India is an interesting market. Modi’s election success boosted equity markets but lately delays in reform have stalled the market which is some 10% of its 2015 highs.

Growth:

• Near term the economy is slowing but long term potential remains strong.

• India has strong demographics with the working age population rising as a percentage of total and is expected to peak only some 20 years from now.

• The urban population in India is rising at an accelerating rate and per capital income is rising.

• Current GDP growth is 7.5% YOY. Inflation is 5%. With a 2 trillion USD nominal GDP economy, India has plenty of room to grow.

• India has for a long time had strong growth potential but was held back by excessive bureaucracy, corruption and inefficiency. A reformist government may unlock this potential.

Government:

• The Modi government has a strong mandate with 282 out of 543 seats in parliament making it the first simple majority government since the Congress government in 1984.

• Modi’s mandate is growth and development. He has been a good Chief Minister of Gujarat with 4 consecutive terms and has shown talent as a strong CEO.

• The government is addressing a number of areas for reform:

  • Ease of doing business, moving to on line licensing and rationalizing other administrative functions.

  • Improving the investment climate, for example increasing FDI limits in selected industries like insurance, defense and railways, circumventing potential for corruption through more transparent processes, and more government co-investment in infrastructure.

  • Fiscal policy, to continue fiscal consolidation and removal of price distorting subsidies, for example in energy and transport, and to make government expenditure more efficient.

  • Taxation, simplifying the tax code, consolidating state and federal taxes into a single GST, expected to be circa 20% – 22%, also lowering corporate taxes from 30% to 25% over the next 4 years.

  • Banking and financial services, take for example the roll out of formal banking services to the general population (target circa 110 million new accounts), and the further augmenting of the bankruptcy law (last week creditors were granted rights to wrest control of management of defaulting companies.)

Corporate sector and Markets:

• RBI has made 3 rate cuts this year, most recently 2 weeks ago to take the repo rate from 7.50% to 7.25%.

• The Indian market is dominated by private sector business with SOE’s conspicuously absent. Companies are entrepreneurial and therefore capital and asset efficient.

• Long run ROEs are 17% compared with 11% for the rest of the world and 12% in emerging markets.

• Current ROEs are circa 15% and EBIT margins are around 10% which are cyclical lows.

• Market PE is 16.3X which is at the long term average. The market is relatively cheap considering that corporate profitability is at cyclical lows.

Risks:

• Things always take longer than planned or expected in India. This is one of the consequences of India’s democracy and bureaucracy. For example, the GST bill is facing opposition in Parliament and will only be reintroduced in July. It is expected to be passed during the monsoon season.

• While bureaucracy is being rolled back and even civil servants are optimistic about the progress legacy issues remain. Take for example the retroactive nature of the Minimum Alternate Tax which has caused much confusion and is still in resolution.

• Inflation may yet rise. The monsoon can affect near term inflation through food prices. India is energy dependent and affected by the oil price. We expect the oil price to remain capped and that long term the oil price will not appreciate significantly.

• Infrastructure remains poor despite the stated aims to increase infrastructure investment.

• INR exposure is difficult or costly to hedge. Interest rate differentials imply FX hedging costs between USD and INR to be circa 7%.

Since the last FOMC meeting in April, economic data have improved. Most recently US payrolls and average hourly earnings have picked up and retail sales have rebounded. Only inflationary pressures have been conspicuously missing. Yet inflation is but one consideration for the Fed. As rescuer of last resort to the economy and the financial system the Fed is now about 7 years into a recovery with all its emergency bail out policies fully deployed. It needs to reset some of these tools in case of another financial or economic crisis. Granted, it also has to do this without precipitating a financial or economic crisis.

The bottom line is that the Fed wants to raise rates. It may not be able to. It has already signalled that it wants to raise rates and it that the path of rate hikes will be gradual. We can see why, the incremental interest expense to each 25 basis point hike (assuming it flows through the rest of the term structure uniformly) will be of the order of tens of billions of USD per annum, not large but not insignificant either.

The Fed has prepared the market for a rate hike for some time and the focus and attention on the next rate hike suggests that the market is prepared for it. What the market may not be prepared for is further delays which could signal a weaker economy than previously thought.

If the Greek’s were hoping for a bailout, their approach to obtaining one is novel. One would have expected a more conciliatory approach. Their current approach suggests that they are unwilling or unable, probably the latter, to comply with the creditors plan. It seems therefore that the choice before the Greeks is austerity in Euros or austerity in Drachmas.

The choice for the creditors is receiving fewer Euros or more Drachmas.

You can’t lend a debtor into solvency. Greece needs to find a long term solution and to do that it needs to decide what it wants to be, not simply what it wants to do. I think that it may be in Greece’s interest to exit the Euro and face the austerity that it will face in any case, in Drachmas, where it will at least have freedom over its monetary policy, although it will be constrained in the international capital markets. As it is, it has no control over monetary policy and it is constrained in the debt markets.

Varoufakis’ game theory experience must advise him that Greece needs to leave the Euro before it is ejected, just as the best strategy for the Eurozone is to eject Greece before it leaves lest other members see exit as painless. The fact is that the pain is not because it is the Eurozone that Greece is leaving but that it is Greece that is leaving the Eurozone. The Eurozone will want to preserve the former myth and the Greeks will probably want to avoid the latter inference. So everyone is served in some way.

The only legitimate complaint the Greeks might have is that the Eurozone suppressed their cost of debt, an analgesic that allowed the country’s deficiencies to persist and accumulate without symptoms for so long. Only the return of country risk in the wake of 2008 awoke the various countries to their conditions as sovereign spreads diverged to reflect individual members’ default risk.

There is some concern that with the internationalization of the RMB and its eventual inclusion in the SDR, that China’s demand for USD and US treasuries will fall. There may be other reasons why China’s demand for USD and US treasuries may fall but the SDR inclusion and RMB internationalization is not a primary concern. China’s decision to hold USD and US treasuries is not determined by the RMBs reserve status. As far as China is concerned, the RMB has reserve status since this is China’s own sovereign currency.

A tighter trade surplus may result in lower demand for treasuries.

I guess central bankers are human too and don’t have a crystal ball. So they don’t know with certainty how the economy will evolve and they have to make decisions which impact the economy in a way that is imprecise. They also have to consider how their actions will impact the economy, in this imprecise way, and how the economy will react, unpredictably, to their actions, as they decide what to do. It is amazing they even bother trying. Its like trying to control a yo yo at the end of a yo yo at the end of a yo yo.

I’d have just decreed that money supply shall be some function of output, and left it at that, being silent about rates, money supply, inflation, output and all of it. If we went back to defining the use of money, and been dogmatic about supplying enough of it to serve those very functions, store of value and transaction enablement, and nothing more, perhaps we’d spend less time trying to second guess central banks in our business and financial investment decisions, believing that central bankers knew what they were doing.

They are just as lost as the rest of us, but far more powerful in affecting the economy in all kinds of unpredictable ways. The wise central banker would quit.