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Can India Ride Out the U.S. Recession Storm?
We've begun 2008 with the unpleasant realization that a possible U.S. recession is becoming reality. Against that backdrop, China is facing monetary policy tightening to curb its internal inflationary pressures, European and Japanese growth rates are being revised downward on nearly a daily basis, and G-7 countries appear to be entering what looks to be a very weak phase in their business cycles. Will the pending global financial storms wreck havoc on the buoyant Indian economy? Although 2007 was a banner year on many fronts in India, this year's gloomy global landscape may result in the temporary loss of its economic momentum. But the structural growth story should remain intact for Asia's third largest economy.
An emerging market such as India lives with economic data that can vary considerably in terms of reliability, timeliness, coverage, and informational content. Given these differences, it's often very difficult to interpret the data and assess what's happening with the corresponding economic activity. With broad money growth at multi-year highs due to massive financial inflows, elevated oil prices, and government spending pressures, there is the potential risk that inflation may continue to accelerate in 2008. The Reserve Bank of India (RBI), India's central bank, is faced with a multi-faceted dilemma this year: maintain strong growth or put the brakes on inflation. On the RBI's monetary policy front, the quarterly meeting last month resulted in a "no-change" to their overnight borrowing rate at 6.0 percent and the cash reserve ratio at 7.5 percent. RBI governor Reddy's accompanying statement reflected their inflation concern versus slowing growth; "volatile international crude prices and the heightened levels of food prices pose clear and present risks to the inflation outlook." India's benchmark inflation rate has climbed recently to a 4-month high at 3.83 percent, though still much lower than the RBI's 5.0 percent target. The government is also facing elections next year and may decide to cut taxes to boost consumer spending should the U.S. slowdown eventually drag down economic growth later this year. Another consequence of the RBI maintaining elevated interest rates (as the U.S. Fed continues on the path of its easing cycle) is the problem of increased investment flows into the country. Should those inflows continue to grow as global investors seek higher returns, the RBI may be forced to employ measures other than tightening rates to limit that activity.
The International Monetary Fund (IMF) recently addressed India's problem of attracting increased foreign direct investment (FDI) inflows in 2007. They noted in a statement earlier this month that as the economy expands, the large capital inflows via FDI will complicate efforts by the RBI to curb the rupee's accelerated gains experienced last year. In 2007, the Indian rupee (INR) gained 12.3 percent against the U.S. dollar as it reflected strong fundamentals, increased productivity, and the policy of a managed float. The IMF also stated its concern that "INR appreciation has adversely affected India's external competitiveness in certain labor-intensive sectors," which ironically is how India's labor-intensive outsourcing revolution got its start!
The impact of elevated interest rates has been somewhat severe for the general economy. Current consensus for GDP growth this year is now at 8.4 percent, down from 9.0 percent in 2007, and 9.4 percent in 2006. Companies in India, already operating with decade-high commercial borrowing costs as a result of the RBI aggressive tightening cycle, are feeling the pain of the overheated economy. The State Bank of India, India's biggest lender, now charges 12.75 percent interest on loans to its best customers, the most since 1999. As a result, India's industrial production growth has recently slowed to 7.3 percent in November from a year earlier, and from 11.8 percent in October according to an official government report. Growth in passenger car sales for example has also halved to 8.8 percent in December from a year earlier, and on the real estate front, local developers are now struggling with slowing home sales and rising vacancies in a market that is best described as "headed for a correction" via weakening consumer demand.
Exports, which account for about 17 percent of India's total GDP (as compared with an average of over 40 percent of GDP in Asia, ex-Japan), continue to fuel India's $906 billion economy. Healthy external demand for India's goods and services should continue to fuel strong export growth, which will help overcome the impact of the rupee's aggressive appreciation, but will ultimately generate job growth and reduce poverty, a focal concern going into an election year. Despite this comparatively low level of trade integration, the Indian economy is likely to be hit by the current slowdown in the U.S., its largest trading partner. Financial results reported in January by India's major information technology (IT) companies were still healthy; however a significant cut in IT spending in the U.S. must be an imminent concern going forward.
In summary, real GDP growth in FY2008 will probably slow below consensus (8.4 percent), and still further in FY2009, with the catalyst for the decline linked to the deterioration of the U.S. economy. The slowdown in Indian GDP growth should prove to be somewhat shallow due to its lack of foreign trade dependency (still among the lowest in Asia), export markets to the rest of Asia remaining relatively strong, and its banks' balance sheets in good shape (lack of U.S. sub-prime related write-downs). Healthy corporate profits, brimming order books, and high levels of business confidence will limit the near-term damage caused by the sharp decline in the U.S. economy.
— Mark Noble, Senior Advisor, SVB Silicon Valley Bank's Global Financial Services
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Flash Alternative
An alternative to the flash memory could soon be on the market. Nanochip's low cost technology offers more storage capacity than flash memory (100 gigabytes for the first prototypes), or ten times that of flash. Eventually, the devices could store terabytes' worth of data. Nanochip recently raised $14 million to complete work on prototypes that it hopes to ship to electronics device makers for evaluation next year. In contrast to flash, Nanochip's technology stores information by writing data to a thin-film material using an array of microscopic cantilevers. (MIT Technology Review)
Middle East Gets Connected
A telecom boom is developing in the Mid East, fueled by oil money and loosening monopolies. Construction firms and telecoms firms in Bahrain, Kuwait, Oman, Qatar, Saudi Arabia, and the United Arab Emirates are expected to collectively invest $375 billion over the next 10 years in upgrading and building telecom infrastructure, according to a report by Prolead. The market is likely to grow as mobile phones and broadband Internet become necessities of life. Despite the opportunity, startups are challenged by long sales cycles and the personal connections necessary to complete a deal. (VentureWire)
IT Spending Slump
U.S. companies and government agencies are expected to increase their spending on information technology by just 2.8 percent this year, a downward revision from the 4.6 percent growth that was predicted in December, reports Forrester Research. Andrew Bartels of Forrester notes that even if a recession does not materialize, fears that it will happen can be enough to make technology buyers more conservative. (VentureWire)
2008: Year of the Stem Cell
Several stem cell companies are expected to announce the results of clinical trials soon, with positive results that would make 2008 an important year for the industry. Most of the research, such as that being conducted by Stem Cells Inc., lies in the area of adult stem cells. But a few embryonic cell companies (Geron Corp. and Advanced Cell Technology Inc.) are also poised to launch clinical trials. Researchers are eager to apply stem cell science to pressing medical needs. (Silicon Valley Business Journal)
Sign of the Times
A decision by drug company AstraZeneca may be the harbinger of a major sea change in the pharma industry. Experts believe the industry may be moving toward a day when Big Pharma limits its work to running late-stage clinical trials, dealing with regulators, and selling and marketing drugs. AstraZeneca has decided to spin off its gastrointesinal research unit to operate as a freestanding company called Albireo Pharma. The company has also been outsourcing key elements of its manufacturing business to factories in China. (Wall Street Journal)
SPACs Work for Startups
Although life science IPOs have been challenged by current market conditions (so far this year seven biotech and medical-device startups have pulled their offerings), SPACs are booming. SPACs or "special-purpose acquisition corporation" are companies that raise money through initial offerings, specifically for the purpose of acquiring other companies. The transactions are often a good deal for startups as a path to the public market and may provide an infusion of capital. The deals are structured like reverse mergers, in which a listed shell company "acquires" a startup for a minimal sum, then assumes the target's name and carries its business. The 18- to 24-month deadline to complete the deal also works in favor of the startup. (VentureBeat)
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February 19, 2008
Going Once, Going Twice . . . Sold!
Today there are thousands of corporations and individuals around the country longing to hear these classic words. No, we're not referring to the gavel falling on some foreclosed, subprime-financed, glitzy condo, but rather the arcane and mysterious world of auction-rate securities (ARCS). This current source of pain was invented by Wall Street underwriters some years ago (those guys, again?) and combines the attributes of a highly rated long-term bond, a floating interest rate, and easy, periodic liquidity through an auction process. Last week more than 1,000 auctions failed, meaning investors had no way to get their money back. Ultimately, there may be bonds valued at more than $300 billion affected by the failed auctions. In the interest of full disclosure, we note that SVB Asset Management does not own any auction-rate securities in any client accounts.
In the Dutch auctions that set the price on these bonds, bidders offer up a money market rate depending on the auction period of seven or 28 days. The lowest rate that cleared the amount at issue would set the rate for all the winning bids. In this way, issuers would benefit from lower rates as a result of the competition and investors would always have a bond price that reset to par. There was only one problem. Many times there were insufficient bids to cover all the bonds being repriced. That is when the Wall Street "masters of the universe" worked their magic. In an effort to assist investors and issuers, the I-bankers would submit the clearing bid in the auction, putting their own capital at risk and taking those last bonds on their balance sheet for resale later. So, in reality, these auctions have been failing for years; the only difference now is that the brokers that organize the auctions are stuffed full of illiquid, subprime loans, repossessed SIVs, unsaleable LBO paper, and an alphabet soup of other exotic structures. They are refusing to take in anymore, which leaves their clients twisting in the wind. Sensing the risk from the lack of liquidity in the auction process, my partners on the bond desk bailed out of the entire asset class way back in '04.
This sort of activity — representing the bond sellers as underwriter and acting as bond buyers in the auction — was frowned upon by the SEC; their term of art was "conflict of interest." After a year-long investigation, 15 investment banks were fined $13 million, or about the equivalent of a few days' commissions on the billions of bonds outstanding. The brokers managed to spin these bonds for all audiences. For municipalities, they were long-term debt with short-term rates. For investors, they were "cash equivalents" with better yields than other money market instruments. For the I-bankers, of course, they were manna from heaven. Today, these deals would put a sleazy, subprime mortgage broker to shame. The Port Authority of New York and New Jersey which has an AA- credit standing, had the interest rate on a $100 million bond jump from 4.2 to 20 percent simply because of market conditions over which they had no control and an underwriter who refused to support their auction.
Now we are faced with the peculiar circumstance of AAA and AA-rated bonds with no discernable market value. In all of this, one has to wonder about the meaning of the "triple-A" designation if no one will buy the paper. In that regard, Moody's has apparently reached a similar conclusion and is considering revamping its rating system for oddball type securities, such as CLOs, CDOs, MBOs, and Oh Oh Ohs. They will shift from letters to 21 numbers instead. Why that will make any difference is a little difficult to ascertain. In reminds us of when Brazil used to change the name of their currency every few years. When inflation got so bad that it took a 10,000 unit bank note to buy a bottle of beer, they would swap the currency out for one that was worth 1,000 times the old stuff. Thus, they went from reais to cruzeiros to cruzeiro novo to cruzado to real, losing value at a pace of an astounding 1021 over a 52-year period. Now, we are not suggesting that the value of Moody's ratings are dropping that fast, but we are worried about their lack of a creative solution. What are they going to use when they need to switch from Arabic numerals — Greek letters?
Pas de Deux
Treasury Secretary Paulson and Fed Chairman Bernanke were grilled by the Senate Banking Committee on Valentine's Day. They both danced around the "R" word, we suppose, because of that Medieval adage that naming a monster will give it life. (Let's just call it "the economic-event-that-should-not-be-named.") We're not sure what their objective was, but the market heard two messages: (1) the economy is trending for a header; and (2) Bernanke will lower rates as needed. The talk sliced another 200 points off the DJIA, and the Fed Funds futures is claiming a 50 bps easing on March 18. Only five of 44 economists on the Bloomberg survey believe the Fed will hold their ground in a few weeks. In actual economic activity, retail sales came in stronger than anticipated, capacity utilization remained strong, as were exports. Everything else (consumer confidence, Empire manufacturing, and continuing jobless claims) was worse.
At a presentation by a Moody's economist earlier in the week, we learned that parts of the country are already suffering from the economic-event-that-should-not-be-named, including California. In a 90 minute session that went from dismal to depressing (and focused on the housing market woes which the speaker claimed to have predicted for some years), one participant pondered aloud, "Do they ever let this fellow talk to the bond rating side of the house?" Good question.
Eliot Augustus
New York Governor Eliot Spitzer declared last week that the monoline insurance companies better raise new capital in the next few days — or else! With New York's top insurance regulator, Eric Dinallo, already heavily involved, it's not clear what the governor's panicked statements implied. We hope it's more than just bureaucratic grave dancing.
— Jim Anderson, Editor
Investment Strategy Outlook is published each week to highlight issues we hope you find relevant and topical. The views expressed in this newsletter are solely those of its authors and do not reflect the views of SVB Asset Management, Silicon Valley Bank, or any of its affiliates.
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Greenspan: U.S. on Edge of a Recession
Former Fed Chairman Alan Greenspan said the U.S. economy is on the verge of its first recession in six years as falling home values hurt consumer spending. "We are clearly on the edge," Greenspan told a group of energy-industry executives in Houston. Greenspan's view has evolved from a year ago, when he saw a one-in-three chance of a recession, citing slowing profit growth and becoming one of the first economists to warn of the risk. Fed Chairman Ben Bernanke acknowledged "downside" risks to the expansion last week, while telling lawmakers he expects growth to pick up later this year. (Bloomberg)
Confidence Drops, Factories Stagnate
Confidence among American consumers slumped to the lowest level since 1992 and factory output failed to increase, indicating the damage from the housing contraction is pushing the economy toward a recession. The Reuters/University of Michigan Index of Consumer Sentiment fell to 69.6 in February from 78.4 the previous month. The Federal Reserve said manufacturing production was unchanged in January after two months of gains, while a gauge of activity at New York factories contracted this month. (Bloomberg)
Import Prices Rising
Prices of goods imported into the U.S. rose more than forecast in January, pushing the increase for the last 12 months to a record, led by rising costs for energy products and food. The 1.7 percent increase in the Import Price Index followed a small decrease the prior month. Prices excluding petroleum rose 0.6 percent. Higher import costs, may increase the chances U.S. companies will try to follow their foreign competitors in increasing prices. Still, Fed policy makers remain focused on risks to growth and are prepared to lower interest rates further. (Bloomberg)
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Auction-rate Meltdown
Goldman, UBS, Lehman Brothers, and Merrill Lynch shocked their investors this week when they refused to let them withdraw money from investments that they had considered as safe as cash. The investments are in so-called auction-rate securities, which are marketed to corporations as safe alternatives to cash but are, in fact, long-term securities. Last week almost 1,000 of these auctions failed. The banks also refused to support the auctions, leaving many investors wondering when they will get their money back. A failed auction does go into default, because the issuer continues to pay interest at the higher rate, or "fail rate." (New York Times)
Muni Regulators Eye Auction-rate Market
In what may be a case of too little too late, securities regulators may impose new rules on brokers in the $330 billion auction-rate bond market where rigged bids left investors unable to sell their holdings and taxpayers with higher borrowing costs. The U.S. municipal bond market's main regulator, the Municipal Securities Rulemaking Board, plans to seek comment on whether dealers should reveal the number of bidders and disclose how often auctions fail in the market for the securities, whose rates are set periodically at auctions. (Bloomberg)
MBIA, Ambac Trying to Beat Out Downgrades
A rescue plan for troubled bond insurers MBIA Inc. and Ambac Financial Group Inc. may be in place before they lose their top AAA ratings, New York Insurance Dept. Superintendent Eric Dinallo said. Regulators are trying to help the companies raise $15 billion of capital to avert downgrades and may consider splitting their municipal bond and subprime-mortgage debt businesses. New York Governor Eliot Spitzer has stated that the insurers must get new money within days or he will step in. (Bloomberg)
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