The fall and rise of Indian stock markets, August 2007

This is a bearish article written at the height of the Indian market bubble in August 2007. I was sure that an unprecedented and unsustainable "wall of liquidity" had pushed up asset prices for all asset classes in all markets around the world, and that a huge global crash was imminent. My convictions grew out of my experience in 2006 and early 2007 working with a large mortgage bank in Los Angeles, which gave me a unique first hand view of the emerging mortgage crisis in the U.S. - both on the "origination" side where risky loans were being approved, and on the "secondary market" where dubious loans were packaged into fancy MBS and CDO securities. By early 2007 subprime loans began defaulting and some US subprime lenders had collapsed, and by mid 2007 when I moved back from Los Angeles to Mumbai it was clear to me that the global liquidity boom was turning into a global credit crunch, certain to be followed by a recession. I was amazed to see that investors in Mumbai were living in a world of excesses, reckless lending/investing, and "bubble mentality", and I hoped that my article would contribute a tiny bit to bring some sanity in a raging bull market. Sadly, the Sensex went up by several thousand points after I wrote this article, and my credibility took a beating. I must admit I felt relieved and pleased that the crash did happen in early 2008. The mortgage bank where I worked in Los Angeles collapsed in 2008, becoming one of the largest bank failures in US history. I am pleased that I correctly anticipated the global crash, but I seriously underestimated the extent of the downturn. After sitting on cash for a long time, I bought stocks in March 2008 after the Bear Stearns crash, when I thought the market had corrected sufficiently for valuations to be reasonable again.

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The fall and rise of Indian stock markets

Partha Sarathy
August 10, 2007

There are three fundamental factors driving Indian stock markets that have not been well understood in India, and these could have a dramatic impact on investors’ returns.

First, the recent rise in stock prices and land prices in India have less to do with the strength of the Indian economy, and reflect a larger global asset price bubble, fuelled by the so-called global “wall of liquidity”. Second, we are now seeing a global credit crunch which could create a global recession and pull down stocks and property prices in all global markets, including in India. Third, the true impact of the “India shining” story has not been completely factored into stock prices, and we should expect stocks of leading Indian companies to rise by many multiples in the next 10 years. Let’s review each of these trends, and see how they could impact Indian investors.

Global asset price bubbles

Many Indian investors believe that high stock prices for Indian stocks reflect their strong corporate profits, long-term growth potential, and global recognition of the “BRICS” investment thesis. While this belief is partially correct, there is also a mistaken belief that Indian stocks will be immune to much of the troubles in global stock markets, especially the ongoing mortgage crisis in the US.

Two important points to note here. First, the rise in Indian stocks since 2004 is not a uniquely India-centric phenomenon; Indian markets have closely followed the same growth trajectory seen in virtually all stock markets around the world. Second, the US mortgage crisis is not a localized issue between some reckless borrowers and imprudent lenders; it is a part of a massive global credit crisis that will take months to unravel, is bound to cause a recession, and will pull down asset prices everywhere, including in India.

Let’s look at the rise in Indian stock prices. Since the 2001-03 recession, when the US Federal Reserve reduced interest rates from 6.5% to 1%, prices of stocks, property, commodities and all other financial assets have risen sharply in virtually all economies. The 154% rise in Sensex since 2004 is ordinary compared to the 365% rise in Shanghai, 195% in Karachi, 173% in Mexico, 101% in Buenos Aires, 90% in Spain, and 87% in Australia. A large part of this rise comes from increased corporate earnings, which is a very healthy phenomenon, but disturbingly a large chunk has come from rising P/E ratios for all global markets. For example the forward P/E ratio for India’s Sensex is 17, which is close to an all-time high, while forward P/E ratios have gone up to 36 in China, 15 in the US, 14 in Indonesia and 13 in Europe.

Similar is the story with property prices across the world. Indian property prices have grown 10%-20% per year, which is in line with property price rises in other markets. According to Knight Frank’s global annual house price index, the markets with highest price rise between Q1 2006 and Q1 2007 were: Latvia 61%, Estonia 24%, Bulgaria 23%, Lithuania 22%, Norway 16%, South Africa 14%, Singapore 14%, Canada 13%, UK 11% and Belgium 9%.

Similarly, global commodity prices have shot up to unprecedented levels since 2004. In the first 5 months of 2006 alone, zinc rose 100%, copper prices rose by 80%, silver by 60%, palladium 50%, tin 40%, gold 39%, aluminum 36% and platinum 36%.

The conclusions are clear. First, Indian stocks have closely followed the global asset price rise that has happened in virtually all markets; they are not driven by unique India-specific issues. Second, the large, simultaneous rise in asset prices across all markets across all asset categories is truly unprecedented, and should make prudent investors wary. Third, the rapid rise in P/E ratios across all global markets is clearly unsustainable, and as normality returns we should expect P/Es to fall steeply. Fourth, if global asset prices were to crash due to the credit crisis, Indian markets will follow closely, regardless of the ‘India shining’ or BRICS story.

Wall of liquidity and interest rates

Why have asset prices risen so sharply across the world? Broadly, asset prices have been boosted by abnormally low interest rates, which have been pulled down by the so-called global ‘wall of liquidity’. Global financial markets have been flooded with surplus liquidity as investment-seeking funds from around the world have poured into various asset categories.

The largest source of global liquidity is the Yen “carry trade”, where investors purchase Japanese Yen bonds at zero interest rate, convert the funds into US Dollars, invest it in US bonds (or any other bonds or stocks) that carry high returns. Since the Japanese bond carries zero interest, the entire return is a profit to the investor, and the profit could be even higher if the investor uses debt to buy the Japanese bond, or if the Japanese Yen depreciates against the Dollar. Japan has become the world’s largest creditor country, and the carry trade runs into hundreds of billions of dollars.

There are many other sources of global liquidity. Middle Eastern oil exporters earn more than $1 trillion every year due to high oil prices, and much of this has flowed into European stocks, bonds and property. In the US, pension funds and mutual funds are sitting on almost $1 trillion dollars of investments by the baby boomer generation; their investments are at a peak as they approach retirement starting 2007. Foreign central banks have invested almost $2 trillion into US Treasury bonds, mopping up their export surpluses to prevent their currencies from appreciating sharply. For example China holds foreign currency reserves of $1.3 trillion, Japan holds $500 billion, Russia $417 billion, and Hong Kong $136 billion.

With all this surplus liquidity looking for investment opportunities around the globe, one dramatic impact has been the fall in interest rates, especially in the US. Short-term interest rates are set by the US Federal Reserve, but long-term rates are determined by supply and demand for US Treasury bonds, which in turn determines interest rates for individual and business loans. Since 2004 the Fed has increased short-term interest rates 16 times, from 1% to 5.25% in order to cool down the economy. However, long-term interest rates have remained unusually low, just above 4% in much of 2004 and 2005. In his testimony to the US Congress in February 2005, US Fed Chairman Alan Greenspan commented on this unusual combination of high short-term rates and low long-term rates; this is now famous as the “Greenspan conundrum”. The low long-term rates are also surprising when you consider that Asian/European buyers of US Treasury bonds receive almost zero or negative real returns since the depreciating Dollar wipes out their nominal returns when converted into their local currencies.

Unusually low long-term rates created an “inverted yield curve” in 2006, with long-term rates lower than short-term rates. For example in February 2007, the rate on 10-year Treasury bonds was 4.81%, while 3-month Treasury bills were at 5.16%. Normally the rates on long-term bonds are higher than short-term rates to reflect additional risk involved in the longer tenure. The yield curve gets inverted when long term bond investors expect a recession and anticipate that interest rates will come down in the following years. Hence the inverted yield curve is a strong predictor of a recession, for example each of the 6 recessions in the US since 1970 was preceded by an inverted yield curve. The prolonged inversion of the yield curve in 2006 strongly indicates an imminent recession in the US.

In addition to low interest rates, the interest rate difference – called the “yield spread” – between safe government bonds and riskier bonds has also been abnormally low. Historically the spread between 30-year mortgage rates and 10-year Treasury rates has been between 1.5% and 2.5%, reflecting the higher risk involved in mortgage loans compared to safe Treasury bonds. But in 2005 and 2006, the spread fell to as low as 1.1%, reflecting unusually low risk aversion by investors. Similarly, the spread on highly risky “junk bonds” issued by private equity firms to fund leveraged buy outs was 8%-10% until a few years ago, reflecting the high risk involved, but since 2004 the spread has come down to as low as 3%.

The inverted yield curve and low spreads have created massive distortions in US financial markets, especially in the credit market. Firstly, it means that since 2004 US bond markets have substantially under-priced risk, i.e. investors of long term US Treasury bonds have been very reckless in not demanding (or at least, not receiving) returns commensurate to the long tenure of these bonds. Second, it means that all day-to-day interest rates that impact individuals and businesses have been under-priced compared to the risk involved, including mortgage rates, car loan rates, corporate bonds, junk bonds raised for leveraged buy outs, and collateralized debt obligations. Huge quantity of funds have flowed into these debt instruments that either should not have happened, or should have at much higher interest rates. Third, the availability of surplus debt funds at unnaturally low interest rates has encouraged individuals and companies to borrow more debt than they should, spend more on consumption than they should, and what is worse, make long-term investment decisions based on unnaturally low rates prevalent at that time. Fourth, once long-term interest rates and credit spreads correct themselves to fully reflect the risk involved in various loans, it will cause a far-reaching re-pricing of virtually all loans in the economy, impacting every individual and corporate borrower.

Sub-prime mortgage crisis

The sub-prime crisis in the US mortgage industry is the most visible illustration of the madness in US credit markets. As the US Fed reduced interest rates in 2001-03 from 6.5% to 1% to mitigate the dot com meltdown and the aftermath of the 9/11 crisis, the low interest rates began to fuel a mortgage boom even before other parts of the economy began to revive. As the economy rebounded, property prices began to rise, but interest rates still stayed low. The combination of rising property prices and all-time low interest rates fuelled a massive mortgage mania, with property prices in some markets rising 20%-40% annually. Not only did consumers take loans to buy new homes, they also took loans to refinance old expensive loans with new cheaper loans. One popular option was cash out refinance, where borrowers refinanced their old loans at lower rates and took out a large amount of money from the equity they had in their homes, while their monthly installments remained the same due to lower rates. This was smart when home prices were rising, but reckless if home prices had remained steady, since few borrowers would have wanted to increase their loan amount and destroy their home equity to spend on SUVs and vacations. The next to get on the bandwagon were “sub-prime” (less credit-worthy) borrowers, many of whom would not have qualified for loans. So the mortgage industry came up with a series of innovative “products”, such as option ARMs (start with a low “teaser rate” of 1%-2% that you can afford, and before the rate “resets” to a higher level in a few years you hope to sell the apartment at a big profit); negative amortization loans (initially pay small installments that do not even cover the regular interest and principal, so the loan amount keeps increasing just as it would in a credit card loan if you just pay the minimum balance); “no income no asset” loans (so-called “liar loans” where you don’t need to provide supporting documents for your income or assets if you have good credit history); and 100% LTV loans (take a regular mortgage for 80% of the loan amount, and another home equity loan for the balance 20%).

Clearly, a lot of mortgages were made to borrowers who didn’t really qualify for them, and at unnaturally and unsustainably low interest rates. Once rates rise and the higher mortgage installments kick in, millions of homes could go into foreclosure, depressing property prices for years and bankrupting many lenders. The culprit here is not reckless mortgage lenders, ignorant borrowers or lax regulation, though all these did play a part. The real culprit was the unique structure of the American mortgage industry, which contains multiple levels of intermediaries, with limited information exchange, conflicting incentives, and no accountability for ensuring credit quality. Mortgage brokers sell complicated (and often inappropriate) mortgage products to ignorant borrowers based on commissions they receive. Mortgage banks compete to fund loans originated by brokers, usually with limited understanding of the credit worthiness of borrowers. But mortgage banks do not hold the loans on their books, they make a profit by selling off loans to larger mortgage banks. Ultimately Wall Street firms securitize these loans by pooling large quantities of loans and selling “mortgage backed securities” (i.e. bonds backed by the interest and principal payments on the underlying mortgages) to investors. These bonds are rated by credit rating agencies, and purchased by large financial institutions, including pension funds, mutual funds and banks. These investors ultimately bear the risk involved in the underlying mortgage loans, but are separated from individual borrowers by so many intermediaries that they have very little understanding of the credit quality of these loans. So a pension fund that purchased seemingly safe AAA-rated mortgage backed securities for its investment portfolio may suddenly find the bond’s value eroding when the underlying loans go into foreclosure, for example when a reckless school teacher in San Diego who took a million dollar Alt-A loan is unable to make payments after the interest rate is reset higher.

The problem with the sub-prime mortgage crisis in the US is not that some reckless borrowers and imprudent lenders will go bankrupt. The real issue is that (1) almost $2 trillion dollars worth of securitized loans of dubious quality have been purchased by large global financial institutions; (2) there is no way to know which of these bonds will diminish in value and to what extent, because of the multiple levels of intermediation and limited information; and (3) if these securitized loans default, it will hurt hundreds of millions of individual investors who have invested in those pension funds, mutual funds, and banks. To a pessimist, this is the worst global financial crisis since the Great Depression.

Private equity mania

Another consequence of the wall of liquidity is the record amounts raised by US private equity firms and hedge funds in 2006-07. The combination of low interest rates and high stock prices created a perfect environment for private equity in recent years. Traditionally, private equity firms generate wealth by cutting costs. They take over a company using a lot of debt and a little equity, restructure the company, shut down unprofitable divisions, fire employees, cut advertising and discretionary expenses, sell underused assets, boost the company’s profits, increase earnings per share, and eventually sell the “new and improved” company at a profit. Private equity firms love to take on huge quantities of debt, since (1) profits from cost cutting are amplified by the leverage obtained through debt funding, (2) debt raised for the acquisition helps reduce taxes, and (3) large debt repayments force employees, suppliers and partners to cut costs.

Instead of this traditional method, since 2006-07 private equity firms have had 3 methods to generate wealth: (1) cost cutting, which is the old method, (2) rising stock prices, which help the private equity firm make a profit even without cost cutting, and (3) low interest rates, which encourages excessive debt since everyone wants to take on as much debt as possible while rates are low. With interest rates and yield spreads at historical lows since 2004, private equity firms have exploited this once-in-a-lifetime opportunity by raising record sums from investors and making incredibly large deals, often at large premiums over prevailing share prices. These deals have helped to push up stock prices further, generating even more profits to private equity firms, and causing even more funds to flow to private equity firms.

Not only have private equity firms been reckless with debt, so have lenders. Faced with surplus liquidity, private equity firms have been able to raise funds from bond investors very cheaply. The yield spreads on “junk bonds” issued by private equity firms to fund leveraged buy outs has come down from 8%-10% a few years ago to as low as 3% since 2004, indicating how reckless borrowers have become. Other contractual terms that private equity firms have demanded, and usually achieved, from bond investors include "covenant-lite" deals for leveraged buy outs, and "toggles" that allow borrowers to pay loans with fresh bonds.

The parallels between the sub-prime mortgage boom and the private equity are ominous – low interest rates, reckless borrowers, imprudent lenders, insufficient collateral, excessive debt, speculative investments, dilution in under-writing standards, poor due diligence, complex and risky loans, and minimal regulatory oversight. The net effect is that too many loans were made that wouldn’t have been made under saner circumstances. In both mortgages and private equity, these errors pushed up asset prices so much that investors overlooked the shortcomings and poured more money into these, setting the stage for a bubble.

Over-leveraged hedge funds

If private equity firms have handled debt badly, hedge funds have been worse. Hedge funds normally make large “hedged” investments (i.e. similar bets in opposite directions) to exploit minor imperfections in market prices, so that they do not lose their capital regardless of whether the market moves up or down. To make money from such small bets, hedge funds employ large debt funding and complicated derivative instruments so that the “leverage” multiplies their profits. In theory, this is a sensible and sophisticated way to invest, and smart hedge fund managers have earned fees of hundreds of millions of dollars for investing other people’s money.

However, two factors have spoilt this neat theory and made hedge funds far more risky than ever. First, in recent years stock prices and all other asset prices have moved consistently upwards, so some hedge funds have stopped prudently hedging their bets in both directions, and sometimes make huge risky leveraged bets in one direction. If that bet fails, the entire firm collapses; this is roughly what happened with Amaranth Advisors in September 2006 when it made large concentrated bets on petroleum prices. Second, low interest rates have encouraged hedge funds to use huge and often incredible amounts of borrowings. A Financial Times article (January 19, 2007) mentions a hedge fund that is two times levered, backed by fund of funds' money which is three times levered, and investing in subordinated tranches of collateralized debt obligations which are nine times levered. Every $1 of investors' capital is leveraged to own $54 of bonds, so a 2% price decline in the bonds could wipe out the firm’s entire capital.

Bubble, bubble, everywhere

Liquidity-driven asset bubbles are not restricted to the US market; this is truly a global phenomenon. Consider Spain, which joined the EU in the 1990s and faced unusually low interest rates set by the European Central Bank. Combined with Spain’s favorable demographics, and access to the European market, the low interest rates have caused Spanish property prices to soar by 270% between 1996 and 2006, which is very high by European standards. The Spanish property boom has been so spectacular that it ignited a passion among North Europeans staying in cold, wet and gloomy locales to buy their “home under the sun” in Spain.

Liquidity-driven bubbles seem to be at work in China, India and other emerging markets as well. Strong economic growth and rising exports have pushed up corporate earnings in India, and these fundamental reasons partially explain the sharp rise in stock markets. However a substantial part of the rise in stock prices comes from rising P/E multiples, which can only be explained by excess liquidity inflows, mostly from low global interest rates and large overseas fund inflows. For example, external commercial borrowings of $20 billion have helped Indian companies to cut interest expense and fund investments, especially since global interest rates are low, and the Rupee is appreciating against the Dollar. Then there is the Yen carry trade, where hedge funds raise cheap Yen funds to invest in Indian stocks and property, and benefit from both the price rise as well as Rupee appreciation.

One peculiar instance of the bubble is the abnormally strong currencies in Asia. Everyone expects Chinese and Indian currencies to appreciate due to the inflow of export earnings, remittances, and foreign investments. The parallel is with the Japanese Yen, which doubled in the 1980s on the back of strong exports. However, Japan had been running large export surpluses since the 1970s, and the Yen appreciated as late as in 1985 after the export surplus began to account for a large chunk of the total currency transactions on exports and imports. In India’s case the export surplus is negative, and even if we include services and remittances the surplus is tiny compared to total exports and imports. Clearly, these fundamentals alone cannot explain the appreciation of the Rupee from 48 to 40 against the Dollar. A large proportion of this appreciation must be due to inflows of hot money, especially the Yen carry trade, which could reverse quickly. This is difficult to prove, but one guess is that the correct exchange rate for the Rupee is closer to 44 to the Dollar, and the rise to 40 in early 2007 is a temporary liquidity-induced phenomenon.

Greenspan conundrum in Asia

A common theme across emerging markets is the inability of central banks to cool down their overheating economies. Rapid growth in Asian economies is creating supply bottlenecks and inflation in input prices. Consider the rise in commodity prices due to massive requirements from Chinese factories, high staff attrition rates and salary hikes due to the rapid growth of Indian IT and BPO outsourcing companies, and shortage of commercial rental space across Asian economies as companies race to set up offices and factories.

Asian central banks have repeatedly hiked interest rates to try to cool down the economy, but given the integration of financial markets, that strategy has not worked. Companies can easily overcome the central banks’ restrictions by raising low-cost funds from developed markets through such means as the Yen carry trade, suitcase transfers from Hong Kong to mainland China, and complicated funding instruments in India that could be selectively interpreted as debt or equity depending upon which government agency is asking. Clearly, this is the Asian equivalent of the Greenspan conundrum where interest rate tightening by the central bank fails to cool the economy since interest rates and liquidity remain high.

Clearly, the combination of high growth and excess liquidity is creating massive asset bubbles across China, India and other emerging markets, as Alan Greenspan recently commented about China’s overheated stock markets.

Minsky asset bubbles and credit cycles

A remarkable aspect of this asset price bubble is the extent to which it is predicted by American economist Hyman Minsky’s financial instability theorem. According to Minsky, asset bubbles are a consequence of the credit cycle, which is the periodic expansion and contraction of debt funding available to companies and individuals. Depending upon their credit worthiness, borrowers fall into one of 3 types: (1) hedge investors who can repay the principal and interest from their cash flows (these are credit worthy investors), (2) speculative investors who can repay the interest but do not have funds to repay principal (unless they reschedule the loan or sell the asset at a profit), and (3) Ponzi investors who can repay neither the interest nor the principal (and must take a new loan or sell the asset to repay the first loan).

In the early part of a credit cycle, when the first type of investors dominates the market, the market is stable and asset prices are reasonable. In the peak of a credit cycle, the third and second types of investors dominate the market, and this creates an asset bubble that is bound to burst. Minsky’s financial instability theorem also states that over periods of prolonged prosperity, the credit cycle moves to a peak, excess credit attracts too many Ponzi investors into the market, and this creates an asset bubble. This phenomenon seems to be playing out in stocks and property markets in all global markets.

The US mortgage crisis is a text book case on how Minsky asset bubbles are created. The boom began with loans made to credit worthy “prime” borrowers in 2003-04, reached mania levels as speculative borrowers entered the market for “Alt-A” loans, and became a crisis when “sub-prime” borrowers flooded the market in 2005 and 2006. Similarly, the Indian mortgage boom began with credit worthy borrowers who bought apartments cheaply in 2003, then attracted speculative borrowers who bought second homes for investment in 2005, and the bubble peaked in 2006 and 2007 as less credit worthy borrowers bought over-priced homes without the capability or intention to repay the full loan, eager to flip the home for a quick profit.

Perhaps the same phenomenon is happening is happening in private equity and hedge funds as well. The good buyout deals in the past usually involved strong companies bought at low valuations and with prudent levels of debt, often at high interest rates. Surplus liquidity in recent years has encouraged private equity players to do risky deals at high valuations with excess debt that they cannot repay if either valuations come down, or interest rates go up.

The bubble has burst

All indications are that we have climbed the peak of the liquidity-driven asset bubble, the bubble has already burst, and we are now seeing the beginning of a global credit crunch that will persist for 1-2 more years. Since the middle of 2007 there is a significant contraction in the global credit markets, which is both pushing up interest rates and reducing the availability of debt funding. Bond issuers are finding it difficult to attract buyers for any kind of bonds, including corporate bonds, junk bonds issued by private equity firms for buyout deals, mortgage loans, and mortgage backed securities.

Evidence of the credit crunch is seen everywhere, and even large private equity deals are running into trouble. When private equity firm Cerberus tried to sell $7.5 billion of bonds to fund the acquisition of Chrysler, the bonds had to be sold at a discount to pacify nervous investors. Many borrowers have dropped or postponed plans to raise more debt, including Carlyle, Arcelor Mittal, MISC, and US Food Services.

The most glaring illustration of the credit crunch is the difficulty faced by mortgage banks in selling securitized AAA-rated bonds to investors. Till the end of 2006, these mortgage backed securities were seen as safe investments, comparable to AAA-rated corporate bonds and priced just a little higher than safe Treasury bonds. However, in recent weeks bond investors have become so nervous that they refuse to buy any mortgage backed security, even AAA-rated securities consisting of high quality “prime” loans. This has thrown the US mortgage industry into a new crisis, one that is distinct from the problem of sub-prime lending. If bond investors refuse to buy mortgage backed securities, mortgage banks must either hold the loans on their balance sheets (as mortgage lenders do in India, but unthinkable given the American industry structure), or shrink their business and sell only “conforming” prime loans that they can sell to Fannie Mae and Feddie Mac, which is what most mortgage banks are doing now.

Following Minsky’s theorem, we have just crossed the Minsky moment, where the credit cycle reverses and a period of surplus credit gives way to a credit squeeze, and the asset bubble bursts. What we now face is a long and painful period of economic realignment and contraction.

High interest rates and global recession

The first consequence of the credit squeeze is rising interest rates. US long-term Treasury rates have jumped an unprecedented 0.55% since June 2007 as bond investors suddenly grew nervous and decided that they needed higher returns to compensate for the risks involved. In the last 3 months, the spread between Treasury bonds and mortgage loans has also suddenly retreated from its all-time low of 1.15% and moved to the historic average of 2%, as bond investors become more concerned with the mortgage crisis. These increases in interest rates are large and unusual given that bond markets usually move a few basis points each day. A sudden 0.55% hike in rates is the financial equivalent of an earthquake, and the aftershocks and tidal waves will continue for some time.

Three factors are pushing up global interest rates. First, many investors have become nervous about credit quality and under-pricing of risk as they understand more about the US mortgage crisis, and they are either reducing their exposure to US bonds, or asking for higher interest rates for the bonds they buy. Second, Asian central banks are reducing (or threatening to reduce) their exposure to US bonds, drying up liquidity further. Third, rapid growth in Asia is overheating global commodity markets and oil prices, prompting central banks to push up short-term interest rates (or at least, retain high rates) to cool down the economy. The US Fed decided on August 6, 2007, to keep interest rates steady at 5.25%, in spite of demands that interest rates need to be reduced to prevent the mortgage crisis from causing a recession.

The combination of higher inflation and rising interest rates is creating a double whammy. While inflation is causing central banks to push up short-term rates, the global credit crunch is pushing up spreads higher and causing long-term rates to move even higher. The inflationary impact of Asian growth and high oil prices is an old story, and has never really impacted the US financial markets. What is new this time is that excess global liquidity, which in previous years helped to push down interest rates abnormally, has dried up causing rates to move up sharply.

A sharp rise in long-term rates could cause a global recession. Corporate profits will decline mildly, investment spending will come down sharply, consumer confidence will vanish, and speculative investments will get wiped out. Consider the US mortgage industry. Default rates are already at very high levels, but could reach crisis levels if long-term Treasury rates climb to 6% and sub-prime adjustable rate mortgages get reset to 15% and higher. Even without high interest rates, the sub-prime mortgage loans are facing very high levels of delinquency and foreclosure, and the inventory of unsold homes is rising. Once interest rates rise, the crisis could spread to Alt-A loans and even prime loans, foreclosures could shoot up, and real estate prices could fall sharply. These disturbances could also ripple into mortgage backed securities and “CDO squared” securities created out of mortgage backed securities, causing billions of dollars of losses to pension funds and hedge funds who have invested in these securitized loans.

Rising rates and widening spreads could create a similar crisis in private equity and hedge funds. At least a few of the recent buy out deals are likely to collapse, reeling under high interest rates, excessive debt, and excessive acquisition prices. Two hedge funds managed by Bear Stearns have already collapsed under the weight of reckless investments and excess debt. They had large exposure to mortgage backed securities and were highly leveraged, so a reduction in the bonds’ values wiped out the entire funds. Boston-based $3 billion hedge fund Sowood Capital Management lost $1.5 billion in July 2007 when its losses in corporate bonds were amplified by its high debt levels. Among its investors were Harvard University’s endowment fund ($500 million) and the Massachusetts state pension system ($30 million).

This is just the tip of the iceberg. When the 2 hedge funds run by Bear Stearns ran into trouble, creditors led by Merrill Lynch forced a distress sale of the hedge funds’ assets, and they found that the securities were worth far less than previously believed. Even A-rated securities were worth just 85% of the face value, and B-rated securities were almost worthless. The banks halted the sale before the distress sale set off a spiral of lower valuations and further distress selling by other hedge funds. Some analysts believe that this was a cover up to protect investors. If the sale had proceeded and the low valuations published, investors across the world would have had to mark down the value of their holdings. That means almost $2 trillion worth of mortgage backed securities could be re-priced, resulting in large losses and panics across the global markets.

If a credit crunch looms, recession is not far away. The scenario of high inflation, high interest rates, and low or even negative GDP growth would be the opposite of the benign global economic environment that we have had for the last 3-4 years. Once long-term interest rates rise, it pushes up the rates for all kinds of loans, including credit card debt, car loans and personal loans. With oil prices at very high levels and American consumers routinely spending more than they earn, these rate hikes could cause high levels of bankruptcy among individual borrowers, distress sale of cars and homes, and sharp reduction in consumer spending. High rates would also hurt corporate profitability, and force companies to cut investments and lay off workers. The combination of rising interest rates, reducing private consumption, lower business investments and rising unemployment could push the economy into a recession.

Once a recession kicks in, stock markets and property prices will fall steeply, perhaps by as much as 20%-30%. The resulting chaos would trigger a massive flight to quality, as investors move to blue chip stocks, safer Treasury bonds, and so on. The flight to quality could hurt exactly those sectors that have seen the sharpest rallies in recent years – private equity, emerging markets, sub-prime mortgages, hedge funds, and so on.

It’s impossible to predict when the correction will happen. When a market is unhealthy, the crash could be delayed for months and years even after everyone knows that a crash is imminent. During the dot com mania stocks fell 2 years after Alan Greenspan warned about irrational exuberance. The US mortgage bubble broke in 2006 though economists had warned about it since 2004. Some commentators have compared stock market crashes to the laws of cartoon physics, where a character runs off a cliff and continues horizontally, until it looks down and discovers that there is no ground under its feet, and only then does it fall down. One could speculate that the global economy has already run off a cliff, but does not realize it yet, and will crash once the realization sinks in.

Fall and rise of Indian stock markets

The sharp rally in Indian stocks since 2004 was driven by excess liquidity from overseas investors who pushed up P/E levels to new highs, with modest participation from domestic investors. Once liquidity dries up and rising rates trigger a global flight to quality, there will be a massive sell-off by overseas investors from the Indian markets. The Yen carry trade will vanish and create its own ripples as hundreds of billions of dollars worth of bonds are sold and investors scramble to buy Yens to cover their trades. Hedge funds and private equity firms that face redemptions from their investors in the US will sell Indian stocks and property at any price they can get. Inevitably, the withdrawal of liquidity will cause the Sensex and property prices to fall sharply.

This crash could happen in spite of everything that is positive about the Indian economy, including strong corporate profits, potential for long-term growth, favourable demographics, and the success of the outsourcing sector. All stocks will get beaten down, including sound companies with excellent fundamentals. The Sensex and property prices could remain depressed for 1-2 years.

However, there are 3 positive factors that could play out. First, the distress sale by foreign investors will give Indian investors a chance to buy undervalued stocks and property. Worse the panic, better the buying opportunity. Second, as foreign investors pull out of emerging markets the Rupee will temporarily depreciate and help Indian exporters. The Rupee could perhaps move to 45 to the Dollar, which seems to be the right value, and help IT and BPO exporters. Third, the recession could give a great opportunity for some leading Indian firms to expend their operations, acquire weak global competitors, and develop into true global giants in the next 5-10 years.

Among the global giants to emerge from this crisis could be Tata Motors, Infosys, L&T, ICICI Bank, and Dr. Reddy’s Labs. Their comparables would be Sony and Toyota, which overcame Japanese economic crises in 1985 and 1991 to become global leaders. As investors begin to differentiate between these global giants and firms that would remain as domestic giants, the stock prices and P/E for the global giants could overtake those of their Indian peers. That differentiation would parallel the divergence in P/E that we saw for Indian software firms after the dot com meltdown, when tier-1 IT firms raced ahead of tier-2 IT firms in revenues, growth rates, profit margins, P/E multiples and stock prices.

So the message for Indian investors is clear. The rise in Indian stocks is less due to the “India shining” story than due to a wall of liquidity that has flooded the global financial markets. This liquidity has dried up, and we are now facing a global recession that could be worst since the Great Depression. This crash will also pull down Indian stocks and property prices, regardless of the strength of the Indian economy. Investors should use the downturn to buy into rising global giants from India, whose shares could multiply many times over the next 5-10 years.