There was no precedent of sustained 6.0% plus growth till then. Additionally, the volatility of real GDP growth declined steadily over the last three decades as the contribution of largely rain-fed agricultural sector fell.
It is tempting to argue that the current reality suggests an entirely different set of possibilities. A caveat though – 28-years of data is just not enough. Almost 200-years of data for the U.S. economy present a picture of remarkable stability of real returns of about 7% per annum. The United States went through numerous structural changes during the last 2-centuries, but 7% proved to be iron clad over long periods. That is not to say that returns did not diverge from this number. However,movements away from equilibrium were corrected by subsequent performance dynamic.
VALUATION AT INCEPTION MATTERS FOR RETURNS
Initial inspection suggests a negative correspondence between starting valuation and subsequent 5-year average returns. The sub-par returns in the second half of the 1990s seem to be a function of the stratospheric price to nominal GDP ratios in 1993 and 1994.
A graph with a few turning points does not lend statistical validity. A simple regression of Sensex’s yearly real returns with 1-year lagged price to nominal GDP as the dependent variable presents a robust relationship.
Real Returns = 53% - 145% * Price to Nominal GDP (-1)
Valuation explains 15% of 1-year forward returns. The coefficient for the price to nominal GDP ratio is negative and statistically significant at the 5% level.
THE GOOD THING ABOUT THE CARNAGE OF 2008: ENTRY POINT FOR MEDIUM-TERM INVESTORS
Often markets cheapen over extended periods by continued earnings growth and range-bound price action. Sub-par price appreciation even in the face of improved economic prospects during 1994-1997 reflects this phenomenon. Real GDP growth averaged 7.0% over 3-years, but stocks failed to deliver.
The sharp decrement in the current year worked to correct the extreme overvaluation (0.45 as of 2007-end) in one shot. The market now looks attractively priced for investors with a medium-term horizon.
The above analysis does not imply that a bottom has been made. The great depression tail-event does not seem to be priced in yet. Additionally, the lowest valuation seen over the last 18-years (2002-end) would imply a Sensex level of about 7500. Going back to the 1980s would suggest still more downside.
Yet, a global recession is now a reality and the already significant equity downdraft globally most likely accounts for it. Cash credit markets in the U.S. continue to price in economic cataclysm. Given the substantial and most importantly, timely policy stimulus in the U.S. and elsewhere, credit pricing will likely converge to equities in the times ahead. Looking back from 2013 investors will probably recount equity returns that will beat fixed income by a decent margin.
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