On the Talk About a Possible Market Collapse in 2017

Chatter in some parts of the unconventional financial press online is increasing, citing investors such as Jim Rogers, that the U.S. stock markets will collapse by 50 – 80%. Parallels are being drawn to the market collapse that began the Great Depression in 1929, the 1999 collapse after the technology bubble burst, and the 2007-08 collapse after the housing bubble burst. Even some conventional economists, including the Bank of Japan, seem to be of the view that the prolonged period of low interest rates, if continued, could lead to market instability and the major central banks worldwide have changed their bias to tightening monetary policy, though it must be pointed out that such bias has arisen because of improving global growth outlook and reflation. Still, it would be useful to compare and contrast the current economic context with 1929, 1999 and 2007-08 to understand if indeed prophecies about a market collapse will materialize.

Leading up to the Wall Street crash of October 1929 were downtrends in commodity prices and industrial production which caused the stock market to fall by 10% by September into correction territory. The stock market bubble that was created in the 1920s preceding 1929 was fueled by hundreds of thousands of people buying stocks with borrowed money. This led to panic selling toward the end of October and put the markets in bear territory. Between 1929 and 1932, the Dow Jones Industrial Average (DJIA) fell by 89% from its peak before selling began in 1929 sinking the U.S economy into a depression. Of course, the U.S. Federal Reserve made the well documented mistake of raising interest rates by contracting money supply thinking that less money in the markets would defuse the stock bubble, causing a string of bank failures from bank runs, turning what was a market correction and recession in 1929 into a full blown depression by 1932.

The bursting of the technology dot-com bubble in 1999 was caused by significant investments in information and communications technology (ICT) firms to commercialize the internet without regard to return on investment in a specific time frame. Moreover, few large ICT firms engaged in illegal accounting practices which exaggerated their profits. The tech-heavy NASDAQ fell by as much as 78% after the dot-com bubble collapsed. The Federal Reserve, unlike in 1929, lowered interest rates and more so after the September 11, 2001 (9/11) World Trade Center (WTC) terror attacks to cleanup after the bubble collapse and to uphold the U.S economy in the wake of the geopolitical uncertainty caused by 9/11, leading only to a short recession.

Central bank response worldwide to the 2007-08 implosion of the housing market has been, though a bit delayed in its scale initially, on a war-footing to prevent a recession turn into a depression as in 1929, though the markets fell by 50%. Major banks had committed fraud by selling unstable housing securities packaged as newfangled investment instruments knowing full well that if the interest rate environment changed these instruments would lose considerable value because of foreclosures in the underlying housing market. The banks that failed had little or no cash cushions and the major banks which were systemically important relied on the Federal Reserve to bail them out. The recovery from the recession which began in 2009 has been slow partly because fiscal policy did not support the monetary easing due to fiscal austerity measures adopted by most governments including the U.S.

The review of the above oft cited market collapses shows that the determinants of crisis are currently non-existent. There is no bubble in any market and U.S is near full employment. Earnings and earnings forecasts of major corporations are healthy and their stock prices – unlike in 1929, 1999 and 2007 – are reflective of healthy performance but not of any bubble. U.S non-financial corporations are sitting on about USD 1.7 trillion cash pile as of 2016 though corporate borrowing in the commercial paper market has gone up due to low interest rates. U.S banks have excess reserves of more than USD 2 trillion at the Federal Reserve.

China’s economy is stable but slower as intended due to timely government policies despite its stock market crash of 50% which did not involve a large segment of China’s population. Debt in U.S and China is manageable and will not cause a crisis. The European Union (EU) is growing at an annual rate that is better than U.S. growth. Japan is back on the growth path (though the growth is slow) even as it addresses its lack of inflation problem. Indian growth, though it slowed a bit because of demonetization, is strong and is forecast to be strong. But for Russia, South Africa and Brazil, the rest of the world economy is on the mend. Commodity prices, including that of oil, are rising again due to rise in global demand and this could help bring Russia, South Africa and Brazil out of their economic funk.

Monetary policy, despite a tightening bias among the major central banks worldwide, is still accommodative, and after the election of Donald Trump in the U.S there are hopes of fiscal easing both in terms of tax policies and higher government spending. Most importantly, the outlook for global gross domestic product (GDP) growth – despite political uncertainties such as Brexit, the election of Donald Trump in the U.S, and the rising political fortunes of the nationalists in Europe – is positive and encouraging.

Any talk of a financial market collapse in 2017, given the evidence, is thus not verifiable in data.

Monetary Policy Outlook for India

The Reserve Bank of India (RBI) sprang another surprise on February 8, 2017. It left the key repo rate unchanged and, more importantly, changed the monetary policy stance to neutral from accommodative. The RBI has done two things: one, it surprised the markets and two, it made policy hawkish by keeping the rate unchanged and by changing the monetary policy stance to neutral from accommodative. Both the surprise and the change in policy stance constitute policy making, unless it is construed by the markets that surprises imply a central bank that is not as transparent as expected in its communication, thereby, confounding the markets.

The following key reasons were given by the RBI for its decision at the February meeting of the monetary policy committee (MPC):

“The decision of the MPC is consistent with a neutral stance of monetary policy in consonance with the objective of achieving consumer price index (CPI) inflation at 5 per cent by Q4 of 2016-17 and the medium-term target of 4 per cent within a band of +/- 2 per cent, while supporting growth.

Excluding food and fuel, inflation has been unyielding at 4.9 per cent since September. While some part of this inertial behavior is attributable to the turnaround in international crude prices since October – which fed into prices of petrol and diesel embedded in transport and communication – a broad-based stickiness is discernible in inflation, particularly in housing, health, education, personal care and effects (excluding gold and silver) as well as miscellaneous goods and services consumed by households.

GVA growth for 2016-17 is projected at 6.9 per cent with risks evenly balanced around it. Growth is expected to recover sharply in 2017-18 on account of several factors. First, discretionary consumer demand held back by demonetization is expected to bounce back beginning in the closing months of 2016-17. Second, economic activity in cash-intensive sectors such as retail trade, hotels and restaurants, and transportation, as well as in the unorganised sector, is expected to be rapidly restored. Third, demonetization-induced ease in bank funding conditions has led to a sharp improvement in transmission of past policy rate reductions into marginal cost-based lending rates (MCLRs), and in turn, to lending rates for healthy borrowers, which should spur a pick-up in both consumption and investment demand. Fourth, the emphasis in the Union Budget for 2017-18 on stepping up capital expenditure, and boosting the rural economy and affordable housing should contribute to growth. Accordingly, GVA growth for 2017-18 is projected at 7.4 per cent, with risks evenly balanced.

The Committee remains committed to bringing headline inflation closer to 4.0 per cent on a durable basis and in a calibrated manner. This requires further significant decline in inflation expectations, especially since the services component of inflation that is sensitive to wage movements has been sticky. The committee decided to change the stance from accommodative to neutral while keeping the policy rate on hold to assess how the transitory effects of demonetization on inflation and the output gap play out.”

RBI interest rate decision and the neutral monetary policy stance, however, could have also been based on neutral or natural rate of interest consideration, where the natural rate is the rate at which real gross domestic product (GDP) is growing at its trend rate, and inflation is stable, with the shock to growth and inflation being seen as transient and one-off effects arising because of demonetization as many analysts and the RBI are interpreting. The RBI is counting on growth to strongly pickup in 2017-18 without having to lower rates. It is focused on bringing down inflation to 4%.

Fiscal policy from the 2017-18 budget, albeit pro-growth, tends to act slower than monetary policy in raising aggregate demand. Therefore, even after the effects of demonetization fade away, in the absence of preemptive monetary stimulus, growth could continue to slow contrary to RBI’s expectations. If RBI decides to tolerate slower growth to keep inflation durably around 4%, especially given the global reflation, it may find itself in the unenviable position of not being able to lower the repo rate even if growth slows down to say 6%. Future RBI decisions will depend on how flexible the monetary policy committee (MPC) is about keeping inflation within the inflation targeting range of 4% +/- 2% rather than focusing on inflation durably being closer to the 4% target.

Expectation of RBI Decision at the Sixth Bi-monthly Policy Meeting on February 8, 2017

Summary

RBI could cut the repo rate – the rate at which the central bank of a country lends money to commercial banks in the event of any shortfall of funds – by 25 basis points to 6.00% at its Sixth Bi-monthly Policy meeting on February 8, 2017 because it is generally agreed that the Indian economy has slowed after demonetization and, therefore, growth will need support from the central bank, especially given that inflation is in check, for growth not to slow further. Also, the 2017-18 budget, by committing to a budget deficit target, gives the RBI fiscal space to lower rates.

Demonetization

Growth is forecast to be slowing by 1% over previous year for fiscal 2016-17. Slowing growth puts downward pressure on inflation. Transient. Growth is forecast to pick up beginning Q1 2017-18 at current interest rates because of a rise in consumption once cash starts flowing in the system again but that is not certain to cover up the lost 1% growth rate in the GDP because of greater curbs on unaccounted for cash in the 2017-18 budget such as banning cash payments over INR 300,000. This could continue to put a temporary damper on consumption until the economy becomes used to traceable transactions. On the other hand, given the higher marginal propensity to consume of low income earners, those earning less than INR 500,000 per year could spend more because of a lower tax burden in 2017-18 and, therefore, higher disposable income.

Inflationary pressures on the horizon for 2017-18

Pro-growth budget, implementation of the GST bill, rising oil prices, implementation of government employees housing allowance, stronger dollar, global reflation, and the challenging 4 per cent CPI target for the medium term.

Decision

In the quarter ending December 2016, net sales of sample companies across sectors have increased 4.3% year-on-year, the slowest in 5 quarters and real investment in the economy is secularly down. If RBI is targeting 7-8% GDP growth rate to create jobs (to address the issue of jobless growth) by raising corporate credit and investment in 2017-18, to provide support to growth it has room to cut the repo rate by up to 100 basis points in increments of 25 basis points given that inflation, on balance, appears to be under control. NPAs in state banks should see some relief because of government infusion of funds in the 2017-18 budget, though not as much as expected. State lenders could, therefore, lower their lending rates sooner for effective monetary transmission to take place.

RBI could cut the repo rate by 25 basis points to 6.00% on February 8, 2017.

Donald Trump, Outsourcing, and India’s IT Services Sector

America’s new president Donald Trump, in his inaugural address, has called for “buy American and hire American.” He has put on notice manufacturing companies such as the big three automakers in Detroit, German car maker BMW, Japanese companies such as Toyota, and others such as Carrier – the maker of air-conditioners – to produce in the United States (US) for the American market by hiring American labor. If they do not comply, he has proposed a border tax on all semi-finished and finished manufactured goods imported into the US by American and foreign manufacturers to make them as expensive as they would be if they are entirely produced within US borders employing American labor.

Foreign production chains have become common in the manufacturing sector not only for cars and other equipment but also for computer hardware. Apple, for example, produces its flagship iPhone in China and Taiwan. China has also become a favorite destination for chip manufacturers with even Intel Corporation making some of its chip line there, moving jobs outside the United States.

Trump has not, however, yet targeted outsourcing in the services sector, primarily the large information technology (IT) industry for similar treatment as manufacturing. Instead, the US Congress has taken up legislation to overhaul the visa program for importing highly skilled workers majority of whom work in the IT services industry. The proposed legislation is bi-partisan in nature, having sponsors in both the major political parties – Democrat and Republican.

The bill, if passed into law, will primarily affect the ability of Indian software companies – which derive more than half their annual revenue of USD 150 billion from North America – to staff their US operations with less expensive Indian software professionals on H1B visas because the proposed law will hike the minimum wage an H1B professional is to be paid to USD 130,000 per year from USD 60,000. Upon news of the legislation which is yet to become law, the share prices of the major Indian software companies which have significant exposure to the bill fell by nearly 4%.

Indian software companies which export software to the US, ironically, may not have much to worry about. The effect of the proposed law could be that, in order to keep the costs of developing software down, US companies could outsource more work to India because much of the technical work of creating software can be done remotely, at a fraction of the cost which could be incurred in the US, without the need to shift personnel from India to the US paying the new and substantially higher H1B wages. Local US staffers of the Indian companies could then be US permanent residents or citizens in sales, marketing and project management functions.

The bigger worry for the Indian IT industry should instead be its dependence on software exports to the US and Europe especially given the rising sentiment in both places to create local jobs by making, buying, and hiring locally. It is very possible that software imports to the US, similar to manufactured goods, could also be charged a border tax to promote making, buying, and hiring American. According to NASSCOM, the association of companies in the Indian IT sector, the Indian domestic market for IT services is only about USD 35 billion a year. For a large country such as India this is a minuscule market that needs desperately to be developed and, hopefully, the Digital India initiative of the Indian government will do that.

As the General Electric (GE) Chief Executive Officer (CEO), Jeffrey Immelt, recently said, the changing nature of globalization does not require ambitious multilateral trade deals setting up large free trade areas to be global but country-by-country arrangements. Indian software firms should have local US offices, produce software locally by hiring American labor for the American market, competing with domestic US IT corporations rather than employing Indians remotely at low cost in India. Likewise, US corporations should set themselves up in India to develop the Indian software market, competing domestically with Indian IT firms. This could be a win-win for both US and Indian IT corporations and for US and Indian workers.

Going local and global will be the key to the future success of the Indian IT industry. The IT companies must expand around the world to cater to local clients using local labor while moving up the technology value chain. The era of outsourcing work to India has come to an end.