Only when the tide turns, you know who is swimming naked
Warren Buffett

What an apt quote that is for what happened in the Indian market recently! Liquidity has finally trumped so-called great fundamentals of the Indian economy. Borrowing rates are finally rising , more so for non-bank financiers. One global analyst, who predicted $100 on oil when crude was still in the 50s, is cautioning about collapse in non-Opec oil supply. Now, if you want to know why capex is not happening in India, I suggest you directly go to this must read paper from BIS “The rise of Zombie Firms” and finally watch silver prices if you are waiting for “When to buy emerging markets” (I would buy Brazil before I buy India)

Simple answer….. first gradually and then suddenly

Banks found an easy way to fund credit through consumer funding and lending to NBFCs. Mutual funds, which couldn’t believe their fortune in the wake of demonetization, used inflows into their debt schemes to fund NBFCs/HFCs. In fact, if Sebi would not have come out with sector-wise limits, some MFs would be happy lending majority of their unitholders’ money to this sector.

The interest rate cycle started turning late last year, but MFs and banks were still having enough short-term liquidity to fund non-bank financiers. But these lenders started shying away from extending long-term funding a few months back. NBFCs had to alter their funding patterns and accept funding mismatch, otherwise cost of borrowing had started rising sharply and this is when the seeds of the current problem were sown. Systemic liquidity has now completely dried, and MFs are only seeing outflows along with banks, which are struggling to attract deposits.

NBFCs require funding, and long-term funding in that. Otherwise, the situation can get out of hand (only when tide turns you come to know who is swimming naked).
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Beware the collapse in non-Opec oil supply

Adam saw $100 on oil when crude was still in the mid 50s… He wrote: “We have reached a tipping point in this oil bull market. Since reaching the lows in the first quarter of 2016, oil prices have advanced almost three-fold, yet investors remain stubbornly bearish towards oil. Surging US shale production and an entrenched belief that global oil demand will peak and markedly decline as we progress into the next decade have caused investors to ignore the positive fundamentals in global oil markets over last 18 months. Although oil-related investments have recently started to perform better, they continue to lag oil price advance. Consensus opinion held that any Opec deal to increase production would cause a near-collapse in prices as a new market-share war (with Russia now thrown in) would break out. Reflecting generally accepted consensus opinion, a Bloomberg headline shouted: “Coming Soon: Opec’s worst meeting ever, Part 2.’ The Saudi about-face on production lays the ground for discord in Vienna.” But a funny thing happened after the June Opec meeting concluded: even though a pact on increasing oil production was agreed on, prices rallied with West Texas Intermediate (WTI) making a new high.

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Oil prices have significantly exceeded consensus forecast over last 12 months and, based upon our modelling for 2019, we believe the analyst community is again significantly underestimating oil prices. As we outlined in this letter’s
introductory essay, investors do not understand the problems currently developing in conventional non-Opec oil production, which has already rolled over and is now declining.

Our research tells us in the next several years declines in conventional non-Opec oil production will accelerate significantly. Adam believes the bull market in oil, (ignored thus far by the investment community in every step of the way) is set to dramatically accelerate on the upside.

The Rise of Zombie Firms

Key takeaways

  • The prevalence of zombie firms has ratcheted up since the late 1980s.
  • This appears to be linked to reduced financial pressure, reflecting in part the effects of lower interest rates.
  • Zombie firms are less productive and crowd out investment in and employment at more productive firms.
  • When identifying zombie firms, it appears to be important to take into account expected future profitability in addition to weak past performance.

BIS writes in a paper….Zombie firms, meaning firms that are unable to cover debt-servicing costs from current profits over an extended period, have recently attracted increasing attention in both academic and policy circles. Caballero et al (2008) coined the term in their analysis of the Japan’s ‘lost decade’ of the 1990s. More recently, Adalet McGowan et al (2017) has shown that prevalence of such companies as a share of total population of non-financial companies (the zombie share) has increased significantly in the wake of the Great Financial Crisis (GFC) across advanced economies more generally.

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The BIS analysis addresses three main questions:

First, are increases in the incidence of zombie firms just episodic, linked to major financial disruptions, or do they reflect a more general secular trend? Answering this question requires taking a sufficiently long perspective. Their database extends back to the 1980s and covers several business cycles. They find a ratcheting dynamic: the share of zombie companies has trended up over time through upward shifts in the wake of economic downturns that are not fully reversed in subsequent recoveries.

Secondly, what are the causes of the rise of zombie firms? Previous studies focused on the role of weak banks that rolled over loans to non-viable firms rather than writing them off (sounds familiar?). This keeps zombie companies on life support. A related but less explored factor is the drop in interest rates since the 1980s. The ratcheting-down in the level of interest rates after each cycle has potentially reduced the financial pressure on zombies to restructure or exit. The results, indeed, suggest lower rates tend to push up zombie shares, even after accounting for the impact of other factors.

Consequences of rising zombies

Previous studies have shown that zombies tend to be less productive. Therefore, the higher share of zombie companies could be weighing on aggregate productivity. BIS concludes… moreover, the survival of zombie firms may crowd out investment in and employment at healthy firms.

The above article by BIS is very relevant in the Indian context, where banks and systems had an incentive for propping up zombie firms. India is in urgent need of an investment cycle, which will also aid employment generation and the cycle cannot kickstart till the financial system is able to tackle this monster of zombie firms.
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Simply follow Silver prices
Lewis Johnson writes… “Our experience has been that the silver-gold ratio is one of the most sensitive leading indicators of liquidity. We believe a fundamental reality lies behind this relationship. Both gold and silver are precious metals. The nature of the supply and demand for these metals, however, varies. Our experience is that silver is the more sensitive of the two to incremental changes in liquidity and/or inflationary expectations.”

My experience in real-time watching the silver-gold ratio move from its lows was helpful in both 2003 and again in 2008. In 2003, its rise indicated that the long bruising decline in emerging markets was finally over. Again in 2008, while the world was crashing, the silver-gold ratio demonstrated its insight by turning up in late 2008. I believe, this ratio can be equally insightful when booms turn into busts, as this indicator amply displayed in mid-2008 and again in 2011.

We are now nearing historic lows for this ratio. This may suggest we are in the zone during which we may reasonably expect the values in many emerging market investments to become compelling (I believe it will be the commodities-heavy markets like Brazil and South Africa). Our discipline, however, learned through many trading cycles, is to pair our valuation-driven insights with an informed view on liquidity. It is our expectation that a sustained turn in the silver-gold ratio may very well be the final link that turns us into more aggressive buyers of select investments that our research team has identified among this challenged asset class.
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