One Step Forward, Three Steps Backwards: Review of Global Economy

8/14/2019 One Step Forward, Three Steps Backwards: Review of Global Economy

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The Era of One Step Forward, Three

Steps Backward.

Comprehensive Review of the Global

Economy

September 2009

Those who understand interest: earn it, those who dont: pay it.

Price is a function of liquidity, it has nothing to do with value

-Charles Biderman, CEO, Trim Tabs.

Research NotePrepared By

S.Ananth


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IntroductionAt the outset it is pertinent that this research note be placed in a perspective to enable the readersto gain a clear understand of what it is and more importantly, what it is not. This research note (Iam not calling it a paper for the simple reason that a paper requires greater care when it comesto acknowledgements and would not like to indulge in plagiarism or worse forms of intellectual

theft). This is essentially a compilation of various problems that we continue to witness in theglobal economy which of late have been conveniently forgotten giving the impression that all iswell in the global economy. This note is based on two fundamental premises on which theargument of this paper are based on. These premises are not based on fancies but are based onmy intellectual understanding of the motors of economic development over the ages. Theseinclude (a) We are in the midst of a structural bear market, which will witness occasionalcyclical bull markets, and (b) The policy makers have not undertaken any structural changesthat are fundamental to solving various problems.

When the idea of a structural bear market view was first put forth in a note on the globaleconomy that I had written in May 2008, there were quite a few who politely derided me and

many who frankly thought that I was insane. The subsequent events only proved that anhistorical understanding of economic development, augmented with a qualitative (notquantitative) understanding of risk based on a solidly social science methodology goes a longway.

A word about source of the information is imperative before delving into the details about thestate of the global economy. I would have to thank the innumerable blogs that I frequent and it isfor that reason that I thought it prudent to claim this not a research paper, but rather a researchnote. As far as possible I will acknowledge the sources to be the best of my abilities.

This research note will not dwell in a large measure about the events of the past and instead willlook at various parameters for the next few months. At the outset, it is imperative to note thatsome of the generalisations are best for the next few months and I would consider them effectiveonly for the next 6-8 months at best. However, there are times when I will make sweepinggeneralisations that may go beyond the 6-9 month period, but these may be more to place thingsin perspective rather than as a forecast. There may be times when I will use various technicalparameters and those should be taken as a forecast based on charts rather than fundamentals.Considering the fact there is often a difference of interpretation based on fundamental analysisand technical analysis this should be kept in mind.

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How did the world escape financial Armageddon?

To recapitulate, the collapse of Lehman led to a complete economic paralysis as very fewunderstood the counterpartys solvency. This led to an unprecedented coordinated intervention bygovernments through out the world. The governments not only pumped cash but also took upvarious measures that assured investors that the banking system was safe, thereby avoiding a run

on the banking system. The factors that enabled the world economy to come back from the brinkincluded: The single most important factor is the governments decision to relax all the rules this

is akin to changing the goal posts just as the opposing team was about to score a goal.These changes including accounting norms among others. Among the other changesinclude the ban on short selling, etc.

Unprecedented monetary stimulus including drastically cutting interest rates. The

different forms of stimulus are estimated to have cost the G-20 countries nearly 14percent of their GDP. There is little clarity that this is the last needed stimulus that wewill need.

Central banks assuming the role of bankers of the first resort in order to overcome

hesitancy of the banks to lend. This has meant that the risks that were previously on thebalance sheets of the private businesses have now been transferred to the balance sheet ofthe government.

Special emergency lending and debt, deposit guarantee provisions

Is the Worst Over?

There is anecdotal evidence would have a logical explanation for the recent spurt in good news.The evidence would include that related to increase in spending on homes and other items. Onecould postulate that a large component of this may simply be the pent up demand or in the caseof homes a simple case of those who were interested in buying a home to live in it. In the case of

the demand for cars, it is clear that the subsidy provided by various governments like the recentUS Cash for Clunkers programme as it was called led to demand being pushed forward due tothe subsidy. These invariably are short-term measures that cannot be sustained. Thus it isincreasingly clear that as long as the government continues to spend money, the world economywill not collapse.

The important question one needs to ask: is this form of government subsidised growthsustainable? The easy answer would be, highly unlikely. It is increasingly becoming clear that weare bound to witness growth in different segments as long as the government continues toprovide different forms of stimulus. To cite but one example, the case of the US housing market:the government provides a tax incentive of US$8000 for the purchase of first home. This coupled

along with the low interest rates have led to buyers rushing into the housing market where therehave been substantial price falls. While invariably this is a short-term positive as a stimulus, theworld over, it is clear that unless the government stimulus provides a fillip, to privateconsumption it is unlikely to see any sustained recovery.

The End of Great Recession as we know it

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The past few weeks have seen euphoria over the fact that the Great Recession (as this fall hasbeen classified) is about to come to an end. The world is about to recovery-at least statistically.Policy makers the world over are patting themselves on the back. Going by the headlines in thepopular press they seem to believe (or at least want the public to believe) that half their job isdone.

By any estimate, this recession is the worst since the Second World War

Indicator 1975 1982 1991 2009 Average

Output per capita (PPP weighted) -0.13 -0.89 -0.18 -2.50 -0.40

Output per capita (Market Weighted) -0.33 -1.08 -1.45 -3.68 -0.95

Industrial Production -1.60 -4.33 -0.09 -6.23 -2.01

Total Exports & Imports -1.87 -0.69 4.01 -11.75 0.48

Unemployment 1.19 1.61 0.72 2.56 1.18

Capital Flows 0.56 -0.76 -2.07 -6.18 -0.76

Per Capita consumption 0.41 -0.18 0.62 -1.11 0.28

Per capita investment -2.04 -4.72 -0.15 -8.74 -2.30

The column average refers to the average of 1975, 1982 and 1991 recession.Source: IMF, World Economic Outlook, April 2009.

The IMF has an interesting chart about the possible ways by which the recovery could takeplace. The zero represents the trough of the recession. If we were to assume that the trough hasactually been reached then we could believe that world trade will take about 4-5 years to reach itpre-crash level. It is likely that employment would take longer. Other estimates speak of theoutput gap being bridged only by 2012. If these were to be assumed to be accurate then we arelikely to witness a slow recovery that would be extremely fragile. The interesting aspect wouldbe to look at what difference the liquidity that is sloshing around would make. If seriousstructural changes were to be made in the world of finance, then this liquidity would disappear soit is likely that policy makers would not risk undertaking drastic structural reforms in the wayfinance operates. We are likely to witness a lot of half-hearted measures with a lot of rhetoricrather than substance. Hence global capital would largely continue to circulate in a mannersimilar to the pre-crisis era.

It is pertinent to note that global finance capital would continue to operate in a highlyfinancialised manner. To cite but one example, take the case of the Exchange Traded Fund,United States Natural Gas Fund (UNG) and the attendant controversy about its operationalparameters. This process of financialised is a process that can be undone in the short-term without dramatic negative consequences. The process of reducing the influence of the financial sectoris presently not only difficult but also prone to various pitfalls considering the rampant

speculative nature that global finance has metamorphosed over the past couple of decades.

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Since the recession has come to a statistical end, it would probably be prudent to take stock ofvarious segments of the global economy. A very interesting observation was made by PIMCO,the largest bond manager in the world. They cited Moodys data to claim that the recovery ratesfor defaulted debt has fallen below 20 percent from about 40 percent and importantly, it believesthat business and economic conditions are worse than in the third quarter of 2008, though creditspreads have returned to pre-Lehman levels1. It apparent that only the heavy hand of thegovernment has enabled the credit markets to maintain a semblance of normality.

The following alternative estimates of US GDP are given below

1http://www.bloomberg.com/apps/news?pid=20601087&sid=ag343PW1Tq5U (Website visited on 2 September

2009)

5
http://www.bloomberg.com/apps/news?pid=20601087&sid=ag343PW1Tq5Uhttp://www.bloomberg.com/apps/news?pid=20601087&sid=ag343PW1Tq5Uhttp://www.bloomberg.com/apps/news?pid=20601087&sid=ag343PW1Tq5U


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What to expect when we pay back the bill?

A look at Japan, twenty years after the crisis started is a look at a very plausible scenario. Thetwo charts of the Nikkei and the rising debt provide a graphical feast of what the world may looklike in the next few years. Both the charts clearly indicate that there are historical precedents inthe near past (not the Great Depression) to look at what can go wrong. The only difference is that

this time the scale is exponentially larger because of the fact that the scale of the boom as well asthe crisis is much larger it is global in nature.

The past twenty five years (which was the era of the credit bubble) was the age that was based ona combination of de-regulation, increased money supply and more importantly lower taxes whichled to higher deficits and the increased frequency of bubbles. Bill Gross, the CEO of PIMCO hassaid that he expects real growth of about 1.5 percent and nominal growth of 3-4 percent over thenext few years that would be half the pace of growth that we witnessed over the past 25 years.The OECD has forecast a moderate recovery and expects the G-7 countries to shrink 3.7percent this year, less than the 4.1 percent it expected in June. It left unchanged its estimate of a2.8 percent contraction in the U.S. this year, while the euro-zone will contract 3.9 percent rather

than 4.8 percent. Japan will slide 5.6 instead of 6.8 percent, the worst slump in the G-7 in 2009.It expects Germany to contract 4.8 percent against the previously estimated 6.2 percent, whileUK will deteriorate and will contract by 4.7 percent, worse than 4.3 percent previouslyestimated.

US Stimulus money: how it will be spent?

The following chart illustrates how the Obama stimulus could be spent2. While the argumentsabout the nature and impact of the Obama stimulus can be endlessly debated, it is clear that theUS will have to live with exponentially large deficits for the next decade (at least).

It is yet to be seen how much of the stimulus money would be spent by different segments andwhat proportion of that would be saved by different beneficiaries in different sections of the

2 Source for the chart: http://seekingalpha.com/article/159355-the-non-stimulating-stimulus-bill

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recipients chain. The recent case of UK and the US consumers clearly shows that people wouldrather save than spend the money.

US Federal Debt held by the Public

Source: http://www.cbo.gov/ftpdocs/102xx/doc10297/06-25-LTBO.pdf

US Federal Debt held with the Public: Past, Present & Future (1790-2050)

Source: US Congressional Budget Office

The spending by the US has come at a cost. The US Congressional Budget Office (CBO) haspointed out that the current tax and spending policies the deficit would jump from US$459billion in 2008, to US$1.6 trillion in 2009 and US$1.4 trillion in 2010 and fall to US$921 billion

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in 20113. It also expects corporate income tax receipts to fall from US$304 billion in 2008 toUS$142 billion in 2009, a fall of 18 percent. It is pertinent to note that they grew by about 30percent a year during the period 2003-074. The US Fiscal Deficit would continue well into thenext decade, even by the projections of the US Congressional Budget Office. The followingcharts clearly elucidate the fiscal problem for the USA in the next one decade. Invariably this

will mean that the era of low taxes is over and on the contrary we are bound to see the era of hightaxes, a factor that will be a long-term negative for taxes.

US Fiscal Position: Past and Present (as a percentage of GDP)

Source: http://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdf

The charts above clearly indicate that the problems for the USA seem to be just starting. Hencethe governments as well as investors need to be prepared for the highly complex problems overthe next 5-7 years. There are a few scenarios for the US economy that we underline. They

include

(a) The US economy moves sideways with the occasional good quarter or two (which wouldbe due to government measures) and it takes time for the excesses to readjust. Thisreadjustment is normally a long-drawn out process.

(b) The economy picks up steam for about two quarters (maximum) and then goes back intoa free fall.

(c) A possible scenario is that the monetary easing leads to a collapse in the value of fiatcurrency and this in turn leads to sharp rises in interest rates in order to combat inflation.However, it is pertinent to note that as long as we have huge spare capacities in the US(where industries are running at 68%) and the rest of the world, inflation should not be a

major concern as long as demand deflation is the major concern.

3 http://www.cbo.gov/ftpdocs/105xx/doc10544/09-01_Update_BusinessCycle.pdf4http://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdf(p.7)

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http://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdfhttp://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdfhttp://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdfhttp://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdf


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The case of Japan is instructive. The borrowing binge invariably leads to a system that will havelong drawn out effect on a country.

Japan: Public Debt over the Years

Source: IMF,Finance & Development, March 2009, p.29

The chart below of Nikkei from 1982 seems to be an excellent indicator of what we can expectthe markets over the next few years. A look at the two charts5(Japan: Public Debt over the Ages)and the chart of Nikkei is clear that a large part of the rally in early part of the century waslargely because of the money being pumped into the system in the form of stimulus. Thereforewe could speculate that we could expect the asset inflation to continue if this liquidity pumpingcontinuing. We could also assume that this would continue as long as the policy makers have

clear cut evidence that the economy is on the recovery path. They would like to err on the side ofcaution after being caught on the wrong foot over the past two years.

Nikkei 1982-2009

The Chart below outlines the movement of the Nikkei 225 (the benchmark equity index in Japan)from 1982 to the present.

The rounded off zones are the times of sharp rallies, essentially bear market rallies. It is clear thatone should not be overly optimistic about the present day sharp rally in the equity markets, forthe simple reason that there is a historical precedent. There have been times when the Nikkeiactually went beyond the previous peak (for various fundamental reasons) only to collapse back

with greater intensity. This is not to claim that the equity markets will collapse like in the case ofJapan, just that one should not rule out their possibility because of the inherent bull in all of us,after all hope springs eternal.

5 Unfortunately, I am not so tech savvy as to diagrammatically extrapolate the two charts.

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Housing

The problems in the US economy started with the problems in the housing sector. Unless there is

a recovery in the housing sector, we are unlikely to see a sustainable recovery. There have been

recent reports that the US housing sector has stabilised at lower levels. This is only partly true.

The growing number of transactions are largely a product of growing number of foreclosures.

According to Moodys commercial property prices have fallen nearly 35 percent since October

2007. This has led to problems of refinancing about US$165 billion worth of commercial

mortgages. There are two estimates of the problem mortgages: One talks about 30% of the

properties being less than the worth of the loan6, another talks about 48% (or 25 million homes)

being underwater7. The chart below shows that the US is set to witness large scale adjustments of

mortgage rates in 2010 and 2011, precisely the time when the consumer can least afford. Wehave provided the details about loans of the US banking sector and it becomes clear that the real

estate and consumer loans are the largest component. The downturn in the commercial real estate

6 http://www.bloomberg.com/apps/news?pid=20601087&sid=aL3gWFhKRt_w7http://www.bloomberg.com/apps/news?pid=20603037&sid=ac9y1xr7yNhQ

10
http://www.bloomberg.com/apps/news?pid=20603037&sid=ac9y1xr7yNhQhttp://www.bloomberg.com/apps/news?pid=20603037&sid=ac9y1xr7yNhQhttp://www.bloomberg.com/apps/news?pid=20603037&sid=ac9y1xr7yNhQ


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sector will only add to the pressure on the balance sheets of the banks. US banks hold nearly30% of the originate-to-hold mortgages on their balance sheets.

Shipping

The shipping industry which is an advance indicator due to the fact that about 90 percent of theworld trade is carried out through the sea routes continues to be mired in problems. By theestimates of the industry participants, if the present conditions continue (which means that thereis no further deterioration) then the industry could probably recover from the middle of next

year. Unfortunately for the shipping market, that is unlikely to be met if the Chinese continue tonot only regulate their capacity but more importantly open some of their mines. The Chineseattempts to encourage local industry would invariably harm the shipping industry, consideringthe fact that the rising in shipping rates since March has largely been due to their large scaleimport and hoarding of commodities.

It has been pointed out that the Industry not only faces the problem of reduced commodityimports from China but also a growing supply of ships, exactly as the market finds that there isless amount of freight.

Even cartelisation has not been successful in raising the freight rates, due to the collapse

in demand. The rate for leasing Capesize ships is expected to drop 50 percent from the

current US$37,865 to a low of about US$18,000 before the end of the year8.

Worryingly the Baltic Dry Index seems to be moving sideways indicative of the period of

stagnation for the world trade. The index has been gradually sliding downwards over the

8 http://www.bloomberg.com/apps/news?pid=20601109&sid=asbi_l0tjZY8

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past 3 months. However, the only positive for the index seems to be that it is in highly

oversold territory.

The Baltic Dry Index reached its peak of 11793 on 20 May 2008 and collapsed to a low

of 663 on 12 May 2009. It now is around 2413 on 3 September 2009. More importantly

the index has been stagnating in a narrow range of 1000 points indicating that the world

trade may continue to languish and stagnate.

OECD predicts a 16 percent drop in world trade in 2009.

The Economistcites various studies that indicate that about 10 percent of the worlds

merchant ships are anchored at different ports due to the collapse in world trade9.

Shipping companies are expected to lose about US$20 billion on a turnover of about

US$180 billion10.

2010 is expected to be worse than 2009 due to an increase in the number of ships that will

hit the routes. This excess supply (which is in addition to the decline in world trade) is

expected to last till 2011-1211.

The volumes of freight on the busy Asia-US route have dropped by nearly 20% in 2009.More than 520 container carriers have been idled as of June 200912 (this excludes other

categories of ships).

Forward freight agreements show that the fourth quarter rates average price will be about

7 percent lower.

Banking & Financial Services

The banking sector with its extreme form of securitisation caused this crisis. The crisis was

aggravated by the fact that the shadow banking system in the form of the banks off-balance

sheet system created the crisis. Unfortunately nothing has been done till date to mend the system.

However, it must be pointed out the government has stopped a run on the banking system that

commenced in earnest after the collapse of Lehman Brothers. The governments not only

provided billions of dollars in capital but also provided guarantees and assurances worth trillions

of dollars that has effectively enabled the stabilisation of the system. The banks have till date

written off more than US$1.4 trillion dollars, thanks to the aid provided by the governments.

The paradox of the Great Recession or crisis, especially in 2009 has been that everybody agrees

that the structural fundamental problems of the banking sector have not been resolved. Infact

there is no effort even to resolve them, yet the banks are making money. This is due to the

largesse of the government. Interestingly, the money making has been possible only because thecentral banks have assumed the risk and are providing a perennial supply of credit at literally no

cost. On the other hand banks simply refuse to lend cash to consumer. There are growing reports

9 http://www.economist.com/businessfinance/displayStory.cfm?story_id=1413379410http://www.ft .com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.html11http://www.ft .com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.html12 http://www.tsacarriers.org/guidelines.html

12
http://www.ft.com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.htmlhttp://www.ft.com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.htmlhttp://www.ft.com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.htmlhttp://www.ft.com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.htmlhttp://www.tsacarriers.org/guidelines.htmlhttp://www.ft.com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.htmlhttp://www.ft.com/cms/s/0/5e5a627e-7ad9-11de-8c34-00144feabdc0.htmlhttp://www.tsacarriers.org/guidelines.html


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to this effect in the USA, Europe as well as other countries. The only exception to this seems to

be China, where the government has directed the banks to lend large amounts. This has enabled

the banks to lend the equivalent of nearly US$1.1 trillion in the first half of 2009, nearly the total

amount lent in the whole of 2008.

A recent Bank of England report pointed out that loans to private non-financial corporations fell

in July, the biggest monthly fall since record began in 1997. Lending for the full year was down

2.9 percent13. Small and Medium manufacturing enterprises in UK continue to complain that

credit is difficult to come by14.

One important aspect of the credit crisis has often been overlooked by a number of observers.

That is the slow but steady increase in the cost of capital, even for companies that are large. This

is a phenomenon that will continue for at least another 3-4 years if not more.

Interestingly various studies have pointed out that the European banks have not yet started theprocess of write offs. The head of the Federal Association of German Bankshas warned that

German banks posses about Euros 800 billion (about US$1.35 trillion) of bad assets from the

previous bubble era on their books and Germany could face a credit crunch15. The British

manufacturers are claiming that credit is hard to come by as the banks are still not willing to

lend. On the other hand the German government has decided that it would lend directly to

manufacturing companies as the banks are not willing to lend.

Banks are still refusing to lend. US Banks are stated to be hoarding cash and have nearly US$1

trillion in the form of various deposits that they have raised but are not lending. This is therefore

either starving businesses of capital or even when capital is available, the cost of borrowing isprohibitive. A large part of the Global banking system survives only because it is able to borrow

at low cost from their respective central banks at about 1 percent or less than that. More

importantly, the central banks have now become the lenders of the first resort. Recently the

European Central Bank lent nearly US$1 trillion dollars for one year at one percent to their

banks. Similarly US, UK and European Countries have given debt guarantees worth trillions of

dollars. In the case of UK the bail outs to the financial sector (including guarantees) are

approximately about 13 percent of GDP.

13 http://www.telegraph.co.uk/finance/newsbysector/banksandfinance/6123076/Banks-hoarding-credit-as-lending-

falls-a-record-8.4bn.html14http://www.telegraph.co.uk/finance/newsbysector/industry/6118682/Manufacturers-struggling-to-gain-credit-

EEF-warns.html15http://www.ft.com/cms/s/0/0f20c03e-85b7-11de-98de-00144feabdc0.html

13
http://www.telegraph.co.uk/finance/newsbysector/industry/6118682/Manufacturers-struggling-to-gain-credit-EEF-warns.htmlhttp://www.telegraph.co.uk/finance/newsbysector/industry/6118682/Manufacturers-struggling-to-gain-credit-EEF-warns.htmlhttp://www.ft.com/cms/s/0/0f20c03e-85b7-11de-98de-00144feabdc0.htmlhttp://www.telegraph.co.uk/finance/newsbysector/industry/6118682/Manufacturers-struggling-to-gain-credit-EEF-warns.htmlhttp://www.telegraph.co.uk/finance/newsbysector/industry/6118682/Manufacturers-struggling-to-gain-credit-EEF-warns.htmlhttp://www.ft.com/cms/s/0/0f20c03e-85b7-11de-98de-00144feabdc0.html


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Source: St Louis Federal Reserve (http://research.stlouisfed.org/publications/es/09/ES0936.pdf)

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As on 7th August 2009.

Employment

Any sustainable economic recovery will have to generate employment. The recent boom whichspanned the financial services and the housing segments not only provided cheap credit but alsocreated employment on a large scale. More importantly as there were greater disposable incomes(and the easy availability of credit) it became possible for a large number of Americans toborrow and own homes. A rise in price invariably meant that there the wealth effect only

facilitated greater spending.

Source: http://www.cbo.gov/ftpdocs/105xx/doc10521/08-25-BudgetUpdate.pdf

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But due to the downward spiral after the bursting of the credit bubble, the falling home priceswere also accompanied by an ever rising tide of unemployment. By official count, theunemployment rate stands at 9.4 percent, unofficial count believes that it is nearly double thatfigure. This difference of opinion is largely the result of the methodology the US governmentadopts to calculate the number of unemployed.

Official estimates claim that the if a person does not find employment for six months, then itwould like to believe that it is because they do not want to work rather than not finding work andhence are not officially counted as unemployed. Irrespective of the manner in which UScommutes its state of willingness of people to work, suffice to say that the US is estimated tohave lost nearly 6.7 million jobs since the recession officially began. There are about another 3million people who are working part-time because they cannot find full time-employment. Thesepeople are not counted as unemployed, so the official statistics may be understating the problemat hand in USA. If there were to be a jump in meaningful employment that is likely to occur onlyafter these part-time workers are absorbed due to the rising need for workers, an event that seemsfar-fetched over the short-term. Europe fares no better with unemployment reaching a 10 year

high to 9.5 percent. European Central Bank estimates that unemployment will peak at 11.5percent in early 2011.

It is commonly believed that employment is a lagging indicator, however the speed ofretrenchment in the present crisis seem to indicate that technological change works both waysand hence it may not be a lagging indicator, though more empirical studies are needed in thisregard.

The following chart provides an alternative to the official government statistics (as on 7 August2009).

Manufacturing

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The good thing about myths (and bubbles) is that it takes only a pin prick to bust the euphoria.The actual pricking of the bubble or bursting of a myth may not seem insignificant at first sight.The recent reports about the pick up in manufacturing as symptomatic of heralding a recovery isa one such event. The report by ADP that companies eliminated more jobs that forecast in Augustproves that the recovery will be more statistical than real.

A pick up in manufacturing is always accompanied by rising business investment and moreimportantly employment neither of which are taking place (or at least are invisible) 16. It seemsvery clear that the pick up in manufacturing is largely because of the spending by thegovernment and more importantly due to an increase in auto production, which was due to thegovernment subsidy. Since that has now concluded, it would be interesting to see how much theinventory correction could lead to a rise in manufacturing.

However, it is pertinent to note that the next three months (at least) would invariably see a rise inmanufacturing as there would be some form of inventory additions. A bottoming of the recessionshould normally be accompanied by an increase in the Capex of the companies. Interestingly,

Capex has been unchanged over the past two quarters indicating the corporate sector is notconvinced about the end of the recession. In other words, they too clearly believe that therecovery will be more statistical than otherwise, hence the hesitancy of the corporate to increaseCapex.

16 http://www.bloomberg.com/apps/news?pid=20601087&sid=a4yuz57GLJQA

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The above chart is indicative of the problem with sales. Inventories have been rising quicklylargely because of the collapse in sales.

A clear trend seems to be emerging in the manufacturing sector. The stimulus and other measureswill enable the growth of the manufacturing sector, but the equity markets may have alreadydiscounted this factor. More disconcertedly, it is clear that the positive impact of the stimulus islikely to fade in the next three months (from September). It is pertinent to note that the July

factory order increased by 1.3 percent, lower than the 2 percent expected by economists.

Consumption

While employment has been one of the concerns that is well documented, a more stealth impact

on the balance sheet of consumers is the fall in wages and salaries. They fell by 4.7 percent in the

past 12 months (upto June). This has added pressure on to the consumer to save more.

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Rising unemployment means that consumer delinquencies are on the way to reach a record. It

has been pointed out by the American Bankruptcy Institute17 that bankruptcies are set to rise by

nearly 34 percent by the end of this year. This will only lead to defaults on the credit card market,

where JP Morgan has estimated that it would reach 10%, the highest in more than a decade.

Europe seems to be no better with unemployment already above 10 percent. In the case of Spain

it is nearly 17.5% and expected to rise further. The IMF has estimated that about 7% of Europesconsumer debt (US$2.467 trillion) could end up in default. In the case of USA this default could

be as high as US$1.914 trillion18.

The chart above clearly highlights that the household liabilities in all forms have continued to

shoot up over the past three decades. Interestingly, on in the last few months do the consumers

seem to have become more cautious, indicating that this will be a multiyear readjustment to the

new reality, where consumers would probably prefer to repay debt rather than assume more debt

which anyway has become unsustainable. There is a lot of evidence that consumers have

become more frugal and more savings oriented. It has been reported that the US shoppers have

increased their use of discount coupons by almost 20 percent this year19. Additionally consumer

bankruptcies continue to rise. In August they rose 24 percent. They are expected to cross 1.4

million this year20. The following chart provides an overview of the fall in retail sales (as

17 http://www.abiworld.org//AM/Template.cfm?Section=Home18http://www.ft.com/cms/s/0/02db48fa-7a11-11de-b86f-00144feabdc0.html19 http://www.ft.com/cms/s/0/55687ba8-97ec-11de-8d3d-00144feabdc0.html?20 http://www.bloomberg.com/apps/news?pid=newsarchive&sid=aqyxH6p.cd_c

19
http://www.ft.com/cms/s/0/02db48fa-7a11-11de-b86f-00144feabdc0.htmlhttp://www.ft.com/cms/s/0/02db48fa-7a11-11de-b86f-00144feabdc0.html


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provided by an alternative websites) clearly point out to the intensity of the fall due to consumer

retrenchment. The data since the end of the Second World War (in the chart below, since 1948)

clearly shows that the recovery from a fall of this magnitude will be a slow and steady process,

which will in the best case will be more like the period after the LTCM collapse and the South

East Asian Crisis. So it is pertinent to keep in mind that the process will be a slow and gradual

process and hence any hope for a V shaped recovery should be tempered with the sober reality

that is dawning in the new age, which will be the age of frugality rather than the other way

round.

US Real Retail Sales

www.shadowstats.com

The chart below shows the savings in billions of US Dollars in the USA. The importantconsequence of this is that it will lead to less reliance of that country on foreigners in buyingtheir debt. That in turn has two sets of consequences, while it is good for the US economy, it isinvariably has negative repercussions on the more export oriented Asian countries. Unfortunatelyfor the Asian countries the reality is yet to dawn on these countries (other than China, which hasnot only realised this but is taking efforts to make the transformation) that they are the flavour of

the season for hot money rather than serious foreign domestic investment (FDI) which is not in ahurry to invest.

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Markets

The markets are a generic term used for the credit, commodity, currency, equity as well as otherdifferent markets. However, for our analytical purposes we will take into consideration only theCredit, commodity, currency and equity markets. A remarkable feature of the equity as well ascommodity markets is the fact that the volumes are extremely low. It has been pointed out that

since March through to August 26; in the equity rally stocks with the lowest quality rating haveoutperformed those with better quality rating. Those stocks with C or C- and below haveproduced an average return of 141.8% while those with an A- or higher quality have gained44.3%. Overall volumes in the NYSE have been around 20% less than normal21. Moreimportantly, if one were to exclude the top traded counters, in terms of stocks traded (whichinclude Citigroup, AIG, Fannie Mae and Freddie Mac) the volumes would be drastically less.

The following chart (as on 2nd September 2009) clearly shows that the volumes in the recent rallyhave been one of the lowest in the recent times. What is interesting is that the volumes wereextremely high, when the market fell by nearly 185 points, technically a bad sign. Moreover thefact that the market broke through a important technical trend line with heavy volumes should be

a sign of things to come.

21http://www.marketwatch .com/story/rally-since-march-especially-speculative-2009-08-28

21
http://www.marketwatch.com/story/rally-since-march-especially-speculative-2009-08-28http://www.marketwatch.com/story/rally-since-march-especially-speculative-2009-08-28http://www.marketwatch.com/story/rally-since-march-especially-speculative-2009-08-28


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Then it would be pertinent to ask the question where we are in terms of the equity market andwhere we are headed. The following chart shows one of the possibilities. While a number ofindicators (technically) have been flashing warning signals, nobody knows when the next shoewill fall. This uncertainty springs from the fact that the market there continues be anexceptionally amount of liquidity in the system. It has never been easier for financial companiesand speculators to borrow directly from the central bank.

The following chart gives us an overview of the amount of money that is there sitting on thesidelines in money market funds. Even if a fraction of the money were to come into the equitymarket (as it seems to doing so), the low volumes will invariably have a magnified impact on theprices. There is about US$3.57 trillion dollars in US Money Market funds. A cursory glance atthe chart below shows that the fear has still not been completely overcome. Though the amountof money in these funds has declined since March 2009, it is still at highest level since 2005.

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Source: Bloomberg

While there is increased talk about risk aversion declining, on the other hand stories about theproblems in the pension and other sectors, especially university endowments means that we areseeing a structural change in the way people invest. This will be a major issue over the next fewyears for the simple reason that the credit crisis has led policy makers to give less importance tothe issue. But the demographics of the western world mean that this is a problem that cannot beoverlooked for long.

Of more immediate concern should be the losses that various pension and other long-term

investors have suffered. It has been pointed out that the US pension funds contributed nearlyUS$1.2 trillion to private equity groups, which was then leveraged and this played a large part inthe stratospheric rise in valuations. The three largest US pension funds have till date sufferedlosses of about US$53.8 billon since they started investing in these funds since 2000 22. This isnot just a USA specific phenomenon. It has also been pointed out that FTSE 100 firms have apension deficit that is now more than 96 billion pounds (more than double the deficit estimatedabout one year ago)23. Another estimate by Deloitte claims that the pension deficit of Britains100 biggest companies is nearly US$490 billion24. This would mean that companies would haveto either forgo paying dividends or would have stop paying pensions.

Another interesting chart is given below and probably explains that there is an historical

precedent for the present move in the equity markets.

22 http://www.bloomberg.com/apps/news?pid=20601084&sid=acWVaiPjU5iw23http://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/5987890/Comment-were-fussing-over-

the-credit-crunch-but-pensions -are-the-real-crisis.html24 http://www.bloomberg.com/apps/news?pid=20601085&sid=aAKUvSXidSao

23
http://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/5987890/Comment-were-fussing-over-the-credit-crunch-but-pensions-are-the-real-crisis.htmlhttp://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/5987890/Comment-were-fussing-over-the-credit-crunch-but-pensions-are-the-real-crisis.htmlhttp://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/5987890/Comment-were-fussing-over-the-credit-crunch-but-pensions-are-the-real-crisis.htmlhttp://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/5987890/Comment-were-fussing-over-the-credit-crunch-but-pensions-are-the-real-crisis.htmlhttp://www.telegraph.co.uk/finance/personalfinance/comment/paulfarrow/5987890/Comment-were-fussing-over-the-credit-crunch-but-pensions-are-the-real-crisis.html


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An interesting aspect would be to look at valuations after the present rally. The following chartindicates the precise health of the US corporate sector. The ludicrous levels of stocks clear forceus to recall the statement of Keynes, who once said that the markets can stay irrational forlonger than you can stay solvent.

One would be forced to ask the question, how rational are investors buying into the index at suchheights. It is clear that stocks have run far ahead of the supposed recovery. One reason could be

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due to the under-ownership of US stocks by various institutions at the end of 2008. Thefollowing chart shows the inflation adjusted earnings of S&P 500 in the USA.

Even if the rate were to go back to the 1990s level of mid 30s, stock prices on a fundamental basis would be grossly overpriced. Interestingly, the present estimate for earnings is aboutUS$13.50. Ironically, the earnings estimates were at the end of March 2009 were US$14.15,while at the end of 2008 they were US$19.92. It is this context that I put forth the argument thatwe could witness an era like that of Japan as can be seen from the Nikkei chart reproduced in thisnote. It is plausible that while the real economy gradually sinks deeper into a morass the markets

could periodically shoot up on a short-term basis, but each short-term up move would befollowed by a sharper and longer fall. The causes for such sharp rallies could be many includingnew stimulus packages, or simply short-covering rallies.

Bond Markets

The bond market is less sanguine about the state of the economy. They are less optimistic aboutthe possibility of a quick recovery that will be more like a V. Instead they seem to be preparingfor long haul. July saw the spreads tighten in nearly all segments of the bond markets. The chartsof most of the US Bonds especially the 10 Year Treasury notes seem eerily similar to the pre-Lehman times. This is not to claim that we are about to witness another collapse. It essentiallymeans that the optimism that pervades in the popular press is not justified. Interestingly, the five

year TIPS have declined nearly 14 bps from their recent highs. Curiously this is happening whenthere is an increasing talk about recovery.

Speculative longs in 2 Year UST are at their highest in recent times.

The difference between high investment grade corporate bonds and the US Treasuries is

still the time of Bear Stearns, though less than during the post-Lehman times. It is stilldouble the average rate of the past 5 years.

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The yields on US Treasuries are similar to those during the Great Depression.

Considering the fact that there is a predominant fear of deflation, how come the yields areso low?

A possible economic recovery should mean that the US 10 Year Treasury notes should be

rising. They are actually falling. Since the US Federal Reserve is not buying these notes

from the open market, this fall should be all the more perplexing, unless there are twothings in mind: (a) the US is not about to recovery, or (b) the bond markets expect sometrouble ahead so investors are rushing back into treasury notes both of which are notexactly a positive for the equity market.

China

A lot hope rests on the ability of China to provide the momentum required to carry the world outof the present economic troubles. The World Bank President claims that the chance of a trulyglobal recovery has increased due to Chinas expansion. Hope springs eternal. Andy Xie, has adifferent take on China. He believes that China is a bubble and the Chinese markets could crashby another 25 percent. It is imperative to note that Andy Xie studied the Japanese bubble for his

doctoral dissertation. It is my personal opinion that greater emphasis should be given to a personsuch as Xie rather than a political appointee of a half wit (George Bush) based on an obscurantistideology rather than intellectual ability. China runs the risk of borrowing growth from the futurefor today as the pace of monetary supply risks creating more capacity which will be detrimentalto future growth. The fact that Chinas exports continue to dip means that any new capacitiesbeing added due to the stimulus will not have the desired affect. Pushing credit to borrowers whoare not exactly in the pink of health is akin to throwing good money after bad money. Rampantand imprudent lending as the Chinese seem to be taking up at the present juncture means that wewill invariably see an increase in bad debts if there is no improvement in business environment.Therefore in the near future we donot have to see any further deterioration, if there is noimprovement in the environment then earning the cost of the repayment of this borrowed money

becomes all the more difficult.

Technical Factors

The technical picture of the financial markets is highly pessimistic to say the least.

There is a gradual slow down of money that is entering the emerging markets. According

to statistics put forth by EPFR, new capital inflows into the Asian Mutual funds hasdeclined to about US$300 million in August from the average of more than US$3.5billion a month between April-July.

This has also been the period when the world biggest pension funds are reducing their

long-term equity exposure at a time when the markets have had their biggest rally sincethe 1930s25.

According to Trim Tabs, Insider selling in August was nearly 30.6 times insider buying,the highest since 2004. Insiders have been bearish and have been net sellers of stocks forthe past four months. They have sold nearly US$105.2 billion in shares.

NYSE short interest continues to plunge and is down by more than 10 perecnt.

Margin debt has jumped by 5.9% in July.

TRIN is at levels that are associated with the market tops of 2000 and 2007.

25http://www.bloomberg.com/apps/news?pid=20601109&sid=aGIATunT3Aao

26
http://www.bloomberg.com/apps/news?pid=20601109&sid=aGIATunT3Aaohttp://www.bloomberg.com/apps/news?pid=20601109&sid=aGIATunT3Aaohttp://www.bloomberg.com/apps/news?pid=20601109&sid=aGIATunT3Aao


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All the above are contrarian indicators that usually signal a market top.

Grappling with the Unexplained:

There are too many parts of the economy that cannot be satisfactorily explained. These include:

The continued correlation between all asset classes. Nearly all commodities are movingin step with oil and equities. Even asset classes that in the past were thought to benegatively correlated are moving in tandem. That should seem odd, considering the wellknown fact that higher commodity prices invariably lead to an erosion in the profits ofthe corporate sector

Higher oil prices invariably mean a decline in the equity markets (at least that has been

the case till now).

If the case for an economic recovery was that solid, then Gold should have tumbled. It

has tumbled, though conversely it has not gone up. So are we heading for years ofsideways movement?

If valuations were actually so attractive, then why are we not seeing an increase in

mergers and acquisitions activity? 51 percent of the PE players expect M&A activity to decline in 2009

The markets seem to have already discounted the present marginal revival in the global

economy with their sharp jump. How would they react to the possible out come of theworld economy moving sideways?

How to explain the fact that there continues to be rise in the inventories of some of the

important metals even while capacities have been shutting down. Copper inventoriescontinue to climb, Aluminium have ceaselessly climbed since October 2008, Lead has asimilar story, only that it has climbed continuously since December. Interestingly theprice of Lead is at a 16 year high, copper has recovered about 70 percent of its fall.

Does all this mean Deja vu all over again? Just like 2001 when all the analysts had called an endto recession only to have the year end at zero percent growth?

The future problems areas:

This section comprises of various problems that could spring a surprise in the future. They areessentially black swan events, which may occur. This is not to claim that they are about to occur,just that they are entirely plausible.

Remember that the threat of deflation has not disappeared. On the contrary it seems to be

winning the battle. The first indication of that would be when the US Treasury notesreach near Zero.

The single biggest risk for the future lies in the growing risks that the sovereign

supported institutions going bankrupt or wilting under the pressure of bailouts. While thisseems far fetched at the moment, it is entirely plausible. To cite one such probleminstitution could be the FDIC (US Federal Deposit Insurance Corporation). Its funds havebeen depleted to the tune of about 40 percent. In order to replenish their funds, the FDICwould have to charge banks, which in turn would reduce their profitability or simply notcover their deposits beyond a certain limit (not politically or economically feasible).

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Sovereign risks may resurface. The era of financialisation has brought about an important

change. A country need not actually be at risk of default but a perception that it maydefault would cause capital to dry up. It is now possible for any investors to have a lookat Credit default swaps and come to their own conclusions. Interestingly the last monthhas seen the credit default swaps of countries such as Mexico and Brazil to rise. Though

this rise is only marginal, it invariably needs to be watched closely. The growing risks posed by small banks in the USA disappearing. The FDIC has a list of

nearly 416 problem banks in its confidential list. Most of these banks are stated to be thesmaller regional banks. As these banks go bust or are closed down, the credit situationwill dramatically deteriorate, leading to an aggravation of the economic situation. It mayalso lead to a number of loans, which till now are not yet problem loans, being recalled,thereby pressurising the balance sheets of the consumer. Invariably it may lead to agreater retrenchment of the consumer instead of leading to the consumer loosening oftheir purse strings.

What would happen when the governments run out of money to pump into the system?

Though this measure is about 2-3 years away, deterioration in the economic conditions

could bring these pressures to the forefront. Banks have still not resolved the problem of toxic assets. They still remain on the books

of the banks. Though the difference has been that the banks are now able to use these assecurity to borrow from their central banks.

Technically, the US Dollar index seems to be set for an up-move. It would be interesting

to see what the impact of this up-move would be on different parts of the world. Over thelast two years, an up-move in the US dollar has been accompanied by a crisis. Does thecurrency portend something? While there is no need to panic on the dollar, the fact thatthe predominant expectation is for the dollar to collapse. If the reverse were to happen,what would happen to those caught on the wrong side of the dollar volatility and whatimpact would that have on the balance sheet and payment related issues? The Chinese

have already set the cat among the pigeons when the regulator is stated to have cleareddefaults on some derivative products26.

How would the world react if another major (or a few hedge funds) were to lose large

amounts of money? Considering the fact that global finance is intricately interlinked, thiscould just be the next major issue.

There is however, one major positive (apart from the huge amount of capital on the

sidelines): a large number of people are still bearish. Though I would not be sure that theywould be bearish for long if stocks were to rally another 5% or 10%.

It is pertinent to note that unlike in the past the governments have little ammunition left to

take up further stimulus measures. The last time, the world faced such a severe recessionwas in 1981-82. The Fed rate was a high 20 percent and the deficit spending helped pushdown the unemployment rate to 7 percent by the end of 1985. This time, the governmenthas no leverage left half way through the crisis.

What about India?

This yet another tricky aspect that this note attempt to grapple with satisfactorily. A lot has beenmade out of the recent GDP numbers as well as the IIP numbers. But the growth was largely due

26 http://www.marketwatch.com/story/scrutiny-for-reported-china-change-on-derivatives-2009-09-01

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to three major items: Electricity and related aspects, finance, mining and related items. All theother components had growth that was less than the last year. It is indeed interesting that much isbeing made about electricity consumption in a country that is deficit in power and that too insummer months. Mining success story may have more to do with Chinas import of commoditiesthan anything else. The easily explained item is that relating to business and financial services.

While undoubtedly there was an increase in economic activity (considering the fact that we hadthe elections, and lot of pent up demand) it is clear that this is largely due to some loans andother disbursals by the banks in the first quarter of the new financial year.

A clear ominous sign is the substantial fall in the Industrial investment proposals. The RBIannounced that the proposed investment until May 2009 amounted to Rs.4,04,380 crores, whilein 2008 they were 15,22,566 crores. Even if we were to double the proposed investment for thewhole year (there is no specific reason why we are only doubling) then it would be about thesame as 2007 (when there were proposed investment to the tune of Rs.827,500 crores27.

As it is the recession has dramatically hurt India far greater than what Indian policy makers are

willing to admit. Despite the recent rains, about half of Indias districts have been declared asdrought hit. Various estimates have pointed out that this could reduce the GDP by 3-5 percent.The recent theory (actually extravagant claims) that rural demand will replace lost demand due toglobal crisis seems to have run aground. The next couple of months should see the decouplingtheory sink. India, China as well as other emerging economies are dependent on the OCEDcountries for their survival and that is not about to change in the next 5 years. This is to be seenin the context of two important factors: (a) exports comprise about 15 percent of the GDP, and(b) India is a capital deficit country. The problem of availability of capital has become moresevere due to the huge government borrowing via the deficit spending route in a case of classicKeynesian pattern. Unfortunately, India is not in a face to effectively overcome the crisis as it isoften perceived. This is because of the consumption profile of the country.

India is now largely a country dominated by the service sector (which comprises about 57% ofthe GDP) meaning that those dependent on the sector are at the bottom of the job market, wherethe incomes are relatively low. This would mean that the cushion that they have in difficult timeswould vanish if the troubles were to go beyond a certain period of time. However, it is difficult toquantify the precise tipping point. The problem of rising food prices only aggravates the situationfor those at the bottom of the pyramid, the class of consumers who the world believes will rescuethe Indian economy. Rising in prices of everyday consumption related items is essentially like atax, only more efficient in burning a hole in the pocket of the consumers. This will invariablylead to consumers postponing consumption of non-essential items over a period of time. This isprecisely what is happening over the past six months. Since this is a slow process, it is lessvisible on a monthly basis. Anecdotal evidence of consumption of items like furniture is clearlyindicative of this trend of downtrading or searching for cheaper replacements in nearly all items.

The boom till 2008 was largely built on empire built on debt. The recent bout of tightening or theimpact of the recession now means that nearly Rs.382,000 crores of money has vanished fromthe system. The government borrowing programme now risks crowding out the private sector.India faces a peculiar problem. Money supply will continue to tighten (as in the rest of the world)

27The Financial Express, 29 August 2009, p.7.

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even if there is an economic recovery as businesses would require huge amounts of capital.Moreover unlike in other countries a large component of the government spending is on theinfrastructure projects which take time to build. Hence the government will find that it will notbe able to complete them even if it finds that the economy is truly recovering. This would createa greater credit crunch (though may not lead to a credit crisis).

Indias manufacturing (which is often claimed to be more dependent on internal consumption) isclearly dependent on the helping of the government, due to the large scale presence of thegovernment in the business arena. However, Indias fiscal position is on more shaky ground vis--vis other countries. While the domestic savings do provide the scare capital needed over thenext 12-18 months, it would be difficult to sustain growth over the long-term. A drought wouldhave disastrous consequences to an already fragile economy which was witness to fiscal profligacy due to the exigencies of the recently concluded elections. The drought wouldimpacting India at a time when it is most susceptible. There is however, one advantage thatIndian companies may witness. In those industries, where India does have a major competitiveadvantage (like Auto), the country may witness some increased interest, especially in the form of

outsourcing. Hopefully, this should reduce the impact of the crisis for those industries positiveaffected. The rest of the industries, especially that depend on exports for more than 50 percent oftheir turnover are likely to be in deep trouble.

An important aspect of this crisis which most of the countries seem to have missed is a changethat is gradually taking place and that change is what actually aggravated the Great Depression.At that point of time we had countries that put up protectionist trade barriers in the form oftariffs. However, in the present times the presence of WTO has led to less of such a directmeasure. Instead, we have system wherein all countries increasingly trying to encourage theirdomestic industry, which has to be come only at the cost of another countrys industry. Only thatthis may take longer to make its impact felt.

There are obvious advantages for India over the medium term. Since only about 15 percent of theGDP is dependent on exports, the economy will be able to weather the storm over a short periodof time. However a prolonged sideways trend in the economy could end of creating havoc on theIndian economy.

Future Prospects for India (personal views)

Indias growth will stall. The government will have the ability to spend money only for

another couple of quarters and hopefully the intensity of the drought will reduce this yearand the next year will be a normal monsoon.

As Indias growth stalls, the government will be forced to spend more money thereby

pressurising its fiscal position. This will invariably lead to pressure on their currency. The longer the above two processes drag on, the more the pressure on the corporate

sector, whose balance sheet is already burdened with excessive borrowing at a time whentheir revenues are being pressurised. The recent crisis has only forced all the majorcompanies to increase their borrowing. Further leverage will only hurt them more.

The prospect of rising prices will only aggravate the situation. With major state assembly

elections in every year from now, the government will be forced to maintain the

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momentum of its spending programmes, infact it will have to increase spending and notthe other way round.

Demand is unlikely to rise due to the lack of expendable surplus among the consumers

Manufacturing growth will continue as long as the government has the ability to spend

money.

Tax revenues are bound to decline Globally we are bound to see an exponential rise in volatility. It is likely that the

corporate sector will be caught on the wrong side of the currency and commodity pricevolatility. So unless the government relaxes

Increasingly the government will have to accept that there is a problem (which could lead topanic) or they could simply relax all the rules so that accounting for the problems could bepostponed for a longer period of time.

What to Do in the era of One step Forward, three steps backward.

The simplest answer would be cautious. Most importantly, one has to realise that we are in an era of one step forward (thanks to

the government) and three steps forward.

As of now (and probably so in the next three months) deflation will continue to be the

major threat, and not inflation.

Load up on cash, especially if deflationary pressures are back as they seem to be as seen

from the continuous fall in the producer prices. However, since this is blamed on baseeffect, it would be interesting to see how the prices behave after October.

Remember cash is best only in times of deflation.

Cash would be of great use as we are bound to witness volatility as the future is like a

minefield where now sovereign ratings are bound to down-graded leading to aprogressive downward lurch.

The case of Japan clearly seems to show that the best opportunities will be there for

traders. Rallies will continue to be extremely sharp as in the case of Japan and the GreatDepression.

Documents

One Step Forward, Three Steps Backwards: Review of Global Economy