Not the time to rock & roll yet...
With rising input costs, small companies will have to explore options

(column by Asif Ahmed)

A whopping Rs.14.895 trillion is what India needs to pump in the infrastructure for the next five years, says CII in a recent report. The private sector, too, will have to contribute an enormous Rs.600 billion every year, further adds the report. According to RBI’s August bulletin, capital expenditure by the private sector has shown a remarkable growth in FY06, but is expected to increase at a decreasing rate in the current fiscal year, courtesy rising input cost. The aggregate capex of the services industry catapulted from a mere Rs.42 billion in 2004-05 to Rs.196.69 billion in 2005-06, taking the total capex to a record Rs.824.50 billion (an 8% increase over last year). Also, there has been a substantial increase in the project cost & average cost, which primarily hints at two things.

First, the increased investment opportunities; and second, considerably high retained earnings of India Inc. – which grew at a pace of 24.9% to increase their share in GDP from 4.4% to 4.8% in 2005. However, with interest rates firming up globally, capital investment plans by the private sector will have to take a backseat. A rise in interest rates means an increased demand for alternate sources of raising money. Rishi Sahai, Director, Indus View Advisors points out that “An increase in borrowing cost from banks will encourage demand for investment through the private equity route, which has infused $3.5 billion in H1 2006.” For companies sitting on huge cash balances, increased borrowing costs hardly mean much; but investment plans of small companies might take a hit. Clearly, they will have to look for other sources of raising funds.

A Clear Faux Pas...
...is taking its toll on indian banks

Out there: Vittaldas Leeladhar, Deputy Governor of Reserve Bank of India, speaking at a meeting in Basel, Switzerland pompously hailed the reforms initiated by RBI and the Finance Ministry. In a speech delivered last December, but documented in a BIS paper titled ‘Banking system in emerging economies: How much progress has been made?’ (released in August 2006), Leeladhar alludes deregulation of interest rates as one of the key features of India’s financial sector reforms. If one goes by his verdict, after the interest rate deregulation, Indian banks are now free to determine their own lending rates. Back home: Public sector banks (PSBs) are receiving the flak from the Finance Ministry, when the PSBs legally and statutorily tried to align their lending rate with the increased cost of borrowings, and that too amidst shrinking margins.

Chidambaram asked PSBs to review their decisions and take prior permission from the government, being the majority shareholder. And not surprisingly, one of the leading PSBs (Oriental Bank of Commerce) did revert back to earlier rates. This ridiculous and illogical act of the ministry has not only put a question mark on the entire concept of deregulation of interest rates, but it could also be taken as a precursor to serious banking troubles, adversely affecting the already worsened situation of banks. A recent example of RBI’s debilitating stance is the refusal to allow a few banks of Singapore to expand their operations in India, even after signing the Comprehensive Economic Cooperation Agreement with Singapore.

And that is after a full banking status was granted by the government of Singapore to SBI & ICICI bank. There are of course no second thoughts that it is India, and not Singapore, which lacks depth in its financial market and badly needs more participation from players. The government needs to position itself in a positive manner by formulating policies that are transparent, and above all, not biased to any players. The policies should be facilitating and not debilitating – which is actually the case now.

(End of Asif Ahmed column)

Why we still cannot do without a 007...
Declining retail sales and low housing affordability are precursors of a bond rally

(column by Marc Faber, Editor & Publisher of “The Gloom, Boom and Doom report,” & author of “Tomorrow’s Gold”)

Asset markets such as homes, stocks, bonds and commodities move in longer term cycles frequently lasting 20 to 30 years. Commodities rose from the 1960s to 1980, but during this secular bull market, the rising trend was frequently interrupted by severe corrections. Not only that! Leadership also frequently changed. Wheat, corn and sugar already peaked out in 1973, coffee & cocoa in 1977, but the CRB index made its final high in January 1980. Similarly, the global bull market in equities, which began in the US in August 1982, when the Dow Jones stood at 800, was interrupted by a very severe correction in 1987 and lesser setbacks in 1990, 1994 and 1998. In addition, leadership (country wise) changed hands over time.

The 1982 – 1990 bull market was primarily led by the Japanese and other Asian stock markets, whereas in the 1990s, it were the technology, media, and telecommunication stocks in the United States that clearly led the advance. I am mentioning this, because while I am very negative about US bonds and the US dollar in the long run, for the next three months, US bonds could outperform equities. But why! After all, though, US bonds and also other bonds around the world have been declining in price since the summer of 2005, and have grossly under- performed global equities since 2003. Moreover, we read every day in the media that inflation is accelerating. The performance of the Nikkei, the NASDAQ and the S&P Housing Index prior and after their bubble peak is visible too.

Two observations! After each bubble peak some economic pain followed for the bubble sector. Japan went after 1989 into a 14-year deflationary period and economic stagnation, and the high-tech sector suffered from overcapacities and weak pricing following March 2000. So, should we expect a housing slump? There are several indications that the housing sector is slowing down rapidly and may start to have a negative impact on the economy. Figure 1 shows that Housing Affordability is at its lowest levels in fifteen years. The reason for housing affordability to be down so much is that while home prices rose rapidly in the last five years, income gains for the typical household – not for the hedge management community – have either been stagnating or declining altogether.

Moreover, as interest rates rose from 1% on the Fed fund rate in June 2004 to 5.25% currently, financing costs have escalated. Poor affordability aside, the inventories of unsold homes and especially of condos have been rising rapidly while home buying attitudes have been declining. The eternal optimists crowding Wall Street will of course tell you not to worry. Yes, there will be a slowdown in the housing sector and home prices won’t rise as much in future as in the past. They even concede that home prices could decline very moderately but it won’t have much of an impact on the economy!

It should, however, be noted that, in the past, housing starts have been one of the most reliable indicators of future economic activity as the home building sector has a tremendous multiplier effect. It directly impacts the appliance, furniture, home improvement, consumer electronic and construction material industries. Moreover, it stimulates the real estate service sector including all the financial intermediaries (sub-prime lenders, insurance, mortgage brokers, etc.) and the real estate brokerage industry.

Also, the latest housing boom allowed households to refinance and extract money from their homes by taking on additional mortgages – a large part of which was spent on consumption. Another point to consider is that, the rise in home prices and the ability to extract money from one’s home also led to a collapse in the personal saving rates. As homes appreciated in value, households found it unnecessary to save from current income. I may add that the decline in the savings rates in the last few years turbo-charged consumption and the economy. My view would therefore be that the coming housing slowdown or slump could actually significantly exceed expectations and lead to across the board economic weaknesses. Don’t forget that if home prices no longer appreciate, home equity extraction will come to a halt.

The consumer will then likely have to begin saving again from current income. Both these factors would obviously depress consumption and retail sales. In fact, it would appear that after several years of out-performance, the retail sector is beginning to weaken compared to the S&P 500, suggesting that a consumer retrenchment is well underway. One more point! The weak sales growth at Wal-Mart seems to con- firm that the typical US household is already struggling. I need to point out that while my friends at Credit Suisse have downgraded the retail sector from a “Buy” to “Overweight”, I would not touch retailers and in particular not home improvement chains like Home Depot (HD) and Lowe’s (LOW) for now.

The stocks of both these companies look like rolling over – another clear indication of an impending housing slowdown. However, it is not only housing that is cooling down. The ISM Non-manufacturing Employment Index is also weakening, while the ISM Manufacturing index has also been weak throughout the duration of this consumption led and highly imbalanced economic recovery, which began in November 2001, and is, therefore, by historical standards, already very mature. So, what are the investment implications? All indicators point to an economic slowdown, but what we do not know is the reaction of the Fed to such a slowdown.

No further tightening or an easing of monetary policies in the coming few months could result in further US dollar weakness measured against gold on concerns that the Fed will rather prefer to fight economic weakness than inflation. This would obviously not be favourable for bonds and is also likely to have a negative impact on equities if they are measured against gold. Alternatively, it is also possible that sudden weakness in economic activity could lead to a further sharp decline in industrial commodity prices and, so, ease inflationary pressures and meaningfully improve the sentiment toward bonds. As can be seen from figure 2, courtesy of the Bank Credit Analyst, the general investor sentiment toward bonds is currently rather negative.

Please note that low bullish sentiment readings on bonds – visible on figure 2 – were followed by a bond market recovery. Also, from early May to mid-June, bonds had outperformed equities. However, in the most recent equity market rebound, bonds again under-performed equities and commodities. But because of the reasons given above, I would expect the market participants to soon recognize that the US economy is weaker than they had believed it to be. Investors will then become increasingly concerned about corporate profits and shift part of their assets back into bonds, which should lead to a temporary out-performance of bonds vis-à-vis equities.

Personally, I am of the opinion that at present, Two Years Treasury notes, which yield around 5.2%, offer an attractive alternative to equities because, in the past, when the Fed stopped raising interest rates, the 2-years Treasury bond yields fell on an average by 120 basis points over the next six months. Equities may actually rally somewhat higher in the very near future as the period between the end of June and late July is usually characterized by some seasonal strength. However, we would use any additional strength as a selling opportunity, as the upside would seem to be very limited, since substantial resistance resides on the Standard & Poor’s 500 at the point between 1290 and 1325.

(End of Marc Faber column)