AUG 7T H 2013

Global macro-economics, trends,

portfolio implications

Topics Important Schools of Economic thought

Modern Monetary Realism

Quantitative Easing Myths

Kalecki equation / Flow of Funds analysis

Outlooks on Different Sectors

Important influencers

Important Economic schools Mainstream / Orthodox Economics (Paul Krugman)

Austrian School / inflationistas (Peter Schiff)

Post-Keynesian Modern Monetary Theory (MMT) i.e. Chartalism Monetary Realism (MR) (Cullen Roche)

Monetary Realism – concepts Monetary Realism (MR) is a description of the fiat monetary system applicable to nations who are issuers of their own currency, but have outsourced the broader money supply to the private banking system.

In many market based systems such as the USA, the money supply is essentially privatized and controlled by private banks that compete to create loans which create deposits (money).

Contrary to popular opinion, governments in such a system do not directly control the money supply or create most of the money.

The Central Bank (Federal Reserve in the USA) and the Government (US Treasury) have a symbiotic relationship and together are issuers of the currency to the monetary system.

Monetary Realism – concepts

The private banking sector issues bank deposits (“inside money”) and the public sector issues coins, paper cash and bank reserves (“outside money”).

Nowadays most means of payment involving private agents are transacted in bank deposits and, as such, the ins and outs of “inside money” are vital to understanding how the modern monetary system functions.

As the issuer of currency, the government has no solvency constraint as there might be for a household or business. The federal government’s true constraint is never solvency, but inflation.

“We generate improving living standards through the efficient use of resources resulting in the optimization of time”

System of flows: In the money system, the “health” of the system is based largely on how this flow results in an improvement in living standards over time. Are the economic agents using this flow to create goods and services that improve the overall standards of living for the system as a whole?

Debunking Myths US government has solvency constraints / it might “have trouble paying the interest on the national debt”.

Interest rates will rise if the Fed stops buying bonds. Fact: after QE2 ended, interest rates tanked). There was no shortage of buyers of government bonds. In fact, Treasury auctions showed stronger bid to covers just as MR predicted.

Money multiplier / Fractional Reserve Banking

Inflation = decline in living standards e.g. purchasing power of US Dollar has declined 90% since 1913; but living standards have soared.

US “money printing” will cause hyper-inflation.

Resource scarcity

Tapering = tightening

QE is money printing.

QE – impact on money stock

Kalecki Equation / Flow of Funds Analysis

Profits = Investment – Household Savings – Government Savings – Foreign Savings + Dividends

Kalecki Equation / Flow of Funds Analysis

Kalecki Equation / Flow of Funds Analysis

Outlooks on different sectors

USA – first the bad news…

USA – next, the good news… Still attracts top talent from all over the world with its immigration policies / opportunities

Manufacturing renaissance – cheap shale gas – lower, local energy costs heavy factory automation stronger Chinese Yuan and higher Chinese wages 3-D printing leading to faster prototyping

Still one of the best places to start / operate a business with minimal friction due to bureaucracy / corruption – this operation of free enterprise / profit motive / capitalist structure with adequate checks and balances works really well

Innovation and research powerhouse of the world

Leads the world in higher education, healthcare, technology

USA – bottom line Despite being the epicenter of the Great Recession, the US response was largely in the right direction.

US has been through a “beautiful deleveraging”, by running huge fiscal deficits when the private sector was weak.

Now the private sector is ready to run with the baton.

EuropeThe Euro alliance was ill-conceived with a monetary union but no fiscal / budgetary union and no mechanism to resolve trade imbalances.

They further implemented austerity to deal with their debt, which has landed them in even greater pain. Huge imbalances between the core / traditional surplus nations (which at this point is just Germany) and the periphery / traditional deficit nations (PIIGS).

The German election towards September end will be instrumental in shaping the further course.

Hope is that they come towards greater unity rather than pushing for a break-up of the Euro (which would be a huge negative for everyone).

Along with that, a move away from forced austerity into some gradual adjustments with fiscal deficits / monetary support should help bring Europe out of its malaise.

Japan The “Abenomics” experiment is a bold move by the Japanese Govt to shake the giant from its sleep.

After a couple of lost decades of deflation, Govt is trying to prod growth and inflation into the system: inflation targeting at a 2% annual rate correction of the excessive yen appreciation setting negative interest rates radical quantitative easing expansion of public investment buying operations of construction bonds by Bank of Japan (BOJ)

It will be very interesting to see how this unprecedented experiment plays out in reality.

China China has become a red flag, as they’re beginning to experience signs of a minor credit crisis due to overinvestment / overcapacity .

But their government tends to be particularly proactive regarding private sector problems so that could alleviate near-term problems even if it creates more long-term problems.

Longer-term trends:

They have run out of the demographic dividend, growing old before they grew rich – one of the first and largest countries to do so.

Political resentment / upheaval risk similar to USSR cannot be ruled out, unless Govt adopts a policy of steady democratization

Some of the worst pollution in the world

Two “Chinas”

Gold Not in favor of the gold standard: the biggest problem is the inherent trade imbalances.

Any single currency system like the gold standard is a lot like the Euro in which everyone uses the same currency so there’s no floating exchange rate, the Govts can’t print money and have trouble redistributing funds from imbalances to rebalance economies and so deflation is the only real answer.

Deflation tends to be catastrophic if prolonged e.g. Spain and Greece. They’re locked in a single currency, trade doesn’t rebalance through FX because they all use the same currency, the Govts can’t print money and so they’re suffering through a depressionary deflation. It’s a disaster. So the gold standard is like putting ourselves in handcuffs.

Some people want to put the Govt alone in handcuffs, but that’s not entirely rational. Govt should work with us and for us. We shouldn’t have to lock it up. Let’s understand our system better. Not revert back to broken ones.

Having said that, Gold is a special component with both commodity and currency aspects and is recommended as a small component in a balanced portfolio.

Commodities Despite Wall Street pushing Commodities as an “alternative” investment class, commodities have not delivered either the promised returns or the hedging.

Correlation between commodity and equity returns has substantially increased after the onset of the recent financial crisis.

Commodities are a cost input that rarely outperforms the pace of inflation over long timeframes.

Commodities have no place in a long-term portfolio.

Oil Do not subscribe to the “peak oil” theory

Consensus is slowly shifting to the idea that it is oil usage that has peaked instead. Great article in the current Economist.

India – first the bad news…

Corruption

Education

Ease of Doing Business

India – my thoughts Strong demographic dividend: its young population is an asset not a liability if properly harnessed and given the right opportunities.

If governance (both political and corporate) can be improved and bureaucracy and corruption can be reduced, we have a great potential ahead of us. Personally, I am pinning my hopes on the next election.

Property observations: Lack of other investment opportunities Black money Rental yields at 2-4% Overbuilding and overcapacity, yet a decent home remains out of reach for a

large section of the middle class Prices of ~Rs. 5 Cr. in middle class suburbs – eerily reminiscent of 2006 US Only saving grace is leverage is in check

My sources / Influencers Cullen Roche:

Blog: www.pragcap.com Paid service: www.orcamgroup.com

Ray Dalio

Felix Zulauf

Marketfolly.com

Thank you!Nikunj Sanghvinikunj.sanghvi@gmail .comwww.l inkedin.com/in/nikunjsanghvi

Backup Slides

Visual Impact of QE - 1

Visual Impact of QE - 2

Visual Impact of QE - 3

QE Summary QE is just Open Market Operations (Fed buys bonds from banks and credits them with reserves) – it is NOT money printing

QE can occur with or even without a deficit. If the US govt were running a budget surplus while also running QE, no one would refer to it as “debt monetization”. But it’s convenient to intermingle fiscal policy with monetary policy when pushing the monetization myth. So it’s important to understand that the idea of QE “funding” the US Treasury would really mean that demand for US debt has dried up (that is, with a deficit, they cannot sell debt to the public). That’s very clearly not true and QE2 ending proved this as yields tanked and demand at US government bond auctions remained very strong despite the end of the program.

QE in Europe can actually “work” because it is essentially a form of fiscal policy that actually helps to fund the countries in Europe (or at least help them avoid losing funding). This would be like the Federal Reserve buying municipal bonds from states in distress who can’t find Federal funding (this would essentially be a form of fiscal policy and would be “money printing”).