The Sensex is tantalisingly close to the hitherto unimaginable 50,000 mark. What explains the disconnect between markets and the real economy? As someone who was amazingly prescient about the 2008 crisis, are we in for a rude shock?
Well it is very hard to say. One has to look around the world. Bitcoin reached $40,000 from $10,000 in the beginning of last year. Bitcoin is the classic bubble, it produces no value. It is an asset which cannot even be used for payment because it is really difficult. As my friend Austan Goolsbee says, they do not take Bitcoin as payment in Bitcoin conferences because it is just too costly and yet it hit $40,000! So why are people buying Bitcoin? They think it will go up and that is very bubblish in thinking. Tesla is another case where it is being priced at many multiples of the price of solid car companies like Toyota or General Motors. One has to have a very firm view of their successes and the spread of vehicles they are making to justify the kinds of prices that are being paid.
It is not as if everything is priced in a way we understand. That does not immediately imply that the bust is coming. There are certainly reasons to believe that there are underlying supports — a very easy monetary policy, very low interest rates and the fact that economies rebounding. I would call it a rebound as Carmen Reinhart calls it, rather than a recovery because a recovery means you go back to the place you were and we are still way below the place we were. We are rebounding quite fast. That rebound is showing up, especially in manufacturing.
It suggests that nothing really happened to impede growth. The truth is somewhat different and, of course, there are lots of small investors with plenty of money — from transfers, from sitting at home and not spending it elsewhere — who are also pointing to the stock market.
So, low interest rates, the fact that manufacturing is back and sometimes is showing healthy growth, the fact that many large companies are benefiting while small companies are going out of business — all that creates a temporary positive sense about where the economy is going.
Of course, a lot of damage has been done and this will show up in the medium term and the question is are the positives enough to offset the negatives? I do not want to be a stock market expert and tell you it is going to go up by this much and so on. I do not know, but I do think that it is a good time to be diversified.
So you do see a disconnect and you did use the word temporary?
Certainly in terms of demand and results. There is pent-up demand from the rich in India. Look at the divergence between auto sales which are growing year-on-year, while two-wheeler sales are not. They cater to two different groups — the upper middle class who are buying four-wheelers and the lower middle class and poor people who buy two-wheelers. As is true of certain industrial countries, this is a two-speed process. The rich, partly because of their wealth, are doing pretty well and the not so well off are not. The question is can we completely ignore that segment? Certainly we cannot politically, but even economically. It is quite important to see how the consumption comes back. By some counts, 18 million jobs have been lost in India.
You do not see the market rise as purely liquidity driven?
What is being priced is not just enumerative. In manufacturing and in tech, enumerative is quite high but the discount rate is also very low because we have very low interest rates. You put those two together you can get a high price. The question is how long the high earnings will remain if the rest of the economy is troubled? After the initial bout of strong demand, is the rest of the economy going to express itself in some ways and the second question is are those rates going to stay low forever, which is what the market seems to be pricing in?
So temporary low performance is being ignored in favour of the idea that we are going to get a strong rebound and things are going to look good going forward. The low interest rates i the near term does not matter relative to the long term. Those are the calculations the market is making, there is of course also the froth that small investors induce into the markets and this is where the things like Bitcoin, Tesla get priced up because people are just jumping in.
I presume there are similar stocks in India where the punters basically think they can make quick money and get out and so things get driven up. At some point — and this is the growing worry in the United States — inflation even if not permanently high given the post global financial crisis experience is going to start showing up a little more. The question is how long will central banks remain on hold if inflation perks up more strongly? The Fed has said it is going to look through initial bouts of inflation and look at what might be permanently higher but everybody is asking how long will the Fed stay on hold right now?
The Fed has said it is not even thinking about raising interest rates and that is a pretty strong argument. It will be quite some time before the Fed raises rates and that is a fair point but markets of course react before the central banks will react and you already see the 10-year bond rates have moved up over the last few weeks.
How do you see the macro economic scenario globally? It will come to India a little later.
The advent of the vaccines certainly puts a time stamp on when we hope the pandemic will be fully contained. There is some uncertainty about the rollout of the vaccines but by the third quarter of next year, most of the population in industrial countries will be vaccinated and therefore the high contact services hospitality, restaurants will be back in business at that point. What is a big uncertainty is two sources of uncertainty — the second wave which is more virulent will be contained and what drastic measures will be needed. The UK just implemented very significant drastic measures to contain the spread of the second wave and that is going to impinge severely on economic activity in the first quarter of this year. Does it have to be longer is the big uncertainty. Between now and the third quarter, what will be the level of economic activity? So far it is still impinging on high contact services and not so much on manufacturing where companies have figured out how to do social distancing. But services are the biggest part of economic activity. Here highly skilled services seem to be continuing. People are doing business, finance, you know consulting online but the low skill high contact services are still in abeyance. That means 10-20% of the economy would be severely affected if these lockdowns continue.
The other big question is the mutation of the virus. Are the new vaccines capable of controlling the second wave of mutated virus? So far the answer seems to be yes but that is not completely clear. There is tail risk that we will not contain the virus fully. But the markets are pricing in a strong recovery from the second quarter of this year and that is part of the reason for the exuberance in the markets across all assets which is partly why Indian market is going up.
Once you have priced up the S&P 500 and gone to value from growth stocks, then you look for emerging market stocks, for high yield bonds. Every asset is being priced up and that is partly the reason that Bitcoin is in the stratosphere. India is not unique in this. Every emerging market is experiencing it and the question is how much of this is justified given economic conditions.
But do you expect the US to be more outward or at least less inward under the Biden presidency?
It is a mistake to think that the Biden administration will turn over and be very friendly to the Chinese administration. The difficulties between the two countries are much deeper. There is a tremendous amount of suspicion in Washington of the Xi Jinping administration in China; past promises not to militarise the South China sea have been violated and the China vision going forward is in contrast to Russia which was a cold war opponent of the US but never a serious economic power.
China is both a serious economic power as also a military power and is doing a lot of work in the areas of dual use technology, in artificial intelligence, in chips, in cyber security etc. So the US is very worried that Chinese progress in these areas will also make it much more of a military threat and so the Biden administration is not going to turn around and bend over backwards to remove the tariffs. What it is going to do is have more negotiation. It is also trying to bring together its allies Japan, Europe, in that negotiation so that it becomes a more across-the-board negotiation with China.
It is going to be discussions about intellectual property, it is going to be discussions about standards and the tariffs will not be withdrawn on day one. They will be held even though the tariffs largely hurt the US and the US consumers paying for it. Withdrawing them from day one will look bad. They will be held as a negotiating tool and over time quite possibly they may be withdrawn but not overnight.
Do you believe that India is experiencing a V-shaped recovery or do you believe that it is much too early to say?
All the numbers typically come from the formal sector of the economy and from large firms. The statistics organisation did try and extrapolate a little bit to the informal sector but we do not know how effective that is. The pandemic had a much greater effect on the informal sector, the small and medium enterprises, the ones that do not have deep resources. The question is how much has both the lockdown as well as the social distancing measures affected these enterprises? Formal employment is down significantly but informal employment is probably down much more and may be 18 million people are unemployed right now relative to before the pandemic.
I believe that we will see a strong wave of growth as any country has to grow after being down 25% of GDP. We will see a rebound but the question is what are we doing to make up the lost ground? The world bank estimates we will have lost $900 billion of GDP by the time this is over and I do not know how good those estimates are but that is one third of GDP! How long will it take to reach the track we were on before the pandemic now?
For the US, people say sometime in the second quarter of this year we will be back; for India, my guess is we probably will not be back till late 2022 to where we might have been before the pandemic and then to make up the ground that we lost because we were growing at 4-5% before that. This is a line which is going up and we need to go back to that line. It will take a little longer and if we go back to status quo late this year or early next year and then make up further lost ground over the course, we would certainly have lost a lot of ground during this process.
Now how this affects demand, how this affects the longer term health of the economy is too early to tell. I also worry about the structural damage done and you know damage done to households, damage done to children who now have been taken out of school for a long time or who have not been able to keep up with their classes and we need to prepare for all that. What kind of remedial systems do we have when a kid which has been out of school for a year goes back to school? Not only have they not learnt over this year but they have forgotten a lot. How do we bring them back to speed or risk a permanent loss in learning in the next generation? These are things we need to prepare for. Looking at the Sensex, one thinks problems are over. No, they are just starting.