Questions, questions

I thought that I would write something on issues on which I do have views but am not myself totally (maybe) convinced. There are so many pros and cons for contra views on the same subject that it is difficult to come to a single view.

Whats the future of gold – Gold bulls abound in this world and the basic logic given by them is that we have lost faith in paper currencies and as such buying gold. However in reality no paper currency has any absolute value. The values are relative to each other. For example when one says that I have lost faith in the USD it is always relative to some other currency as USD by itself has no value. The currency appreciates and depreciates against other currencies. As such if someone has lost faith in the USD then the bet has to be on the Euro or the Yen or the Yuan (which is illiquid at this stage) or the Aussies, Swiss Franc etc etc. As such if someone has their parent currency as the Euro and their bet is that the USD will loose huge value going forward and he ends up buying gold whose prices are denominated in USD and gold prices double while the USD halves, then what is the value of the trade. 

The other logic for buying into gold is that the huge money printing binge by first the US FED and now Super Draghi will ultimately lead to hyper inflation and such unprecedented Central Bank monetary base expansion will be difficult to control going forward. This is something that I also believe in and as such the probability of high inflation in the future is much higher than the forecasts of these money printers. Under the circumstances, why are then the bond yields in the US (10 yr at 1.7% approx), Germany (1.5%) and Japan so low. If the forecast is for high inflation in the medium term then the bonds should be selling off big time. This does not seem to be happening. What this implies is that at this stage the markets seem to be betting on below par growth and low inflation/deflation in these economies. Under the circumstances the inflation trade does not seem to hold much logic. 

The third and most damning evidence against gold is that it is today the favourite investment destination of individual investors, hedge funds and not Sovereign Funds. The most favoured investment destination can continue to perform for some time as we have seen in most bull markets, however it cannot sustain over long periods of time. My guess is that the day monetary tightening starts in the US (maybe 2 years from now) the collapse in gold prices will be unprecedented. 

Whats going to happen to commodities – The entire move in commodities ex of crude oil has been driven by the boom in China. Most industrial commodities like steel, copper, aluminum, coal etc owe their boom entirely to China. Let us not try to attribute it to global growth as in each of these commodities China now comprise 30-60% of the entire global demand. These levels used to be in the range of 5-15% just around 10-12 years back. The huge over-investment boom in China driven by state led investments and not actual demand has lead to sub-optimal investments which are unlikely to make money over the medium to long term also. It is estimated by analysts that the Return on Equity for Chinese companies is likely to fall from the current levels of 13% to below 10% over the next 2-3 years. 

The investments of the Chinese public is also unfortunately directed in a way with controlled interest rates on deposits, which yield such low returns that investors are forced into structured products, real estate, gold and other risky products. There could be several bubbles in these products as structured products are very difficult to understand even by professional fund managers let alone retail investors. A controlled currency and currency controls at this stage also restrict investments out of China for most investors. This will also need to change going forward as China moves towards making the Yuan a global currency.  Most people are still building in increase in consumption of most industrial commodities in China. It is also probable going forward that the demand for some of these commodities will actually fall or grow much lower than the real GDP growth as the economy shifts from investment led growth to consumption led growth. As an example lets see steel consumption growth trends in China over the last decade

2000-2005  18.7%

2006-2010   11%

2011-2015E 4.5%

2015-2020E  2.5%

As such we can see that steel consumption growth in China was much higher than the GDP growth over the first decade of the 2000s. At this time growth was totally driven by investment and exports which comprise 85% plus of GDP. A shift away from over-investment and the real estate boom could actually lead to demand growth much slower than what is indicated above. Per capita steel consumption in China has already reached 500 kgs which is much higher than the global average of 215 kgs per annum and also very high for a country at the stage of per capita GDP that China is at. At a per capita GDP of  $5400 the consumption of steel per Chinese is $400 (approx) per year, which is abnormally high and atleast twice of the next nearest country. 

The same logic works for most industrial commodities ex of Crude oil and also food related commodities where consumption might continue to increase. As the above growth shows, copper consumption in China shot up from 1500 TPA to 8000 TPA this year and analysts are projecting a continuation of the parabolic move, which is highly unlikely. 

Real estate now comprises 12-13% of China’s GDP. By some estimates if the total construction of urban housing that is planned and under construction today gets completed by 2015, filling the same will take atleast 10 years after that.As such it will be in the interest of Chinese authorities to control the growth in housing stock and maybe an actual decline in absolute numbers is possible in the foreseeable future. This will be disastrous for lot of commodities. 

Where will the rupee go – By any logic that I go by, which includes long term demographics and growth potential, the pricing power and inflationary pressures in the economy, the huge under investment in the economy with the potential of huge returns in real terms in the long term, the low debt of households and also Debt/GDP of the government etc etc the INR only has to appreciate in the medium to long term. The entire theoretical logic of inflation differentials built up over the last few years now getting factored into the value of the rupee as absurd at best. Given the extremely conservative central bank and the real cost of capital in this country the near term concerns of the Current Account Deficit will be more than compensated by the higher return potential. If the US FED is right and inflation and interest rates are going to remain subdued in the developed world for a prolonged period of time then the case for money flow into India, if we ourselves do not shoot us in the foot is extremely huge. 

The current weakness of the INR, as such could be one of the last ones in the long term. 

A NEW BULL CYCLE, or not yet – With most brokerages suddenly having turned bullish on the Indian Markets after “Statements of Intent” by the Indian Government without very little to yet show on the ground a vast majority of brokerages have turned bullish on the markets and increased their Index targets. Given that most started off extremely negative on the markets at the beginning of 2012 and missed the first 15% move they were just looking for an excuse to change their stance. On the other hand foreign fund managers were smarter and kept on putting money into India amongst all negativity as well as weakness of the INR. The key is that is this a pull back rally or the start of a new upmove. The probability of a new upmove is higher given the following – 

As such the last question at this stage is “Is this a new bull market”. More questions to debate later.